Today the Treasury has released a report on the potential currency arrangements for an independent Scotland. Here, I will leave aside the issues of who ‘owns’ the Bank of England and who owns the ‘rights’ to produce the pound sterling. I will also assume that existing currency arrangements will continue in relation to banking regulation, the functions of the central bank and so on. However, for the record, I fail to see why Scotland could vote to be independent of the UK and then choose to take with it ‘its share’ of the Bank of England (though some readers might feel that Scotland is welcome to all of this institution founded, in fact, by a Scot).
What are the options and what are the real (as opposed to perceived) problems? The first option is to join the euro. That is a sure referendum loser and is therefore off the table. However, it should be noted that, when Scotland renegotiates to join the EU, she will probably have to commit to entering the euro when convergence is reached.
The second option is to create a ‘sterling zone’ rather like the euro zone (hopefully, it would not take on the spelling ‘Sterlingzone’ given that most commentators spell the euro zone ‘Eurozone’). There would be a jointly managed central bank and monetary policy with two independent states. This is what the Scots want and it is feasible. However, if there were only one Scottish member of the MPC for every ten or so English members (roughly in proportion to national income) there would be little Scottish influence on monetary policy. The Treasury is arguing against this on the ground that this would be like the euro zone only worse. England would completely dominate the institutions and completely dominate the economy of the sterling zone. The Treasury also argues that there would need to be tight fiscal control by the joint institutions on government borrowing. This would especially affect Scotland given that it would have an exceptionally large national debt with no repayment record and very high government spending.
The Treasury seems to have learned the wrong lessons from the euro crisis: the same wrong lessons that the EU has learned. Such a currency union does not need a fiscal or debt union, but it needs very strong rules to ensure that neither the central bank nor each member government become responsible for government debt of the other partner. This should be relatively easy to manage in a two member sterling zone. The main problem with this arrangement, in fact, relates to the management of the banking system (see below).
Nevertheless, it is not obvious that Scotland would gain anything from this arrangement. She would have no real control over monetary policy, there would probably be huge frictions between England and Scotland, and there would be big costs if Scotland were to leave the arrangement.
It would seem more sensible – if Scotland wants to use an existing currency - to simply allow Scottish businesses and individuals to choose their own currency and have no formal government currency arrangements at all. In the short term, this would probably lead to Scotland becoming ‘sterlingised’, though sterling could be used alongside the euro and, perhaps, private currencies. This would decouple the currency from what would be a highly indebted government thus preventing debasement and inflation as a method of dealing with government debt. Unfortunately, there are aspects of EU law which surely torpedo this.
Andrew Lilico has argued that the above arrangement would be a dream-come-true for those who believe in free markets and free banking. Scottish banks would have no access to lender-of-last-resort facilities and deposit insurance would probably become infeasible. There is a big problem, though. Firstly, EU law requires deposit insurance so we will probably end up with incredibly tightly regulated Scottish banks to avoid a cost to the public purse of a bank going bust. However, worse than this, there is nothing to stop Scottish banks domiciling in England and operating in Scotland through branches rather than subsidiaries and thus receiving the same central bank support as English banks (albeit regulated by the Bank of England, subject to EU constraints). Indeed, this is precisely what would happen and EU law would require England to allow it to happen. Effectively, we would end up with a sterling zone, with the Scottish banking system being backed by a central bank just as if there had been a formal monetary union. The Scots may as well accept this. They will have no indigenous Scottish banking industry (but there is no reason why the jobs should migrate south) and no responsibility should banks fail. They will have no say over interest rates – but then they would effectively have no say in the sterling zone option either. The implicit subsidy to the Scottish banking operations would be provided by the English and there is absolutely nothing George Osborne can do to prevent this. If a bank, largely operating in Scotland, but domiciled in England, needs lender-of-last-resort support, it will receive it from the English central bank. If a bank, largely operating in Scotland, but domiciled in England, needs a bail out it is likely to get it from England as its failure would bring down English banks.
The EU requirement to allow financial institutions to operate throughout the EU using branches rather than legally separated subsidiaries brings few benefits as far as free trade is concerned. However, it is creating the conditions in which regulation is being unified and debt socialised and thus accelerating the path to ever-closer union. Unless all central banks in the EU are abolished, this policy also ensures that alternative monetary arrangements that do not involve central banks will never be able to compete on an equal footing given that all banks in the EU will be able to obtain access to a central bank subsidy from somewhere.