The political appeal of currency union and disunion

By G.I. | WASHINGTON, D.C.

I HAVE watched the debate over Scotland’s independence with a certain déjà-vu. In 1995, I along with everyone else in Canada watched nervously as Quebeckers voted on whether to separate. Like Scotland’s separatists today, Quebec’s then said they would continue to use the old country’s currency. Jacques Parizeau, the separatist leader, traveled in a bus decorated with the Canadian dollar and insisted that Canadian objections could not stop Quebec from using it.

Yet for a new country to keep another's currency is, on its face, an odd decision. It robs a country of many tools of autonomous economic policy: monetary policy, of course, but to a great extent fiscal policy as well, since monetary policy is no longer available to cushion expansionary or contractionary fiscal shocks. If it doesn’t want a euro-style crisis, it will have to run persistent current-account surpluses to accumulate sizable reserves of the anchor currency (much as Hong Kong has), a process that would probably involve deflation, austerity, or both. It loses control over its banking system since it no longer has the means to act as lender of last resort.

What, then, is the appeal of retaining the old country’s currency? Facilitating trade and capital movements is only one part of the story. Another, I think, is political and emotional. Forming a new country is fraught with risk. For savers, in particular the elderly, one risk looms especially large: that one’s retirement savings are suddenly redenominated in a new currency whose value is then inflated away. In both Quebec and Scotland, independence is mostly a movement of the left, and a separate currency would create the ever-present temptation to use the printing press to accommodate fiscal expansion and industrial policy. By promising to keep the old currency, separatists are reassuring savers that they will not succumb to the temptation of inflation.

How realistic are such promises? How long would a newly independent Scotland (or Quebec) tolerate the strictures of a currency union in which they had little say? Historical precedents are not altogether informative. When the Soviet Union broke up, the currency union swiftly followed. The Baltic states and Ukraine were the first to leave; the chaotic introduction of a new rouble in 1993 led the rest, except Tajikistan, to follow. (The IMF view is here.) The dissolution of Yugoslavia, which was in part driven by monetary considerations, also led to the rapid introduction of new currencies.

Of course, Russia and Yugoslavia were monetary basket cases which made monetary independence an easy choice, economically. Scotland (and Quebec) would be part of a highly credible monetary union. But that may not be enough to keep them in. When Norway and Sweden split in 1905, surely one of the most amicable separations in modern history, the currency union lasted just nine more years. Things happened faster when the Czech Republic and Slovakia broke up. Originally, a currency union was intended to continue after the velvet divorce. But Slovak residents began moving funds to Czech banks in anticipation of a devaluation post-split; Slovak importers repaid their debts as quickly as possible, while Czech importers did the opposite, notes this study by Jan Fidrmuc, Julius Horvath and Jarko Fidrmuc. The political union ended on January 1st, 1993; the monetary union ended five weeks later.

The euro may be an example of a currency union that (so far) survives without a fiscal or political union. But keep this in mind. Many countries stick with the euro despite the enormous costs precisely because it has always been seen as on the path towards political union. For Greece and Cyprus, being part of the euro means being part of modern Europe, which is why both countries want to stay despite the devastating price they have paid for membership. For Estonia, Latvia and soon Lithuania, any economic hardships associated with the euro are far outweighed by the political benefits of moving closer to western Europe and further from Russia.

This all means that if Scotland becomes independent and adopts sterling as its currency, do not assume the arrangement will last long. Sooner or later, the same independent impulses that drove the political split will probably be felt in the monetary arena as well.