A speculative idea about currency unions

Angela Merkel wants unemployed Europeans to move, this after Paul Krugman pointed out the dangers that this has within a currency union in the absence of fiscal integration. A country gets into trouble: recession and high unemployment leads to budget deficits and a run up in the government debt levels. If the population then leaves to work elsewhere there will be no-one to restore the fiscal balance and, ultimately, repay this debt. Can currency unions actually work then?

How about this for an idea: the central bank guarantees a level of nominal GDP growth at the level of the whole union. States within the union issue bonds denominated in the currency of the union, but indexed to their own relative level of nominal GDP - the level of which is not guaranteed. This means that if bonds are issued to cover recession induced deficits but the young then emigrate, the level of the debt will be written down in respect of the relative fall in nominal GDP.

The only issue I can see is ensuring the objectivity of the entity which reports the relative level of the nominal GDPs of the countries within the union.

Related: the more I think about it, the less convinced I am about a Sterling Zone for a post independence Scotland. I'm becoming more pro Eurozone again - it's a much more symmetric grouping of countries, and to first order it is, like the USA, a closed economy. But there are all sorts of reforms needed: hence the ideas!

Passed...

... my PhD!

Some celebratory tunes:

Secova - Kindle

Also I am profiled in The Actuary magazine. Bet Paul Krugman cannae say that!

Independence as a “Real Option”: Explaining the campaign so far

A common refrain from pro-union campaigners has been for the SNP to provide detail around “what independence would look like”. To the extent that a vision of an independent Scotland has been provided by the SNP (not necessarily by Yes Scotland), differences with the status quo have been minimised.

The vision that the SNP have articulated has suggested a great deal of continuity: the Common Travel Area between the UK and the Republic of Ireland provides a model of continuing open borders; maintenance of the monarchy; continued membership of the EU and NATO; an emphasised “Social Union”; evidence that maintenance of the level of tax-and-spend is affordable; and, especially, the favoured option of a Sterling Union. This vision has led to the response from some on the pro-independence side that this does not optimally use the levers of independence, but it has also seemingly provoked the pro-union side (who might be expected to view this vision of continuity as second-best after their preferred union option) who also argue against this vision partially on the grounds that it would fail to deliver “genuine freedom”! Can we economically rationalise these positions?

Assume that, unless explicitly changed, “things” (by which I mean essentially everything) will continue to be the “same” after independence. What then is the value of independence? Independence could be viewed under the lens of real option theory: a real option is “the right — but not the obligation — to undertake certain … initiatives”. Under union, the Scottish Parliament cannot award itself new powers and “things” will of course continue to be the “same”. Under independence, “things” are the “same” until such time as, presumably, we don’t like this “same” path for “things” and the Parliament exercises this option and decide to change these “things”. Options are always valuable (since they represent a right but not an obligation). This means that if the SNP can make the case that “things” will continue to be the “same” after independence, and that independence represents an “option” to change things then, by this logic, independence is objectively optimal.

This is a potential explanation for the Independence-lite vision of the SNP which essentially points to how similar “things” will be after independence. It presents a scenario under which independence is almost objectively optimal. This is also a potential explanation for the vociferous objections to this vision from those opposed to independence. To counter the SNP vision, the pro-union campaign has to convince voters that “things” will not be the “same” after independence and they essentially have three channels in which to do this:

1. the first is to assert that “things” will not be the “same” even under the SNP’s vision because of, for example, transition costs or risk exposures;
2. the second is to claim that the SNP’s vision is impossible to implement, and so we cannot keep “things” the “same” (as in the HM Treasury paper on a Sterling Union);
3. and the third channel is to argue that “things” won’t be the “same” because the option will be exercised immediately: an independent Scotland will choose “genuine freedom” instead of keeping “things” the “same”.

This sums up many of the campaign dynamics so far: the logical optimality of independence under the assumption of keeping “things” the “same” perhaps explains the SNP’s Independence-lite vision; And the third channel available to the pro-union campaigners perhaps explains the enthusiasm with which they point out that constrained independence does not represent real independence.

Originally posted on esrcscotecon

End May Links

Nick Rowe's Monetary stimulus vs financial stability is a false trade-off is a great description of general equilibrium outcomes as against the micro-mechanisms that they arise from: lower interest rates may induce me to save less from my (exogenous) income; but at the macro level, lower interest rates do not imply that there will be a lower savings rate applied to the (endogenous) national income.

Simon Wren-Lewis and George Kerevan discussing, in completely different ways, the rise of UKIP. My favourite UKIP post though was this spoof from the Daily Mash.

Paul Krugman makes the point that needs made again and again: to the extent that something which we might call "austerity" is needed, this austerity should be about working harder and not seeing the rewards in terms of higher consumption i.e. more work, less play; it should not be about mass unemployment.

Fascinating: French fertility fall

Concentrating economic activity in London

I've posted my first blog post at ESRC The Economics of Constitutional Change blog. It's entitled The decision to concentrate economic activity in London. Comments should be left here though as we're not accepting comments on the ESRC site.

End April Links

# Another good defence of the economics that I understand from Noah Smith: What is an economic equilibrium?

# "Paying more in" than you take out, unless you're unfortunate, is fundamental not only to insurance but also to communitarian and cooperative society. As Chris Dillow says, some people need reminded of this, including the Labour party it seems.

# I probably need to link to something Thatcher related. Chris Dillow describes Thatcherite roots of the crisis

# The stupid cruelty of the creditor

# Edinburgh doing well: Scotland's tech start-up capital?

# Another outstanding post from Interfluidity, The mother of invention. A quote: "

Abundance, ultimately, is a choice variable for the political class. “We” are presented with a devious choice, a Faustian seduction. We can choose abundance, for ourselves, by maintaining a distribution under which a relatively small fraction of humanity claims a sufficiently large share of world purchasing power that the economy’s capacity to produce will remain safely in excess of that group’s needs. Or we can choose scarcity, by distributing purchasing power widely enough to put our productive capacity under pressure, leaving all of us, even the affluent, at risk of actual shortage.

If we choose the abundance, we can expect Tyler Cowen’s “Great Stagnation” to continue. Technology will stagnate, because purchasing-power weighted necessity is the mother of invention, but people with needs have little purchasing power while people with purchasing power have trivial needs. If we choose scarcity, we take a risk. We may fail, and end up impoverished relative to where we (some of us) might have been, had we chosen the more conservative path. But purchasing-power-weighted necessity is the mother of invention, and in the past, mass affluence has inspired extraordinary innovation in pursuit of the mass dollar. If you believe in the power of capitalism and technology, then you should favor choosing scarcity, both for your own benefit (robots, yay!) and to expand the “we” by whom some level of abundance might plausibly be claimed."

Sterling, The Big One

It's been the big issue of the past week, so let's discuss some of the currency options for an independent Scotland and the advantages and disadvantages of each.


1) Join the Euro
Won't fly politically and doesn't sound optimal until there are a decent set of institutions for it to operate under. Barely worth considering at the moment, and nobody seems to be advocating it, but it may be a future aspiration if e.g. a transfer union can be agreed. In particular it is a much more symmetrical arrangement than a Sterling Zone, with Germany constituting approximately 30% of Eurozone GDP relative to rUK's 90% of Sterling zone GDP.

2) A Scottish currency
Will probably put people off in the referendum and there are real transaction costs involved for trade. There are also transitional issues (i.e. contracts denominated in Sterling will take a while to expire: a debt in Sterling and an income in a Scots currency would lead to a large exchange rate risk). May expose the rest of the economy to the 'resource curse' if oil exports cause an overvalued currency and other industries are therefore uncompetitive. Would allow monetary policy to be 100% weighted towards Scotland. Advocated by Jim Cuthbert and the Jimmy Reid Foundation.

3) Use Sterling without monetary union
This is feasible but means abdicating monetary policy levers entirely: you import the monetary policy of the country whose currency you are using. No lender of last resort in the currency you are shadowing.

Given the flaws that these three options clearly have, let's focus on the issue of the week:

4) Use Sterling in a monetary union with rUK
This is the Scottish Government's preferred option, and in what looks like a bit of pre-negotiating, something that the UK government says will not work. Alastair Darling claims:
"that keeping the sterling as currency would simply make no sense and much less worth to bother with independence because the country would still be in an economic union with the rest of the United Kingdom which would be a mini-version of the eurozone. Furthermore, Scotland would not have any say in interest rates if it would have a common currency with a foreign country because the latter would not set the interest rates according to the interest of Scotland. What Darling is trying to say is that breaking off from the union and keeping the pound as currency would undermine an eventual Scottish independence because the country would need to play by the rules set from outside."
This argument would hold more weight if anyone was actually credibly proposing e.g. a federal UK. To say that the independence that would be achieved as an independent country within a monetary union is not 'real independence' is perhaps an argument that a proponent of independence can plausibly make: but it makes no rational sense (though it may make campaigning sense) coming from the No campaign. There would be more autonomy for Scotland under the fiscal arrangements of a currency union than there would be under the current situation. Given the large combined support for independence or more devolution, the constraints of a currency union may be something that is consistent with the preferences of the electorate.

And there would be constraints. A government with the technological/institutional feasibility of running a primary surplus, in a country with its own currency, cannot go bankrupt: whatever its debt situation it can always devalue and repudiate the debt using inflation rather than default. However, within a currency union, this instrument may be needed for one member but not the other parties. In this case this policy lever disappears because the other countries are not willing to accept the devaluation, and default risk arises. To minimise this risk, a deal would have to be struck on deficit limits, but I do not accept that such a deal has to cover government spending levels: in the language of an economics class, it's (G-T)/Y that matters, and not G/Y or T/Y separately. Therefore, if Scotland wishes Scandinavian style levels of tax and spend, whilst rUK leans more towards the US style levels, then I don't see any reason why this is incompatible with monetary union so long as both are running similar government deficits/surpluses. Once a fiscal pact on deficit limits had been agreed, then so long as the government had not reneged on the terms of this agreement, the central bank would be obliged to act as lender of last resort to the government.

The monetary policy framework would be setting interest rates to meet some target at the level of the whole Sterling Zone. Scotland specific problems therefore would not have much weight - as is the current situation.

There would have to be a banking union, with the central bank guaranteeing lender of last resort status to solvent commercial banks irrespective of where they are headquartered. This also doesn't seem to be a difficult issue to arrange: so long as it's done in advance. The difficulty with this issue currently in Europe is that the need for a banking union has only become apparent after the banks in various European countries had already become certain to need such a facility. It's very difficult to gain insurance once the probability of a claim reaches 100%!

As Paul Krugman and Martin Wolf have pointed out, the best predictor for troubles within a monetary union is not fiscal deficits but rather current account deficits vis-a-vis other members of the union. The combined public and private sectors of the surplus countries within a currency union are net lenders to the combined public and private sectors of the countries with relative current account deficits. If this lending is withdrawn (as was the case when e.g. German banks stopped lending to Spanish banks), the economies of the deficit countries have to contract sharply to dampen imports and restore a Balance of Payments. The aggregate position vis-a-vis lenders from outwith the currency union is much less important for economic activity, because if these lenders withdraw their funding, the value of the currency falls to restrict imports rather than the quantity of economic activity falling. So what is the Balance of Payments situation in a notional Sterling Zone comprising Scotland and rUK? I calculate the following current account series for a notional Sterling Zone over the past couple of years. Assumptions at the foot of the post.

This is certainly not the 'Scotland makes a £40B contribution the the UK Balance of Payments' that has been trumpeted (a claim which Brian Ashcroft has already convincingly taken apart), but it's not a strain on rUK, and there are (small) trade benefits for rUK in having the same currency as us. So unlike the Treasury, Brian Ashcroft, or Simon Wren-Lewis, I'm a bit more optimistic about the reasonableness of the rUK government post a Yes vote. I think a currency union with rUK is probably both the politically and economically optimal policy for the Yes campaign to adopt.

The major problem with a Sterling Zone currency zone is the long term rather than the short term: Scotland's current benign position with respect to a Sterling Zone currency union is a function of oil. This is declining in quantity (though who knows the path for quantity times price) and needs to be eliminated for climate change reasons anyway. Major new exports, or a massive curtailing of imports, are needed if Scotland was to run a current account surplus without oil. If Scotland were to run large current account deficits within a Sterling Zone then we would be in the precarious position that Krugman and Wolf diagnose as being at the root of the Euro's ills. There are two solutions to this:
# Membership of a Sterling Zone is only a temporary measure and we intend to leave (either to a reformed Euro or to a separate Scottish currency) over some planned period. This could cause problems with any debts issued in the period that we used Sterling: if the term was longer than the expected period of the currency union or if the debt was expected to roll over then we'd effectively be borrowing in a foreign currency.
# The other (preferred?) solution is a transfer union within the Sterling Zone where members running current account surpluses are obliged to recycle these surpluses to the governments of the deficit countries. This could be a difficult pact to negotiate. Though as we can see from the above chart, initially and whilst the oil is flowing, such transfers are likely to be from north to south.


Data & assumptions for graph: spreadsheet available on request
# UK data from ONS Quarterly National Accounts, Q4 2012
# Scottish onshore GDP and trade data from the Scottish National Accounts Project, SNAP, 2012 Q3
# Extra Scottish GDP in respect of geographical share of North Sea Oil (assumed to be entirely taxes and profits, with wages already in the onshore GDP) from GERS 2013
# Value of North Sea output is based on £40B p.a. figure from UK Oil & Gas: but I suspect that this is a a headline grabbing rounded up figure so I've multiplied by 90%. [This means that Scottish wages associated with north sea are 90% * £40B * 94% (Scottish share of activity from GERS) - £25B (profits and taxes imputed from extra Scottish GDP figure from GERS) = £7B]
# UK transfers abroad split between Scotland and rUK in proportion to (onshore) GDP
# Net factor income from abroad (always positive) assumed to belong to rUK (to reflect ownership of these assets by upper tail of the distribution - which tends to be in rUK)
# rUK assumed to own all the profits from Scotland's share of North Sea oil (to reflect ownership of these assets by upper tail of the distribution - which tends to be in rUK)
# Capital account is proportional to (onshore) GDP
# All oil exports from Scotland go to rUK since UK as a whole is rough net balanced w.r.t. oil
# Oil consumption is split between Scotland and rUK in proportion to onshore GDP