Currency substitution occurs when a country uses another currency without any official backing and without a Central Bank – instead of using its own currency.
For example, Panama uses the US Dollar as its currency. Even though it has no formal currency union with the UK. Jersey uses Sterling unofficially too.
The advantage is that a country like Panama gets to use a currency which has a stable value and international respect. The disadvantage is that it has little control over monetary policy and doesn’t have a Central Bank to act as lender of last resort to print money during periods of liquidity. Also, you lose the ability to devalue the exchange rate (which some may argue has advantages too)
Sterlingisation for Scotland
If Scotland vote for independence, Sterlingisation is seen as the best outcome for an independent Scotland. (Possibly as a precursor to a second stage where Scotland creates its own Central Bank and print its own ‘Scottish Pound’)
Sterlingisation would mean Scotland continues to use the Pound, but without a Central Bank as lender of last resort. It also means monetary policy would be set by the Bank of England.
Does it matter if Scotland doesn’t have a lender of last resort?
Given the problems of the Eurozone in recent years, there is an unfortunate precedent of countries being severely damaged by a lack of a Central Bank willing to act as a lender of last resort. However, there are two possible factors which could help Scotland.
- Firstly, some argue that having no Central Bank encourages banks to act more responsibly and avoid taking on excess risks. The Adam Smith Institute have produced a paper which is optimistic about the potential of ‘Adaptive Sterlingisation’ arguing that the period of free banking in Scotland in the eighteenth century was largely successful – with banks secured by shareholders. – How sterlingization and free banking could help Scotland flourish at Adam Smith – Institute.
- Would the Bank of England want to allow banks in the British Isles to fail? If Scotland gained independence, the Bank of England would have no compulsion to act as lender of last resort, but the UK banking systems is closely integrated; a collapse in confidence north of the border would have implications south of the border too. Would the Bank of England want to allow a failure of our near neighbour – when the financial and economic fortunes of the two countries are so closely tied together?
Problems of Sterlingisation / Dollarisation
In a crisis, a country has no ability to print money. This could lead to higher bond yields and pressure to pursue austerity. Markets have a long memory and the recent Euro crisis is still fresh in people’s minds. In 2010 countries like Italy, Portugal and Spain had relatively low levels of government borrowing (at least compared to UK) but with markets concerned at the absence of a Central Bank to secure liquidity – countries saw rising bond yields and a pressure to cut government spending. Scotland’s free banking system might have worked up to 1844 – but does the Nineteenth Century provide a reliable guide for the Twenty First Century – post credit crunch world?
No ability to devalue. With Sterlingisation / dollarisation a country has no ability to devalue. If the country becomes uncompetitive, it will be stuck with an overvalued exchange rate – leading to lower exports and current account deficit. This has been a major problem for Eurozone periphery countries who have needed to pursue internal devaluation to restore competitiveness.
Scotland’s economy is fairly closely integrated with rUK so this divergence in competitiveness may be less likely than between say, Greece and Germany. High labour mobility between Scotland and England could also help deal with trade imbalances. But, even high labour mobility comes with problems; e.g. a net migration from Scotland would upset tax plans.
Capital flight. Another concern over ‘Adaptive Sterlingisation’ is – would shareholders be willing to take on the greater risk of securing bank lending? Given the recent history of Scottish banks, shareholders may be less attracted to hold shares in Scottish banks when there is greater risk and no lender of last resort. It is also complicated by the fact that a bank like the Royal Bank of Scotland is 80% owned by the UK government and has suggested it will move south of the border post independence.
Advantage of Sterlingisation over independent currency
Some argue that Sterlingisation has the advantage of avoiding speculative attacks on the currency. A fixed exchange rate would also help create certainty over exchange rates and encourage trade. With Sterlingisation there is less need to build up foreign currency reserves to withstand speculative attacks.
To what extent does Panama provide a model for Scotland
Dollarisation may have been successful for small Latin American countries – but Scotland would be a bigger economy, with a more important banking system and an economy more dependent on oil prices and oil production. There are many differences between small Latin American economy and a Scottish economy, which is seeking integration into the EU.