Would A New Scottish Currency Depreciate By 30%?

Anti-independence economist Ronald MacDonald recently made the claim that a new Scottish currency would devalue against the pound Sterling between 20-30% upon its launch. MacDonald's 677 word analysis was laid out in a 15 page slide on his new website, adopting his own economic model titled "Behavioural Equilibrium Exchange Rate" (BEER). He calculates that households would be roughly worse off by around £7,300, comparing Scotland's currency devaluation to the likes of Mexico in 1994, Argentina in 2018, and the UK in 1976.

(Above: Ronald MacDonald in a anti-independence campaign video)

Quick Points

MacDonald's opening slide makes the statement "The SNP want a Scottish pound on their timetable...". This is, however, not strictly accurate. The Scottish Government's new economics paper makes clear it will be for the Scottish parliament, and therefore any participating parties elected to it, decide when a new Scottish currency would be established. If, say, the Scottish Greens and Scottish Labour wished to establish a currency launch on day one, and a vote was passed, then this would be the case. Whilst a fair criticism of the government's paper is a sense of vagueness, it is simply wrong to argue it is only the SNP stablishing the currency timetable (they can't anyway - they don't hold a majority of seats in Holyrood).

Strangely, MacDonald then goes on to write: "Renters would also be hit because landlords would pass these costs on." MacDonald has either not noticed or forgotten that there is a rent freeze in place across Scotland. There are almost no circumstances where landlords can pass on costs with the freeze in place. Future housing policy surrounding rent controls can stop landlords passing on these costs to renters.

MacDonald also states "All experts agree that a Scottish pound would be worth less than the British pound – by as much as 30%." However, there is no citation or any form of evidence provided that "all experts" agree with MacDonald. This is such an extreme claim that it is hard to imagine being made by a serious economist. In our analysis we shall link to experts who take an opposing view. Readers can follow our linked citations and view the materials for themselves.

Later MacDonald states "Higher interest rates on our national debt would trickle down into higher mortgage rates too." This assumes that markets determine the interest rate, however this is largely false. This is an argument we have debunked before, however readers can also find analysis from experts such as economist Scott T. Fullwiler, Professor Steven Hail, economists Warren Mosler and Phil Armstrong, and economist Brian Romanchuk.

The Comparisons

The suggestion that an independent Scotland would be in a similar position as historic case studies such as the UK, Mexico and Argentina is offensive, as it largely removes the deeply violent and different economic and political contexts of each case study.

In the case of Mexico, MacDonald failed to mention that the reason investors shifted their assets was due to the Zapatista Army of National Liberation declaring war on the Mexican government. This would further escalate when Mexican presidential candidate Luis Donaldo Colosio would later be assassinated, thus leading to investors placing risk premiums on their financial assets. Political instability and violent drug wars within Mexico's border severely harmed the Peso on foreign exchange markets, and was not aided by the country's central bank issuing short-term bonds (tesobonos) which were indexed in US dollars. This led to the Mexican government facing a bill of around $40 billion, and since they could not issue the US dollar they were forced to exchange peso on foreign markets to repay short-term debts. Between political instability, violence and mismanaged monetary policy, this caused a large devaluation of Mexico's currency. For MacDonald to suggest that an independent Scotland risks civil war and political assassinations is deeply inappropriate. Further, the Scottish Government's new economics paper does not consider issuing short-term debt indexed in pound Sterling. Therefore this comparison can be dismissed entirely.

(Above: Union Tribune headline on the assassination of Luis Donaldo Colosio)

Argentina's case study is also extreme, and once again MacDonald removes political and economic context. MacDonald failed to mention that Argentina's devaluation largely came down to two factors. First, the country had failed to pay off a huge foreign debt that it had accumulated, leading it in a large international legal battle after its sovereign default. Argentina also suffered from drought, which was considered one of the worst natural disasters recorded in 2018. This massively reduced the country's production of soy and damaged the government's tax returns. Again, the suggestion that an independent Scotland would face a massive natural disaster is simply ridiculous. Further, as international law and various legal/economic experts have pointed out, an independent Scotland does not need to obtain a share of the UK's national debt (which is largely the UK's very own financial assets). Therefore the suggestion that an independent Scotland could find itself in a similar situation to Argentina can be dismissed entirely.

(Above: Farmer and son inspect carcass of cow during drought in Benito Juarez, Argentina)

This leaves us with the last case study of the UK in 1976. Large tax cuts by the 1972 Conservative Chancellor Anthony Barber fuelled inflation (something we almost saw this year with Liz Truss), which then led to the "1976 Sterling Crisis" under Labour Prime Minister James Callaghan. Whilst MacDonald correctly acknowledges tax cuts fuelling inflation, he fails to mention the political backdrop, which included tensions between the UK and Organization of the Petroleum Exporting Countries (OPEC) for siding with Israel during the Yom Kippur War. OPEC members and their allies began to sell of Sterling-denominated assets from their central banks, whilst the fall of oil production fuelled inflation across the West. Due to keeping a currency peg with the US, the Bank of England drained their foreign exchange reserves and eventually floated the currency. There is no evidence to suggest that an independent Scotland faces the same international tensions as the UK did in the 1970s. Economic actors will not hold large amounts of financial assets denominated in the Scottish currency before its launch. The 1976 UK comparison can also be dismissed entirely.

(Above: a destroyed Israeli tank during the Yom Kippur War)

This would not be the first time MacDonald has removed political and economic context to exaggerate his claims. Previously the anti-independence economist made the claim that an independent Scotland would need around £300 billion in foreign exchange reserves, in comparison to Hong Kong.

We debunked this claim previously, and pointed out:

The pattern of entirely removing political and economic context severely harms MacDonald's analysis.

Putting aside MacDonald's extreme economic comparisons, what does economic literature tell us about the end of currency unions? Research from Professor Andrew Rose, an expert on international trade patterns and exchange rate determinations, concluded that most countries that leave currency unions are more often larger, richer, and more democratic compared to their counterparts. Further, his research also concluded that around the time a country leaves a currency union there is very little macroeconomic volatility before, during, or afterwards. Professor Volker Nitsch, Chair of International Economics at Darmstadt University of Technology, also reached similar conclusions in his research. The vast majority of case studies show the end of currency unions are not apocalyptic, and to suggest otherwise for a developed and market diverse economy like Scotland is hard to take seriously.

BEER Meets a Sober Reality

The BEER model was developed in the 1990s by Ronald MacDonald, due to his frustration that older orthodox economic models failed to predict exchange rates. In his own words, MacDonald describes the model as using "econometric methods to link the behaviour of exchange rates with underlying economic variables, such as the current trade balance, productivity, terms of trade and the government deficit."

Does the BEER have better accuracy with exchange rate movements compared to older models? No, not really. At least that's according to research from economic and policy experts Professor Yin-Wong Cheung, Professor Menzie D. Chinn, visiting scholar Antonio Garcia Pascual, and Dr Yi Zhang. In their 2019 research paper analysing the BEER model alongside other similar ones they conclude that "models that have become popular in last fifteen years or so might not be much better than the older ones," further adding "the average results from all the models are not very successful, on either the MSE or consistency criteria."

Similar findings were also found by researchers at the European Central Bank, who also argued "the literature does not provide much evidence about the predictive content" and that it the BEER model had "highly inaccurate forecasts" for the UK, Switzerland, and Norway.

This is unsurprising, as the premise of the BEER model was flawed from its inception and suits economic discourse more suited for pre-1970s. On reviewing MacDonald's BEER model, economist and exchange rate expert Professor John Harvey argued that it was "not descriptive of the world in which we actually live". Harvey instead argues the expediential growth of financial flows plays a far larger role in the influence of a country's exchange rate. This point is clear with recent data from the Bank for International Settlements showing that foreign exchange market transactions were 90 times the amount on world trade. Harvey further makes the point "Trade imbalances can continue indefinitely and, for deficit countries, they represent a drain on the level of economic activity no different than that created by a rise in savings or a fall in investment."

Whilst orthodox economists place economic fundamentals at certain positions of importance, modern day unorthodox economists acknowledge that economic fundamentals entirely depend on context of the economy. Economic agents will explore various economic factors of a nation, in particular wider policy decisions made by the government, to forecast future exchange rates.

Even MacDonald himself acknowledges the possibility that he might be wrong, writing in a previous paper: "… it is our contention that for a sample period such as the current float, net capital flows will not go to zero and, therefore, they should be explicitly recognized in modelling the measure of the long-run exchange rate currently adopted in the literature."

Further to MacDonald's analysis, zero discussion is even attempted to consider Scottish fiscal and monetary policy which could influence the exchange rate. For example, the fact the Scottish government plans to launch a currency without enforcing it upon citizens creates a policy bias towards appreciation. This means there is a natural shortage of Scottish financial assets and far more difficult for a sudden rushed sale of the new currency. Whilst this alone does not guarantee a new Scottish currency would appreciate, it plays a crucial role as to how a currency operates upon launch. But instead MacDonald assumes an independent Scotland would operate as a mini-UK. This is once again an extreme claim to make, and would certainly not be backed by most public policy experts.

Other experts also question MacDonald's extreme claim of a 30% devaluation of the Scottish currency upon launch. Dr Alberto Paloni, an economist and senior lecturer based in the Adam Smith Institute in the University of Glasgow, argued that MacDonald's attempt to predict the exchange rate was "closer to writing fiction than economic analysis".

What Does The Evidence Tell Us?

It has already been established that the vast majority transitions ending currency unions are smooth and usually result in greater economic benefits, but it's worth exploring the claim that economic fundamentals, including trade balances, play a large role in a country's exchange rate. In Harvey's 2009 book "Currencies, Capital Flows and Crises", he concludes that the data simply does not support the orthodox argument. Eric Tymoigne, Associate Professor of Economics, agrees with this conclusion and cites Mexico and the US as two examples with having an indirect relationship between trade balances and exchange rates.

Economist Brian Romanchuk also provides the case study of Canada. With a small open and developed economy with a floating currency, Canada has seen wild exchange rate fluctuations of 20% for the last twenty years whilst the domestic economy experienced stable inflation, growth, and a gradual decline in unemployment.

Another case study we previously touched on was Australia, running a trade deficit (at times twice the size of Scotland’s) for nearly thirty years, yet experienced either declining or stable inflation.

Even the UK has run almost consistent government and trade deficits over the last 20 years. Yet large exchange rate fluctuations did not occur because of these twin deficits, but rather the Great Financial Crisis in 2008 and Brexit.

There is very little evidence to suggest that developed countries, with mixed and open markets, experience sharp falls in exchange rates of around 30% with no recovery. Yet in MacDonald's analysis there is zero detail as to when Scotland's exchange rate would stabilise. Somehow he concludes it would be permanent, as no further detail is given. This is even more bizarre when exchange rate fluctuations are rather normal for most developed economies year on year. It's difficult for anti-independence campaigners to complain that their opponents are champions of exceptionalism for Scotland when they are rather guilty of it themselves.

It's also increasingly bizarre that MacDonald did not consider that, as the Bank of England had indicated previously, it would support an independent Scotland's currency choice in order to maintain market stability. It's worth noting that upon a Yes vote it would be UK markets making any potential financial swaps, rather than an independent Scotland that would still need to establish independent financial institutions. Indeed the establishment of a futures-market could ease a transition towards a new currency with a temporary peg, again supported by the Bank of England along with a Scottish central bank. Put on top the Scottish government's support for a Job Guarantee, this too would only be positive for the domestic economy and Scotland's exchange rate. Below Professor Randy Wray briefly explains why, and readers can read our policy paper on it here.

The very fact none of these scenarios or policy positions are even considered by MacDonald leaves much to be desired. MacDonald's analysis seems more aimed to catch quick headlines in newspapers, rather than advancing a more healthy discourse on a new Scottish currency.

Considering the above case studies, research, and either missing details/mistakes made in MacDonald's analysis, it is clear that a new Scottish currency would not devalue around 30%. Readers can also find out more on Modern Money Scotland's FAQ section by clicking here.