Before seeking to make significant – even historic – changes to one of the most fundamental features of an economy, namely its currency, I believe those in positions of power would do well to learn from past crises.
History shows us, very persuasively, that monetary union without fiscal union is a broken model, and a risk to be avoided at virtually all costs.
Meanwhile, with a matter of months until the referendum on Scottish independence, the SNP leadership is essentially suggesting that a devolved Scotland should take full control over its tax revenues, while at the same time maintaining a monetary and banking union with the rest of the UK.
In short, they are proposing monetary union without fiscal union, precisely the model which has shown itself to be so prone to failure.
As such, it is difficult not to concur with recent comments by Bank of England governor Mark Carney, who met with Alex Salmond for the first time in Edinburgh on 29 January 2014.
Carney commented that the Scottish government’s proposal for a continuing monetary union with the rest of the UK “requires some ceding of national sovereignty”.
Even the sequence of events around this issue was somewhat irregular, with Salmond talking about the subject – almost as if it were a fait accompli that an independent Scotland would remain in currency union with the rest of the UK – before he had actually met with Carney.
Probably the most recent example to illustrate why monetary union without fiscal union is so problematic is found in Europe.
Europe consists of a collection of countries, cultures and economies. In truth, some run budgetary surpluses, some run deficits.
They always have, and this is precisely why the one-size-fits-all approach to monetary policy that came into being with the creation of the euro was, in a sense, doomed to either failure or extreme difficulty.
Provisions – in the form of the Maastricht Treaty, for example – were made to deal with this intrinsic tension by, in effect, limiting national deficits. The problem with these, and any such provisions, is that they are ultimately ineffective, either because they can be circumvented through window dressing of national accounts (or accounting sleight of hand), or simply ignored.
The very existence of the Maastricht Treaty demonstrates that these risks were well understood; the near-death experience of the euro as the financial crisis unfolded shows that controlling them is a very different matter.
The uncertainty created when the durability of a monetary union is called into question can be extreme.
As became clear when the resilience of the European banking system was tested – notably in peripheral countries, but also in Belgium – we saw with alarming speed how bank deposits and other capital moved from financial institutions based in one set of countries, to those based in another.
Performance of eurozone banks over 7yrs
Source: FE Analytics
Such an eventuality led depositors to question whether a euro deposited in, for example, a Greek bank had the same value as a euro deposited in a German institution.
Clearly, the two should be entirely fungible, but for a period of time it seemed as though this characteristic had all but disappeared, undermining the collective confidence in the value of a currency that is of course central to the stability of any financial system.
Europe is not the only example of a currency union that has been severely tested by the emergence of perceived or actual differences in the worth of identical currency units deposited in different places.
The 1933 month-long run on American banks saw a country-wide flight of capital across the banking system, culminating in the Chicago Fed refusing to lend to the New York Fed in January that year; it was, in effect, a breakdown of a currency union.
Stability was restored only when the Emergency Banking Act saw the introduction of bank holidays, during which the US financial system was effectively shut down for days at a time.
Scotland, with a banking system that is proportionately vast relative to its GDP, would potentially be highly vulnerable in the event that depositors were spooked by questions over the integrity of the union.
I believe it would be deluded to imagine that the kind of bank runs witnessed in the 1930s US could never occur in the UK today.
The long-term solution to the problems of capital flight in the US was to put in place guarantees at a federal level.
Again, this sets something of a historical precedent; in Europe now, the Asset Quality Review (AQR) is arguably a precursor to the introduction (at an equivalent “federal” level) of European bank regulation.
Meanwhile, European politicians are already discussing a “federal-wide” guarantee for bank deposits. Sound familiar? Of course it does.
The UK currently has what is arguably the world’s strongest currency union; a Scottish bank note (notwithstanding the occasional suspicious look from bemused English shopkeepers) is fully fungible with a Bank of England-issued one.
The example bears further scrutiny. An account held with Royal Bank of Scotland-owned NatWest is, by and large, viewed in much the same light as an account held with, for example, HSBC or Barclays.
That Lloyds Banking Group plc (the ultimate holding company of Lloyds Bank, TSB Bank and HBOS) is in fact registered in Edinburgh becomes suddenly more interesting.
The point is that any doubt – for whatever reason – over the integrity of the union and the implicit guarantees enjoyed by UK financial institutions could, I believe, seriously challenge that status quo.
The UK’s banking union works, and we should question long and hard any person or act that may jeopardise this. Introducing uncertainty over the fungible status of English versus Scottish pounds risks doing just that.
More generally, it is worth noting that Salmond’s current stance in favour of an independent Scotland maintaining the pound is somewhat at odds with his previous comments; in 1999, he famously described the pound as “a millstone around Scotland’s neck”, while in a 2007 address in New York to the Council on Foreign Relations he declared that “we have everything it takes for a Celtic Lion economy to take off in Scotland”, words that ring hollow given the subsequent near-collapse and UK government-brokered rescues of Scotland’s two largest deposit-takers.
The main predicament now is that the whole debate around what is really a technical point – namely the integrity of a currency union – has become far too political.
This is a classic example of why politics and the economics of popularity make uneasy bedfellows.
Again, the recent example from the eurozone serves to illustrate the point now, with political tensions between Germany and Greece at times casting doubt on the continuing viability of that currency union.
The emergence of similar currency-related tensions between a devolved Scotland and the rest of the UK would doubtless be profoundly destructive.
I believe the medium-term outcome of the uncertainty that the recent debate around the future of Scotland’s currency has created can only have a negative economic effect.
The reality is that an effective currency union promotes free mobility of capital and labour; there is every reason to believe that picking apart an efficacious currency union would be detrimental.
The lessons are ones to be learned from history. There is much evidence that monetary and fiscal unions work – Mark Carney knows this.
The question is whether Alex Salmond has thought about and fully understood all of the risks of full fiscal independence while being part of a currency union with a foreign country.
Anthony Gilham is the manager of the Old Mutual Voyager Strategic Bond fund. The views expressed here are his own.
