Monetary opportunities of independence can unlock the indyref debate

If there is anything you don’t understand about economics, write about it in the comments on The National’s website, and if I can, I will try to respond.

Over the next 18 months, opponents of independence will hurl all sorts of questions at us. The more people who can talk confidently across a wide range of economic topics, the easier it will be to defeat the new Project Fear.

This week, I am going to address just one comment from last week: “The Scottish currency question answered in just eight words: Scotland is capable of managing its monetary policy.”

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I was rather puzzled by this. It uses some of the words which I used in my column, but in a way which makes very little sense.

The mention of monetary policy in my article was in the context of the freedom of a currency issuer to engage in what used to be called demand management, back in those wonderful days immediately after the Second World War, when it seemed that with a few tweaks to tax rates and interest rates, governments could keep both inflation and unemployment low. Monetary policy is a short-term response to economic fluctuations. By itself, it will not build the economy, and it will not be part of the case for independence.

I have also written several times about the importance of Scotland acquiring fundamental capabilities. Of immediate relevance in this case is the capability to issue money.

That requires a central bank, which will manage the currency, setting interest rates for inter-bank finance, and make payments on the government’s behalf.

Setting up the central bank, and ensuring that it will be able to implement monetary policy, will be essential in the transition to independence. This is exactly the sort of arrangement about which we need to be certain when putting together the independence prospectus, and answering fearful nay-sayers.

I would generally add in the importance of very closely related capabilities of government, such as collecting taxes, and issuing public debt – without having to pay investors very high interest rates.

The reader’s comment confused monetary policy, which is just a set of tools, used in the everyday business of keeping the economy running smoothly with the capabilities needed for a government to be able to conduct its monetary policy.

In the process of becoming independent, Scotland will acquire many of these quite fundamental capabilities, on which it will draw in subsequent decades. Only when they are in place that the ordinary business of politics, messy and inconclusive as it is, will begin. Elections will decide who should form the government, and the government will then try to turn manifesto commitments into realistic policies.

Having dissected that rather obscure comment, consider this alternative answer to the reader’s “currency question”: Scotland, the country which invented economics and modern banking, is capable of commanding confidence in its currency.

Just over a century ago, JP Morgan, the American banker who founded perhaps the most successful financial institution of the 20th century, gave evidence about his lending practices to Congress. Facing questions about simply lending to his friends, or for his own benefit, Morgan was very clear. His lending was based on assessment of character. Without character, no business could expect to borrow a cent from his bank.

The governments of countries also have character, and financial markets are in many ways the arbiters of character. Inevitably, the UK Government takes on its character from the Prime Minister. I struggle to imagine JP Morgan lending to bombastic Boris. But what would Morgan make of the Scottish government on independence day?

It will have no history of borrowing. That means the country will have no record of defaulting on its debt, but it also means that it will have no record of regular payments. At independence, then, Scotland will not have a credit history. That will make banks very suspicious. In lending, they will insist on charging more interest.

Secondly, the country will still be building its tax system. No-one can be certain how much revenue that will generate for the government. Much as there are good reasons to laugh at the GERS purists, it is likely that Scotland will have a substantial fiscal deficit. That, in itself, will not be problematic for bankers – but they will be looking to see how the Scottish Government plans to address any questions of policy credibility.

Scotland will have its own currency. And a currency issuer can always finance its deficit, since the government can simply instruct the central bank to make payments. A government which abuses this capability, though, will be judged, and found wanting. Within the country, excessive monetary expansion can lead to inflation. The value of money, in terms of goods and services, will fall. In foreign exchange markets, relatively high inflation will tend to push a currency’s exchange rate down.

Usually, to try to bring some stability to the foreign exchange markets, governments hang together, like thieves, lest they are hanged separately. Scotland really does not want to be friendless – and that means that its government must have character, so that other governments will trust it.