Scotland, Quebec, and currency union

I don't have anything to add to this, except to express my relief that the Permanent Secretary to H M Treasury (UK) said what needed to be said, especially given the dreadful experience of the Eurozone currency union (which is not over yet in my opinion), and that Canadians should read it. (H/T David Smith).

"Currency unions between sovereign states are fraught with difficulty. They
require extraordinary commitment, and a genuine desire to see closer union
between the peoples involved. As the Treasury paper points out, the great
thing about the sterling union between Scotland, Wales, Northern Ireland and
England is that it has all the necessary ingredients: political union, economic
integration and consent. What worries me about the Scottish Government’s
putative currency union is that it would take place against the background of a
weakening union between the two countries, running counter to the direction
of travel in the eurozone.

I would advise strongly against a currency union as currently advocated, if
Scotland were to vote for independence. Why?

First, the Scottish Government is still leaving the option open of moving to a
different currency option in the longer term. Successful currency unions are
based on the near universal belief that they are irreversible. Imagine what
would have happened to Greece two years ago if they had said they were
contemplating reverting to the Drachma.

Secondly, Scotland’s banking sector is far too big in relation to its national
income, which means that there is a very real risk that the continuing UK
would end up bearing most of the liquidity and solvency risk which it creates.

Thirdly, there is the problem of asymmetry. The continuing UK would be at
risk of providing taxpayer support to the Scottish financial sector and
sovereign. An independent Scottish state would not face the same risk as
it is inconceivable that a small economy could bail-out an economy nearly ten
times its size. This asymmetry could only cause continuing UK problems unless

Scotland is prepared to cede substantially more sovereignty on monetary and
fiscal matters than any advocates of independence are currently
contemplating.

Finally, Treasury analysis suggests that fiscal policy in Scotland and the rest of
UK would become increasingly misaligned in the medium term. Of course, if
the Scottish Government had demonstrated a strong commitment to a
rigorous fiscal policy in recent months, it might be possible to discount this.

But recent spending and tax commitments by the Scottish Government point
in the opposite direction, as do their persistently optimistic projections of
North Sea revenues, which are at odds not just with the Treasury but with the
Office of Budget Responsibility and other credible independent forecasters.

There is a substantive point here. If the dashing of Scottish expectations were
perpetually blamed on continuing UK intransigence within the currency union,
relations between the nations of these islands would deteriorate, putting
intolerable pressure on the currency union.

If you follow Treasury advice and this week rule out a currency union in the
event of Scottish independence, you can expect the Scottish Government to
threaten not to take on its share of the United Kingdom’s debt. I do not believe
this is a credible threat. First, the sooner an independent Scotland established
economic credibility, the better it would be for its economic performance. An
extensive wrangle about its share of the debt would increase uncertainty and
hence its funding costs. Secondly, the debt is one of a number of issues which
would have to be settled post independence, where the new Scottish state would
require the cooperation of the international community including the continuing UK.

As for the impact of the threat, much will depend on the markets’ assessment
of the probability of a pro independence vote and the likelihood of the Scottish
Government seeing the threat through. In the short run, any uptick in gilt*
yields is likely to be small. And in the worst case scenario, it is more than likely
that the increase in funding costs, which the continuing UK would face, would be
smaller than that which would result from an ill thought out currency union
with Scotland.

And so to sum up, I would advise you against entering into a currency union
with an independent Scotland. There is no evidence that adequate proposals
or policy changes to enable the formation of a currency union could be
devised, agreed and implemented by both governments in the foreseeable
future."

SIR NICHOLAS MACPHERSON
Permanent Secretary to H M Treasury

* "gilt yields" are interest rates on government bonds.

Comments

[Steve Ambler]

Jim Flaherty (and Nicolas Marceau) please read.

[Squarely Rooted]

The most bizarre thing about Scottish independence to me is the currency issue. I suppose they are trapped; by wanting to remain in the EU, they would have to accept the Euro or strike some sort of separate (and unlikely) deal. The way to avoid that is to remain on the pound. But Scotland would be far be best off with its own currency (the Scot? the Kilt? the Blancmange?) rather than a currency union with anyone, yet the whole debate is about which currency union it ought to be in.

[W. Peden]

Squarely Rooted,

There would be costs to setting up a new currency as well. And the existence of any sort of costs goes against the "everything will be great after 2016" narrative of the Aye campaign.

The point that Nicholas Macpherson makes re: currency union in the context of increasing union and currency union in the context of separation is an interesting one that I hadn't considered before.

In general, I think that independence is a bad idea, poorly sold, and we'll stay in the UK in spite of a perfect storm in the nationalists' favour.

[Wonks Anonymous]

How does a "currency union" differ from "dollarization"? Nobody seems to care about political union & economic integration (or the U.S' consent) in the latter case. On the other hand, dollarization is generally resorted to by countries that have decided they're so screwed up they can't be trusted to manage their own currency.

[Nick Rowe]

Steve: yep.

Squarely: I think (not sure) that an independent Scotland, if it wanted to stay in (legally, join) the EU, would be required to adopt the Euro. It would need an exemption from EU rules if it wanted to have a new currency, and I don't see that happening. The pound sterling was grandfathered (at least, for the time being). Currency union with the rest of the UK (which the UK government has said it will oppose); currency union with the Eurozone (which the EU will probably insist on, if it leaves sterling); or leave the EU and set up its own currency (bring back the old Scottish Pound). A very ugly choice. If I were an SNP supporter, I think I would choose to leave the EU. (I left Scotland 35 years ago, so don't think I can still vote, but wouldn't anyway, given I have no intention of living there.)

[Nick Rowe]

Wonks: having a lender of last resort, having direct access to the clearing house. (But the lender of last resort thing hasn't worked so well in the Eurozone).

[W. Peden]

Nick Rowe,

The Swedish precedent would suggest that provided you pretend to want to join the euro someday, it's ok, even if you take no particular steps towards joining the euro. However, it's a legal grey area, brought on (as usual) by the fact the EU law is unworkable, and in the grand tradition of laws that cannot be consistently implemented and thus almost necessitate corruption, which is what Swedish macroeconomic policy basically is, as far as I can see.

There is the option of a Hong Kong-style currency union with the pound, but I've seen very little talk about this idea, suggesting that it has a lot of flaws I haven't realised yet.

[Min]

Nick Rowe: "But the lender of last resort thing hasn't worked so well in the Eurozone."

The Eurozone problem is complicated, but I have followed it a little. I thought that the ECB was not originally set up to be a lender of last resort, and that the resulting vulnerability of the Eurozone to a depression was one reason that Thatcher kept the UK out. Also that the ECB has only reluctantly been drawn into acting to some extent as a lender of last resort. No?

[Nick Rowe]

W Peden: didn't the Swedish Krona get grandfathered, like the UK pound? Google tells me Sweden joined the EU in 1995, maybe that was too late for a grandfather clause?

I don't know much about the Hong Kong currency board, and how it handles the lender of last resort problem. The Argentine currency board of the early 1990's was a salutary lesson though.

Min: I think that's my reading too.

[Donald A. Coffin]

Is there any recent example of a country gaining independence and setting up its own currency/monetary system? The last batch of those I know of involved acts of independence by *colonies,* or the break-up of the Soviet Union, not the secession of a fairly well-off region or a very well-off country. I ask, because relevant comparative cases seem not to exist, unless I have missed something. (The break-up of the USSR may be the most relevant set of experiences.)

[W. Peden]

"didn't the Swedish Krona get grandfathered, like the UK pound? Google tells me Sweden joined the EU in 1995, maybe that was too late for a grandfather clause?"

The Swedes have what Wikipedia euphemistically calls a 'de facto opt-out'-

http://en.wikipedia.org/wiki/Euro_convergence_criteria

"Sweden, while obliged to join the euro under its Treaty of Accession, has chosen not to join ERM II, meaning that Sweden fails the convergence criteria."

(Sweden passes all other convergence criteria for adopting the euro.)

[W. Peden]

"I don't know much about the Hong Kong currency board, and how it handles the lender of last resort problem."

I know that Selgin (and presumably some other opponents of LoLR who aren't also Rothbardians) argues that what matters in a financial crisis is the provision of GENERAL liquidity, rather than liquidity to depository institutions. In other words, provided you have OMOs ensuring that you don't get an NGDP shock, you don't get an economic collapse. As I understand it, the Argentine economic collapse was a financial crisis that was accompanied by a deflationary shock.

[Frances Coppola]

I doubt if the UK government would agree to a HK-style currency board either. It would leave the UK's central bank in the position of having to provide general liquidity to an independent Scotland which was not a participant in the central bank's fiscal backstop. I know everyone keeps talking about the US's relationship with Panama and Ecuador, but these are tiny compared to the US: the chances of them ever being at the heart of a financial crisis large enough to destabilize the US are vanishingly small. The same is hardly true of the UK and Scotland.

The real issue here is Scotland's mammoth banking sector - 12 times its gdp and with most of its operations in England and Wales. Scotland could not possibly bail out these banks on its own, especially as it would have no central bank. Selgin's ideas are not going to work with such a huge and concentrated financial sector: free banking can only really be stable with a large number of small banks, but what Scotland has is three behemoths. The UK would have no choice but to bail out the Scottish banks in another financial crisis.

However, if Scotland goes for independence and the UK sticks to its guns about currency union, it's almost inevitable that Scotland's big banks(RBS, Bank of Scotland and Clydesdale) would reincorporate in England.They could not afford to lose Bank of England support.None of them are really Scottish anyway: RBS is owned by the UK government, BOS is owned by the English bank Lloyds, and Clydesdale is owned by the National Australia Bank. If they reincorporated in England, the financial crisis risk from an independent Scotland would disappear. In which case little Scotland could carry on using something it calls the "pound" which would not be recognized by the Bank of England, and the UK could safely ignore it.

[David Beckworth]

Nick, for a good contrarian view and proposal on the Scottish currency question see Lawrence White:

http://www.iea.org.uk/blog/should-an-independent-scotland-keep-the-pound

[Frances Coppola]

David, I've read Lawrence White's idea and I don't think it could possibly work. He makes the following assumptions:

- Scottish prices would continue to be included in inflation measures used by the MPC when determining monetary policy
- the Bank of England would continue to guarantee to exchange Scottish pound notes issued by the Scottish banks at par.

In other words, the Bank of England would act as the Scottish central bank even though there would be no formal currency union. Really White is arguing for currency union by the back door. I don't think either the Bank of England or the Treasury are likely to be fooled.

[Determinant]

I participate in another chat board with a lot of Scots and English, and the parallels with Quebec are spooky. It's all the same arguments we saw in Canada 25 years ago, though slightly more advanced. Oil and Hydro, anyone? Sovereignty-Association? (Not to mention the fact that Churchill Falls is in Labrador, not Quebec, which poses hefty political risk.)

The political issue of a currency union and therefore of many of the SNP's (and PQ's too) positions is that you can't tell the UK or Canada, which you just left, to do what you want them to do. They can and probably will ignore you. They have no obligation to you anymore and won't be in a mood to compromise. Unless you are willing to honestly acknowledge that "sovereignty" will mean, and can only mean, complete and utter independence (that you will become no different than Barbados is to Canada and the UK) then your political project is just tilting at windmills.

The one difference between the two debates is that the English, to a large extent, have given up on the Scots already. Canada didn't give up on Quebec. Countries don't die when they dissolve, they die when people stop believing in them. 'Twas a very close run thing in 1995, but people never stopped believing in Canada, which was why the "No" rally was so necessary. The UK doesn't have that same feeling and same champion, and that's the rub.

Jacques may shoot me for any or all of this commentary at his leisure. ;)

[Nick Rowe]

David and Frances C: This is what I read in Larry White:

"Should Scotland retain the sterling standard, private banknotes would continue to provide better currency (more reliably redeemable for Bank of England notes or one-pound sterling coins) than currency issued by a new Scottish central bank or currency board. A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued."

I didn't read him as saying: "- the Bank of England would continue to guarantee to exchange Scottish pound notes issued by the Scottish banks at par. "

It sounds more like free banking, as under the old Scottish system, only with Sterling replacing gold.

[Frances Coppola]

Yes, it is. But where are they going to get those sterling reserves from? They are going to have to buy them on the open market, probably at a considerable discount to par. And Scottish banknotes would not be acceptable for cross-border trade (they aren't now). Unless Scotland either borrowed heavily in sterling - with the obvious risks arising from large externally-denominated debts - or ran a substantial trade surplus, I don't think it would be long before the Scottish banks were bankrupted by the implied exchange rate difference. The only way this could be remotely viable would be if the Bank of England agreed to exchange Scottish notes at par as it does now, which would give Scottish banks access to Bank of England liquidity. Without that, his idea is a non-starter.

If Scottish notes were NOT forcibly valued at par with sterling, but could devalue in accordance with the implied exchange rate, the system might be viable. But they would then arguably be a separate currency, wouldn't they?

[Nick Rowe]

Frances: "If Scottish notes were NOT forcibly valued at par with sterling, but could devalue in accordance with the implied exchange rate, the system might be viable. But they would then arguably be a separate currency, wouldn't they?"

They definitely would be a separate currency. In fact, they would be several separate currencies -- one for each Scottish bank. If a bank was unable to redeem its notes in sterling at par, those notes would trade at a discount.

[Frances Coppola]

No, White says that if a bank was unable to redeem its notes in sterling at par, it could be sued. Indeed he contrasts this legal requirement to maintain parity favorably with government issuance or a currency board, which could devalue:

"A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued. A government central bank or currency board that devalues against sterling cannot. The importance of maintaining its reputation in a competitive environment would deter a commercial bank from acting in ways that might endanger its ability to maintain par redemption. A government monopoly faces no such reputational constraint, since its customers have nowhere else to turn."

So White NOT envisaging those notes trading at a discount. He is proposing legal enforcement of a fixed 1-1 exchange rate. In effect this would be like a very strict gold standard.

[Frances Coppola]

Sorry, slightly misunderstood your comment, Nick. Yes, there would be multiple currencies, all floating in respect to sterling. I don't actually have a major problem with that idea, but I don't think people would use them for long if they devalued significantly versus sterling, which I suspect they would. People would use sterling instead - so the end result could be real "sterlingisation" of Scotland. I think that is why White suggests enforcing parity, but I don't think that would be remotely viable without permanent Bank of England swap lines. Between a rock and a hard place, really....

[Nick Rowe]

Frances C: Yep. In a worst case, it would be rather like suing the banks in Cyprus, or Iceland. (It might make for an interesting new type of bank run: the run to get your suit in first?) Under the old Scottish system, IIRC, banks would temporarily suspend convertibility, but would then be required to pay a penalty interest rate on deposits.

[Frances Coppola]

Nah, the new type of bank run would be the run to reincorporate south of the Border.

[Min]

Larry White:

"Should Scotland retain the sterling standard, private banknotes would continue to provide better currency (more reliably redeemable for Bank of England notes or one-pound sterling coins) than currency issued by a new Scottish central bank or currency board. A Scottish commercial bank that fails to redeem its notes or deposits at par in sterling can be sued."

Nick Rowe:

"It sounds more like free banking, as under the old Scottish system, only with Sterling replacing gold."

I am reminded of the story about the bank in Rhode Island in the 19th century that issued notes backed by Spanish Dollars (pieces of eight). It issued $600,000 in notes with 7 bits in its vault. ;)

Libertarian heaven, I suppose.

[Frances Coppola]

I thought libertarians didn't like fractional reserve banking?

[Min]

Frances Coppola: "Yes, there would be multiple currencies, all floating in respect to sterling. I don't actually have a major problem with that idea, but I don't think people would use them for long if they devalued significantly versus sterling, which I suspect they would."

Wasn't the plethora of currencies in the US, many of which were devalued significantly because of the uncertainties about their issuing banks, one reason the US adopted the Federal Reserve system?

[Min]

Frances Coppola: "I thought libertarians didn't like fractional reserve banking?"

No, but they do like free banking. That's why it's a joke.

[Frances Coppola]

Hehe. Roll on a Scottish central bank issuing its own currency.

[Determinant]

http://en.wikipedia.org/wiki/Pound_Scots

Roll on inflation, the Pound Scots didn't do too well against the Pound Sterling.

[Jacques René Giguère]

Determinant: On the road, working. I'll pontificate tomorrow...

[W. Peden]

Frances Coppola,

"I thought libertarians didn't like fractional reserve banking?"

Some libertarians.

Min,

"Wasn't the plethora of currencies in the US, many of which were devalued significantly because of the uncertainties about their issuing banks, one reason the US adopted the Federal Reserve system?"

There's not good evidence that the above was anymore than a post-hoc rationalisation of something adopted for other reasons that were closer to the heart of the founders of the Federal Reserve System. George Selgin has a lot of work on the subject, if you're actually interesting in getting a good idea of the varieties of views of libertarians on the history of the Fed and on fractional reserve banking.

[Min]

Thansk, W. Peden. :)

[stone]

I totally agree that currency unions, currency boards and Montenegro style currency substitution are all a bad idea. What I don't think is being discussed enough is how Scotland could thrive with its own floating currency. The issue of what to do with Scotland's share of UK treasury debt could also be dealt with in a constructive way too. I had a go posting about that:
http://directeconomicdemocracy.wordpress.com/2014/02/17/lets-be-constructive-about-currency-and-debt-arrangements-for-an-independent-scotland/