A Scotsman founded the Bank of England, and it took another to reform it. Next year we celebrate the tercentenary of the Act of Union, an Act strongly supported by Adam Smith. And we now have a successful and prosperous union between our two countries with a common monetary institution which embodies the ideas not only of Adam Smith and his great friend David Hume, but also of the key principles that should govern institutional design. From the division of labour in the pin factory to the need for our mutual “sympathy” to be embodied in carefully designed institutions, Smith’s writing is remarkable by its comprehensive and eclectic examination of ideas and facts. So it is appropriate that tonight here in Kirkcaldy, where Adam Smith found contentment in study and reflection, I can announce that tomorrow the Bank of England will  19  There is some evidence that committees make, on average, better decisions than individuals. See King (2002), Blinder and Morgan (2000) and Lombardelli, Proudman and Talbot (2005). 6  BIS Review 102/2006  reveal its new £ note. And the figure celebrated on the new note will, of course, be Adam Smith the first economist and the first Scotsman to appear on a Bank of England note. From next spring, when visitors to our country look carefully at their new £ notes, they will be able to see an engraving showing the division of labour in pin manufacturing with the words “and the great increase in the quantity of work that results”.
Hong Kong can be regarded as being subject to this law of nature. In any event, Hong Kong’s currency board system rules out the creation of money except in exchange for foreign currency, and therefore serves as an operational safeguard against monetary financing of the budget. In order to fund its deficit, the government has a choice between running down its assets (the fiscal reserve) and borrowing, from banks or the markets,. It has chosen for the time being the former route. The monetary impact would in either case be neutral. It may be worth explaining the process. If the fiscal reserve is drawn from the Exchange Fund and the Fund consequently needs to realise foreign currency assets, the foreign exchange is sold in the market. The counterparty surrenders HK dollars. These accrue temporarily to the Exchange Fund and are then transferred to the government, which will in turn pass them to some other party, as the counterpart of the budget deficit. The net result is a change in the ownership of HK dollar money but not in the quantity outstanding. Similarly, borrowing HK dollars to fund the deficit would involve a shift in ownership of those dollars around the economy, but no net increase in quantity. The mechanics of financing the deficit ought not therefore raise any concerns in Hong Kong in the context of monetary stability. Nevertheless, in practice the markets do appear to exhibit a degree of negative reaction to the deficit. Why? A number of possible explanations come to mind.