Sam Bowman is Research Director of the Adam Smith Institute.
During last Tuesday’s debate between the Alex Salmond and the former Chancellor Alastair Darling, the SNP leader’s case seemed to founder on the question of currency: if the rest of the UK did not agree to a currency union with an independent Scotland, what would Scotland do?
But this – the weakest part of Mr Salmond’s debate against Mr Darling – could be one of the best reasons to support Scottish independence. Were Salmond to look to Scotland’s own history, he would see that all of the ‘drawbacks’ of being outside a formal currency union could turn out to be significant advantages.
In practical terms, there’s virtually nothing stopping any country in the world from using any other country’s currency as its own. Indeed, some countries already do this – notably, the ‘dollarized’ economies of Panama, Ecuador and El Salvador.
So Scotland could keep using the pound with or without a currency union. The difference would be that a ‘currency union’ would force the Bank of England to consider Scottish interests when making decisions about things like setting interest rates, and – crucially – acting as a lender of last resort to Scottish banks, lending to them when they were illiquid.
So what if Scotland went ahead without the currency union? For now, let’s put the first part aside. Scotland’s five million people cannot play much of a role in the Bank of England’s macroeconomic policymaking, the country’s large banking sector notwithstanding (and since that sector is large because of its presence in the English economy, the Bank of England’s calculus would remain mostly unchanged).
The much bigger issue is whether Scotland could manage without a central bank acting as a lender of last resort. The answer is that it could – and has.
Between 1716 and 1844, Scotland had no central bank. The era of ‘free banking’, as it was known, was a success. Its financial system was stable and its economy boomed: in one hundred years, Scottish GDP per capita rose from being less than half of England’s to almost the same.
During this period, banks made private arrangements for clearing houses to provide liquidity to solvent banks with short-term cash flow problems, though these provisions were severely limited compared to what a modern central bank has to offer. When banks did fail, their shareholders and bondholders took the hit, not taxpayers. The system worked, and only ended when the largest banks successfully lobbied the state for protection from competition.
Today, one country that may offer a model for Scotland to follow: Panama. (Coincidentally, the site of Scotland’s ill-fated foray into colonialism.) Panama is about two-thirds as populous as Scotland, and about a third as wealthy, but as it uses the US Dollar outside a currency union it is in the same position that a sterlingized Scotland would be in, with no central bank acting as a lender of last resort, and no bank reserve requirements or deposit insurance laws.
Consequentially, Panaman banks are remarkably stable and have been praised by the IMF and the World Economic Forum, which ranks Panama’s banks as the seventh soundest in the world. Because Panaman banks do not have a public safety net to fall back on, they have to act far more cautiously. All three of the Latin American dollarized countries – Panama, El Salvador and Ecuador – have been praised by a Federal Reserve Bank of Atlanta for their financial stability, arising because of their unusual monetary arrangements.
If Scotland were to go it alone, it could do with surprising ease. Scottish banks already issue their own banknotes which are treated as interchangeable with the pound sterling. Nothing would need to change after independence – banks would treat their sterling reserves as ‘base money’ on which they could issue more or fewer promissory notes according to demand.
The best objection to this is that the existing large Scottish banks, HBOS and RBS, would move their headquarters south to England. This is probably true, but there is no reason that they would bring the jobs they provide to Scots with them. A HQ move would be legally significant, but it would not affect Scottish employment, and, of course, Scottish taxpayers would no longer be on the hook for Scotland’s gargantuan financial sector.
There are good arguments against Scottish independence, but if Salmond were feeling bold or desperate, he could look to one of Scotland’s finest eras and turn his biggest weakness into a strength. Ordinary Scots would not notice a difference – but over time, they may wonder why their financial system was so robust and healthy, compared to that of the country they had left behind.