Wednesday, 2 November 2016

A tale of two unions

This is a short post to explain why I devoted so much attention to sector balances in the last couple of posts this one on Scotland's onshore economy, and this one extending it to include the North Sea.

Although sector balances will seem rather remote and abstract to many, they do have important implications for currency which does play a much more tangible role in our everyday lives. And it's not just that we can literally hold bank notes in our hands — it's whether our pay is in the same currency as our debts and savings, and how that affects our confidence in the future and even our outlook on life.

But there's a more fundamental reason to pay attention to how countries balance their economies against each other and one that calls for action that transcends national boundaries.

Imagine two countries that mainly trade with each other but where one is a net exporter and the other a net importer that runs a trade deficit. In time, the exporter, which runs a trade surplus, will build up a stock of the other's currency from the proceeds of selling its exports.

Clearly this trade imbalance cannot be sustained indefinitely otherwise the exporter will end up with all the money and the other none, leading to economic collapse in the importing country. Thankfully, there are a number of ways that rebalancing can occur before the situation gets too extreme.

If the countries have different currencies, the net importer can let its currency devalue which will make their exports cheaper to the other country and that should, in time, reduce the importer's deficit and balance the trade.

Flexibility with currencies helps keep trading economies in balance. But it's important to realise that a country that permits a devaluation is effectively allowing all its citizens to become poorer relative to the rest of the world. The alternative, to ask workers in certain industries to take a cut in their wages to help reduce the price of exports, may be equivalent in theory, but would cause an outcry politically.

But what if both countries use the same currency?

One option is that the exporting country with the surplus lends money to the importing country with the deficit. But this is not sustainable either because the accumulation of the net importer's currency is just replaced by a build up of debt, and the importer will face mounting interest payments which can only make the situation worse. This is essentially what has happened with Germany and southern European countries that use the Euro.

A better solution, if politically feasible, is to balance the economies with fiscal transfers. In other words, set up a common public sector that spans the countries with spending and taxation powers that can redistribute the money to where it's needed. This is the mechanism that currently operates within the UK in tandem with the Sterling monetary union, but which is absent from the EU and its Euro monetary union.

And this brings us to why sector balances and currency are not mere technical details but fundamental in understanding unions of countries.
If the EU does not put in place a surplus recycling mechanism between exporting and importing countries then it's hard to see how the Euro can survive because imbalances of trade will result in long-term, ever-increasing accumulations of debt.

If Scotland leaves the UK then the UK's fiscal recycling mechanism will need to be replaced with a solution involving currencies. As yet, it's not at all clear how this might be done.
Interesting and uncertain times are ahead for both unions. But as Bertrand Russell pointed out, uncertainty is no excuse for inaction: it is important to accept what can be known with some certainty, hold one's beliefs with a certain element of doubt, but still act with vigour.

Unfortunately, reality is somewhat backwards in this regard. What has been researched and established on evidence is often dismissed in the face of untested beliefs that are held with great certainty, and what action there is by government is diluted variously by dithering, timidity and, in the worst cases, ideology. That said, perhaps it is just as well that governmental vigour is kept in check by the electorate.

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