Independent or not, Scotland will still be vulnerable to monetary manipulation by other nations, writes Peter Jones
While we in Scotland have been engaged in our own little currency fisticuffs over post-independence sterling unions and the like, the rest of the world has been worrying about the next round of what some fear is a global currency war. Regardless of how our domestic currency debate pans out (I’ll give my view on that at the end of this column), the real world currency battle could radically re-shape the global economy in which the Scottish Government wants to be a new player in 2016.
What is a currency war? The term was coined by Guido Mantega, Brazil’s finance minister, in 2010. He was concerned that other countries – mainly the United States – were manipulating their currencies to reduce their value, which would make Brazil’s exports to them more expensive, damaging Brazil’s growth and employment prospects.
On the other hand, American exports would get cheaper, boosting world demand for them, increasing US output and jobs. So Brazil, Mantega fretted, would be the loser and America the gainer, just through a bit of currency manipulation.
Cynics note that American policy-makers call what they are doing “monetary policy” (intended to achieve good things for the US economy), but when others do it, Americans call it “currency manipulation”, ie, other people doing bad things.
In Britain and Europe, the Bank of England and the European Central Bank (ECB) have been doing it too, except that in our snooty old world way, we call it “quantitative easing” (QE) or “unconventional monetary policy”. The intended effects, however, add up to the same thing.
How is it done? The conventional way is for a central bank to reduce short-term interest rates, making the currency less attractive to overseas investors, which reduces demand for it, so causing it to fall in value. But these days interest rates are already close to zero.
The next stage is unconventional: increasing the amount of money available. This, in domestic terms, is intended to have virtuous effects. The process gives commercial banks more money to lend, which should make more mortgages and more business loans available, so stimulating activity.
But two secondary, or spillover effects, may not be so virtuous. If the supply of money increases faster than real wealth in the economy does, then inflation should occur. This means that the real interest rate paid to investors becomes lower than the nominal interest rate and can even be negative – ie that money put in a supposedly safe place loses value even when the interest paid is taken into account.
Currency investors, being smart people, know this, so they stop buying a currency until it reaches a lower value where expected future increases in its worth (caused by its economy improving) are better than the predicted loss in value caused by inflation.
These two, potentially negative, spillovers may be counterbalanced by a third, potentially positive, spillover effect. This is that the economic stimulus caused by monetary expansion may be so big as to stimulate other economies. Consumers may become so buoyant that they increase their spending on not just domestically produced goods (which may have a lot of imported components) but also in imported goods.
Complicated, I know, but if you are still with me, we have now reached the point where there is a big debate – is quantitative easing having overall good or bad effects? And are policy-makers – in concentrating on short-term benefits – ignoring the long-term problem of inflation?
The short answer is that nobody really knows; debate on the topic is fierce. And despite there being lots of analysis done on the QE that has occurred over the last five years, and on when it happened in the 1930s (when countries devalued by abandoning the gold standard) the evidence is pretty mixed.
Tomorrow, we will learn whether the US Federal Reserve will carry on with its QE programme of expanding the money supply by about $85 billion a month (the expectations are that it will), and on Thursday whether the ECB will cut its interest rate (market folk reckon it will, but not until June). The Bank of England is thought likely to indulge in more QE sometime this year, but probably not at next week’s meeting of the monetary policy committee.
Meanwhile, Japan’s central bank is aggressively using QE, having announced this month it will try to end two decades of economic stagnation by pumping a massive $1.4 trillion into the economy.
Amongst QE practitioners, the Bank of Japan is unusual in that it has quite explicitly said its aim is to cause inflation. The reason is that the cause of the stagnant economy has been deflation, causing consumers and companies to hoard money rather than spend it. The prospect of inflation, it is hoped, will cause people to go out and spend.
The immediate effect of QE has been to cause the Japanese yen to fall in value, prompting Japanese investors to bring back money held overseas, yielding a profit, and to invest it in the Japanese stock market, where there ought to be still more profits to come from a stimulated economy.
To me, what this adds up to is that the proof of the QE pudding will only come in a few years, when we will know whether the desired outcome – more economic growth – has happened. I side with the doubters. Growth is not happening in Britain or Europe, and while it is occurring weakly in the US, that is arguably because of cheap energy prices rather than QE.
It is too soon to know the outcome in Japan, and meantime there are ominous signs of slowing growth in China. And if global economic growth does not match monetary growth, we will be stuck with inflation, meaning declining real incomes and savings, plus asset price bubbles.
This is not a pretty prospect, whatever your position on independence. In the union with sterling, or independent and still with sterling, there is no escaping it. There is a case for a separate Scottish currency, but that also has other costs and, as any QE-caused inflation will be global, a Scottish poond doesn’t escape that either.
On this debate, my view is that it would be in the UK’s interest to accept a sterling union with an independent Scotland, though the inhibitions on Scottish fiscal freedom would be pretty severe. I suspect, however, that by September 2014, what to do about inflation caused by currency wars will be a more pressing question.