The economics of Scotland’s currency choices, by Ronald MacDonald

The recent decision by all of the major unionist parties to rule out an independent Scotland participating in a sterling monetary union has created much political heat. So much so, that there is a danger that the light of the underlying economics will be extinguished in the maelstrom. As an economist, and a specialist in currency regimes, I think it is wise to return to the basic economics of this issue lest some costly mistakes are made for both Scotland and the rest of the UK.

When questioned about the suitability of a sterling monetary union, the Scottish Government’s stock response is to say that its Fiscal Commission (FC)1, comprising a number of eminent and distinguished economists, considered all of the potential currency options open to an independent Scotland and settled on the sterling monetary union as its preferred option. However, in coming to that decision it is striking to note that the FC considered how the Scottish economy compares to the UK today rather than what the economy is likely to look like post independence, which is surely the relevant comparison.

For example, the FC note that ‘…the latest data for 2011 has Scottish productivity at either 97% or 99% of the UK average …..while GVA per head in Scotland was 99% of the UK average.’ But as I understand it, one of the key planks in the Scottish Government’s manifesto for independence is that it wants to improve Scotland’s productivity and economic growth vis-a-vis the rest of the UK.

However, one of the best-established empirical results in open economy macroeconomics is that productivity differences between trading partners has a profound effect on their relative trading competitiveness (usually explained in terms of the so-called Balassa-Samuelson effect2). For a country with a very rich and diversified non-oil traded sector this would be bad news indeed, since as part of a monetary union an independent Scotland would have no means of rectifying this through, say, an exchange rate change so there would be consequences for employment and output.

In its discussion of the choice of an exchange regime for an independent Scotland the FC also fails to recognise the fact that post-independence an independent Scotland would be a net exporter of hydrocarbons. This would be another important source of post independence divergence, pushing the country’s competitiveness in ways that would have profound effects on its non-oil trade. In its discussion of fiscal issues the FC argues for the creation of a stabilization fund to smooth the volatility in oil prices; however, there is no indication how this would be done in the early years of independence when Scotland would be running a fiscal deficit and there is no indication how the effect of volatile oil prices on private sector spending would be smoothed.3

It is interesting to note that in its discussion of a sterling monetary zone the FC considers the Belgium-Luxembourg economic Union (BLEU) as a useful comparison to the Scottish case. They claim that this was a currency union and one that allowed both countries to have ‘significant differences in corporation tax rates…’ However, the BLEU was not a currency union at all. It was in fact the classic textbook example of a dual exchange rate system in which current account transactions went through a fixed exchange rate and financial or capital account items went through a flexible exchange rate system4. And the only way such a dual exchange rate system could work was with severe capital and trade controls. This is clearly not the kind of exchange rate arrangement that is currently labelled as a sterling monetary union by the Scottish Government and its advisors.

Why one wonders does the above matter? It matters because exchange rate regimes are governed and policed by international investors / speculators in free and unfettered capital markets with a huge array of sophisticated derivative assets. They are not ultimately determined by politicians or chancellors of the exchequer, of whatever political hue. Such investors are essentially interested in making capital gains from currency speculation, and as George Soros so amply demonstrated for Sterling, and its short lived period in the ERM, have no interest in what politician A or B may think of their actions; there actions are determined by their own self interest.

The arguments I have given above make clear that a sterling zone with the rest of the UK is not a tenable option for Scotland or indeed for the rUK. International investors will make sure of that. And because expectations are so central in currency markets (see MacDonald (2007)) the future becomes the present very quickly indeed and there would be no time for an independent Scotland to put in place a credible alternative. The certain collapse of such a union would be hugely costly for a Scottish government and the rest of the UK and create huge uncertainty for all parties involved. The kind of sums that are currently being mentioned as the transactions costs of not re-forming a monetary union with rUK would be small beer indeed compared to the massive costs of the inevitable collapse of the monetary union (the so-called speculative attack literature makes this point very clearly indeed – see MacDonald 2007).

The economics of exchange rates clearly indicates that a sterling monetary union is not a runner. What then would be? The option of adopting the pound anyway (so-called sterlingisation) can be ruled out as a runner pretty quickly. As we have noted, Scotland post independence would have a complex trading set up with both North Sea oil and our traditional exports vying for the correct policy decisions. This would be impossible if we were to adopt another country’s currency as we would have no control over interest rates, our exchange rate or inflation, and there would be no central bank to provide day to day liquidity in the money markets as the demand for money changed and act as a lender of last resort in times of crisis.

Another option that is currently widely discussed in the media is for an independent Scotland to issue its own currency, through say a newly established monetary authority, but peg the currency to sterling on a parity (one to one) basis. This would in all likelihood have to be set as a currency board arrangement along the lines of the Hong Kong currency board. However such a mechanism is set up it is a form of fixed exchange rate regime. To run and defend a fixed exchange rate regime against speculation you need to have huge foreign exchange reserves.

For example, at the time of writing Hong Kong has 312200 USD Million of reserves and on a population based measure Scotland would have 8468 USD million which would be small beer if the parity level was not appropriate, which it would not be given our arguments above (note that sterling at the moment is a flexible exchange rate system which does not require massive foreign exchange reserves to manage)5. Of course fixing an exchange rate, as in the sterling zone arrangement, means that although you can have a central bank you cannot have an independent monetary policy (since monetary policy is run to defend the currency). So statements made by politicians along the lines of ‘here’s tae us wha’s like us’ may resonate well at home but mean nothing, even in translation, to international investors.

Joining the euro-zone would raise the same type off issues relating to trading competitiveness that would arise in a sterling currency union. Furthermore, an independent Scotland would be unlikely to meet the relevant criteria for membership, which are likely to become even stricter in the future. Furthermore, a 2 year period of shadowing the euro would mean such a move would at best be a long term aspiration of an independent Scotland.

This then leaves a separate currency as the only viable economic option for an independent Scotland. This would involve creating a central bank along with the associated regulatory framework. This would clearly take time as highly skilled staff members would need to be recruited and in place to staff the bank. Clearly this would be achievable although most likely over a longer time horizon than the transition proposed by the Scottish Government. As we have noted, an independent Scotland is unlikely to have sufficient foreign exchange rates to run a fixed exchange rate regime and so the exchange rate of an independent would, at least initially, have to be free floating; that is, determined by the interaction of the demand and supply for its currency on international markets.

One key feature of floating exchange rates is that they tend to be volatile (see MacDonald (2007)) and such volatility can impart exchange rate risk into the economic environment with the consequent knock on effects this has for trade and investment. However, as Milton Friedman noted in his classic article on floating exchange rates6, such rates tend to be volatile if governments pursue macroeconomic policies that are non credible and are themselves unstable.

An independent Scottish Government that has no track record in raising the revenues to pay for its expenditure would need in the transition period to run fiscal surpluses to create the required credibility in international capital markets7. In other words, the government of an independent Scotland would need to run an austerity programme with all of the implications this would have for taxation and public spending. However, once the Scottish Government’s reputational credibility had been established in international markets it would then be able to design an optimal exchange rate policy – one designed for both its oil and non-oil sectors – such as the kind of managed float used by Norway. But how long would the transition be and how bearable would it be to residents of Scotland?

The purpose of this short essay has been to argue that the economics of currency arrangements clearly indicates that it is financial markets that will ultimately determine the currency regime of an independent Scotland. It is therefore simply not an option for a Scottish government to dictate to others what their own preferred currency regime is, especially when there imposition would create huge disruption elsewhere in the UK and in Scotland. There is only one currency option that the economics of currencies suggests will be credible to financial markets and that is an independent currency. That, however, may come at considerable cost and disruption to Scotland in any transition period. But then it would be remiss of an economist not to point out that just as in life so to in currency matters: there is no such thing as a free lunch!

Ronald MacDonald

Adam Smith Professor of Political Economy

University of Glasgow

 

[1] See: Fiscal Commission Working Group – First Report – Macroeconomic Framework, 2013, The Scottish Government.

[2] See: Ronald Macdonald, Exchange Rate Economics, 2007, Routledge.

[3] For the effect of hydrocarbon exports on exchange rates and non-oil trade see: Ronald MacDonald and Abdulrazak Al Faris, Currency Unions and Exchange Rate Issues, 2010, Edward Elgar

[4] See Ronald MacDonald, Floating Exchange Rates: Theories and Evidence, 1988, Allen and Unwin.

[5] On the appropriateness of choosing the correct exchange rate peg see: Peter Clark and Ronald MacDonald, ‘Exchange rates and economic fundamentals: A methodological comparison of BEER’s and FEER’s’, 1998, International Monetary Fund.

[6] Milton Friedman, The Case for Flexible Exchange Rates, 1953, Chicago University Press.

[7] The importance of credibility in the design of an exchange rate/ monetary regime is discussed in some detail in: Michael D Bordo and Ronald MacDonald Credibility and the International Monetary Regime, 2012, Cambridge University Press.

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