Why Fixed Exchange Rates are Incredible

As in, “not credible.”

All macroeconomic frameworks should have the flexibility to evolve if circumstances change, this is a key aspect of economic sovereignty.

From Currency Choices for an Independent Scotland, via Krugman.

The problem is so very basic. One of the following two things must be true. Either

  1. The currency union is inviolable, in which case independent Scotland has sacrificed monetary independence, or
  2. The currency union is subject to renegotiation, in which case independent Scotland maintains its macroeconomic independence.

If the point of independence is economic sovereignty, then you should not believe that this currency union is credible.

There is one big caveat: a currency union will appear credible just long as Scottish interests don’t diverge too much from rest-of-UK interests. So a successful Scotland-rest of UK currency union is one in which the two economies become tightly harmonized as a result of the currency union (see Barro and Tenreyro 2007 on “shocks”). If independent Scotland ever did find itself in disharmony, then it would face the dilemma above. And given that just about everyone agrees that the costs of Scotland leaving the pound are enormous, that would mean that Scotland’s economic sovereignty had been purely in name only.

Posted in Current Affairs, Economics
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