Saturday, 6 October 2012

Why monetary union may not survive independence

The SNP have said that they wish to maintain monetary union with the Rest of the UK (rUK) post independence. But although it might have been possible to maintain such a monetary union in the past, when a number of countries, albeit most often with a colonial relationship to the UK used the pound as their currency, it is looking less and less likely that this model of monetary union is possible given modern economic conditions.

The experience of the breakup of Czechoslovakia is especially illustrative of why a currency union between rUK and Scotland would not necessarily last, even if there were good will on both sides. The Slovak Parliament declared independence on 17th July 1992 and after negotiations with the Czech side of the union it was agreed that Czechoslovakia would be dissolved on 31st December 1992.

The intention of both sides was to mitigate against the economic consequences of break-up by maintaining the currency union of the Koruna for at least six months with the possibility of extending this union if both governments agreed. However, this currency union lasted just six weeks.

What were the causes of the failure of monetary union in the newly independent Czech Republic and Slovakia? The answer is capital flight. From the moment independence was announced, money began flowing out of the Slovak half of Czechoslovakia into the Czech half and this flow became a torrent once Slovakia actually became independent.

The Slovak half of Czechoslovakia had developed somewhat differently from the Czech half during communism. It was dominated by heavy industry that had become obsolete. The Czech half of the union was up to 20 % richer per capita and was perceived to dominate the union of the two peoples. With the introduction of democracy in 1989, the Slovaks began to voice their resentment and started to vote for nationalist parties. Mutual resentment continued until the June 1992 elections, when Czechs voted for Czech parties and Slovaks voted for Slovak parties. At this point divorce became inevitable.

What caused the capital flight? The same thing that is causing capital flight in the Eurozone. If a person has 100,000 euros in his Greek bank account and Greece were to leave the Euro and these Greek Euros were  then to be converted into new Drachmas, which were then to depreciate against the Euro by 50 percent,  the 100,000 Euros, which were in the Greek bank account, would now only buy 50,000 Euros. It is therefore rational for a Greek fearing that Greece will leave the Euro to send his money either into a German bank account, or perhaps better still into a US dollar, Swiss, or Sterling bank account. This can now be done almost at the touch of a button.

Slovaks thus fearing that their money would soon be denominated in a new Slovak Koruna, chose to move their money into Czech banks, supposing that a new Czech currency would be stronger than a new Slovak currency.

In the end, it was the Czech authorities which broke up the currency union between the two countries. The capital flight from Slovakia, was such that it was unnerving the Czech authorities, who then imposed capital controls. The run on the Slovak banks, of course, unnerved and destabilised  the fledgling Slovakia too and they agreed to the breakup of the currency union, on February 2nd 1993, just over a month into independence. The border was briefly closed. The physical  notes of each country were stamped so as to mark them as Czech or Slovak. And as predicted the Slovak Koruna depreciated against the Czech Koruna.

The lessons for Scotland are obvious. Even if both Scotland and rUK  wished to maintain the present currency union, it might not be possible to do so. Capital flight from Scotland could be such that  the Bank of England would be forced to introduce capital controls and overnight all banknotes in Scotland could be stamped as new Scottish pounds which could either appreciate or depreciate against rUK pounds. Would this happen? Who knows. Could it happen? Absolutely. It is happening in the Eurozone at present and it happened a few years ago in Czechoslovakia.

Ask yourself if independence was announced today what would you do with your money? Personally, I would instantly move all my money into an English bank account or if I was sufficiently worried I would move it into a dollar account or a Swiss account. Why would I do this? Because I would be worried that the currency union with rUK would not last and if a new Scottish pound were created, that it would fall relative to the rUK pound. This would mean the value of my savings would fall and I would lose money. This does not, of course, mean that the currency union would fail. But my knowledge of economics and the recent experience of the Eurozone tells me that modern currency unions require fiscal and political union. They require one government. Without these things, which is the inevitable consequence of Scottish independence, currency break up is always a possibility, always a risk. It is this risk which caused capital flight in Slovakia, which created a self fulfilling prophecy. It is the same risk, which could create a self-fulfilling prophecy in Scotland post independence. The mere fact that the pound zone could break up might make it inevitable that it would break up leaving all Scots poorer.

We have enough economic troubles at the moment without the question of independence adding to them. Canny Scots would be well to look at their pocket books when they contemplate breaking up the union. How would you like to see your savings, your house, your salary paid in devalued new Scottish pounds?

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