THE gloves are finally off. The London political establishment's message to Scotland is clear: stay in the UK, or lose the pound. The nationalists are in deep trouble on this question, but as ever the argument is more complex than both sides might imagine.
Is the Scottish National Party (SNP) right that it could keep sterling, even against the UK's wishes? Yes, barring implausibly draconian UK legislation which imposed sanctions on any British firm or individual that used sterling when dealing with Scots. It would have to be the kind of rule that made US anti-terrorist and anti-money laundering sanctions look soft. But is the London establishment right to say that Scotland could be excluded from a banking union and from support from the Bank of England? Absolutely.
If Scotland left the UK but kept the pound, and was cut off in every other way, it would end up like Ecuador, El Salvador and Panama. These economies are dollarised (Scotland would be sterlingised); they use the greenback but don't benefit from a banking union or any other kind of assistance from Washington or the Fed. In the event of a banking or sovereign crisis, they wouldn't be bailed out by anybody; and they wouldn't be able to print any money themselves as they don't control the currency.
As a report on dollarisation and banking systems by the Federal Reserve Bank of Atlanta points out, not having a lender of last resort means banks are forced to hold far more reserves. Moral hazard is abolished; creditors and banks behave with extreme caution, hence why despite no formal safety net, Panama's banks are ranked seventh in the world out of 148 for stability by the 2013-14 World Economic Forum Global Competitiveness Report. The IMF explains that "Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages ... The authorities emphasised that these features had contributed to the strength and resilience of the system."
Crucially for the SNP, however, this is not really good enough. The IMF, El Salvador and Panama agree that there is a need for permanent liquidity facilities to compensate for the absence of a central bank. In El Salvador, the IMF reports that the liquidity fund under consideration would be funded by pooling a fraction of banks' current reserve requirements and would be able to provide cash to solvent banks facing liquidity pressures for up to 90 days, charging a penal rate of interest. These sorts of schemes are fascinating: they are reminiscent of historic, free banking systems where private banks developed devices to cope with the risk of liquidity crises, successfully clubbing together in private clearinghouses; Canada didn't have a central bank until 1935 and yet its banks escaped unscathed from the Great Depression.
If the SNP is serious about retaining the pound, it needs to explain what alternative arrangement it has in mind to deal with the possibility of a liquidity crisis. Any fund would need to be large enough to deal with big institutions; a robust resolution plan to tackle a solvency crisis at a bank or insurer would also be vital. Yet the SNP has no credible solution. The nationalists still believe in a traditional lender of last resort; it's just that they want somebody else to pay for it, and are threatening to default on their share of UK gilts if they are removed from under the Bank of England's umbrella. Given that Scotland's biggest challenge would be to prove the robustness of its financial system, this would be suicidal.
The problem for Scotland is that even if it came up with a credible, alternative way of providing liquidity, big financial firms may well feel that it is easier for them to relocate to London and to benefit from tried and tested rules and protection. My own guess is that an independent Scotland would join the euro, a sub-optimal solution for all concerned, and much more quickly than anybody seems to think.
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