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.

Interest rates are set in the market place

The London housing market is booming. According to Nationwide, prices rose 14.9% over 2013. According to Halifax, they climbed 9.4%. According to the Land Registry they were up 11.2%. The Office for National Statistics hasn’t quite got data for the whole year yet, but their numbers show prices up 11.6% in London in the 12 months to November 2013. No doubt Rightmove, LSL, Hometrack and all of the many other indices echo this finding. While we at the ASI have pointed out how the government has jacked up demand with the Help to Buy scheme (some have quipped it might more accurately be termed “Help to Sell”) the Bank of England and Treasury have dialled down the housing element of the Funding for Lending Scheme in response to worries about a bubble and unaffordability.

But however much these schemes are artificially adding to demand, it is certainly clear that London houses—a desirable place for natives and people across the world to live—face a huge demand and are in limited supply. Since this is clear, I have been loath to call the situation a “bubble”—a bubble seems bound to pop, but tight supply and ample demand suggests a situation where prices will remain high (see an excellent post from my colleague Sam for more detail). However, it was recently pointed out to me that since a high fraction of UK mortgages track the Bank of England’s base rate, a jump in rates, something we’d expect as soon as UK economic growth is back on track, could make mortgages much less affordable, clamping down on the demand for housing.

This didn’t chime with my instincts—it would be extremely costly for lenders to vary mortgage rates with Bank Rate so exactly while giving few benefits to consumers—so I set out to check the Bank of England’s data to see if it was in fact the case. What I found was illuminating: despite the prevalence of tracker mortgages the spread between the average rate on both new and existing mortgage loans and Bank Rate varies drastically. For example, it was almost one percentage point in January 2004, fell to 0.5pp by July, rose to around 0.6pp where it stayed until July 2006 when it crashed to nearly zero in a year, before rising to 1pp in October 2008 and then almost 3.5pp in April 2009. Since then it has steadily trended down to around 2.5pp. There are lots of interesting and obvious stories to tell here, hearkening back to my piece about the confusion between interest rates as a stance of monetary policy and interest rates as the actual cost of borrowing firms and consumers face, but what is clear is that tracker mortgages be damned, interest rates are set in the marketplace.

What this means is that the fact the Bank’s base rate will almost certainly be hiked in the next couple of years if economic growth continues at its current healthy pace is not a reason to worry that London’s housing bubble will pop. Indeed, the only way London house prices are likely to drop from their current stratospheric levels is if we get a good honest bit of planning deregulation. Moving the green belt out just one mile would allow us to build one million houses, after all. And it could add percentage points of pure supply-side driven growth to GDP and living standards.

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.

Low rates doesn’t mean low rates

I got called up last Wednesday to ask if anyone at the Adam Smith Institute would go on the Daily Politics to explain why the Bank of England should raise its base rate (not exactly in those words). The producer was familiar with common free market ideas that argue that artificially low interest rates are blowing up a housing bubble which will later burst. I had to try to explain to the producer why I both agree and disagree with these sentiments: low interest rates do underlie economic limbo, but raising the base rate is not a solution and may produce yet lower real interest rates where it matters—throughout the economy.

The problem comes from the dual use, in the popular economic press, and even by top economists, of the term “interest rates” to mean both the stance of monetary policy and the cost of borrowing. This is understandable because during the Great Moderation of 1992-2008 all the world’s most important macroeconomic authorities attempted to control the overall economy through adjusting one or a small number of key interest rates to achieve a consumer price inflation (CPI) target. At the same time, we are familiar with interest rates through our normal life: on loans, mortgages, savings, credit cards and so on. But acting as though the Bank of England directly controls these rates when it adjusts policy seriously obfuscates how the macroeconomy works and contributes to a lot of sloppy thinking.

Whereas the Federal Reserve has always used a form of quantitative easing (QE) to adjust a market interest rate—the Federal Funds Rate—the Bank of England has typically adjusted its base rate, which it calls Bank Rate, instead (updated). Bank Rate is the flat (nominal) interest rate it charges commercial banks for short term funding, and pays on their excess reserves. This sets a lower bound on overnight commercial lending, since it is always an option to lend or borrow money at Bank Rate, and therefore it is included in some market contracts, like tracker variable rate mortgages. The current UK base rate is 0.5%, a nominal number which translates to a negative real rate, but secured loans charge more like 3% in nominal terms, unsecured loans 8%, and credit cards 10%.

So we’ve established that the Bank of England sets a lower bound on interest rates with its Bank Rate. And we’ve also established that Bank Rate affects some other rates directly, principally tracker mortgages. We might also expect it to affect other rates in the economy—for example a cut will “ripple out” through the economy, because all other things being equal, it is now cheaper for banks to borrow from the BoE and they will thus be more willing to do so. Economists call this the liquidity effect. They will thus be more willing to lend cheaply and less willing to borrow from savers. So one effect of lowering the Bank Rate is to directly lower some rates, put a lower lower bound on others, and make others cheaper.

However there is an opposed reaction. Lowering Bank Rate doesn’t just make loans cheaper, but it increases demand. It does so by injecting extra money into the economy (from the extra loans), but more importantly by signalling to markets that it intends demand to grow faster and that it is willing to take measures (such as further lowering Bank Rate or boosting the money supply through a QE programme) to make sure this happens. This is why stock markets react so strongly to a (policy) interest rate cut—all businesses are worth a bit more because they expect higher total revenues over their future.

But if firms expect higher demand in the future they will in turn demand more investment funds to put into projects to service that demand. This means that cutting the BoE’s base rate puts pressure on effective market interest rates in both directions. It is an empirical question which direction the overall effect goes in—but this means that the simple coincidence of low real effective interest rates out in the economy and a low, by historical terms, Bank Rate, shows nothing. It could be that the best way to raise interest rates out there in the economy is to cut the Bank’s base rate, or, since it can’t go much further now, print money to raise inflation (which would ceteris paribus cut the rate in real terms). Look at the graph above for an illustration of how the Fed’s changes in their QE programme (the red line) and their Federal Funds rate (the dark blue line) don’t produce big shifts in (real) market interest rates like corporate bond returns and 30-year mortgages.

So my view on low interest rates is complicated. I think the Bank should get out of the business of setting rates altogether, and vary the size of the monetary base to control nominal income in the economy. But if the Bank is going to use rates as its key policy tool, it shouldn’t raise them when a recovery hasn’t quite taken hold—it’s uncertain whether it’ll raise market interest rates, but it will certainly choke off the demand we need for solid growth.