Scottish Affairs Committee - Minutes of EvidenceHC 140-II

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Oral Evidence

Taken before the Scottish Affairs Committee

on Wednesday 5 February 2014

Members present:

Ian Davidson (Chair)

Mike Crockart

Jim McGovern

Graeme Morrice

Sir James Paice

Mr Alan Reid

Lindsay Roy

________________

Examination of Witnesses

Witnesses: Dr Angus Armstrong, Head of Macroeconomics and Finance Group, National Institute of Economic and Social Research, Professor David Bell, Professor of Economics, University of Stirling, and Professor Ronald MacDonald, University of Glasgow, gave evidence.

Q4447 Chair: Gentlemen, could I welcome you to this meeting of the Scottish Affairs Select Committee? As you are aware, we have been conducting a number of hearings into the possible impact of separation in Scotland. Of course, for this particular issue, we also want to raise with you the question of what the impact would be on the rest of the United Kingdom of Scotland breaking away, because that is one of the issues that has not perhaps been covered as adequately as it might. Could you introduce yourselves and tell us the relevance of your background to the particular issues about the currency? Let’s start in alphabetical order.

Dr Armstrong: My name is Angus Armstrong. I am Director of Macroeconomics at the National Institute of Economic and Social Research, a research member of the Centre for Macroeconomics and an Economic and Social Research Council fellow, looking into issues around the Scottish referendum-in particular, currency and debt issues.

Professor Bell: I am Professor David Bell. I am Professor of Economics at the University of Stirling. Like Angus, I am one of the ESRC fellows looking into the future of the UK and Scotland. I focus mainly on the fiscal side but interact with Angus over currency.

Professor MacDonald: My name is Ronald MacDonald and I am Professor of Economics at Glasgow university. One of my main areas of interest has always been exchange rates and currencies. I have advised various Governments on exchange rate matters, exchange rate regime issues, and I am currently a monetary adviser to the International Monetary Fund.

Q4448 Chair: We all understand that this is an enormously complex area. It would be helpful if, as much as possible, you could give us answers in words of one syllable so that we and those who are watching this can understand. I understand it is not always possible, but, if you could simplify things as much as possible, it would be desirable.

Could I start off by asking a general question? It is often said that the choice of currency would be the most important economic decision that an independent Scotland would take. Why is that?

Professor MacDonald: As a currency man, I would have to agree with that, because the exchange rate of the currency is the price that affects all prices within a country, whether they are traded prices-that is the goods and services we trade and import and export with the rest of the world-or so-called non-traded goods, the service sector, which is usually sheltered from the trading sector. All of these sectors are, none the less, affected by movements in a country’s exchange rate. It is a very central macroeconomic variable. It is the key variable, in my view.

Professor Bell: I agree.

Chair: That is excellent. If people agree completely, there is no need to repeat it. So that is fine.

Dr Armstrong: The choice of currency also determines whether you have an exchange rate policy, and also monetary policy, whether it is going to be determined within your own country or elsewhere, and to an extent it has a bearing on fiscal policy. It also impacts on the other areas of macroeconomic policymaking.

Q4449 Chair: How does the currency relate to issues of monetary policy and interest rates?

Professor MacDonald: Say, for example, that we thought of an independent Scotland with a new currency. What would it have to do with that currency? Would it fix it to another currency, as is currently being proposed, or would that currency be flexible? If the currency is fixed to another country, you are relinquishing any control over your monetary policy-that is, your interest rates and the control of the money supply. If you decide to have a flexible exchange rate, it gives you control over your money supply, and particularly your interest rates. Those really are the polar positions. If you are fixing your exchange rate, especially if you are engaging in a monetary or currency union, you are relinquishing any monetary control that you are likely to have as a sovereign state, and you have no control over interest rates, nor indeed your exchange rate, of course, by definition.

Professor Bell: It is worth thinking of the interest rate as the price of money, and the central bank controls the supply. The economy determines the demand and, effectively, the interest rate is the outcome of the supply and demand side in the money markets.

Dr Armstrong: I would emphasise that having the same interest rate is, of course, the same policy for overnight or short-term interest rate. The interest rates that Governments borrow at-the 10-year interest rate or even the 20 or 30-year interest rate, if you have long-term bond markets-depend not only on the short-term interest rate, but other factors such as the credit risk of Governments, the potential currency risk and so on. When we say that the monetary policy is the same, we mean the short-term interest rates are the same, with either a tied or a single currency across two countries.

Professor Bell: It is important to realise that there are a variety of interest rates. There is one that the central bank controls and then there is a spread of interest rates depending on how long the loans are for. A lot of this discussion, in terms of the eurozone, for example, has centred on 10-year interest rates, which Governments cannot control directly. It is mainly the market that controls those 10-year rates.

Q4450 Chair: Could I ask, just for clarification, how the currency question relates to fiscal policy-tax, spending and borrowing?

Dr Armstrong: At the very simplest level, Government borrowing is about issuing Government debt, which is bits of paper with a promise to pay and which earn an interest rate for the holder. A large part of the money supply in the UK is reserves of banks held at the central bank, the Bank of England; they are called bank reserves. They are liabilities of the Bank of England, which actually earn an interest rate, which starts to sound remarkably like other Government instruments. There are differences, which mean that you cannot see them as one to one, but we can see that, when there are difficult times, it is quite often convenient that you can issue your own currency. That is where the link between Government borrowing and monetary authorities starts to be made. That is just one area of the links. There are many others, but maybe we will keep that simple bit first.

Q4451 Chair: Can I seek clarification on how the question of currency is related to the national debt?

Dr Armstrong: What is important is that Governments have enough capacity to respond to their economy as it may need it. Bad things happen to all countries at some times, and so, of course, do good things. For example, in the 1970s we had the energy crisis, in the early ’80s we had very high unemployment, and in the noughties-I don’t need to tell you this-we had the financial crisis. Things happen. The question is, how does a Government respond to help its citizens? It can use monetary policy and fiscal policy when it has its own currency. If you have somebody else’s currency, you cannot use monetary policy, because that depends on somebody else. So now you are down to fiscal policy. Your capacity to use fiscal policy depends on the amount of debt you have. You can imagine that, if your income goes down and you have lots and lots of debt, perhaps your credit card company or your bank does not feel quite so keen about lending you any more money, but, if you don’t have lots of debt, you have plenty of potential to use your credit card or to go to the bank and borrow money. That is why the existing stock of debt matters very much for the sort of policy capacity that countries have to respond to shocks.

Q4452 Chair: In this context, it is a bit like the position of an individual: the banks will lend you money if you don’t need it, but if you do need it they are not nearly as willing to lend you the money.

Dr Armstrong: That is right. What we see, which is quite interesting, is that countries that have successfully tied themselves to other currencies-for example, Hong Kong has done it very well for 30 years, since the mid-’80s-do it by not having debt. When the Asia crisis came along in ’97 and ’98, what did they do? They had plenty of capacity because they have lots of assets. You can do it there; it is, effectively, self-insuring. But if you have lots of debt and you get this nasty shock, you have to think about the adjustment path that you would make. How would you respond? That is where it starts getting difficult. That is why the amount of debt matters when deciding what the optimal currency policy is.

Professor Bell: The adjustment path has to be credible, too. There are countries that have less debt than the UK but they have not had very credible adjustment paths, like Greece, for example. That is where suddenly the cost to them of selling bonds increased quite dramatically, because they did not have a credible way out. As well as the stock of debt mattering, the credibility of the path out matters, too.

Q4453 Sir James Paice: Can I pick you up on this? Obviously, we are looking at the issue of Scotland. A lot of people were slightly puzzled about why Greece, Italy, Spain and so on had the problems they did within what appeared to be a single currency. You are saying, quite clearly, that it is because in some cases they already had a massive national debt themselves, but also that, if you like, their creditworthiness-their ability to pay-and their recovery plans were weak, so that was why their interest rates were rising sometimes day on day, despite being within a single currency. Am I right to say that the read-across to a Scottish situation would be that, even if they were in a currency zone-whether it is sterling or the eurozone is immaterial-unless Scotland was managing its finances properly and had a national debt that was within sensible bounds, there could be risks that, if they wanted to borrow money, they would have to pay very high interest rates on it? Have I read that right?

Professor Bell: I think that is right. We saw in the eurozone prior to 2007, effectively, that the costs of all Government borrowing were the same. Then in 2008, 2009 and so on they suddenly spread wide apart. That was to do a lot with their credibility in terms of how the markets assessed their creditworthiness. In a sense, it is all about whether they have a plan: if I am lending you money, give me assurance that I will get that money back.

Dr Armstrong: To try and extend the analogy of the Chair a little bit further, suppose you have a large credit card debt. The nice thing is that, when you have your own currency, you can actually influence the interest rate that you pay on the credit card. When times are difficult, do you know what? You can reduce your interest rates. But if you don’t have that option, it depends on whether the credit card company is going to give you some more money. If you don’t have any debt, they would be more than happy to do that, I presume, but, if you have a lot of debt, presumably they will start asking for some repayments quite early or charging you more money for it. This is what economists describe-I am wary of the Chair’s suggestion to keep to words of one syllable, but I will deviate, if I may, just for one second-as the "off equilibrium path." You have to ask what happens on the rainy day. It is no good saying, "We want to talk about currencies on the good days." You have to ask what happens on the rainy day. To not ask that question is not to give a service to this issue.

Professor MacDonald: I would like to respond on a different tack, given that we have introduced some of the Mediterranean countries in the eurozone. This is pertinent for the Scottish-RUK case, and presumably we will come back to this later. People tend to forget that a lot of the problems in the euro area are balance of payments problems. There are balance of payments imbalances between, particularly, peripheral countries and Germany. One of the key ways that an independent sovereign state can adjust a balance of payments deficit is to alter its currency-to alter its exchange rate. That is the key thing, of course, that these guys have not been able to do. I don’t think that we should forget that when thinking about Scotland and the rest of the UK in its choice of currency.

Q4454 Mike Crockart: Effectively, this is about a basic financial product. It is about the pricing of risk. If the financial markets regard your plan, your level of debt or your over-reliance on resources, as a small economy, as being risky, they will price that into the cost of borrowing. Is it just as simple as that?

Chair: One thing that Hansard does not record is nodding. Therefore, regrettably, you actually have to say something.

Dr Armstrong: Sorry. It is the level of debt. It is credit risk factors together with the currency arrangement. The UK is hardly a stand-out example of fiscal sobriety or a low-debt country, but the fact is that it has its own currency. As Professor MacDonald pointed out, when difficult things happen, the currency tends to depreciate and you make an adjustment. It is the credit factors, as you quite rightly pointed out, together with the currency arrangement, which are the important bits. Credit risk factors, when you are using somebody else’s currency, are a wholly different game from credit risk factors when you have your own currency. They are different games.

Q4455 Chair: Could I come back to the question of debt? It has been suggested that, if Scotland does not get its way on getting the pound, they would repudiate any share of the national debt. Is that a realistic possibility?

Professor MacDonald: Personally, I do not think it is a very good starting point for an independent country. It gives a very poor signal to financial markets which, ultimately, will determine the success or failure of macroeconomic policies. I do not think it is a very credible statement. I think it is a very poor statement for a policymaker to be making.

Q4456 Chair: I am sorry, but there is a difference between credible and poor.

Professor MacDonald: Yes.

Q4457 Chair: Poor, in a sense, is a judgment. When you say that it is not credible, do you mean that it could not be done or that it could be done but there would be consequences? And what would the consequences be?

Professor MacDonald: Of course it could be done. The consequences would be that we would be paying an even bigger premium on our debt than we would be if we were financing, or prepared to accept, the debt levels that most people agree would be Scotland’s share.

Q4458 Chair: Presumably, if a separate Scotland repudiated the debt, it wouldn’t have any, and therefore wouldn’t have any interest to pay on it?

Professor MacDonald: No indeed, but it is going to have to borrow in the future. If I am an international bank and the Scottish Government come to me and say, "Do you want to buy some of our bonds?", I would say, "You’ve got a very poor credit rating. I’ll buy your bonds if you pay me a 100% interest rate" or some ridiculous number. They may not even be able to finance their debt in the future, because interest rates could be so penal.

Professor Bell: To amplify that a little-I am sure that Angus will develop one part of this answer-if you want to join various international bodies, like the EU, how would they regard that kind of behaviour?

Picking up Ronnie’s point, Scotland will have to issue debt pretty quickly. The reason has to do with the statement by the UK Government a couple of weeks back about its standing behind UK debt, and that there will be some kind of agreement that an independent Scotland would, somehow or other, service that debt, so it would pay the interest on its share of the interest on UK Government debt. But some of that debt will be maturing, so Scotland will have to start selling its own bonds in order to cover the payments. Suppose that £100 million-

Q4459 Chair: No, surely not, because Scotland would not face any difficulty in repaying its share of the UK’s debt if it had already repudiated that debt.

Professor Bell: I am saying that, if it repudiates the debt, almost immediately it has to float new debt. Oh, I see. In terms of the servicing costs-if it refuses the servicing costs as well, yes.

Q4460 Chair: How sensible an idea is that, and is it credible and is it likely to happen? It has been floated by the First Minister that a separate Scotland would simply repudiate its share of the UK debt. We want to be clear as to whether that is a viable option, and what would the consequences be of that option?

Dr Armstrong: In my opinion, as an economist, it is not a viable option. I say that for two reasons. One is the precedent that it would set to the rest of the world about part of a sovereign state, rightly, having a referendum and being free to choose, but also then unilaterally deciding that it no longer has any obligations, which would have been by most people’s assessment, on both sides of the debate, fair obligations. In other words, if you were other countries around the world that had a lot of debt, perhaps you might start thinking, "Maybe I want to be independent as well and walk away from that debt." The precedent that this would set around the world would make it difficult. You have to think about other agreements that would have to be settled in the interim period after a yes vote and before independence took effect. There are a lot of agreements that have to be struck between Scotland and the rest of the UK Government. Those would clearly be affected if you started off the negotiation process with, "We don’t have any of this debt."

Finally, even if you repudiate the debt-this is a bit like the history of what has happened in some countries around the world-it does not mean that the debt has gone. You still owe it. You can repudiate it if you want, but you still owe it, so when you issue your first pound of new bond-suppose the debt share was, as people have discussed, between £120 billion and £150 billion, or whatever the number is; let’s take the mid-point of £135 billion as the amount it will be-it is not £1 but £135 billion plus one, because, even though you have repudiated the debt, that obligation still stands in the eyes of the other person. If you owe me money and you decide not to pay me, it doesn’t mean that I don’t think that you still owe me money.

Q4461 Chair: No, but if I was borrowing any more money I wouldn’t try and borrow it off you; I’d try and borrow it off him.

Dr Armstrong: Absolutely. The "we" here is the international financial markets, which the UK borrows from; presumably, the UK will be big investors in anybody’s bonds, pensions and so on. I don’t think it is quite as easy as saying, "I will borrow it from Professor Bell rather than borrowing it from me," because it is a global market. Professor Bell will have an interest in looking at how you treated me and will behave accordingly. It would be quite strange if he thought, "I will ignore Dr Armstrong’s obligation and lend you the money at the same price."

Q4462 Sir James Paice: What about the impact on the rest of the UK if this was to happen? If Scotland were to repudiate the debt, even within the context that Dr Armstrong describes, what would be the impact on the economy of the rest of the UK?

Professor Bell: The UK has never reneged on any debt.

Sir James Paice: No.

Professor Bell: So it would end up paying that debt, which would mean some fiscal adjustment.

Q4463 Sir James Paice: Because a smaller country would be carrying the same big debt.

Professor Bell: Yes.

Q4464 Sir James Paice: But if Dr Armstrong is right-that Scotland could not actually repudiate it in terms of the perception in the wider global marketplace- would the rest of the UK still be obliged to service the full debt?

Dr Armstrong: Yes. The UK statement three weeks ago made it clear that, in any circumstances, it will service in full all the outstanding debt of the United Kingdom Government. If Scotland becomes independent, and because Scotland does not have £135 billion in its back pocket-whatever the share of the debt would be; for the sake of argument, let us say it would be £135 billion, although people differ on that view and it would have to be negotiated-there would have to be a bilateral agreement, over a certain repayment period, where you discount the payments and so on. The UK’s initial debt position-either gross debt or public sector net debt, which is the one used in the Budgets-is that the debt ratio or the debt burden, which is debt divided by income, would rise by about 10 percentage points, almost irrespective of whether they repudiate or not. What you would end up giving me is an agreement-an IOU-from the new independent Scottish Government to the UK Government. My debt obligation, as confirmed three weeks ago, is to back 100%, as always, as for the last 450 years, all the outstanding UK debt. The rest of the UK’s debt burden, the debt over GDP ratio, will rise by 10 percentage points, which is considerable, so it is a mistake to think that the rest of the UK can shrug its shoulders here.

Sir James Paice: Thank you. That is what I wanted to know.

Q4465 Mike Crockart: I want to explore this example of making it personal rather than talking about large numbers for countries. You said that if the Chair owed you money and did not pay it back, then it would still, effectively, be counted as the Chair owing you money, but it is not quite as simple as that, is it? It is more as if I joined with the Chair, however unlikely that may seem, and we jointly borrowed money from you, but then I said that I am not paying back, but the Chair has already said, "Don’t worry, I’m going to pay it back anyway." How does that then leave me still owing you money? A lot of people in Scotland have been absolutely cock-a-hoop about the announcement that the UK Government made three weeks ago that they will stand behind the debt. They read this as being, "Yahoo, we won’t owe any money at all."

Dr Armstrong: I understand that some people read it that way. I read the statement a few times. The statement came about because the gilt-edged market makers had an annual meeting, and some people were saying, "What do you mean by ‘dividing up the debt’? We have heard this term and nobody clarifies what on earth it means." The aim was to try and provide some clarity-that in no way this means going out.

Mike Crockart: Absolutely.

Dr Armstrong: The UK merely reaffirmed what was an absolute obvious position since Charles II that it has not defaulted and does not intend to default on any debt. The rest of the UK Government might have a side agreement with another Government, which may or may not come to fruition, but all the people who hold the existing gilts will be paid in full by the UK Government, whatever direction the negotiations with the third party-the other country which will become a new country-take. That is what the Government said.

Q4466 Mike Crockart: I understand that, but how does that read across when Ian is going to pay you back the £1,000 that we jointly borrowed, but my share is £135?

Dr Armstrong: Then my share has just gone up. If the UK Government borrow £1.5 trillion and we say that £135 billion of that is somebody else’s debt, and we have jointly borrowed it, as you say, but you do not pay me, it means that the money that the rest of the UK Government owe has, effectively, gone up for the rest of their people. This is what the debt burden rising means. It means that for the rest of the UK people-the citizens in the rest of the UK-the amount of debt faced by each man, woman and child is higher. That is the debt burden. It definitely does go up.

Of course, presumably in this side agreement, if Scotland honours it and repays in full, once it has got repayment in full, it is washed. It doesn’t make any difference. But in the interim, in those years when Scotland has to raise money to pay it back, it is not cash; it is a bilateral agreement. Sometimes bilateral agreements work and sometimes they do not. I presume, for all the reasons we stated, that, if a country is to have a low borrowing cost in international capital markets, you want to be seen as never questioning this issue, which is exactly why the UK, and presumably the Scottish Government in the event of independence, would like still to be able to issue sterling. Sterling is perceived as a very credible asset where, on the instruments that have been denominating this, there has been this remarkable record-yes, a remarkable record.

Professor Bell: One way of putting it is to say that, unfortunately, you and the Chair do not have a credible pre-nuptial agreement.

Chair: That is taking things too far. Enough. I am trying to get that picture out of my head.

Q4467 Mr Reid: In the scenario that we have been exploring of the Scottish Government having this debt to the rest of the UK Government but the Scottish Government saying, "We’re not paying," would it be possible for the Scottish economy to survive without having to borrow any money from any other source?

Professor Bell: At the moment the fiscal position of Scotland is that it has about a 5% deficit, and that deficit is coming down. It is slightly less than the UK deficit. Think of that as needing to borrow 5% of the equivalent of GDP.

Q4468 Mr Reid: If you then take into account the fact that it is not having to pay this debt to the rest of the UK, does that make any difference to that scenario?

Professor Bell: Debt interest. That would take it down by £3 billion or thereabouts. The Scottish deficit is lower at the moment than the UK deficit. That depends very much on North sea oil. I suspect, for the latest year, which will be 2012-2013, that when the figures are announced in a month’s time, they will show that the revenues for the last fiscal year have fallen somewhat, which will be adverse in relation to Scotland’s fiscal position. If you don’t pay the debt interest, you are saving around £3 billion and a bit.

Q4469 Mr Reid: How does that £3 billion relate to the percentage deficit?

Professor Bell: The deficit is round about 7. That makes certain assumptions about the way Scotland would spend its money, such as that it would spend £3 billion on defence. I think that the Scottish Government position seems to be that it would spend less on defence.

Q4470 Mr Reid: The deficit would be, what, about 2.5%? If I understand you correctly, you said that half of the deficit would be the debt.

Professor Bell: The debt interest payments; yes.

Mike Crockart: You would still have to borrow.

Q4471 Mr Reid: That would be about 2.5%. Effectively, if they were not going to borrow, they would either have to increase taxes by 2.5% or cut public spending by 2.5%. Is that correct?

Dr Armstrong: Mr Reid, can I suggest that this is a hypothetical question? It is an extraordinary scenario where one country has turned round and said that they are not going to honour the debt. This is not normal. As I mentioned, there are lots of bilateral agreements that have to be agreed. Scotland does not have a tax office at the moment-a tax revenue collection office. That comes under HMRC. These deficit numbers are predicated on the basis that the money moves from HMRC seamlessly. There are a lot of agreements here that would have to be honoured. I have no idea how this would work, but it is not very credible to turn round and say, "We can do this and we don’t expect you to respond in any way at all." That does not strike me as a particularly credible scenario.

Q4472 Chair: The idea that repudiating the debt is not credible is sufficient for us at the moment.

Can I, in the final part of the introductory questions, set things in context? I want you to clarify how the choice of currency is connected to the regulation and the management of the banking and financial system.

Professor MacDonald: In broad-brush terms, obviously, it is going to change in the UK context with the new Financial Services Bill, but traditionally financial supervision and regulation are often conducted by the central bank. If you give up the right to issue your own currency and stay in a sterling zone, as the SNP are proposing, presumably you are leaving the regulation of your financial system to the regulatory mechanisms in the rest of the UK-the Bank of England and the Treasury-in future.

Q4473 Chair: Do you have to do that?

Professor MacDonald: You don’t have to. Indeed, the EU is keen for sovereign states to have their own regulatory mechanisms, but they would be incredibly costly and take a huge amount of time to put in place. There would be anomalies, given the way in which Scottish banks work. They have a lot of cross-border trade, of course, with the rest of the UK, which introduces a huge amount of complexity into the regulation of our banks.

Q4474 Chair: Am I correct in thinking that, if a separate Scotland remains under the supervision of the Bank of England for financial matters, effectively, the Scottish Government will have no control over how the banks and financial houses are regulated at all, because it is ceding all control over that to the Bank of England?

Professor MacDonald: If you look at the Fiscal Commission document it is, effectively, ceding the majority of control. It says that it may set up some of its own supervisory operations, but they are very vague on that point. As things stand at the moment, the broad-brush answer is, yes, they are effectively ceding control over the banks to the rest of the UK.

Dr Armstrong: The way I characterise this is that, if an independent Scotland decided to introduce its own currency, it could also have its own banking system, banking regulator, central bank and everything. It would be starting from new. If you want to use sterling in something like the formal monetary union that the White Paper points out, then Governor Carney’s point of last week was that you would need to have a banking union. Why would you need to have a banking union? It would be for factors such as that you would like to have the same deposit insurance operating both sides of the border. Otherwise, presumably, you would say, "I am not so sure about deposit insurance from this Government. I would rather have it from that Government, so I will move some money." That is why it becomes important that you have a banking union, if you want to have a monetary union like that.

How do you have a banking union? You need to have some fiscal arrangements so that if there is another financial crisis-let’s hope there is not another financial crisis one day but they do tend to reoccur-there is a mechanism by which one state could have a claim on the other state, which makes it very difficult to repudiate, by the way, where they say, "Actually, you have to pay us back the money that we spent." There would have to be some sort of resolution mechanism, perhaps paying out your depositors and so on. If you want to have the currency union that is pointed out in the White Paper, it implies that you need to have some sort of banking union, which implies that you need to have some sort of fiscal arrangement between the two sovereign states.

You can also go for a different type of currency union where you can use the currency of another country and say, "I am willing to cede all control of my financial system, and I will have my own financial system," which becomes this dollarisation process, but that is a very different animal from the one that is pointed out in the White Paper.

Q4475 Sir James Paice: Can you clarify what you mean by dollarisation?

Dr Armstrong: Dollarisation is where you use the currency of another country but you have no access to the monetary authority of that other country.

Q4476 Sir James Paice: As in Panama.

Dr Armstrong: As in Panama.

Q4477 Sir James Paice: We will come back to lots of other issues, I know, but on this narrow issue of regulation and management of the banking system, are there any implications if a country uses somebody else’s currency and cedes all monetary policy in that way, as you describe? Could it still have its own financial institutions in its own country, operating under its own rules?

Dr Armstrong: Yes.

Q4478 Sir James Paice: It could still have control over their regulation.

Dr Armstrong: There are different types of currency union. One extreme version would be some sort of dollarised arrangement, where Scotland would have to develop new types of financial institutions. The UK would want to ring-fence its own institutions, as far as possible, which would mean adding lots of things; for example, you could only operate subsidiaries in the foreign country, which would mean that they would have to have their own balance sheet in a different country and so on. You could get a currency union where the Scottish banking system would be very different from what it looks like today. It would be an entirely different system from what it is today. On the other hand, you could have a currency union where the banking system looks like it is today and that would require a banking union. The thing about the banking union is that at some point you also need to have some sort of fiscal agreement, and that is where the nub is on the banking union. By the way, if you are going to have a banking union, you would probably want to have some sort of federal union in terms of tax and spend policy, because there are other things that can go wrong in an economy. It is not just the banking system.

Q4479 Chair: But it would be a federal union that starts very much resembling the United Kingdom again, wouldn’t it-or would it?

Dr Armstrong: The United Kingdom is a very centralised collection of nations, so it is not the only model out there. There are plenty of other models. There are different federal models. The question here is whether you can cross independent states. In Europe this is exactly the experiment they are trying at the moment. Can you have independent sovereign states but where you can cede some of the sovereignty and pool the sovereignty? That is the experiment we have in Europe at the moment and whether they can make any progress on doing that; this will be the example.

Q4480 Sir James Paice: And that is picking up the much lamented convergence criteria with the constraints that you talked about.

Dr Armstrong: No. It will be more than the convergence criteria. This would be a banking union where you have pooled money being used for future banking crises, but also a certain degree of tax and spend distribution.

Q4481 Sir James Paice: That is what I was referring to by convergence. A lot of the convergence criteria were about-

Dr Armstrong: Getting to the right position to start with. There are a few things. First of all, you have to get to the right position to start with. Secondly, you have limits on the amount of debt you can get. The trouble with limits is that you want to break the limits, because it almost makes sense for you to break the limits when it really is the rainy day, because then you just get really badly imposed fiscal tightening. Then you want to have a way of clawing the money back in the good days, and that is when you have the risk sharing. So you say, "Mr Davidson, yes, we understand that you are having a bad day at the moment, but we are going to let you spend some more money because we know we can get it back from you in the future." That is what Europe is trying to construct, this level of federal government, while having sovereign states. The question becomes whether that would even be possible. These institutions have never been fleshed out, and we are looking at Europe thinking, "Could you do it?", and that is the interesting question here.

Sir James Paice: Indeed.

Q4482 Chair: Can I just be clear on this question of a shared currency and what scope there is for separate control and regulation of the banking system? With a shared currency, is it inevitable that there has to be a single authority that controls the whole thing, or is there scope for variations, say, on a Scottish basis in these circumstances?

Dr Armstrong: Okay. In words of one syllable, if you want a banking system that looks like this, you are going to have to have one banking regulator. If you want a totally different banking system-under dollarisation you can imagine a very different banking system-then you can have your own regulator.

Q4483 Chair: The SNP proposal is to have a shared currency. Does that automatically or necessarily mean that you have a single financial controller, as it were, setting policy for control of the banks right across the UK and there is, therefore, no flexibility for a separate Scottish regime?

Dr Armstrong: No, it does not imply that. One of the difficulties with Governor Carney’s speech last week is that we use the term "currency union" without saying what it actually is and it covers a multitude of sins. What do you mean by "currency union"? It can cover the European Union. He used the example of Canada-most people think of that as a single country-or the United States, but you can use it there as well. Does it include currency boards, like Hong Kong? Does it include dollarisation countries? These are completely different monetary arrangements. There is a world of difference between the dollarisation that Panama and Montenegro run-but it is a currency union-and the monetary system that the United States runs, which he has called also a currency union. We have to be very careful about what type of monetary arrangement we are talking about within the umbrella term "currency union."

Q4484 Chair: So it is possible, under a currency union as proposed by the Scottish Government, to have a degree of control over the banking system from Scotland and in Scotland.

Dr Armstrong: Okay. That is a slightly different question.

Chair: I understand that.

Dr Armstrong: To answer your first question, under a currency union, is it necessary to have one single regulator? We have pointed out the example that there are countries around the world which are dollarised and which do not share the regulator with the country that they are dollarised to, so the answer to that question is that it is not a necessary condition.

If you want to have a monetary union of the sort that is pointed out in the White Paper, then you need to have a banking union. As Governor Carney pointed out, banking unions need certain criteria, one of which is a single form of regulation.

Q4485 Graeme Morrice: Can I go back a moment to the issue of the debt? We know, obviously, that an aspiration of an independent Scottish Government is to be in a currency union. Presumably, we are talking about the sterling zone. If that is the case, there would be negotiations between Scotland and the rest of the UK with regard to what Scotland’s debt would be, and, obviously, looking at carving up UK assets. As we discussed earlier, we are aware that, if we don’t see agreement among the two parties on having a currency union, Scotland would repudiate its debt. Who would determine what Scotland’s debt would be at that point in time for us to know the amount that has been repudiated?

Professor Bell: There is no terribly clear precedent on this. There are no international laws that you can appeal to around the allocation of debt. A common approach is to do it just on a per capita basis. There are more sophisticated ways of dealing with how much public spending per head there has been over a period of time, and then there is the method favoured by the Scottish Government, which is to go back to 1980 and aggregate all the fiscal deficits since 1980. When you do that, you come to a much lower figure than Angus has quoted for Scottish debt, largely because, during the 1980s, if Scotland had been attributed 90% of the oil revenues, it would have been running a very substantial surplus. I don’t think there is an answer to your question. It is part of the negotiation. The simplest rule, of course, is just to do it on a population basis.

Then there is a debate about assets as well as debts. Of course, there are also the contingent liabilities, things like public sector pensions, PFI agreements and so on, which do not form part of the net debt that is quoted in the Budget, but which are liabilities, effectively, over the future on either the UK or the Scottish Government.

Q4486 Graeme Morrice: Presumably, there would not be any negotiations if the rest of the UK agreed that Scotland was going to be part of the sterling zone, because the Scottish Government said that they would repudiate the debts. Presumably there would be no discourse on that whole issue. A ball would be taken away on that.

Professor Bell: As Angus said, there are lots of other agreements and contractual arrangements with the UK Government which the Scottish Government would want to take over itself. The UK Government are not in an impossible position when it comes to the negotiations, it seems to me.

Dr Armstrong: Whenever we at the National Institute look at this issue, we break it down to three things. What debt are we talking about, so what amount? First, we have to get agreement on that. After you have agreed the amount, you have to have a fight over what is the share. How much is yours; how much is mine? Then, after that, it is how is one side going to repay the other? There are three bits that have to be taken into consideration.

On the question of what debt, in my view, the best account is the whole Government accounts which are produced, unfortunately, with a bit of a lag. The last ones are for the financial year 2011-2012, so ending March 2012. They have all the assets of Government. All Government Departments are consolidated, including the Bank of England, including all the quantitative easing assets. All of them are in there, including infrastructure-roads, everything. It is an incredible set of accounts. Against that, you have all the liabilities, so you have market-issued debt, which is some, but you also have debt which has not been market- issued-things that David was pointing out like teachers’ pensions, where they have done the work but they have not got their pension yet. That is clearly a debt. For that year, we are given the net liability, which the report states is the closest equivalent to what the public debt would be-this is debt after taking the assets, which is the point I am getting at. You can’t say that there are assets against it; this is after the assets. That is why the analogy has to be against a credit card and not a mortgage, because a mortgage has a house. A credit card is used for a reason. So the net liability, after assets-once again, according to, I think, the 2011-2012 accounts; I could be wrong on the year but it is the 2011-2012 accounts, I’m nearly sure-is £1.35 trillion, which is remarkably close to the gross debt figure, which is £1.3-something trillion. They are measuring different things, so that is more coincidental than anything else, but in terms of what is the debt number to use, that is, at least conceptually, probably the cleanest measure out there to use.

Who pays what share? It could be per capita. You could also say that it should be on ability to pay. Ability to pay would be GDP. Is it yesterday’s GDP or GDP the day after independence, in which case GDP per head in Scotland is higher than the rest of the UK, because the oil goes that way, so Scotland would end up taking more? It could be that we are going to start the clock running from 1980, so you get the argument on how you divide up this debt after you have agreed the amount. As I say, whole Government accounts are probably the cleanest amount. I think the White Paper, for its measure of assets, uses the whole assets in the whole Government account, so it is obviously consistent. Then you have to have the argument about how much is whose. That depends. Then we come to the issue we discussed earlier of how the payment is going to be made and over what term. Is it over 10 years, two years or what? These are negotiations to be part of the broader negotiations and, as has already been said, there are a lot of contracts to be agreed.

Q4487 Chair: But all of that is doable. It is big sums but it is all doable.

Dr Armstrong: Yes. All that can be done.

Q4488 Graeme Morrice: You certainly make it sound simple. We know that the Scottish Government seem to be very confident that a currency union will continue post-independence. Do you think that, gentlemen?

Professor MacDonald: From my perspective, I would ask the question: is that the most appropriate regime for an independent country? As a guy who looks at currencies, that would be my starting point, and I would say no. One of the key reasons is that, as we have said, post-independence, Scotland would be allocated, presumably, the share of oil that it is so keen to get its hands on, as it were. As soon as you do that, you open the country to what we call "asymmetric shocks," because the rest of the UK is not going to be an oil producer. As soon as Scotland becomes a sovereign state, were it to happen, it is open to these so-called asymmetric shocks. You need some way of adjusting to these shocks. One way is through a transfer mechanism, which works very well at the moment in the UK because the shocks are internalised within the whole country, but with a separate Scotland it would need some mechanism to adjust that. One of the key measures is that the nominal exchange rate would adjust. If you had a separate currency, your exchange rate would take up the adjustment, but, of course, if you are part of a monetary union, you won’t have that.

Graeme Morrice: That is an interesting point.

Professor MacDonald: That, for me, is one of the key deciding issues as to why, whatever we want to call it, a currency union or a monetary union would not work.

Professor Bell: The other mechanism, which is often described as an "internal devaluation," is around movements in wages. If you can’t adjust your exchange rate, you have to make an adjustment if you are going to remain competitive on your costs. That, principally, would be through wages. One of the difficulties around the Mediterranean countries has been that their labour markets have been pretty inflexible in terms of responding to the lack of competitiveness that Ronnie was talking about earlier. Actually, the UK and Scottish labour markets are reasonably flexible, but only up to a point. If there is a massive asymmetric shock, you would expect that the first mechanism of response would be an adjustment of the exchange rate.

Dr Armstrong: Just to follow that and picking up on both Professor MacDonald and Professor Bell, when talking about the asymmetries which emerge, Professor Bell said that you don’t have a perfectly flexible system of wages and prices. People don’t accept large reductions in wages where there is a large shock. If I may, I just happen to have in front of me a quote from Robert Mundell in "A Theory of Optimal Currency Areas." People always go back to this. This is what Governor Carney’s speech was about and so on. It says: "It is patently obvious that periodic balance-of-payments crises will remain an integral feature of the international economic system as long as fixed exchange rates and rigid wage and price levels prevent the international price system from fulfilling a natural role…" This is not rewriting economic textbooks. This is the one that most people actually go back to when you have those rigidities and asymmetric shocks that arise.

Q4489 Sir James Paice: Professor MacDonald, am I right to conclude from what you have just said that that applies to any currency union, not just a sterling union, and that therefore, in your view, the most sensible way forward would be for an independent Scotland to have its own independent currency?

Professor MacDonald: If you look at a profile of a post-independent Scottish economy, the answer would have to be yes. The reason why Norway is not part of the eurozone, for example, is that the exchange rate implications of joining a monetary union can be absolutely disastrous. As we have all said, if you look at how the southern Mediterranean countries have suffered, neither the exchange rate nor wages adjusted in the appropriate way, so quantities adjust, and you have massive unemployment. That is the consequence of getting it wrong, basically.

Q4490 Chair: Could I just seek clarification on one point? As I understood it, you said that, if there was a shared currency, there would be a divergence, and the pressure on Scotland would be to split away and have its own currency. Where does England stand in all of that? What would the impact of divergence be upon the rest of the UK? Is there an argument why they shouldn’t sign up to that in the first place?

Professor MacDonald: As we know, Scotland is a relatively small portion of the UK. This is my view: if they were to get the currency arrangements wrong, it could have very significant effects for the rest of the UK. It could lead to a currency crisis. We saw that in the context of the ERM crisis when we were ejected spectacularly from the ERM. Of course, that was a fixed exchange rate system. At the moment, we are on a managed floor. The exchange rate is flexible. None the less, if there was great international unease-shall I say?-about the currency arrangements within the UK, speculators and international investors would be inclined to move assets out of sterling, out of the UK basically, which could lead to a very precipitous fall in sterling, with all the consequences that could have for the rest of the economy.

Q4491 Sir James Paice: That could happen because of something that was happening in the Scottish economy. I just want to get this clear.

Professor MacDonald: Yes. If the currency arrangement is seen by international markets to be ill-founded-it won’t last-that could have serious repercussions for the rest of the UK, because they are going to have to sustain the currency union and make it credible, basically; yes.

Professor Bell: There are lots of arguments in terms of the extent of trade between Scotland and the rest of the UK-in favour-but that is not the only criterion on which you base a currency union or a monetary union. It is rather that arrangements should be in place, such that, if things go wrong, parties are not adversely affected. That almost inevitably means that in some way or other they share risk.

Dr Armstrong: Mr Morrice asked, if there is a yes vote, does that mean that you can’t have a currency union? I think that was your question. Professor MacDonald answered and gave what the answer would be in his view. I think the technical answer, though, again going back to what you really mean by a currency union, is, could you dollarise? Yes, you could. It might not be a good idea. It might lead to a very different financial system, and so on and so forth from what you are expecting, but some sort of absurd logical answer to that question is, yes, you could have a form of currency union. It might not be good for you, but is it at least technically viable? I think the answer would be yes. I am not, for one moment, advocating it. I am just pointing out that, technically, the answer to that question could be yes.

In terms of the rest of the UK, one of the peculiarities of this is that monetary union sounds like a coming together of several nations, but because of the asymmetry in size-one is 10 times bigger than the other-only one country is really in the monetary union here, and that would be the independent Scotland. The UK has nine out of 10 votes, presumably, on the MPC. It is not bound by anybody else’s interest rates. It will still set them however it wants.

Q4492 Graeme Morrice: I understand all that. There is an absolute logic in what you say, so why are the Scottish Government so adamant in saying-it is in the White Paper-that it is in Scotland’s best interest to be in a currency union with the rest of the UK: in other words, to keep the pound? Business as usual, in effect.

Professor Bell: Partly it is to do with the optimal currency area arguments. On the basis of trade, and when everything is going swimmingly, you can see that case. The issue is what happens if it doesn’t go swimmingly, if there are imbalances or shocks to one side or the other.

Q4493 Graeme Morrice: We could argue that. You have argued it well, and there is a logic to that. Is it because it may be seen as the safe option for political reasons, so that they are not frightening the children?

Professor MacDonald: Yes; I think it essentially is. What would the alternatives be? One would be to have a flexible exchange rate, to have an independent currency and for it to be determined in the market. If you don’t have a well thought-through policy as to how you are going to manage your exchange rate, and you don’t have much in the way of foreign exchange reserves, the exchange rate would probably move around a lot. As David was saying, that would have a nasty effect on trade with the rest of the UK. They are trying to take away this uncertainty from people’s minds, but I feel that they are trying to trick people, essentially, in what they are doing. David mentioned the optimal currency area idea, but asymmetric shocks are an important element of that, and they do not address that anywhere that I have seen, yet it is absolutely fundamental in the economics literature.

The other interesting issue is that, when they talk about optimal currency areas, they talk about productivity levels in Scotland being similar to the rest of the UK-at the moment. But in their response to the IFS document about potential fiscal deficits that Scotland would have, they said that they were wanting to improve productivity. This was one of the big issues that they were going to do when they had economic levers. There, immediately, is an important anomaly. Once you start the independence clock ticking, and, if they are correct, your productivity is going to diverge, that is another reason why a currency union would unravel. As I pointed out before, financial markets are pretty smart. They know that these issues are pertinent. They know that these are the relevant issues for countries. So I don’t think the currency union would last long, however well it is designed. Currency markets are going to know that these shocks are going to hit Scotland; there will be downward sticky wages. Is a Scottish Government going to say, "We are going to have large levels of unemployment"? No. "We are going to adjust the exchange rate."

Q4494 Graeme Morrice: Having a currency union with the rest of the UK does not sound like independence to me, but maybe that is another issue.

The Scottish Government’s Fiscal Commission set out some plans for a currency union. Do you regard them as realistic?

Professor MacDonald: Given what I have said, no.

Graeme Morrice: I like simple answers.

Dr Armstrong: They spoke about a shareholding arrangement. I think there were two arrangements they suggested with the central bank. One would be a share, 50-50. Frankly, it is quite hard to see why the rest of the UK would agree to give a country a tenth of your size half the vote. I think they will leave that aside. It may even be in a footnote; I am not quite sure. The main thing they suggested is a shareholder arrangement in proportion to population size, I believe, which gets you one vote out of 10. I don’t know how many votes you are hoping to win with one vote out of 10. This again gets to the point that you would not have control over monetary policy. Then it gets to the question that you are going to start off life with a reasonably high level of debt. Then you get exactly the points that we have been talking about. What happens on the rainy day? What happens when things don’t go well? That is where it gets interesting. It is that question that needs to be answered, not "What happens if everything goes swimmingly for a couple of months?" It is what happens on the rainy day.

If I may, on Friday, we are about to produce our review, which has six papers about Scottish independence in it, one of which looks at these issues of equilibrium paths on currencies.

Chair: You managed to work in an advert. That was part of the script when you came.

Q4495 Mr Reid: We heard earlier that an independent Scotland would be starting off with a deficit of about 5% of GDP. Clearly, borrowing costs are important. Would a currency union help or hinder borrowing costs?

Dr Armstrong: In a paper that we produced in October at the National Institute, we made an estimate of what we thought independence borrowing costs would be relative to the rest of the UK. These were 10-year borrowing costs. To do this is quite awkward because you have to find another monetary union in order to compare what it would be like in a monetary union. We used all the European countries between 2000 and 2012 to estimate it. Without going into the details-unless you would like to, which would be great-we came out with a number between 0.7% and 1.7% higher than the rest of the UK.

Q4496 Mr Reid: Is that when it is within a currency union?

Dr Armstrong: That is within a currency union. I have to make a major proviso. This is based on the idea that you go into a currency union that looks like the European one, where you have a high degree of political convergence and no currency risk, because everybody who is in the eurozone believes in a single currency. Despite all the upheavals, nobody has voted to get out of it. The tricky bit is that, if you are a sovereign state, you quite correctly have the right one day to decide to leave it. That is what sovereignty means. It means that you make the rules up for your people. Our basis of calculation, assuming you are going to be in this union which has a great deal of political convergence and agreements at a federal level, is saying, "Let’s pretend that is what it would look like post-independence." The difficulty, as we now know, is that Scotland has said, on page 111 of the White Paper, that in future years it would be up to the Scottish people to decide whether that remains the best currency arrangement; in other words, they could vote to get out of it. Well, hang on. If one side can vote to get out of it, I presume the other one can as well. Now it is not quite the same comparison, because you don’t just have credit risk, which is what the original work was based on, but you have the possibility that you might vote to get out of it one day. I would suggest, looking at the numbers that we estimated, which again were 0.7 to 1.7 percentage points above the UK on 10-year Government borrowing costs, that they are probably on the low side if you start introducing the possibility that you could leave this thing.

Q4497 Mr Reid: That was your calculation for Scotland within a currency union. Did you do a comparable calculation for Scotland having its own currency?

Dr Armstrong: It is very difficult because it depends where the currency is. At what level is the currency? Is it par with the UK? Is it below by 10% or is it above by 10%? It depends, because-shall I just leave it that it depends?

Mr Reid: I think we get the message.

Dr Armstrong: It is not simple. The methodology does not carry over if you have your own currency, because you have currency risk to take into consideration as well as credit risk to take into consideration. In other words, when you hold an asset in a foreign country, you have, first of all, credit risk, but you also have the possibility that the currency might be higher or lower on the day that you get the money back from your investment. That is where it becomes different.

Q4498 Chair: Before Alan carries on, can I follow up one point about borrowing? When you referred to borrowing, most people, either watching or reading any note of this hearing, will relate to borrowing for their mortgage. Do mortgage borrowing rates bear any relationship to the figures that you are talking about in terms of borrowing by Governments? Is my mortgage likely to be affected by any of this?

Dr Armstrong: I said that these are 10-year Government bond yields. Most mortgages are not priced off 10-year Government bond yields, because they depend on base rates, for example. In fact, most of them depend on something like the two-year swap rates, plus a bit of credit risk for the institution. It depends on the bank funding costs. It is not a simple question to go from one to another.

Q4499 Chair: So that is a no then, in the sense of my constituents being worried about whether any of this is affecting their mortgage rates.

Dr Armstrong: No. Again, the answer-I will try and be monosyllabic-is that the yields the Government borrow at are relevant to other borrowing costs in that country. Is it a one-to-one transfer from 10-year bond yields to mortgage rates? No, it is not, because they tend to depend much more on short-term interest rates. I said at the beginning that there are lots of different interest rates. But would it be fair to say that it has nothing at all to do with the costs that the Government are borrowing at? No, that would not be fair. They will have some impact but the impact is not a one-to-one at all.

Q4500 Chair: Again, coming back to this, I appreciate that it is not one-to-one, but is it likely, under the proposed currency union, that borrowing rates for mortgages in Scotland, first, would simply remain the same as in the rest of the United Kingdom, and, if not, secondly, would they go up, because that is what real people are interested in?

Dr Armstrong: If you manage to get a banking union, it is difficult to see why there would be a significant difference in, say, mortgage rates, although I will point out that in the eurozone, borrowing costs were different. They were very small but they were different; they were nothing like the 10-year bond yields sought by Governments, but there were differences.

If you don’t have a banking union, household borrowing costs basically depend on banks’ funding costs, and these would be the funding costs of banks in Scotland, not in a banking union. The critical question is, can you create a banking union? If the answer to that question is yes, the funding costs should be the same or very similar for both banks and there should not be that much difference for people’s borrowing costs north and south of the border. If you can’t have a banking union, the funding costs north and south of the border of these institutions will be different, so the borrowing costs for households will also be different.

Q4501 Mr Reid: If you have a banking union, does that mean there has to be a common set of rules down to a very detailed level? Would there have to be a common set of rules for bank bonuses, for example?

Professor Bell: The financial services industry in Scotland would wish to be under a pretty much identical set of rules, because that gives customers assurance. Of course, they deal on both sides of the border quite extensively. I don’t know if it would go as far as bonuses, but in terms of things like liquidity and how liquidity is managed, absolutely, they would have to be the same.

Q4502 Mr Reid: Looking at a currency union from the UK point of view, are there circumstances where the outcome of the negotiations would be such that it would be in the UK’s best interests? If you were negotiating on behalf of the UK, what would your negotiating objectives be?

Dr Armstrong: One of the advantages to the rest of the UK of being in a currency union is that you have a fixed exchange rate for doing cross-border trade, and so on and so forth. That is a plus. That is definitely in the plus side of the accounts. The problem with that, as we have suggested, is that there are disturbances that hit. Ronnie has pointed out some, David has pointed out others and I have pointed out what happens on the rainy day. So you would have to have mechanisms around that to have this pro, on one side of the accounts, and then you would have those negatives, but the person you have the union with is going to have difficulties in adjusting. It is not often that you really want to have a union with somebody who you know could have difficulties in adjusting. The question is, can you create the institutions in order to circumvent those factors? The sort of institutions that we are dealing with here are transfer payments, which would have to be fiscal transfer payments, presumably, to make these things happen, which of course currently happen.

Q4503 Mr Reid: Would you explain fiscal transfer payments for a lay person?

Dr Armstrong: Yes. It is where in one area the real exchange rate becomes out of line with the rest of the currency union. Whereas you can have things like nominal wages and do the adjustments, it is very uncomfortable for people to have these sorts of adjustments. So to ease that burden of adjustment, there is a financial payment, like unemployment insurance, paid to the other person to tide them over those difficult times. That is the fiscal transfer. You would presumably require fiscal transfers, plus a banking union, and then you would say, "Okay, this works." Funnily enough, this looks remarkably like what you have at the moment. Just as the Governor was at liberty to use the United States and say that that is a currency union, we can also say that the United Kingdom is a currency union today.

Q4504 Mr Reid: I am sorry; I am still not quite following the fiscal transfer part. The United Kingdom, like the United States, is all one country. If unemployment is higher in one part of the United Kingdom, obviously more unemployment benefit is paid out in that part. In this independent Scotland, independent of the UK, if unemployment was higher in Scotland, I can’t see the rest of the UK passing over more money for unemployment benefit.

Dr Armstrong: So you do get the issue.

Mr Reid: Yes, but I was not quite sure what you were meaning by fiscal transfer.

Dr Armstrong: Fiscal transfer would be the way of getting something that shadows the first one that you discussed, which is through the unemployment insurance. You make a fiscal transfer-in this case a spending transfer-from one part of the union to another part of the union. That is the fiscal transfer. As you quite rightly pointed out, when you have sovereign states, you don’t have that same level of fiscal transfer. So what we are saying is that to compensate for these misalignments and shocks, you would have to create institutions which would enable that but allow you to feel confident that, whatever transfers go that way, one day they also come back the other way.

Professor Bell: One analogy is with the US and the eurozone. Both currency unions experienced massive shocks in 2007 and 2008. Actually, the one in the US was quite specific in certain parts of the US, like Florida, Colorado and California. The fiscal transfers, in the form of unemployment insurance and various other mechanisms, enabled those parts of the States to recover and move on, and the US economy starts to do reasonably well again. Of course, that is exactly what did not happen in the eurozone, because the northern European states were not really willing to effect fiscal transfers to the Mediterranean states without big strings attached, which they are still negotiating over.

Q4505 Sir James Paice: Is that partly because the US is also a political union, whereas the EU is not?

Professor Bell: Yes.

Sir James Paice: And the scenario with Scotland and the UK would not be.

Q4506 Mr Reid: I follow that. I am sorry, but what I still cannot grasp is how you have a currency union where these fiscal transfers take place. One of you said that money would come back at some later date. Are you saying that there would have to be something in the treaty setting up the currency union, that if there was a shock to one part but not to the other money would be transferred to the country that had some of the shock, but at a later stage they would have to pay that back? Is that what you are saying?

Dr Armstrong: Yes. Europe was basically a monetary union but without having fiscal transfers. I thought David made a very nice analogy about the United States. Nobody questioned will that state leave the US dollar. It just was not a question, because it is completely federal. Period. Even though the states have a lot of fiscal autonomy, that arrangement is federal. There are transfers and it is done at a federal-board level.

In Europe, there were not these federal transfers for things like unemployment insurance and so on, and that is where some countries got themselves into a mess. In the end, they did have to have these transfers. They were not completely voluntary. The ECB did not really have a great deal of choice in the end, and Draghi had to say that they would do whatever was necessary. Repayment and all of that still has to be agreed; it has not been sorted out. Whether they can actually get to these institutions is still the question of the European project. Can it have a full banking union in the future? We don’t know the answer to that question yet.

In some ways, that is a forerunner or an example to see if this is possible across sovereign states. So far, there are very few, if any, examples. Actually, I don’t think there any examples where this has been achieved. The question is, is it achievable? We know already that Europe is finding difficulties in getting there, but that does not mean to say that it cannot get there. The UK is not Europe, but the UK would have to have arrangements. If you had a banking union, you would have to have some sort of fiscal transfers, because the day one country’s banking system goes down is usually the day that they can least afford to pay it back. It is not much of an agreement if you can’t pay me back, and, by the way, you can leave as well. That is not an agreement I would really want to be in unless I have some control over it.

Professor Bell: If Europe cannot get the fiscal transfer mechanism in place, what it is trying to do at the minute is ensure that there is little likelihood of the types of shocks that we have been discussing occurring. There is this stabilisation pact, which is currently under negotiation. Effectively, that says that deficits should never exceed 2% of GDP, and the cyclically adjusted deficit should not exceed 1% of GDP. It is trying to force states into a position where they are pretty close to balanced budgets, which means that they are less susceptible to external shocks.

Q4507 Mr Reid: Are you suggesting that, if the rest of the UK was negotiating a currency union with an independent Scotland, it would be inserting clauses such as that into the agreement-that would put a limit on annual budget deficits and structural deficits?

Professor MacDonald: I think that is what Mark Carney was getting at last week, particularly when he referred to 25% of GDP, which has important implications, of course, for how much you can spend. Your point is a very good one. Why would the rest of the UK make these transfers because, presumably, the transfers would be, maybe, going in one direction, and there would be an incentive for a Scottish Government, perhaps, to renege on its duty to repay the transfers at a later date? Obviously, there has to be a tie-down clause, and the tie-down clause seems to be quite draconian if you are locked into ruling out 50% of your public spending.

Q4508 Chair: Can I clarify one point? I am assuming that the establishment of a bail-out fund-Scotland-would be the UK position. It is inconceivable-or is it?-that Scotland, to be realistic, would be in a position to bail out the United Kingdom should the United Kingdom be in financial difficulties, so we are presumably talking about a one-way street. I am not clear, entirely, what is in it for the rest of the UK. Is it not better in these circumstances to say, "Look, off you go. This is the time to have your own currency"?

Dr Armstrong: The question from yourself and Mr Reid is what are the obstacles to getting to a fiscal transfer mechanism that could possibly work.

Q4509 Mr Reid: Yes. The clear advantage to the UK is that there are no transaction costs for switching currency. That would be an advantage, but we are trying to find out whether the disadvantages outweigh the advantages by so much that the UK just would not entertain them.

Dr Armstrong: That is for the UK Government. Let me point out that there are two fundamental problems with negotiating this agreement, one of which the Chair has pointed out. One country is 10 times the size of the other. You can’t really get round this thing; it is just a fact. It is conceivable-let’s hope it never has to happen-that Scotland could need some support from the rest of the UK one day, but it is pretty inconceivable that Scotland could give support for the rest of the UK. It is just too small. That is one problem. This game is pretty asymmetric.

The second problem is that, because, after a yes vote, there would be two independent sovereign states, it means you can pull out at any time. Forming international agreements for countries that can always have a vote and decide the will of the people becomes very difficult. That is why in international law it is so hard to make binding agreements. These are the two big issues that would have to be overcome to make some sort of pact-I should say ground pact, because as the Government pointed out, we are not dealing with 2% or 3% of GDP here. We are dealing with a quarter of federal budgets. It would be a ground pact, but you would have to overcome those two rather immutable issues.

Q4510 Sir James Paice: From the perspective of the rest of the UK, there seems to me, from what you are all saying, to be little advantage in maintaining or creating this sort of agreement with Scotland.

Professor Bell: It is a costs and benefits argument.

Q4511 Sir James Paice: It seems to be heavily costs.

Professor Bell: It depends on how the UK Government assess the chances of Scotland having difficulties, and their credibility in relation to whatever agreement they might put in place. If you were sceptical, you might say, as Angus has said, that agreements are always subject to electoral variation.

Chair: I have been told that a Division is coming up. Since we have come to a nice end point, shall we just break where we are as the Bell will sound at any moment? This is the advantage of having a television that you can see. We will break for 15 minutes. We will be back as quickly as we can. Perhaps you could talk among yourselves.

Sitting suspended for Divisions in the House.

On resuming-

Chair: Apologies for that break due to the vote. Jim.

Q4512 Sir James Paice: Can we leave behind now the issue of any formal currency union with the rest of the UK and move to what we talked about earlier-the possible dollarisation or sterlingisation that people have talked about? We keep hearing from Scottish Ministers that the rest of the UK could not stop Scotland from using sterling if it wanted to do so, by which, I assume, they mean outside any formal currency union. Is that correct? Is there any way that the rest of the UK could stop that happening?

Professor MacDonald: I don’t think so, no.

Q4513 Sir James Paice: We have already this afternoon talked about Panama and Montenegro as two countries that follow that sort of route. Are there any others of any significance whatsoever? Presumably, there is the odd island here and there.

Professor MacDonald: Not really, no.

Q4514 Sir James Paice: So it would really be a remarkable action for Scotland to take.

Professor MacDonald: It would be. For a country at Scotland’s level of development, it would certainly be very unusual, yes.

Q4515 Sir James Paice: Am I right in assuming, if it was to follow that route, that there would be no central bank and it would have no control over it, as I think you said? I am really seeking confirmation that it would have no control over interest rates or monetary policy at all.

Professor MacDonald: That is correct.

Q4516 Sir James Paice: How would that read across to that independent Scotland’s tax and spending policies? It is an open question. How would it affect them?

Professor MacDonald: Clearly, an independent Scotland would still be able to tax, spend and borrow. Going back to the arguments that we gave earlier, it is unlikely that financial markets would view that as a terribly credible regime for an independent Scotland. Presumably, there would be a premium on the debt, a credit risk premium and perhaps a sovereign risk premium as well. Certainly the Government could tax, spend and, presumably, borrow, but, given its far from ideal regime, there would be the kind of problems that we mentioned earlier.

Q4517 Chair: Can I clarify the point about borrowing? Panama can borrow, can it, even though it does not have its own currency and just uses the dollar?

Professor MacDonald: I am not entirely sure about Panama in terms of borrowing.

Q4518 Chair: What about Montenegro or Kosovo?

Professor MacDonald: Montenegro can borrow, yes.

Dr Armstrong: Governments borrow in foreign currency, often. It tends to be developing countries, but they do it. Argentina borrows in dollars.

Q4519 Sir James Paice: I see. An independent Scotland using sterling could still borrow in dollars or, indeed, in any other eurozone currency.

Dr Armstrong: Yes.

Q4520 Chair: It would be a question of interest rates, wouldn’t it?

Sir James Paice: Exactly, yes. The interest rate would reflect the risk involved in that.

Dr Armstrong: Yes. We tend to think that these things are quite smooth, that you pay higher risk premiums, but of course you have higher interest rates. This is where we keep coming back to the debt. Paying higher interest rates when you don’t have much debt means that you can borrow some more. But if you already have so much debt that the debt interest payments start to matter as the debt rolls over, it starts meaning that your debts get into a worse position with higher interest rates. So higher interest rates are the last thing you need. You get into, again as Governor Carney mentioned, self-fulfilling or destabilising fiscal situations, which was a point we made in our October paper about disequilibria and what happens when things go wrong. It is not necessarily a smooth issue. These ideas about dollarisation on their own, when you have a lot of debt, put you in a difficult corner. It does not mean to say that you necessarily can’t do it, but it could well be far from optimal.

Q4521 Sir James Paice: To challenge you on that point, notwithstanding earlier discussions, if Scotland took its share of the UK debt, which you said would be £135 billion, roughly, would that be considered a lot of debt, to use your expression?

Dr Armstrong: For a small country with a small open economy-I don’t use "small" at all in a pejorative way; it is an economic term; the UK is a small country relative to the global economy-with no track record of issuing debt, whose main assets are very importantly the skills of its people, and its other main asset being this thing called oil, which is volatile, it would, in my view, be considered, even at that level, which is lower than the debt burden for the rest of the UK, a high debt burden.

Q4522 Sir James Paice: Thank you. Following this path of a dollarised or sterlingised situation in Scotland, what would be the impact of that and the likely reaction of the financial sector in Scotland, which, as we know, is quite strong, quite major?

Professor MacDonald: Connected to that, I would have to say that the whole aspect of this focuses on the supply of money. In the context of dollarisation or sterlingisation, one has also to think of the demand for money. If Scotland became a sovereign state, the demand for money would actually change because the economy would become more divergent, as we were saying earlier. It may be that people in Scotland do not want to hold sterling and they may want to hold other currencies rather than the one that their Government want to hold because they don’t have confidence in this system being maintained in the future. The demand for money could create a huge asymmetric shock, and it could shift the whole balance about whether that system would be successful to any degree. I think that point has been overlooked when people talk about dollarisation or sterlingisation. The demand for money-what you and I want to hold in terms of cash balances, say, in our bank accounts-is affected by the behaviour of the economy. If the economy changes quite fundamentally, we may change our preferences for money. The literature shows that that can have a highly destabilising effect on a country’s ability to borrow and, indeed, to operate in any credible and systematic way.

Q4523 Sir James Paice: If I understand aright, there are a number of African countries where a lot of people would prefer to be handling dollars than the actual currency of that country.

Professor MacDonald: Sure.

Q4524 Sir James Paice: Is that the sort of thing that you are talking about-that you have two currencies, or maybe more, running as almost alternative economies?

Professor MacDonald: Yes. It is referred to as currency substitution; you substitute your local currency for another currency because you are not very happy with the local currency. That is usually because these kinds of countries have run high inflation regimes, so they don’t want the domestic currency. What we are talking about here is a formalisation of currency substitution, where the Government say that it is legal tender, but of course it is for the people in the country to say, "Do we really want this as our legal tender?"

Dr Armstrong: To comment on a couple of those issues, you asked what the banking system would look like in a dollarised system. I think that was the question. In a dollarised system, you would have either new Scottish banks created, and other financial institutions, or subsidiaries of foreign banks. The rest of the UK banks would form subsidiaries in Scotland, which would have to have their own balance sheets. The difficulty is that, if people think that the deposit guarantee from the Scottish Government is not worth the same amount as the rest of the UK, presumably people would rather have their money in rest of the UK bank accounts. That means that Scottish depositors would have to be paid more to compensate, which means that the bank funding costs would be higher, which goes straight into higher borrowing costs. So you have a very different financial system, which becomes much more of an own banking system, ring-fenced away from the rest of the UK banking system where you have subsidiaries. They have to have their own balance sheets and would probably have higher borrowing and lending costs than the rest of the UK.

As a final point on what Ronnie was saying about dual currency systems, it does not have to be African countries. In, I think, 1998, in Hong Kong, when the Asia crisis was going on, people started using US dollars alongside Hong Kong dollars. It never got up to equal shares, but the share of US dollars in the domestic money supply rose, as it does in periods of uncertainty. It is not only African states.

Sir James Paice: No. I was not being exclusive.

Dr Armstrong: No problem.

Sir James Paice: I think that fairly knocks on the head the issue of sterlingisation.

Q4525 Chair: I want to be absolutely clear on this. You made a point about interest rates; in the event of sterlingisation, does that read directly across to mortgage rates?

Dr Armstrong: Yes. What matters is bank funding costs-what it costs a bank to raise money. Within a monetary union or banking union-one with fiscal sharing because you need to have that to have the banking union-the cost to banks in the United Kingdom of raising money is the same, because you raise it out of London’s capital markets and the banks use it within the same group. If you now have subsidiaries where you need your own balance sheets, the cost of funds for these banks in a foreign country reflects conditions in the foreign country. There I would expect you to have higher funding costs for banks, and that would translate into higher borrowing costs.

Q4526 Chair: So my constituents would have to pay more for their mortgage.

Dr Armstrong: In that scenario, to be very clear, where we are talking about sterlingisation-to bastardise the term-yes.

Professor Bell: That is partly driven by both of these effects. One is that people may prefer to hold their money in rest of UK banks but also, if they want to hold their money in another currency, it becomes more difficult for the subsidiary banks now operating in Scotland to raise cash, increasing their costs, which in turn affects your mortgage.

Q4527 Chair: Can I be clear on this reference to subsidiary banks and so on? Would the Royal Bank of Scotland and the Bank of Scotland become subsidiary banks, or would they be Scottish banks? What would happen to those banks under sterlingisation?

Dr Armstrong: I would imagine that they would become RUK banks, which then have a choice about what they do about the offices that are run in Scotland. Do they become branches? If they are branches, they are under UK deposit insurance. It is not quite obvious to me why you would like to have that in a foreign country. Most of the time in international cross-border regulation, the direction of travel is towards what is called "subsidiarisation" or creating subsidiaries, which means that they are regulated by the people in that country, and deposit insurance and so on is provided by people in that country. They are subsidiaries of this now RUK bank, called Royal Bank of Scotland or something. The Royal Bank of Scotland becomes based and headquartered in London, which to all effects it is already, because 83% of the shareholders are here in that building. RBS’s operations in Scotland under a sterlingised system would, if they chose to, be subsidiaries, just like they would be subsidiaries in other countries.

Chair: I understand that.

Q4528 Sir James Paice: I omitted to ask this, and I should have done, but it is because I think I probably know the answer. In the event of sterlingisation, would there be any consequences, positive or negative, for the rest of the UK if Scotland adopted that route?

Dr Armstrong: Interestingly, what is in the rest of the UK’s interests here? The rest of the UK’s interests after a vote for independence are to see Scotland as stable. If one was to take a view that the sterlingisation system is not particularly stable, this is difficult for the UK as well, which is exactly why the rest of the UK would say that the UK banking system is now going to be ring-fenced.

Q4529 Chair: In those circumstances, is it more advantageous to the United Kingdom to avoid sterlingisation and accept a sterling currency zone?

Dr Armstrong: I am sorry, what was the last bit of the question?

Chair: Rather than have Scotland going towards sterlingisation, is there not then a strong pressure, to go to the point that we were discussing previously, to incorporate Scotland and accept a sterling zone?

Professor MacDonald: Before you could answer that, you would need to know the costs and the benefits of each of the two regimes you are referring to. It is very difficult to get an off-the-cuff answer to that. We are not really comparing like with like. For example, just following up your last question, which was, "Would the rest of the UK like this?", I suspect they would not, because it is going to make RUK monetary control harder if people, as Angus was saying, consider RUK bank deposits differently from Scottish bank deposits-Scottish bank deposits being inferior, shall we say, to the RUK ones. That is going to create cross-border flows, which is going to make the control of the RUK money supply difficult. From that perspective, they would not like a dollarisation system. That is another cost, but I think it is very difficult to compare that cost to the other costs of the full-blown currency union.

Q4530 Sir James Paice: I think the point the Chair is making is that those negatives of sterlingisation from the rest of the UK would be an element of pressure on the rest of the UK to be more sympathetic towards the possibility of a proper currency union.

Professor MacDonald: Perhaps, yes.

Dr Armstrong: I guess that this goes back to the question that we had earlier, where I tried to point out that the problem with the term "currency union" is that it includes different arrangements. Sterlingisation is a type of currency union, as is monetary union a type of currency union, so we have to be absolutely clear which one we are talking about.

Sir James Paice: I was talking about a monetary union.

Dr Armstrong: In relation to the monetary union that we were talking about earlier on-it is much easier if we use these terms-we were pointing out that the agreements that would have to be made to make this work, just reiterating what the Governor said last week, are a banking union and a fiscal union, but my overlay on top of that is that you have two immutable problems. One is that one party is a tenth of the size, and the other is that you can always vote to get out of it, which makes it very difficult to see how you strike that agreement. That specific type of currency union, which is the one in the White Paper, becomes very difficult.

Where we are talking about dollarisation or "sterlingisation" to use the term, the question is, is this at least feasible? The answer is that it is probably feasible. Is it optimal from the rest of the UK’s point of view? Of course it is not optimal, but that doesn’t mean to say that it would give you any incentive to go to the other one, because the other one would mean that you were in for a lot of money. This one just means that your neighbour is in a difficult situation, but you have to remember that it is one tenth the size. It does not change the calculus to say that all of a sudden a monetary union becomes feasible. I don’t think that changes the calculus.

Q4531 Chair: That’s the point. The UK would not feel obliged to accept a complete union, because the prospects of sterlingisation were so bad and the UK could just ride that over.

Dr Armstrong: Correct. The UK would ring-fence its banking system and say that it would help to the extent that it could. I think that the rest of the UK would try to help because it is interested in getting Scotland stable, but that is not the same thing as saying, "Therefore, we are going to create these unions"-unless there can be an agreement. Again, there are two immutable problems. How do you make an agreement across sovereign states, when one is smaller compared with you and they can both pull out of it? We discussed things like the debt-for-oil swap a long time ago, but it just does not want to get any traction. If we can’t get those sorts of agreements, that does not mean to say that you start accepting things such as sterlingisation. That means it is not particularly good for the rest of the UK, but that is not a reason why, therefore, you would accept the other thing at all.

Q4532 Jim McGovern: Until recently SNP policy was that a separate Scotland should keep the pound until it was time to join the euro. Why do you think that the SNP changed that policy? John Swinney is quoted as saying that he cannot foresee circumstances in which an independent Scotland would want to join the euro, which is a U-turn from an earlier position. Why do you think they changed their position?

Professor MacDonald: First of all, there was uncertainty; originally, they thought that they would automatically become full EU members almost immediately, and we now know that there is going to be an adjustment period for that. We also know that there are certain criteria that countries have to meet before they can enter the eurozone, and Scotland would pretty much fail on the majority of these in terms of the fiscal deficit. Okay, we have had a big discussion about what the debt would actually be, but, if it was a fair division of debt, it would probably be outwith the so-called Maastricht guidelines as well. The other reason is that the majority of Scotland’s trade is with RUK rather than with Europe. In terms of the argument that I think David particularly emphasised, if you are trying to remove the uncertainty of the effects of exchange rates on trade, you are probably better to do it in terms of RUK.

Q4533 Jim McGovern: Is it right that a country has to have its own currency for so long to prove its stability with other currencies before it can join?

Professor MacDonald: Yes.

Dr Armstrong: Yes. You have to be a member of ERM2 for a period of time, which means that you have to have your own currency and prove that it can be kept stable for a period of time before you are allowed to join the euro area.

Q4534 Jim McGovern: The euro is a currency that seems to serve many different countries with very different economies. Why couldn’t it work for Scotland, or why shouldn’t it? Or could it?

Professor MacDonald: If you look at the eurozone, there certainly aren’t any net oil exporters within the eurozone. I think I am correct in saying that. The only one that comes close, which has decided to stay outside, is Norway. For me, that would be another reason why you wouldn’t want to join the eurozone; an independent Scotland would face these asymmetric shocks which would be very uncomfortable in a one-size-fits-all monetary union of that nature.

Dr Armstrong: I have a slightly different take on this, which is simply that we don’t know what the euro is going to be. The euro is in transition. It nearly broke apart. It has been put together with some emergency help from the central bank. They are under negotiation as to whether they can do a banking union. If the answer is no, the euro is going to have trouble again. If the answer is yes, we are dealing with a whole different beast. When we look at currency unions again, and the different things underneath, that gives you another type of arrangement. These are fundamentally different arrangements. What the euro area will be in the future could look very different from what it has been in the last 15 years, and, in that, there would be fiscal adjustments. Some of these problems of misalignment get dealt with; they are trying to go to this federal system. We don’t know if they will get there yet, but if they did one day get there-it is not necessarily optimal because most of the trade is with the UK-maybe you would lose some of that gain from being with sterling, but you get a lot of other advantages. You would become an equal member in a big club and you are no longer next to a guy who is 10 times bigger than you. You are next to 19 other guys all with an equal vote. That is a different structure. Where we are today is a stab in the dark because we don’t know what Europe is going to look like.

Q4535 Jim McGovern: Given your answer, I think you have answered the next question along with it. Would it be easier for Scotland to borrow money if it was part of the eurozone?

Dr Armstrong: It depends what the eurozone is going to look like

Q4536 Jim McGovern: I expected that. I saw that coming. I walked on to a punch. What would the implications be of joining the euro for Scotland’s trade and industry?

Dr Armstrong: This is the point that Ronnie was making. Because most of Scotland’s trade, by far, is with the rest of the UK, the best arrangement is that, if Scotland continued to use sterling, it would not have to go through these transaction costs. You wouldn’t have to change money every time you wanted to go south of the border or do a transaction with somebody south of the border. That is why it would beneficial, but the first best is probably not attainable in any of these options, so it might be what the next best one would be, depending on what Europe looked like in the future.

Professor Bell: To some extent the trade-off follows the choice of currency rather than necessarily the other way round. We have seen Ireland quite substantially expand its trade with Europe, when previously the vast bulk of its trade was probably with the UK, but it has taken a very long time for that to happen.

Q4537 Jim McGovern: It has been suggested that the eurozone is having structural problems, which you have just referred to, Dr Armstrong, because it is not a fiscal union, a banking union or a political union. Could you explain the significance of each of these ideas?

Dr Armstrong: Yes. We have discussed a banking union, which means that you have a single financial system where everybody pays very similar borrowing costs. Let us call it the same borrowing costs. We have a single financial system. In order to have a banking union, you need also to have some form of fiscal union. You can’t have it without the fiscal union, because what do you do when something goes wrong on the other side? You need to have some way of paying me back. Banking union requires fiscal union, and what does fiscal union require? Some sort of political agreement, which is some form of political union. It does not have to be the centralist political union that we have in this country at the moment. It might be a federal union, as they have in the United States. It might also be a federal union among independent states, as Europe one day is striving to be. We don’t know whether that can be achieved yet. To have a banking union, you need to have some sort of fiscal union, and to have some sort of fiscal union, you need to have some sort of political union.

Q4538 Jim McGovern: Does anyone else have anything to add to that? As the Chair said at the start, there is no need to repeat anything. Has that covered that answer?

Professor Bell: It seems to me it has, yes.

Chair: We always quite like it if people disagree, so, if there is any disagreement, by all means make it clear. Graeme, you wanted to come in on this section.

Q4539 Graeme Morrice: Yes. I wanted to pick up on the answer that Professor MacDonald gave earlier with regard to an independent Scotland applying to enter the eurozone. He suggested that it would probably fail most tests. Of course, to enter the eurozone you would need to be a member of the EU, and on day one of independence Scotland would case to be a member of the EU, because that would fall upon the rest of the United Kingdom, and an independent Scotland would have to apply as a new member state. On the basis of what you said-that it would probably fail most of the tests of joining the eurozone-would that make it much more difficult for Scotland to join the EU on the basis that a new member state would have to join the eurozone, or there is an assumption that eventually new member states would have to join the eurozone?

Professor MacDonald: I am not an expert in EU issues, but I suspect it would not make their joining the EU any more difficult. These tests relate to joining the euro per se, so obviously, joining the EU-

Q4540 Graeme Morrice: Is it not chicken and egg, though?

Professor MacDonald: Presumably, as Dr Armstrong said, you would be given a transition period. You have to join ERM2 and there has to be a convergence, and I think that is a period of two years. Presumably, if you do not get it right in that period, they may allow you a longer period-I am sure they would-but there would be an expectation that during that two-year period you would meet the criteria.

Professor Bell: I think you would have to commit to joining the euro.

Professor MacDonald: You would have to commit, yes. That is right.

Professor Bell: But what that exactly means is difficult.

Q4541 Chair: They would commit to joining the euro like what Sweden has. Sorry, nodding is not recorded.

Professor Bell: I am sorry. Yes.

Chair: An extremely sceptical nod is fair.

Q4542 Lindsay Roy: I was going to say good evening, gentlemen, because it is almost good evening. It is late in the afternoon. I want to turn now to a separate currency. What would be the implications of creating a new Scottish currency as suggested by the chairman of the Yes Scotland campaign and the former depute leader of the SNP?

Professor MacDonald: The implications in terms of the practicalities?

Lindsay Roy: Yes.

Professor MacDonald: In terms of our discussion today, we would need to set up a whole new infrastructure, a central bank and supervisory and regulatory mechanisms for the financial sector. We would need to introduce a currency, clearly, and we would need to have an arrangement whereby that currency related to other sovereign state currencies. Would it be fixed against other currencies, which would have implications for monetary policy and, presumably, fiscal policy, or would it be allowed to float freely or in a managed way? These are all the big issues that would arise if Scotland were on its own.

Q4543 Lindsay Roy: Have you any indication at all as to how long it would take to set up a new central bank and create a new currency? Have you any examples?

Professor MacDonald: I think it would take longer than the 18-month period that the SNP are allowing for. Scotland is a very highly developed country, obviously. It is one of the richest countries in the world, so the exchange rate policy would need to be a very sophisticated policy, in my view. It would entail having sufficient foreign exchange reserves, for one thing. We may start off with our share of the foreign exchange assets of the Bank of England, but they are unlikely, in my view, to be enough to sustain an independent exchange rate, so where would the reserves come from during the transition period? All of that would lead me to believe that it would be a much longer process to set up than the SNP are allowing for.

Professor Bell: Another thing that you would have to think about is how assets that are currently denominated in sterling would be legally valued in the new currency. Some mechanisms would have to be put in place for the millions and millions of pounds-worth of assets that are currently denominated in sterling to somehow or other be converted to the new currency.

Dr Armstrong: Outwith, of course, the liabilities. Everybody’s mortgages, which are currently in sterling pounds, would be in I don’t know what pounds-local Scottish currency pounds, presumably-otherwise households would be taking a huge exchange rate risk. They would have to be converted as well. There is a list of institutions that you would need to create. It is not impossible. I completely accept Ronnie’s point that, because Scotland is such a sophisticated financial system and rich country, this is not like introducing a new currency in an eastern bloc country-a former Soviet Union country-where they have lots of experience and you can put capital controls on and do it fairly smoothly because you don’t have a sophisticated international banking system. In Scotland’s case, you would have to have a list of institutions, which would take time to do. The one institution that was not mentioned, which is kind of big, is that you would have to do a currency conversion law. This gets into the very question of what you do about existing contracts. Whose law are they written in and what do you do about these laws? There is, I think, a precedent-not a precedent; there is a general assumption that, if the activity takes place in this geographic zone, you can convert it into the currency of that geographic zone. What households would like to do is a different thing. All this is to say that, yes, it can be done. There is an enormous list of institutions, and it would be very difficult, because of the sophistication of Scotland. What you don’t want to be doing is springing this on people the day after the referendum, saying, "This is what we always meant. Let’s start now." That is not a good idea.

Q4544 Lindsay Roy: What level of information have you gleaned from the White Paper about a separate Scottish currency?

Dr Armstrong: I gleaned from the White Paper that the only proposal was a formal monetary union.

Professor Bell: Although they did say that they reserved the right.

Dr Armstrong: I beg your pardon. I am sorry. You are quite right. Thank you. They did say, as is mentioned on page 111, that they reserved the right to change that. There was a very fulsome discussion about own currency in the Fiscal Commission Working Group paper, where I think they said that this gives a higher degree of economic sovereignty to an independent country. There has been discussion about it, clearly.

Q4545 Lindsay Roy: Do you think, given the evidence that has been presented today, that it would be wise for the Scottish Government to start considering this matter, which is very complex indeed?

Professor MacDonald: I certainly do. I honestly think they are doing the people of Scotland a disservice by not considering other options to the proposed sterling zone, yes. It could be extremely damaging to the Scottish economy and perhaps, as we were saying earlier, to RUK as well.

Q4546 Lindsay Roy: Could you give us a conservative estimate, or indeed a liberal estimate, as to how long it might take to set up this new currency?

Professor MacDonald: There is really no precedent for a country like Scotland, no.

Dr Armstrong: The difficulty is the level of sophistication. It is quite interesting as to what would be the interests of the rest of the UK at this point. Suppose that the referendum was-obviously-about independence, plus Scotland having its own currency, and the answer was yes. There could be no gripes at all, because that does not involve the rest of the UK. The UK’s job is how to make the transition as smooth as possible and to be as supportive as possible throughout the transition. Quite clearly, it is not in its interest to have disruption, so a lot of assistance could be given. The difficulty is the level of sophistication of financial markets. At the moment, there are no new Scottish currencies existing, but financial markets create what are called "synthetic instruments," which means that you do not need to have the underlying. You start guessing what it is. They are called "non-deliverable forwards," where you just start thinking, "Suppose there was a currency; what would the right price be?" These derivative trades make the transition process very difficult. That is not to say it is not possible, but it becomes difficult.

Q4547 Lindsay Roy: Any transition would depend on the good will of the rest of the UK.

Dr Armstrong: Absolutely.

Q4548 Lindsay Roy: And it would be a fairly prolonged process, from what you are saying.

Dr Armstrong: Yes. But one would also say that it would be in the rest of the UK’s interest to make this a successful process, to the extent that it can.

Q4549 Lindsay Roy: Even with the best will in the world, it would be more than one and a half years.

Dr Armstrong: Yes. It would be very difficult but that does not mean that it can’t be done.

Q4550 Lindsay Roy: What would any Scottish Government have to do to establish trust and confidence in the new currency?

Dr Armstrong: It would have to operate a sound fiscal policy. It would probably have to maintain balance of payment surpluses for a number of years to make sure that there is more demand for the Scottish currency than for the supply of the Scottish currency going out. You would have to operate balance of payment surpluses, I would imagine, for at least the early years. You would have to run strong fiscal positions, so you would have to start building up your credibility to make it easier and easier to borrow. These are the sorts of things that would be required, which are possible.

Professor Bell: You would have to have a well-regulated banking system. Ireland pretty much did what Angus has just said, but it did not have a well-regulated banking system and that was what caused the crisis in Ireland in 2007-08. All of these things have to be in place.

Q4551 Lindsay Roy: What vulnerabilities would there be around this new currency for a Scottish Government?

Professor MacDonald: It would depend on the particular regime they chose. If it was a fixed-rate regime, if they did not get the kind of mix that we have been talking about correct, and if credibility was not given to financial markets, they would tend to say, "This isn’t a credible fixed rate," so they would tend to undermine the rate. That could be very damaging to the economy. The alternative would be to have a floating rate, and if the elements that we have talked about-fiscal discipline, and I would add monetary discipline and inflation control-were in place, and the markets believed that these were credible, then the system may well function in a well-behaved manner, which would not undermine the economy. It is getting these things right, basically, and saying to markets, "We are committed to this." Making statements that you are going to join a sterling zone, but on day one of independence you are going to do something else, is a very bad mistake, in my view. It sends out exactly the wrong signal.

Q4552 Lindsay Roy: It would diminish any trust or confidence there might be.

Professor MacDonald: Yes.

Q4553 Lindsay Roy: There are a number of small countries that have their own currency. What strategies do they follow to manage their economy well, and how do they manage risk?

Dr Armstrong: There are a couple. Obviously, you have the Scandinavian countries that often have their own currency, some tied to the euro, but it gives it a degree of flexibility to make adjustments periodically. When Europe was going through the worst of its times, there was some flexibility. Others have used this latitude quite generously, although they keep it fairly pegged. It is the sort of menu that Professor MacDonald was talking about; you can go from a very hard fix to a float-they are the extremes-and then you have a whole range in the middle, which allows some degree of flexibility.

The small European countries that have the same sort of per capita GDP and the same sort of population as Scotland, on the whole, have their own currencies. Around the rest of the world, there are a couple of countries worth thinking about, where they have hard pegs. Hong Kong, obviously, has a very sophisticated financial system. A common feature of the Scandinavian countries and Hong Kong, or Singapore, which has more mobility in its exchange range, is, guess what? They all have low levels of debt.

Q4554 Lindsay Roy: And none of these has a model of being co-ordinated within an economy for 300 years.

Dr Armstrong: No.

Lindsay Roy: Thanks.

Q4555 Mike Crockart: Hopefully, we are on the home straight. We have covered a lot of ground and a lot of different options. It would seem that most have advantages and disadvantages, but I am not hearing that many advantages. If we were looking at all the options for an independent Scotland, so we are ruling out the status quo as it stands, what is the best approach for a separate Scotland, or is there not a best approach? Is it a sliding scale where some have high costs, some have low costs, but others give better advantages for those costs?

Professor MacDonald: In terms of the exchange rate regimes, specifically, from my own perspective, as I indicated earlier, the crucial thing to recognise would be that, if Scotland became independent, it would be a net exporter of hydrocarbons, and this would have a fundamental effect on its exchange rate. Angus mentioned the concept of a real exchange rate earlier. Irrespective of what the regime is, this will have profound effects on Scotland’s real exchange rate. That, basically, means its inflation rate relative to its neighbours’ inflation-the rest of the UK. That is a measure of a country’s competitiveness. If you have no means of controlling that by adjusting the exchange rate, you can get into the situation that we discussed earlier, where you could have unemployment if you had an adverse shock to the price of oil, say.

My own view is that you have to have some flexibility, some shock absorber, in the normal exchange rate. So I would advocate, if I was starting from first principles, that you would have to have your own currency and you would have to have an exchange rate regime which recognised the significance of oil on the exchange rate, on Scotland’s competitiveness, and that would mean some flexibility. I don’t think a purely flexible system would be a good one, but one with some flexibility where you maybe fix your currency around a basket of your trading partners but allow that to adjust in the light of adverse shocks to, for example, oil. Of course, as we have been saying, there could be other shocks which are external financial shocks. We have to recognise the importance of these shocks, certainly.

Q4556 Mike Crockart: So that is one vote for your own currency.

Professor MacDonald: I think that is inevitable.

Q4557 Mike Crockart: Are there other views?

Professor Bell: I share a lot of Ronnie’s sentiments. It is important to distinguish between the short, medium and long term here; a lot of the costs may occur during the period of adjustment or transition. Eventually, you get things more or less right. In the very long term, you end up adjusting to whatever set of natural resources, the skills of the work force and so on can command in international markets, it seems to me. But you do not want huge costs either on Scotland or incurred on the rest of the UK during a period that may extend over a considerable period of time.

Q4558 Chair: What is a considerable period of time? Does long term mean when we are all dead, especially those of us here, or a shorter term, which means, possibly, the staff? I am not quite clear what sort of a transition period you are indicating.

Professor MacDonald: I personally think it would be a generation.

Q4559 Chair: And by "generation," you are meaning what-25 years?

Professor MacDonald: Roughly speaking, yes.

Q4560 Chair: So it will be 25 years of misery.

Professor MacDonald: Possibly, yes.

Q4561 Chair: Do you agree with that, Professor Bell?

Professor Bell: There would be a lot of adjustment necessary. It would be compressed at the start, but it could take a very long time to work it all through.

Q4562 Chair: "Adjustment" is one of these euphemisms. What does "adjustment" mean to people in my constituency? Does it mean unemployment, their mortgages going up or prices going up? What does it actually mean?

Professor Bell: It is risks of these things happening to them, such as adverse shocks causing unemployment, high inflation, dislocation of trade, that sort of issue, if you don’t get the right monetary and fiscal arrangements in place.

Q4563 Chair: The Scottish Government would, presumably, say that they would get the right monetary and fiscal arrangements in place. Does that mean then it wouldn’t be 25 years of misery?

Professor MacDonald: No. If you take the example of the oil shock that I mentioned, obviously, oil prices can go up and they can go down. Say there is a dramatic fall in oil prices. That has severe budgetary implications for an independent Scotland. If they were part of the sterling zone, they would then have to rely on a downward wage adjustment. That is not going to happen. So the consequence, as we have seen in southern Europe, is unemployment. That is what your constituents would have to bear.

Q4564 Chair: It would be entirely unemployment, would it, or would it be higher taxes as well?

Professor MacDonald: It could well be higher taxes, yes. If they want to maintain a certain level of public spend, obviously, it could well mean higher taxes, yes.

Professor Bell: A lot of this has been about adjusting the fiscal balance, which sounds very abstract and esoteric, but what that means is either more taxes or less spending on public services.

Q4565 Mike Crockart: I am still not entirely sure what you are voting for in what’s best for Scotland.

Professor Bell: I think the issues around the setting up of the common monetary arrangement are such, probably, that the best arrangement is likely to be a separate currency.

Q4566 Mike Crockart: But you are not saying that with any great relish.

Professor Bell: No, because there are costs associated with both courses of action.

Q4567 Chair: Does it make it easier, rather than asking for the best, to ask what the least bad is? Is that a better way of putting it? What is the least bad option for Scotland, Dr Armstrong?

Dr Armstrong: I was trying to answer the other way. I’ve got a page of notes. I am going to try it your way, which is the least bad. What you want to avoid is a non-credible currency proposal. So you don’t want to go into September with a currency proposal that nobody thinks is actually going to happen. That is a recipe for capital flight and for all sorts of difficulties. On the basis of that, from what we have discussed today, one type of currency union is the formal monetary union that we have been talking about. There are two problems. One is that you can’t tie a country down, and the other is that one is so much bigger than the other it means that it is very difficult to negotiate. My view is that, because Scotland would start off with that level of debt, I doubt that that monetary union can be negotiated.

Then you start by asking what the other options are. So you get to another type of currency union, which is the dollarisation or sterlingisation, which we have talked about, or your own currency. Between those two, it depends on what could be negotiated around this sterlingisation system to make a hard choice, because you have your own currency, which gives you a lot of economic sovereignty, but, as we have discussed, you have this very difficult transition period; or you have this sterlingisation, which gives you very little economic sovereignty, but you could manage to put some adjustment factors in to make this easier. It then becomes a choice between those two. My view is that it is no surprise, when you look around the world and see countries the same size of Scotland, with the same sort of wealth as Scotland, that they have their own currency.

Q4568 Mike Crockart: Unfortunately, that is not the plan. The plan is that we have a monetary union. If that is the overriding aim, what has to happen in those negotiations to ensure that that is achieved?

Dr Armstrong: The first thing to say is that the monetary union requires two to agree. The Scottish Government have given their desire. The rest of the UK has messed around from unlikely to highly unlikely. I don’t know what adjectives they are going to use next time. They are suggesting that pretty clearly from its perspective. One could argue that that is just positioning. When you look at the economics around how this would have to be, maybe you have to forget the positioning and ask what the economics look like.

That is why what the Governor said last week was important. As to the economics, as he pointed out, he said that you have to have contingencies for what happens on the rainy days. If you have no debt, you can have your own contingencies because you have your own money. You can spend it on your citizens when there are difficult times, but you are not going to be in that position. You are going to be in a position with quite a high debt burden. Under that scenario, the question becomes, can you envisage how you could negotiate these sorts of fiscal arrangements to allow the banking union and the fiscal arrangements? You can never say never, but, if you look at what is in the interests of the rest of the UK and the fact that one is 10 times the size of the other and that you can both pull out when you want, it is very difficult to see how those agreements could be made. That is why we have come to the view that the monetary union is probably not the likely outcome and that we would have to go for a different system. It is imperative to have a discussion as to what a different system would be before the referendum and not afterwards. You don’t want to be having this the day afterwards.

Q4569 Mike Crockart: Are we in danger of ending up with the worst option, because you have all said that, on balance, having our own currency would probably be the best option for a small country with a risk of shocks and to be able to deal with those? If we are ploughing everything into creating a monetary union, and that is not going to happen, then what is the next most likely, surely, is sterlingisation, which none of you seem to be saying is a worthy option. Are we in danger of backing ourselves into that corner-of that being the only port left to us at the end?

Dr Armstrong: The worst option is where people are just left with complete uncertainty. Economists use this term and people say, "What does that mean?" Basically, it means that, if one side says, "We want a full monetary union and we are going to deliver this to our people," and the other side says, "You’re not getting it," now what do you do? That sort of uncertainty is not a very sensible situation between two Governments and what will become two independent sovereign states. You, as Scottish citizens, no longer know what the monetary arrangements are going to be, and that is not a good situation to be in. That is why these so-called "plan Bs" would be much better put out and represented ahead of the referendum rather than afterwards. It might win you the election by not talking about it, but that is not what we are after here. We are after what is the optimum thing for Scottish citizens.

Q4570 Sir James Paice: It sounds to me that you are saying that it would be more helpful, setting aside the possibility of just positioning, if the current UK Government were to say, clearly, that they would not enter into a monetary union.

Dr Armstrong: Or they would. The uncertainty is not helpful here.

Q4571 Chair: On this question of ending the uncertainty, we discussed what is the least bad or the best for Scotland. In the event that there is a yes vote, what is the least bad for the rest of the UK in these circumstances? Is it best for the rest of the UK that Scotland moves to have a separate currency?

Professor MacDonald: I would think it probably is, yes. If the currency can move, it will help to insulate the rest of the UK from bad shocks hitting Scotland.

Professor Bell: Effectively, it is taking on transaction costs, the cost of changing money, but it is unlikely that it is taking on additional risks.

Dr Armstrong: Yes; I think I would agree with that.

Q4572 Chair: If we assume that the rest of the United Kingdom acts rationally and what is in its best interests, am I hearing that all three of you are saying that it would be in the United Kingdom’s interest to say to Scotland, which had just voted for independence, "No, you should have your own currency," which means, then, that they would say, "No, we are not agreeing to this concept of a shared currency"? Am I right in thinking that that is the logic of it? Why I ask that question is that, yesterday, for the first time, when we had David Willetts, the Minister of State for Universities and Science, in front of us, he said that, in the event of separation, the research councils would be redrawn so that Scotland would not be within them. That is the first time, to my knowledge, we’ve actually had a Minister saying what the contingency plan is. This is in the same context. Just to be absolutely clear, if you were Chancellor, or in a position to make that decision, your view would be that the most sensible thing for the UK would be to say that what Scotland should do is abandon this idea of a shared currency and move to going into independence with their own currency.

Dr Armstrong: In relation to the last bit, I don’t think it would be for a rest of the UK Chancellor to decide. A rest of the UK Chancellor may come to the conclusion that, in their judgment, a formal monetary union is not in the interests of the rest of the UK. What an independent Scotland would decide to do after that is up to the independent Scotland. It is not for the UK Chancellor to say, "By the way, if you want my advice, I’d do this, that and the other." An independent Scotland would then have to say, "What are the pros and cons of something like a currency area which looks like sterlingisation or dollarisation?", which is very, very different from what is in the White Paper. Let me emphasise that that is extremely different from what is in the White Paper. But that is one possibility that the rest of the UK would not be able to say no to. That would be in the Scottish Government’s gift. Creating their own currency would also be in the Scottish Government’s gift. It would be for them to decide that second leg of the answer.

In relation to the first leg of the answer, clearly, you would need to have both parties playing. One of those parties would be the Chancellor of the Exchequer. From the statements that we have given, with that sort of level of debt, it is difficult to see how that could be in the interests of the rest of the UK, as it has been laid out in the White Paper, i.e. a formal monetary union.

Q4573 Chair: Can I ask the other two witnesses whether you concur with that view? Again, nodding or shaking your heads is not recorded.

Professor Bell: Yes, I concur.

Professor MacDonald: As do I, yes.

Q4574 Chair: I think we are just about closed. Can I just pick up a couple of smaller points that we maybe have not touched on adequately? One of the issues that I do not think we have touched on is, in the event of a sterling zone and controls over fiscal policy, the question of the extent to which a separate Scotland would have control over its fiscal policy even if you had a complete monetary union. My understanding is that fiscal limits would be set in terms of overall borrowing and spending. However, within that limit there would be complete flexibility. Again, nodding doesn’t cut it.

Professor Bell: It would be, I think, in the interests of the rest of the UK to consider very carefully if there was tax competition resulting. So you can have the overall fiscal balance, and maybe that is satisfactory, but then you might have, say, a very low income tax rate in Scotland and use that as a mechanism to shift resources towards Scotland and have a very high council tax, which you can’t shift.

Q4575 Chair: The one that has been quoted as a possible example is corporation tax. The Scottish Government have argued that, yes, there will be a fiscal framework, but they would have complete, total and absolute flexibility within that. Now, unless I am mistaken, you are saying that that is not the case. What would be the mechanism by which that would come to pass-that the UK Government said, no, that is not acceptable? If you had a macroeconomic framework with fiscal rules set and so on, there is no provision within a general fiscal rule that says, "However, you can’t do such and such." Would that be a side agreement? What is the mechanism of this? Again, people in Scotland need to be clear about whether or not this proposal to have ultra-competitive corporation tax rates would be permissible or conceivable under this arrangement that the Scottish Government are proposing.

Professor MacDonald: For me, it is the difference between what is available in principle and what is available in practice. If you look at the Basque country, for example, they are obviously part of Spain and part of the monetary union, but, in principle, they have complete control over taxes. In practice, can they use them very much? No, they can’t, because they are constrained heavily by the fiscal pacts that they have agreed to. In principle, yes, the Scottish Government could cut corporation tax; they could cut income tax; and they could vary VAT subject to agreement with the EU. But I doubt that they could do it very much if there were very strict pacts in place, which it looks like there would have to be.

Q4576 Chair: I am sorry but I am not clear. To be clear about this, the fiscal pact either includes the overall level and it is very strict, or it includes the overall level and the detail. The assumption that has always been articulated is that the nature of the fiscal pact would simply be covering, as it were, the high-level overall figure. Are you saying that, in your view, it would cover the detail of the tax levels as well?

Professor MacDonald: No, I don’t think it would. Given the fiscal deficit that Scotland is likely to have, given its indebtedness, they would have few degrees of freedom in practice to alter rates very much, but they would, in principle, be able to do that. There is nothing in a stability pact that would stop them from altering the rates.

Q4577 Chair: Even though you are saying it is a very tight fiscal pact, the Basques do actually have the flexibility at the moment to cut their corporation tax to next to nil, if they wished.

Professor MacDonald: That is really what I am getting at. You can’t cut taxes to nil given the stability pact. It is very unlikely that you could do that, but you can tax at the margin. You can change at the margin. A few per cent is what the Basques have been able to do. They have had some success in using taxes in that way. I think the stability pact is going to limit big tax movements. That is what I am saying. In principle, if your budgetary position was very favourable, then you could, perhaps, have these large tax changes.

Q4578 Sir James Paice: For clarity, bearing in mind the overall tax burden or the share of GDP, whichever way you want to describe it, as opposed to individual taxes, I would presume that the stability pact would say that basically you’ve got to raise x amount in taxes, in simple layman’s language, and, as you say, it would not lay down individual taxes. So they would have quite a lot of flex within the overall tax burden, would they not?

Professor MacDonald: It would be my assumption that they could.

Q4579 Sir James Paice: So they could cut corporation tax significantly, as long as they compensated for it by increasing alternative taxes so that the yield was the same.

Professor MacDonald: Yes; that, in principle, is right.

Dr Armstrong: We have discussed what would be in the RUK’s interest to go into this form of monetary union. Changing corporation taxes between two different locations, while it sounds like a good idea for the one that reduces the corporation tax, is economically quite inefficient. In economics terms, you want to have resources allocated on where they are best used, not where the tax rate is cheapest, because, if they go to one part because the tax regime has been altered, guess who loses? It’s the other party.

Q4580 Sir James Paice: I am not advocating it. I am simply trying to establish the flexibility.

Dr Armstrong: No, no, I know you are not. What I am trying to say is that, from an RUK negotiating position, are you going to allow somebody, where you are encompassing quite a lot to create this formal monetary union, to carry out policies that are going to hurt yourself? I find that difficult to understand. You might allow a marginal amount, but I find it hard to believe that you would allow that as part of this formal monetary union. If it is not a formal monetary union, the game has changed, and, clearly, you can do what you like. When I say you can do what you like, that is a sterlingisation issue, which is a different thing.

Professor Bell: The general language of fiscal pacts has been around the deficit that you run, but issues like tax competition via corporation tax have come much more on to the agenda in the last five or 10 years. It would be very surprising to me if RUK, in its negotiating stance, did not have some way of dealing with that issue.

Q4581 Chair: I said before we started that, at the very finish, we would give you the opportunity to answer any questions that we had not asked. Are there any points that you feel you want to leave us with that we have not touched on already? It does feel as if we have covered the whole world, but just in case there is anything we have not covered. Dr Armstrong has managed to work in his advert for his publications later on. That was well done. I thought you might have left that to the end, but no. Are there any other points that you would wish to raise with us?

Professor MacDonald: No, I do not have any.

Q4582 Chair: Does that apply to your colleagues?

Professor Bell: Yes.

Dr Armstrong: Yes.

Chair: Could I thank you very much for coming along? This has been a very interesting session. We will, obviously, have some difficulty in writing it all up and making a report. My head is hurting, but that is the job of the staff. So thank you very much.