The Future of Scotland’s Monetary Policy

September 17, 2014 – On Thursday, September 18th, Scotland 3414062968_33a2528c6a_zwill vote on whether or not to declare independence from the United Kingdom. Scotland has not been an independent nation since the Treaty of Union in 1707, so the idea of independence has led to a number of questions about Scotland’s place in the world. One of the more talked-about questions has to do with the status of independent Scotland’s monetary policy and banking system.
The first, most obvious question is, what will Scotland use as money? The Scottish government seems intent on using the British pound sterling, while the UK government has stated that it will seek to ban Scotland from using the pound. Realistically, however, there is nothing the UK government can do to prevent Scotland from using the pound. Consider the cases of El Salvador, Panama, and Ecuador, all of which use the US dollar as their currency, which the United States cannot prevent.
Or consider the cases of Jersey, Guernsey, and the Isle of Man, each of which accepts the pound sterling while also issuing their own local currencies set at parity to the pound. The Republic of Ireland used the British pound when it first gained independence, then introduced the punt and maintained that currency at parity with the pound sterling for the next 50 years. Scottish banks today already issue their own banknotes, which are issued under regulations issued by the Bank of England, are backed by Bank of England notes, and circulate in Scotland (and occasionally in the rest of the UK) alongside Bank of England notes. There is no reason private banknotes could not continue to be issued in an independent Scotland. The effort to influence a “No” vote by stoking fears that Scotland would have to abandon the pound are completely without basis.
If Scotland does vote to break away from the UK, it would not automatically become part of the European Union (EU). It appears that it would have to enter into negotiations with the EU in the hopes of joining the EU as a full-fledged member on the date of independence. Some have claimed that Scotland would not be able to be able to retain use of the pound if it wants to join the EU, that it would have to accept the euro. There are also questions about whether or not Scotland would have to form its own central bank, as the Scottish government hopes to enter a currency agreement that would allow it to participate in monetary decisions made by the Bank of England.
Denmark and the UK currently have opt-out provisions with respect to the euro, and several other nations legally obliged to adopt the euro either have not met the convergence criteria for euro acceptance or continue to delay the process of euro adoption. So Scotland has quite a strong argument for continued use of the pound. And while EU treaties seem to take the existence of a central bank as a given, there really isn’t any legal requirement to establish a central bank.
Besides, it isn’t as though the EU actually holds its member states to the terms of treaties anyway. The budget deficit and total debt provisions were repeatedly ignored by the larger member states, who were not penalized for their transgressions. When flouting of those same provisions by the Greek government led to their financial crisis, the ECB was only too willing to bend the rules to prevent a catastrophic failure.
There is also the question of Scottish banking institutions and the threat of bank runs. Royal Bank of Scotland and Lloyds have threatened to move their operations to England in the event of Scottish independence, and some commentators have speculated that there could be large-scale bank runs due to the uncertainty of access to deposits or due to depositors preferring to hold their deposits in established English banks. While that remains to be seen, Scotland could easily enact regulations to free up the banking system and allow it to become more resilient against bank runs.
It seems unlikely that the UK will allow Scotland any participation in the Bank of England, so that retaining the pound as legal tender would render Scotland dependent on UK monetary policy decisions. Given the Bank of England’s continued easy money policies, adoption of the pound under such circumstances would mean that Scotland would be at risk of importing the UK’s inflation. All the more reason to allow multiple currencies to circulate within the country. Scotland would also not be able to act as a lender of last resort to Scottish banks, which is actually a good thing. Banks would be forced to act in a sound and disciplined manner, as they would know that they could not be bailed out.
An independent Scotland would have a rare and unique opportunity to implement a sound monetary system. As we in the US know, once a central bank is established it is next to impossible to eliminate it. Scotland will be starting with a blank slate and has the ability to create an ideal system of money and banking from the ground up. No central bank, competing currencies, and a banking system that is forced to behave through market discipline are pipe dreams in most of the world. If the Scottish people vote for independence, let us hope that their leaders make the right decisions and do not follow the rest of the world down the ruinous path of central bank-led loose monetary policy.

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