SCOTTISH INDEPENDENCE AND ITS CURRENCY

Sam Bowman (Adam Smith Institute) posted (26 August) in the Yorkshire Post (England) a well-argued case for an independent Scotland’s banking system, post-independence.  HERE (originally published on the Adam Smith Institute’s web site).  

"Answer to Scots’ currency dilemma”

"In a new paper for the Adam Smith Institute, I offer a solution to Salmond’s problem. I argue that an independent Scotland should continue using the pound sterling without a currency union. Combined with a system of financial reform based on Scotland’s most successful period in economic history, this system of ‘adaptive sterlingisation’ could give Scotland a highly stable banking system and economy in the long run.

“lan I propose, they would continue to issue these ‘promissory notes’, but would be free to start doing so on a fractional reserve basis. This means that for reserves of, say, one billion pounds sterling, a bank may lend out notes worth two billion pounds in the expectation that not everyone would try to redeem their notes at the same time. Bank runs can be avoided by including an option clause in the notes, allowing banks to defer repayment at the cost of additional interest for the customer.

When Adam Smith wrote his Wealth of Nations, it was during a golden age for Scotland. This period, known as the Scottish Enlightenment, saw thinkers like Smith, David Hume and Robert Burns revolutionise the way we think about the world, and took place against a backdrop of stunning economic growth for Scotland, unrivalled before or since.

Smith singled out Scotland’s banks as one of the main factors in its 18th century flourishing. But this banking system was fundamentally different to ours: banks could not rely on bailouts from the state, had to make their own arrangements to access liquidity when funds were short, and were free to issue their own bank notes according to demand.

The result was one of the most stable banking systems the world has ever seen, and it was only wound up with the passage of a Banking Act in Westminster that was designed for England but needlessly imposed on the Scots as well.

An independent Scotland could reinstate this system while maintaining its use of the pound without permission from Westminster. Scottish banks already issue their own notes. These are backed on a one-to-one basis by one million and one hundred million-pound notes stored at the Bank of England.

Under the ‘adaptive sterlingisation’ pUsually, when people are worried about the future, they spend less, creating a vicious cycle leading to economic slowdowns. Giving Scottish banks complete freedom over note issuance would allow them to expand and contract the supply of money in accordance with their customers’ desire to hold cash, effectively creating an automatic stabiliser in downturns.

Outside a currency union, Scottish banks would have no central bank acting as an unlimited lender of last resort to provide liquidity when they needed it.

Three Latin American countries – Panama, Ecuador and El Salvador – use the US dollar in a similar way. These countries have been praised by international institutions such as the International Monetary Fund and World Economic Forum (WEF) for the soundness of their banks. According to the WEF, Panama has the seventh soundest banks in the world.

Other bailout mechanisms should be removed too. Deposit insurance means that bank customers have nothing to lose if their bank fails, so banks have no reason to avoid risk.

Without deposit insurance, depositors would have a strong incentive to choose safe banks.

This proposal should not be seen as a panglossian case for independence. There are other issues at stake. … But removing bailout protections for banks and letting the market sort out money has worked before and should work again. If he is willing to look to economic history, Alex Salmond [Leader of the Scottish National Party and First Minister of the Scottish Government] may find an answer from his countryman Adam Smith: if you want prosperity and stability, get out of the way.”

Comment

[Disclosure: I am a Fellow of the Adam Smith Institute.]

The Scottish Referendum is drawing towards a close on 18 September, when 4 million-plus Scots voters go the Polls to answer 'YES' or 'NO' to the single question: "Should Scotland be an Independent Country?".

One of the main issues is on the currency in an independent country. The 'NO' campaign has taken the stance that Westminster will not allow and independent Scotland to be in a currency union with the rest of the UK (mainly England, of course, with tiny Wales and Northern Ireland remaining part of the rest of the UK).

The Bank of England, set up as a private bank in 1694 (one of its prominent founders was a Scotsman) when England and Scotland were in a union Crown under A Scottish King resident in England.  The two countries formed a Union of Parliaments in London in 1707. The Bank of England was nationalised after the World War II as the whole of the UK’s central bank. Its most famous currency is the Pound Sterling. 

The current argument is about the currency of an independent Scotland.  Alec Salmond, leader of the Scottish National Party, is an economist, educated at St Andrews University, Fife, Scotland.  He favours an independent Scotland in a currency union the the rest of the UK (rUK) because it is in the best interests of both parties.  The UK party leaders have announced that they will not agree to a currency union with Scotland.  Salmond considers this is a cynical bluff to  frighten voters into supporting a ‘No’ vote.  

He includes a commitment that an independent Scotland would be responsible for its proportionate share of the current UK’s historic National Debt and has budgeted it as annual debt payments into Scotland’s future, post-independence, annual commitments to the Bank.  This too is controversial, because the UK parties in rejecting a currency union insist that Scotland continues to pay off the UK’s national debt but they do not agree that Scotland would continue to have its share of the National Assets of the B of E.

In response, Salmond warns that an independent Scotland that is denied its proportional share of the BoEs national assets cannot be expected to contribute its annual share of the National Debt. The ‘No’ camp’s leaders say that this amounts to a repudiation of a debt which would shock world bankers into bankrupting Scotland!  This is an absurd assertion.  Bankers understand basic book-keeping that is based on balancing columns of Assets with columns of Debts (invented in Italy) and highlighting whether the columns balance or not, as practised all over the world in commerce and in banks. If denied its share of the joint assets, Scotland cannot be expected to pays its share of the joint debts.

However, Sam Bowman highlights the options on currency for an independent Scotland and the technical details in plain English.

Incidently, I shall vote ‘YES’ in the independence Referendum.