As the slow unwinding of the eurozone continues, attention in Britain has turned to the monetary implications of a different unwinding: the possible break-up of the United Kingdom through Scottish independence. What do we mean by a currency union, and what conditions are needed to make such a union possible – and sustainable?
Since 1983 the value of the Hong Kong dollar has been fixed at HK$7.8 to the US dollar. The monetary policy of Hong Kong is in effect determined by Ben Bernanke and his colleagues at the Federal Reserve. The Hong Kong Monetary Authority implemented the currency peg unilaterally, and could abandon it unilaterally. If it did, the value of the Hong Kong dollar would almost certainly rise.
Despite that, I would not advise trying to settle your Kansas motel bill in Hong Kong dollars. Hong Kong and the US plainly do not have a currency union. Yet the US dollar is readily accepted in Hong Kong. Not because there is a currency peg, but because the US dollar is readily accepted almost everywhere.
Montenegro, a state formed in the break-up of Yugoslavia, does not have its own currency. All transactions take place in euros. Montenegro is not a member of the eurozone – nor even of the European Union. It is not a signatory to Europe’s growth and stability pact. It does not border any EU state. Montenegro has simply decided to use the euro, and there is nothing anyone can – or at least will – do to stop it.
The euros that circulate in Montenegro are imported, largely by German tourists, who hike in Montenegro’s mountains, sun themselves on its beaches and part with currency in its bars. Foreign investors make payments in euros in the development of the country’s infrastructure. The need to attract monetary inflow, and to ensure that beers and beach huts are competitively priced against those of Greece and Spain, imposes discipline on Montenegrin economic policies.
The government and private banks of Montenegro cannot look to Berlin or Frankfurt for support. The Central Bank of Montenegro cannot print euros. Or perhaps it could, but it is likely that even in Montenegro most people would prefer euros issued by the European Central Bank to euros printed by the Central Bank of Montenegro.
Money is accepted when people accept it, and a currency union exists when people believe it does. The US is a real currency union because no one asks whether this is a Californian dollar or a Massachusetts dollar. And that equivalence is true not just of bank notes but of the monetary units in which the world makes deposits, incurs debts, and writes contracts.
It was not always so. Dollars from different parts of the US would frequently trade at a premium or discount until the second half of the 19th century, and only the formation of the Federal Reserve System in the 20th century definitively established a single currency. Even then the interstate payment system broke down in the banking crisis of 1933. There might have been Californian and Massachusetts dollars once more had not legislation quickly provided federal deposit guarantees on a common basis across the US.
Currency is a confidence trick: its value depends entirely on the belief that it has value. For a decade the eurozone sustained the belief that a euro was a euro – and always would be – through confident assertion and a treaty that had no exit clause. But the erosion of that belief is evidenced by the flight of deposits from Greek banks and the increasingly careful protective positioning of funds and contracts by large businesses. The illusion of equivalence will be difficult to restore.
What does this mean for Scotland? A currency union requires that everyone believes a Scottish pound is indistinguishable from an English pound, otherwise the costs and uncertainties associated with separate currencies are unavoidable. And equivalence can exist only if it is believed to be irrevocable. That outcome can be achieved by a treaty, with appropriate fiscal rules – although the eurozone experience means that the world will in future take a sceptical view of similar arrangements.
Such a treaty could certainly be agreed. It might, however, cause people to start wondering what the point of independence was in the first place.