Ronald MacDonald: Scotland caught in currency crossfire

FISCAL retrenchment is now under way in many countries including, of course, the UK and is soon to arrive in Scotland. Here the debate has focused on whether the proposed retrenchment is too great, too fast, or just right. Whatever the correct answer is, there can be little doubt that fiscal retrenchment is a necessary response to the over-exuberance of the recent property boom. But since the fiscal deficit in the UK is the rough counterpart of the savings of the private sector, the current and future cuts raise a key question about which other component of aggregate demand will fill the gap, if any.

With consumer spending, the largest component of aggregate demand, flat, there are only two other key sources that can plug the gap - private sector investment and net exports. The latter component can be a very significant driver of economic growth and has certainly been underrated in the Scottish context. However, at the same time governments are paying the price for the excessive exuberance of the Noughties, there are significant currency wars raging on the global stage, which could have serious ramifications for export-dependent economies.

The underlying source of these currency wars is two forms of imbalance in the world economy - external and internal. Internal balance refers to the need for advanced industrial countries to place greater reliance on private sector demand, rather than government demand that opened up during the crisis.

External balance requires that advanced industrial countries, currently running large current account deficits (such as the US) put greater reliance on net exports as a source of aggregate demand.

Also, countries running massive current account surpluses, most notably China, should put their houses in order and spend these resources on goods and services produced in the rest of the world. Unfortunately, these rebalancing processes are taking place too slowly, and it this that has generated the currency wars. On one side of the battlefield we have the Chinese current account surplus and the Chinese refusal to undertake a substantial revaluation of the reniminbi.

Despite being the world's number two economic powerhouse, China still regards itself as an underdeveloped country and cannot let the reniminbi float freely or appreciate.Rather, to ensure that there will be jobs for its vast pool of underemployed labour, China manages the level of its currency through capital controls and constant intervention in foreign exchange markets, producing massive foreign exchange reserves (currently $2,648 billion).

On the other side of the battlefield we have the US Federal Reserve central bank attempting to counter the fall in domestic demand with so-called quantitative easing (QE), which essentially amounts to the Fed printing money to buy government-backed bonds at different maturities. This, in turn, is intended to decrease (medium to longer term) interest rates, thereby encouraging firms to invest more and creating a rally in equity and corporate bond markets. We have now had two rounds of QE that has pumped a total amount of liquidity into the US economy of approximately $2,000bn.

By forcing the yields down on US government bonds, QE has resulted in massive capital outflows from the US, as investors seek higher returns overseas. The counterpart of these capital outflows has been capital inflows into emerging market countries creating real and present difficulties for the macroeconomic management of these countries.

For example, countries such as Brazil, Chile, Australia and South Korea have been forced to revalue their currencies, thereby worsening their competitiveness, and retaliating by intervening in their foreign exchange markets and introducing capital controls. If the present situation is left to drift, then the further introduction of capital and trade restrictions can only be expected to increase. The battlefield could get very messy indeed.

Unfortunately, finance ministers at the last G20 meeting in Seoul failed to show the kind of co-operative spirit that was evident at the height of the banking crisis and side-stepped the currency wars. There is, therefore, a very real danger that these currencies wars could exacerbate the recessionary pressures stemming from fiscal retrenchment.

What should be done? Let's consider this question at both the global and at the Scottish level. At the global level, I would argue we urgently need to reform the international monetary system (IMS), that is, in essence, the exchange rate relationships between countries. A new system should be based on a quad polar relationship between the world's key currencies - the US dollar, the reniminbi, the euro and yen. Some kind of fixed and predictable relationship between these currencies would be desirable to impart stability into the IMS.

Perhaps the arrangement would be one in which the currencies can adjust in response to competitiveness pressures - a so-called crawling peg. In this proposal, the US dollar would be replaced as a reserve currency by special drawing rights (SDRs), already in existence at the IMF (although they would need to be rebased to reflect the new currency arrangement).Moving down to the local Scottish level, how might we get our net export sector to perform better in the light of the currency wars and, indeed, in an environment where these wars have been addressed? At the moment Scotland is part of monetary union with the rest of the UK and has a rigidly fixed exchange rate vis--vis the rest of the UK. It cannot, therefore, pursue a policy of undervaluing its currency relative to the rest of the UK and trying to grow its economy, as China and other countries have successfully done, through a competitive exchange rate.

But let's suppose Scotland was in a position where it could choose its own exchange rate, would that make a difference? I would argue not. Choosing, for example, to have a flexible exchange rate against our trading partners is unlikely to be useful since for a small country a flexible currency would be highly volatile, with all of the negative implications that would have for trade and investment that already exists within Scotland. As the experience of other countries has demonstrated, it would also be socially unproductive to try to smooth such volatility using foreign exchange reserves.

An alternative would be for Scotland to fix its exchange rate to an alternative to the pound, such as the euro. But the recent Irish experience suggests that swapping the one-size-fits-all sterling monetary union for that of the euro would not be a wise decision for Scotland.

That said, as someone who has studied exchange rate relationships for developing and developed countries, I find the paucity of useful statistical data on the Scottish economy a real drawback to conducting independent research. Ten years into our devolution settlement we do not, for example, have a good-quality Scottish price index. Is this really befitting a developed country?

Given the current exchange rate relationship in the UK, how could Scotland boost its net exports and private sector investment? The recent example of Germany, a country of different size but similar level of development to Scotland, is a salutary lesson of how a country can become competitive internationally, within a monetary union, by implementing labour market reforms and creating a business-friendly environment.

The many new highly-paid jobs and the strengthening of the profitability of German companies that this policy has created have produced a virtuous cycle of strong export growth and private sector investment. In a Scottish context, there would seem to be much that a Scottish Government could do to produce a similar result. For example, a sharper focus on providing a skills set geared to the export sector and incentivising potential companies in this sector by, say, slashing their business rates, and/or giving them corporation tax rebates, would be a good start.

Of course, devoting more of the Scottish budget to developing our export sector means that there will be less to spend elsewhere in government.But surely this is exactly the kind of accountability that all sides of the political spectrum are now agreed that Scotland needs. Without a clear vision of how we can create new highly-paid, hi-tech jobs with the resources we have, rather than squabbling over what economic tools would be desirable in an ideal world, it seems the economic underperformance that Scotland has faced in the past will likely remain, particularly with currency wars raging in the background.

• Ronald MacDonald, FRSE, is Adam Smith Professor of Political Economy at the University of Glasgow