One of the bigger arguments proposed by opponents of Scottish independence is the idea that establishing an independent Scottish state would result in a dangerous amount of borrowing. The borrowing levels would be so out of control that it would make the Scottish economy collapse.
But here’s the catch – an independent Scotland with its own currency and central bank would not borrow a penny. Not because Scotland is a magical utopia, but because we would use the same monetary powers that the UK uses right now. What we describe as “borrowing” is an accounting adjustment that changes our currency. This may seem confusing at first, but this will become clear as we explain how the monetary operations work.
Two points before diving deep into the discussion. First, many commentators have often referred to a new currency for an independent Scotland as the “Scottish pound”. To avoid confusion with the UK pound, this article will instead label a new Scottish currency as the “krona”, a currency name which is used by Sweden and is like that other Nordic nations (such as the Norwegian krone, Danish krone and the Icelandic króna). Second, this article will refer to an independent Scotland’s central bank as the “Scottish Reserve Bank”. Also note, the description of the monetary system is the same system the UK has in place, so opponents of Scottish independence will find this information equally useful.
First things first – what is a bond?
If you buy a bond, the issuer of the bond is making you a promise to pay you a set rate of interest every year and will repay you the original amount you invested at a set date in the future. For example, let’s say I issue you, the reader, a ten-year bond of £100 with an interest of 2%. Each year I would pay you interest, which in total is £2. Then on the last year I would pay you the total bond value with interest, which is £102. Bonds can be issued by governments and private companies to help fund their investments. But bonds are only useful to raise funds for investment if the institution is a currency user (i.e. they don’t have their own currency and central bank). They must “find the money” in order to expand any projects they have in mind.
If a government with its own currency is issuing bonds, then the operations are coordinated with a central bank. A Scottish Reserve Bank would oversee the currency transactions of the Scottish Government. Together they would coordinate the auction of Scottish bonds to financial markets, how many Scottish bonds are on offer and how long they would last. These transactions, along with government spending and taxation, all work smoothly together.
From an outside perspective it looks like an independent Scottish government is collecting kronas from taxpayers and bond buyers in order to raise funds and pay for public spending. This framework is also known as (TAB)S – taxing and borrowing precedes spending.
However, recall what we learned at the start of the article – only governments that do not have their own currency and central bank would use bonds to raise funds for investment. An independent Scotland with a Scottish Reserve Bank would not be in that situation, and when they issue bonds a different process is happening. What is occurring is that the Scottish Government is offering a different type of government money, one that earns interest over time. This is what could be called interest-bearing kronas. Economists often refer to government currency as “green kronas/pounds/dollars” and government bonds as “yellow kronas/pounds/dollars”. Every year when there is a government deficit, more green kronas are going into our pockets.
In recent history governments have chosen to sell bonds to match its deficit spending. If an independent Scotland had spent fifty billion kronas into the economy but only taxed back forty billion kronas, the government would issue ten billion worth of Scottish bonds. This is not borrowing, it’s simply the Scottish government allowing people to transform their green kronas into interest-bearing yellow kronas. Also note that the ten billion worth in Scottish kronas that is needed to buy bonds needs to be spent first by the Scottish government’s own deficit spending. Therefore, countries that spend using their own currency are effectively self-financing themselves.
What are the markets for selling bonds?
There are two markets for selling bonds – the primary market and the secondary market. The primary market (where buyers are called “primary dealers”) is the first place the government sells bonds. The main buyers in the UK are Santander, Barclays, Deutsche Bank, NatWest, Goldman Sachs International etc. These are large institutions that hold a large amount of capital. The secondary market is where buyers will include pensions, hedge funds, state and local government, insurance companies and foreign investors.
In order to win government bonds in both markets, bidders will begin to compete by offering reasonable yield rates to win the bid. The bidders that offer rates closet to the government target (which are usually low) always win.
There are two very important points worth noting here. First, the primary market is established by the government, and therefore it is the government that is ultimately the boss. Whatever interest rate the government sets, bond bidders will need to match as closely as possible. Over one third of the current global bond market trades at negative rates, because central banks across the world have set it. Secondly, the government is not desperate to “borrow” – bond bidders are eager to have a triple A savings account at central banks. By offering an unreasonable rate, they risk the chance of losing out to others.
Would an independent Scotland have to borrow from the rest of the UK?
Some commentators have suggested that an independent Scotland would need to “borrow” from the UK because they will hold Scottish kronas and convert them into bonds. But let’s first take a step back to consider how the UK would get these kronas and what they would do with them.
The UK is Scotland’s largest trading partner, and Scotland is in the top five of the UK’s biggest trading partners. UK data collection on trade flows between the UK and Scotland is generally weak, however with the limited data available it is suggested that the UK has a trade surplus with Scotland (meaning we have a trade deficit). In the case of Scotland being an independent country, we would pay for the UK’s goods in kronas, and those payments would be credited to the UK’s bank account at the Scottish Reserve Bank.
The UK (by “UK” we mean individuals and businesses based in the UK) has a few options on what to do with those kronas. The UK could sit on those kronas or use them to invest/purchase more Scottish goods in the currency. But if the UK sat on those Scottish kronas they would not be earning interest on them. What the UK is most likely to do is simply shift their kronas into a savings account at the Scottish Reserve Bank. This is done with the UK purchasing Scottish bonds. This is simply an accounting adjustment. The Scottish Reserve Bank simply subtracts numbers from the UK’s current (reserve) account and adds those numbers to its savings (security) account. Those kronas will still be sitting there, but now the UK is holding yellow kronas instead of green ones. To pay back the UK, the Scottish Reserve Bank will simply reverse these accounting entries – so the UK’s security account is marked down, and its reserve account is marked up. This is simply done using a keyboard at the Scottish Reserve Bank.
An independent Scotland would not be “borrowing” from the UK. This is either purposely misleading or a misunderstanding of the monetary system. The only thing we owe to the UK is a bank statement.
(On a side note, many traders may use third parties to convert their currency before making any trade, such as Transmate. For example if a Scottish company wanted to buy supplies from a South Korean company, Transmate would sell Scottish kronas on behalf of the Scottish company and then deliver Korean currency [South Korean won] to the South Korean company.)
Could an independent Scotland be at the mercy of bond vigilantes?
Despite this, certain economic think tanks and commentators repeat this misinformation around borrowing and attempt to go even further. Some have argued that the UK holding Scottish securities is a danger, since financial markets could sell off our assets in order to drive down the price for Scottish bonds and increase the yield (interest) on them. Those who attempt to force sharp changes in the prices and interest of financial assets are normally referred to as “bond vigilantes”. Many readers may recall in 2016 when the Centre for Policy Studies infamously made the claim that Scotland would be “like Greece without the sun.”
But this does not make logical sense and would not work in the favour of the UK government. First, since the UK has a trade surplus with Scotland it cannot avoid accepting the Scottish krona. The only possible way to do that would be to flip their trade surplus with Scotland into a trade deficit. This is highly unlikely to happen, especially considering the ideological position of UK parties favours having a trade surplus.
Second, an independent Scotland with its own currency would not be in a situation like Greece. With Greece abandoning the drachma currency in 2001, it had lost its monetary sovereignty to the European Central Bank. This meant that Greece’s debt is redenominated into a currency it is not the monopoly issuer of, thus they would be forced to use taxation and bonds to raise funds for government spending. Anyone who did purchase Greek bonds were taking on a risk not faced by countries with their own currency – a default risk. This is because Eurozone countries could literally run out of Euros. 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, then followed by the 2009 Eurozone crisis.
With the 2008 financial crisis Greece suffered from job losses, declining tax revenues and a spike in demand for welfare protection. Therefore, Greece’s was forced to push the country’s government deficit to 15% of GDP in response to the crisis, well above the 3% of rule under the EU (these rules are more accurately described as “recommendations” for monetary sovereign countries in the EU since they don’t face harsh financial fines). Without Greece controlling its own central bank, they could not clear all its payments. Lenders were unwilling to buy Greek bonds unless they had high interest on them. From 2009 to 2012 Greece’s interest on 10-year government bonds increased from 6% to over 35%. This was the result of countries that were forced to accept the (TAB)S framework.
Meanwhile a monetary sovereign country like the UK did not face the same risks because it uses the S(TAB) framework – spending precedes taxing and borrowing. 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.
Financial markets also accept that monetary sovereign countries have control over their interest rates. The main interest rate that central banks focus on is the overnight rate. As Professor of macroeconomics Stephanie Kelton states – “They rigidly fix this rate and then allow longer-term rates to reflect market sentiment about the expected future path of the short-term policy rate. That means that the interest rate that’s paid on the longer-term government bonds is related to the overnight rate that its own central bank is setting.”
Some countries go even further to control their long-term interest rates. An example of this is Japan, who have recently made moves to have the yields (interest) on bonds to almost zero percent. To do this, the Japanese government sold ¥6.9 trillion directly to the Bank of Japan in June of 2019. Japan didn’t achieve this because it had a magic wand or secret recipe, this was achieved because they used their monetary levers. This is something that all monetary sovereign countries can do.
So, whilst financial markets have a bit of influence over the interest rate that monetary sovereign countries must pay on bonds, the government is ultimately the boss. This would be the case if an independent Scotland sets up its very own Scottish Reserve Bank.
We now know that an independent Scotland would not be at the mercy of bond vigilantes and would not need to “borrow”. An independent Scottish government, with its own currency, would issue bonds to support our interest rate – not to borrow.
Could an independent Scotland meet the interest payments on bonds?
Usually the last argument would be that an independent Scotland would struggle to pay the interest on government bonds, with also a large inflationary risk on the interest too. The krona that we spend on paying interest for bonds is an income for the bondholder. If the interest payments become too large, then it would create an inflationary pressure for an independent Scotland and could reduce an individual’s purchasing power.
It is misleading to argue than an independent Scotland cannot meet interest payments. Such a payment is done the same way other transactions are made through the S(TAB) framework – the Scottish Reserve Bank credits the relevant accounts. There is a guarantee that payments can be met. It is true that inflation is the primary economic factor that a monetary sovereign country should focus on. However, the inflationary risk through interest on bond payments is relatively small.
Let us consider the kind of people who will be holding bonds. In macroeconomics we use a term called the “marginal propensity to consume” (MPC) which helps us understand how much every extra currency we receive (through tax cuts or pay rises) will be spent into the economy. Ask yourself this – how much extra are the wealthiest in society going to spend into the real economy? Will the wealthiest buy a new car, boat or home? Will they use their extra disposable income to create jobs and expand the private sector?
The answer is generally no. A small percentage of the wealthiest in society will reinvest back into the real economy. However, real life data through the MPC reveals that the wealthiest in society have already consumed what they’ve wanted. Instead of investing money directly into the economy, they will purchase shares, stocks and real estate. Whilst there is no sudden increase in ordinary price inflation (measured by CPI), there is an increase in asset inflation.
Why is this important? Because bondholders are most likely to be some of the wealthiest individuals in society, and therefore are unlikely to reinvest back into the real economy. This means there is a limited inflationary risk. Secondly, recall that Scottish currency is going to the UK through our trade deficit. This means that our interest payments will also be going outside of Scotland, so the likelihood of it being spent back into the real economy is also limited.
This does bring new challenges, as increasing the value in assets may lock out regular consumers from markets, whilst large financial bodies could also use their kronas to buy real estate and use it as speculative vehicles. However, these problems can be resolved in multiple ways, such as targeted tax increases at the wealthiest (breaking down their built wealth at the top), maintaining a low interest-rate (which is normal for monetary sovereign governments) or creating a government body such as a Scottish Foreign Investment Review Board. But whatever challenges come our way, an independent Scotland with its own currency can always pay the interest on bonds.