One of the big issues in the Scottish referendum debates has been the ££££ – will the Scots be able to keep the pound if they vote Yes to independence this week?

This post is a shortened version of the post that first appeared 15 Sept 2014 on The Conversation website – in it, Keith Cuthbertson, Professor of Finance at City University, London and who has worked at HM Treasury and the Bank of England, suggests that although it is sterling that has grabbed the headlines, the real issue is that of debt levels. As long as debt (personal debt, government debt, bank debt) is kept at manageable levels, he says, Scotland can prosper as an independent state., and since sterling is an international currency, there will be no problem about the Scots using it.

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Professor Cuthbertson writes:  In 1707 it took bribes (mainly paid to the Scottish nobility) to get Scotland into the Union with England and Wales. Now hard currency is the centrepiece of divorce proceedings, or as Alex Salmond, the leader of the Scottish Nationalists would have it, a separation where we continue as “just good friends”. The real issue, however, has been obscured in the pow wow over the pound.

Divorce can be either amicable or expensive, to both parties. But the main thing the Scots have to fear is excessive debt; household, bank and government debt. Keep these at manageable levels and Scotland can prosper as an independent state.

There is no problem in the Scots using sterling. It’s a world currency, created mainly by private sector banks [see Chris Daley’s podcast here at Pod Academy on how this works].

All Mark Carney, the Governor of the Bank of England, can do is alter interest rates and I can’t see that an interest rate which is appropriate for rUK (the rest of the UK economy) will be any worse for Scotland than it will be for Cornwall say. In any case, Scotland under the current system has to accept interest rates set by the Bank of England.

Under such “sterlingisation”, the Scottish government could run a budget deficit and finance it by issuing sterling denominated debt – in the same way that different countries in the Eurozone do. Initially, it may have to pay higher interest rates than say, the UK government – but if it is fiscally prudent and can demonstrate it can pay interest from future tax receipts, this is not a problem. So, it’s the debt stupid, not the currency, that’s the key to the economic argument.

The nationalists’ preferred option is a sterling currency union. This involves less sovereignty in return for an insurance policy issued by rUK. It would mean that Scottish banks could use the Bank of England as a lender of last resort. If a Scottish bank is short of cash but it can show that it is solvent, then the Bank of England would provide short-term liquidity – thus helping to prevent a run on the bank.

The lender of last resort facility is only available to solvent banks. If the bank is insolvent, (its assets do not cover its deposits) there will be no lender of last resort facility. The decision is then whether to allow the bank to go into liquidation or to rescue it using taxpayers money. But in a currency union, Scottish taxpayers would be liable for a proportion of any liabilities of a bank which is rescued by the Bank of England – just as it is now.

Credit where credit’s due

Without a formal currency union, Scotland would require a line of credit from other financial institutions to cover any short-term potential cash outflows from a legally domiciled Scottish bank facing liquidity problems. This issue needs to be dealt with. But it should not be too difficult. If a Scottish government wishes to discourage banks being legally domiciled in Scotland it could set high capital requirements. That would mean “Scottish banks” holding less in the way of deposits and raising more funds from shareholders – thus making their deposits safer because the shareholders would take “the first hit” should the bank get into difficulties.

Alternatively, banks could freely operate in Scotland but be legally domiciled in London (say) – which is likely to happen in the short-term. The “company nameplate” is changed but most of the economic activity stays in the same place. Such banks will be regulated by the Bank of England.

In a currency union with a bail-out commitment by the UK government on Scottish government debt, the Scots would have to accept some restrictions on deficits and debt levels. This they already have conceded. A currency union restricts their sovereignty but they may feel it is a price worth paying for the additional insurance provided by the rUK government.

What Scotland gets in return for these undoubted short-term complications is control over all of its tax revenues. Its success then depends on how wisely these are spent on health, education, infrastructure etc and how this affects productivity and innovation.

Whatever the outcome of the vote on September 18 the Scots, one way or another will end up in a new civil partnership with the rest of the UK – hopefully with the emphasis on “civil”. The Scots want a new deal and in voting Yes “the only thing which they have to fear is fear itself”, to paraphrase Franklin D Roosevelt. Personally, I hope it’s a “Yes we can” – partly because it might act as a catalyst for a major decentralisation of power from Westminster.

Tags: Scotland, Scottish Referendum, Sterling, The pound