It is amazing what passes as “analysis” these days. If you are a Professor and stick up a website, you can announce a few hundred words as “analysis”. If you criticise the SNP, the Scottish Government or the idea of independence, you are nailed on to get a chunk of mainstream media coverage in Scotland and the UK.
Enter the 644-word analysis from Professor MacDonald on his new ourmoney.scot website. The headline figure is that: the average Scottish household faces 20% hit to income because of a 30% drop in the value of the currency. The actual drop is a whopping £7,300 a year. The analysis doesn’t say “in the first year” or anything like that it says “every year”. So the drop is a permanent one. There’s not even a chance of bouncing back!
Here’s a summary of my analysis:
- The analysis lacks any supporting information. No data sheets, figures, explanation of underlying methodology or assumptions.
- New currencies don’t drop like a stone. It has never happened to a new currency in a country comparable to Scotland.
- Governments put in protection normally pegging a currency to ensure that a drop does not happen.
- If a currency drops, it normally always bounces back (as its exports are cheaper) and demand rises after a short while. A substantial drop without a rebound is almost an economic impossibility but this is the Professor’s statement.
- The analysis used the BEER methodology that was recently criticised by the European Central Bank, saying that “the (academic research) literature does not provide much evidence about the predictive content”
- In a test run by the ECB the BEER model delivered a “highly inaccurate” forecast for the UK
- Without any information, it is impossible to know what economic measures were used and why they were chosen. This is highly irregular for serious analysis.
- An academic analysis leading to this conclusion would normally run to 10,000 words with a supporting appendix.
So here we will look at Professor Ronnie MacDonald of the University of Glasgow’s analysis that gives us the headline for the Scotsman and The Times, among others. The figure is broken down like this:
|Rise in cost of imports causes inflation||
|Pay off British pound debts in Scottish pounds||
|Interest rates increase||
|Total estimated impact||
This would immediately hit Scottish households because a new currency is devalued by 30%. Before we try to work out where these figures are from, the website has a point about how Scotland ends up with its own currency.
Nicola Sturgeon needs lenders to hand over billions pounds worth of sterling to pay for our services
But because she’s pledging to move to a new currency, she can’t guarantee they’d be paid back in sterling (or at all)
As a result, lenders would increase the cost of debt – if they were willing to lend at all
This would force the scottish government to shift immediately to create a new devalued scottish currency
Your first question is probably why is this all so personal? Professor MacDonald, to do him the courtesy he has not offered to Scotland’s First Minister (aka Nicola Sturgeon / she), makes this all about our FM. At this point, he is talking about Sterlingisation. What this has to do with his household loss/depreciation figure, I can’t figure out. But the Professor has a point to make.
And that is, Scotland would somehow be the only independent European nation unable to borrow foreign currency. This exceptionalism is always at the heart of any pro-union biased economic analysis of Scotland’s economy: where is the evidence in this analysis that the need to borrow foreign currency would “force the scottish government to shift immediately to create a new devalued scottish currency”? It simply isn’t the case.
If Scotland needs to pay higher borrowing rates, guess what? It will just borrow at a higher rate. This is a terrible economic idea in the medium to long run. Borrowing significant amounts in a foreign currency is one sure way to hamstring a newly independent economy. It is also one of the main reasons that Scotland should have its own currency from day one. So where is Professor MacDonald’s evidence that having to pay a higher cost of borrowing pounds in the short term leads to a point where Scotland couldn’t borrow at all? Well it is not contained in his analysis, that’s for sure.
The picture he paints is Scotland being uniquely incapable of borrowing foreign exchange and is an exceptionally weak jumping-off point. It undermines the rest of the Professor’s analysis. As does the Nichola Sturgeon fixation.
If you were an unbiased editor, you would be thinking at this point, is this something that adds anything to the debate about Scotland’s post-independent future?
So on to the main analysis. The 30% depreciation. It isn’t clear if this comes all in the first day, first few months or first few years. There is no data on this. Personally, before giving this headline airtime, I would have asked: when does this impact the Scottish economy? But it seems that no one who covered the story decided to ask that question. Or any questions to be honest.
We are left to work things out for ourselves (because there is no data). The analysis doesn’t say “in the first year” or anything like that. It says “every year”. So we have to assume the drop is a quick and permanent one and there’s not even a chance of bouncing back! Because if there was, you would show that in your analysis. Is Professor MacDonald suggesting that the depreciation happens and is irreversible?
The first thing to do based on the dataless data is to see if anything like this has happened to a similar European nation. This is the sense test, and it is a very useful heuristic for any economic analysis. You can use the guide here when you read something that seems a bit fishy. This gives you an idea of the likely/possible outcome of the modelling. Professor MacDonald is saying three things:
- A drop very quickly after a launch
- A HUGE drop within a year
- No chance of a rebound
So let’s deal with those.
There is no instance of any wealthy, well-run country comparable in terms of basic economic factors similar to Scotland having to significantly devalue its currency immediately or even soon after launching it. So it is OK to be sceptical that Scotland would be the first.
That is because most currencies are launched with a fixed exchange rate band. One of Europes’s newest currencies is the Czech Koruna. It was launched In 1993, a couple of years after the collapse of the former Soviet block. When the Czechs launched their currency, it sat comfortably with the currency peg, and this was credited for delivering much-needed stability to the economy (1). Governments put in place actions to ensure drops like Professor MacDonald predicts don’t happen. So they don’t happen. See the chart below:
The second thing to look at is volatility. Do currencies in similar nations jump and drop to such an extent over a short period of time? The answer again is no. Modern developed economies don’t fluctuate anywhere near this extent.
Here are three currencies from similar-sized GDP nations tracked against the pound sterling across twenty years or so.
You will see that they have all appreciated compared to the currency that Scotland would be leaving behind. But that is a whole different conversation.
You can see a 20% – 30% rise across two decades against the pound. This is the starting point for a new currency in Europe. How does a 30% immediate drop AGAINST sterling look in this context?
You can also see that after every drop there is a rise shortly after. This is what economists expect and will be explained later. Professor MacDonland doesn’t think this will happen to Scotland though: it’s down and stay down for the Scottish pound for reasons, of course, that are not explained.
A 30% drop in the value of European currency against another currency besides the USD over a short period would be an unchartered collapse. The volatility of this magnitude is normally caused by wars, civil unrest, mad government economic decisions or high dependence on urgent raw materials needed from abroad. It also tends to only happen outside of a global crisis in the developing world.
But something similar did happen to the pound during the great financial crisis against the US Dollar. Here is US Dollar against sterling over the last twenty years.
Here is the pound against the Euro for the same time period. The drop post-GFC is much smaller compared to the Euro. So even with a massive drop against the Dollar, the pound didn’t drop more than 20% against the Euro and then it rebounded.
Apart from the fact that sterling has weakened against the five currencies, you can see that ups and downs are very regular regarding exchange rates. This is the normal ebb and flow. However, 30% in normal times would be exceptional.
Scotland entering the economic arena as a wealthy, modern, well run and well-educated independent nation is very far removed from any of these scenarios.
The Professor is predicting a ‘black swan’ episode. Something that has never happened, and there is no evidence to suggest that it will happen; however, it is possible. Anything is possible.
So breaking down the main claim into three parts allows us to easily challenge the figure and the basis for his general prediction of a shock drop in the value of the Scottish pound.
Professor MacDonald has evidence. He used a methodology and a list of assumptions to reach his figure. When I challenged Professor McDonald for his methodology, he suggested I google “behavioural equilibrium exchange rate”. So I did. Normally analyses come with links and don’t ask people to google the methodology.
The BEER model is one he has been developing for over twenty-five years. All too often, someone can get so involved in their own particular theory or methodology that they only see the trees and not the forest. A classical example is the William Nordhaus DICE model, which spurts out an “optimum level of global warming” at 4 degrees above preindustrial levels. Climate scientists like Will Steffen think that at 2 degrees, the earth may end up on a “hothouse” trajectory that will likely exceed our ability to adapt. This may lead to food shortages and price increases, the likely flooding of many of the world’s global cities and significant destruction of infrastructure (2). Hardly optimal and a clear lesson in the dangers of looking at the world through the lens you created.
A Behavioral Equilibrium Exchange Rate (BEER) model links real exchange rates to fundamental economic factors (3). Like all models, they are predictions based on a set of assumptions; they are a guess at the future. BEER is one of three models used to predict long-term exchange rates by neoclassical-minded economists and institutions. A recent European Central Bank paper looked at the three models, and it said regarding BEER:
“the literature does not provide much evidence about the predictive content” and “Less positive findings on the predictive power of the BEER model are reached”
So not a particularly good review from the ECB. But to be honest, and in the models’ defence, any model that attempts to predict the impossible is never much better than random guesses.
The BEER model attempts to predict foreign exchange rates based on three main “economic fundamentals”, GDP per capita / Net Foreign Assets / Terms of trade (3). It also seems to be a model used for long-term foreign exchange rates, so I am not sure how it gives us the price of the Scottish pound so quickly after independence, but I am sure the Professor knows how it works. He just can’t be bothered explaining the model.
But does the model work? Well, the ECB Economists tested the predictive abilities of the BEER model to find that it:
“delivers highly inaccurate forecasts for CHE, GBR and especially NOR”
Here is the “highly inaccurate forecast” for Great Britain.
This is the model Professor MacDonald used for his figures for Scotland. The “highly inaccurate” one.
Oh, and we may as well go back to that ECB report:
the link between real exchange rates and economic fundamentals is feeble and
the link between exchange rates movements and current accounts is much less predictable than often assumed
This evidence from the ECB should allow any reader to look at the Professor’s figure with; I would say, more useful information.
Most models that try to precisely predict the unpredictable and don’t include real-world assumptions aren’t very useful and should be taken with a dose of scepticism.
There is another way to look at the likely exchange rate between a new Scottish pound and a pound sterling in the short term that has nothing to do with any of the factors in the BEER model. That is to consider what currency speculators think about the Scottish pound in relation to sterling. The expectations of traders are likely a more powerful short-term driving factor for an exchange rate than the economic fundamentals. But Professor MacDonald doesn’t believe that, and even if he did, he is unlikely to suddenly announce that his neoclassical equilibrium model was a waste of time.
The near BEER analysis
Getting towards the end of the analysis.
“One Scottish pound would be worth 70p (and he provides a link)”
Professor MacDonald now uses the following economic fundamentals for his analysis (not the GDP per capita / Net Foreign Assets / Terms of trade of the BEER model). No, he uses:
- The current account deficit on the balance of payments with a figure of 10% on the day the currency is launched
- And the fiscal deficit with at 10% on the day the currency is launched
This may be perfectly consistent with the BEER model, changing the economic fundamentals; however, it strikes me as strange that you would use only these two fundamentals and not others. Maybe of course he used others, but he hasn’t provided any data.
The above figures are maximum figures from past best-guess past data for Scotland “as part of the UK”. You could choose a mid-range figure if you wanted to show different scenarios for a more balanced outcome. But that isn’t the case.
Assumptions are crucial because sometimes “your assumptions can be your conclusions” (4). Professor MacDonald told me to google the methodology but not any underlying assumptions. A proper analysis would lay out the assumptions.
From the above, you can see that he assumes that Scotland’s position on the two economic fundamentals will not change after an independence vote. That is an assumption which sets up his conclusion.
The analysis continues
Everything we have covered so far leads us to the meat in the analysis (I really have to stop calling it that):
This way won’t work. We agree with pro-independence economists who say introducing a new currency is the only way that Scotland can have true control over economic policy. It is a power, however, that does not come without a cost. In fact, we estimate that it would cost the average Scottish household £7,300 a year.
So how does the Professor get to this figure?
It is impossible to tell as there are no details, and the economic fundamentals are unclear. So you have to pick your way through what information there is.
There are seven reasons given as an explainer, I think, of the assumptions that Professor MacDonald has used within the BEER methodology. But this is not clear as there is no information. His points are in italics.
1. All floating currencies have their value determined by international money markets. This value reflects the underlying strength of a country’s economy
There is an assumption that Scotland will have a floating currency. Not a fixed one. That’s an assumption that has a big impact on the conclusion. Scotland’s currency is likely to have a fixed rate for a period of time when it launches. This will be designed as I have explained to avoid a chance of what the Professor says will happen. The next part of his statement is only partly true. The value of a currency is partly determined by international money markets, but it is also partly a policy decision. Governments across the globe spend a considerable amount of time and foreign exchange defending the value of their currency. It looks like there is an assumption that Scotland wouldn’t do that: again, exceptionalism. Would Scotland’s Government just sit by and watch the currency depreciate? He is correct with the last part. The value partly reflects the perceived value of an economy. The perceived value will be impacted by how much of a wedge a city-wideboy thinks he can make by betting on it, or against it. This real-world impact will be missing in his calculations. There is no way to know what the ‘market’ will think about an economy that doesn’t yet exist and at some time in the future. Scotland’s currency may be valued above the pound sterling, which is just as likely.
2. All experts agree that a Scottish pound would be worth less than the British pound – by as much as 30%. One Scottish pound would be worth 70p
Maybe all the experts he speaks to.
3. This makes imports more expensive – by between 25-43%
Assuming Ceteris paribus (all other things being equal, and of course, they are not), then imports would be more expensive if the Scottish pound is devalued. Devaluation is good and bad (5). If the pound drops against other currencies or just against the pound (which may fall as well, although the loss of Scotland from the UK miraculously doesn’t seem to reduce the pound sterling in the Professor’s calculations), then our exports are cheaper for the rest of the world to buy. So people would likely demand more Scottish pounds to buy our cheap goods. This is the classical example of a system that has an inflow and an outflow (6). It looks like Professor MacDonald is only interested in the negative inflow and not the positive outflow. Which, of course, means there is no balance.
4. Businesses will find it harder to trade with the rest of the UK, so these transaction costs will be passed on to consumers.
rUK businesses and individuals will face increased transaction costs no matter the exchange rate as it will cost, let’s say, 1p in the pound, changing sterling into Scottish pounds. This may reduce their demand for Scottish products. But a substantial price drop (see 30% drop in the cost of Scottish goods) would completely negate this. The transaction costs would be insignificant. Also, the transaction costs go both ways. So Scottish businesses may start to buy from local suppliers to avoid the costs and get things for 30% less than they cost in England. All this depends if a good can be substituted (which isn’t always the case – for example, English Whiskey is not up to scratch yet, but you may buy English gin instead). But see above, all of a sudden, Scotland’s products would now be 30% cheaper, according to the Professor’s figure. So the demand for our goods would increase.
5. Your existing mortgage and existing credit card bills would still be paid out in British pounds
I think he means paid and not paid out, as mortgages and bills aren’t paid out. But yes, if you still have a mortgage in pounds, you will need to repay it in pounds unless it is exchanged for a Scottish pound-denominated mortgage. The Scottish Reserve Bank site explains what could happen with mortgages in sterling.
6. Renters would also be hit because landlords would pass these costs on.
We are now getting into the weeds here. I am not sure why we have focused on rents but let’s deal with that. If you rent from a private landlord, any increase in costs they face may be passed on. But as we have seen from the Scottish Government’s rent freeze, this doesn’t always happen. And anyway, only 15% of Scottish households rent from private landlords. The 23% who pay social rents wouldn’t face the same costs.
7. Higher interest rates on our national debt would trickle down into higher mortgage rates too.
If you have a mortgage in pounds with an rUK bank and you pay it in pounds, you will pay the same interest rate you always have until you are set to renew your mortgage. 74% of mortgages are currently fixed in the UK. An rUK bank may ask you to pay a higher rate, but in that case, you would probably change your mortgage provider. Plenty of new Scottish banks will be looking to secure the safest of all private sector assets: your mortgage. It would be great to have more mortgages in Scotland than in rUK banks. The Scottish Government would be mad not to offer very low-interest rates for anyone who wanted to switch their mortgage to a Scottish state bank. The interest rate set by the Scottish central bank to reflect the ‘borrowing costs on our national debt’ won’t directly affect people with a mortgage unless they have a mortgage in Scottish pounds. And back to inflows and outflows: high interest is great for some households with savings in Scottish pounds. Is this accounted for? We have no idea.
And that’s it. With a few popups that offer some more information, that is his analysis. A scattergun, mud-slinging approach to a post-independent economy. There is no consistency in the analysis, data, figures, base comparisons, and no clear explanation of the methodology or why this has been chosen above another approach. It takes no account of real-world impacts on the likely exchange rates. In sum, this is something, but it is not an analysis.
If something so shallow and slapdash was written about any other topic other than the obvious Scotland bashing we see here, it would have no chance of being covered by any serious publication. It is worrying when media across Scotland and the UK parrots dubious findings without any kind of analysis.
No academic journal would have published this. It would have unlikely made the letters pages. So you have to question why something like this is not only classed as analysis but is given such a large profile in the mainstream press?
But we are used to this. This dogged the 2014 campaign. Remember the analysis from Sir Ian Wood about the oil running out? Buckle up. It seems like they still don’t even have to make an effort.
1. Bank of international settlements. The Czech experience with capital flows: challenges for monetary policy . Available here: https://www.bis.org/publ/bppdf/bispap44j.pdf
2. Will Steffen et al. Trajectories of the Earth System in the Anthropocene. Available here: https://www.pnas.org/doi/10.1073/pnas.1810141115
3. The European Central Bank: Working Paper Series The predictive power of equilibrium exchange rate models. Available here: https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2358~4382d88430.en.pdf
4. Professor Steve Keen. The appallingly bad economics of neoclassical economics. Available here: https://mahb.stanford.edu/wp-content/uploads/2021/07/The_appallingly_bad_neoclassical_economics_of_clim-1.pdf
5. FRED research. Is a strong dollar better than a weak dollar? Available here: https://research.stlouisfed.org/publications/page1-econ/2015/03/01/is-a-strong-dollar-better-than-a-weak-dollar.
6. Thinking in Systems. Donella H. Meadows. Published 2008.