Does sterlingisation make sense for Scotland? Or would a separate currency be better?

Angus Armstrong writes:

Sterlingisation appears to offer continuity but in fact much would change. This is the riskiest of all currency arrangements being considered. With a debt burden of more than 80 per cent and projected fiscal deficits, Scotland would have little capacity for independent macroeconomic policy. It would have no capacity to provide emergency liquidity to its financial sector and little scope for a credible deposit insurance scheme (for instance, Panama does not offer deposit insurance).

Financial services are Scotland’s largest export sector. Scotland’s non-oil trade deficit has been around 7 per cent of GDP over the past three years. Therefore, the loss of financial services exports would leave the balance of payments very exposed to declining oil and gas revenues. The fall in general prices and wages to restore competitiveness could be substantial. As we have seen, governments with high debt levels, no control over their currency and external deficits can also need emergency support.

That is from an FT symposium on Scottish currency choices, which is interesting throughout, at least for those of us obsessed with the theory of optimum currency areas.

Euro adoption does not generate much sympathy as an option.  Opinions are mixed on an independent, floating currency.  In the steady state it could work fine, as is the case for Sweden.  I worry about the transition, however, and finding a proper conversion rate for current Scot bank deposits denominated in sterling.

If the expectation is that those deposits will be undervalued in the process of conversion, bank runs may ensue.  Another option is continuing uncertainty about future monetary policy for New Scot Lanarks, combined with prices which are slow to adjust to the new medium of account.  In fact pricing in terms of English pounds might remain the dominant practice for years.  In that case exactly what kind of monetary policy promise is the new Scot central bank making in the first place?  Everything is priced in terms of pounds, and the New Scot Lanark floats against the pound in a meaningless fashion.  Who should want to hold the New Scot Lanark in the first place?  Won’t any combination of announced conversion rates/monetary policy reaction functions involve some risk of a weak Scot currency and thus again ex ante bank runs?

Even Ronald MacDonald, who favors the independent currency option, wrote this in the symposium:

The currency is likely to be very volatile in any transition period and this would have implications for trade. However, the macroeconomic benefits of a separate currency clearly vastly outweigh the microeconomic costs, although the transition period is likely to be very painful.

I guess we’ll know soon enough how they vote.


Everything is priced in terms of pounds, and the New Scot Lanark floats against the pound in a meaningless fashion. Who should want to hold the New Scot Lanark in the first place?

Isn't TC the one who tells us that dollars are better than bitcoins because the government expects taxes in dollars? I expect he's right about that, but it can't be a universal truth, otherwise it would be easy for an independent Scotland to start its own currency.

Or maybe it will be easy. Surely many countries have done this before, and they can't all have been disasters.

A currency backed by a country is better than a currency backed by nothing. But that backing isn't sufficient to ensure the stability of the currency. There are lots of cases of national currencies crashing.

Who is doing the backing matters. The Bitcoin argument referred to backing by the U.S. government, not any ol' government. I'm sure Tyler wouldn't have made the same argument with reference to the Zimbabwean dollar.

It's this concept of "backing" that I am trying to understand. When dollars were backed by gold, that was easy to understand. But if we believe (and I do believe) that a national currency is made valuable because taxes are demanded in it, then the concept becomes murkier.

I don't quite understand it. I don't quite understand the link between how strongly backed a currency is and how fiscally prudent the government is. Yet there is such a link, and I would like it explained.

I think the "backing" actually comes from the assets of the central bank. The central bank preserves the currency's value --- limits inflation --- by selling assets to reduce the money supply (opposite of QE). That requires the central bank to have assets to sell. Under the gold standard, the asset bought and sold is gold, and the nominal target is the nominal price of gold instead of the nominal price of a basket of goods.

Has there been a successful fiat currency without a central bank sufficiently capitalized to sell assets to tighten money?

Those assets that central banks hold are almost all government bonds. Ie one part of the government owing money to another part. The Scottish state could create a trillion worth of bonds and give them to the Scottish central bank. *Poof* the currencies now "backed". All of this is meaningless though without the power of the Scottish state to tax its citizens. So even with a central bank balance sheet a currency's still backed by the power to tax

Good point. I understand that when the central bank buys a bond from a member bank, the CB credits the member bank's account with reserves --- that's how (base) money is created. Does the state also have an account at the central bank that can be credited with reserves in exchange for a bond issued by the state, i.e., does any money actually get created in the way that you describe?

On the connection between taxes and fiat currency, suppose a sovereign wealth fund became so large that the government could permanently fund all of its operations using investment proceeds. If all taxes were abolished forever, would the currency collapse, i.e., is too much prosperity combined with fiscal frugality a threat to currency stability?

>When dollars were backed by gold, that was easy to understand. But if we believe (and I do believe) that a national currency is made valuable because taxes are demanded in it, then the concept becomes murkier.

The way I understand it, which admittedly is murky at best, in both situations holding dollars as an asset is equivalent to a bet that the US Sovereign will remain functional and stable. Should the US gov't fail, whether or not dollars are convertible is a moot point, since no one will be around to hold up the gold-exchange end of the bargain.

It's tautological that the value of an asset is directly related to its liquidity/future demand. As such, what you care about is whether people in the future will still accept your dollars. In this light, it is sufficient that there be a future demand for dollars and how that demand is "bootstrapped" is kind of irrelevant.

Thus, the world we live in now holds that dollars will always be in demand because the US government only accepts dollars for tax payments. At the end of the day, for as long as the US government is around, there will always be an "intrinsic" demand for dollars. Gold is valuable/liquid because someone will buy for its aesthetic value or industrial use; US dollars are valuable/liquid because someone needs them to pay taxes.

Therefore, if you're running a failing state the risk that no one in some future time frame will be interested in your Zimbabwe dollars is rather high.

As a comparison to bitcoin, they neither have an industrial/aesthetic use nor are they "intrinsically" in demand. So, the risk that a sufficiently large group of people simultaneously decides that they are worthless is a lot higher than that of the US government failing or no longer collecting taxes.

Backing by gold vs backing by state authority:

If you really understand backing a currency by gold, you have to understand the bit about why gold is valuable in the first place. Simplistically speaking, gold jewelry makes women look pretty, which they like, and gifts of gold jewelry make pretty women more likely to have sex with men, which the men like, so there is a finite demand for gold wholly independent of any government's fiscal policies. A very strong and nearly irreducable demand. Yet, the supply is very limited. Apply basic microeconomics here.

If a certain quantity of New Scot Lanarks is absolutely required to avoid being sent to jail for tax evasion in Scotland, that creates a demand that is almost as strong and irreducable as the bit with pretty women and sex. If the Scottish government is reasonably good at ensuring the supply of NSL is limited, the same microeconomics applies except that the NSL can be made more convenient to use in most transactions than actual gold bullion coins.

'Euro adoption does not generate much sympathy as an option.'

Well, if Scotland decides to join the EU, joining the euro will be one of the basic conditions the EU will require for admittance.

And it is interesting to read so much of this theory, when the example of the Irish and British pound, and their tight coupling, is so readily available.

'From continuing to use sterling after independence (1922), the new Irish Free State brought in its own currency from 1928.[4] The new Saorstát (Free State) pound was defined by the 1927 Act to have exactly the same weight and fineness of gold as was the sovereign at the time, having the effect of making the new currency pegged at 1:1 with sterling. De facto rather than de jure, parity with sterling was maintained for another fifty years.


Breaking the link with sterling

In the 1970s, the European Monetary System was introduced. Ireland decided to join it in 1978, while the United Kingdom stayed out.[5]

The European Exchange Rate Mechanism finally broke the one-for-one link that existed between the Irish pound and the pound sterling; by 30 March 1979 an exchange rate was introduced.[6]

This period also saw the creation of the Currency Centre at Sandyford in 1978 so that banknotes and coinage could be manufactured within the state. Prior to this, banknotes were printed by specialist commercial printers in England, and coins by the British Royal Mint.

1979–1999: independence

Until 1986, all decimal Irish coins were the same shape and size as their UK counterparts. After this, however, all new denominations or redesigned coins were of different sizes to the UK coinage. The new 20p coin introduced that year and the £1 coin (introduced in 1990) were completely different in size, shape and composition to the previously introduced UK versions. When the UK 5p and 10p coins were reduced in size, the Irish followed suit, but the new Irish 10p was smaller than the new UK version introduced in 1992 and the new Irish 5p was slightly larger than the UK version introduced in 1990. The Irish 50p was never reduced in size (as it had been in the UK in 1997).'

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Looks like some spam over running the comment section.

The currency issue is overblown. Many countries are dollarized and have no problems with the arrangement over long periods. Yes, there is a risk of divergence and that risk will eventually, over a very long period, catch up with them. But in the case of a sterlingized Scottland that risk is comparatively small because the economies are relatively aligned, goods and people move relatively freely, and Scottland will have 1st world monetary and fiscal standards. That gives them a long time to establish credibility before eventually allowing the lanark and pound to diverge, preferably at some distant time when the lanark's value is increasing.

Is the problem the already high debt levels in Scotland's case creating a short term hurdle to get to what you are refering to? For us, does that mean we should get lots if small countries hooked on dollar debt?

An independent Scotland should go back to using the Unicorn as their currency like they did under James III.

An opportunity for some impressive banknotes.

If the problem is that Scotland couldn't credibly insure pound-denominated deposits, surely the answer is that the new Scotland should decline to insure pound-denominated deposits. This would make sense regardless of whether Scotland used the pound, the Euro, or some new Lanark, and indeed could motivate people to migrate to the Lanark.

I don't understand why they couldn't do this. Can't they just insure those deposits at whatever the floating exchange rate is? Yes, there is more uncertainty, but I don't see why they couldn't. Similarly, wouldn't guaranteeing current deposits can remain pound-denominated for future withdrawals prevent the bank runs mentioned above?

Ecuador uses the US dollar as its official currency. Scotland could probably get along just fine with no official currency at all, let the people decide what they wish to use as a medium of exchange. Wouldn't that be the "democratic" option? Lack of deposit insurance would be a feature, not a bug, eliminating the moral hazard issue in banking.

Ive always wondered why small countries have their own currency anyway. Look at Iceland, for instance, What would be the harm in, as you say, simply accepting whatever form of currency the people choose to use? You could 'peg' your taxes to some foreign currency if you like so that everyone knows that at the end of the year, you must pay X amount as measured by say dollars or pounds or whatever, but you can pay that in whatever currency you like, assuming that currency has a minimum credibility/convertibility.

I used to think that any central bank (CB), including a New Scot CB, could target whatever nominal variable it wanted, including the nominal price of pounds, because the CB controlled the supply of money. While I still believe the CB can expand the money supply to raise nominal prices, it seems like tightening money supply, e.g., to preserve the value of the currency, is less straightforward. To tighten, the CB needs to sell assets, for example GBP-denominated assets, which would seem to require that the CB has assets to sell. Thus, it would seem that the key to a successful new currency would be for the CB to be sufficiently capitalized so that it could both credibly tighten *and* loosen money, as necessary. (Not sure how that's done, contributions from member banks? How was the Fed capitalized?)

Assuming that the CB can be established with sufficient assets, then I would think that the initial policy would be to target a fixed exchange rate with the GBP, e.g., to prevent bank runs, establish confidence in the new currency, etc. The CB would promise to do "whatever it takes" to maintain the currency peg, as long as expected (Lanark) NGDP or inflation is not below target. The Scots should also establish a NGDP futures market or, perhaps less radically, a Scottish TIPS market so that they will actually know what expected NGDP or inflation is. Since initially the Lanark would presumably be weak, it would be unlikely that expected inflation would be below target. (The perceived risk would be the currency crashing and inflation skyrocketing.)

Eventually, however, the tight-money policies required to maintain the fixed exchange rate would be "too tight", leading to Scottish AD falling relative to British AD. We would know that point was reached when expected NGDP or inflation fell significantly below target (hence, the need for the NGDP or inflation market). At that point, the Scottish CB could permanently change from exchange-rate targeting to NGDP or inflation targeting, i.e., the *market* would let the Scots know when to change from Sterlingisation to an independent, free-floating currency. Again though, the key would be that the CB needs to have enough assets initially to credibly tighten policy when necessary (to maintain the currency's value).

Aside: I used to think that fiat money "wasn't backed by anything". It seems, though, that it is actually "backed" by the assets of the CB. The CB promises to allow "conversion" of currency into those assets, i.e., to sell those assets in exchange for currency, whenever NGDP or inflation rises above a certain target. That would seem to be a straightforward generalization of promising to sell gold in exchange for currency whenever the nominal price of gold rises above target. Then, is the defining characteristic of fiat currency that the nominal target is something different from the nominal prices of the assets that are bought and sold to achieve that target? Perhaps, we should call interest-rate targeting the "bond standard" since bonds are bought and sold to achieve a nominal bond price (interest rate) target.

I'm going to be honest. I have no idea which option would lead to the best results for Scotland. But I want Scotland to secede just so I can watch the fallout. It would be Kim Kardashian for political economics.

Do it for the data points, Scotland.

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Am I the only one who read it first as "Does sterilisation make sense for Scotland ..."?

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There will be no problem if they easily adopt the currency but if doesn't they should separate currency to avoid problems in the future. It's a matter on how the people in Scotland will embrace the new currency.

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