La feria de Abril de Barcelona,

exchange rate management. Adopting the currency of a credible anchor country can help an inflation-prone country eliminate the inflation-bias problem of discretionary monetary policy3_{. This bias may stem from two sources: attempts to over-stimulate the economy} and incentives to monetise budget deficits and debts. For many developing countries, dollarisation provides a much better commitment device than alternative forms of fixed exchange rates.

4.3 Operational cost is also a factor. Under sterlingisation a Scottish monetary authority with a limited role to manage the money supply, rather than a full central bank, would probably suffice. The required institutional apparatus needed to manage an independent currency can be more complex and expensive to establish and maintain. However, it is unlikely that either of these two motivations would apply to a newly independent Scottish state.

4.4 The closest alternative to full sterlingisation would be a currency board that tied the currency to sterling. Under this option an independent Scotland would have its own currency, but the Scottish currency would be fully convertible at a fixed parity with sterling and fully backed by sterling reserves. A currency board scenario is described in more detail in Chapter 6 but a comparison of sterlingisation with a currency board illustrates some key features of the sterlingisation option, and will be discussed through this chapter.

Transaction costs

4.5 With sterlingisation Scottish households and businesses would simply continue to use sterling as before, and there would be no, or very limited, transition costs for day-to-day economic activity.4 _{In contrast, the currency board option would require Scotland to} introduce its own currency to replace sterling. This would clearly have higher transitional and transaction costs. In fact, the absence of a separate Scottish currency would represent a useful commitment device to the sterlingisation strategy, given the practical difficulties of replacing the currency. This should strengthen confidence in the long-term commitment to use sterling. Transaction costs would be kept low, even for long-term decisions, including cross-border investment.

4.6 Commitments to currency boards are inherently less binding and this is reflected in their history. While Hong Kong has successfully maintained a currency board with the US dollar since 1983, the Argentine Currency board was abandoned in 2002 and the peso devalued against the dollar (Box 6C provides more detail). The degree of political commitment is clearly important, but the greater logistical ease with which this approach can be abandoned may have implications for transaction costs, especially on long-term operations or in times of financial pressure.

Monetary policy

4.7 Experiences from countries that have unilaterally adopted a foreign currency suggest that an independent Scottish state could either have no central bank (Panama) or have a central bank with limited powers and responsibilities (Montenegro), and this would not be a currency issuing bank. Either choice could potentially conflict with the institutional requirements for EU membership.

2 _{Berg, Borensztein (2000) “The Pros and Cons of Full Dollarization”.}

3 _{Barro and Gordon (1963) “Rules, Discretion and Reputation in a Model of Monetary Policy”.} 4 _{This would raise a question about the use of Scottish banknotes – see Box 2D for more detail.}

4.8 Countries using a foreign currency unilaterally have very limited control over their monetary policy. There is no central bank with the ability to create reserves in the banking system and influence the wider supply of money in the economy i.e. to “print money”. The money supply is market driven. The currency used for day-to-day transactions must be obtained by exporting goods or services or borrowing capital from abroad. Hence a surplus in the balance of payments would lead to an expansion of the money supply (which would tend to be inflationary for the Scottish economy) and a deficit to a contraction of the money supply (which would tend to be deflationary).

4.9 A degree of counter-cyclical monetary policy may be possible. There may be some scope for a Scottish monetary authority to manage changes in the money supply by building reserves in times of balance of payments surpluses, limiting the monetary expansion, and then running down reserves to limit the contractionary effect of balance of payments deficits. However these powers are likely to be extremely limited. By contrast, a currency board may have more scope to control its issuance of domestic currency in response to inflows of foreign reserves.

4.10 Monetary policy and exchange rate adjustments would therefore be almost entirely subject to policies conducted in the continuing UK. The continuing UK would be responsible for deciding if it wished to accommodate the needs of the Scottish economy. The US position on dollarization (known as The Three “Nos”)5 _{has been to not modify its institutions or its} policy stance to accommodate the needs of dollarized economies:

• the US does not extend financial supervision to banks registered in dollarized countries;

• the US does not provide access to the Federal Discount Window to banks registered in dollarized countries; and

• the US does not modify the procedures or orientation of its monetary policy to take account of conditions of dollarized economies.

4.11 Alongside the ability to influence its domestic monetary conditions, Scotland would also lose access to the seigniorage benefits of currency issuance. The Bank of England’s note issue is wholly backed by a variety of high-quality securities and assets, including those acquired through the Bank’s open market operations, and UK Government bonds. The income from these assets, less the costs of the production, issue, and custody of banknotes, is paid to the Government as seigniorage. This was worth £851m in 2011/12.6 4.12 In addition to limited control over the total amount of liquidity available in the country,

countries using a foreign currency unilaterally may have difficulties managing the

composition of the available liquidity. It can be a particular problem to provide sufficient quantities of coins and smaller bank notes for everyday transactions. A local Scottish currency, fully backed by sterling, might be issued to facilitate domestic transactions (as is the case in Panama with the Panamanian Balboa).

5 _{Larry Summers, then US Secretary of States, said in 1999 that it would not be appropriate for the US}

authorities to “extend the net of bank supervision, to provide access to the Federal Reserve discount window, or adjust bank supervisory responsibility or the procedures or orientation of U.S. monetary policy in light of another country deciding to adopt the dollar” (cited in Kenen (2000)).

4.13 Finally, an independent Scotland would be unable to rely on exchange rate adjustment mechanisms in response to a very large shock to its economy. The inability to use monetary policy effectively to manage demand in the Scottish economy would therefore place greater emphasis on other sources of economic adjustment, in particular fiscal policy, but also highly flexible labour and product markets.