The unbalanced Sterling Zone

Suppose that Scotland and the rest of the UK (rUK) form an Optimal Currency Area (OCA). This means that there are net benefits associated with the formation of a currency union.

The fact that net benefits arise from the OCA means that the benefits from reduced trade costs (which primarily benefit the smaller party, Scotland) outweigh the costs of one-size-fits-all monetary policy which can amplify idiosyncratic shocks (and which also primarily fall upon the smaller party, Scotland). The majority of these net benefits therefore fall upon Scotland; which is a workable scenario, unlike the situation in which the benefits fall to Scotland and the costs fall to rUK. All else equal, this is a so called pareto-improvement (a change that improves welfare for at least one party, without making anyone else worse off) relative to a situation with separate currencies.

However, all else is not equal. In times of crisis, the central bank of the Sterling Zone may have to intervene to backstop the banks or the governments of one or other party to the currency union. As outlined in de Grauwe (2013): banks which borrow short and lend long, or governments who need to borrow to allow the operation of automatic stabilisers; are both vulnerable in times of crisis. Providing funding in such times should be a role of the central bank. However, the resources that are supplied in these circumstances do have to be paid for: whether as an explicit levy on the citizens of the union, or as a hidden inflation tax. The root of the current euro crisis is that the need for central bank funding is becoming obvious, but there was no ex-ante agreement in place as to who should pay for the resources that must be transferred.

At any one time, perhaps it is only one of the parties to the union that require help from the central bank; but this help is to be funded by a levy across the whole union. There is therefore a mismatch between who benefits and who pays. As a consequence of this mismatch there is a problem of moral hazard: if you know that you can benefit from a system and spread the cost onto other parties, you may be more inclined to run risks and put yourself in a position in which you need to take advantage of these benefits. Any currency union would have to implement constraints on the policies and behaviours of its constituent states in order to minimise this problem of moral hazard.

The issue of moral hazard is a cost which lowers the OCA net benefits of a currency union. Allowing for this, the currency union may still have net benefits, and two symmetrical parties who wanted to create such a currency union (especially if they had learnt the lessons of from the Eurozone), may still agree that a mutually beneficial arrangement was possible. Minimising moral hazard would involve giving up some autonomy, but each party could be acknowledged as a sovereign state whilst recognising that this arrangement required a great deal of pooled sovereignty (I dealt with the claim that ’constrained independence does not represent real independence’ in a previous post). However, the asymmetry between Scotland and rUK causes real problems for any proposed Sterling Union.

With asymmetrical parties, not only are the net benefits from the OCA unevenly split and weighted towards the smaller party, the moral hazard costs are split and weighted towards the larger party. If Scotland received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, and its citizens would eventually pay 10% of the costs of providing these resources. However, if rUK received resources from the central bank then it would get 100% of the benefit from the receipt of these resources, but its citizens would eventually pay 90% of the costs of providing these resources. There is therefore a clear incentive for Scotland to put itself in a position where it is likely to need central bank support, whilst there is no great incentive for rUK to put itself into a similar position. The problem of moral hazard for Scotland is therefore exacerbated and rUK is likely to recognise this in evaluating the costs and benefits of a Sterling Zone.

If a Sterling Zone does provide net benefits overall, then it may be that the asymmetry between Scotland and rUK scuppers a project which could in principle be mutually beneficial. This is an example of a tragedy of the commons situation in which the incentives faced by the parties mean that a valuable resource is rationally squandered. In summary: the majority of the net benefits of an Optimal Currency Area likely accrue to Scotland due to asymmetry; and the majority of the costs of moral hazard fall upon rUK – again due to asymmetry. If Scotland were to conduct a cost benefit analysis of the value of a Sterling Union then it might likely agree that it was the policy to pursue.  If the rUK were to undertake the same calculation, they are likely to reject the policy. This seems to be consistent with the campaign positions that we see.

About David Comerford

Post-doctoral researcher in economics
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