This article was written by written by Sam Bowman, director of research at the Adam Smith Institute, who seems to have a less patronising view of Panama that the failed chancellor, Darling. It is reproduced here without permission and the pictures (except Sam's portrait) are my additions. Darling and his friends have tried to paint a picture of use of sterling without a formal agreement, as some sort of dodgy "South American" idea. In fact Panama has the 7th most stable banking system in the world. (Canada leads, with Sweden, Luxembourg and Australia following. The UK is not looking too great, according to Moody's... That was kept a bit quiet!)
When Scottish voters go to the polls in their independence
referendum next month, they may ultimately make their decision on the basis of
a single question: if we voted Yes, what currency would we use? The question
has massive implications for Scotland’s economy, and since the “Plan A” of a
formal currency union between Scotland and the rest of the UK was ruled out by
the chancellor, doubts about “Plan B” have dominated the campaign.
Alex Salmond has suggested that “Plan B” may be unilateral
use of sterling without a currency union, a system known as “sterlingisation”.
As I argue in a new paper for the Adam Smith Institute released today, with the
right reforms to Scottish financial regulation, Plan B should be Plan A.
The “adaptive sterlingisation” plan would work like this:
the Scottish government would announce no change in its use of sterling as the
currency it does business in. Scottish banks currently issue their own notes
that are backed on a one-to-one basis by sterling notes held at the Bank of
England (million pound “Giants” and hundred-million pound “Titans”).
Post-independence, they should be free to issue notes backed by their sterling
reserves without restriction.
These notes would be redeemable on demand for pounds
sterling. But as promissory notes, the banks would be free to issue more or
less of them according to their customers’ demand to hold cash. This would act
as a market-based mechanism to stabilise demand during downturns, preventing
the sort of economic catastrophe that the Eurozone is now enduring.
But to keep Scottish banks honest and prudent, the financial
regulations that currently protect established banks from failure would have to
be removed. Deposit insurance currently means that depositors have no incentive
to put their money into safer banks, because riskier banks can pay more
interest without any downside for the depositor.
This should be replaced by extended liability over
shareholders in the event that a bank fails. This would mean that even an
insolvent bank would still be able to honour most of its liabilities. Although
shareholders would be liable in the event of bank panics in the short run, in
the long run, the cost of this would be borne by the depositors themselves in
the form of bank charges (to compensate shareholders for the increased risk of
owning shares).
Central banks are usually seen as an essential part of a
financial system, acting as an unlimited lender of last resort to illiquid
banks. And a sterlingised Scotland would have no central bank, so solvent but
illiquid banks would have to create their own ways of accessing short-term
funds.
But this is not as big a problem as it may seem.
International capital markets are now highly efficient and could probably be
relied upon to lend to solvent banks in a tight spot. Or in a return to an
older way of doing things, private clearing houses could be established by
banks to provide the same function.
All that Scotland would lack was an institution that could
provide unlimited funds to a bank. But central banks can be a double-edged
sword, supporting insolvent banks and lending either too freely to
irresponsible banks or not enough during systemic panics (as happened during
the Great Depression).
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| Panama City: Makes london look a bit tatty. |
And looking at the “dollarised” economies of Latin America,
having no central bank may be a good thing. Panama, Ecuador and El Salvador all
use the US dollar without formal agreement with the US, and all have remarkably
healthy financial systems. Ecuador dollarised to end a financial crisis in the
early 2000s, and along with El Salvador has been praised by the Federal Reserve
of Atlanta for the success of its dollarisation policy. But Panama, which has
used the US dollar in this way for over a century, might be the best model.
Panama’s banks also lack the regulations that a sterlingised
Scotland should look to drop, and it has no central bank. Because of this, its
banks are extremely careful – according to the World Economic Forum, the
country has the seventh soundest banks in the world, and does extremely well on
all of the Forum’s measures of financial health.
During the eighteenth and nineteenth centuries, Scotland had
a monetary and financial system similar to the one I propose in this report.
The so-called “free banking” era gave birth to the Scottish Enlightenment. At
the start of the period, Scots were half as rich as their English neighbours;
by the end of it they had almost overtaken them. None other than Adam Smith wrote
in the Wealth of Nations that Scotland’s banking system deserved much of the
praise for this flourishing.
It may be difficult to persuade Salmond of the benefits of
market regulation over state regulation, but he has surprised in the past. If
Scots want a financial system that is more stable than the one they – or the
rest of the UK – have now, Adam Smith may have one more lesson for them.
