The weird notion of a Sterling zone

The weird notion of a Sterling zone

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Prior to the creation of the Euro, many macroeconomists from various different backgrounds (but especially modern monetary theory) warned that the Euro had an inherent weakness. That weakness was that the nations comprising the currency zone were fiscally sovereign, but not monetarily sovereign. In order for a fiscal sovereign to have strong credibility — to avoid bond vigilantism, and all that — it must be to a decent degree capable of printing up media of exchange to be able to avoid running out of money. The Euro created a system where governments were capable of running out of money — mimicking the gold standard — and inevitably this has led to fiscal crises and bond vigilantism. 

In other words, for a currency union to succeed it also must be — at least to some extent — a fiscal union. If not, there will at some stage be at best dysfunction, and at worst breakup. The Eurozone has managed to smooth some of the panic in markets through Mario Draghi’s expansionary monetary policy, and by enacting the European Fiscal Compact which is a step closer to a fiscal union although one that in the long run may do more harm than good as it demands balanced budgets, which leaves governments powerless to spend borrowed money to fight unemployment and invest in infrastructure in a slump.

This gradual trend away from a monetary union and toward a fiscal union was even anticipated by E.U. officials. In fact, Romano Prodi — at the time the president of the European Commission — as early as 2001 warned that "I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

So it is especially weird that Alex Salmond wants Scotland wants to leave the United Kingdom, but remain part of a Sterling zone. Scotland would be fiscally sovereign, and monetarily not so. Salmond seems to want to take the fragility that has wrecked Greece and Spain’s economies, leading to 25% unemployment and a huge, cataclysmic depression and introduce it to Britain. This is especially jarring, given that Scotland is already quite independent, with vast room to manoeuvre in terms of domestic policy, yet fiscally bound to Westminster, insulating Scotland from the prospect of fiscal crises and bond vigilantism. That is probably the best possible end state in the Eurozone, and yet Salmond wants to go backward.

Mark Carney very correctly slapped down Salmond’s nonsensical proposal this week, telling Salmond that Scotland would need to give up significant areas of its sovereignty and reach a watertight deal with Britain on banking, taxation and spending if a new sterling zone were to avoid the risks and instability which had plagued the euro. In other words, in Salmond’s vision of a Sterling zone, Scotland would not really be sovereign. 

The alternatives for Salmond would either be to join the Euro — good luck pursuing a progressive anti-austerity agenda with Angela Merkel holding the purse strings, Alex — or to introduce its own central bank and mint its own currency, a costly, complex and risky endeavour to accomplish from scratch

Now, perhaps I am also a little uneasy toward the idea of Scotland breaking away and striking out on its own because Scottish independence would create a seemingly unbreakable Conservative majority in Westminister. Scottish progressivism is a counterbalance to English conservatism in our union, producing a mixed economy featuring both a relatively free market as well as social safety nets. Losing the counterbalancing forces could be bad for both countries, but probably worse for Scotland as Scotland — whose banks make up a very large share of its GDP — faces a real risk of becoming the next Spain, Greece or Ireland either in the Eurozone or the Sterling zone.

Fortunately, I think most of this discussion is hot air. As Nate Silver notes, Scottish independence is a very unlikely prospect compared to Scotland reluctantly remaining in the union, and bookmakers agree. It is, at most, a tail risk. But what a nasty tail risk.


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Frances Coppola


I can't agree with you that the "rUK" would be dependent on Scotland for energy. The UK is not self-sufficient in energy now, importing both oil and gas from various suppliers, particularly Norway, with whom we have our second largest trade deficit (the largest is with Germany). Scotland would of course need to use part of its energy production to meet domestic needs. Therefore as far as I can see the rUK would need to source most of its energy needs from other suppliers. Indeed it would be sensible for it to do so. Complete reliance on a single energy supplier is a very bad idea - as Ukraine could tell you.

A UK wide debate on currency would benefit everyone save the central bank and it's monetarist allies. It would allow many voices to be heard on the question of austerity as the central policy of our time. It is the weird conventional wisdom on what money is and what it does viz the real economy that forces upon us a dysfunctional adjustment to globalization. Given this dysfunction there no reason NOT to vote for independence. Yes such a vote carries risks, many of which are not tail risks at all. However voting No brings the certainty of further monetary dysfunction and further predation by the friends of the coalition on our public services and on the commonweal.

Most of the currency debate hinges on where oil revenues will flow, although the fiscal and monetary sovereignty issues are important. However, a two block currency union would be easier to manage than the euro area.

If Scotland were to gain a geographic share of oil, the rest of the United Kingdom would be dependent upon Scotland for energy. Where the current United Kingdom is a current net exporter of oil, Scotland would become a net exporter of oil to England, Wales and Northern Ireland.

In this case, it would be in the political interest of the new UK to accept a currency union with Scotland to avoid fluctuations in exchange rates impacting upon the prices of petrol and diesel faced by the population of mini-Britain.

In addition, the continued revenues from the export of oil will help Sterling stave off a nasty depreciation that would sharply increase goods inflation. Again, it would be in the political interest of mini-Britain to avoid this.

If Scotland were to create a new currency, a soft Sterling peg would be more feasible in the short to medium term than a US-Dollar peg. The Sterling revenues Scotland would gain from oil export to mini-Britain would be a large percentage of their foreign reserves stock, and as such would be easier to defend. As the Scottish economy would still be highly integrated with the rest of the UK, it would make more sense for the new Central Bank to maintain a stable exchange with Sterling.

All this being said, the vote will probably not be returned in favour of independence. It will, however, speed up the devolution of power to Scotland's Parliament. Although the article is correct on pointing to Scotland having a degree of fiscal freedom, spillover effects from policy changes return to Westminster.

For example, the Scottish Parliament redistributed some of its funds towards increasing Student bursaries and loans from this year. Although the higher consumption from this transfer to credit constrained students will mainly take place in Scotland, all VAT and other tax receipts would flow to Westminster rather than to Holyrood.

May be you did not intend for this to be taken literally...

'The alternatives for Salmond would either be to join the Euro — good luck pursuing a progressive anti-austerity agenda with Angela Merkel holding the purse strings, Alex — or to introduce its own central bank and mint its own currency, a costly, complex and risky endeavour to accomplish from scratch'

But as a thought experiment might alternatives be
- launch own currency with explicit peg to the US$, so requiring much less central bank apparatus
- denominate all national debt in US$ and let US$ become legal tender, not even the Scottish banks could drag down the US economy as they could the UK

There's probably others

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