An Independent Scotland will set "Borrowing" Conditions - Not Free Markets
Updated: Dec 19, 2021
Claims that a monetary sovereign Scotland would pay a premium on Scottish bonds should be dismissed.
Every couple of months the media will report the common myth that an independent Scotland would be forced to pay a premium when issuing government bonds to financial markets under Sterlingisation. The two problems with this is that it deliberately misleads people on the Scottish National Party’s (SNP) currency policy, whilst misunderstanding how government bonds actually work. Today we will address both.
The SNP’s policy is to implement a new currency within the first parliamentary term post-independence. The institutions for a new currency would be built during the transition period towards independence. This leaves a window to implement a new currency on day one to the last day of that term. During the SNP’s 87th national conference, delegates passed a motion noting the preference for a currency sooner, whilst supporting the drafting of a bill for the establishment of a Scottish Reserve Bank. Any suggestion that SNP policy is to maintain Sterling for the medium or long-term is simply wrong.
What we describe as “borrowing” for countries with their own currency and central bank (monetarily sovereign) is misleading. A better description for these monetary operations is asset swapping. When a monetarily sovereign government issues bonds, it is simply turning normal currency into interest-bearing currency. This interest-bearing currency will sit in a savings account at the central bank and does not finance any government spending programmes.
There are two markets for selling bonds - the primary market and the secondary market. The primary market is for institutions with large amounts of capital (multinational banks) whilst the second market focusses on pension funds, hedge funds, local government pensions and foreign investors.
There a few points worth considering. First, a monetarily sovereign Scottish government would be the boss when setting conditions for issuing bonds. The primary bond market is established by the Scottish government, who sets the overnight-rate of interest on the bonds they issue. However, the value for a bond should (roughly) equal the expected average of the overnight rate for the lifetime of the bond.
Because bond bidders want access to triple A savings accounts at the Scottish Reserve Bank, they will offer rates close to the government target. Those who offer unreasonable rates will lose out on these accounts.
Monetarily sovereign governments may take it a step further to set long-term interest rates by simply selling bonds directly to their central banks. This is what the Japanese government did back in 2019 by selling ¥6.9 trillion of government bonds directly to the Bank of Japan. Japan achieved this by simply using their monetary levers - this is something that all monetarily sovereign countries can do.
Any suggestion that free-markets can force a premium on Scottish bonds should be dismissed. Most of the world’s bond markets are not offering low rates out of the kindness of their hearts – but because central banks are saying so. Further, for bond bidders to place their currency in a savings account at the Scottish Reserve Bank they would first need to receive it. Therefore, countries that spend in their own currency are effectively self-financing.
Opponents of independence will further argue that bond vigilantes will sell off their Scottish assets in order to drive up the rate of interest on bonds. This was often followed by comments that an independent Scotland would become "Greece without the sun". Not only are there very few cases of this through history, let alone for a developed and stable economy like Scotland’s, but it makes little sense to do from the bond holders perspective. Bond holders would be making the loss and harming their own portfolios.
Countries with their own currency would not be in the same situation as Greece. When Greece abandoned the drachma in 2001, it lost its monetary sovereignty to the European Central Bank. This meant that Greece’s debt is redenominated into a currency that it is not the monopoly issuer of, therefore Greece is forced to use taxation and bond issuance to raise funds for additional government spending. Anyone who purchased Greek bonds was taking a risk not faced by countries with their own currency – a default risk. This is because Eurozone countries can literally run out of Euros and when such a risk exists, financial markets will demand a premium when lending to a state that cannot guarantee a return. This was a problem faced by many EU countries during the 2008 financial crisis, which was then followed by the 2009 Eurozone crisis.
During the 2008 financial crisis Greece suffered huge job losses, declining tax revenues and a spike in demand for welfare protection. Greece was forced to push the country’s government deficit to 15% of GDP in response, which was well above the arbitrary 3% deficit rule of the EU. NB - These rules are more accurately described as recommendations for monetarily sovereign countries within the EU, since they don’t face the same harsh financial fines. As Greece no longer controlled its own central bank, they could not clear all its payments. Thus lenders were unwilling to buy Greek bonds unless they yielded high interest. From 2009 to 2012 the interest on 10-year Greek government bond increased from 6% to over 35%.
The UK government deficit increased to 10% of GDP in 2009, but the interest on 10-year government bonds decreased from 3.6% to 1.8%. Such a decrease was similarly seen by most monetary sovereign countries because they had their own central banks to control their own currency. Because monetary sovereign countries can always meet their payments denominated in their own currency, this reassured financial markets that they would see a return when creating a savings account.
Other opponents of independence will point out Scotland is a net importer – which in real terms of trade is a positive – meaning there is a “leakage” of Scottish currency going to the UK. Therefore, if the UK is holding Scottish financial assets, then we would be forced to borrow from them with a weaker exchange rate and increased levels of inflation.
We now know this is not true. The Scottish Reserve Bank will simply subtract numbers from the UK’s current accounts and add those numbers to its savings accounts. This is a simple accounting adjustment using a keyboard and spreadsheet. The only thing we would owe the UK would be a bank statement. If the UK did not want to place Scottish assets into savings accounts, they would be free to reinvest back into the economy or keep the currency within their foreign exchange reserves.
A Scottish currency that floats would see no measurable effect on domestic inflation. Canada, a small open and developed economy with a floating currency, has seen wild exchange rate fluctuations of 20% for the last twenty years whilst the domestic economy experienced stable inflation, growth, and a gradual decline in unemployment.
Another case study is Australia, which has run a trade deficit (at times twice the size of Scotland’s) for nearly thirty years...
…yet has experienced declining and stable inflation.
A new Scottish currency will not take markets by storm, nor will it crash and burn. Instead, it will simply operate like most floating currencies – underwhelming normal.