The money set to flee an independent Scotland

If Scotland votes for independence, expect to see more central bank intervention, says Merryn Somerset Webb.

How much do you really need a central bank? A chat with Australian business journalist Trevor Sykes this week convinced me that you need them a bit.

We talked about the great Australian financial crisis of the 1890s. This came at the end of a few decades in which Australia experimented with free banking. There was no central bank, no central deposit guarantees and very little regulation of any kind. Pretty much anyone could (and did) set themselves up as a bank, create money and lend it at will.

This system is supposed to remove moral hazard entirely and so bring the kind of personal responsibility that begets stability into the system. Sadly, it didn't work that well in 1893.

There had been a speculative boom in the property market in the previous decade. A bust followed (as it always does) and prices collapsed in the late 1880s, kicking off a nasty period of depression. Corporate bankruptcies and then bank failures swiftly followed.

In the early part of 1893, half of the banks ended up suspending payments to their depositors and by the end of the year the majority of the banks that had been around in 1891 had closed their doors for good. By the end of 1893, Australia's real GDP had fallen over 15%.

Academics still argue as to what this says about free banking. Some say the lack of regulation meant the banks had hugely overexpanded and along the way tied up far too much in illiquid property investments.

Defenders of full-on monetary freedom say that the sudden collapse in capital flows from England in the wake of the Panic of 1890 (caused by one of Barings Bank's early brushes with bankruptcy) created a global credit crunch the likes of which no bank could have withstood.

However, one thing that (I think) most can agree on with hindsight is that a little regulation might have helped: a capital ratio rule, a small deposit guarantee system or perhaps a central bank with the powers to prevent the lending system shutting completely.

But if free banking suggests that a state is doing too little for its monetary system, at what point might you start to think that a central bank is doing too much? My guess is about now.

Western economies and markets are in thrall to the Fed, the Bank of England and the European Central Bank (ECB). This week the ECB's master of market manipulation, Mario Draghi, announced that the ECB's interest rate is to fall from a very low 0.15% to a ridiculously low 0.05% and that the ECB is to step up its asset buying programme.

This has caused some excitement for the simple reason that it looks a lot like quantitative easing. But it isn't quite the same. The QE introduced in the UK and the US was explicitly designed to create a wealth effect: by buying up sovereign bonds, the Fed and the BoE put vast amounts of new money directly into the markets, depressing yields and pushing up the prices of all assets. That supposedly made people feel more confident about their finances.

That may or may not have worked economic historians will let our descendants know the conclusions in a few centuries' time, once they've settled matters arising from the great Australian financial crisis of 1893.

But Draghi's plan has a different emphasis. It is smaller, and focused on buying asset-backed securities (ABS) from the banks. The idea is not to make people who already own assets richer, but to encourage banks to lend.

It seems that many of these securities would be bought from the banks, rather than in the markets. This is a dull but vital point: US and UK QE went straight into the markets, instantly pushing up money supply and asset prices.

Shovelling money into tottering banks doesn't mean they will increase lending, and even if the buying of ABS encourages banks to lend more in order to create more saleable ABS, it will be a relatively drawn out process.

That means that the ECB purchases won't necessarily have the happy and immediate effect on markets as those across the Channel. For investors, it might turn out to be less 'QE lite' than 'QE useless'.

This brings me to the main thing on my mind at the moment. If Scotland votes to separate from the UK on 18 September, then there is a strong chance of capital flight from Scotland.

The Bank of England will have to step in to provide liquidity to Scottish banks, just as the ECB does to all European banks. The ECB is taking collateral denominated in euros in return for cash, and the Bank of England will be taking collateral currently denominated in sterling for cash.

'Currently' being the operative word. As CLSA's Russell Napier points out, the collateral may not always be denominated in sterling. What if Scotland ends up with its own currency? The other option is capital controls, as used in Cyprus in 2013.

The result? During the negotiation period for separation, a Scottish pound would not be worth the same as a UK pound. London taxi drivers already think it isn't; Edinburgh airport has a cash machine that issues only English notes for the benefit of southbound travellers.

Life for those of us living north of the border could be pretty nasty if everyone agreed with the cabbies.

The way to hedge this risk is to shift your money out of banks with their headquarters in Scotland, something top of my to-do list for next week. If you find on arranging the transfer that you have more cash than you need, you might stick it in a European fund and wait for some real QE.

Once the ECB has finished taking the Japanese route, they'll start down the UK and US route. The economic data is still horrible and it is hard to see how, now they have intervened so enormously, any central bank can ever stop. I wonder if the ECB might be beginning to wish it had never started.

This article was first published in the Financial Times.




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