When I was in London recently, I was repeatedly assailed with the idea that the…
This is Part 2 in my two-part series analysing the 354-page report from the Scottish Growth Commission – Scotland – the new case for optimism: A strategy for inter-generational economic renaissance (released May 25, 2018). In Part 1, I considered their approach to fiscal rules and concluded, that in replicating the rules that the European Commission oversees as part of the Stability and Growth Pact, the newly independent Scotland would be biasing its policy settings towards austerity and unable to counter a major negative shock without incurring elevated levels of unemployment and poverty. In Part 2, I focus specifically on the currency issue. The Growth Commission recommends that Scotland retain the British pound, thereby surrendering its independence. Moreover, while it is part of the United Kingdom, the British policy settings have to consider the situation in Scotland. Once it leaves, it will still be bound by British fiscal and monetary settings but those settings would be designed to suit the remaining British nations. So if the British government continues with its austerity obsession, Scotland would be forced to endure that end. Hardly, the basis for an independent nation with progressive aspirations.
The currency issue
The Growth Commission only considers it a “possibility that the Scottish Government may choose to establish a separate currency at some future date” rather than an essential aspect of being an independent sovereign nation.
Their justification for maintaining the UK currency is based on the conclusions of the 2013 Fiscal Commission:
The rationale was that sterling was the currency that fits the optimal currency area criteria best between Scotland and the rest of the UK.
An Optimal Currency Area exists if the geographic area bound by the OCA is best served by one currency. What best means is another matter.
The crucial point is that OCA theory defines strict conditions under which several independent countries will be better off by forming a monetary union (sharing a currency).
The absence of one or more of those requirements voids the whole exercise and will deliver sup-optimal outcomes. One cannot have a ‘bit’ of or an ‘approximation’ of an optimal currency area.
The OCA concept emerged from the work of three economists, Canadians Robert Mundell (1961) and Ronald McKinnon (1963) and American Peter Kenen (1969).
The relevant references are:
Kenen, P.B. (1969) ‘The Optimum Currency Area: An Eclectic View’, in Mundell, R.A. and Swoboda, A.K. (eds.) Monetary Problems of the International Economy, Chicago, University of Chicago Press, 41-60.
Kenen, P. (1994) ‘Exchange Rates and the Monetary System: Selected Essays of Peter B. Kenen’, Aldershot, Edward Elgar.
McKinnon, R.I. (1963) ‘Optimum Currency Areas’, American Economic Review, 53, 717-725.
Mundell, R.A. (1961) ‘A Theory of Optimum Currency Areas’, American Economic Review, 51, 657-665.
In its original formulation, Robert Mundell defined three conditions, which if in existence, would justify the formation of a monetary union as an Optimal Currency Area:
- The countries economic cycles move together and they face common consequences if hit by a negative shock (for example, a decline in private spending) – thus there should be no major asymmetric shocks which would affect one region/state significantly more than another. A consequence of this condition would be, for example, that unemployment rates should be similar across the countries in the union;
- There should be a high degree of labor mobility and/or wage flexibility within the group of countries such that if unemployment rose in one country, workers could quickly move elsewhere to find jobs. Mobility also refers to a lack of cultural and institutional barriers (for example, a pension entitlement in one nation would be transferable to another without cost);
- There is a common risk-sharing structure so that fiscal policy can transfer resources from better performing to poorly performing countries without constraints.
Crucially, for Mundell, “optimality relates to the state of the labor market” such that if “the currency regime within a given area causes unemployment somewhere in that area (or accepts some other portion of that same area to accept inflation as the antidote to unemployment), it is not optimal” (Kenen, 1994: 41).
McKinnon (1963: 717) considered optimality to mean a “single currency area within which monetary-fiscal policy and flexible external exchange rates can be used to give give the best resolution of three … objectives: (1) the maintenance of full employment; (2) the maintenance of balanced international payments; (3) the maintenance of a stable internal price level …”
Consider the components – both monetary and fiscal policy are important and the goal of full employment is not subjugated to price stability ambitions. Policy has to achieve the ‘best resolution’ of all the goals and not pursue one (price stability) by deliberately undermining another (by creating unemployment).
If a collection of nations cannot combine and use economic policy in this way then they do not belong together.
This is crucial for it requires that the regions or countries that enter a OCA arrangement with a single currency also share the same fiscal policy setting mechanisms, which are then used to transfer net spending capacity between the regions or countries in relation to their internal situations.
So if, for example, Scotland was to experience a negative private spending shock and unemployment rose above that elsewhere in the UK, then the ‘federal’ fiscal authority that administers fiscal policy for Britain and Scotland (as Member States) would increase net public spending in Scotland (and perhaps reduce it elsewhere). Adjustments in taxes could also be made in this asymmetric manner to increase non-government spending in Scotland.
If you think about that requirement then the idea of a single currency being shared between the newly independent Scotland and the remaining British nations is ludicrous.
Either the remaining nations would have to create a new fiscal capacity that is shared with Scotland or the newly independent Scotland would have to rely on British fiscal initiatives.
Neither is consistent with creating an independent nation.
Not only would Scottish monetary policy be set by the Bank of England but it would also have no independent fiscal policy.
In what sense, then, would the nation be sovereign and independent?
In 2014, when this issue was first broached, the British Government categorically rejected any notion of a currency union with Scotland, a fact acknowledged by the Growth Commission’s Report:
While it remains a feasible outcome for both Scotland and the rest of the UK, it would create too much economic uncertainty for the formal currency union policy to be part of the proposition in a future referendum, since it is possible that a future UK Government could take a similar obstructive position. The blocking itself created unnecessary confusion and uncertainty for individuals, businesses and investors.
So why would the Growth Commission still advocate a common currency on the basis of the OCA justification when clearly the most essential condition for that currency arrangement to be effective is acknowledged to be absent or unworkable?
Their response was symptomatic of the whole assertive nature of the Report:
The case for a sterling currency union remains strong since Scotland and the rest of the UK remain a close approximation to an optimal currency area and would continue to be so for some years after Scotland became independent. It would also provide continuity and stability.
Sorry. A close approximation is a nothing concept. The OCA literature is clear – a geographic area either satisfies the required conditions or it does not.
If it does not, the ‘optimal’ characteristics are no longer present.
Being near enough is nowhere.
And, the fact is that the lack of any ‘federal’ fiscal capacity is hardly redolent of a ‘close approximation’ anyway.
Which means Scotland would be in the position of sharing a currency with a very strong neighbour who has no need nor responsibility to make fiscal and monetary policy decisions that benefit the smaller nation.
The Growth Commission claims that this would just “mean that Scotland’s government would cede effective sovereignty over monetary policy”.
It does mean that, but it means much more than that.
It also means that effective fiscal sovereignty is also ceded.
Which is why Growth Commission moves on to recommend the unworkable fiscal rules that I considered in Part 1.
In trying to justify their recommendation of the retention of sterling as the currency of a newly independent Scotland, the Growth Commission also produces some extraordinary and flawed arguments.
First, we read that “Unlike households, when states borrow on international markets they tend to borrow in widely used global currencies such as US dollars, euros, sterling or yen”.
Which states do that?
The Australian government doesn’t borrow in foreign currencies. The Japanese government doesn’t. The US government doesn’t. And, the British government does not borrow in foreign currencies.
How many more would you like me to list?
So where is the evidence to support the Growth Commission’s claims?
In the main, only nations subjugated to IMF-type programs or otherwise in desperate straits borrow in foreign currencies. That is, in addition to the Eurozone Member States, and we have seen how much trouble that has caused.
Second, the Growth Commission writes that:
In today’s world, no one ‘owns’ a particular currency and the more widely acceptable the currency the less the issuer is able to restrict its use. What happens with respect to currency the day before an independence vote would happen the day after and continue to happen until such time as the elected Scottish Government seeks to do something differently.
This is patently false and diverting the argument into some irrelevant notion of who ‘owns’ a currency is deceptive.
In effect, the Growth Commission statement is meant to engender the conclusion that there is no particular status as the currency issuer.
But that assessment is in denial of the capacities that a currency-issuer has under a fiat monetary system, which would be absent if Scotland chose to retain the British pound as its on-going currency.
The capacity of the issuing government goes well beyond “setting interest rates”, which is all the Growth Commission is prepared to concede.
Consider these essential characteristics for a democratically independent nation:
1. In a fiat monetary system, the currency-issuer can purchase whatever is for sale in that currency including all idle labour.
2. Such a sovereign government is never revenue constrained because it is the monopoly issuer of the currency.
3. Such a government has no need to borrow from the non-government sector to cover spending beyond taxation revenue. A progressive government issuing its own fiat currency would of course not issue any debt to match its deficits.
4. If such a government voluntarily chooses to match its net deficit spending with debt-issuance it is always able to control the yields on that debt-issuance including being able to borrow at zero (and negative rates) if it so desires.
5. And, moreover, such a government would never need to borrow in a foreign currency.
A newly independent Scottish government would lack all of those capacities.
Its spending capacity and thus command over real resource would be limited by its taxation revenue and the forced debt-issuance in a foreign currency.
Its capacity to borrow would be determined by private bond markets and it would have to accept the yields demanded from those private markets.
It would never be able to guarantee payment on its liabilities because they would be denominated in a currency that it uses rather than issues.
It would never be able to guarantee stability in its banking system including protecting deposits.
The viability of non-government sector debt would be dependent on the capacity of the nation to generate exports and earn pounds.
Taken together it is difficult to argue that the newly independent government would be able to focus on its socio-economic-ecological objectives when its financial capacity to command the necessary resources lay in the hands of the non-government sector (especially private bond markets and banks), whose goals would not likely be aligned with the welfare of all Scottish people.
And it would have to accept interest rate structures that the Bank of England determined were suitable for the UK rather than specifically suited to Scotland.
This is the same problem that the Southern European states faced in the build-up to the GFC. They were forced as Member States of the Eurozone to accept ECB interest rates that were specifically tailored for Germany as it laboured in the early 2000s with recession and the impacts of absorbing East Germany.
Third, the Growth Commission claims that:
As a result of the development of global capital markets and electronic transfer it is now virtually impracticable for an open economy to impose effective capital controls in the medium or long term.
Tell that to Malaysia in 1997 and Iceland in 2009. Both small economies used capital controls to great effect to restore or maintain currency stability in the face of major financial crises.
Both nations demonstrated categorically that the nation state can use its legislative capacity to regulate capital flows in and out of its sovereign borders.
To claim otherwise is just to rehearse the neoliberal mantra that eschews capital controls. Not even the IMF runs that banal lie anymore.
The neoliberals know that if they can persuade the nation state to allow capital mobility, speculative profits will be higher, irrespective of the impact of that mobility (in or out) on the well-being of the citizens in each state.
Fourth, the Growth Commission engages in scaremongering – of the ‘state might rip your assets off you’ type – by noting (emphasising strongly) that private assets and liabilities are private and not the property of the Scottish government.
They warn against redenomination of existing financial assets or liabilities upon the introduction of a new currency.
This is just a ruse.
We know that introducing a new currency does not require the redenomination of existing financial assets or liabilities held by the non-government sector.
For the new currency to be effective, the only initial requirement is that the government legislated that the new currency must be used to extinguish any tax or other contractual obligations the non-government sector has to the state.
In my view, the state would be wise to provide incentives to private citizens to convert what would become their foreign currency holdings into the new currency. But it is not necessary nor an urgency.
The Growth Commission tries to claim that there would be recourse to the European law and IMF rules should “a future Scottish Government … [try] … to alter existing contracts”.
But what is undoubted – and I explain this at length in my 2015 book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – is that international law recognises the principle of Lex Monetae or ‘The Law of the Money’ as a well-established legal principle, backed up by a swathe of case law across many jurisdictions.
This principle states broadly that the government of the day determines what the legal currency is for transactions and contractual obligations within its national borders.
Within a nation’s own legal system, under the principle of Lex Monetae, a newly independent Scottish government could determine that all contractual liabilities currently specified in pounds or whatever would now be valued in the new currency.
I explained that in this blog post (which was part of the draft of that book) – Options for Europe – Part 79 (May 6, 2014).
So again, the Growth Commission is simply making assertions that are not necessarily consistent with international law.
The Growth Commission is obsessed with the primacy of monetary policy and considers the currency issue within that frame – so a separate currency is unnecessary as long as “the economic cycle in Scotland is … [well correlated with] … the rest of the UK.
This is consistent with the mainstream New Keynesian assertion that fiscal policy doesn’t matter in the long run and that monetary policy should focus on price stability (after which optimal growth rates will follow).
It is not an assertion that stands up to any evidential scrutiny.
Prior to the GFC, the mainstream macroeconomics had deemed the ‘business cycle to be dead’ and that ‘fight inflation-first’ monetary policy had delivered unprecedented stability – the so-called Great Moderation.
They claimed that role of fiscal policy was to just passively support the main counterstabilisation tool – monetary policy. This was in contradistinction to the previous Keynesian orthodoxy where fiscal policy was seen to be a powerful and flexible policy tool to manage the non-government spending and saving cycle.
But being dispatched to a secondary status, the mainstream set about designing fiscal rules that worked to ensure there was a bias towards surpluses and fiscal drag.
Please read my blog post – The Great Moderation myth (January 24, 2010) – for more discussion on this point.
The GFC exploded all those myths and taught us that:
1. Monetary policy is largely ineffective as a counter-stabilising stimulatory tool. It is indirect and no matter how large bank reserves become (say, as a result of Quantitative Easing), banks will not increase lending if there are no credit worthy borrowers queuing up for loans.
2. Fiscal policy is extremely effective at redressing short-falls in private spending and saved millions of jobs when it was expanded. In many nations, government stimulus was withdrawn too early and too quickly and the result was continued stagnation in many nations.
3. The only nations that encountered trouble with their government bond markets were those that do not issue their own currency. This is because the bond investors knew that the assets issued by currency-issuing government were risk free (unless some extraordinary political motive triggered default) and, Eurozone Member State debt, say, carried credit risk because the governments were using a foreign currency.
So one cannot fully appreciate how restricted a nation would be using a foreign currency unless we consider fiscal policy to be the primary (effective) counter-stabilisation policy tool.
For example, the newly independent Scottish government would not be able to run an independent full employment policy with large-scale public sector job creation if the UK government was running an austerity bias and the Scottish government was forced to target fiscal balance due to lack of tax revenue or borrowing capacity in the foreign currency.
Take another example.
If the remaining British citizens decided to increase their overall net saving (meaning that the private domestic sector aimed to spend less than its income), then, given its external deficit, unless the British government increased its fiscal deficit to ‘fund’ the new saving aspirations of the private domestic sector, the British economy would go into recession and its fiscal deficit would rise anyway via the automatic stabilisers.
The situation in Scotland would be dire and its government would be largely defenceless.
A major British recession would impact directly on Scotland in three important ways: (a) its tax revenue in pounds would slump; (b) its ability to borrow in pounds to fund a rising deficit would be compromised; and (c) its export revenue would decline.
From this state, the application of the fiscal rules proposed by the Growth Commission would force the Scottish government to cut its spending for fear of running short of pounds.
As a consequence its recession would be magnified and the Scottish government could do little to avoid the damage.
With its own currency, the Scottish government would always be able to implement counter-cyclical fiscal policy to offset any recessionary forces coming from the south via its close trade connection with Britain.
Take another example.
Imagine the British trade deficit increases and the pound starts to depreciate. Given that Scotland would be using the British currency, its price level would be dependent, in part, on British exchange rate movements.
So Scotland would be forced to import inflation via the British pound depreciation despite nothing fundamentally changing in terms of its own unit costs. This is purely because it chose to forego the benefits of its own currency.
As we will see these examples would make a mockery of the ‘Fiscal Tests’ the Growth Commission proposes as the hurdle that Scotland should pass if it wanted to introduce its own currency.
Further, Scotland would have to take UK interest rates as given (so no room to create incentives or disincentives for financial flows) and nominal movements in the pound would drive Scotland’s real exchange rate, which is the accepted indicator of international competitiveness.
There are situations where importing such dynamics from Britain would be favourable but there are also many situations where they would destabilise the Scottish economy.
You could imagine a situation, for example, where productivity growth in the British economy was accompanied by favourable capital inflow which was pushing sterling up in foreign exchange markets.
There was no coincident productivity growth in Scotland.
As a result, Scotland’s real exchange rate would rise and its international competitiveness would decline, while the productivity growth in Britain would offset the loss of competitiveness via the nominal exchange rate increase.
Further, the interest rate environment is clearly determined by what the Bank of England deemed to be suitable for advancing its agenda, which certainly would not include any consideration of the impact of different interest rate choices on Scotland.
Why does this matter?
If the economic cycles of the two nations start moving in different directions, then being forced to adopt interest rates that are designed for the current state of the UK economy will result in ‘pro-cyclical’ policies being implemented in Scotland.
So, for example, if the UK is facing an inflationary surge while Scotland was in recession and the Bank of England starts hiking interest rates, Scotland would have to endure higher interest rates even though the responsible direction for Scottish policy is to relax monetary policy.
Of course, this may not matter that much given that monetary policy is not a very effective policy tool for controlling aggregate spending patterns anyway.
But usually, fiscal policy is forced into passively supporting the monetary policy stance. And then the pro-cyclicality of the policy positions becomes deeply problematic.
Would the Scottish currency dive?
There is a huge difference between introducing a new currency altogether, which has no volume in foreign exchange markets and breaking a peg of an existing currency or abandoning the use of a foreign currency which is already being bought and sold in the international currency markets.
In the case of Scotland, as long as the government could enforce local tax obligations in the new currency, there would be a demand for that currency.
Initially, the supply of the currency would be restricted by the government spending (given that this is the way the currency would enter the monetary system).
So massive excess supplies of the currency are not likely immediately, and that is the requirement for depreciation in a floating exchange rate system.
Eventually, as the currency volumes increased in the foreign exchange markets, buying and selling on international markets would determine its value.
There is no reason to assert that the new currency would then collapse.
The currency tests
When might a newly independent Scottish government be in a position to introduce its own currency?
The Growth Commission produced a list of hurdles (“tests”) which would be used to determine whether Scotland was ‘ready’ for its own separate currency at some future date.
It reads like an IMF Bible and includes adherence to unworkable fiscal rules, central bank credibility, sufficient foreign reserves, and relevance of trade and investment patterns.
The problem is that the requirements are so ideologically-biased that Scotland might never pass these neoliberal hurdles.
As we saw in Part 1:
First, who says that adherence to deficits of 3 per cent of GDP over a cycle is responsible, if over that cycle the nation maintains an external deficit and the private domestic sector desire to save overall?
Would we judge a nation unsuited to having its own currency if it encountered a deep recession and its fiscal deficit rose to much higher proportions of GDP?
In that case, many nations including Britain itself would be deemed unqualified to have its own currency.
The point is that there is no valid economic argument to justify the claim that a fiscal balance should be at any particular level over any particular time period.
Responsible fiscal practice indicates that the fiscal balance should be whatever it takes to support the non-government spending and saving decisions and ensure there is sufficient spending in the economy to achieve full employment.
If that requires continuous fiscal deficits of 10 per cent of GDP then so be it. It is required permanent surpluses of 10 per cent of GDP then so be it.
There is no meaning in the statement that deficits are bad and larger deficits are worse and vice-versa.
It all depends on context.
For a nation with a very large external surplus (say a large energy exporter) that can support strong private domestic saving, high levels of employment and first-class provision of public services, then a fiscal surplus might be appropriate.
But most nations will have external deficits of varying magnitudes and then if the non-government domestic sector desires to save overal, the public balance has to be in deficit, or else a recession will ensue.
The only way around that is if the private domestic sector goes on a debt binge and maintains spending growth in that way. But that growth strategy is ephemeral, as we have seen with the GFC, and eventually the private sector stops the credit glut and tries to restore its balance sheet – at that point, fiscal drag kills growth.
So no standalone rule like a ‘balanced budget over a cycle’ makes any sense at all. It all depends on the spending and saving decisions of the non-governent sector and they can change.
Second, why is an adherence to deficits of 3 per cent of GDP over the cycle responsible if mass unemployment is at elevated levels over that cycle?
Third, what does it mean to say that “the Scottish Central Bank and Government framework …[have] … established sufficient international and market credibility evidenced by the price and the stability of the price of its debt issuance” when fluctuations in the British economy can seriously undermine the newly independent nation’s capacity to raise pounds in international markets if it continues to use the British pound?
Refer back to the examples above.
Fourth, how would we decide whether “a separate currency meet the on-going needs of Scottish residents and businesses for stability and continuity of their financial arrangements and command wide support”.
If we imposed all tax and other obligations to the state in the new currency then it would immediately “meet the on-going needs” because Scottish residents and businesses would have to acquire the currency.
Further, if the newly independent Scottish governments used its newly acquired currency-issuing capacity to bring idle resources into productive use (for example, via a national job creation scheme – Job Guarantee) then it would be hard to say that that the on-going needs of Scottish residents were not being met.
Fifth, why would it be necessary for “Scotland … [to] … sufficient reserves to allow currency management” if it floats its currency?
It would be madness for the new nation to peg its new currency to the pound or the euro or any currency and then try to manage that peg.
Like all nations that issue their own currencies, the newly independent Scotland would be advised to float its currency on international currency markets.
The float will settle at the level that matches its relative productivity and domestic costs.
It frees the central bank from having to compromise domestic policy to defend a peg and also means it does not have to accumulate foreign reserves.
The fear that a float would destroy the currency is neoliberal scaremongering.
In a situation of stress, the Scottish government could deploy capital controls to advantage though.
The Growth Commission recommendations are consistent with the mainstream neoliberal consensus of these issues. They are not conducive to the creation of a vibrant, progressive nation.
Scotland would be exposed to British government decisions yet have no political stake in those decisions.
If the Scottish people determined that they wanted to retain the use of the pound as the national currency, then Scotland would be better off staying within Britain and exerting internal political pressure to improve its situation.
That is an inferior outcome to establishing an independent nation with its own currency.
However, it would be much better than declaring independence but then continuing to use the pound and accept whatever monetary and fiscal policies the British government decided.
Yes, in that situation, the Scottish government (as now) could have some fiscal initiatives. But, ultimately, when the crunch came, it would face a shortage of pounds and austerity would be required.
Overall, an independent nation has to have its own currency and monetary policy. Otherwise, the independence is a sham.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.