Currency choice of an independent Scotland: what role for the central bank?

Were Scotland to become independent, its choice of currency would be a key decision. Whether the country remained in a formal or informal currency union with the UK, adopted the euro or established a new currency would have significant consequences for the role of a Scottish central bank.

The currency choice of an independent Scotland has always involved questions around the role of a Scottish central bank. Recent developments – from the growing economic and political roles of central banks to the expansion of central bank purchases of government bonds – have increased the importance and breadth of this issue.

How do these developments influence the way a central bank might operate in an independent Scotland? How would they affect an independent Scotland’s choice of currency?

What is the traditional role of the central bank?

A central bank has broad areas of responsibility. It has several day-to-day routine functions that it undertakes, including providing liquidity for the banking system, currency issue and management, and banking services to the government.

In addition, central banks typically have two main policy responsibilities:

Monetary policy: typically involving the setting of short-term interest rates, but in recent years moving beyond this, with a view to achieving an inflation target.
Financial stability: most importantly as the ‘lender of last resort’ for the liquidity needs of solvent commercial banks that find themselves short of liquidity. This can also include responsibility for financial supervision to the extent that this is not covered by a separate agency.

What are the central bank options for an independent Scotland?

An independent Scotland would face an important choice about its currency arrangements (MacDonald, 2022). The choice of currency would then have implications for how the country’s central bank should be designed and the functions it could undertake.

Under the option of a formal currency union – whether with the rest of the UK or with the European Union (EU) – an independent Scotland would share a central bank with the other member(s) of that union.

The shared central bank – the Bank of England or the European Central Bank (ECB) – would have responsibility for inflation and for lender of last resort activities across the currency area (including Scotland). In the case of the euro area, this would also involve potentially working with local national subsidiaries. Members are represented in the decision-making of the central bank, as on the ECB’s Governing Council.

In the 2014 independence referendum, the Yes campaign’s proposed policy was for a formal currency union with the UK. No agreement was reached, but the Scottish government envisaged having Scottish representation in the governance of the Bank of England, which would have responsibility for central bank policy in Scotland as well as for the rest of the UK.

A second option – an informal currency union using sterling – was proposed by the Scottish National Party’s Sustainable Growth Commission. In this case, there would be no separate Scottish monetary policy, but a Scottish central bank might still be required to undertake a number of functions related to managing the government’s accounts and currency reserves. It would also be at the centre of the Scottish payment system.

The Bank of England’s role in this case would be less clear-cut; indeed, it may assume no role. Most importantly, the Bank of England’s responsibilities towards Scotland in such a scenario would be decided entirely by the authorities in the rest of the UK. In normal economic conditions, it would be unlikely to pay specific attention to Scotland in deciding policy. An example of this can be seen in the United States where the Federal Reserve has no responsibility for economic conditions in Ecuador or Panama – two countries that have informally adopted the US dollar.

To the extent that Scotland’s economy is close in nature to the rest of the UK (it is part of what economists call an optimal currency area or OCA), this may not matter for some aspects of central bank policy. In such a situation, for example, and at least in the short term, UK interest rates would be appropriate to Scotland. If the UK is not an OCA, then a central bank setting interest rates only for rest of the UK would not be appropriate for Scotland.

In an informal union with the rest of the UK, a Scottish central bank would not have the capacity to fulfil all of the responsibilities of a central bank to any meaningful extent (Armstrong and McCarthy, 2014). In particular, there would be reduced capacity to act as lender of last resort to the banking system or undertake ‘unconventional monetary policy’ involving the purchase of financial assets (see below). This is because, while it might be able to build up some reserves to help with this over the long term, ultimately this capacity depends on the ability of a central bank to create (or ‘print’) the domestic currency. A Scottish central bank could not do this in an informal currency union.

The Bank of England may choose, with the support of UK elected policy-makers, to have some responsibilities – perhaps indirectly – towards an independent Scotland’s economy or banking system. An informal currency union does not preclude agreement between two countries about central banking, and the lack of agreement does not prevent any subsequent support.

Central banks often reach agreements between themselves. The UK government participated in the bailout of Ireland in 2010, despite not being a member of the euro area. What these agreements might look like, and the circumstances under which they might be implemented, are uncertain, as is any agreement.

Under the third option – a separate Scottish currency – an independent Scotland would have its own central bank with the full capacity to perform all the functions discussed above. This central bank would be expected to be accountable to the Scottish government and to the Scottish parliament, including with regard to the issues discussed below.

With this option, monetary policy would be set for the needs of Scotland alone, although decisions would have to take account of international influences. Crucially, in contrast to other options, this policy would allow an independent Scotland to create or print its own currency. This enhances the lender of last resort liquidity support available to Scottish banks and the ability to perform unconventional monetary policy, in particular the quantitative easing (QE) that has become increasingly common since the global financial crisis of 2007-09.

How have recent developments affected the potential role of a Scottish central bank?

Even before the Covid-19 crisis, central banking was entering a period of change (Goodhart, 2010). The response to the pandemic and parallel debates around the role of central banks have increased their economic and political importance. This has the potential to increase the range of central bank capacities available were Scotland to have its own currency.

The most important change has been the increased influence of central banks on government borrowing through the buying of government bonds as a part of unconventional monetary policy. Central banks are responsible for monetary policy; governments are responsible for fiscal policy. The separation of responsibility for monetary and fiscal policy is fundamental to present-day central banking. But this separation is never absolute.

Monetary policy, through the setting of short-term interest rates, has always had an influence on governments’ borrowing costs. When short-term interest rates are low, these are usually low. When rates are high, this will generally increase the interest rate on government bonds (Baker et al, 2016). Similarly, the economic impact of fiscal policy will influence a central bank’s monetary policy decisions. The buying and selling of short-term government bonds has also long been a normal part of monetary policy.

Unconventional monetary policy, most commonly QE, involves central banks seeking to support increased economic activity by buying financial assets, including government bonds. With QE, the lines between monetary and fiscal policy have begun to blur significantly, but in the UK stopped short of ‘monetary financing’ (McMahon and Macchiarelli, 2020).

Monetary financing is when a central bank directly finances the government’s fiscal deficit – the gap between public spending and income from tax and other revenues. Permanent monetary financing is expected to cause inflation. It is, for example, banned under the treaty that established the ECB.

But recent research from the International Monetary Fund (IMF) argues that modest monetary financing in countries with a track record of responsible economic policies does not raise inflation expectations (Agur et al, 2022).

During the Covid-19 crisis, central bank support for government borrowing increased markedly, even when compared with previous episodes of QE. In the UK, for example, government borrowing was at its highest since the Second World War.

Some economists argue that QE during this time made the Bank of England effectively the ‘buyer-of-last-resort’ (albeit by matching government issuance with buying in the secondary market rather than directly financing the government).

Investors in the market for UK government bonds (gilts) have doubted the government’s ability to borrow to finance its needs in this period without the Bank of England buying gilts (Financial Times, 2021). From March 2020 until November 2021, the Bank of England purchased over £400 billion of gilts, almost exactly matching the UK government’s net cash requirement – a measure of its borrowing requirement – month by month.

The Bank of England’s actions are a temporary response to an unprecedented health and economic emergency. Additional gilt purchases can stop as monetary policy dictates, and the Bank of England retains the option to sell the gilts it holds over time, or not to buy any more as those they hold are repaid.

This partly underpins the argument that this is not monetary financing, as it is not permanent. But, 13 years on from the start of QE, the Bank of England has remained a significant holder of gilts and QE will continue to be part of central banks’ policy tool kit.

In a formal currency union, QE can work across member countries. During the pandemic, the ECB has created euros to purchase members’ government debt, keeping borrowing costs unusually low. An informal currency union would not have any such arrangement, and a Scottish central bank would have no capacity to create sterling to support Scottish government borrowing (and therefore expenditure).

This is not to say that an independence Scotland would be unable to borrow at all, but we cannot be confident as to how much it would be able to borrow in an informal currency union.

A new Scottish currency would mean that Scotland would have a central bank able to create money to purchase government debt, as many governments have done during the pandemic.

Policy would still have to focus on inflation, and the value of the currency and would depend on the new central bank establishing a reputation for policies perceived as responsible (Besley and Dann, 2022). Once this is achieved, a Scottish currency is likely to allow the greatest crisis-related government expenditure.

How else are central banks politically important?

Are there other policy options for an independent Scotland’s central bank? Recent developments suggest that central banks are increasingly considering policy areas that would be important for an independent Scotland: inequality, house prices and climate change.

There remains a debate among central bankers themselves as to the extent to which they should be involved in such issues (Tucker, 2018). The concern here is not that debate, but the implications for Scotland’s currency options.

With its own currency, Scotland would decide whether (and, if so, how) these issues should be part of its central bank’s concerns. In a formal currency union, these debates would be part of a discussion across all countries. In an informal union, the Bank of England and the Westminster government would decide.

Inequality

There has been a debate almost since QE was introduced as to its distributional consequences. QE pushes asset prices higher, as is in part its intention, and this price appreciation favours the holders of these assets.

But financial assets are held disproportionately by the wealthy and, as a result, QE risks increased wealth inequality. Against this, by supporting economic activity, the incomes of the poorest, who are most vulnerable to recession, are supported, with positive implications for income inequality (Bunn et al, 2018).

Inequality has implications for the performance of an economy, justifying central bank attention, but the nature and extent of central bank actions on inequality are also a political issue.

Housing

In February 2021, the New Zealand government required its central bank to consider house prices in its decisions (Powell and Wessel, 2021). This was prompted by widespread concern about rapidly rising property prices.

The debate around this move is linked to a broader debate about whether central banks should act to address asset price inflation more generally, including seeking to address bubbles in the equity market, for example. The Bank of England already considers house prices in the context of banking regulation and financial stability, and the Reserve Bank of New Zealand may do similarly. But going further, a policy focused on the rest of the UK would have important consequences in Scotland.

Climate change

ECB president Christine Lagarde has been particularly vocal about the need for central bank policy to consider climate change. Arguments for doing so include risks to financial stability from the damage caused by rising temperatures. Central banks have powerful tools in this regard. For example, climate-related risks to banks and insurance companies can be regulated more aggressively.

In addition, as part of QE, many central banks buy bonds issued by companies, supporting their prices. Excluding fossil fuel companies from such programmes could have a significant impact on their borrowing costs.

No action would also be an influential decision. If central banks buy an equal share of the corporate bonds in the market, heavy emitters of greenhouse gases benefit most, as they issue higher volumes of bonds.

Conclusions

A Scottish central bank would not only be key to monetary policy but could also be involved in some of the most important political issues that an independent Scotland would face. Whether Scotland decides on these issues, or if decisions are taken elsewhere, is closely tied to its currency choice.

An independent Scotland would need an independent central bank, regardless of the functions that the choice of currency allows. This would be a requirement for market participants to have confidence in policy, especially if Scotland has its own currency.

Yet, central bank independence is never absolute. Decisions by – and about the institutional design of – central banks are inherently political, rather than simply technical, because they have distributional consequences. The decision on what powers the central bank should have, and therefore the currency choice, is as much political as economic.