On the cost of foreign exchange: Scottish independence edition

artiste_207Well gentle readers, it’s come to this. Scottish independence is going down to the wire. It is hanging by a thread, though if you are concerned that I am mixing my metaphors, I think you’re flogging a dead horse after it’s bolted.

In any event, in the question of Scottish independence the question of what currency it will use is the elephant in the room – the sporran on the kilt. If you’ve not been paying attention, the Scottish separatists have been insisting that they can pick up someone else’s currency – the Euro or the Pound – and otherwise enjoy independence.

Paul Krugman is horrified that so soon after the debacle of the Euro the Scots could contemplate this. He’s studiedly agnostic as to whether it might be worthwhile if they had their own currency and focuses on the prospect that they might repeat the disaster of the Euro, or imaging that a monetary union might be a Good Idea outside of a political union. I’m in broad agreement though I think he might be overdoing it a bit.

Meanwhile Joe Stiglitz fancies the idea of Scottish independence if it can help carve out of the British Isles a more egalitarian nation leading him to rather downplay the significance of leaving a political union without also leaving its monetary union. I’m sympathetic to his deprecation of economies of scale as being a big part of the decision. Firstly if you want to be a nation, if you incur a few costs in doing so, that shouldn’t be a big deal in your decision. Further, quite a lot of Scottish governance is already different to British governance so the costs are already there. (As Adam Smith thought in the area of education, some Scottish governance may well be superior. When I was in law school my Evidence teacher was very much enamoured of the Scottish legal institution of the Procurator Fiscal [which is nothing to do with fiscal policy by the way]. But I digress.)

Anyway, one thought that seems largely absent from the debate is that, in this age of the internet, it might well be possible to run a separate currency at a tiny fraction of its current economic cost at least as far as access to foreign exchange (FX) in the spot market is concerned.

A large corporate spends around 7 to 15 basis points on exchanging foreign currency. One might ask why it isn’t a lot lower than this. With over $4 trillion a day in trading, and trading simply being the swapping of liabilities and assets on a leger with your bank’s bots talking to another bank’s bots, 7-15 basis points seems like an awful lot. After all, to write this post, my bots talked to a bunch of other bots, and they did it all for free. But what’s really amazing is that this is the tip of the iceberg. Most transactions – even relatively substantial business transactions – generate spreads that are at least an order of magnitude higher than this. More commonly they’re around double that, and some FX transactions like remittances for those on low incomes are around two orders of magnitude or one hundred times higher!

In the age of the internet, I’m not sure why the economics of this can’t be made similar to the economics of the internet which would enable such transactions more or less freely providing people meet any fixed costs of attaching themselves to the network. The internet is the only perfectly competitive bit of infrastructure I can think of. But banking is monopolistically competitive and so suffers from pricing that is in some regards radically at odds with costs, as is the case with the pricing of text messages or ‘international roaming’ in telcos. (If you’re interested, this fascinating article argues that the situation is much worse than the simple inefficiencies of monopolistic competition.)

So the Scots could establish a separate currency. They could then task their central bank or other agency with appropriate backing, with getting cost reflective foreign exchange to their businesses, citizens and to as many of those who trade with the Scottish as possible. I’m thinking aloud here, so would be happy to be corrected and/or to receive better suggestions, but the way I think this might be done would be something like this.

  • The Central bank, or a nationally owned bank or a private bank which contracts with the government to do so, purchases foreign exchange with Scottish Sporrans (the new currency). It cuts in anyone who wants to participate and who pays some cost reflective set up fee to be part of the system whatever  brokerage it takes to sell them the foreign exchange without making a loss.
  • It can quote two prices – one which is a price which includes some risk margin because the bank is guaranteeing a set rate for the transaction. The other can be without any risk margin to the bank, because the price will be determined in the market in the next few nano-seconds. It imposes cost reflective charges for each kind of transaction.
  • There are two important limitations.
    • The futures market is a major part of the workings of the foreign exchange market and I have no particularly bright ideas here. However it may well suffer from inefficiencies derived from the spot market which might be moderated by a more efficient spot market or might be alleviated in ways which are similar to the measures I’ve proposed in the spot market. Ideas and comments welcome.
    • The aim is to reduce the FX margin on Sporrans for Scots and non-Scots in both directions. This might be enough for businesses to efficiently transact Sporran FX but there’s more work to be done to get these prices to everyone in the market. I’m thinking of my own FX arrangements when travelling which are delegated to credit card providers. They run platforms which have considerable pricing power, not just because there aren’t many of them and they’re hard to replicate, but also because even though they price way above the costs of delivery, their charges are still very low as a percentage of the transactions – and so price elasticity of demand is low. (Economists’ mental models, accustomed as they are to abstracting from transactions costs tend to airbrush this out of their intuition. They should pay much more attention to de minimis phenomena.)  It should be possible to think of some worthwhile actions here, but we’ll leave that for another day – or for comments below.

So O Troppodillians, I ask ye, what is there not to like?

Oh and of course if this reasoning is on the right track, it raises the broader question of why we don’t do this more broadly.

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I used to be and still am Not Trampis
I used to be and still am Not Trampis
7 years ago

Nick,
looks like you kilt this!

rog
rog
7 years ago

I’m starting to think that the Clearances reduced the gene pool to dangerous levels. They already have a mostly independent government and the vote for separation is restricted to residents only, expat scots are excluded and visitor residents are included, regardless of their nationality.

rog
rog
7 years ago
Reply to  rog

Regarding the Clearances, it would not have been possible without the collusion with the clan chiefs. They sold their people down the river so that they could enjoy more of the bright lights of London. Which makes a mockery of the one of the arguments put out by the separatists, that an independent Scotland would have more fair and truthful MPs and better governance. The Iraq War has been trotted out as an example but the clan wars have been apparently forgotten.

I used to be and still am Not Trampis
I used to be and still am Not Trampis
7 years ago

to be serious Simon Wren-Lewis has been good reading on this and anything else!

stephen
stephen
7 years ago

Good thought starter. What occurs to me, having recently returned from Zimbabwe, is how well a country can manage with no currency of its own. Zimbabwe does perfectly well with the $US. And they apparently do that without permission or official endorsement of any sort from the US government – they just use whatever $US they can get through sales of goods and services to businesses and tourists. One can still buy Zimbabwean dollars, but only from street vendors as a tourist novelty: billions of $Zim for a few $US.
In the Scottish case, there is obvious merit in using the pound, given that in the event of independence there will be considerable cross-border trade. There’s a piece by Salmond from 10 August (link found via your Stiglitz link) which makes the case cogently, and is headed, quite accurately, “there is literally nothing anyone can do to stop an independent Scotland using the pound”.
Using another country’s currency makes sense if you have confidence they will manage it in their own interests and if you think broadly their interests align with yours. That seems to be the case here. Not only that, but you avoid the additional costs and risks of managing your own central bank.
So although there might be quite cost effective internet based approaches, the counter-factual is piggy-backing on another currency, which is even cheaper.

Dave
Dave
7 years ago
Reply to  stephen

This might be the first time in history that someone has said that any country – much less a highly-developed one – should emulate Zimbabwean monetary policy. True, I don’t know firsthand how well Zimbabwe is managing “with no currency of its own” as you allege… but the accounts I’ve read in the Economist of what it’s like to actually live in Zimbabwe sound absolutely miserable.

Patrick
Patrick
7 years ago
Reply to  stephen

I am not sure that “piggy-backing on another currency” has proved to be “easy” or even “not insane” for other small countries in the Euro. Which I think is Paul Krugman’s point (and NG’s further below in these comments).

What to your mind would Scottish policymakers do when unemployment is rising and Scottish NGDP is falling at the same time as the Pound is rising (and the Scottish government running a deficit due to Pound-denominated costs rising whilst income shrinks)?

About their only options, I think, would be to cut minimum wages and other labor regulation and taxes in general.

But unlike monetary policy, taxes and labor regulations DO have a very real zero bound.

Or is there some magic in economics that I’ve missed? (certainly could be!!)

derrida derider
derrida derider
7 years ago
Reply to  stephen

Patrick has said it well. But it’s not only the Euro experience that points to the problem – have a look at the South American experience with dollar currency boards (a method of de facto using another country’s currency and hence subjecting yourself to monetary policy run in their, not your, interest).

The “stylised fact” among economists is that monetary unions without fiscal unions tend to end badly. In fact the reaction to a lot of monetary economists to the Euro crisis was surprise that it took a full 20 years after Maastricht to happen.

Christiaan Hofman
Christiaan Hofman
7 years ago

Having their own currency is almost certainly the best option for an independent Scotland, and you give very good reasons for it. That’s why it baffles me that neither side actually proposes it. Because of this, in the current context, this is purely academic, because there is no third choice on the ballot. The choice is between the UK and an independent Scotland on the Pound. And when that’s the choice, I’m with Krugman that the obvious choice is remaining in the UK.

Kevin
Kevin
7 years ago

My best guess to the problem is bank monopoly/greed.

One banker was very clear to me that some clients get 5 bp while most are getting 200. I go through a US Dealer-Broker and get 3 bp.

But since people want to convert bank deposits to bank deposits, I’m not sure how you get bank greed out of the loop without having the Scottish CB allow retail/corporate deposits.

Kevin
Kevin
7 years ago
Reply to  Nicholas Gruen

As in the article it’s not clear why the margins are so high. One guess is that if I want to exchange via a bank, there is no automated method – I have to *call* a human. That human is expensive. The method I use now is entirely automated – computers only. Computers work below minimum wage.

Kevin
Kevin
7 years ago
Reply to  Kevin

So if there are plenty of automated platforms there should be plenty of competition. And the marginal cost of exchange (by computer) is near zero. So we’re back to your original statement of why on earth are exchanges so expensive? I’m still with bank monopoly, but if there are plenty of automated platforms doing this cheap, then no need for Scottish CB to be involved – just invite one of the existing providers.

I’m still boggled at how the banks can charge so much.

Paul frijters
Paul frijters
7 years ago

Once independent, there is nothing to prevent the Scots from changing their currency. The current intention by the Scottish nationalists to stick to the pound is probably just politically expedient, done to minimise the fallout from criticisms that raise fears about current wealth. One shouldn’t confuse this expediency with what is likely to happen down the line and hence judge the referendum by it. So this is a bit of a red herring.
As to the large fees charged by commercial banks for currency exchange and other relevant services, there are two usual explanations: market power and mistake-pricing, where the latter taxes ignorance of fees. Both rely on entry barriers to be sustained and a public provider indeed could undercut the existing banks. I think there is a lot to be said for a central bank with which every citizen has an account and that provides some core non-investment services, like currency exchange, mortgages backed by salaries, and money printing in GFC times.

derrida derider
derrida derider
7 years ago
Reply to  Paul frijters

Indeed yes, Paul. That is pretty exactly why the Commonwealth Bank was created in the late 1940s – it wasn’t just from political hatred of “the money power” but from a pretty clear-eyed appreciation of what was needed for financial market efficiency.

But of course it was privatised in the 1980s when people forgot all this and worked off the general principle “private=efficient, public=inefficient”.

stephen
stephen
7 years ago

It’s still not clear (either from the article or subsequent comments) why a separate currency is so desirable. The concept seems a hangover from the nineteenth century development of the nation state, where one’s own national currency was a symbol of having “arrived” at nationhood (similarly, prior to the nation state monarchs thought a coin with their face on it desirable). These days, separate currency is not that important. It’s a second order issue, maybe a ‘nice to have’ for some people but by no means the question on which the much more important issues at stake should depend.

stephen
stephen
7 years ago
Reply to  Nicholas Gruen

Having done so on occasion (not the whole of the population, but some influential economists from both Ireland and Spain) the answer is yes. There are much more important things for those countries than currency (for example, in Spain, youth unemployment is a bigger issue than the peseta). Unless you are implying that being in the eurozone has been the cause of the other economic problems they face. Not sure that such an argument stands up to evidence, but would need a much bigger thread to explore in full.

derrida derider
derrida derider
7 years ago
Reply to  stephen

That is just silly Stephen. Are you really claiming the issue of unemployment in Spain is not related to the adoption of what was always, from Spain’s POV, a massively and innately overvalued currency that its government is powerless to affect the value of?

Of course their “other economic problems” have been massively exacerbated by being in the Eurozone and having that currency managed in Germany’s, not Spain’s, interests.