The problem of currency union, UK edition

In my last post, I discussed Richard Murphy's "green QE" proposal in the context of a functioning currency union in which the decision to monetise debt would be made by the UK government. But the context of Richard's piece opens the door to a disturbing idea. Some Scottish Nationalists interpreted his proposal as meaning that a fully fiscally autonomous Scottish government could demand that the Bank of England buy Scottish government bonds (whether or not issued by a Scottish Development Bank) in order to prevent Scotland's debt/GDP rising as a consequence of infrastructure investment.

The Scottish Nationalists who raised this possibility homed in on this part of Richard's piece:
In March 2014 Bank of England Governor Mark Carney confirmed in a letter to Green MP Caroline Lucas that “It is possible that if the Monetary Policy Committee did vote to increase its asset purchases in future, it could expand the range of assets it purchased. Such a decision, however, would need to be agreed with the government.” In other words. Green infrastructure quantitative easing, about which she was asking, is possible
What that means is that the SNP does have it within its power to demand this type of quantitative easing to pay for investment in Scotland. That’s important precisely because quantitative easing debt is effectively cancelled almost immediately after it is issued because it is effectively the issuing of new money, and not debt. And what that means is that in reality this new type of quantitative easing could be used to pay for the investment programme the SNP wants to build Scotland’s future without the debt going on the books of the Scottish government. Or to put it another way, Paul Johnson’s assumption that Scotland cannot afford to fund its growth is just not true if this innovative finance mechanism is used: it can.
So, having started by saying that the SNP should persuade the Westminster government to instruct the Bank of England to monetise infrastructure bonds issued by a UK government agency, Richard appears to have moved on to suggesting that the SNP should demand that the Bank of England monetise Scotland's debt. I don't think this is quite what he meant, but it is all to easy to interpret this section in that way. But whether he meant direct monetisation of Scotland's debt, or monetisation of infrastructure bonds issued by a Scottish development bank, this is a non-starter. The reason concerns the nature of a currency union and the status of the Bank of England.

The Bank of England should more correctly be named the "Bank of the United Kingdom". It is the monetary authority for the whole of the UK, just as the Bank of Canada is the monetary authority of the whole of Canada and the ECB is the monetary authority for the whole of the Eurozone. It is required to manage the monetary conditions across the UK as a whole, without favouring individual parts of the UK. Some may argue that the Bank of England tends to favour London, because of its links with the City: this is not a discussion for this post, but my counter-argument would be that if the Bank favours London it does so because London is dominant in the UK economy, just as the ECB is seen to favour Germany because Germany is dominant in the Eurozone economy.

In a currency union it is the job of fiscal policy, not monetary, to ensure that regions within the union do not diverge so much that monetary policy loses traction. In the Eurozone, this has proved extremely difficult because of the lack of a common fiscal authority, common automatic stabilisers (taxes & benefits) and fiscal transfers. The UK's fiscal union is undoubtedly flawed: London and the South East are far too dominant and other regions have suffered badly from foolish industrial policies of the past. But it is a whole lot more coherent than the Eurozone.

And it is this coherence that the Scottish National Party wishes to destroy. The Scottish First Minister's long-run ambition is for there to be full devolution of tax and spending to the Scottish Government ("full fiscal autonomy"), accompanied in due course by dismantling of the Barnett formula. This would reduce the UK to the same condition as the Eurozone - an incomplete and incoherent currency union. The arguments against this were fully rehearsed prior to the independence referendum. But it seems they need to be aired again.

So let me make it clear. It is not possible for members of a currency union to have full fiscal autonomy. Attempts to achieve full fiscal autonomy damage, and ultimately destroy, the currency union.

The SNP should now be told in no uncertain terms that full fiscal autonomy is not on the table and never will be. "The Vow" promised extensive devolution of powers to Holyrood. But it did not promise full fiscal autonomy. And the Smith Commission has also stopped well short of recommending full fiscal autonomy. That is where the debate must now rest.

But it is not just the SNP that is treating the UK's successful currency union in a cavalier and destructive manner. UKIP's manifesto proposes dismantling of the Barnett formula, not to replace it with something better (which would be sensible) but to "save money" by forcing Scotland, Wales and Northern Ireland to become self-funding. UKIP's policy is thus for England to remain "UK core" while Scotland, Wales and Northern Ireland become "UK periphery". And they claim that this has been signed off by CEBR economists? Good grief.

And the Conservatives are equally destructive. Their proposals for "English" income tax rates and benefits would dismantle UK automatic economic stabilisers, widening regional divergence and putting pressure on the currrency union. This is utter folly. Since they have actually been in government, they should know better.

However, let's assume for a moment that the SNP gets its wish: Scotland achieves "full fiscal autonomy" and creates a new Scottish Development Bank with a mandate to finance infrastructure development in Scotland by issuing bonds. Could Scotland legitimately demand that the Bank of England monetise these bonds?

SNP supporters claim that it could, on the grounds that Scotland is part-owner of the Bank of England. Monetising Scottish bonds would be done according to Scotland's capital share, much as the ECB's current QE purchases are done according to the capital shares of the Eurozone member states.

But hang on. Scotland has only a minority interest in the Bank of England. Since when has the owner of a minority interest been able to force a company to do something against both the wishes and the interests of the majority shareholder? If the SNP cannot persuade the Westminster government to instruct the Bank of England to monetise UK infrastructure bonds, it can have absolutely no power to force the Bank of England to monetise Scottish infrastructure bonds.

I'm not going to discuss the importance or otherwise of central bank solvency, since this has been exhaustively covered by Karl Whelan and Paul De Grauwe, among others. What concerns me is the lack of democratic accountability. The decision to issue infrastructure bonds would rest only with the Scottish government and its bank. The rest of the UK - over 90% of the population - would have no say in the matter. Under what version of democracy would the Bank of England be forced to backstop the fiscal expansion of one small part of the UK without the agreement of the rest?

Dismissing this as "merely a political argument" will not do. Democracy matters. Indeed the argument for Scottish autonomy is fuelled by the perceived failure of democracy in a Westminster government dominated by London and the South East of England. How would replacing this democratic failure with an even bigger one improve matters?

The fact is that while it remained in the currency union, a "fiscally autonomous" Scotland would have much less autonomy than it would like. It would not be able to run high deficits without the agreement of its union partners, since to do so would put the value of the common currency at risk. It could not monetise debt, for the same reason. And it would soon find that sharply divergent tax and spending policies proved impossible to maintain, particularly as North Sea Oil revenues dried up. It would be forced to adopt fiscal policies compatible with those of its largest partner. If it tried to escape from this straitjacket with a large programme of debt-fnanced fiscal expansion, then unless growth was spectacular (which, pace Richard, seems unlikely) it would either be forced out of the union or end up in permanent debt peonage - as Greece knows all too well.

The lessons from the Eurozone are plain to see. It is hubris to believe that they would never happen here. They could, and they would. We must not go down that road.

Related reading:

Smith, Barnett and the wily Salmond - Pieria


  1. Perhaps we will see as a condition of the SNP joining a Labour/SNP coalition government that the Bank of England issue "efflux" without "reflux" for the bonds of a British Investment Bank democratically accountable to the members of the Union.

    1. Please read the predecessor post to this one - link is in the first paragraph. It sets out the reasons why Bank of England monetisation of bonds issued by a British Development Bank would be a really bad idea.

      When did Labour issue that? They aren't going to raise much from payday lenders. The FCA stamped on them last year and they are mostly going out of business. Even Wonga is making huge losses.

  2. This funding idea quoted in the post is based on a non understanding of the monetary system. QE does not cancel debts, if the BoE ended up holding the Scotish bonds the issuer would still have to stump up the capital sum on the day of the maturity. So no debt relief there. And the coupon interest payments collected from the issuer that are then paid from the BoE to the treasury would go to the UK treasury, not Scotland, so no debt releif there either

  3. There are quite a few ideas joshing around with each other in connection with the concept of a British Investment Bank. First of all to argue that central banks lose their ability to regulate inflation if they are placed in a position of automatically having to “sanctify” a BIB’s (British Investment Bank’s) bonds which are “money” or “near money” by buying them raises a set of issues.

    First of all it poses the question whether control of base rate as opposed to a form of rapid and progressive taxation is the best way of regulating abnormal inflation (I think it was the Radcliffe Report that suggested the use of base rate hikes was slow in its effect).

    Secondly, as Geoff Tily argues in his book “Keynes Betrayed” a very valid point was made by Keynes that the cost of borrowing money should be kept as low as possible not merely to keep the cost of goods and services low but that higher borrowing interest rates increases the margin of risk for investments thereby increasing the potential for instability in an economy or economies.

    Thirdly, the record of the US and UK central banks in controlling house price churning inflation has not been good. This reflects the age old problem of the human species (and of course Nature in general) that there will always be defectors from the necessity to balance nurturing of self with that of others. Central banks are therefore subject to capture by defectors just as supposedly democratic governments are. Effectively by having a central bank and a government treasury it can be said that you are making the task of democratic control more difficult by splitting that control into two institutes and especially if you further permit a veil to be thrown over the operations of the central bank in the supposed interest of it being allowed to operate with a degree of independence (to which the big question then becomes after a financial crash from abnormal debt inflation who’s “interest!”). Of course, the house price instability bubble was not caused by high base rates but a failure of the central banks to regulate private bank underwriting standards including house price valuations and the operation of the quasi-private securitisation agencies Fanny Mae and Freddie Mac which resulted in excessive quantities of debt being issued for house purchase.

    Moving onto the second main issue in Geoff Ingham’s book “The Nature of Money” on page 54 he states the following:-
    “As Cencini argues, following Tooke, credit-money does not flow; rather, it is an emission that ‘appears’ and ‘disappears’ in the credits and debits of double-entry bookkeeping.” In effect Ingham is making reference to the creation of “efflux” and “reflux,” a ‘going out’ and a ‘going back.’

    Elsewhere in the book (I forget where) he argues that money can only be created as debt. This is an axiom he lays down.

    I would argue in connection with the idea of a British Investment Bank as a “work-around” current “political” monetary restrictions we now need to ask two questions, firstly, whether the time has come (given that we no longer have “rogue defector” monarchs) to reincorporate central banks back into government with greater democratic control of both. Secondly, that to understand money better we have to drop the notion that in order to create “state money” or “high-powered” money there has to be both “efflux” and “reflux” and only “efflux” is necessary whereas private bank leverage of “state money” requires both. Here is what I consider a detailed support of “state money” is ultimately only “efflux” by Stephanie Bell (now Kelton):-

    1. Money, speaking as bank depost money, is created by commercial banks. The Government collects taxes in bank deposit money and it spends using the same deposit money. Taxes are not paid in reserves taxes are paid in deposits, the amount of which there is in the economy being a result of the actions of buisineses and households. Reserves may move around but they are issued at the request of the commercial bank sector, to facilitate clearing.
      Generally The government doesnt issue any currency at all, it is the borrowing of buisiness and housholds that results in the creation of the currency. After taxes have cleared through Bacs and Chaps then they are available in the governments account , The Consolidated fund of the United Kingdom, and are then available for spending by the government.

  4. The payment of interest on private bank loans has to come from somewhere you simply cannot continue to take out additional loans with interest to pay the interest on previous loans that is a Ponzi scheme ultimately doomed to collapse. In the domestic non-government sector all profits come out of the pockets of other members of that sector and therefore cancel out. You cannot, therefore in aggregate, rely upon these profits to pay the interest on private bank loans. In addition private bank loan deposits are subject to reflux through the taxation process and profit taking by the private banks that may not automatically be actively circulated immediately within the economy. It is government creation of future income for the domestic non-government sector that allows private bank loan interest to be repaid.

    1. No, you dont mathematically need extra money to re pay the capital plus the intrerest on bank loans in aggregate as one single £1 can circulate round and round paying off the capital and interest as it goes round.

      Government borrowing doesn't create currency. The government sells bonds and aquires deposits that had been created allready.

  5. "No, you dont mathematically need extra money to re pay the capital plus the intrerest on bank loans in aggregate as one single £1 can circulate round and round paying off the capital and interest as it goes round."

    No it can't! Immediately a private bank loan deposit is spent into the economy it starts to be destroyed or "refluxed" by taxation in particular sales tax unless it's exempt but even that is often a brief respite!

    1. No, what the government taxes , it then spends.

    2. Dinero,
      Government spending works by crediting bank account always - whether "financed" by taxes, bonds or "printing money" (QE.)
      The government taxes during, before and after it spends.
      But either spending or bank lending has to come first before tax else there is no currency to pay the taxes.
      Spend and tax are independent. Spending is effectively forced bank money creation. Taxing is forced money destruction. This is because of the peg between the central bank and commercial banking system.

  6. The net sum of all private bank created financial assets and liabilities is zero. For the private bank to have a net financial asset in the shape of interest it has to come from outside the domestic non-government sector.The only other domestic sector it can come from is government. However, like the private banks if a government taxes all that it spends this too nets to zero. It must accordingly "deficit" spend or "efflux only" some of the money it creates to pump into the domestic non-government sector. The creation of money is therefore a partnership between the two domestic sectors. It is wrong therefore to argue that money creation originates only from domestic private banks.

    1. Are you aware that you are putting your own concepts in quotation marks. I point that out because it is awkward to respond to those comments as the use of quotation marks is usually used to indicate that one does not wholly accept the concept in the quotation marks.
      As I pointed out before £1 can circulate eliminating debts and debt interest. You have it confused in your model of the monetary system that accouting entries indicate a stock of something rather than he reality that an accouting entry indicates a series of future transactions.
      The Government doesnt create currency. It could , but it does not. It did in the 17th century when it took bonds to the BoE and came away with BoE bank notes and paid people with them but it does not do that anymore.

    2. "The Government doesn't create currency."

      I suppose they just put the Queen's head on it as opposed to Coco The Clown's (to pick a name at random and of no symbolical significance) and offered to exchange the currency for gold once upon a time up until 1931 (which is the twentieth century) just for the hell of it!

      You are failing at the end of the day to do your balance sheet analysis correctly at an aggregate level and at a minimum of the two sectors government and domestic non-government. This is the fundamental difference between our two viewpoints on money creation.

    3. When the government borrows it sells bonds and in doing so it obtains deposits that were already created. When households and businesses arrange mortgages and overdrafts, they create the pool of currency that the private sector and the government sector use for transactions and taxation and government spending, and so it is fair to say that the government doesn't create the currency in the modern economy.

    4. Dinero
      Where are you getting your views from? You are mixing two sets of accounts up, the aggregate commercial liabilities of the commercial banks and the BoE balance sheet.
      The govt accounts (HMRC OPG CF NLF and DMA) sit on the BoE sheet. They cannot leave it. All spending and taxing occurs as DB/CR operations between these and private reserve accounts on that one balance sheet. Period. The banks then go and do their liability side accordingly. From that side it may appear that we are taxed in bank credit. We are not. If I want to pay a tax or buy a govt bond my agent (the private bank) must use reserves or the operation cannot complete. Nothing else will do. Money (final payment) is not exclusively reserves. Bonds are also money as the BoE will swap them for reserves on demand. Govt spends bonds into existence. It does not get anything from the non govt that it has not already created in the past.

    5. Relatively small amounts of reserves shuttle back and fourth between the accounts of intermediaries, HMRC included, in order to facilitate the transfer of funds between deposit accounts of tax payers and recipients of government spending. Government taxation, bond selling and ultimately government spending is instigated and finalized between deposit accounts. Its is facilitated by the small amount of reserves shuttling back and fourth, but those reserves recirculate to facilitate a further transfer of funds between deposit accounts and so on and so on. The deposit accounts are the the source of government taxation and spending.

    6. Your retention of a role for reserves reveals your lack of understanding of the “hidden” roles played by modern money.

      All modern money now tends to be after a long process of historical development a state established “single trustworthy measuring device” or technically a sole fiducial unit of account for each country or group of countries. Unless it is put into circulation it cannot be effective. Since the state also needs resources to provide communal goods and services it is spent into circulation as well as given away. Once in circulation private banks can use it to leverage profit by multiplying or augmenting it under state license. Reserves are used by the state both to ensure smooth running of the payment settlement system and to control the base interest rate or not. Combine these two forms of money creation, state and private, and you get a useful partnership that creates three forms of demand; government, business investment borrowing and consumer borrowing. Cut government deficit spending into economies and you will at a global aggregate accounting level reduce demand. Reduce that spending at a single or group economy level without the availability of counter-vailing export earnings and you will also reduce demand. Clearly combatting abnormal inflation will require demand reduction.

    7. Government spends from the procedes of taxation and bond selling. Once the funds have cleared through BACS and CHAPS they are then available in the government's bank account to fund government spending, and so the source of funding for government spending is commercial bank deposits, it doesn't create currency.

    8. Thank you Dinero now we know that all along the private banks could have rescued themselves in 2008 simply by creating the money and not bothering anybody else with their problems! Wow to think it wasn't even news worthy!

  7. Frances,

    Very good article. I’ve just one minor quibble relating to where you say “the ECB is seen to favour Germany because Germany is dominant in the Eurozone economy.”

    That could be taken to mean “dominant” as in “largest economy in the EZ”. Actually the logic in the ECB favoring Germany (and other core countries) is that there is much to be said for more stimulus in the core than in the periphery because the core has a balance of payment surplus – arguably a chronic surplus. And one way of dealing with that core surplus / periphery deficit is more stimulus in the core than the periphery.

    1. Balance of payment imbalances between core and periphery wiithin a monetary union are not the concern of the monetary authority. So the logic in the ECB appearing to favour Germany has absolutely nothing to do with the core needing stimulus to correct a BoP surplus. It is simply due to the fact that Germany, as the largest economy in the union, dominates the aggregate figures. Mathematics, that is all.

  8. I have the idea of an award for certain economists etc. called The John Law Award relating to imaginative ways of creating money that will lead to creating chaos and crashes. Richard's scheme for Green easing is a front runner for this. As well as the inherent complexity and risks quite why inflation is deemed a necessary good given the harm it will do to so many, let alone real economic growth, is a mystery.

  9. Should serious consideration now be given to the creation of a three-tier banking system to accommodate the regional development of finance in the UK. The creation of a market in banking would require three forms of banking license; in ascending order;
    a) local authority area (or group of LA areas) based banks that could not invest outside a specified local authority area (or group of LA areas) and then only to the level of its customer’s deposits (or a factor of them if it is considered viable).
    b) nationally based banks that would be able to create money determined by a multiplier of their previous years deposit levels (determined by the BoE monetary policy committee (MPC)) - they could not invest outside the UK,
    c) nationally based international banks who could invest outside and inside the UK.

    International PLC bank’s, being deprived of their ability to create money in the national financial jurisdiction would have to rely on the confidence that institutions, corporations and high net worth individuals (from within or without the UK) had in them or by raising money from the global markets to finance themselves. Presently they are permitted to hold the nation to ransom because of Bank Deposit Protection Scheme which would in future be restricted to UK area banks. They and their clients would have to go to the market to obtain protection for any of their deposits or investments .

  10. The problem of currency union, UK edition

    The adoption of three species of banking license could address a democratic deficit in the present financial system - choice - the banking system has developed in such a way as to enable the international banking cartel to ‘hoover up’ all the population’s money and allocate the accumulated capital where they can generate the greatest profit for them, this situation denies choice to those businesses and citizens who wish their money (pensions, wages, salaries, savings and benefits) to be used to support their local or national economy which they could if national and territorial restricted banks were available. There would be no problem with the Scots or any other division of the UK supporting any one of the banks licensed to operate within their area (which would include international and national banks). The strength of support people have for their own economies would become apparent as would support from other parts of the UK’s since through LINK the Scots (for example) anywhere in the UK could access their accounts in a regional Scots bank.

    1. This is not about banks, Geoff. The problems of currency union are macroeconomic ones. I have no problem in theory with your proposal, but it doesn't have anything to do with the subject of this post. Sorry.

  11. Origins of Money:-


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