Optimal Currency Area Theory and Scottish Independence

Ronald MacDonald (Glasgow) concludes that a currency union will not work for Scotland. From The Guardian:

One of the world’s top economists has warned that an independent Scotland’s economy would crash within seven years if it tried to use sterling.

Professor Ronald MacDonald, a currency expert who advises the International Monetary Fund and the European Central Bank, said the Scottish government’s plans to use sterling after a yes vote were fundamentally flawed, even if Alex Salmond’s proposals for a currency union were accepted by the UK. The Scottish economy would shrink by up to £100bn by 2023, MacDonald said.

For a more technical exposition, see this paper. Discussion of optimal currency area theory applied to the euro zone is here

See also the points laid out by Paul Krugman, focusing on the importance of fiscal federalism in currency zones.

13 thoughts on “Optimal Currency Area Theory and Scottish Independence

    1. 2slugbaits

      Patrick R. Sullivan I’m not following you. Scottish banking practices since 1707 are not what’s at issue here. The question addressed by Prof. MacDonald was about Scotland having an independent currency not tethered to Sterling. Political independence without an independent currency is a recipe for bad times.

      In any event, Scottish banking hasn’t exactly covered itself in glory in more recent times:

      http://www.theguardian.com/business/2011/dec/12/rbs-collapse-timeline

      1. Patrick R. Sullivan

        Well, Menzie links to Krugman saying;

        ‘But Canada has its own currency, which means that its government can’t run out of money, that it can bail out its own banks if necessary, and more. An independent Scotland wouldn’t. And that makes a huge difference.’

        Canada didn’t have a central bank until sometime in the 1930s, and had a less severe depression than the USA. As far as I know Canadian banks have never been bailed out by their central bank (because they don’t have crises). Their banks more or less regulate themselves, as could Scotland’s, whatever currency unit they choose to use.

        True, Scotland would not be able to inflate its way out of a recession, but that might have a sobering effect on its politicians. Or maybe not, but Zimbabwe did put an end to some of its miseries by eliminating its currency a few yaars ago. The Rand, Euro, Pound and USD circulate there now.

        1. baffling

          Patrick, many people argue today that Canadian real estate is in a bubble. If this is true, and it bursts at a time when the global economy is slowing, how well will a resource exporting country and its banks perform? Would canada be better off with its own currency, or a currency controlled by some other central bank? You operate under the unsubstantiated condition that canada will never have a crisis, so why worry? But they are always under the threat of unknown contagion.

  1. Ricardo

    We have real world examples for Scotland to follow concerning their choice of currency. Panama has used the US dollar as its currency (along with the Balboa) since 1904 and has never had a currency crisis. Then in 2000 Ecuador converted the use of its sucre to use of the dollar at a 25,000:1 exchange rate. Today the dollar and sucre are both used as currency in Ecuador.

    Scotland uses the pound Sterling today. It would be foolish for them to change. They do not need a currency board and they do not need to create a new currency (an invitation to disaster because their economy is small and subject to currency attacks). The pound Sterling is historically linked in the minds of Scots and there is no reason to change. Unless the UK forces a change for Scotland – because they vote for independence – the Scots should leave well enough alone. Changing to the euro or to a domestic currency will introduce unnecessary confusion and potential problems that are totally unnecessary. There is no reason the Scots cannot remain in the UK currency union, their optimal currency area.

    They definitely need to stay away from any advice from Paul Krugman. He single-handedly brought the monetary flu to SE Asia in the late 1990s. As Jude Wanniski wrote:

    In an October 14 letter to [Malaysian] Finance Minister Anwar Ibrahim, I explained why Thailand was the first country hit by the dollar deflation:

    “The other Southeast Asian economies were not chosen by the speculators as the primary target because they were stronger than Thailand at the outset. Thailand’s special problem was that it took seriously the advice of Paul Krugman, a prominent American economist, who two years ago toured Southeast Asia warning your countries against “hot money” flows. You wisely ignored Krugman’s advice and continued to welcome equity capital, which is what he considers “hot.” Bangkok fell for his advice and tightened up on capital inflows, which stalled the country’s growth. It became the weak link when the dollar deflation appeared this year. When the baht’s devaluation weakened the whole region, because of the interlacing of trade among your countries, the speculative pressures shifted to Kuala Lumpur, Jakarta and Manila.”

    On October 23, 1997, we were the first to label the problem “The Asian Flu,” noting that “What began as the sniffles in Bangkok has turned into a widespread influenza,” with “no doctor anywhere in sight…who seems to know how to arrest its spread…Our weakest link is the Japanese economy, where old-fashioned Keynesians at the Finance Ministry and Bank of Japan are combating recession with an insanely deflationary monetary policy of close to zero interest rates and tax increases designed to balance the budget. Meanwhile, the witch doctors of the IMF are running amok in the region, demanding tax increases and ‘free floats’ in exchange for cash.”

  2. baffling

    ricardo, ask ireland, greece and spain what if feels like to have a sovereign country operate with a central bank and currency controlled by others with different interests.

  3. Patrick

    Ricardo: The Bank of Montreal was the for all intents and purposes the central bank. But more importantly, the Great Depression was WORSE in Canada than in the US. GDP dropped 40%, as opposed to 37% in the US.

  4. westslope

    If you believe that fiscal policy is the best way to tackle structural unemployment, then leaving central bank decisions to some one else is not necessarily a bad idea.

  5. MacroMacro

    I am familiar with OCA theory, and acknowledge that Scotland would face some serious challenges, if not risks, by going out on its own politically and hanging on to Sterling. However, at a basic level it would seem to me that business cycle convergence between Scotland and the UK is and will remain strong, and accordingly, BOE policy will be pretty appropriate for Scotland. Much of real activity is and will be tied to what happens in the City. Additionally, I can’t imagine the the BOE’s policy reaction function has ever been heavily dependent on what is happening in Scotland, so again, Sterling will probably do no more harm to Scotland than it has ever done in the past. The biggest problem might be RBS: it is may simply be too big for Scotland to save under the restraints of Sterling. If Scotland is disciplined, it may do OK on its own.

  6. weareastrangemonkey

    This is bonkers!

    “The Scottish economy would shrink by up to £100bn by 2023, MacDonald said.”

    This cannot possibly be true!

    The Scottish Economy has an annual GDP of around a £135 billion. There is almost no imaginable circumstance in which the economy is going to shrink by 75% as a result of independence.

    As a No voter I get really annoyed when the economic facts of the No campaign are wrong. Too many people think that there is an international conspiracy of economists, bankers, oil merchants, and businessmen to lie to the Scottish people about the economics. Then someone goes ahead and publishes this!

    No one would be stupid enough to lie so badly so the best explanation is an enumerate journalist mixed up millions and billions. But skimming the paper I couldn’t find any figures that it would be easy for an enumerate journalist to misquote like that. Perhaps in an interview he was talking in millions.

    How the hell did no one catch this obvious blunder! I mean the Yes campaign could have used such a blunder (and it must have been) mercilessly. One must assume that the proponents of the Yes vote are as enumerate as the Guardian journalist.

    But there is surely no reason for Menzie Chinn not to notice it.

    Am I totally misunderstanding this or do people think that a currency union could cause more economic devastation to a country than any war, recession, or disaster of the 20th century.

  7. weareastrangemonkey

    I might have misread the above. If this is the cumulative lost output over a 9 year window then a 8% point drop in output over 2015 without a bounce back would be about enough. Given that this is an extreme case, relative to his point estimate of 30 billion (about a 3% drop in output over 2015), this is within the realms of plausibility.

    If this is what was meant, apologies for calling the journalist and Yes campaigners enumerate.

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