In a speech in Edinburgh, Mark Carney, Governor of the Bank of England, considered the implications of Scotland retaining the pound if the Scottish people vote yes for independence. His speech was intended to be non-political. Rather he focused on two main questions: first whether a currency union of Scotland and the rest of the UK (RUK) would be an optimal currency area; second how much economic sovereignty would need to be shared with RUK as a consequence of Scotland keeping the pound.
On the first question, Mark Carney argued that the current UK is close to an optimal currency area as there is a high degree of economic integration and factor mobility. Sharing a currency eliminates exchange costs, improves pricing transparency and hence encourages competition, promotes cross-border investment, improves the flow of technology and ideas, and increases the mobility of labour and capital.
But sharing a currency involves sharing a monetary policy. This would still be determined by the Bank of England and would have to geared to the overall economic situation of the union, not the specific needs of Scotland.
There would also need to be a banking union, whereby banks in difficulties would receive support from the whole currency area. In Scotland’s case, banking accounts for a very large proportion of the 
economy (12.5% compared with 4.3% for RUK) and could potentially place disproportionate demands on the currency union’s finances.
And then there is the question of fiscal policy. A shared currency also means pooling a considerable amount of sovereignty over taxation, government spending and government debt. This could be a serious problem in the event of asymmetric shocks to Scotland and RUK. For example, if oil prices fell substantially, Scotland may want to pursue a more expansionary fiscal policy just at a time when its tax revenues were falling. This could put a strain on Scotland’s finances. This might then require RUK to provide support from a common pool of funds, such as a ‘regional fund’.
Being in a currency union can amplify fiscal stress, and increase both the risks and consequences of financial instability. In the situation just described [a fall in demand for exports], 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.6 Such adverse feedback loops turned recessions into depressions in several European countries in recent years.
A separate Scottish currency, by contrast, would, according to Carney, be a valuable shock absorber if domestic wages and prices were 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.
But despite the problems of ceding a degree of monetary and fiscal sovereignty, Scotland and RUK are well placed to continue with a successful currency union if Scotland becomes independent. Economic conditions are very similar, as are language, culture and institutions, and there is an effective banking union – assuming such a banking union were to continue post independence.
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 desirability of Scottish independence is a normative question for the Scottish electorate to decide. Nevertheless, economists have an important part to play in informing the debate. Mark Carney’s economic analysis of currency union if the Scottish electorate votes yes is a good example of this.
Video of speech
Speech at lunch hosted by the Scottish Council for Development & Industry, Edinburgh Bank of England, Mark Carney (29/1/14)
Text of speech
The economics of currency unions Bank of England, Mark Carney (29/1/14)
Articles, podcasts and webcasts
Independent Scotland would be forced to cede some sovereignty if it keeps pound, says Carney The Telegraph, Szu Ping Chan (29/1/14)
Scottish independence: Currency debate explained BBC News, Andrew Black (29/1/14)
Scottish independence: Key extracts from Mark Carney speech BBC News (29/1/14)
Scottish independence: Carney says Scots currency plan may lead to power loss BBC News (29/1/14)
The sterling price of Scottish independence BBC News, Robert Peston (29/1/14)
Independent Scotland ‘needs to cede sovereignty’ for currency union with UK The Guardian, Severin Carrell (29/1/14)
Mark Carney warns Scotland over currency union hopes Financial Times, Mure Dickie and Sarah O’Connor (29/1/14)
How independent would Scotland really be? Channel 4 News (29/1/14)
BoE’s Mark Carney in currency sovereignty warning The Scotsman, Tom Peterkin (30/1/14)
Carney Says Scotland Must Heed Euro Crisis in Pound Debate Bloomberg, Emma Charlton and Jennifer Ryan (29/1/14)
Independent Scotland ‘meets criteria’ for currency union BBC Today Programme, Gordon MacIntyre-Kemp and Iain Gray (29/1/14)
Scotland must play a high-stakes poker game with Westminster over the pound The Guardian Larry Elliott (12/2/14)
Questions
- What are the conditions necessary for a successful currency union?
- To what extent do Scotland and RUK meet these conditions?
- What are meant by asymmetric shocks? Give some examples of asymmetric shocks that could affect a Scotland–RUK currency union.
- Why is there a potential moral hazard in a whole currency union providing fiscal support to members in difficulties?
- Why is banking union such an important part of a successful currency union? What lessons can be learned here from the eurozone currency union?
- What constraints would currency union impose on Scottish fiscal policy? Would such constraints exist in an optimal currency area?
World markets were taken by surprise by a large rise in Turkish interest rates on 28/1/14. In an attempt to combat a falling lira and rising inflation, the Turkish central bank raised its overnight lending rate from 7.75% to 12%. Following the decision, the lira appreciated by over 3%.
Since the start of this year, the Turkish lira had depreciated by 7.1% and since the start of 2013 by 22.8%. Along with the currencies of several other emerging economies, such as India and Brazil, speculators had been selling the Turkish currency. This has been triggered by worries that the Fed’s tapering off its quantitative easing programme would lead to a fall, and perhaps reversal, of the inflow of finance into these countries; in the worst-case scenario it could lead to substantial capital flight.
Consumer price inflation in Turkey is currently 7.4%, up from 6.2% a year ago. The central bank, in a statement issued alongside the interest rate rise, said that it would continue with a tight monetary
policy until the inflation outlook showed a clear improvement.
The Turkish Prime Minister, Tayyip Erdogan, has been opposed to rises in interest rates, fearing that the dampening effect on aggregate demand would reduce economic growth, which, as the chart shows, has been recovering recently (click here for a PowerPoint of the chart). A slowing of growth could damage his prospects in forthcoming elections.
World stock markets, however, rallied on the news, seeing the rise in interest rates as a symbolic step in emerging countries stemming outflows of capital.
Articles
Turkey raises interest from 7.75pc to 12pc The Telegraph (28/1/14)
Emerging markets forced to tighten by US and Chinese monetary superpowers The Telegraph, Ambrose Evans-Pritchard (28/1/14)
Turkey Gets Aggressive on Rates The Wall Street Journal, Joe Parkinson (28/1/14)
Turkish central bank raises lending rate to 12% BBC News (28/1/14)
Asian stock markets stage relief rally after Turkey rate rise BBC news (29/1/14)
Turkey raises rates to halt lira’s slide Financial Times, Daniel Dombey (29/1/14)
Turkey Rate Increase Stems Lira Drop as Basci Defies Erdogan Bloomberg Businessweek, Onur Ant and Taylan Bilgic (29/1/14)
Fragile economies under pressure as recovery prompts capital flight The Observer, Angela Monaghan (2/2/14)
Data
Main Economic Indicators (including Turkish data) OECD
Data on Turkey, World Economic Outlook database IMF
Turkey price indices Central Bank of the Republic of Turkey
Questions
- Why did the Turkish central bank decide to raise interest rates by such a large amount?
- Why has the Turkish lira been depreciating so much over the past few months? How has this been linked to changes in Turkey’s balance of payments and what parts of the balance of payments account have been affected?
- Why did global stock markets rally on the news from Turkey?
- What will be the impact of the central bank’s actions on (a) inflation; (b) economic growth?
- How has the USA’s quantitative easing programme affected developing countries?
Christine Lagarde, managing director of the IMF, has warned of the danger of deflation in the eurozone. She also spoke of the risks of a slowdown in the developing world as the Fed tapers off its quantitative easing programme – a programme that has provided a boost to many emerging economies.
Speaking at the World Economic Forum, in the Swiss Alps, she did acknowledge signs of recovery across the world, but generally her speech focused on the risks to economic growth.
Some of these risks are old, such as a lack of fundamental bank reform and a re-emergence of risky behaviour by banks. Banks have taken steps towards recapitalisation, and the Basel III rules are beginning to provide greater capital buffers. But many economists believe that the reforms do not go far enough and that banks are once again beginning to behave too recklessly.
Some of the risks are new, or old ones resurfacing in a new form. In particular, the eurozone, with inflation of just 0.8%, is dangerously close to falling into a deflationary spiral, with people holding back on spending as they wait for prices to fall.
Another new risk concerns the global impact of the Fed tapering off its quantitative easing programme (see Tapering off? Not yet). This programme has provided a considerable boost, not just to the US economy, but to many emerging economies. Much of the new money flowed into these economies as investors sought better returns. Currencies such as the Indian rupee, the Brazilian real and the Turkish lira are now coming under pressure. The Argentinean peso has already been hit by speculation and fell by 11% on 24/1/14, its biggest one-day fall since 2002. Although a fall in emerging countries’ currencies will help boost demand for their exports, it will drive up prices in these countries and put pressure on central banks to raise interest rates.
Christine Lagarde was one of several speakers at a session titled, Global Economic Outlook 2014. You can see the complete session by following the link below.
Articles
Lagarde warns of risks to global economic recovery TVNZ (27/1/14)
Lagarde Cautions Davos on Global Deflation Risk Bloomberg News, Ian Katz (26/1/14)
Davos 2014: Eurozone inflation ‘way below target’ BBC News (25/1/14)
IMF fears global markets threat as US cuts back on cash stimulus The Guardian, Larry Elliott and Jill Treanor (25/1/14)
Davos 2014: looking back on a forum that was meant to look ahead The Guardian, Larry Elliott (26/1/14)
Speeches at the WEF
Global Economic Outlook 2014 World Economic Forum (25/1/14)
Questions
- Why is deflation undesirable?
- What are the solutions to deflation? Why is it difficult to combat deflation?
- What are the arguments for the USA tapering off its quantitative easing programme (a) more quickly; (b) less quickly?
- How is tapering off in the USA likely to affect the exchange rates of the US dollar against other currencies? Why will the percentage effect be different from one currency to another?
- What are Japan’s three policy arrows (search previous posts on this site)? Should the eurozone follow these three policies?
World leaders are meeting at the World Economic Forum in Davos, in the Swiss Alps. This annual conference is an opportunity for politicans, economists and businesspeople from around the world to discuss the state of the world economy and to consider policy options.
To coincide with the conference, the BBC’s Newsnight has produced the following slide show, which presents some economic facts about the world economy. The slide show provides no commentary and there is no commentary either in this blog – just some questions for you to ponder.
Using the economics you’ve learned so far, try answering these questions, which focus on the reasons for the patterns in the figures, the likely future patterns and the policy implications.
Slide show
Davos: 22 facts people should know BBC Newsnight (23/1/14)
Data
For additional international data to help you answer the questions, see:
Economic Data freely available online Economics Network
Questions
- Go through each of the slides in the Newsnight presentation and select the ones of most interest to you. Then, as an economist, provide an explanation for them.
- Identify some patterns over time in the statistics. Then project forward 20 years and discuss whether the patterns are likely to have changed and, if so, why.
- What policies could governments adopt to reverse any undesirable trends you have identified? How likely are these policies to be implemented and how successful are they likely to be?
As the old year gives way to the new, papers have been full of economic forecasts for the coming year. This year is no exception. The authors of the articles below give their predictions of what is to come for the global economy and, for the most part, their forecasts are relatively optimistic – but not entirely so. Despite a sunny outlook, there are various dark clouds on the horizon.
Most forecasters predict a higher rate of global economic growth in 2014 than in 2013 – and higher still in 2015. The IMF, in its October forecasts, predicted global growth of 3.6% in 2014 (up from 2.9% in 2013) and 4.0% in 2015.
Some countries will do much better than others, however. The USA, the UK, Germany and certain developing countries are forecast to grow more strongly. The eurozone as a whole, however, is likely to see little in the way of growth, as countries such as Greece, Spain, Portugal and Italy continue with austerity policies in an attempt to reduce their debt. 
Chinese growth has slowed, as the government seeks to rebalance the economy away from exports and investment in manufacturing towards consumption, and services in particular. It is still forecast to be 7.3% in 2014, however – well above the global average. Japanese growth has picked up in response to the three arrows of fiscal, monetary and supply-side policy. But this could well fade somewhat as the stimulus slows. The table shows IMF growth forecasts for selected countries and groups of countries to 2018.
Much will depend on what happens to monetary policy around the world. How quickly will monetary stimulus taper in the USA and in Japan? Will the ECB introduce more aggressively expansionary monetary policy? When will the Bank of England start raising interest rates?
Growth within countries is generally favouring those on higher incomes, with the gap between rich and poor set to continue widening over the coming years. The pay of top earners has continued to rise considerably faster than prices, while increasingly flexible labour markets and squeezed welfare budgets have seen a fall in living standards of many on low incomes. According to a Which? survey (reported in the Independent article below), in the UK:
Only three in ten expect their family’s situation to improve in the new year, while 60% said they are already dreading the arrival of their winter energy bill. The Which? survey also found that 13 million people could afford to pay for Christmas only by borrowing, with more than four in ten using credit cards, loans or overdrafts to fund their festive spending. A third of people (34%) also dipped into their savings, taking an average of £450 from their accounts.
If recovery is based on borrowing, with real incomes falling, or rising only very slowly, household debt levels are likely to increase. This has been stoked in the UK by the ‘Help to Buy‘ scheme, which has encouraged people to take on more debt and has fuelled the current house price boom. This could prove damaging in the long term, as any decline in confidence could lead to a fall in consumer expenditure once more as people seek to reduce their debts.
And what of the global banking system? Is it now sufficiently robust to weather a new crisis. Is borrowing growing too rapidly? Is bank lending becoming more reckless again? Are banks still too big to fail? Is China’s banking system sufficiently robust? These are questions considered in the articles below and, in particular, in the New York Times article by Gordon Brown, the former Prime Minister and Chancellor of the Exchequer.
Articles
Global economy: hopes and fears for 2014The Observer, Heather Stewart and Larry Elliott (29/12/13)
Looking ahead to 2014 BBC News, Linda Yueh (20/12/13)
Low hopes for a happy new financial year in 2014 Independent, Paul Gallagher (29/12/13)
Brisk UK economic growth seen in 2014 fuelled by spending – Reuters poll Reuters, Andy Bruce (12/12/13)
GLobal Economy: 2014 promises faster growth, but no leap forward Reuters, Andy Bruce (29/12/13)
My 2014 Economic Briefing Huffington Post, Tony Dolphin (27/12/13)
Three UK Economy Stories that will Dominate in 2014 International Business Times, Shane Croucher (27/12/13)
Who You Calling a BRIC? Bloomberg, Jim O’Neill (12/11/13)
Hope and Hurdles in 2014 Project Syndicate, Pingfan Hong (27/12/13)
On top of the world again The Economist (18/11/13)
Digging deeper The Economist (31/10/13)
BCC Economic Forecast: growth is gathering momentum, but recovery is not secure British Chambers of Commerce (12/13)
Eight predictions for 2014 Market Watch, David Marsh (30/12/13)
Stumbling Toward the Next Crash New York Times, Gordon Brown (18/12/13)
Central banks must show leadership to rejuvenate global economy The Guardian, Larry Elliott (1/1/14)
Global economy set to grow faster in 2014, with less risk of sudden shocks The Guardian, Nouriel Roubini (31/12/13)
A dismal new year for the global economy The Guardian, Joseph Stiglitz (8/1/14)
Forecasts and reports
World Economic Outlook (WEO) IMF (October 2013)
Economic Outlook OECD (November 2013)
Output, prices and jobs The Economist
Bank of England Inflation Report: Overview Bank of England (November 2013)
Questions
- What reasons are there to be cheerful about the global economic prospects for 2014 and 2015?
- Who will gain the most from economic growth in the UK and why?
- Why is the eurozone likely to grow so slowly, if at all?
- Are we stumbling towards another banking crisis, and if so, which can be done about it?
- Why has unemployment fallen in the UK despite falling living standards for most people?
- What is meant by ‘hysteresis’ in the context of unemployment? Is there a problem of hysteresis at the current time and, if so, what can be done about it?
- Explain whether the MINT economies are likely to be a major source of global economic growth in the coming year?
- Why is it so difficult to forecast the rate of economic growth over the next 12 months, let alone over a longer time period?
economy (12.5% compared with 4.3% for RUK) and could potentially place disproportionate demands on the currency union’s finances.
