IF Scotland had voted for independence in 2014, and was an independent country today, how would its economy be performing? Much recent discussion surrounding this question has focused on the sustainability of the budget deficit an independent Scotland would face, given the precipitous fall in the price of oil. However, there is a much bigger issue that is rarely, if at all, discussed and that is the effect of the fall in the oil price on an independent Scotland’s currency regime.

Currency choice was at the heart of the 2014 referendum debate and the Scottish Government’s preferred option was to remain in a formal sterling zone arrangement post-independence. Alternatively, informal use of the sterling zone by adopting sterling seemed to be plan B. Both choices implied that an independent Scotland would have a fixed exchange rate.

However, as I argued in 2014, because of their fixity neither of these regimes would have lasted very long, with a classic currency crisis the inevitable outcome, creating huge disruption to the Scottish economy, and of a magnitude similar to the recent financial crisis. Why?

As the recent dramatic fall in the price of oil has demonstrated, the oil sector plays an extremely important role in the Scottish economy, directly and indirectly via various supply chains. As part of the UK’s political and monetary union, Scotland’s economy has had the support of fiscal transfers from the rest of the UK and the oil-related downturn resulting from the oil price fall was thus attenuated.

However, and in contrast, as an independent country these transfers would have ceased and the oil shock would have resulted in an unsustainable fiscal deficit and a painful internal adjustment process. Such internal adjustment refers to the need to gain competitiveness, by cuts to real wages, and fiscal sustainability by public spending cuts and/or tax rises. This is pretty much the process Greece has followed due to the absence of a co-insurance mechanism in the euro area and, crucially, because it is locked into the fixed exchange rate euro area.

The alternative for an independent country is external adjustment, whereby the exchange rate depreciates in nominal and real term, thereby encouraging resources to move from the oil sector to other sectors. This should attenuate the effects on employment and economic activity. Such external adjustment could only have been achieved by abandoning sterling zone membership and its implied exchange rate fixity.

Financial markets, knowing this was the only tenable option, would have massively speculated against the fixed exchange rate system, perhaps from day one of independence or before, creating a full-blown currency crisis with all of its attendant consequences.

In revisiting the Scottish exchange rate issue in the future, it may be argued that the oil effect will become less of an issue in the design of an appropriate exchange rate mechanism. But an increase in the price of oil could generate another oil boom and that would again require a sufficiently flexible exchange rate adjustment mechanism. There may well be other important shocks too – from, say, the financial sector – that would require such adjustment.

At the heart of the difficulty in designing a suitable exchange rate regime after independence is how the economy’s macroeconomic needs are balanced with ensuring that residents north and south of the Border are not forced to be unwilling and unwitting currency speculators due to the many billions of pounds of cross-Border financial assets and liabilities between Scotland and the rest of the UK.