Sam Bowman: 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.

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’ plan 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.

Usually, 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. And, perhaps crucially, EU regulation means that it seems likely that RBS and Lloyd’s would be legally domiciled in the City of London whatever currency Scotland used. How many jobs they would take with them is unclear.

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 may find an answer from his countryman Adam Smith: if you want prosperity and stability, get out of the way.