Nicola Sturgeon, leader of the Scottish National Party (SNP), has declared that there will be a second independence referendum by 2021. This is not unreasonable given the major constitutional change of Brexit. There was a significant amount of comment by IEA authors around the time of the first referendum and then in the period afterwards. The model of a federal Britain, with very few powers reserved for the UK government and with the centralisation of any further powers requiring unanimity, has been widely debated by the IEA, including with SNP politicians. The SNP are not keen on this model, despite the fact that it would give them almost everything they want – perhaps because they realise that it would be popular within Scotland. The binary option on the ballot paper at the last referendum was very much to the benefit of the independence side.

In the end, despite running with the advantage of independence being the only alternative to the status quo, the independence side lost the 2014 referendum. One of the reasons they lost was that they struggled to develop a credible policy on currency arrangements post-independence. This time they have made their policy clear in advance.

Where should the SNP stand on the currency question if Scotland gains independence?

Option one: adopt the euro

Before the financial crisis, and the perilous state that a number of euro zone countries reached in the period 2009-2012, this was the obvious option for Scotland. Though supporters of free markets tend to oppose the adoption of the euro in the UK, the idea of a common currency operating across national boundaries has merit. The euro is somewhat independent of the political systems of the countries in which it is a currency. It is not, as Otmar Issing once proclaimed, a Hayekian solution along the lines of the denationalisation of money. But, the ECB certainly has greater independence in the operation of monetary policy than any central bank of a sovereign state and there are, therefore, grounds to support the adoption of the euro in Scotland if one believes in sound money and a free economy.

The arguments against Scotland adopting the euro are similar to those against the UK as a whole adopting it. If a country adopts a currency with no independent control of monetary policy and there are severe fluctuations in the real economy, the consequences may be high levels of unemployment and cyclical variation in output unless the country liberalises product and labour markets. Indeed, the relationship between recovery from the euro crisis and a country’s economic freedom is extraordinarily close.

The adoption of the euro, therefore, should be part of a broader liberalisation agenda that would, in itself, be beneficial. However, it is likely that this will not be the direction of travel of a Scottish government. That, together with the fact that the euro is now tarnished, makes it a politically unappealing option.

Option Two: a currency union with the rest of the UK 

The problem in the last referendum campaign arose because the SNP stated that they would remain part of a currency union with the rest of the UK and the UK government then announced that they would not! It takes two to tango. The SNP has now said that Scotland will would remain in a currency union with the rest of the UK until its six economic tests are met and then it will adopt its own currency. So, what might a currency union with and without consent look like?

Option Two A: a currency union with consent

With consent, there would, in effect, be no difference between Scotland being in or out of the UK when it came to all matters to do with currency, banking and probably financial regulation and fiscal controls. It would be impossible to imagine the rest of the UK (RUK) agreeing to Scotland keeping sterling and also accessing central banking facilities such as lender of last resort unless prudential financial regulation remained uniform across the UK. To do otherwise would create huge moral hazard unless there is total credibility in any policy to not bail out banks (which is unlikely). The use of government debt in central bank operations would be problematic for both RUK and Scotland. The unified central bank could end up taking either Scottish or RUK sovereign debt risk unless there were strict limits put on budget deficits and debt levels. All the problems that we see in the euro zone would be replicated and probably multiplied and many of the perceived benefits of independence would not be achieved.

Option Two B: a currency union with the rest of the UK without consent

The best option may well be monetary union without consent. The SNP should have called George Osborne’s bluff in the last referendum campaign. Scotland should be like Montenegro with people using sterling, the euro or any other currency as it sees fit. Countries do not need their own currencies. Scotland could then (de)regulate its own banking system and, preferably, return to the free banking system that was successful in earlier times. There could be no lender of last resort facilities for banks and no significant deposit insurance under a sterlingisation or euroisation of Scotland because there could be no central bank or a government able to print money to bail out depositors. Moral hazard would be eliminated and discipline would have to come from the market, as happened under free banking.

All this is made much more complicated by EU law should Scotland re-enter the EU (which is by no means a formality). That is a discussion for another day. The most successful period in Scottish economic history (certainly relative to England) was under a free banking system. Scotland could operate such a system and not worry about having its own currency or central bank at all. This would put to bed the issue of the currency in the Scottish independence debate. Scotland would not have to issue its own currency nor would it have to rely on the goodwill of RUK or the EU in order to allow its residents to use their currency of choice. If they wished, to put a Scottish gloss on these arrangements, Scottish banks could issue token money: “Scottish euros”, or “Scottish pounds” exchangeable at par backed by the real thing on a one-for-one basis just as they do now.