Q. I see the previous UK Chancellor of the Exchequer Alastair Darling, the well known economist Professor Patrick Minford and others, have argued that the Bank of England would not act as a "lender of last resort" to Scotland if Scotland became independent and retained sterling. Are they correct?
A. It is correct to say that the UK authorities would have to agree to this. However, if it is agreed between Scotland and rUK that an independent Scotland remained within the sterling monetary union then the Bank of England (BOE) could become the Bank of Sterling (BOS). The situation would then be formally similar to the position of the ECB to Eurozone member countries. Under current rules the ECB can act as lender of last resort to member country banks but not directly to member states.
Q. Is it likely that the BOE would become a BOS equivalent to the ECB?
A. No, I don't think so. The rUK government would not want the rUK to have the current status of France to the ECB. Because this means that rUK would effectively be borrowing in a "foreign" currency while the BOS, not the rUK, would be issuing the currency. In such circumstances the risk of default on borrowing is perceived by the financial markets to be greater and so the yield paid on rUK Treasuries would be higher than present UK Treasuries, other things equal. This is not going to happen.
Q. So, what does this mean for Scotland if it is in the sterling union?
A. It means that Scotland would not be equal to rUK. The BOE would be the rUK's central bank performing some necessary financial and monetary stability functions for the sterling union. There would be no Scottish central bank. There would be a common nominal interest rate across the sterling union. The BOE would act as "lender of last resort" to all banks in the monetary union, including Scottish banks, but would do so at 'penal' or above market rates. It would also require Scottish banks to satisfy UK financial stability rules, implementing the proposals of the Vickers' Commission and so on. The BOE would need to do this as part of its objective of ensuring financial stability in both rUK and the wider sterling union. The Scottish government would be issuing its own bonds but in sterling. It would effectively be borrowing in a foreign currency and would have no ability to print money. Accordingly, the markets are likely to demand a higher yield premium on Scottish 10 year and 30 year bonds than rUK Treasuries and present UK Treasuries.
Q. Are there any implications for the Scottish government's fiscal - tax and spend - policies of a politically independent Scotland remaining in the sterling monetary union?
A. Yes, the BOE and the rUK government would require the Scottish government to observe an agreed set of fiscal rules which would likely cover limits on the scale of borrowing, the size of the primary budget deficit in relation to Scottish GDP and the level of Scottish government debt to GDP. The demands from the rUK government could be quite restrictive. Accordingly, the Scottish government might not observe these rules and the financial markets would be uncertain what would happen if Scotland, being unable to print or change the value of its own currency, defaulted on its debt. We have seen the difficulties this has caused with the financial markets in their uncertainty about whether the ECB will support member states by buying their bonds. Again the result would be Scotland's sterling denominated bonds trading at a premium to present UK Treasuries.
Q. So, would full fiscal autonomy in the present UK political and monetary union be better?
A. This could be either a better or worse solution than political independence. It would almost exactly mimic the situation in the Eurozone, with what happened in Greece being the worst case - admittedly unlikely - scenario. The likely outcome under full fiscal autonomy for Scotland within the UK is that the UK government would unilaterally adopt a US State solution where the Fed and the Federal Government explicitly refuse to bail out states - see John Kay here. Markets then price in the perceived greater risk of default by charging a premium. Scotland's bonds would trade at a premium for the reasons noted above. John Kay notes California's issue of 30-year Build America bonds at a yield 325 basis points (3.25% points) above comparable US Treasuries. The premium could be less than under political independence if the markets believed that being part of the UK political union made a bailout, if required, more probable. The premium could be higher than under political independence with a separate currency if the markets believed that no bailout from the UK government was credible. Having a separate currency offers the possibility of a devaluation, higher growth and hence higher tax revenues, so limiting the risk of default.
Q. Alex Salmond has said that a British chancellor would be "biting our hands off" for an independent Scotland to keep the pound. Is that fair comment?
A. It is true that the contribution of oil and whisky exports is favourable to the UK balance of payments and to UK tax revenues. Sterling probably trades at a higher rate because of this. However, if the UK government was not receiving the tax revenue from the income earned by these exports it might baulk at the penalty paid by UK exports of manufactured goods and financial services through the loss of competitiveness due to the higher exchange rate. Accordingly, while the UK government might reasonably wish to hang on to the tax revenues, and keep Scotland within the UK political union, I can't see how Alex Salmond's statement can be correct.
Q. Given what you say might it not be better if Scotland adopted its own currency?
A. A case can be made for an independent Scotland having its own currency. At the most basic level, if Scotland's competitiveness began to move out of line with its main trading partners then the nominal Scottish currency would adjust to maintain the real exchange rate. A loss of/rise in competitiveness would lead to a fall/rise in the nominal exchange rate. But as I noted in this post it would be extremely dangerous if Scotland immediately adopted its own currency. The exchange rates of currencies of small independent states are extremely volatile unless they link in one way or another to a larger monetary union. The small scale of the foreign currency reserves held means that such countries are extremely vulnerable to speculative attack, extreme swings in their exchange rate, the exchange risk and heightened uncertainty for business. A small country would have great difficulty in smoothing the path of its exchange rate, without running the risk of inflation or deflation. It would therefore have to strike a deal with a friendly neighbour - the rUK? - for their central bank to step in to support its currency and withstand speculative attack. Denmark has such an arrangement with the ECB so that its currency can trade within the limits of the old ERM 2. But such an agreement would again come at a price of required monetary and fiscal restrictions, which an independent Scottish state might not find acceptable.
Q. So, it's going to have to be the Euro then if Scotland does go independent?
A. Are you kidding?