"From the date of the Treasury’s promise on gilts, the Scottish government effectively conceded its maximal demand already. Furthermore it couldn’t use market volatility to revive the issue: any share of the debt it paid would be to the UK government. The market itself would trade on the UK’s gilt guarantee...."In other words, because the UK Treasury has guaranteed to honour all existing UK debt issuance, the SNP's threat to repudiate Scotland's share of UK debt if it doesn't get currency union has no market impact. It is therefore hollow. The lesson for the SNP is - never, ever underestimate the deviousness of Treasury mandarins. Wily though he is, it seems Alex Salmond is no match for Sir Nicholas MacPherson.
So where does this leave Scotland's currency conundrum? The following options remain (assuming, of course, that the Scottish people vote for independence on September 18th):
- using sterling without currency union ("sterlingisation"), or another currency such as the dollar ("dollarization")
- creating a new Scottish currency
- joining the Euro.
Andrew Lilico has ably discussed the third of these and I shall not cover it further here except to say that if Scotland joined the EU (or remained in it, depending on your point of view) it would have no choice but to join the Euro. That leaves Sterlingisation and creating a new Scottish Currency. As I shall discuss, there is really little difference between the two.
First, let me make it clear that an independent Scotland could use sterling as its currency if it so chose, with or without the agreement of the UK government, just as any foreign country can. The UK government cannot prevent it from doing so. Nor would independence mean Scottish banks having to relinquish existing holdings of sterling reserves, as some have suggested. They would simply become foreign exchange reserves on their balance sheets. Scottish banks would no longer have access to Bank of England liquidity facilities, of course, which might make payments a bit clunky until everyone adopted mobile money platforms. But as long as Scottish banks could continue to obtain sterling on the open markets, they could continue to fill their ATMs with sterling notes and issue loans in sterling. Sterling coins would remain legal tender as at present (sterling notes are not, in Scotland).
So far, this is no different from the many small countries that use the US dollar or the Euro. Sam Bowman of the Adam Smith Institute cites Panama as an example of a small country that is successfully using the US dollar as its own currency. Indeed it is. But I fear he is comparing apples with nuclear warheads.
Joseph Cotterill (op.cit) describes full sterlingisation of the Scottish economy as "rather ill thought out" (i.e. batshit insane) given the size of its banking sector. I have to agree. The small countries such as Panama that use foreign currencies do not have banking sectors that are somewhere between 8 and 12 times GDP depending on who you talk to, as Scotland's currently is. For comparison, Iceland's banking sector at the time of its collapse was about 9 times its GDP and Cyprus's banking sector was 7 times its GDP. Furthermore, Scotland's cross-border liabilities post-independence would dwarf those of Iceland. Scotland could not possibly bail out its banks in the event of a financial crisis like that in 2008. But neither the UK Government nor the Bank of England would have any responsibility for doing so either. Full sterlingisation could therefore result in the disorderly failure of Scotland's banks, with catastrophic consequences not only for Scotland but for its principal trading partner, the UK. This is indeed "batshit insane".
Scottish currency with fixed sterling peg
Sam Bowman and Lawrence White of the Institute of Economic Affairs both argue that despite the risks, Scotland would still do best to use sterling without currency union. They argue the case for use of sterling as an anchor for "free banking", in which commercial banks issue banknotes at par with sterling and there is no central bank. As this is how Scottish banking used to work prior to the 1844 Bank Charter Act (though the anchor at that time was gold, not sterling), emotionally this approach might have considerable appeal to supporters of Scottish independence.
But this is not full sterlingisation of the Scottish economy. What they are actually suggesting is a Scottish currency called the "pound" which is legally fixed to sterling at par. This is a logical extension of the present situation in Scotland. Scottish banks issue their own banknotes which are 100% backed with sterling reserves. In Scotland they are exchangeable at par with sterling notes and coins, and both sterling and Scottish notes circulate freely.
Unfortunately the same is not true south of the Border. Scottish notes are not widely accepted in payment for goods and services, although banks will accept them in exchange for sterling. But English banks only accept them because they know that the Bank of England will honour them at par - and that is because of the existing currency union. If the currency union were to end at independence, there would be no reason for English banks or the Bank of England to accept Scottish notes at all, let alone at par. They would, in effect, be a foreign currency.
This creates a massive problem with White's ideas for free banking based on Scottish currency backed by sterling reserves. White envisages banks being free to issue whatever currency they wish without reserve restriction (the existing 100% reserve requirement would be lifted). But they would be legally required to guarantee exchange of Scottish notes for sterling at par.
At independence, Scottish banks would retain whatever reserves they already have on their balance sheets. But after independence, banks would no longer have access to Bank of England lending facilities, so they would have to obtain sterling reserves in the open market, either by borrowing or purchasing. This raises a difficult question. FX transactions are an exchange. What would Scottish banks have to offer in exchange, if Scottish bank notes were not a tradeable "currency"? And borrowing these days is collateralised (repo). What would Scottish banks have to offer as collateral for sterling reserve borrowings in the open market? Their own government's debt is unlikely to have the standing in the market that UK gilts have. Admittedly they currently have sizeable holdings of gilts, just as they currently have large quantities of reserves. But once they started fractional reserve issuance of Scottish notes, their reserve holdings would quickly diminish. To start with they would no doubt repo out their safe liquid assets for sterling, but once they have encumbered their safe asset holdings, what then? I'm not sure exactly what line a new Scottish regulator would take on the shrinkage of Scottish bank liquidity buffers due to fractional reserve issuance of Scottish notes, but international liquidity standards are getting ever tighter: would a Scottish regulator really buck this trend in the interests of maintaining the Scottish money supply? Under regulatory pressure, the Scottish banks might be forced to restrict both note issuance and credit creation in order to avoid running down sterling reserves. And of course, they would cease to provide sterling notes to the economy at all.
White seems rather keen on this idea (my emphasis):
Should Scotland retain the sterling standard, private banknotes would continue to provide better currency (more reliably redeemable for Bank of England notes or one-pound sterling coins) than currency issued by a new Scottish central bank or currency board. A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued. A government central bank or currency board that devalues against sterling cannot. The importance of maintaining its reputation in a competitive environment would deter a commercial bank from acting in ways that might endanger its ability to maintain par redemption. A government monopoly faces no such reputational constraint, since its customers have nowhere else to turn.So, legal enforcement of exchange parity between Scottish banknotes and sterling would be a fixed currency peg, preventing the Scottish currency from devaluing and forcing everyone in Scotland to use Scottish notes. In effect, White is saying that a democratically-elected Scottish government couldn't be trusted to protect its currency. But in proposing a fiat sterling anchor (as opposed to gold) he is implying that a democratically-elected UK government CAN be trusted to protect its currency. This is hardly a ringing endorsement of Scottish independence.
The history of the "Pound Scots" does not suggest that such an implied peg could reliably be held. Reserve-restricted banking is a profit-killer for banks when reserves are in short supply and expensive. And the resulting tight money supply and restricted credit creation can be a serious brake on economic growth. Banks would inevitably resort to fractional reserve money creation, both to improve their own profits and in response to political pressure: I have no doubt that, faced with a credit crunch due to reserve constraints, a Scottish government would want to "get banks lending" just as the UK government has done in recent years. This would implicitly devalue the Scottish notes relative to their sterling reserves. So they would not only be worthless OUTSIDE Scotland, they would be worth less than sterling WITHIN Scotland too. How long does White think the Scottish banks would remain solvent?
White is pinning his hopes on Scotland becoming an offshore tax haven similar to the Channel Islands (since Scotland would be similar to a Crown Dependency after independence). This would attract continual inflows of sterling in much the same way as a persistent trade surplus. If it worked, this would of course ensure an ample supply of sterling reserves, so the liquidity crunch I described would not be a risk. But he should be careful what he asks for. If there is one thing we have learned from the Eurozone crisis, it is that fixed currency pegs and free movement of capital can be a very bad thing. If Scotland attracted all this money, what would it be used for? And how long before private and, perhaps, public debt burdens became unsustainable, as inflows of hot money fuelled credit bubbles?
Anyway, why on earth does he think the UK government would tolerate Scotland becoming a sterling tax haven? I suppose he is looking at the UK's inaction over Ireland and assuming it would do nothing about Scotland. But Ireland is a Euro tax haven. Scotland would be a sterling one - and that is a very different matter. I can't see the UK government doing nothing about it. At the very least I would expect significant cuts in corporation tax, and possibly withholding taxation of cross-border sterling flows - especially if, like the Channel Islands, Scotland remained outside the EU.
But what about the banks?
But there is a much bigger problem here. It's not unusual for economists to take no account of the commercial interests of banks when suggesting changes to monetary arrangements. And I am always amused at their surprise when the results are not what they expected. But in this case they have failed to see a simply enormous elephant.
NatWest is a wholly-owned subsidiary of RBS which is incorporated in London. Post independence, therefore, NatWest would continue to have access to Bank of England liquidity facilities. Its parent, RBS, would not. If I were running RBS, faced with loss of Bank of England support for my Scottish operations, no Scottish central bank, and a fixed currency peg that would quickly drain my liquidity reserves, I would reincorporate in England. Wouldn't you? Indeed, if the Scottish government refuses to accept a share of the costs of bailing out RBS in 2008, the UK government - currently the largest shareholder - might insist that RBS reincorporated in England, to eliminate the risk that a Scottish government might force RBS to drain liquidity from its UK subsidiary to support its Scottish operations. In fact it might push for this even if Scotland did buy some of the shares.
The other big Scottish bank, HBOS, is already a wholly-owned subsidiary of the English bank Lloyds. HBOS is currently incorporated in Scotland. But faced with the loss of Bank of England liquidity support not only for its Scottish operations, but also for its important Halifax mortgage lending portfolio, wouldn't Lloyds also decide to move its Scottish subsidiary to England? And even if it decided to leave BOS itself in Scotland, the UK regulator might force separation of the Halifax lending book into a new UK subsidiary. Scottish independence could have the perverse effect of forcing further deconglomeratisation of Lloyds.
So I question whether, in the absence of a Scottish central bank, the large Scottish banks would remain either large or Scottish. This might be a good thing for Scotland, since it would reduce the size of its banking sector to something more compatible with its GDP. But how would the Scottish government feel about Scottish currency note issuance being done entirely by foreign banks?
A genuinely independent Scottish currency
It's entirely possible that the Scottish government would not like Scottish currency issuance to be entirely in the hands of foreign banks. Politically this would certainly be problematic, since currency is part of national identity. So I guess the answer is obvious. Create a new Scottish central bank responsible for issuing Scottish pounds, fully backed by the Scottish government. And end the anomalous creation of Scottish notes by banks.
In the interests of cross-border liquidity, it would be wise for the new currency to be tradeable. But the Scottish government would have to decide whether or not to allow the new currency to float. It might be wise for a new Scottish currency to be pegged to something, probably sterling but potentially also either the dollar or the Euro. New currencies tend to take a beating on foreign exchange markets, especially when the country's debt doesn't have a good credit rating either - which in Scotland's case it won't, simply because of the lack of any credit history. In the interests of inflation control, therefore, a peg to a stable currency in good standing would be a sensible move, although I think it should not be a fixed peg such as White suggests - a crawling peg or something similar would be more sensible.
But Scotland's government should understand that this dilutes its independence. In effect, it would be giving up control of monetary policy to the country whose currency it is using as its anchor. And this would also to some extent dictate its fiscal policy too, since monetary tightening or loosening due to changes in the value of the "anchor" currency would require a fiscal response that might not be what the Scottish economy needed or its people voted for. Is this what the SNP really want?
If it really wants independence, then the only alternative is a new tradeable Scottish currency floating freely against all others (although it could be pegged to a commodity such as gold or oil). Whether it is issued by a Scottish central bank or by commercial banks in a "free banking" model is really not that important. What matters is that the currency should be genuinely independent. If it is not, then neither is Scotland.
For those who are not clear why a fixed currency peg combined with free capital flows necessarily means that monetary policy cannot be independent, I am adding this link about the so-called "impossible trinity" or "trilemma". It's Wikipedia, but pretty clear and about right, and has a handy diagram.
Here are two further links, respectively from pro-independence and anti-independence writers, both arguing that currency union is not a flier. Sillars (pro-independence) is strongly in favour of a Scottish currency. Tomkins (anti-independence) is more noncommittal but gives a very good explanation of the reasons why the UK will not agree to currency union.
Time for wise leadership on currency - In Place of Fear (Sillars)
The SNP's currency nightmare - Notes from North Britain (Tomkins)
And here is the BBC's writeup of Andrew Marr's discussion with Jose Manuel Barroso, President of the European Commission, in which Barroso confirmed that an independent Scotland would have to apply for EU membership and might find it difficult.