Speech given by Mark Carney, Governor of the Bank of England, at a lunch hosted by the Scottish Council for Development & Industry, Edinburgh 29 January 2014.
It is a pleasure to be in Scotland today and to have the opportunity to hear directly from businesses about the economy. The recovery that began in Scotland has now taken hold in the UK with the economy growing at its fastest rate since 2007.
Although a few quarters of above-trend growth driven by household spending represent a good start, they aren’t sufficient. Even though employment is growing and unemployment has fallen – particularly so recently in Scotland – the recovery has some way to run before it would be appropriate to consider moving away from the emergency setting of monetary policy. The Monetary Policy Committee has noted that, when the time eventually comes to increase interest rates, any such move would be gradual. That should help to reassure businesses in Scotland and all around the UK that the path of interest rates will be consistent with achieving a sustained and balanced recovery in the face of the remaining headwinds stemming from the financial crisis.
Scotland is a land rich in history and ideas, and one to which I owe a great debt. Scots built the very foundations of my native land, Canada, whose first Prime Minister Sir John A. Macdonald was born in Glasgow. Scots have shaped the modern world through their contributions to culture and science. The pioneering work of Scottish economists from Adam Smith to Sir James Mirrlees has had great influence on my profession. Among them is David Hume, born just a short walk from here and a great friend and collaborator of Smith. While better known as a philosopher, Hume’s essay “Of the balance of trade” set out the theory of how trade imbalances between nations sharing a currency (gold) would self-correct as inflows of money to surplus countries raised their prices and reduced their competitiveness.
As an empiricist, Hume would doubtless admit that recent euro area experience of persistent current account deficits leading not to self-correction but instead to crisis requires a more elaborate explanation. Fortunately economists have over the years obliged with substantial work on the economics of currency unions.
Given the recent focus here on the currency and the fundamental role of the Bank of England in maintaining monetary and financial stability across the United Kingdom, I want to draw on that body of economics today to review some of the most important issues with respect to monetary union.
I will stick rigidly to what Thomas Carlyle described as the dismal science. Any arrangement to retain sterling in an independent Scotland would need to be negotiated between the Westminster and Scottish Parliaments. The Bank of England would implement whatever monetary arrangements were put in place.
What follows is not an assessment of whether Scotland will be overall better or worse off under independence – that is a multi-faceted judgement for the Scottish people. It does not pass judgement on the relative merits of the different currency options for an independent Scotland, but instead draws attention to the key issues. This is a technocratic assessment of what makes an effective currency union between independent nations.
The costs and benefits of currency areas
Let me begin by outlining the basic rationale for sharing a currency.
Economist Robert Mundell first wrote about what determined an ‘optimum currency area’. Spurred by the breakdown of the Bretton Woods system and the move to floating exchange rates as well as by the formation of the European Monetary Union, others have elaborated and extended his work. We now have a fairly comprehensive sense of the costs and benefits of sharing a currency.
For Mundell, the main benefit was that it eliminates the transactions costs associated with using, and switching between, different currencies. The European Commission estimated the size of these direct benefits for Europe to be almost 0.5% of GDP every year.
Sharing a currency can promote investment by reducing uncertainty about currency movements and giving businesses access to deeper, more liquid financial markets. It can also reduce borrowing costs for countries with a history of high inflation and currency devaluation. By tying themselves to the mast of the monetary policy of others they can import credibility. This is exactly what the UK and other European countries aimed to do in joining the Exchange Rate Mechanism.
Sharing a currency also helps promote integration. It does so by eliminating one of the barriers between markets, improving transparency of pricing and increasing competition. Sharing a currency can also help to increase the mobility of labour and capital, raise trade in goods and services, and improve the flow of technology and ideas. In these ways, members of a currency union can exploit more fully comparative advantage and ensure greater dynamic efficiency.
Set against these benefits are the potentially large costs of giving up an independent monetary policy tailored to the needs of the region and a flexible exchange rate that can help absorb shocks.
A flexible exchange rate acts as a valuable shock absorber when domestic wages and prices are sticky. For example, suppose demand for a country’s exports falls. All else equal, its output will fall, unemployment increase and current account deteriorate. With an independent currency, exchange rate depreciation can dampen these effects by improving competitiveness, and monetary policy can become more accommodative, supporting demand and employment. However, if the country were part of a currency area with its foreign market, its exchange rate would by definition not change, putting the full weight of adjustment on wages and unemployment – a significantly more protracted and painful process. In addition, the responsiveness of monetary policy to weak demand in that country would be diluted by the needs of the broader membership.
Being in a currency union can amplify fiscal stress, and increase both the risks and consequences of financial instability. In the situation just described, fiscal policy would ideally help smooth adjustment to the external shock. But its ability to do so could be limited by the budgetary impact of the falls in output, prices and wages. To maintain credibility, fiscal policy may even become pro-cyclical, with the resulting austerity exacerbating the initial fall in demand. In the extreme, adverse fiscal dynamics could call into question a country’s membership of the union, creating the possibility of self-fulfilling ‘runs’ on bank and sovereign debt absent central bank support. Such adverse feedback loops turned recessions into depressions in several European countries in recent years.
What makes a successful currency union?
The success of a currency area hinges on whether its features mitigate the costs of losing the flexibility that comes from an independent monetary policy. These features generally promote the alignment of economic cycles, and the maintenance of price and financial stability within the union.
The most obvious feature is the degree of similarity amongst members. Similar economies won’t suffer from a ‘one size fits all’ monetary policy. Surprisingly, a review of major currency areas suggests that similarity is neither necessary nor sufficient for success. For example, the industrial structures of the core and periphery of the euro area are more similar than those of the constituents of Canada or the US. Yet few would argue that the euro area is the most effective currency union of the three. Conversely, the Canadian monetary union works well despite having substantially larger industrial variation than even the US.
The similarity of the industrial structure of Scotland and the rest of the UK depends on how offshore oil is allocated. With oil split on a per capita basis Scotland and the rest of the UK look about as similar as the core and periphery of the euro area; but with oil split on a geographic basis they look about as diverse as the United States. Despite any differences, the close integration of the Scottish and rest of UK economies has helped ensure that their economic performance has been very similar over a long period – output growth is highly correlated.
So theory notwithstanding, being similar doesn’t necessarily help and being different doesn’t necessarily hinder. This suggests we should look elsewhere for the ingredients of a successful union: to the mobility of labour, capital and goods; to institutional structures promoting financial stability; and to institutions that mutualise risks and pool fiscal resources.
An economic union with free movement of labour, capital and goods
The ‘five tests’ formulated by the UK Government to analyse the merits of joining the euro in 2003 were crafted in large part around the degree of integration of the UK and the euro area. That is because greater openness and integration within a currency union not only enhances the benefits of a shared currency but can also mitigate the cost of losing exchange rate flexibility.
Mundell originally argued that currency areas should coincide with regions which had high internal factor mobility. The idea was that by moving from areas where demand has fallen to those where it has risen, workers help moderate changes in wages and unemployment.
There are clear practical impediments to labour mobility within the euro area including language and culture. As a consequence, it has the lowest cross-border mobility of the five currency unions in table 2**. This has contributed to the need for painful internal devaluation for some countries in the euro area to restore competitiveness.
Given that more than 700,000 Scots live in the rest of the United Kingdom and over 500,000 from the rest of the UK live in Scotland, one would be tempted to assume that labour mobility between the two is high. In fact gross migration flows between Scotland and the rest of the UK are lower than in the constituent parts of some other currency areas.
That probably in part reflects the fact that economic conditions in Scotland and the rest of the UK have been very similar, such that the incentive for migration is relatively limited. It is reasonable to think that the similarities between Scotland and the rest of the UK mean that there is the potential for higher labour mobility should that become necessary. Given differences in industrial structure, this would put a premium on ensuring barriers to mobility are not allowed to develop if monetary arrangements were to change.
It is not just an integrated labour market that helps adjustment within a currency union. Openness to trade and free movement of goods also assists in diluting the effect of shocks by spreading them across the union. If one part of the union imports a large share of what it consumes from other parts, changes in demand will be quickly transmitted. This helps to align economic cycles and makes a common monetary policy more appropriate.
Scotland and the rest of the UK are highly integrated. 70% of Scottish exports are destined for, and 74% of imports into Scotland come from, the rest of the UK. A word of caution applies here. There is a body of evidence that national borders can influence trade flows, even between otherwise highly integrated economies. The high degree of integration between Scotland and the rest of the UK may in part depend on their being part of the same sovereign nation.
Mobility of capital can also promote necessary adjustment to shocks. Moreover, if capital in one part of a union is owned by those in other parts, the effect of a given shock is diluted across the union. Simply put, risks and rewards are shared. Similarly, the ability to borrow from other parts of the currency union in deep and liquid cross-union credit markets or integrated banking systems allows one part of a union to smooth out temporary falls in incomes.
However, free movement of capital can be a mixed blessing. If the funds provided by one part of a union to another can be withdrawn easily, these outflows can – if the right structures are not in place – undermine financial and economic stability of all members.
This brings me to the second feature of a successful currency union – banking union.
Effective currency unions need a wide range of institutions to support an integrated and efficient financial sector. These are often referred to as a “banking union” and include:
• Common supervisory standards,
• Access to central bank liquidity and lender of last resort facilities,
• Common resolution mechanisms, and
• A credible deposit guarantee scheme.
Without a banking union, cross-border capital flows can be restricted, the effectiveness of monetary policy impaired and, in the extreme, the viability of the union itself undermined.
It is as difficult to separate the institutions that support banking union from national fiscal arrangements as it is to separate the creditworthiness of banks and sovereigns. Let me explain.
In recent years, doubts about the resilience of major financial institutions have created expectations of sovereign support. The scale of these potential liabilities can in turn generate doubts about public finances undermining the resilience of both banks and sovereigns.
When such concerns emerge, the consequences can be dramatic. The banking systems of peripheral European countries experienced outflows of between 10% and 85% of total deposits from elsewhere in the euro area in the three years following June 2010. Bank funding spreads in those countries ballooned by 5 percentage points from the beginning of 2010 to the middle of 2012. Bank lending to the real economy collapsed and credit conditions tightened massively.
Clearly something must be done.
It is in the interests of all countries to sever the link between banks and sovereigns by ending too big to fail. Governments must put in place regimes that impose losses on bank management, shareholders and creditors rather than taxpayers. That is exactly what is established by the UK’s recent Banking Reform Act, and the recently agreed European Bank Resolution and Recovery Directive. The Bank of England is at the forefront of efforts to establish the common global requirement that is needed to finish the job.
While ending too big to fail should mean that taxpayers no longer have to bail out banks, it will not fully break
the bank-sovereign loop, for three reasons.
First, banks hold substantial amounts of their national government’s debt in order to manage liquidity, meet collateral obligations and hedge exposures – European banks hold more than €1trn of home country sovereign debt amounting to 5% of total assets.
Second, confidence in deposit guarantee schemes relies on a national backstop. The European process illustrates the difficulty of building the institutional arrangements for a common insurance scheme across sovereign states. This is unsurprising since mutualised deposit guarantee schemes imply a pooling of risk and loss of sovereignty. All member states must be persuaded that they won’t simply be left with the bill for the mistakes of others.
Third, a currency union requires a common fiscal backstop for its central bank. Central banks must be able to act as Lender of Last Resort, both to financial institutions that are solvent but experiencing an unwarranted loss of confidence and to provide bridging finance to institutions that are being recapitalised using new resolution regimes. Under the current governance arrangements in the UK, these operations require an indemnity from, and the approval of, the Chancellor, because they would put substantial public funds at risk.
The existing banking union between Scotland and the rest of the United Kingdom has proved durable and efficient. Its foundations include a single prudential supervisor maintaining consistent standards of resilience, a single deposit guarantee scheme backed by the central government, and a common central bank, able to act as Lender of Last Resort across the union, and also backed by the central government. These arrangements help ensure that Scotland can sustain a banking system whose collective balance sheet is substantially larger than its GDP.
The euro area has shown the dangers of not having such arrangements, as well as the difficulties of the necessary pooling of sovereignty to build them. An independent Scotland would need to consider carefully how to develop arrangements with the continuing United Kingdom that are both consistent with its sovereignty and sufficient to maintain financial stability.
While banking union requires common fiscal backing, there are two broader justifications for shared fiscal arrangements within a currency area.
The first is that deeper fiscal integration between members can play an important role in smoothing shocks
that affect only part of the currency area.
It is no coincidence that effective currency unions tend to have centralised fiscal authorities whose spending is a sizeable share of GDP – averaging over a quarter of GDP for advanced countries outside the euro area. That offers scope for a significant degree of stabilisation, much of it happening automatically as slowing growth in one part of the union causes tax revenues there to fall and welfare spending to increase. Those automatic fiscal stabilisers are important within the UK – it is estimated that for every £1 that output falls the reduction in taxes and increases in transfers are together worth about 50 pence.
What matters for individuals is the extent to which this risk sharing insulates their disposable income from shocks. In the UK there is evidence that around a fifth of variation in regional personal income relative to the national average is stabilised by central government transfers. That is probably an important factor in accounting for the close harmonisation of economic performance within the UK. The degree of stabilisation in France and the US is similar, with a slightly lower figure for Canada.
Fiscal stabilisation is particularly important in a currency union because it helps mitigate the loss of exchange rate flexibility. But being in a currency union can amplify fiscal stress for individual nations, limiting their ability to perform this valuable role just when it is most needed. So it makes sense to share fiscal risks across the whole currency area. A localised shock is less likely to stretch the fiscal position in a larger more diversified currency area, especially if it shifts demand between different parts of the area. That makes a given shock to Nova Scotia less severe than the equivalent to Portugal.
The second justification for shared fiscal arrangements is that problems in one country are very likely to spill over to others. For example, the threat of default by one country may trigger a generalised crisis, particularly if the liabilities of the crisis country are held by the banking system of the broader currency area. It will be in the interests of other countries in the union to bail out a country in crisis, and that reduces the incentives for countries to run their finances prudently in the first place. At a minimum, this ‘moral hazard’ problem suggests the need for tight fiscal rules, to enforce prudent behaviour for all in the union, although credible sanctions for breaking those rules are hard to develop.
There is an obvious tension between using robust fiscal rules to solve this problem, and allowing national fiscal policy to act as a shock absorber. This reinforces the need for fiscal risk sharing between nations.
As the Presidents of the European Council, European Commission, Eurogroup and European Central Bank argued in their report, European monetary union, which has so far relied on fiscal rules, will not be complete until it builds mechanisms to share fiscal sovereignty. Possible options range from a transfer union to a pooled employment insurance mechanism. Whatever is ultimately chosen, the degree of fiscal risk sharing will likely have to be significant.
Similarly, in a monetary union between an independent Scotland and the rest of the UK the two Parliaments would have to agree on whether fiscal rules were sufficient or whether similar risk-sharing mechanisms were necessary.
The Scottish government has stated that in the event of independence it would seek to retain sterling as part of a formal currency union. All aspects of any such arrangement would be a matter for the Scottish and UK Parliaments. If such deliberations ever were to happen, they would need to consider carefully what the economics of currency unions suggest are the necessary foundations for a durable union, particularly given the clear risks if these foundations are not in place.
Those risks have been demonstrated clearly in the euro area over recent years, with sovereign debt crises, financial fragmentation and large divergences in economic performance. The euro area is now beginning to rectify its institutional shortcomings, but further, very significant steps must be taken to expand the sharing of risks and pooling of fiscal resources. In short, a durable, successful currency union requires some ceding of national sovereignty.
It is likely that similar institutional arrangements would be necessary to support a monetary union between an independent Scotland and the rest of the UK.
I suspect you have reached your limits of endurance of the dismal science, so you’ll be relieved to know that economics can take us no further. Decisions that cede sovereignty and limit autonomy are rightly choices for elected governments and involve considerations beyond mere economics. For those considerations, others are better placed to comment.
**US, Australia, Canada, Scotland/rUK and EU27.