Friday, 27 April 2012

Does Monetary Policy Matter?

"It will not be the case that the south will get the so-called wealthy states to pay. Because then Europe would fall apart. There is "no bail out rule", which means that if one state by its own making increases its deficits, then neither the community nor any member states is obliged to help this state" Horst Koeher, former German Finance Secretary, April 1992.

As everyone now knows, that particular clause of the Maastricht Treaty of 1993 which set up Economic and Monetary Union, has been ignored, just as the Growth and Stability Pact, which was introduced so that no single country would ever need to be be bailed out, has also been ignored right from the outset. The German people were deeply concerned that they would have to pick up the tab if their southern European neighbours overspent and ran up deficits they could not cover. The assurance given to the Germans by Herr Koeher may have been sincerely meant at the time, but it turned out to be meaningless. The eurozone is on the verge of collapse with Greece in dire straights and Spain, Italy, Portugal and Ireland deeply in debt and in the throes of austerity measures which are making life almost intolerable for large sections of their population.

Last year, Greece brought its debt down from 368 bn euros or 163% of GDP, by "forcing" the private holders of 206 bn euros of bonds, to accept an effective 74% loss on their loans. This then allowed a second bail-out by the EU and the IMF of 130 bn euros, on top of the 110 bn euros which had already been loaned. This means that by 2020 the Greek debt will still be 120% of GDP, despite austerity measures which at their worst, have caused families to give up their children into care because they cannot afford to feed them. Unemployment in Greece is 21% overall and is 50% of those under the age of 25 and despite those frightening figures, the Greek government intends to cut another 150,000 jobs in the public sector over the next three years. Despite the assurances from the EU bureaucrats that the euro will survive, Greeks are preparing for a Greek exit from the single currency. Some 16 bn euros have been sent out of the country since 2009 and bank deposits in Greece have fallen by 79 bn euros over the same period.

Greece represents just 2% of the eurozone's GDP but the fall out of the crisis in that country, together with the policies in their southern neighbours, has caused a contagion of the crisis in Spain, Italy and Portugal, with Ireland of the more northerly member states, suffering from similar problems. Spanish debt currently stands at 735 bn euros and this pushed borrowing rates to 6% in March this year, a rate which analysts contend is simply unsustainable over time. The Spanish government aimed to cut the deficit to 6% of GDP in 2011 but the actual figure was 8.51%. The aim is to cut the debt to 5.2% in 2012 and to 3% in the following year. The austerity cuts have created unemployment of 25% overall, the highest rate in the EU, and 53% of the youth of the country. In March Spanish banks borrowed 316 bn euros from the European Central Bank (ECB).

The austerity measures being forced through by the EU are now having some unexpected impacts on countries which were expected to not just cope, but to embrace the measures willingly, as the best way to deal with the problems of the eurozone. Despite the governments having signed up last month, to the German-inspired agreement to deal with the crisis, the populations in some of the member states have shown they are not as willing to accept austerity as their governments. Prime Minister David Cameron was castigated for refusing to sign up to the agreement, condemned for having "isolated the UK". Now, a matter of a few weeks after the agreement was supoosed to have been accepted by every other government in the EU, the Dutch government paid the ultimate price and collapsed last Sunday, after failing to get the austerity package through parliament. Fitch, the credit agency, threatened to down grade the Netherland's AAA status if it failed to cut the country's deficit from its current level of 4.7% to 3% by 2013. The Netherland's government intended to introduce another 14 - 16 bn euros in cuts, on top of the 18 bn euros it had already imposed; VAT was to increase from 19% to 21%, wages in the public sector were to be frozen, the pension age increased to 66 and the health budget cut so that every prescription was to cost 9 euros. On Saturday 21st April, almost 100,000 people demonstrated against the cuts in Prague, in the biggest popular demonstration since the fall of the Communist government in 1989.

There is no doubt the profligacy of the governments of the stricken countries is to blame for the debts incurred but the failure to deal with the problems, both in the individual countries and the eurozone as a whole, is a consequence of the "one size fits all" monetary policy of the eurozone. There are those who argue that coming out of the single currency would be a disaster for Greece and, there is no doubt that a return to the drachma would not be a panacea for all the ills. For a start, the Greek debt, which is currently in euros would soar as the "new" drachma was devalued against the euro, but would the devaluation of the currency be any worse than the massive problems with which the country obviously cannot cope? If Greece had not joined the euro, it would not have been in the position to run up the massive debts it has nor would it have been able to borrow as much as it has, at such attractive rates. The contagion which has spread throughout the eurozone would also have been largely absent.

Despite all of this, all of it common knowledge throughout the world, Scotland's First Minister, Alex Salmond announces in a speech to the Institute of Directors in London, that, "Monetary policy is very important. But you can exaggerate the flexibility of monetary policy. Fiscal Policy in the modern world has primacy. It can set levels of (business) investment." What message was Alex Salmond trying to get across? He is right that the flexibility of monetary policy can be exaggerated, as the experience of those caught up in the problems of the eurozone can testify. Of course, a country which controls its own monetary policy, can make it as flexible as they need it to be and will obviously tailor their monetary policy to suit their own circumstances, not, as in the eurozone, have it dictated by the interests of more powerful partners. Of course, Mr Salmond was not talking about the eurozone, therefore his message made little or no sense.

Mr Salmond was speaking about the position that an independent Scotland, under a SNP-led government, would be in, with its monetary policy dictated by Westminster and using the pound sterling as its currency. The message he was trying to get across was that monetary policy did not really matter all that much and as long as Scotland had control of taxation, a Scottish government could do very much as it pleased as far as economic policy and the encouragement of business, is concerned. Taken in that context, his message was total nonsense and goodness knows what his audience of business people thought of it. It is a line the First Minister has pushed on several occasions over some time now. He has tried to sell the idea that Fiscal Autonomy was all that Scotland needed in order to be "really independent in the modern world", hence the nonsense that "Fiscal Policy has primacy". That idea was being floated long before the announcement that sterling was to be retained and it was on the announcement about sterling, that the Fiscal Autonomy claim began to make sense.

When the SNP first announced the party, if it formed the government of an independent Scotland, would retain sterling as the Scottish currency, it also announced the Bank of England would act as the lender of last resort. This came as a surprise to everyone, including the Bank of England and to ensure there would be no problems about the Bank agreeing to this, the Secretary for Finance, John Swinney said he would "give the Bank of England an assurance that an SNP government would act responsibly in its Fiscal Policy". He went on to emphasise that the SNP government would not be allowing the Bank to see the spending plans, or to have any say in their structure. That would hardly be necessary because the first time the spending plans were deemed to be "out of line" with Bank of England policy, the SNP government would be brought back into line rather smartly - or else. Fiscal Autonomy therefore, in the context of the Bank of England controlling interest rates in an "independent" Scotland and sterling being the currency of choice, would be somewhat meaningless, particlarly in light of John Swinney's promised re-assurance to the Bank of England on Scottish spending plans. It has been made even more meaningless after the announcement today by Alex Salmond that an "independent" Scotland will retain UK income tax rates.

The SNP has often claimed that once it had control of corporation tax, it would make Scotland more competitive by lowering the rate of tax, as Ireland has done. The EU has been putting Ireland under pressure for over two years, to bring its corporation tax more into line with the rates of other EU members, something the Irish have consistently refused to do. As the EU builds more pressure to create fiscal harmonisation, particularly in light of the debacle in the eurozone, it is highly doubtful if the EU would look kindly on an independent Scotland emphasising its "independence" by reducing corporation tax. That is not to say Scotland should be put off or even think of allowing the EU to dictate, but the SNP's history is hardly one of standing up to the dictats of the EU. When the potential pressure from the EU is added to the commitment to keep the Bank of England happy on fiscal policy, the SNP would appear to have boxed itself into a corner.

In May 2011, Professor James Mitchell, wrote in Perspective in The Scotsman, that the SNP's problem "is one of linguistics, rather than conception" as it strives to persuade its members and supporters, that its position on independence has not really changed. I wrote a response which stated that it would take more than mere lingusitics to explain the volte face that had taken place on the currency. That is a year ago and in that time, the problem with linguistics faced by the SNP, has grown arms and legs.

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