Aug 15

Monetary policy in an independent Scotland – currency union and beyond

There is now just over a month to go before the Scottish independence referendum on September 18th 2014.

My purpose in this analysis is not to express a political opinion on the desirability or otherwise Scottish independence. It is rather to give a view as a professional economist on Scotland’s optimal monetary policy, if it were to become independent.

As stated in my Financial Times letter of February 2014 (“Mr Salmond and the £” on this website), my view is that the currency union concept is flawed.

If it is set up, it may not last very long. It may well be true, as advocates of currency union argue, that we are now in a “Goldilocks” era, where the Bank of England’s stance is too hot for London – where property prices are in an unsustainable bubble – too cold for the North of England, which continues to suffer from high rates of unemployment – but just right for Scotland. However, there is no reason to suppose that this will continue to be the case over the next 5, 10 or 15 years. And if there is a divergence between Scotland’s economic interests and those of the rest of the United Kingdom, there is no doubt which will dominate the decisions of the Bank’s Monetary Policy Committee.

Strains within the currency union could lead a simple choice for a future Scottish Government. Either to leave it, or to maintain it at the cost of economic stagnation, as has been the fate of the peripheral eurozone countries.

The better choice would be to leave the currency union. This is a choice which may be forced upon The Scottish Government anyway, if the Westminster Government simply refuses to engage in negotiations to set up a currency union in the first place.


Outside a currency union, Scotland could continue to use the £, but without a formal central bank. This is how the Republic of Ireland operated immediately after it achieved independence in 1922. It is an option that has secured support from some surprising quarters, including economists at the Adam Smith Institute and Institute of Economic Affairs in London who advocate a “free banking” system. This doesn’t mean that banking services are provided free of charge, but rather that there is minimum regulation of the banking system, no central bank and no possibility of banking bailouts.

This approach is based on the theories of the Austrian economists Ludwig von Mises and Friedrich Hayek, classical liberals who followed the Jeffersonian adage that “the best government is the least government.” In the Austrian view, the lack of a safety net would impose market discipline on commercial banks and avoid moral hazard risks. In simple terms, it removes the possibility of a “heads we win, tails you lose” approach, whereby reckless and greedy bankers take risks which will generate hefty bonuses for them if they pay off, but leave any losses to be picked up by the government and the taxpayer.

A Scots Pound

The reasons that libertarians like Sterlingisation is that it would leave a future Scottish Government with no role in the nation’s monetary affairs.

To my mind, this would expose a relatively small independent country to international crises with no means of combating them. It might be different if the rest of the world also adopted a free banking approach, or if international trade were carried out through a unit of exchange independent of national governments, such as gold. But as matters stand, sovereign states need control over their own currency if they are to protect themselves from crises emanating from the irresponsible policies of their trading partners. As, for example, Switzerland and Germany did in the 1970s, when they allowed their currencies to appreciate in order to sterilise the effects of rampant dollar inflation originating in the USA. Or more recently here in the UK, when the external value of the £ depreciated in the wake of the global financial crisis. Between the onset of the credit crunch in July 2007 and “Blue Monday” on January 19th 2009 when the Royal Bank of Scotland announced the biggest corporate loss in British history at £28 billion, the trade-weighted value of the £ fell by almost 30%. This external adjustment helped to stabilise the UK economy and stimulate a fragile recovery.

To a limited degree, responsibility for monetary policy is already shifting to Scotland. From 2015, the Scottish Government will have the right to issue bonds for an amount of up to £2.2 billion. How it uses this power will influence monetary conditions in Scotland. If it sets up a Scottish Debt Management Office to manage its borrowing programme, it will, in effect, already have created the embryo of a central bank. The first function of a central bank is to act as the government’s bank.

Its second function is to act as “the bankers’ bank”, by providing banking services to regulated financial institutions within its territory. They deposit funds at the central bank, which are used to clear inter-bank balances on a daily basis and ensure the smooth functioning of the money markets. The central bank may also use its deposits to make loans to any financial institution in temporary need of funds. This is the famous “lender of last resort” facility, where the central bank acts as the ultimate source of finance for commercial banks.

Under a currency union, these functions would be carried out by the Bank of England.

The Better Together campaign argues that, if a currency union does not exist, an independent Scottish Central Bank could not act as lender of last resort or bail out major banks such as RBS and Lloyds-HBOS which had run into trouble. Their implication is that this would be a retrograde step.

I take a different view, which could be termed “quasi-Austrian”. It is helpful that a Central Bank of Scotland could not underwrite commercial banks operating in Scotland to an unlimited extent. With the safety net removed, banks will be encouraged to behave more prudently.

But I don’t go the whole way with the Austrians in advocating no central bank support. A Scottish Central Bank should be able to lend limited amounts to financial institutions within Scotland to help them meet short-term liquidity requirements. But there should be no presumption that the central bank is the sole provider of funds in such circumstances. After all, Barclays Bank turned to Qatar for the funding it needed in preference to the Bank of England’s Asset Protection Scheme, while more recently the Co-op Bank was restructured without the assistance of any taxpayer support.

A final role for a Scottish Central Bank will be to ensure the convertibility of a Scots Pound. To fulfil this function, it would deploy Scotland’s foreign exchange reserves, initially to maintain parity with the £ Sterling, but with the ultimate ability to adjust upwards or downwards against Sterling as domestic economic conditions within Scotland require.

This would not be an easy option. It would require an independent Scotland to maintain strict monetary discipline and, at least initially, to run a Balance of Payments surplus to build up foreign exchange reserves. However, over the longer term, I believe that sound money would deliver significant economic benefits compared to the alternative of a currency union dominated by England. Underpinned by strong and dynamic economy, there is no reason why the external value of a Scots £ should not appreciate against Sterling, as have the currencies of a number of other small nations, including Switzerland, Singapore and Australia.

Such a strategy would address the fundamental paradox that lies at the heart of the economic strategy set out in the Independence White Paper. If it is the case that no-one will look after Scottish interests better than the Scottish people themselves, exercising their sovereign will through a democratically elected Scottish Government, how can it be that the monetary and financial affairs of an independent Scotland are best managed from London?

At the very least, the creation of a Scots Pound is an option that should be considered in greater detail. In considering alternatives to currency union, the only thing we have to fear is fear itself.

Michael Nevin
August 15th 2014

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Mar 18

The morning after the night before: six steps to Scottish economic independence

For success in politics or business, leaders need a coherent and effective “Plan A” to submit to the public and their key stakeholders. But they also need a viable “Plan B” – a contingency plan that can be rolled out in the event that Plan A cannot be delivered for reasons beyond their control.

The SNP’s plan a for a currency union and continued EU membership on the same terms as at present has increasingly been called into question. As an economist, I have no comment to make on the political case for Scottish independence. However, from an economic viewpoint, there is no reason why an independent Scotland could not survive, and indeed thrive – provided the Scottish Government puts in place an appropriate policy framework. This policy framework could involve rolling out a “Plan B” for both the currency and relations with Europe, as set out below.

Six steps on the path to Scottish economic independence.

1. Referendum Night: September 18th / 19th 2014.

In the headquarters of the “Yes” campaign, joy is unconfined, as news comes in of a decisive vote in favour of independence. The music is raucous and the water of life flows freely. Until, that is, at around 3 AM, when the plaintive voice of a junior adviser, who has imbibed slightly less copiously than others present, is heard above the hubbub, asking the killer question:
“What the (expletive deleted) do we do now?”

2. The Hangover: September 19th 2014.

As the revellers slowly come back into consciousness, sometime around midday on September 19th, the reality of the situation becomes apparent. Despite opinion polls showing gathering support for the Yes campaign in the months leading up to the referendum, the markets had genuinely failed to discount the result. The London Stock Market is in meltdown. The FTSE 100 records its worst one-day fall since the collapse of Lehman Brothers. Major companies, including RBS and Standard Life, announce that they are implementing plans to transfer their head offices from Edinburgh to London – and with them will go several million pounds of corporation tax and the income tax paid by their senior executives. Elsewhere in Scotland, major investment projects are put on hold as funders state that they are reviewing their commitments “pending clarification of the independence settlement.” The Scottish property market seizes up – there is a complete absence of buyers for both commercial and residential properties, and those who wish to buy are finding it increasingly difficult to raise money from the banks to complete their purchases.

3. The Emergency Budget: late September 2014.

Faced with the threat of a flight of human and financial capital from Scotland, Finance Secretary John Swinney gathers together his closest and most trusted advisers. Mr Swinney has proved himself to be a competent and prudent Finance Minister within the devolved administration, but nothing has prepared him for the panic that threatens to engulf Scotland even before the first date for detailed negotiations on the independence settlement is set. The Finance Ministry team devise a plan to combat the panic. An Emergency Budget is introduced, developing commitments given in the Independence White Paper to cut corporation tax to 12.5% and reduce Air Passenger Duty. More widely, the Finance Secretary gives an unequivocal commitment that income tax in an independent Scotland will be levied rates no higher than those that apply in England, and that the Scottish Government will manage its affairs to comply with the Maastricht criteria. This means that the Scottish Government will not at any time run a budget deficit that exceeds 3% of national GDP.

The message is clear. Companies are free to relocate from Scotland to England if they so wish. But if they do so, they will face a higher corporation tax bill on their profits, and their employees will have to pay higher taxes on their incomes.

Faced with this message, the threatened haemorrhage of Scottish companies south of the border slows to a trickle, as their Chairmen announce they are adopting a “wait and see” approach before taking any final decision.

4. The Medium Term Financial Strategy (MTFS): 2014-2015.

One implication of the Finance Secretary’s commitment to a competitive taxation regime is that public expenditure has to be kept under tight control. Over the succeeding months, the Finance team at Victoria Quay works well into the night and over weekends to develop a public spending strategy for post-independence Scotland. Out go previous expenditure plans that will no longer be affordable within the framework of the MTFS, such as the proposal to increase defence expenditure in an independent Scotland above the levels that applied within the UK (Why? Does an independent Scotland fear invasion from England – or perhaps from Russia?!). Little by little, as the resource constraints that an independent Scottish Government will face become clear, the Finance team is forced to look at more radical options, including a fundamental shake-up of the welfare system. The spending review concludes that minimum welfare standards must be guaranteed for all, but that real increases in benefits funded from general taxation are neither economically beneficial nor financially affordable. Instead, an independent Scotland will move towards an insurance-based system similar to those of Scandinavia or Germany, as Lord Beveridge himself envisaged in the 1940s.
Little by little, Scotland is weaning itself off the dependency culture of the UK, and moving towards a self-sustaining system of social insurance.

5. The End of the Currency Union: 2015-16.

While the Finance Secretary is creating a sustainable fiscal system for an independent Scotland, the Deputy First Minister is tasked with leading delicate negotiations with the rest of the UK on the thorny issue of the proposed currency union.

Perhaps Nicola Sturgeon will be proved right, and the Unionist Parties have been bluffing in ruling out a currency union in the run-up to the Independence Referendum. But I hope not. For if they were, she and her team face months if not years of arduous and difficult negotiations with a reluctant and probably sullen counterparty, who will quibble over every minor issue, and seek to squeeze every concession they can from the Scottish negotiators. The end result is likely to be an unstable and unsatisfactory compromise, which will probably collapse within a few years, as the First Minister appears to recognise.

A far better alternative would avoid going down this blind alley. Instead, an independent Scotland takes complete control of its own currency and monetary policy. The Government announces the creation of a new Scots pound, pegged at parity with the £ Sterling – in exactly the same way as the Irish pound used to be – to be managed by a newly created Reserve Bank of Scotland.

The powers and operations of the Reserve Bank are modelled on those of the successful Hong Kong Currency Board, established 30 years ago when the Hong Kong dollar was pegged to the US dollar, at a rate which has prevailed ever since, through years of radical constitutional change and financial turbulence.

John Greenwood OBE, one of the main architects of the Hong Kong currency board, has set out six conditions for such a board to operate successfully. On my analysis, an independent Scotland could fulfil all six.

Prime among them is the need to maintain high levels of gold and foreign exchange reserves. A couple of days ago, George Soros cautioned against the option of creating a new Scottish currency, warning that it would inevitably come under attack from currency speculators at some point (I wonder whom he could possibly have had in mind?). There is no doubt that Mr Soros is correct. It would therefore be imperative for the Reserve Bank to accumulate sufficient foreign currency to repel any speculative attack. It should also keep its own interventions in the foreign exchange markets a closely guarded secret, so that speculators would never know from day to day when the Bank might enter the market with heavy Buy orders for Scots Pounds, driving up its value and causing severe losses for any speculators naïve enough to believe that they could make easy profits by going short of the currency.

In order for the Reserve Bank of Scotland to command respect in international markets, it is important that it maintains reserves of foreign currency that are significant in relation to the value of Scottish GDP. This in turn implies that an independent Scotland would need to run a Balance of Payments surplus at least for the first few years after independence. So the fiscal framework put in place by the Scottish Government would need to encourage exports – electronics, IT, oil, renewable energy, financial services, whisky, and tourism. For example, the Republic of Ireland applies a 9% VAT rate to hotels and restaurants, recognising that a competitive VAT regime is essential if they are to compete in highly price-sensitive international tourism markets. As a result, Ireland has gained market share at the expense of the UK, where VAT is applied at 20%. An independent Scotland should follow the Irish model in this regard.

6. Relations with Europe: 2015-16.

Immediately after the Referendum result is announced, the First Minister makes contact with the European Union seeking to confirm the terms of Scotland’s continued membership.

There are two alternative scenarios of what happens next. Under the first scenario, EU leaders would enter into a constructive and positive dialogue. This is the scenario for which Alex Salmond – and indeed myself – would hope. In which case, Scotland’s continued membership of the European Union, on broadly the same terms as at present, is assured.

However, there is a second scenario, which has to be considered following recent ill-judged remarks by Mr Barroso and others in the EU hierarchy. These hint that Scotland’s continued membership of the EU in the event of independence is likely to be fraught with difficulty.
It would be demeaning for the leaders of an independent Scotland to go like a beggar to the banquet pleading for crumbs from the rich man’s table. There seems to be an attitude, exemplified by Mr Barosso and others, that wee Scotland should be grateful for any attention the panjandrums of Brussels deign to give us, and we should be duly humble if these great men so much as admit us into their august presence.
Nothing could be further from the truth. The reality is that the EU needs Scotland more than Scotland needs the EU. Whatever the merits of the European Union as originally conceived, in recent years it has increasingly corrupted into a self-regarding and self-serving bureaucracy whose incessant demands for the transfer of more power, wealth and influence to the centre has weakened the peripheral Member States – Portugal, Ireland, Italy, Greece and Spain – and, yes, Scotland.

The leaders of an independent Scotland should make it unequivocally clear from the outset of any post-independence negotiations that they are not prepared to join the EU club on any terms they care to dictate. If the terms are not acceptable, Scotland has a perfectly viable “Plan B” – namely, to remain outside the European Union but with a commitment to free trade and open frontiers with it – going the way of Norway, Switzerland, the Channel Islands, Monaco and others – none of whom seem to have suffered unduly as a consequence.

Following these six steps, within two years of a Yes Vote, despite current scaremongering and a reaction that is likely to be negative in the short term, Scotland could put in place three key pillars of stable growth and full employment – fiscal prudence, sound money and free trade. If it does so, the foundations of prosperity in a free society will have been laid.

MJN, March 2014

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Feb 07

Mr Salmond and the £

As the date of the Scottish independence referendum approaches, a key issue is the question of Scotland’s currency if it were to become an independent nation. The policy advocated by the Scottish National Party is to maintain a currency union with England, a proposal that is causing increasing concern among many economists, myself included. I put these concerns to Scotland’s First Minister, Alex Salmond, at a meeting just before Christmas, and in fairness he did make a couple of valid points in response:

1. His Council of Economic Advisers, which includes Nobel laureates James Mirrlees and Joseph Stiglitz, has concluded that Scotland and England constitute an “optimal currency area”.

2. Evidence that Scotland and England constitute an optimal currency area is provided by the current performance of the two nations. Mr Salmond argued that the Bank of England’s monetary stance, with Base Rate at a record low of 0.5%, could be regarded as too loose for London – whether the labour market is tight and property prices are soaring – but too tight for the north-east, where unemployment remains high and house prices depressed. But it seems to be about right for Scotland.

Notwithstanding these points, I am not reassured, and set out my concerns in a letter published in the Financial Times on February 5th 2014:

“Dear Sir

In article, “England must reject currency union with Scotland” (January 31st), Martin Wolf exposes the flaws in the SNP policy of a currency union with England post-independence. It can only work with a banking union and shared fiscal resources. But these are incompatible with independence.

At a meeting with the First Minister just before Christmas, I put this to him and pointed out that, while the currency proposals in the Independence White Paper – under which an independent Scottish Government would be a shareholder in the Bank of England and have the right to nominate Board members – were all very well, the hard fact is that they have been rejected out of hand by the Westminster Government. In response, Mr Salmond argued that, if his proposals were rejected, an independent Scotland would simply refuse to accept a share of the UK’s National Debt. The Scottish Government then claimed victory a few weeks later, when the UK Government announced that it would underwrite all of Britain’s National Debt, irrespective of the outcome of the Independence Referendum.

But the Scottish Government’s policy is not credible. If an independent Scotland simply refuses to accept a reasonable proportion of the UK’s national debt, its ability to borrow on international markets will be fatally compromised.

I suggested to the First Minister that a preferable alternative would be to adopt the strategy discussed by John Greenwood in his FT article on January 16 (“A hollow independence if Scotland keeps sterling”). Namely, that Scotland should follow Hong Kong’s line in creating its own currency board. The Hong Kong currency board has operated successfully for 30 years of financial turbulence and radical constitutional change, and there is no reason why a Scottish currency board could not do likewise, guaranteeing the convertibility of a Scots Pound, initially at parity with the £ Sterling, but with the ultimate ability to adjust upwards or downwards against the £ Sterling as domestic economic conditions within Scotland require.

This would not be an easy option, as Mr Greenwood quite correctly points out. In order to sustain a currency board, an independent Scotland would have to maintain strict monetary discipline, as has Hong Kong. However, over the longer term sound money would deliver significant economic benefits compared to the alternative of a currency union dominated by England. An independent Scotland could survive and indeed thrive – but only if it has ultimate control of its own currency and monetary policies, as do Norway, Sweden and Denmark, which are frequently cited by the Scottish Government as comparators.

If it is to avoid being skewered on this issue as the independence debate evolves this year, the Scottish Government should have
the courage to propose that a currency board option is a viable “Plan B” in the event that its own “Plan A”, of full currency union with England, proves impossible to deliver on the terms it wishes.

Yours faithfully
Michael Nevin.”


Other authorities are expressing similar concerns. The Governor of the Bank of England, Mark Carney, summarised the issues that would need to be addressed in order for a currency union to be sustainable in a balanced and judicious manner, carefully avoiding political comment, during his visit to Edinburgh last week. And yesterday, the Chairman of the House of Commons Treasury Select Committee, Andrew Tyrie MP, stated that he did not believe that a currency union would gain parliamentary support from an English Parliament in the event that Scotland became independent. He proposed that it should therefore be rejected outright at this stage.

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Aug 29

Have central banks given up on fixing global finance?

In an article in the Financial Times on August 28, “Central Banks have given up on fixing global finance”, Robin Harding concludes that,

“a reliable backstop (to the international monetary system) is impossible when the international system relies on a national currency – the US dollar – as its reserve asset…. The answer is what John Maynard Keynes proposed in the 1930s: an international reserve asset, rules for pricing national currencies against it, and penalties for countries that run a persistent surplus.”

This is exactly the conclusion of The Golden Guinea. Agreed, such an international reserve asset is not going to be created any time soon, but the final comment in the Harding article, that this should not stop the search for a stable international financial system, is entirely valid. Under current arrangements, the world is lurching from one currency crisis to another – the recent instability of the Indian Rupee being merely the latest manifestation. One also wonders what Angela Merkel’s comment that Greece should never have been allowed into the Euro portends for the European single currency after the German elections are out of the way in September.

Whatever happens, it is easy to predict continuing currency instability under “business as usual”, which will be harmful to international trade, investment and employment.

As to the rules of a new international monetary accord – one rule that could be supported by supporters of floating rates and advocates of some form of fixed rate system is that national monetary authorities should commit themselves to maintaining a stable ratio of foreign-exchange reserves to GDP. This would avoid the dangers of a “mercantilist” policy pursued by nations seeking to run permanent Payments surpluses with the aim of building up their foreign exchange reserves without limit.

It would imply that national authorities manage their exchange rates in such a way as to achieve a broad external balance of payments, which is an essential condition for international monetary stability.

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Jul 03

The Outlook for the Bond Market

In my comment on April 3rd, “Are Sterling Bond Prices in a Bubble?”, I concluded that,

“Quantitative easing has led to an artificial bond bubble. Investors should be very cautious in committing new funds to UK fixed-income securities. Their risk / return profile is distinctly unappealing – none moreso than gilts issued by the UK Government.”

The reversal that was foreseen in that comment is now occurring. Bond prices have fallen sharply. My PIBS Price Index – a weighted index of Permanent Income-Bearing Shares issued by UK banks and building societies – has fallen by 20% since the end of May, with a commensurate rise in yields.

The reason is that the US Federal Reserve recently announced that they might be looking to withdraw from quantitative easing – i.e. stop buying US government bonds – removing the artificial support for their prices, and sending them tumbling.

In the UK, this has been compounded by the Co-op Bank debacle, with holders of Co-op PIBS still in a limbo, uncertain of how much of their face value they will recover. The only certainty is that any recovery will be significantly below their par value, as bondholders are “bailed in” as part of the Bank’s proposals to restore its capital.

These uncertainties have led to significant outflows from bond funds as investors have panicked in the face of steep price falls. A front page article in today’s Financial Times reports that Pimco has suffered record outflows, which are “the latest sign of nerves among bond investors after a market rout that has seen the worst performance for fixed-income assets since the financial crisis”.

As a consequence, Pimco and other bond funds are having to sell their bonds to raise the cash to repay their investors.

Result: prices are falling to levels which may be artificially depressed, giving an excellent buying opportunity once they settle down.

The key is patience – the PIBS price index needs to bottom out and start to recover before committing any new funds to the bond market. In the meantime, cash is not a bad place to be. Then when the market turns, an investor will be ready to buy into a recovery at prices that represent reasonable value, with PIBS yields of between 8% and 10%.

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May 16

Sir Mervyn King as Governor of the Bank of England – Marks out of 10

As Sir Mervyn King enters his final days as Governor of the Bank of England, the time is right to assess his overall record over the past 10 years.

1. Monetary policy before the credit crunch. The initial phase of his tenure, between 2003 and 2007, appeared at the time to be a period of monetary stability. But as events transpired, serious problems were beginning to build up in the monetary system. The Bank of England presided over rates of monetary growth well in excess of the growth of output, with the increase in two standard measures of money supply – M3 and M4 – accelerating from approximately 6% per annum when Sir Mervyn took the reins to 15% per annum by 2007. The Bank of England could and should have taken measures to restrict monetary growth, most obviously by raising the Base Rate, but failed to do so. Mark for Sir Mervyn = -1.

2. Banking regulation before the credit crunch. The consequence of rapid monetary growth was an increase in leverage throughout the banking system, a bubble in asset prices, and an escalation in the UK’s external Balance of Payments deficit from less than £1 billion in 1997 to more than £50 billion by 2007. In a public statement in 2012, Sir Mervyn acknowledged that the Bank of England had failed to take account of the dangers of rising bank leverage, let alone take any measures to restrain it. Mark = -1.

3. The Bank of England’s immediate response to the credit crunch of late 2007 was badly fumbled. The first victim of the freeze in international money markets was Northern Rock, but Sir Mervyn vetoed a “white knight” approach from Lloyds TSB to rescue it, opting instead to spend his time lecturing the City on the dangers of moral hazard. Technically he was correct, but his timing could not have been worse. To take an analogy from the world of cricket so beloved of the Governor – it was rather as though the batsman had executed a cover drive that was technically beautiful, but appallingly mistimed, with the result that, instead of the ball flying to the boundary, it lobbed gently up into the air to offer an easy catch to the fielder.

Mark = -1.

In this case, the fielder did not take the catch. Sir Mervyn was fortunate indeed not to be sent back to the pavilion, and to have his mandate renewed. He was a beneficiary of the “camel in the tent” syndrome. The Prime Minister, Gordon Brown, apparently decided that it was safer to retain Sir Mervyn as Governor than to have him as a disgruntled ex-Governor outside the tent criticising the Labour Government’s own distinctly mixed record.

4. Banking regulation after the crisis. In his second term, Sir Mervyn’s record on banking issues improved. He was a strong advocate of the separation of investment banking and retail banking. He recommended restructuring the broken banking behemoths, in particular RBS – “if a bank is too big to fail, it is too big”, as he quite correctly stated. The Bank of England was also reasonably supportive of the entry of new banks into the market, increasing competition and customer choice. Mark = +1.

5. Monetary policy after the crisis. After 2008, the Bank of England aggressively cut Base Rates to an historic low of just 0.5% in early 2009, where they have remained ever since. In my view, quite correctly. Mark = +1.

6. The Introduction of Quantitative Easing. In early 2009, the Bank of England introduced a new measure to stimulate recovery – Quantitative Easing (QE) – in simple English, printing money. I would not criticise the initial decision to attempt QE in the context of early 2009, when there was a general desire that “something must be done”. Mark = 0

7. Later rounds of QE. Where I do criticise the Bank of England, however, is that it persisted with QE long after its damaging effects became all too evident. The mechanism by which QE reduced the real incomes of savers, pensioners, the low-paid and those on fixed incomes and stifled economic recovery has been set out in other comments on this site and in The Golden Guinea, and will not be repeated here. Yet, like an alcoholic who can’t keep off the drink, Sir Mervyn persisted in repeating the dose again and again. In late 2012, he seemed to accept that QE was not stimulating the recovery in output and jobs for which its advocates had hoped, but by early 2013 he was again pressing for a further round. Fortunately, he found himself in a minority on the Bank of England’s Monetary Policy Committee, so it didn’t happen.

As I wrote in my forecasts for 2013 on December 28th 2012

“If the Bank of England responds with yet more quantitative easing, my prediction is that it will have precisely the same effects as QE has had already – driving down real incomes, driving up inflation and sending the British economy back into a stagflationary recession. However, if QE is consigned to the dustbin of history, then there is a realistic prospect for a recovery in the UK economy in 2013.”

Such has indeed proved to be the case, but no thanks to Sir Mervyn.

Mark = -3 for each round of QE supported by Sir Mervyn after the initial round.

In summary, Sir Mervyn King’s tenure at the Bank of England has been distinctly mixed. Yes, it has been a period of turbulence and not all the problems were of his making. But having said that, he presided over an excessively loose monetary policy before the credit crunch, fumbled his response to Northern Rock crisis, and persisted in pursuing the economically destructive policy of Quantitative Easing despite its comprehensive failure to achieve any of the objectives that the Bank of England set for it when it was introduced in March 2009.

Applying a starting mark of 10 – by definition, his record as Governor on taking up the post was unblemished – by my reckoning he finished with a mark of 6 (= 10-1-1-1+1+1-3). A 9 or 10 would be the mark of a great Governor. A 7 or 8 would mark a “safe pair of hands”. A mark of 6 must be judged as only fair.

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May 13

The Reinhart-Rogoff Controversy and predictors of sovereign debt default

There has been much debate in the financial press recently about the implications of new evidence that seems to contradict the Reinhart-Rogoff rule.

The strong version of the rule states that, once the ratio of national debt to GDP rises above 90%, it has a significant negative impact on the rate of economic growth.

The implication is that sovereign governments should take whatever measures are necessary – including extreme fiscal tightening – to ensure that national debt remains below this level.

But an American Ph.D. student who tried to replicate the RR results discovered that there seems to be no simple relationship between debt levels and growth rates – thus apparently undermining the case for fiscal austerity. In a slightly sheepish article in the Financial Times in April, Reinhart and Rogoff argued that the occasions when high economic growth occurred with national debt greater than 90% of GDP were exceptions to the general rule, typically after major wars. In the UK, national debt was significantly above 90% of national income in 1815, at the end of the Napoleonic Wars, 1918 after the First World War and 1945 when the Second World War ended. In all three cases, the British Government of the day had borrowed heavily to finance the war effort. Once the war was over, demobilisation released human and financial resources to rebuild the private sector, stimulating economic growth and generating taxation revenues sufficient to bring debt levels down.

What is different about the current situation is that national debt has risen to levels unprecedented in peacetime, with no prospect of demobilisation or the release of pent-up demand to stimulate private sector growth.

In The Golden Guinea, I cite a weaker version of the RR thesis – “historically, governments have struggled to service national debt once it exceeds 90% of national GDP” (p. 183). The reason that I was happy to put my name to this weaker version was that it was borne out by research that I did thirty years ago, never published or reported, as a sanity check for an internal policy debate at the European Investment Bank.

At that time, the EIB lent to African countries from two windows – risk capital, which were grant funds that the Bank managed on behalf of the European Community for investment in equity and soft loans in Africa, and own resources, or funds that the Bank itself raised on international capital markets. Understandably, the EIB was very cautious in placing its own capital at risk. I was the Loan Officer for Malawi at the time, and advocated supplementing risk capital operations in the Republic through the use of our own resources. Other colleagues cautioned that Malawi was not sufficiently creditworthy for the EIB to lend from its own resources.

I pored over IMF statistics of sovereign debt defaults to identify whether there were general indicators of sovereign solvency, and discovered a very interesting relationship. Drawing a graph of sovereign debt default rates on one axis, and a nation’s external debt service obligations as a percentage of its export earnings on the other, I discovered to my surprise that the relationship was not linear. Rather, an inflection point occurred when the debt service/export earnings ratio rose above approximately 20%. Below that level, in general, sovereign governments in Latin America, South Asia and Africa seemed able to service dollar-denominated debt. But once the ratio rose above 25%, the risk of default was very high indeed.

I remember looking up from my graph and gazing for some moments through my office window to the fields of the Kirchberg and the woods beyond, and experiencing a growing realisation that my more cautious colleagues had a point. For at that time, the external debt service/ export earnings ratio of the Republic of Malawi was almost exactly 20% – the inflection point at which it might struggle to service additional hard currency debt.

On reflection, the result was not perhaps as surprising as I found it at the time. Nor does it uniquely apply to governments. Households and businesses may be able to service their debt up to a certain critical point, yet experience severe distress above that point. As Mr Micawber observed,

“Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and sixpence, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

The danger is that the empirical weakness of the strong RR thesis that growth is always low once national debt exceeds 90% of national income – which I agree is far too simplistic – will lead highly indebted governments to relax their efforts to bring their borrowing levels under control. That would be a big mistake. For in my view the weak version of RR still holds. If national debt rises beyond 90% of GDP, there will inevitably come a point where a sovereign government will struggle to meet its debt servicing obligations, and ultimately default.

As I wrote in The Golden Guinea, “The trigger (for default) is likely to occur when bond investors start to lose confidence in a sovereign government’s ability to service its debt. It is impossible to define precisely the moment at which this may happen, as it depends upon interplay of many factors, including investor psychology.”

However, at a time when the national debt of the southern EU Member States has risen to over 100% of their GDP, it is difficult to avoid the conclusion that further borrowing is likely to lead to debt servicing problems in the future.

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Apr 03

Are Sterling Bond Prices in a Bubble?

The news that Coutts, the private bank for high net worth clients, has just warned its clients against investing in high yield bonds brought to mind the analysis of a paper published many years ago in an Italian academic journal (“Dilemmas in Development Banking”, Savings and Development, Milan, 1985).

Coutts is warning its clients against exposing their fortunes to a potential collapse in the high-yield debt market, and are reported to be instructing their managers to be wary of extending credit to clients who propose using borrowed money to buy bonds. “If and when yields rise, the impact of these bonds, magnified with leverage, could lead to serious losses,” one Coutts investment manager was quoted as saying in the Daily Telegraph yesterday.

Are the manager’s words of warning justified?

My Savings and Development paper, written almost 30 years ago when I was a Loan Officer at the European Investment Bank (EIB) in Luxembourg, set out a general mathematical model of banking in 15 equations. It provided the framework I applied to analyse the collapse of Northern Rock and RBS in “The Golden Guinea”. Although the paper was written in the search for an answer to another question – namely, how multilateral institutions such as the EIB could cost-effectively channel credit to finance the growth of the SME sector in Africa – 20 years later, in 2005, the model of banking solvency that it set out suggested that major banks were sailing into uncharted and dangerous waters.

The equation that defines the fundamental condition for banking solvency is:

[r – i] = a + p + pr

This equation states that, in order to break even, a bank’s on-lending margin – the difference between the rate at which it lends [r], and the rate at which it raises money for lending [i] – must be equal to the percentage costs of administering the loan [a] and the assessed probability of loan default [p + pr]. If it is not, the bank will accrue losses and ultimately become insolvent.

This simple equation can be used to explain the banking crisis of 2008/09. During the credit boom of 2004-07, banks globally chased new business far beyond the minimum point defined by the Fundamental Equation of Banking Solvency:

• accepting a decline in on-lending spreads [r – i];

• absorbing a rise in administrative costs [ a ] – not least because banks were prepared to pay ever greater sums, in both basic remuneration and bonuses, supposedly in pursuit of the best talent in the global financial marketplace (who, as events transpired, often turned out to be no more than prime examples of the old adage that in a high wind even turkeys can fly); and

• advancing new loans on lower security to borrowers of deteriorating quality, leading to a rise in the probability of default [p + pr].

This appears fairly self-evident now, but it still seems remarkable that these three clear signs of looming problems were completely overlooked or ignored by financial regulators and Central Banks.

After the credit crunch and collapse of Lehman Brothers, I reworked the equation to calculate the probability of default implied by the yields offered on good quality bonds, assuming administrative costs are zero for a retail bond investor. The equation then becomes:

p = [r – i] / (1 + r)

I subsequently discovered that the same equation had been derived by other economists, e.g. David Xu & Filippo Nencioni in their paper, “Introducing the JP Morgan Implied Default Probability Model: A Powerful Tool for Bond Valuation”, JP Morgan Securities Inc. Emerging Markets Research, New York, September 20th 2000.

My analysis assumed a risk-free rate of interest and cost of funds [i] of 3.5%, being the social rate of discount set in HM Treasury’s Green Book and also close to the long-term rate of interest on UK gilts at that time.

An analysis on the basis of this second equation led to the conclusion that bond yields in 2008/09 implied a risk of default significantly greater than actual default rates for all bonds at the trough of the Great Depression in the 1930s. The inference was that, provided the entire capitalist system did not implode, Sterling corporate bonds represented good value. Corporate bond prices in early 2009 were much lower (and yields much higher) than justified by their true probability of default.

Since then, corporate bond prices have recovered strongly and yields have fallen – so that now the gross redemption yield on, for example, Marks & Spencer’s 5.625% bond maturing on March 24th 2014 is only 1.7% – well below the 3.5% Treasury Green Book discount rate and below the rate of inflation – implying a negligible (or even negative!) probability of default and offering negative real returns. Similarly low yields are offered by other corporate bonds.

So the model suggests that the concerns expressed by Coutts are valid. Quantitative easing has led to an artificial bond bubble. Investors should be very cautious in committing new funds to UK fixed-income securities. Their risk / return profile is distinctly unappealing – none moreso than gilts issued by the UK Government itself.

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Mar 28

Sad Cyprus

As banks in Cyprus reopen for business after 10 days, it would appear that international currency and securities markets have taken the latest Eurozone crisis in their stride – “a tempest in a teacup” to quote Jamie Dimon on another occasion.

But just as Mr Dimon’s observation failed to sweep JP Morgan’s problems under the carpet, so current market reactions may under-estimate the longer term fallout from the Cypriot banking collapse.

German Chancellor Angela Merkel is determined to maintain the single currency at least through to the German Federal elections in September. But she has only succeeded by, metaphorically speaking, holding a gun to the heads of the Government of Cyprus. Furthermore, the write-down of Cypriot bank deposits, imposition of capital controls and limitation of bank withdrawals to just €300 per day marks the first step in the fragmentation of the single currency – two years ahead of my prediction that the euro would start to fracture between 2015 and 2017. The reality is that a euro in Cyprus is now no longer the same currency, or with the same value, as a euro in Germany.

Many Cypriots are questioning whether they were right to surrender their sovereign currency for the euro, and they are right to do so.

If the Government of Cyprus is properly serving the interests of its citizens, it should now as a matter of urgency be putting into place a contingency plan for its withdrawal from the Eurozone and the orderly restoration of the Cyprus Pound. The governments of Portugal, Ireland, Italy, Greece and Spain should be doing the same.

So also, in my judgement, should the Government of France. As the economic situation there deteriorates, it is far from clear that it is in French national interests to remain part of the single currency indefinitely.

This would leave a core Eurozone of Germany, Austria, Finland, the Netherlands, Belgium and Luxembourg, and possibly some of their neighbours – although it is clear that the Scandinavian countries other than Finland do not currently wish to be part of what would in effect be an enlarged Deutschmark zone.

It would be extraordinarily naive to believe that the reopening of the Cypriot banks marks the end of the Eurozone crisis and the restoration of a stable equilibrium. As Emile Durkheim wrote in “The Division of Labour in Society”,

“If the conquered, for a time, must suffer subordination under compulsion, they do not consent to it, and consequently this cannot constitute a stable equilibrium.”

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Mar 26

The longer term consequences of the Cypriot banking crisis

As the Cypriot banking fiasco stumbles towards a resolution, some financial commentators have noted the comparatively modest impact it has had on bond markets elsewhere in the Eurozone. The conclusion they draw is that the situation in Cyprus poses no systemic threat to the euro and, once their banks reopen, things will continue much as before.

While this may be true in the short term, over the longer period such a view may prove too sanguine.

The Cypriot crisis has marked a new and worrying development. As the headlines in today’s Financial Times state, “Eurozone shifts burden of risk from taxpayers to investors”. For the first time, bank losses are being absorbed directly by the write-down of bank deposits. True, the write-downs only apply on deposits of more than €100,000, but this concession was only elicited after the Cyprus Parliament decisively rejected EU proposals to impose a levy on all deposits.

Ordinary depositors are not in a position to assess the financial stability of the banks in which they place their savings. In the past, they had the assurance that these banking institutions were supervised by regulators who would protect their interests. In the event of failure, their deposits were guaranteed by their national governments. One way or another, their money was safe.

This has now been thrown into doubt.

Added to that, there is uncertainty about the extent to which banks elsewhere in the Eurozone are exposed to the bad debt problems that brought down the Laiki Bank. Laiki’s senior management could be forgiven for feeling slightly aggrieved by the turn of events. And in particular, their response to appeals from Europe’s leaders to show solidarity with their neighbours by investing in Greek sovereign bonds, on the assumption that these bonds would be honoured, if necessary with the support of the ECB. When Greece defaulted on its sovereign debt, Laiki was left dangerously exposed.

But Laiki was not the only bank that invested heavily in Greek sovereign debt. Many banks across the Eurozone did the same, including, reportedly, a number of leading French banks.

The problem is that there is no way that an ordinary depositor can gauge the exposure of the bank in which their savings are deposited.

The real threat to the Euro is not a sudden and catastrophic collapse, but rather the gradual erosion of trust in the system’s financial and political institutions. It doesn’t take Nostradamus to foresee that the longer-term consequences of the Cypriot banking collapse is likely to be a loss of confidence among depositors, leading to the gradual withdrawal of funds from banks, in preference for cash kept under the mattress or converted into gold and silver.

This in turn will lead to a further decline in the rate at which money circulates around the economy, and further reductions in economic activity and employment.

As I wrote in The Golden Guinea:

“The case put by supporters of the Euro for maintaining the single currency is that the alternative is so much worse. Yet the narrative put forward by apologists for the European single currency completely discounts evidence of the damage done by the Euro. The Eurozone authorities have sought to address this damage by successive bailouts, adding to the national debt of sovereign states that are already over-borrowed. This has led onwards to attempted fiscal consolidation on a scale that has plunged the continent of Europe into the most severe and prolonged recession seen since the Great Depression, causing mass unemployment and social distress on a scale not experienced in living memory.

This is the legacy of the failed Euro experiment.

Throughout the Euro’s prolonged and painful death throes, Europe’s political elite have asked the wrong question. The question they are asking is, “How can we save the Euro?”

In reality, the ultimate fate of the Euro is already sealed by what Tolstoy described as “the slow shifting of the registering hand on the dial of the history of mankind.”

The question that needs to be asked is “How can we dismantle the Euro in an orderly manner, to minimise its negative impact?”

And, following from this, “What should be put in its place?””

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