Currency union: some arguments

Bella Caledonia published a shortish piece of mine on the political economy of a currency union with Scotland, post-independence. I argued that disputes here reflected both the overwhelming strength of finance inside the UK economy, and the hidden weakness of its current account position. This provoked some debate; my reply is as below.

Thanks for the various comments above. I wanted to pick up on what seem to be three bones of contention:

1. “Scottish banks”. You can argue that this is an unfair designation – Charles Goodhart, ex-MPC member, has elsewhere suggested that Scottish banks are “in effect” headquartered abroad. Like everything else, however, this is a political issue, rather than one based on logic or justice – as far as the Treasury is (now) concerned, much of RBS and parts of Lloyds Bank Group are very definitely Scottish banks, and therefore a theoretical liability for Scotland (I link to the report above, but for reference it’s here.) You can argue that this is unfair – that the worst excesses of RBS were committed in London under a UK-wide banking regime, and certainly there is a case can be made (as I suggest in the piece) that an independent Scotland cannot reasonably be held responsible for decisions taken under an authority it no longer accepts.

But that case has to be made. For now, the fact is that the position of the UK government is that these are Scottish banks and that, in the event of a crisis, they would *not* bail them out, following what it cites as international precedent – however unreasonable this position may be when considering the banks’ operations. Were (under this hypothetical scenario) an independent Scottish government refuse to accept responsibility for these banks and parts of banks, they would simply fail; the threat from HM Government is that Scotland would therefore be an economic basket case, if it cannot afford to bail its banks out. Furthermore, whilst HMG was able eventually to call on what amounted to significant overseas contributions to its own bailouts in 2008, these relied on the globally systemic importance of the City of London, significant commitments from the UK government to also making a contribution of funds, and the UK’s well-developed relationships with other global powers. An independent Scotland would not have the first, find the second exceptionally difficult, and as for third – I would be astonished if some efforts are not being put in by the Treasury and the Foreign Office right now to ensure future support will not be forthcoming from the rest of the world. Scottish banks would, in short, be allowed to fail alone – that is the Treasury’s threat.

Now, as Iceland demonstrates (and as, again, I refer to), this inability to bail need not be such a bad thing for a small economy with its own currency. The UK government’s bluff can and probably should be called. It would be better, however, to manage that process of shrinking and derisking, aiming for something along the lines my colleague Tony argues for here. (It’s worth noting in passing that a genuine localisation of banks would be unlikely to seriously affect useful employment in the sector, with local branches protected and expanded, although no doubt a fair few at the top of the tree would be expected to find gainful employment elsewhere).

2. FlimFlamMan raises some direct issues regarding the macroeconomic balance – not just the balance in the private sector (which is what I largely cover above), but that of the whole economy, including the public sector. I think it is a sensible idea to bring the public sector in but I don’t, in practice, attribute the casual weight he does to the issue. UK public sector debts are certainly substantial, but pale beside the liabilities of its private sector, and particularly those held by its financial institutions. Similarly, the current public sector deficit is significant, but neither this nor the total public debt warrant the excessive concentration that the Coalition government, amongst others, have been paying on them. The dirty secret of the UK macroeconomy is its current account deficit, chronic, now, for decades, and its is around this persistent imbalance that we have to understand how the economy is structured – not the relatively less important issue of the public sector imbalance, however much attention is generally paid to it. The limits to what the UK can and can’t do, economically, are established by its internal balance – not by its public sector position, which (as FlimFlam suggests) has been able to move flexibly to cope with serious shocks like 2008 (however socially appalling the consequences).

This is a constraint that won’t apply to an independent Scotland with healthy oil revenues, but will become much the worse for the UK in the event of Scottish independence and the loss of those revenues: it has not been a binding constraint for the last decade or more because of the ability of the UK to mobilise external funding. It is not clear to me that this ability will stretch to cover what will be, other things being equal, a very serious persistent current account deficit, post-independence.

I’m not so sure about the issue he raises of “hard constraints” inside a formal currency union, however. These may be written in to a treaty, but they need not apply in practice. Recent experience from the eurozone suggests that whatever efforts are made to constrain independent fiscal authorities inside a currency union, these can (and will) be broken in practice – France and indeed Germany were the worst offenders in this respect, prior to the crash. It was the market perception that the euro was a stable currency that counted far more than the formal constraints in the Maastricht Treaty. Once this perception vanished, as in autumn 2009, crisis erupted. For Scotland, I don’t believe that these constraints would ever be assumed to be binding by financial markets, and they would therefore never apply: a currency union would already be subject to the assumption that it cannot last.

For an informal union (ie Scotland carries on using the pound, whatever Whitehall and the City want), the constraints are not even notionally binding, so far as can be told. The possible sanctions here are for the Bank of England and HMG to apply restrictions on money and credit creation in Scotland, via the common currency, but at the risk of also damaging activity in the remainder UK – in other words, they well appear to be just not credible threats. (Mind you, note in this regard former Bank of England governor Eddie George’s claim that lost jobs in the north are “an acceptable price to pay for low inflation in the South”.)

3. On the currency appreciation expected, post-independence: other things being equal you would expect a new Scottish currency to appreciate in value, given the current account position with oil exports. This would squeeze exporters (although would probably make life seem quite pleasant for those in the domestic sector), as is well-known. However, a sudden (anticipated) currency appreciation is generally much easier to deal with that a depreciation, for instance in the sterilisation of the currency and the purchasing of foreign reserves, and could even (as I suggest) be treated as useful for an initial burst of capital investment. (The effects can further be mititgated, more directly,  via direct taxes and subsidies – which could potentially be used alongside wider efforts to rebalance and reindustrialise the economy.)

That said, although it is not necessarily the case that the same effect operates from currency appreciation as depreciation, recent experience of the pound falling in value since 2008 is that it has remarkably little impact on the UK current account position. This points to structural factors that would limit the impact of currency price changes on the domestic economy, in either case – that UK exporters have got used to an overvalued currency. It is arguable that the response of Scottish exports to an increase in its currency would also be more limited than might be supposed.