These words are written on every UK banknote, but what happens if you put them to the test? What does it actually mean? And how can we choose which currency an independent Scotland should use without understanding what makes a currency valuable.

So present a £20 banknote and ask to be paid. What do you expect to get? Two £10 notes with the same promise leaves you no further on. Once you would have received a weight of twenty pounds of silver coins. The Pound Sterling gets it name from its coins of Sterling Silver alloy, the addition of three parts in forty of copper made a much more durable metal than the near pure silver coins it replaced. Coins and weights of silver were practically interchangeable. A half penny was originally a silver penny coin that had been cut in half – try doing that on an exact fare only bus.

A pound of silver became a 22 carat gold sovereign coin in 1816, until Britain left the Gold Standard in 1931. The US also being on a gold standard meant £1 = $4.85. The 1940 Bretton Woods agreement pegged Sterling to the US Dollar at a lower rate, which was then progressively devalued to $2.40 by 1971, when the USA also came off the Gold Standard.

Today a pound coin is 9.8g of nickel and bronze, but it is merely a token, like Monopoly money, rather than valuable for its metal content. The only precious metal coins in common circulation are pre 1992 copper coins, industrial demand having for copper having exceeded the coin’s face value. But more recent copper coins are merely copper plated steel discs, far cheaper to manufacture. Notably the act of making money turns a significant profit for the government, taking cheap metal and paper and producing valuable coins and notes. Money held electronically can be created with a tap of a keyboard, at a marginal cost of zero.

So what gives currency its value, if it is no longer tied to an intrinsically precious metal? Most people understand that money having value is a collective act of delusion. You cannot eat it if you are hungry, nor will it keep you warm if you are cold. Our money is far closer to the seashells or carved rocks of the primitive South Pacific islanders than the gold and silver coins of their colonial discoverers. But money actually retains a more fundamental value. Just like Monopoly money is needed to pay the demands of the game’s banker, we ultimately collect money because we need it to pay our taxes, or we go to jail. The government will not accept tax payments in kind, the sacks of grain or head of cattle of bygone times. Instead it demands pounds, shillings and pence. If it demanded Euro, or USD, we would want to be paid in these currencies instead of Sterling, and we would want to buy or sell things using these currencies instead of Sterling. Sterling itself would become worthless overnight. Try buying anything using Francs, Pesetas or Deutschmark that you have found in a drawer from an old holiday.

Here are the underpinnings of Modern Monetary Theory. Governments make the currency. They distribute it by spending it on paying staff and buying goods and services. People accept it because the government will demand it back as taxes, indeed they need it or they risk jail for non-payment. If the government spends more than it taxes, the amount of money in circulation in the economy increases, and the value of that money drops – inflation. If the government spends less, it is extracting money from the economy, and the value of the remaining money will rise – deflation. So to control inflation, the government manages the deficit.

Note that rather than spending the money it receives as taxes, it is possible for the government to make all the money it spends, and physically destroy all the money it receives as tax! All that matters is the difference between money in and out.

Normally the government is portrayed as a household, only able to spend the money it receives. Budgeting is drummed into us from the moment we are first handed a coin to buy a sweetie as a child – if we want something we need to save for it, and is concisely formulated as Mr Micawber’s famous dictum:

Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six [£19.975 for younger readers], result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, [£20.025] result misery.

Children understand the concept of borrowing too: “Can I get [toy] now, and I won’t ask for a birthday present?” But this does not apply to households that have a printing press in the basement. Obviously if you get caught printing your own money, you go to jail. The government does not.

In the media narrative, the government debt is usually referred to as a credit card, not a mortgage. Mortgages are sensible borrowing to invest in a house that can only go up in value (except when it goes down), credit cards are expensive short term borrowing for shoppers lacking the patience to save for a new outfit or television. But a government bond is a promise to pay the bearer the specified amount. The difference between a bond and a banknote is that a banknote was redeemable on demand, the bond is not redeemable until a specific date. To make up for this, a bond also pays an additional amount of interest. A government that was short of gold to make payments would sell bonds for gold, and would be safe that the bond holders couldn’t demand their gold back too soon. But today the government does not need gold to make its payments. The bond provides a safe investment, and the issuing of bonds sets a floor on all other debt. Everyone else that borrows money does so at a premium above the government rate to reflect the risk of that debt not being repaid. So the government can influence the cost of everyone else’s debt by changing the rate it pays on its own.

We still generally follow the gold standard requirement that the government issues bonds to cover the difference between taxation and spending, but the gold standard required it because issuing currency was expensive, it required the same value of gold. Now it is free, and the government could just issue more currency instead of bonds. But issuing bonds is still useful, as it controls the interest rates in the rest of the economy. It is still useful because investors are interested in risk free investments. But the government offering of bonds should be entirely divorced from taxation and expenditure. We can go further, and suggest that the bonds should always be offered, even when the government is running a surplus.

The exception was the recent program of Quantitative Easing (QE). The Bank of England (BoE) bought £375bn of assets, mainly UK government debt. Where did it get the money from? It was created electronically. Where did it go? The BoE bought government debt from financial institutions, which then had to reinvest in riskier shares or corporate debt. The US Federal Reserve and European Central Bank had similar programs. So now £375bn of the UK national debt is owed to the Bank of England, which is owned by the UK. Over a quarter of the £1400bn UK national debt has effectively been repaid. And as a side effect, it boosted the valuation of shares, as the £375bn was reinvested in company shares or bonds.

So far we have only covered how government finances actually work, in countries that have control over their own currency. So it applies to the UK, USA, Norway, Switzerland etc. It does not apply to Scotland within the UK, or to states in the US. It does not apply to the countries in the Eurozone, but applies to the Eurozone as a whole. It applies to countries that have currencies that are pegged to others, but their freedom to apply it is severely limited by having to keep at the pegged rate. The next step is to examine how this understanding should influence government policy.

Running a deficit or surplus will raise or lower inflation. There are many other factors that cause inflation, but the deficit is one which the government controls. The response to above target inflation should be austerity, the response to low inflation should be Keynesian stimulus.

Deflation, prices and wages falling as the relative value of money increases, is bad. Consumers delay purchases, as their money will go further the longer they wait. Debts become harder to pay off, as wages fall. Unexpectedly high inflation is also bad, as it erodes the purchasing power of savings and pensions. But it also erodes debt, wiping out past financial mistakes. So the target is stable low inflation, rather than zero inflation. It encourages people to invest, rather than just hide money under a mattress, and actually acts like a tax on wealth. Rather than having to assess everyone’s assets and tax them to fund spending, the value of money simply falls slowly.

Currently the BoE has a target of 2% inflation. Coming out of a housing market boom and crash, erring on the side of higher inflation should help rebalance the ratio of earnings to house prices while trapping people fewer people in negative equity than waiting for house values to drop back to more normal levels. Instead the government is keeping house prices high by inflating the market with help to buy schemes, but this leaves the government exposed if the housing market stalls, and it is difficult to wind down the scheme without risking causing such a stall.

As the economy expands, it will naturally result in deflation if the money supply does not expand too. Historically the money supply expanded with the mining of gold and silver, the only connection to the size of the economy was the amount of effort that made mining economical increased during periods of deflation. Now the money supply expands when the government deficit spends into the economy. Gordon Brown’s promise to balance the budget over the economic cycle was unnecessarily restrictive. The current concern of debt to GDP ratios are more accurate, as it reflects that a government can deficit spend as the economy grows, but it is still too weak. A government should deficit spend as the economy grows.

Another influence is the Bank of England base rate, which is the rate that banks borrow from the Bank of England, so ultimately determines the price of businesses or consumers borrowing from the banks. This was passed from control of the Treasury to the BoE Monetary Policy Committee by Gordon Brown, to stop politicians manipulating it for political advantage. Perhaps control of the size of the deficit should be taken out of the Chancellor’s hands too.

Other factors are out of the control of government. Just as important as the total amount of money in circulation is the speed at which it circulates. Confidence encourages people to borrow and spend money, creating demand and jobs. Crises make people fear for their jobs, increase their savings and put off purchases just in case the worst happens. Demand falls, people lose their jobs, and the economy spirals downwards. The coalition narrative was that government spending was crowding out private investment, strangling the economy and requiring austerity. In fact it was austerity that was strangling the economy, growth picked up once the government stopped cutting spending and allowed the stimulus of QE, Lending for Business and Help to Buy to take hold. Oddly enough, George Osborne never announced that it was time for Plan B. He always denied even having one. But we certainly aren’t still on Plan A, with the promise of a balanced budget always being put back, and the debt continuing to grow.

Fortunately, the size of the debt does not really matter. It affects our vaunted credit rating, but we can always print money instead of borrowing it, so will never default on the debt. Obviously this will lead to inflation, and devalue our currency against others. This is what the global markets are worried about, that a pound invested in Britain now will be worth far less when they get it back. And we have the same concerns, that the pound falls making imports more expensive and we are worse off. But a falling pound also makes exports more competitive, increasing the number of jobs in Britain and lowering unemployment. So the talk of Britain’s credit rating should be taken with some salt. The trade-off is simply do we accept higher unemployment to keep imports cheap.

So, what does this all mean for Scottish independence?

To take full advantage, Scotland would need its own currency, floating on international markets. This is estimated to cost Scotland-rUK trade £500m/year on each side in transaction costs when changing currency, and hedging to minimise the effects of future changes in exchange rate. So roughly £100 per person in iScotland, and £10 per person in rUK.

Currently the UK can use all of the powers listed above, but is not. So an independent Scotland using Sterling without currency union would lose some powers that aren’t (officially) being used. Better Together should be listing all of these benefits, and the lack of transaction costs, and screaming them from the rooftops. But they then torpedo the austerity narrative that the Coalition has used to justify its cuts, and Labour does not oppose. Either George Osborne, Ed Balls, Danny Alexander, Alastair Darling et al haven’t noticed QE, or even the end of the Gold Standard, or they are too scared of losing their rich donors to acknowledge an alternative.

Without a currency union, iScotland would need to aim for a balanced budget over a fiscal cycle. It could borrow on the financial markets, but where rUK pays an interest rate based on future inflation expectations through choice, and could indulge in further QE, iScotland would pay an interest rate based on the rUK rate plus a premium to reflect the risk that iScotland defaults on its debt. This premium would be a reflection of iScotland’s credit rating, so iScotland would probably accept total debt of some target percentage of GDP to fund investment at an affordable interest rate.

Interest rates for businesses and mortgages for Scots should not change, they already reflect the likelihood of default. There would be a risk that Scotland does adopt a new currency in the future, unilaterally converts all debts to the new currency and then devalues it, but a speculated 1% interest rate premium for this in a competitive banking market is absurd.

A separate currency pegged to Sterling would gain some of the advantages of a separate currency, without incurring too many transaction costs. Scotland already has separate banknotes that aren’t always happily accepted in England, so nothing would change there.

An independent Scotland within a currency union would have some influence, but no control over the currency. A seat on the MPC can swing tied votes, but will otherwise be ignored. Scotland would need to maintain a similar or smaller deficit than rUK, because the BoE would be keen to avoid any situation where it might bail out iScotland and not rUK. Interest rates would be the same for both governments. Any future QE would see the BoE buying assets, and returning the income from it proportionally to iScotland and rUK, potentially leading to a situation where one government is effectively a substantial creditor to the other. One option that has not been mentioned by Better Together is reforming the MPC to give Scotland an explicit voice after a No vote.

If Scotland adopts the Euro, just reread the last the four paragraphs replacing rUK with Eurozone.

Which option Scotland takes will be decided after the referendum. Better Together insist a currency union is impossible, but refuse to acknowledge a downside for rUK if iScotland leaves Sterling. Paradoxically, the more likely Scotland is to adopt a different currency, the stronger the case for currency union is for rUK. If there is no currency union, a likely path is for iScotland to initially keep Sterling after independence, then probably a party will campaign to transition to a new currency pegged to Sterling, and after that there will be a campaign to let it float, possibly as a precursor to joining the Euro. This essentially duplicates the Irish experience. There could be a desire for a faster transition to the Euro, once the Eurozone recovers.

The other driver for rUK agreeing to a currency union is the amount of UK debt repayment that Scotland agrees takes on. Alastair Darling was widely quoted as saying that with a total budget of £700bn, “you have to be sort of phlegmatic about £5 billion”. It will be interesting to see the three main parties campaigning on a platform of £5bn per year of spending cuts to avoid a currency union, or an equivalent tax rise. A penny on income tax or VAT should cover it. And that is just the interest costs, it totally ignores £100bn actually repaying the debt. One can’t help but wonder if £5bn per year is so inconsequential, why the Coalition were so determined to save a tenth of that with the bedroom tax.