Building trust in a post-independence Scottish government’s commitments to sound economic policy and sustainable public finances would require strong, operationally independent institutions – including a debt management office, a strengthened fiscal watchdog and a new monetary authority.
Scotland already has devolved powers over many areas of public policy – from running the NHS and schools to its own legal system, as well as some power over tax and social security policies. But not since 1707 has Scotland had complete control over its own monetary policy and public borrowing.
One of the big adjustments that an independent Scotland would need to make, therefore, would be to set up the institutions needed to support its own currency regime and to ensure that the government was able to borrow any money it needed. In particular, it would require a new debt management office, a strengthened independent fiscal watchdog and a new monetary authority to take over activities currently performed for the UK as a whole by the Debt Management Office (DMO), the Office for Budget Responsibility (OBR) and the Bank of England.
There is no precedent for establishing a new economically advanced country. But we can still draw lessons for an independent Scotland by examining the macroeconomic institutions that existing advanced economies have developed (Pope and Soter, 2021; Tetlow and Soter, 2021).
What new institution would be needed to issue government bonds?
Currently, most of the borrowing that is done to bridge the gap between the tax revenues raised in Scotland and the public spending done for the benefit of Scotland is issued by the DMO, which is based in the City of London. While the decision about how much to borrow is a political one, deciding what types of debt to issue should not be. It is instead a technical matter and is, therefore, handled by this independent institution.
The DMO helps to minimise the amount of interest the UK government is charged on its debt by matching the type of bonds issued to the demand that exists. If there is high underlying demand for a particular type of debt, it can be issued at lower cost. For example, over the past decade, the DMO has increasingly favoured issuing index-linked debt (that is, debt on which the interest payment varies in line with the rate of inflation). This is because there has been high demand for such inflation-protected assets from private pension providers (HM Treasury, 2021).
The DMO makes sure that the government’s debt stock is manageable over time – for example, by issuing bonds of different maturities to avoid any spikes in refinancing requirements. It can also issue debt in different currencies: invariably UK government debt is denominated in sterling, although the UK has occasionally issued bonds denominated in other currencies, such as the Chinese renminbi (HM Treasury, 2014).
To help to ensure that it could borrow at the lowest possible cost, an independent Scotland would need to establish an effective debt management office of its own to carry out these functions (Pope and Soter, 2021). This task could be entrusted to a new central bank (as is done in Denmark) but it is regarded as international best practice to have a separate debt management office.
This is because there can be a conflict of interest for a central bank. If Scotland were to have its own currency, the central bank (as we describe further below) would be responsible for setting the base interest rate, which feeds through into economy-wide interest rates, to achieve whatever target it was set (such as stabilising inflation or maintaining a currency peg). But if the central bank was also responsible for issuing government bonds, it could be tempted instead to use its interest rate setting powers to reduce the cost of government borrowing.
A new Scottish debt management office would need to establish good relationships with investors worldwide to determine what demand there was for different types of Scottish government debt and to enhance Scotland’s reputation with those potential investors. It would also need a sound institutional framework to attract investors.
The UK’s DMO provides a good model, as it is well regarded internationally. It maintains a good relationship with the Treasury, while retaining the power and resources to make independent decisions.
But demand for Scottish government bonds would not be determined solely by the actions of a new debt management office. Investors’ appetite would also depend on their view of the creditworthiness of the Scottish government and the country’s exchange rate regime.
How could institutions bolster the credibility of Scottish fiscal policy?
The borrowing costs facing an independent Scottish government would depend on what investors thought were the prospects for Scotland’s future economic growth and how credible they perceived the country’s economic and fiscal policies to be. Fiscal policy covers all tax and spending policies – and the resulting levels of borrowing and debt.
To a large extent, investors’ perceptions would be shaped by what the government chose to do. But their confidence could also be reinforced by bolstering the role of the existing Scottish Fiscal Commission after independence. In the past decade, many countries have adopted independent forecasters or fiscal councils – such as the OBR in the UK – to assess the reasonableness of their government’s fiscal position. These fiscal councils have been shown to be associated with more fiscal discipline, provided they are credibly independent (Debrun and Kinda, 2016).
The Scottish Fiscal Commission has already established a reputation for delivering credible and independent forecasts (OECD, 2019). But the Commission’s role would need to expand if Scotland were to become independent, since the fiscal powers of the Scottish government would grow. It would also be important to address existing weaknesses in the operation of the Commission – in particular, its lack of timely access to some necessary information and gaps in some Scottish economic statistics, such as on wages and earnings (Scottish Fiscal Commission, 2020).
Expanding the Commission’s role in this way would require some extra resources and reinforcement of its independence from government, including allowing it to conduct more in-depth analysis of longer-term fiscal risks and fiscal sustainability.
Further empowering the Scottish Fiscal Commission in this way and ensuring that it had the resources to succeed would be an important signal from the Scottish government to international markets and should help to develop better fiscal policy.
What new monetary authority would an independent Scotland need?
After independence, Scotland would need to decide what currency regime to have. This would have wide-ranging implications for people’s day-to-day lives, how businesses would transact with one another within Scotland and overseas, the currency in which government debt would be issued and what demand there would be for it. The decision would also influence the shape and size of Scotland’s economy as it would affect the ease of trading with other countries.
Several different options may be available to an independent Scotland – from retaining the pound in some form or joining the euro to issuing a new Scottish currency that could either float freely or be pegged to another currency. The different options would have deep implications for the Scottish economy, as discussed elsewhere in this series (MacDonald, 2022). They would also affect what type of monetary authority Scotland would need (Tetlow and Soter, 2021).
All advanced economies now have an independent institution (usually a central bank, such as the Bank of England) that operates monetary policy, with a mandate from the government. This separation of monetary policy setting from politics helps to insulate monetary policy from any temptation that politicians might have to use it for short-term political gain. This has been effective in promoting price stability and financial stability (Lybek, 2004).
Research shows that it will be important for an independent Scotland to establish a similar sort of credible, independent monetary authority with appropriate funding and staffing (Tetlow and Soter, 2021). The targets of monetary policy (such as price or output stabilisation or maintaining a currency peg) are more credible when independent experts make decisions rather than politicians who may be swayed by short-term political calculations.
A credible, independent central bank would also make investors more confident in investing in Scotland and buying Scottish government debt because it would reduce the perceived risk that inflation or large currency devaluations would erode the value of their assets.
The responsibilities of a new monetary authority would depend on Scotland’s choice of currency arrangement. There would be three main potential roles for a new monetary authority:
- First, it might be tasked with stabilising demand in the economy and/or prices by setting interest rates – and, if appropriate, engaging in less traditional forms of monetary policy such as quantitative easing (QE). QE is the practice of central banks printing money to buy bonds – mostly their government’s own bonds but also other long-term assets – to increase the supply of money in the economy, which effectively decreases interest rates. The monetary authority would use these tools to meet a mandate specified by the government – such as controlling inflation, as the Bank of England does.
- Second, the monetary authority might act as what is known as a ‘lender of last resort’ to the financial sector. In this capacity, it would provide access to cash for banks and other financial institutions that are solvent but face short-term liquidity problems – as many banks around the world did, for example, during the global financial crisis of 2007-09.
- Third, the monetary authority could act to stabilise the exchange rate between Scotland’s currency and other currencies by buying or selling domestic and foreign currency.
If an independent Scotland were to adopt its own, new currency and allowed this to float freely against other currencies, its new central bank would mainly perform the first two of these functions. If instead it adopted a new currency but wanted to manage its exchange rate against other currencies, the monetary authority would focus on the third task.
In the extreme, if Scotland were to emulate the sort of strong peg operated by Hong Kong, it could adopt a currency board. This would issue Scottish notes and coins, all of which would be backed up by foreign reserves of the pegged currency, with the currency board buying or selling Scottish or foreign currency as appropriate to maintain the peg. The ability of the monetary authority to act as a lender of last resort would be much more constrained with a pegged, rather than floating, exchange rate.
The responsibilities of a new monetary authority would be most limited if Scotland were to remain in some form of currency union with the rest of the UK. If there were a formal currency union, monetary policy could continue to be made by the Bank of England, although some changes would be needed to its governance arrangements.
The Bank of England could also, potentially, continue to operate as the lender of last resort for financial institutions in Scotland. But Scotland may nonetheless need its own monetary authority to implement policies set by the Bank of England, as members of the euro area currently do for policy set by the European Central Bank.
If there were instead an informal currency union between Scotland and the rest of the UK – that is, Scotland simply carried on using sterling but without any formal agreement with the UK – Scotland would not necessarily need a monetary authority at all. (This is the currency regime advocated by the Scottish National Party’s Sustainable Growth Commission in 2018, at least for the first few years of independence.) For example, Panama, which uses the dollar informally, does not have a monetary authority.
Scotland might still want to set up a central bank to provide clearing facilities for Scottish banks. The country might also choose to set up a central bank if it intended eventually to join the euro area or have its own currency. In both cases, at that stage it would need a central bank, so having one during a period of informal currency union would be an opportunity to develop its capabilities and credibility.
How could an independent Scotland ensure that its new institutions were successful?
These new institutions would entail some upfront and continuing costs. But these costs need not be high – and they certainly are not sufficiently large as to affect the judgement that one would make either about the merits of Scottish independence overall or the appropriate choice of exchange rate regime after independence (Pope and Soter, 2021; Tetlow and Soter, 2021).
But there could be challenges in attracting the right calibre of people to lead a new debt management office or monetary authority. Having the right leadership would be critical to ensuring these institutions’ success, as both would need to establish a good reputation quickly with the private sector at home and abroad.
There may not be sufficient suitably qualified people already based in Scotland and so an independent Scotland may need to pay a premium to attract talent from elsewhere. The UK, for example, found that salary was a sticking point in its attempt to recruit suitably qualified candidates to fill new senior trade roles after Brexit – a type of expertise that the UK civil service had not needed as a member of the European Union (Dean, 2017).
A newly independent Scottish government would need to ensure from the start that these institutions were adequately resourced and given sufficient operational independence. This would be crucial to the success of the new country, as it would help to reassure investors and the wider world that the new government was committed to credible, stable economic and fiscal policies. Scotland could model these new institutions on successful examples in other advanced economies.
Where can I find out more?
- Currency options for an independent Scotland: Report from the Institute for Government summarising the different currency regimes that an independent Scotland could choose from and the implications of these for the economy, different types of businesses and households, and for the macroeconomic institutions needed.
- How would an independent Scotland borrow? Report from the Institute for Government summarising how Scotland would borrow if it were to become independent, and at what cost, including a discussion of the institutions that would be required to do this.
- Strengthening post-crisis fiscal credibility: Fiscal councils on the rise – a new dataset: Journal article presenting key characteristics of fiscal councils among International Monetary Fund members.
- Central bank autonomy, accountability, and governance: Conceptual framework: Report setting out the reasons why central bank autonomy and accountability facilitate price and financial sector stability.