Sterling currency zone would not include a Fiscal Compact or Banking Union, and resemble 'dollarization'
13 May 2014 10:29 AM
New research by Dr A. Armstrong and Dr M. Ebell
of NIESR entitled “Monetary Unions and Fiscal Constraints”,
published in the National Institute Economic Review, 228, May
2014
Any negotiation to form a monetary union between two
sovereign states substantially different in size, and each acting in their own
self-interest, is likely to result in a currency arrangement that resembles
‘dollarization’ in practice. Contrary to statements from both the
UK and Scottish governments, if there were to be negotiations over a monetary
union there would be no need for the UK to constrain Scotland’s fiscal
policy, and no reason for the rest of the UK to accept any such constraint.
Moreover, a banking union is unlikely to be sustainable. The likely outcome
would therefore be a sterling currency zone without either fiscal constraints
or a banking union. This would resemble a 'dollarization'
arrangement.
The authors believe that this is the first research to
show the very different properties of a monetary union with two sovereign
states of such different size, compared to traditional theoretical models which
assume several countries of similar size.
This research shows that in a monetary union between two
different sized nations there is no incentive for the larger country to impose
fiscal constraints on the smaller country. In addition, the larger country
knows that the smaller country cannot afford a banking union. Even if a
monetary union were agreed to in principle, without fiscal constraints or a
banking union this would resemble de facto ‘dollarization’. These
are general results which apply to monetary unions of two sovereign states of
very different size. Armstrong and Ebell apply these insights to the case of
Scottish independence, where the rest of the UK is more than ten times the size
of independent Scotland by population.
To illustrate these results, the authors assume that the
Fiscal Commission Working Group’s (FCWG) conception of a monetary union
between the rest of the UK and an independent Scotland, with representation in
proportion to the relative size of population, is actually agreed. This
suggests, for example, that an independent Scotland would have at most one
representative on the Monetary Policy Committee, compared to the rest of the UK
having eight. It follows that the rest of the UK would dominate every decision
and Scotland would have no effective influence on policy.
Therefore, the Scottish government’s fiscal or
borrowing decisions could not directly influence monetary policy in the
sterling area, which removes the rationale for borrowing constraints on an
independent Scotland. Scotland might prefer to impose borrowing constraints on
the rest of the UK, but there is no reason for the latter to agree. Because
constraints on an independent Scotland would be worthless, agreeing to them may
invite the perception of culpability and therefore an expectation of a bail-out
if necessary. Perception of possible support might undermine the very market
discipline which ensures an independent Scotland does not
over-borrow.
The FCWG also proposes a banking union between an
independent Scotland and the rest of the UK. Armstrong and Ebell show that the
banking union is unlikely to be sustainable. In a banking union each country
would be expected to make transfers to the other in the event of a banking
crisis, in order to assist in the recapitalization of the crisis
country’s banks. In the event of a banking crisis south of the border,
the size of a potential fiscal transfer from Scotland to the rest of the UK
might be so large as to outweigh the benefits from remaining in the banking
union. An independent Scotland would therefore have no incentive to
participate. If the UK understands this participation problem, then it might
see the banking union as one-sided to its detriment, and might decline to
participate from the outset.
In terms of policy, the report
concludes:
- Both HM Treasury and the Scottish Government are
incorrect to argue that borrowing constraints would be a necessary requirement
for a monetary union. Since an independent Scotland could not effectively
influence monetary policy in the rest of the UK, it would have no incentive to
over-borrow, which means there is no rationale for fiscal
constraints.
- If
an independent Scotland cannot influence monetary policy in the rest of the UK
(under the FCWG proposal it may have one of nine seats on the Monetary Policy
Committee) then there is no guarantee that monetary policy would be appropriate
for Scotland. Indeed, Scotland may be best served by mimicking the UK’s
fiscal policy so its monetary policy is appropriate.
- Because the fiscal constraints on Scotland would be
worthless, agreeing to them may invite the perception of culpability by the UK
and therefore an expectation of a bail-out if necessary. Perception of possible
support might undermine the very market discipline which ensures an independent
Scotland does not over-borrow.
- A
banking union between an independent Scotland and the rest of the UK is not
likely to be sustainable. In the event of a banking crisis south of the border,
the size of a potential fiscal transfer from Scotland to the UK might be so
large as to outweigh the benefits of being in a banking union. An independent
Scotland would therefore have no incentive to participate.
- Since there is no economic rationale for fiscal
constraints or a banking union between an independent Scotland and the rest of
the UK, any agreements to create them would be seen to be worthless. Indeed,
such agreements are more likely to invite perceptions of culpability and an
expectation of cross-border bail-outs and therefore undermine market
discipline.
- The
Bank of England would offer Lender of Last Resort operations to Scottish Banks
in the UK conditional on them posting appropriate collateral and at an agreed
price. However, if UK tax payers’ capital is ever at risk, there is no
reason for the Chancellor to agree to extend support to institutions domiciled
in a foreign country, including in an independent Scotland.
- Governments which do not issue their own currency can
also require Lender of Last Resort operations in extreme market conditions.
There is no reason why the rest of the UK via the Bank of England would provide
this option to an independent Scotland.
- Without a banking union in a sterling zone, adverse
feed-back loops between banking sector risks and sovereign risks may arise.
These occur in countries that have high debt burdens and which cannot influence
monetary policy. This may encourage Scottish banking institutions to
re-domicile in the rest of the UK.
- If
banks re-domicile from Scotland to the rest of the UK, this makes participating
in a banking union even less (not more) justifiable for an independent
Scotland.
- Monetary union without fiscal constraints and a banking
union would resemble so-called 'dollarization'. Even if a monetary
union was negotiable, 'dollarization' would be a likely outcome of
negotiations between two sovereign states of such different size acting in
their own self interest. We have shown in previous work that it is doubtful if
'dollarization' with a high level of debt is a sustainable
regime.
References
Fiscal Commission Working Group, First Report –
Macroeconomic Framework, 2013 Armstrong, A and Ebell, M, Scotland’s
Currency Options, 2013 Armstrong, A and Ebell, M, Scotland’s Currency
Options and Public Debt, 2014
Notes for Editors:
1. This press release is based on an article entitled
“Monetary Unions and Fiscal Constraints” contained in the National
Institute Economic Review, No 228, May 2014. This is a quarterly, peer
reviewed, economic and social sciences journal. The full Review is published
from midnight on Friday 9 May 2014.
2. This report is part of the National Institute of
Economic and Social Research’s “Future of the UK and
Scotland” work to inform the Scottish referendum
debate.
3. Contact details for authors are: