There is now just over a month to go before the Scottish independence referendum on September 18th 2014.
My purpose in this analysis is not to express a political opinion on the desirability or otherwise Scottish independence. It is rather to give a view as a professional economist on Scotland’s optimal monetary policy, if it were to become independent.
As stated in my Financial Times letter of February 2014 (“Mr Salmond and the £” on this website), my view is that the currency union concept is flawed.
If it is set up, it may not last very long. It may well be true, as advocates of currency union argue, that we are now in a “Goldilocks” era, where the Bank of England’s stance is too hot for London – where property prices are in an unsustainable bubble – too cold for the North of England, which continues to suffer from high rates of unemployment – but just right for Scotland. However, there is no reason to suppose that this will continue to be the case over the next 5, 10 or 15 years. And if there is a divergence between Scotland’s economic interests and those of the rest of the United Kingdom, there is no doubt which will dominate the decisions of the Bank’s Monetary Policy Committee.
Strains within the currency union could lead a simple choice for a future Scottish Government. Either to leave it, or to maintain it at the cost of economic stagnation, as has been the fate of the peripheral eurozone countries.
The better choice would be to leave the currency union. This is a choice which may be forced upon The Scottish Government anyway, if the Westminster Government simply refuses to engage in negotiations to set up a currency union in the first place.
Outside a currency union, Scotland could continue to use the £, but without a formal central bank. This is how the Republic of Ireland operated immediately after it achieved independence in 1922. It is an option that has secured support from some surprising quarters, including economists at the Adam Smith Institute and Institute of Economic Affairs in London who advocate a “free banking” system. This doesn’t mean that banking services are provided free of charge, but rather that there is minimum regulation of the banking system, no central bank and no possibility of banking bailouts.
This approach is based on the theories of the Austrian economists Ludwig von Mises and Friedrich Hayek, classical liberals who followed the Jeffersonian adage that “the best government is the least government.” In the Austrian view, the lack of a safety net would impose market discipline on commercial banks and avoid moral hazard risks. In simple terms, it removes the possibility of a “heads we win, tails you lose” approach, whereby reckless and greedy bankers take risks which will generate hefty bonuses for them if they pay off, but leave any losses to be picked up by the government and the taxpayer.
A Scots Pound
The reasons that libertarians like Sterlingisation is that it would leave a future Scottish Government with no role in the nation’s monetary affairs.
To my mind, this would expose a relatively small independent country to international crises with no means of combating them. It might be different if the rest of the world also adopted a free banking approach, or if international trade were carried out through a unit of exchange independent of national governments, such as gold. But as matters stand, sovereign states need control over their own currency if they are to protect themselves from crises emanating from the irresponsible policies of their trading partners. As, for example, Switzerland and Germany did in the 1970s, when they allowed their currencies to appreciate in order to sterilise the effects of rampant dollar inflation originating in the USA. Or more recently here in the UK, when the external value of the £ depreciated in the wake of the global financial crisis. Between the onset of the credit crunch in July 2007 and “Blue Monday” on January 19th 2009 when the Royal Bank of Scotland announced the biggest corporate loss in British history at £28 billion, the trade-weighted value of the £ fell by almost 30%. This external adjustment helped to stabilise the UK economy and stimulate a fragile recovery.
To a limited degree, responsibility for monetary policy is already shifting to Scotland. From 2015, the Scottish Government will have the right to issue bonds for an amount of up to £2.2 billion. How it uses this power will influence monetary conditions in Scotland. If it sets up a Scottish Debt Management Office to manage its borrowing programme, it will, in effect, already have created the embryo of a central bank. The first function of a central bank is to act as the government’s bank.
Its second function is to act as “the bankers’ bank”, by providing banking services to regulated financial institutions within its territory. They deposit funds at the central bank, which are used to clear inter-bank balances on a daily basis and ensure the smooth functioning of the money markets. The central bank may also use its deposits to make loans to any financial institution in temporary need of funds. This is the famous “lender of last resort” facility, where the central bank acts as the ultimate source of finance for commercial banks.
Under a currency union, these functions would be carried out by the Bank of England.
The Better Together campaign argues that, if a currency union does not exist, an independent Scottish Central Bank could not act as lender of last resort or bail out major banks such as RBS and Lloyds-HBOS which had run into trouble. Their implication is that this would be a retrograde step.
I take a different view, which could be termed “quasi-Austrian”. It is helpful that a Central Bank of Scotland could not underwrite commercial banks operating in Scotland to an unlimited extent. With the safety net removed, banks will be encouraged to behave more prudently.
But I don’t go the whole way with the Austrians in advocating no central bank support. A Scottish Central Bank should be able to lend limited amounts to financial institutions within Scotland to help them meet short-term liquidity requirements. But there should be no presumption that the central bank is the sole provider of funds in such circumstances. After all, Barclays Bank turned to Qatar for the funding it needed in preference to the Bank of England’s Asset Protection Scheme, while more recently the Co-op Bank was restructured without the assistance of any taxpayer support.
A final role for a Scottish Central Bank will be to ensure the convertibility of a Scots Pound. To fulfil this function, it would deploy Scotland’s foreign exchange reserves, initially to maintain parity with the £ Sterling, but with the ultimate ability to adjust upwards or downwards against Sterling as domestic economic conditions within Scotland require.
This would not be an easy option. It would require an independent Scotland to maintain strict monetary discipline and, at least initially, to run a Balance of Payments surplus to build up foreign exchange reserves. However, over the longer term, I believe that sound money would deliver significant economic benefits compared to the alternative of a currency union dominated by England. Underpinned by strong and dynamic economy, there is no reason why the external value of a Scots £ should not appreciate against Sterling, as have the currencies of a number of other small nations, including Switzerland, Singapore and Australia.
Such a strategy would address the fundamental paradox that lies at the heart of the economic strategy set out in the Independence White Paper. If it is the case that no-one will look after Scottish interests better than the Scottish people themselves, exercising their sovereign will through a democratically elected Scottish Government, how can it be that the monetary and financial affairs of an independent Scotland are best managed from London?
At the very least, the creation of a Scots Pound is an option that should be considered in greater detail. In considering alternatives to currency union, the only thing we have to fear is fear itself.
August 15th 2014