An independent Scotland should use the pound without permission from rUK, says new ASI report

Today the Adam Smith Institute has released a new paper: “Quids In: How sterlingization and free banking could help Scotland flourish”, written by Research Director of the Adam Smith Institute, Sam Bowman. Below is a condensed version of the press release; a full version of the press release can be found here.

An independent Scotland could flourish by using the pound without permission from the rest of the UK, a new report released today by the Adam Smith Institute argues.

The report, “Quids In: How sterlingization and free banking could help Scotland flourish”, draws on Scottish history and contemporary international examples to argue for the adoption of what it calls ‘adaptive sterlingization,’ which combines unilateral use of the pound sterling with financial reforms that remove protections for established banks while allowing competitive banks to issue their own promissory notes without restriction. This, the report argues, would give Scotland a more stable financial system and economy than the rest of the UK.

According to the report, adaptive sterlingization would allow competitive, private banks to issue their own promissory notes backed by reserves of GBP (or anything else – including USD, gold, index fund shares or even cryptocurrencies like Bitcoin). With each bank given powers to expand and contract its balance sheet relative to demand, this system would be highly adaptive to changes in money demand, preventing demand-side recessions in modern economies such as the ones that led to the 2008 Great Recession.

The report’s author, Sam Bowman, details Scotland’s successful history of ‘free banking’ in the 18th and 19th centuries and the period of remarkable financial and economic stability which accompanied it. Historical ‘hangovers’ from this period, like Scotland’s continued practice of individual bank issuance of banknotes, are still in place today, making Scotland uniquely placed for a simple transition to the system outlined in the report.

The report highlights evidence from ‘dollarized’ economies in Latin America, such as Panama, Ecuador and El Salvador, which demonstrate that the informal use of another country’s currency can foster a healthy financial system and economy.

Under sterlingization, Scotland would lack the ability to print money and establish a central bank to act as a lender of last resort. Evidence from dollarized Latin American countries suggests that far from being problematic, this constraint reduces moral hazard within the financial system and forces banks to be prudent, significantly improving the overall quality of the country’s financial institutions. Panama, for example, has the seventh soundest banks in the world.

The report concludes that Britain’s obstinacy could be Scotland’s opportunity to return to a freer, more stable banking system. Sterilization, combined with reform of Scottish financial regulation that:

  • removed government liquidity provisions to illiquid banks,

  • established mechanisms to ‘bail-in’ insolvent banks by extending liability to shareholders, and

  • shifted deposit insurance costs onto banks and depositors rather than taxpayers,

would improve standards and competitiveness in banking, while significantly reducing the prospect of large-scale bank panics and financial crises.

Commenting on his report, the Research Director of the Adam Smith Institute, Sam Bowman, said:

The Scottish independence debate has repeatedly foundered on the question of currency, but if Scots look to their own history they will find that their country is a shining example of how competition in currency and banking can ensure a stable and effective banking system. Scotland’s free banking era was an economic and intellectual Golden Age, and its system of competitive note-issuance was recognised by such thinkers as Adam Smith as one of the root causes of the country’s prosperity during this time.

The examples of Panama and other dollarized Latin American economies are proof that countries can thrive when they unilaterally adopt another country’s currency. Combined with a flexible, adaptive banking system, the unilateral use of another country’s currency can instill a discipline in a country’s financial sector that neither a national currency nor a currency union can provide. Scotland’s banking system is almost uniquely primed for such a system of ‘adaptive sterlingization’. The path outlined in this paper would go almost unnoticed by the average Scot – until the next big economic shock, when they might just wonder why their system was so much more stable than that of the country they’d left behind.

Regulation seems to cause bank crises, not prevent them

City AM’s Pete Spence (formerly of this parish) reminded me of Mark Carney’s claims in January that free banking systems are more unstable than regulated ones. I’m not so sure. Take a look at these two charts from George Selgin’s Are Banking Crises Free-Market Phenomena?, which mark an x for every instance of a banking panic. The first chart is for unfree systems, the second for free systems:

In this case at least, it looks like the evidence is against Mark Carney.

How Scotland could flourish by unilaterally keeping the pound

Between 1716 and 1844, Scotland had one of the world’s most stable and robust banking systems. It had no central bank, no lender of last resort, and no bank bailouts. When banks did fail, it was shareholders who were liable for paying back depositors, not taxpayers. Scottish GDP per capita was less than half of England’s in 1750; by the end of the era in 1845 it was nearly the same. Now that George Osborne has ruled out a currency union if Scotland votes for independence, the Scots have an opportunity to return to this system more seamlessly than any other place in the world could.

As I said to the press this week, there’s nothing really stopping Scotland from continuing to use the pound unilaterally. (Unless the remaining UK introduced strict foreign exchange controls, which would be absolutely crazy.)

What the Chancellor’s announcement actually means is that the Bank of England (BoE) would no longer consider Scottish interests when it determines monetary policy and that illiquid Scottish banks would no longer be able to use the BoE as a Lender of Last Resort.

I’m not sure that the first point really matters at all. Scotland’s five million people can’t have much of an influence over the BoE’s policy for the UK’s 63 million people as it is. And, frankly, I’m not sure the BoE knows what it’s doing well enough for it to matter whether it cares about you or not.

The second point is the interesting bit. George Selgin has pointed to research by the Federal Reserve Bank of Atlanta about the Latin American countries that unilaterally use the dollar. Because these countries – Panama, Ecuador and El Salvador – lack a Lender of Last Resort, their banking systems have had to be far more prudent and cautious than most of their neighbours.

Panama, which has used the US Dollar for one hundred years, is the most useful example because it is a relatively rich and stable country. A recent IMF report said that:

By not having a central bank, Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages. The authorities emphasized that these features had contributed to the strength and resilience of the system, which relies on banks holding high levels of liquidity beyond the prudential requirement of 30 percent of short-term deposits.

Panama also lacks any bank reserve requirement rules or deposit insurance. Despite or, more likely, because of these factors, the World Economic Forum’s Global Competitiveness Report ranks Panama seventh in the world for the soundness of its banks.

I suspect that there would also be another upside. Following Walter Bagehot, central banks are only supposed to lend to illiquid banks, not insolvent ones. Yet since the start of the Eurozone crisis the ECB has clearly made significant bond purchases to prop up both insolvent banks and insolvent governments. This may have been a lesser evil than letting them collapse altogether, but it’s hard to say that this kind of moral hazard is not present.

So, given that some countries do survive and even flourish without a central bank, how would Scotland do it?

The basic mechanics, I think, would be this: in a hangover from the old free banking period, Scottish banks currently issue their own banknotes. After independence, they could continue issuing their own notes that entitle the bearer to GBP on demand. BoE pounds, in other words, would be the ‘base money’ that Scottish banks use to back their own private currencies, in the same way gold was used during the last Scottish free banking era.

A banknote from a Scottish bank would be, in effect, a promissory note redeemable on demand in BoE-issued pound sterling. (Scottish notes are already promissory notes, but issuance is closely regulated by the BoE.) Of course, there should be nothing stopping banks from issuing notes redeemable in something else, like US Dollars, gold, Bitcoins, or Tesco Clubcard points. Scottish banks would have to arrange private clearing houses, as they did in the last free banking era, to provide loans to illiquid banks, or they could follow Panama in simply maintaining very high reserves.

No bank would have monopoly privileges: any ‘bank’ could issue notes and it would be up to the market to decide whether to accept them as money or not. As Selgin explains here, banks free to issue their own notes will set their reserve ratios according to people’s demand for money, stabilising nominal spending.

With respect to other regulations, I quote Selgin again:

It is, in any event, desirable that there be no Scottish public authority capable of bailing out insolvent banks and of thereby introducing a moral hazard. Deposit insurance should be resisted for the same reason. Foreign banks should be admitted, by way of branches rather than subsidiaries, and should enjoy the same rights as Scottish banks. (Of course the major “Scottish” banks are themselves no longer really Scottish anyway.) Finally, re-establishing some form of extended liability (though not necessarily unlimited liability) wouldn’t be a bad idea.

We take no position on Scottish independence — it is up to Scottish voters to decide. And while a return to free banking in Scotland may seem fanciful, this week’s announcement makes it much more likely. Keeping the pound and treating it as the ‘specie’ on which banks can base their notes would make the transition virtually seamless for the average Scot, while giving them a banking system that is unrivalled anywhere in the world for being stable, open, and free.

An alternative ‘Agenda for Hope’

Owen Jones has written a nine-point ‘Agenda for Hope’ that he argues would create a fairer society. Well, maybe. I’m not convinced by many of them. Then again, it would be quite surprising if I was.

But it got me thinking about what my nine-point agenda would be — not quite my ‘perfect world’ policies, but some fairly bold steps that I could just about imagine happening in the next couple of decades. Unlike Owen’s policies, few of these are likely to win much public support. On the other hand, most of the political elite would think these are just as wacky as Owen’s too.

Nine policies to make people richer and freer (and hopefully happier):

1) The removal of political barriers to who can work and reside in the UK. Removing all barriers to trade would increase global GDP by between 0.3% and 4.1%. Completely removing barriers to migration, though, could increase global GDP by between 67% and 147.3%. Those GDP benefits would mostly accrue to the poorest people in the world. We can’t remove these barriers everywhere but we can show the rest of the world how it’s done. Any step towards this would be good – I suggest we start by dropping the net migration cap and allowing any accredited educational institution to award an unlimited number of student visas.

2) A strict rule for the Bank of England to target nominal GDP instead of inflation, replacing the discretion of the Monetary Policy Committee. Even more harmful than the primary bust in recessions is what Hayek called the ‘secondary deflation’ that comes about as people, fearing a drop in their future nominal earnings, hold on to more of their money. That reduces the total level of nominal spending in the economy which, since prices and wages are sticky in the short run, leads to unemployment and a fall in economic output. NGDP targeting prevents those ‘secondary deflations’ and would make economic busts much less common and harmful. In the long run, we should scrap the central bank altogether and replace it with competition in currencies (see point 9, below).

3) Significant planning reform that abolished the Town and Country Planning Act (which includes the legislation ‘protecting’ the Green Belt from most development) and decentralised planning decisions to individuals through tradable development rights (TDRs). This would give locals an incentive to allow new developments because they would be compensated by the developers directly, allowing for a reasonably efficient price system to emerge and making new development much, much easier. The extra economic activity from the new home building alone would probably add a couple of points to GDP growth.

4) Legalisation of most recreational drugs and the medicalisation of the most harmful ones. I think Transform’s outline is pretty good: let cannabis be sold like alcohol and tobacco to adults by licensed commercial retailers; MDMA, cocaine and amphetamines sold by pharmacies in limited quantities; and extremely dangerous drugs like heroin sold with prescriptions for use in supervised consumption areas. The sooner this happens, the sooner producers will be answerable to the law and deaths from ‘bad batches’ of drugs like ecstasy will be a thing of the past. Better yet, this would bring an end to drug wars like Mexico’s, which has killed around 100,000 people in the past ten years.

5) Reform of the welfare system along the lines of a Negative Income Tax or Basic Income Guarantee. As it is, the welfare system disincentivises work and creates dependency without doing much for the working poor. A Negative Income Tax would only look at people’s incomes (not whether they were in work or not in work), reducing perverse incentives and topping up the wages of the poorest earners. This would strengthen the bargaining position of low-skilled workers and would remove much of the risks to workers associated with employment deregulation. Of course, the first thing we should do is raise the personal allowance and National Insurance threshold to the minimum wage rate to give poor workers a de facto ‘Living Wage’.

6) A Singaporean-style healthcare system to replace the NHS. In Singapore, people have both a health savings account and optional catastrophic health insurance. They pay a portion of their earnings into the savings account (poor people receive money from the state for this), which pays for day-to-day trips to the doctor, prescriptions, and so on. The government co-pays for many expenses but the personal cost disincentivises frivolous visits to the doctor. For very expensive treatments, optional catastrophic health insurance kicks in. This is far from being a pure free market system but it is miles better (cheaper and with better health outcomes) than the NHS. (By the way, if you really like the NHS we could still call this an ‘NHS’ and still get the superior system.)

7) A school voucher system and significant reform of the state education and free schools sectors. This would include the abolition of catchement areas and proximity-based admission, simplification of the free schools application process, and expansion of the free schools programme to allow profit making firms to operate free schools. These reforms, outlined in more detail in two ASI reports, would increase the number of places available to children and increase competition among schools to drive up standards.

8) Intellectual property reform. As both Alex Tabarrok and Matt Ridley have pointed out, our IP (patent and copyright) law is too restrictive and seems to be stifling new innovation. Firms use patents as barriers to entry, suing new rivals whose products are too similar to their own. In industries where development costs are high but imitation costs are low, like pharmaceuticals, patents may be necessary to incentivise innovation, but in industries like software development where development can be cheaper than imitation, patents can be a terrible drag on progress. Tabarrok recommends that we try to tailor patent length in accordance with these differences; as a sceptic about our ability to know, well, anything, I’d prefer to leave it to private contracts and common law courts to discover.

9) Last but not least, the removal of the thicket of financial regulation and the promise of bailouts for insolvent banks. Known as ‘free banking’, this system of laissez-faire finance has an extremely strong record of stability – though bank panics still occurred in free banking systems, they were much less severe and rarely systemic. Only once the government started to intervene in the financial system to provide complete stability did things really begin to go wrong: deposit insurance, branch-banking restrictions, and other prudent-seeming regulations led to extremely bad unforeseen consequences. The financial crisis of 2008 probably owes more to asset requirements like the Basel accords, which heavily incentivised banks to hold ‘safe’ mortgage debt over ‘risky’ business debt, than anything else. Incidentally, the idea that having a large number of local banks is somehow better than having a few large banks is totally wrong: during the Great Depression, 9,000 of America’s small, local banks failed; at the same time not one of Canada’s large banks failed. The small banks were more vulnerable because, unlike the big banks, they were undiversified.

Now, if only there was a think tank to try and make these dreams a reality.

What’s the true free market monetary policy?

Let’s imagine we are in a world where central banks are given key roles in the macroeconomy, and have been for decades or even centuries in almost every country. In this imaginary world, studies into the relative efficacy of free banking regimes have been undeservedly overlooked, and the orthodoxy among major economists, even ones otherwise sympathetic to free markets is that they are a bad idea. Major policymakers, let’s imagine, are completely unaware of the free banking alternative, and most even use the term to mean something completely different. Proposals to enact free banking have not been mentioned in law making chambers for decades or centuries, if at all. It has not been in any party’s policy platform for a similar period of time, in this imaginary world.

What’s interesting about this imaginary world is that it is in fact our world. Economists like George Selgin, Larry White, Kevin Dowd (among many others) have done very convincing research about the benefits of free banking. And free banking may one day become a real prospect, perhaps in a new state or a charter city. But free banking has lost the battle for the time being, and abolishing the central bank and government intervention in money is as unlikely as abolishing the welfare state. Now one might say that if free banking is a desirable policy, it is worth continuing to wage the intellectual war for the benefit of future generations, who could benefit from the scholarship. Work done now could end up influencing and improving future monetary policy.

I do not discount the possibility this is true. At the same time, free banking is a meta-policy, not a policy—a way of choosing what monetary regime to enact, rather than a specific monetary regime. After all, it is at least possible that free banks could together target consumer prices, the GDP deflator, the money base, the money supply measured by M2, nominal income/NGDP. And for each of these different measures there are an infinite number of theoretical growth paths, and a large number of realistically plausible growth paths they could aim for. Now, free bankers say that the market will make a good decision, and I can buy that. But let’s say we’re constrained to choose a policy without the aid of the market mechanism: can we say there are better or worse central plans?

The answer is: of course we can! Old-school monetarism, targeting money supply aggregates, was a failure even according to Milton Friedman, whereas CPI targeting, for all its flaws, delivered 66 quarters of unbroken growth and a period so decent they named it the Great Moderation. The interwar gold standard brought us the stagnation of the 1920s (in the UK) and coming off us brought us our relatively pleasant experience of the Great Depression. Literally the order in which countries came off the gold standard is the order they got out of the Great Depression. And even though the classical gold standard worked pretty well, few of its benefits would obtain if we went back. Some central plans (the interwar gold standard, M2 targeting) don’t work, some work a bit (the classical gold standard, CPI) and arguably some work pretty well (NGDP targeting is one in this category, according to Friedman, Hayek and I). If we are stuck with central planning, then why not have a good central plan?

And just because I’m allowing the term “central planning” to describe NGDP targeting, we needn’t describe it as “government intervention in money”. I don’t think they are really the same thing. “Government intervention in money” brings to mind rapid inflation, wild swings in the macroeconomic environment; in short the exact circumstances that NGDP-targeting aims to avoid. Targeting aggregate demand keeps the overall macro environment stable—a truly neutral monetary policy—allowing firms and households to make long-term plans, and preventing recessions like the last one, caused as it almost certainly was by drastic monetary tightening. Indeed, as monetary policy determines the overall path of aggregate demand, we might easily call “sound money” policies aiming for zero inflation or a frozen base as dangerous government meddling—they allow the actually important measures like nominal income to fluctuate drastically.

Consider an analogy: school vouchers. Many libertarians may favour a system where parents can spend as little or as much as they want on schooling (considering distributional concerns separately), rather than having central planners decide on the voucher-set minimum. But we usually see a voucher system as an improvement on the status quo—parents may not be able to fully control how much is spent on their children’s education but at least they can pick their school. Popular and successful schools grow to accommodate demand, while unpopular and unsuccessful schools can be wound down more quickly. Libertarians may see this as a way from the ideal situation, but none would therefore denounce the policy. The analogy isn’t perfect, but I like to see NGDP targeting as similar to school vouchers, versus status quo schooling as the CPI target. Libertarians shouldn’t make the perfect the enemy of the good.