People in Scotland are heading to the polls today to decide the question of secession. One of the major policy questions for an independent Scotland is whether the country should attempt to keep the pound. As many have now begun to appreciate — with a little help from the eurozone spectacle — this would likely be a big mistake.
In “Euroland’s Original Sin,” Dimitri Papadimitriou and L. Randall Wray explained why a separation between fiscal and monetary sovereignty — when countries do not issue their own currency yet retain responsibility for fiscal policy — is the root of the problem in the eurozone. Any country with this setup will face budgetary constraints to which currency-issuing nations are not subject; the kind of constraints that can generate a sovereign debt crisis if, for instance, the country’s fiscal authority is forced to handle the fallout from a large banking crisis. This is a drum that many people affiliated with the Levy Institute have been banging for some time (well before the eurozone fell into its current mess).
Recently, both Paul Krugman and Martin Wolf have written columns in which they make similar arguments in the context of Scottish independence (and the SNP’s ostensible plan to retain the pound). Philip Pilkington wrote a policy brief a few months ago in which he also argued, with the aid of an analysis of Scotland’s financial balances, that retaining the pound would leave the country open to a eurozone-periphery-style crisis. Pilkington’s story focuses on Scotland’s reliance on oil and gas revenues and the particular instability that could be generated, for a currency-using (vs. issuing) Scotland, by oil price fluctuations.
Although Pilkington suggests it might make sense to retain the pound in the short run (during which time he advocates the use of “tax-backed bonds” to limit instability, a proposal Pilkington originally developed with Warren Mosler [see here and here] for the eurozone), he argues that Scotland ultimately needs to move toward issuing its own freely-floating currency. The question is how to move from the first to the second phase with a minimum of disruption. The policy brief thus lays out a “dual currency” transition plan for Scotland:
The key problems that Scotland would face in issuing its own currency are (1) the uncertainty with regard to the initial exchange rate and (2) establishing institutional arrangements that would allow the currency to be accepted as a means of payment. In order to overcome these difficulties, we advocate that Scotland issue its new currency gradually. In order to do so it should begin paying local government workers some percentage of their salaries in the new currency—let’s say 15 percent as a provisional starting point. While the new currency would be allowed to freely float, the salaries would nevertheless be indexed to the sterling. If, for example, the new currency lost 10 percent of its value vis-à-vis the sterling, then the Scottish government would have to increase the amount being paid to local government workers in the new currency by the same amount. In this way, the government would ensure that these workers’ salaries did not increase and decrease based on fluctuations in the new currency.
In order to generate instantaneous demand for the new currency, local governments would also be obliged to accept it in payment of taxes. In this way, even if the local government workers could not initially use the new currency to purchase goods and services in private businesses they could simply use the portion of their salaries paid in the new currency to meet their tax liabilities at the end of the year. Private businesses, however, would quickly come to see that the new currency had real value insofar as it could be used to pay taxes, and would soon accept the new currency as a means of payment. This process could be greatly accelerated if the Scottish government mandated that private businesses had to display prices in both sterling and the new currency. It would be further accelerated if the Scottish government mandated that banks within Scotland had to accommodate the new means of payment.
Once the currency began to enter the payments system, it would also begin to gain a stable market value. This stable market value would then signal to the Scottish government the relative strength of its currency. Based on this benchmark, the Scottish government could speed up or slow down the amount of new currency circulating by mandating that local governments increase or decrease the amount that local government workers are paid in the new currency. Other benefits could then be compensated in the new currency—such as state pensions, tax rebates, and welfare payments.
Initially, the new currency could be issued by the Scottish central bank with no debt backing and distributed to local governments according to a plan set out by the Scottish government. As the issuance increased, however, the Scottish government could decide that it should sell bonds prior to the issuance of more currency. In such a case, either the central bank could issue the bonds directly or the Scottish government could issue them alongside the sterling-denominated tax-backed bonds laid out in phase I of this proposal. In either scenario, the bonds could be sold to raise either sterling reserves or quantities of the new currency, but would only make payments for goods and services in its new currency.
We anticipate that this dual currency framework would stabilize after a period, and, once the Scottish government deemed it safe, the country could gradually move off the sterling completely and transition to the new currency. It would do this by making all of its payments and receiving all of its tax revenue in the new currency. As the Bank of England ceded its role as the issuer of the currency of Scotland, the newly empowered Bank of Scotland would begin to undertake all of the functions now undertaken by the Bank of England, such as setting monetary policy and maintaining system-wide liquidity. Monetary operations could gradually move away from using sterling-denominated bonds to remove reserves from the banking system and toward using bonds denominated in the new currency.
Alternatively, the Bank of Scotland could simply pay interest on reserves in order to hit its monetary policy target. (This innovative new approach has already been undertaken with great success by the Bank of England and the US Federal Reserve; see FRBSF 2013). This would also eliminate the need for the Scottish government to issue sovereign debt altogether. Some economists, however, may feel that this option would eliminate constraints on the Scottish government to engage in deficit spending and might lead to inflation. These considerations may be ill founded given that any government with a monetary regime featuring an independent central bank that aims at a monetary interest rate target is already financially unconstrained. But if this were a serious issue for policymakers, government debt could easily be issued in order to ensure that the Scottish monetary regime was of a kind that economists have long been familiar with—that is, one in which immediate funding needs are met through the issuance of government debt in the primary market, which is then purchased in the secondary market in order to stabilize the overnight interest rate.