With the impending referendum over Scotland’s place in the Union, the inevitable question of the currency of a newly independent Scotland has come to the fore.



Though much of the debate surrounding the currency of a potentially independent Scotland has been laden with politics and fiscal concerns over monetary arguments, the newly independent country could use the opportunity to embrace an independent monetary system. Not just free of the Bank of England, but free of state control of money.



It is highly unlikely that the Scottish people will vote for independence on 18 September, ending the Union that has been in place since 1707.



But with concrete plans for a post-Union Scotland rarer than a sober Glaswegian on a Friday evening, the concept of an independent Scotland throws up some interesting scenarios from a currency perspective.



The Euro, Sterling, or a Scottish Pound



The three mainstream options proposed have been to establish a new Scottish currency, to adopt the Euro or to retain the pound sterling.



The euro option is unlikely for a number of reasons. And it goes hand in hand with one of the reasons that the vote of Scottish independence is likely to fail. If the vote had been held 6+ years ago when the European Union was ostensibly in a much healthier state, with periphery countries accessing credit as cheaply as the core, then Scottish voters may have been more likely to unhitch themselves from England and hitch themselves to the European Union and the European single currency. As it is, the new European countries and some of the older ones are in trouble. They borrowed when it was cheap and are now feeling the pain now that credit risk has been more appropriately priced. And without the sweetener of a prosperous Europe, a newly-independent Scotland, swept along with nationalistic fervour is unlikely to then go and cede monetary control to Brussels.



The option of retaining use of the pound sterling is a more complicated issue. As the example of the European Union has demonstrated, monetary union without fiscal union is a problematic state of affairs. However, the main opposition may be political rather than from an intellectual position on monetary policy.



The Jimmy Reed Foundation, a left wing and Scottish nationalist think tank, published a report last year setting out its position on retention of sterling as tender. While the report is heavily politically biased, it is aligned with the thoughts of the Scottish National Party and gives an indicator as to the prevailing thought should Scotland achieve independence. The report supports the use of the pound sterling as a transitional measure but claims that the Bank of England as the central bank has "sacrificed productive economy growth for conditions that suit financial speculation". It argues that an independent Scottish currency would insulate Scotland from these problems.



However, the likely reality couldn’t be further from the truth. Scotland makes a net negative contribution to the UK. It accounts for 8.4 percent of the UK population, 8.3 percent of the UK's total output and 8.3 percent of the UK's non-oil tax revenues. However, it receives 9.2 percent of total UK public spending.



Scottish nationalists stake the claim that over 90 percent of the North Sea oil revenues should belong to an independent Scotland, something that the rest of the UK is likely to heavily dispute should independence happen.



But let’s for the sake of argument cede all UK North Sea oil revenues to Scotland. From a fiscal point of view it would add another GBP4.8bn to Scottish revenues. However from a monetary point of view it would have much more significant repercussions for a newly-minted Scottish currency. Rather than the claims made by the Jimmy Reed Foundation that an independent nationalised Scottish currency would be isolated from “financial speculation”, it would instead operate as a commodity currency driven by global oil demand. In addition, the newly-independent Bank of Scotland would likely follow the path of central banks in other fragile economies and pursue a path of inflation and artificial credit expansion to service debts accrued by the newly “liberated” country.



An independent currency for an independent Scotland



But instead of fighting over which should be the single, national currency of Scotland, the country should instead seize the opportunity to embrace private money, with competing currencies and an escape from the cyclical credit of fractional-reserve banking.



The mythical history of Scottish free banking



There is a prevalent idea that before the Peel Act in 1845, Scotland operated a free banking system, resulting in a more stable monetary environment than the fractional-reserve banking system south of the border. While the Bank of England allowed monetary debasement and the over-leveraged credit, from 1716-1845 the Scottish banking system operated on a full reserve basis, with each bank holding its own specie reserves. Arguably the Scottish “free banking” era began later, interrupted by a currency war in 1727, after which the Bank of England and Bank of Scotland came to a cooperative equilibrium with both banks accepting the other’s notes.

But while I would argue that free banking and privatisation of money is a good thing, pre-1845 Scotland did not have an honest system of free banking and those lauding that system as one of monetary soundness are wide of the mark.



A free banking system would see market forces of supply and demand controlling the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (historically gold) or fiat money artificially limited by a central bank. However, a classical implementation of free banking would see no central bank acting as a lender of last resort, nor government deposit insurance. The result would see credit based on the soundness of banking institutions rather than on the implicit underwriting of counterparty risk by a central bank as a quasi or de facto government agency. Note-issuing banks would exist along the same lines as any other business operating within company law, and without government support their existence in the market place would rely on their ability to raise sufficient capital and to establish public confidence in the soundness of their issuance.



But unfortunately, during the period Scotland did not see free banking in its strictest sense. Much like those who point to the instability of the post-classical gold standard period, destabilising cyclical boom and busts of the Scottish economy under the ostensibly free Scottish banking system we no less frequent than under the English system with the BoE acting as a lender of last resort.



However, the problem with this is that Scotland was not actually operating free of the cycle-generating influence of a central banking system, and was instead built on top of the English monetary system. Scottish banks joined the Bank of England in suspending specie payments on the outbreak of war with France, violating one of the tenets of free banking by ignoring the property rights of depositors and promissory note holders while continuing to profit from that property through payments from debtors. But before this, the Scottish banking system had already veered from independence after the Bank of England bailed out two Scottish banks in 1793 with the issuance of GBP400,000 in Treasury notes. This government underwriting of bank risk fundamentally eroded credit risk pricing and triggered a surge in Scottish bank paper issuance.



Embracing a truly free banking system



But rather than the bastardised free banking system in place in Scotland before Peel’s Bank Charter Act of 1844, which restricted the powers of British banks and monopolised note-issuing powers to the Bank of England, a newly independent Scotland should embrace a system based on denationalised money and currency competition.



While a Bank of Scotland would be free to issue notes, it would do so only under the same conditions of any private enterprise operating under Scottish law. But alongside this newly floated currency, sterling, US dollars or euros could be used as a gross substitute with the new Scottish currency. The result would be to increase the elasticity of demand for the new Scottish currency and reduce the government's monopoly over the money supply.



Their’s law, as stated by Arthur J. Rolnick and Warren E. Weber and named economist Peter Bernholz, in honor of French politician and historian Adolphe Thiers, says: "In the absence of effective legal tender laws, Gresham's Law works in reverse. If given the choice of what money to accept, people will transact with money they believe to be of highest long-term value. However, if not given the choice, and required to accept all money, good and bad, they will tend to keep the money of greater perceived value in their possession, and pass on the bad money to someone else. In short, in the absence of legal tender laws, the seller will not accept anything but money of certain value (good money), while the existence of legal tender laws will cause the buyer to offer only money with the lowest commodity value (bad money) as the creditor must accept such money at face value."



In the reverse of Gresham’s law, outside of the monopoly of legal tender laws, and institution that moved to debase its tender, and so favouring the debtor over the creditor, would see its tender overtaken by a more sound monetary alternative, keeping issuers honest through market mechanisms.



Indeed the slew of opposition to the use of sterling as currency by an independent Scotland would only make the case for sound money and currency competition stronger. Should Scotland denationalise money and use reserve currency in the same way as the dollarization of countries such as Panama and Ecuador, it would close the door on corruption of the private banking system by access to Bank of England or Federal Reserve credit lines, keeping note issuers honest.