One of my readers asked this week if I could write something on what is involved in setting up a central bank. I am sure it was related to the leaders’ debate on TV a few days ago when Alex Salmond was put under sustained pressure to explain what would happen if monetary union is not possible with the rest of the UK.
The reality is that whether an independent Scotland had a currency union with the UK or had its own currency, it would still need a central bank.
The responsibilities of a central bank are:
- To control monetary policy (set interest rates, manage currency, and the supply of money);
- Supervision of the financial sector (financial services and banks);
- Supervision of the financial markets;
- Ensure the payment and settlements system is fully functional;
- Oversight of the country’s cash savings, debt and investments;
- Act as lender of last resort.
Given that the UK government has stated it would not enter into a currency union with an independent Scotland, there have naturally been no discussions over what responsibilities the Bank of England would bear (in the event of a currency union) with respect to Scotland.
If there was monetary union, I do not think it is politically likely that the Bank of England would take over all six central bank responsibilities for an independent Scotland. The most likely would be (1) monetary policy and (6) lender of last resort.
This means that a Scottish central bank would still need to be created to carry out the other responsibilities listed above.
In answer to the original query, given the degree of existing regulation in the EU and the UK, I do not think it would be that difficult to set up an institution (Central Bank of Scotland) to undertake oversight activities.
However, the big (but not insurmountable) challenge is if a Central Bank of Scotland had to deal with monetary policy and become a lender of last resort. This would happen if the UK government continues its refusal to enter into a monetary union.
I now discuss each in turn.
- Monetary policy.
The Scottish Government’s plan A is for full monetary union and they have completely avoided discussion of any other option. If Scotland had to take control of its own currency, it would need to manage its interest rates and decide on money supply to ensure that prices (inflation) remained stable.
Without a doubt, this would be a challenge but given that the objective of the Scottish government is to enter the EU, many monetary policy decisions are constrained by the union.
Verdict: Challenging, but there would be a lot of support from the Bank of England and the EU.
- Lender of Last Resort
This is the elephant in the room when discussing Scottish independence and monetary union. As soon as the SNP says it would consider other currency options, the next question would automatically be, ‘How could Scotland afford to be a lender of last resort?’
It is this that is the really difficult question to answer as the only options I can see are:
- Divert oil revenues to create reserves
- Raise taxes
- Change regulation so that Scottish banks cannot grow to such an extent that they are too big to fail.
Verdict: No option is particularly palatable and it would be the biggest challenge facing a new Scottish government. Each solution is achievable but there would be drawbacks for each option that would be politically upopular.
In the event of independence, I fully expect Scotland to create a central bank whether it is able to enter into a monetary union or not.
How much power it has will be dependent upon whether monetary union is agreed and the outcome of negotiations in other areas, notably the share of oil and UK debt.
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