MARRIAGE AND DIVORCE: MONEY AND NATIONS - The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King

The End of Alchemy: Money, Banking, and the Future of the Global Economy - Mervyn King (2017)


‘So they [the government] go on in strange paradox, decided only to be undecided, resolved to be irresolute, adamant for drift, solid for fluidity, all-powerful to be impotent.’

Sir Winston Churchill, Hansard, 12 November 1936

‘Elections change nothing. There are rules.’

Wolfgang Schäuble, German finance minister, 31 January 2015

What is the relationship between money and nations? From the role that money plays both in normal periods and, even more, in times of crisis, it is clear that there is an intimate link between the nation state and the money that circulates within it. That link runs very deep. The main building of the International Monetary Fund in Washington DC is shaped roughly as an ellipse. As you walk around the corridor on the top floor, on one side are symbols of each of the member nations. On the opposite side are display cabinets of the banknotes used by those countries. There is a remarkable, almost uncanny, one-to-one relationship between nations and their currencies. Money and nations go hand in hand.

Should this surprise us? Is it a natural state of affairs? Although money moves across frontiers at ever-increasing speed, we are no closer to the world currency that idealists like Walter Bagehot imagined in the nineteenth century. Economists have typically looked to economic factors as determining currency arrangements. They argue that we should expect to see fewer currencies than countries because at least some countries will see advantages in forming a currency union with others. The novel idea that money and nations are not synonymous, and that an ‘optimum currency area’ could encompass several nations, or regions within nations, was popularised by the Canadian economist Robert Mundell in 1961.1 Sharing a currency reduces the transaction costs of trade within the union. If each of the fifty states in the USA used its own dollar then the cost of doing business across states would be much greater than it is today. Just as there is a federal system of weights and measures, so the dollar is the single monetary unit of account. But whereas there are single international systems of weights and measures for time, length and weight (the last expressed in two forms: imperial and metric), there is no single world currency.

Sharing a currency means pooling monetary sovereignty - accepting a single official interest rate throughout the union. How restrictive and costly that constraint is depends on the degree to which countries would choose different interest rates if they were free to do so. If one country wants to raise rates - because demand is strong and might push up inflation - and another wants to lower rates - because it is facing weak demand, pushing inflation down - then tensions will arise between the members of a currency union. Such ‘asymmetric shocks’ to demand require, within the union, a flexible labour market encompassing the entire area so that labour can move easily from a country with little demand for it to a country where demand is high.

In contrast, retaining a separate currency means that it is possible to use movements in the exchange rate to coordinate in terms of foreign currency the changes in domestic wages and prices that are necessary following shocks to competitiveness, and to respond to a local fall in demand. In that way it is possible to avoid the high rates of unemployment that might otherwise be required to decrease wages and prices in domestic currency in a decentralised market economy. Experience of the inter-war period across Europe showed that exchange rate changes were more effective than either government edict or mass unemployment in coordinating necessary reductions in real wages.

‘Optimal’ currency areas comprise countries or regions that experience similar shocks and have a single labour market. They also share similar attitudes to inflation. These embrace the choice of a long-run average inflation target, decisions on the trade-off between inflation and employment in the short run, and credibility in the eyes of markets in delivering those objectives.2 Far from being solely economic, such factors are highly political. So we should not be surprised that currency arrangements are determined as much by political as by economic factors.

Money and nations are both important social institutions with a long history. As the historian Linda Colley has written, nation states are:

synthetic and imperfect creations and subject to change, and most have been the result of violent conflict at some stage … In order to persist and cohere, states usually require effective political institutions, a degree of material well-being, efficient means of defence against external enemies, mechanisms for maintaining internal order and, very often, some kind of religious or ideological underpinning.3

Much the same could be said of money. As John Stuart Mill put it in the nineteenth century, ‘so much of barbarism, however, still remains in the transactions of most civilised nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbours, a peculiar currency of their own’.4 As if to illustrate the point, on 14 November 2014, the extremist militant group Islamic State announced that it intended to issue its own currency, comprising coins made of precious metal, to help create a new country - the caliphate.5

More often than not, force was the factor that brought about the domain of empires and their subsequent destruction, creating new nation states in the process. It is important not to see either nations or their monies as fixed. Much of what we now take for granted in the identity and composition of nation states was far from obvious at earlier times - we should not only look through the back window but imagine also peering through the front windscreen to try to understand what did determine the creation of currencies and the nations in which they were used. There has been a remarkable expansion of the number of countries in the world during the post-war period. Today, there are 196 countries in the world (the 193 members of the United Nations plus Kosovo, Taiwan and the Vatican) and 188 members of the International Monetary Fund. And there are around 150 currencies in use in those countries.6 Back in 1945 when those organisations were founded, there were far fewer countries - fifty-one members of the United Nations and twenty-nine members of the IMF - and a correspondingly smaller number of currencies. Of course in 1945 there were more countries than members of the United Nations. Adjusting for that, the number of countries has still more than doubled in little more than half a century. The increase in the number of nation states reflects the process of decolonisation and the fragmentation of former nation states created by force or by delegates at peace conferences who did not represent the area. One might expect that the expansion of international trade, and the growing use of the English language in finance and commerce, would have strengthened the case for common currency areas and led to a reduction in the number of currencies. That has evidently not been the case.

Monetary unions have a chequered history. There have been many successful marriages, and a number of spectacular divorces. The welding of the North American colonies into the United States of America, with a single currency and a collective federal fiscal policy, guided by the determination of the then Treasury Secretary Alexander Hamilton, is one of the most successful unions. The Continental Congress authorised the issuance of the US dollar in August 1786, and the status of the dollar as the unit of account throughout the new republic was established by the Coinage Act of 1792. The importance of the dollar rose with American economic and political power. In 1871 the Meiji government of Japan adopted a new currency - the yen - which has since become one of the world’s major currencies. And one of the oldest currencies in the world, the pound sterling, the origins of which are lost in the mists of time, became the currency of the United Kingdom after the Acts of Union between England, including Wales, and Scotland in 1707.7

There have also been a number of break-ups of monetary unions. When empires or nations split up, the associated monetary union also tends to dissolve. That was true of the Roman Empire, the Austro-Hungarian Empire and, more recently, the Soviet Union.8 When the latter broke up in 1991, the IMF recommended that the successor states continue to use the rouble. But within a short time, they had all adopted new currencies. Less spectacularly, but no less completely, when the British Empire metamorphosed into the British Commonwealth during the post-war period, the sterling area faded away. When Czechoslovakia was divided into the Czech Republic and Slovakia in 1993, the two new states soon moved to distinguish their currencies, and in 2009 Slovakia joined the euro area. That was a relatively amicable divorce. Much less happy was the break-up of Yugoslavia in the 1990s, ultimately into seven successor states, each with its own monetary arrangements.9

Monetary unions comprising more than one sovereign state all ran into trouble. In 1866 the Latin Monetary Union (LMU), comprising France, Belgium, Italy and Switzerland, and from 1868 also Spain and Greece, was formed. It fell foul of the temptation of one part of the union to create money in its own interests rather than those of the area as a whole. The LMU was based on a bimetallic standard that set currency values in terms of fixed quantities of gold or silver, with a fixed price of silver in terms of gold. When the market price of silver fell, some member states started to export silver coins and exchange them for gold in order to exploit the difference between the official and market price of the two precious metals. In effect, they were debasing the currency for their own benefit. Not surprisingly, the resulting lack of trust between its members undermined political support for the LMU and from 1878 it was little more than an agreement to conform to the gold standard.10 Inspired by the example of the LMU, Sweden and Denmark set up the Scandinavian Monetary Union in 1873, with Norway joining two years later. It came to an end in 1914 when Sweden decided to abandon the gold standard.

The case of Ireland is also telling. After the Easter Rising of 1916, and the subsequent political and military struggle, Irish independence became a reality. The 1921 Anglo-Irish Treaty recognised the Irish Free State but implied that it would remain part of the British Empire. That interpretation was not accepted in Dublin, although the new Free State continued to use sterling as its currency. It made no attempt to design or issue banknotes because those printed by the Bank of England, at that time a private company, did not depict the UK sovereign.11 When distinctive Irish coins were introduced in 1928, with inscriptions entirely in the Irish language and depictions of animals instead of British heraldry and the King’s head, they ‘were intended to be unambiguous in declaring a distinct Irish identity and in announcing the arrival of a new sovereign state to the community of nations’.12 Following independence, the Irish Republic maintained an informal monetary union with the United Kingdom but left in 1979, first to cohabit with and then formalise its relationship with the euro area.

None of the decisions to join and then leave those monetary unions had much to do with the concept of ‘optimum currency areas’. Whatever the efficiency considerations, it makes little sense to remain in a currency union with partners who do not share the same objectives and commitment for the management of money. The choice of which money to use is a political act.

Three examples illustrate the complex relationship between money and nations. The first is monetary union in Europe - an example of many countries with a single currency. It is the obvious counter to the post-war trend of fragmentation and its fate will affect the whole world economy. As a marriage of currencies accompanied by no tying of the political knot, it is developing into a battle between political will and economic reality. The second is very different in scale and scope, but no less interesting. It concerns the currency arrangements in Iraq before and after the invasion in 2003, an example of one country with two currencies. And the third relates to the new currency arrangements that might have emerged from the referendum on Scottish independence held in 2014 had the result been ‘yes’ rather than the actual ‘no’.

European Monetary Union

European Monetary Union (EMU) is the most ambitious project undertaken in monetary history. Launched in 1999, it now comprises nineteen members.13 It was, and is, a great economic and political experiment. No monetary union has survived unless it has also developed into a political union, and the latter usually came before the former, as when a single currency followed the unification of Germany under Bismarck. EMU has not proved to be an easy marriage, with the enterprise trying to navigate a safe passage between the Scylla of political ideals and the Charybdis of economic arithmetic. Since concerns about the Greek economy emerged in late 2009, there has been a series of crises to which the European authorities have responded by trying to build the foundations of a more enduring political union. But the diverging economic performance of the member countries has led to tensions about the appropriate design of any such development. The European Central Bank has found itself in the middle of a political debate and been forced to take what are in essence political decisions in order to hold the monetary union together.

Almost 150 years ago, Walter Bagehot overestimated the longevity of the Latin Monetary Union when he wrote that ‘Before long, all Europe, save England, will have one money.’14 Monetary union in Europe has always been about France and Germany. In 1929, Gustav Stresemann, a politician in the Weimar Republic and a recipient of the Nobel Peace Prize for his attempts to achieve reconciliation between the two countries, recommended a European currency to the League of Nations. And during the German occupation of France in the Second World War, the head of the bank Société Générale, Henri Ardant, at a reception at the German Embassy in Paris, expressed ‘his hopes that Germany would set up a single customs zone in Europe and create a single European currency’.15

After the war, proposals for a single currency were planted in the fertile soil of European integration. During that period, several attempts were made to link exchange rates in Europe, of which the most serious was the Exchange Rate Mechanism (ERM). One of the reasons so many countries wished to join the ERM in the 1980s was the belief that by linking their exchange rate to the Deutschmark they would inherit the same commitment to price stability as had been demonstrated by the Bundesbank over many years. But the mechanism broke down first in 1992, when the UK and Italy left it under the pressure of currency speculation, and then more completely in 1993 when the bands within which currencies were permitted to fluctuate against each other were widened to such an extent that the mechanism was ineffective. It did so for two reasons. First, markets saw that countries did not in fact all have the same commitment to price stability; some, when push came to shove, showed themselves unwilling to pay the price to maintain an indefinite commitment to a fixed exchange rate against the Deutschmark. Second, and especially following German reunification, economic conditions in Germany were very different from those in other countries, and different monetary policies were self-evidently appropriate.

The move to European Monetary Union in the 1990s was designed to overcome the weaknesses of a fixed exchange-rate system by making a permanent commitment to a common currency, the euro. From the German point of view, this had the major disadvantage that the political culture surrounding the management of money would now be determined by a larger group of nations and no longer by the history and experience of Germany itself. Creating a monetary union of separate sovereign states was and remains an enormous gamble, one that required a high degree of mutual trust to be successful. As its founders were aware, there is no successful example of a currency union among independent states that have not gravitated to a high degree of political union. Of course, all great historic steps are gambles. But not all gambles result in historic steps forward. Before the euro was launched, the view in Germany was that monetary union should follow political union only with a time lag, and a long one at that. Elsewhere, especially in southern Europe, the view was that the creation of monetary union would lead to crises that would force the pace of political union.16 Everything that has happened since has confirmed the wisdom of the former view and the risks of the latter. How long this marriage will last is something known only to the partners themselves; outsiders cannot easily judge the state of the relationship.

A century ago, Mrs Patrick Campbell, a British actress and close friend of George Bernard Shaw, suggested that a married union represented ‘the deep, deep peace of the double-bed after the hurly-burly of the chaise-longue’.17During the long engagement among the European partners prior to the creation of the euro, culminating in attempts to consummate the relationship by fixing exchange rates through the ill-fated ERM, there was plenty of hurly-burly. But whatever description the members of EMU would give to the first fifteen years of their marriage, it is unlikely to be a deep, deep peace.

To celebrate the launch of monetary union a glamorous ceremony was held in June 1998 for the assembled European elite at the Alte Oper (the old opera house) in Frankfurt, featuring the Irish Riverdance performers.18 It was no time to remind them of the difficulties in persuading the peoples of Europe, with their different languages, histories and cultures, to accept the massive sacrifice of national sovereignty required to create a stable economic and monetary union. Ten years later, on a very hot day in June 2008, the elite reassembled in the Alte Oper, this time for a concert of a more traditional and less exuberant kind, to celebrate the first decade of the euro. Within two years the euro area found itself deep in crisis.

The basic problem with a monetary union among differing nation states is strikingly simple. Starting with differences in expected inflation rates - the result of a long history of differences in actual inflation - a single interest rate leads inexorably to divergences in competitiveness. Some countries entered European Monetary Union with a higher rate of wage and cost inflation than others. The real interest rate (the common nominal rate of interest less the expected rate of inflation) was therefore lower in these countries than in others with lower inflation. That lower real rate stimulated demand and pushed up wage and price inflation further. Instead of being able to use differing interest rates to bring inflation to the same level, some countries found their divergences exacerbated by the single rate. The best measure of ‘inflation’, which captures a country’s international competitiveness, is the GDP deflator - a measure of the average price of all the goods and services produced within a country. From the start of monetary union until 2013, prices on this measure rose by 16 per cent in Germany, 25 per cent in France, 33 per cent in Greece, 34 per cent in Italy, 37 per cent in Portugal, and 40 per cent in Spain.19 So although the birth of the euro brought about some initial convergence of expected inflation rates, the consequence of a single interest rate was to generate subsequent divergence of inflation outcomes.

The resulting loss of competitiveness among the southern members of the union against Germany is large, even allowing for some overvaluation of the Deutschmark when it was subsumed into the euro. It increased full-employment trade deficits (the excess of imports over exports when a country is operating at full employment) in countries where competitiveness was being lost, and increased trade surpluses in those where it was being gained. Those surpluses and deficits are at the heart of the problem today. Trade deficits have to be financed by borrowing from abroad, and trade surpluses are invested overseas. Countries like Germany have become large creditors, with a trade surplus in 2015 approaching 8 per cent of GDP, and countries in the southern periphery are substantial debtors. Although much of Germany’s trade surplus is with non-euro area countries, its exchange rate is held down by membership of the euro area, resulting in an unsustainable trade position. Because of sharp reductions in the level of domestic demand, which have cut imports, the trade deficits of periphery countries have fallen sharply since the global financial crisis, and are now broadly in balance. But unless there is a significant improvement in external competitiveness, they will re-emerge if domestic demand picks up and full employment is restored. When the crisis hit in 2008, employment levels were much higher than today and the trade deficits of Portugal and Spain were around 6 per cent of GDP and in Greece around 11 per cent of GDP. Restoring competitiveness within a monetary union (where there are no intra-union exchange rates to adjust) is a long, difficult and painful process that places strains on a democratic society.

Tensions are inevitable where political identity is aligned with differences between creditors and debtors. None of this has anything to do with the fiscal policies adopted by countries before or after the creation of monetary union. Most of today’s fiscal problems are the result of falling demand and output, partly as a result of the downturn in the world economy following the crisis of 2007-9 and partly because the downturn has been exacerbated in the periphery countries by the loss of competitiveness. Fiscal problems have been largely consequences, not causes of the crisis of the euro area.

The crisis in the euro area started in Greece at the end of 2009, when a new government elected in October revealed that the previous administration had been under-reporting the budget deficit, resulting in an increase in the estimated deficit from around 7 per cent of GDP to almost 13 per cent (later revised up to 15 per cent). Trust in the accuracy of Greek statistics, never high, was further damaged. It seemed that Greece had been admitted to the euro area on false pretences. The problem became more serious during 2010 when Greece found itself increasingly unable to borrow from global financial markets and turned to its partners in Europe for emergency loans. At the beginning of May the first of many emergency summits of euro area leaders met in Brussels, and it was agreed to set up a €500 billion fund to bail out Greece and other countries that might find themselves in difficulty. But the crisis did not really subside over the following year. Countries with trade deficits were finding it difficult to borrow from abroad, and the interest rates at which their governments could borrow rose sharply, not only but especially in Greece. As foreign banks and hedge funds withdrew their money, the sharp reduction in those inflows of money to the periphery countries necessitated an equally sharp reduction in the excess of imports over exports. With no ability to use a depreciation of the currency to stimulate exports, the only way to close the gap was to reduce imports. Reductions in government spending and increases in taxes lowered domestic demand and imports. As a result, output fell precipitously.

In July 2011, the euro area crisis took a turn for the worse. It was increasingly difficult to pretend that the problems of countries such as Greece were solely a shortage of temporary liquidity rather than a question of underlying solvency and loss of competitiveness. Yields on the sovereign debt (that is, government bonds) issued by Greece, Ireland and Portugal reached near record highs, making new borrowing very expensive, and Portugal joined Greece in having its debt downgraded to junk status (meaning that the debt was judged by the rating agencies to be a highly speculative investment and therefore not one suitable for a range of funds, including many overseas pension funds). Soon Italy was drawn in, not least because government debt there, at €1.7 trillion, amounted to the third largest in the world, comfortably exceeding the resources available through existing euro area rescue funds.

The summer of 2011 was the start of a six-month period during which governments and commentators regularly called for Germany to act decisively and in an overwhelming show of force to demonstrate its unequivocal support for the continuation of the euro. Unfortunately for Germany, the decisive action envisaged by others was for it to provide sufficient money to enable the periphery countries to regain market confidence. Those countries still had insufficient export revenues to pay for imports and the servicing of overseas debt. Since they also had little access to private markets, the solution envisaged by many was to ask for very significant transfers from German taxpayers to the southern members of the euro area. It was never likely that Germany would be willing to make such a commitment, and certainly Angela Merkel, Germany’s Chancellor, was in no rush to do so.

Monetary union was starting to challenge democratic governments elected by their own citizens. A secret letter, leaked later, signed by both the outgoing and incoming ECB presidents, Jean-Claude Trichet and Mario Draghi respectively, was sent to the Italian Prime Minister, Silvio Berlusconi, on 5 August 2011. It demanded that Mr Berlusconi make drastic cuts in public expenditure, open up public services, and enact a number of reforms, including changes to pay-bargaining and employment laws. The letter went well beyond the usual remit of central banks. When its contents became public, Berlusconi’s authority was weakened, and after losing his parliamentary majority, he resigned on 12 November. A technocratic Prime Minister was appointed in his place: Mario Monti, a highly respected economist and former European Commissioner. From personal experience, I know that it would have been difficult to find anyone better than Mario Monti to lead Italy in such difficult circumstances. Yet he had not been elected, and had no parliamentary majority. His ability to put in place reforms to improve the supply-side performance of the Italian economy was limited, and his proposals met stiff resistance from numerous interest groups, including lawyers, taxi drivers and, indeed, members of parliament.

Politicians in the euro area believed that they were fighting a battle against the markets. One very senior euro area politician had said at a meeting I attended that ‘we will show the markets that we shall prevail’. The strategy adopted by the new President of the ECB, Mario Draghi, who replaced Jean-Claude Trichet on 1 November 2011, was to avoid, as far as possible, controversial purchases of sovereign bonds and instead to channel support directly to the banking system because any immediate threat to the euro would be visible in a run on a major euro area bank. By the following February, the spotlight was back on Greece. Although for years Greece had suffered from incompetent and corrupt governments, which made it difficult for its partners in the euro area to sympathise, the mood inside the country was captured by Archbishop Hieronymos of Athens, who wrote to the Greek Prime Minister setting out the concerns of the Church:

Our hearts are shattered and our minds are blurred by recent events in our country. Decent people are losing their jobs, even their homes, from one day to the next. Homelessness and hunger - phenomena last seen in times of foreign occupation - are reaching nightmare proportions. The unemployed are growing by the thousands every day … Young people - the best minds of our country - are migrating abroad … Those making decisions are ignoring the voices of those in despair, the voices of the Greeks. Unfortunately, we cannot find a response - neither to explain what has happened, nor to the demands made by foreigners. Indeed, foreigners’ insistence on failed recipes is suspect at best. And their claims against our national sovereignty are provocative. The exhaustion of the people cannot be ignored.20

Greece became the first major European country to experience a depression on the scale of the 1930s Great Depression in the United States. Between 1929 and 1933, total output in the US fell by 27 per cent. In Greece, output fell between 2007 and 2015 by slightly more than that, and domestic spending (consumption and investment in both private and public sectors) by no less than 35 per cent, an outcome I would never as a student in the 1960s have imagined possible with our new-found understanding of how to prevent depressions. There were, and remain, many inefficiencies in the Greek economy. But in the absence of political union, decisions about them are for the citizens of Greece. In March 2012, Greece defaulted on, or to be precise ‘restructured’, its debt. The restructuring transferred much of the debt from private to public sector creditors. By 2015, around 80 per cent of Greek sovereign debt was owed to public sector institutions elsewhere in the EU or to the International Monetary Fund. Monetary union, far from leading to greater political integration, was proving the most divisive development in post-war Europe.

By the end of July 2012, exit from the euro for Greece and perhaps others was becoming accepted as likely. The ECB, the European Commission and the German government had plans for how to handle a Greek exit. It was widely assumed that exit would imply the imposition of capital controls in Greece, and probably a bank holiday to allow the government to nationalise many, if not most, of the local banks. Then came the démarche that transformed market sentiment. At a Global Investment Conference on 26 July to mark the start of the London Olympic Games, I chaired a panel of central bank governors. One of them was Mario Draghi. As he stood up to make his remarks, I noticed that, unusually, he did not intend to read from a prepared text. The ECB would, he said, ‘do whatever it takes to preserve the euro. And believe me, it will be enough.’21

His words reverberated around the world, but just as important was the joint statement made the following day by Chancellor Merkel and President Hollande, indicating their full commitment to the euro and support for Draghi’s intention. It was clear that the ECB would buy, or was actively considering buying, Spanish and Italian sovereign debt. Spanish ten-year bond yields fell back from 7.6 per cent to below 7 per cent. Bank shares in the euro area rose between 5 and 10 per cent on the day. It was the start of a marked change in sentiment that was to result in significant falls in sovereign bond yields over the next two years. By the end of 2014, ten-year yields in Greece had fallen from 25 per cent to just over 8 per cent, Portuguese bond yields from over 11 per cent to under 3 per cent, and those in Spain from over 6 per cent to below 2 per cent. Indeed, by the end of 2014 Spain was able to borrow more cheaply than the United States government. Draghi’s commitment had obviously done the trick.

But it had also raised a serious problem. The mandate of the ECB does not extend to fiscal transfers. And it was obvious from comments made both publicly and privately that the Bundesbank was strongly opposed to any selective purchases of sovereign debt, which it believed might well be unconstitutional.22 Certainly, on the face of it, it is hard to reconcile the sovereign debt purchase programme with the ‘no bailout’ clause in the European Treaty. So it was some weeks before the ECB announced a programme of Outright Monetary Transactions to allow it to buy the government bonds of periphery countries in return for requests from them for assistance from the new European Stability Mechanism (ESM). By 2015, no purchases had been made. Overall, however, the Draghi promise to ‘do whatever it takes’ brought a sense of calm to financial markets and an end to a long series of crisis weekends. It appeared that Germany had abandoned the idea of a Greek exit from the euro. Investors from outside the euro area were seduced into buying financial assets, particularly sovereign debt, in the periphery countries, bond yields fell further and the ECB was able to reduce its lending to banks.

But the purchase of sovereign debt by overseas investors pushed up the value of the euro. Its effective rate would rise around 10 per cent over the next two years. That led to the next challenge for the euro - in France. The higher exchange rate of the euro exacerbated the loss of competitiveness that had been increasingly evident in the French economy. Unemployment rose and activity stagnated. It was all very well for countries like Greece or Portugal to suffer substantial falls in output, but it was unthinkable politically for France to suffer the same fate. The euro was born out of Franco-German cooperation; divisions between the two would be fatal to the project.

By early 2015, the ECB had decided to embark on a programme of monetary expansion, following the example of the Federal Reserve and the Bank of England some six years earlier. In January of that year it announced a programme of bond purchases to expand its balance sheet back to its previous peak some two years earlier. The aim was clear - to lower the value of the euro. And its initial effect was to do just that. The euro fell to its lowest level against the dollar for more than a decade.

January also saw the election in Greece of a new government, led by the Syriza party, committed to reducing the burden of austerity imposed on the country by the much-disliked ‘troika’ of the European Central Bank, European Commission and International Monetary Fund. Fruitless negotiations ensued, with all the focus on the country’s debt-servicing obligations, which had been significantly reduced by the earlier debt restructuring and rescheduling, rather than on the underlying cause of the problem of weak demand, namely the inability of Greece to find a new lower real exchange rate through devaluation.

Within the confines of monetary union, the route to a lower real exchange rate is via an ‘internal devaluation’, which entails sustained mass unemployment in order to bring down wages and prices in those sectors of the economy that produce tradeable goods and services. Unemployment remains extremely high in a number of euro area countries. By the autumn of 2015, the unemployment rate was over 10 per cent in France, around 12 per cent in Italy and Portugal, 22 per cent in Spain and 25 per cent in Greece. Depressingly, youth (under-twenty-five) unemployment was close to 50 per cent in both Greece and Spain.23 In recent years several hundred thousand young people have emigrated from Greece, Italy, Portugal and Spain.24 By contrast, the overall unemployment rate had fallen to 5 per cent in both the United States and United Kingdom, and to similar low levels in the euro area countries with trade surpluses; the rate stood at 6.9 per cent in the Netherlands and just 4.5 per cent in Germany.

Increasingly acrimonious negotiations between Greece and its partners in the euro area led to a breakdown of negotiations in the summer of 2015. Greek banks were shut on Monday 29 June following a decision by the ECB to cap lender of last resort support to them. Cash payments from ATMs were limited to €60 a day and the economy started to grind to a halt. On 30 June, Greece became the first advanced economy to default on a payment due to the IMF. A few days later, on Sunday 5 July, in a national referendum, the people of Greece rejected by a large majority the proposals of their ‘partners’ in Europe for further austerity in return for a further bailout. Yet the leaders of the euro area reacted to the referendum result by demanding even tougher proposals for reforms from the Greek government. There was no prospect for growth in Greece without substantial debt relief. In practice, that would mean significant losses for taxpayers in Germany and other euro area countries.

By July 2015, it was clear that neither side was prepared to contemplate a Greek withdrawal from the euro. On 13 July, after all-night negotiations, an agreement was reached under which Greece accepted virtually all the creditors’ demands for reforms - including, bizarrely, the introduction of Sunday trading hours - in return for additional finance in the form of loans of some €87 billion and the promise of discussions on some debt restructuring. Since the agreement implied an increase in Greece’s already unsustainable debt burden and no measures to boost overall demand, it was unclear why either side saw any benefit to it other than preserving the shackles of euro membership. The Greek Prime Minister, Mr Tsipras, called the proposals ‘irrational’ but said he was willing to implement them to ‘avoid disaster for the country’.25

Within twenty-four hours the IMF published a report that, given its position over the previous four years, belatedly recognised the obvious. It stated that ‘Greece’s debt can now only be made sustainable through debt relief measures that go far beyond what Europe has been willing to consider so far’, and pointed out that since debt was expected to peak at around 200 per cent of GDP over the following two years, it would be necessary to extend by thirty years the grace period for debt repayment to the rest of the euro area or to make explicit annual transfers to Greece.26 The rug had been pulled from under the German position that monetary union did not require transfers from creditors to debtors. The spectre of crisis eased after the Syriza government consolidated its position in elections unexpectedly called in September 2015, albeit on the lowest turnout in a Greek election since the restoration of democracy in 1974. Quite how the agreement would restore growth of the Greek economy was unclear, and the underlying problems of lack of competitiveness and unsustainable debt remain.

The approach being followed by the ECB is a ‘finger in the dyke’ strategy. Of necessity, it adopts the policy best suited to help the country most likely either to exit the euro in the near future or to suffer politically from continuing membership. When Greece was in danger of exit, sovereign debt was forgiven; when other periphery countries were in danger, it bought sovereign debt from those countries in order to bring down their bond yields; and when France was facing a deeper downturn, it adopted a policy of general sovereign bond purchases and money creation to lower the value of the euro. As a result, the ECB has had to choose between allowing the euro to fail and becoming a politicised institution. Naturally, it chose the latter. In years to come that may return to haunt the bank if there are attacks on its independence for straying into political territory.

Before the Treaty on European Union, signed in Maastricht in 1992, the Bundesbank argued that monetary union required the degree of solidarity characteristic of a nation: ‘all for one and one for all’.27 The experience of monetary union has not demonstrated that degree of solidarity and trust. That is hardly surprising given that for Germany today interest rates are too low - and their savers are losing money - whereas in the periphery countries real interest rates are too high, exacerbating the depression. Keeping the show on the road is a challenge to which the ECB has so far successfully risen. But it begs the question of how a longer-lasting solution to the travails of the euro area can be found.

The economics of such an answer are straightforward. The real challenge is not the state of the public finances but a country’s external competitiveness. So the euro area must pursue one, or some combination of, the following four ways forward:

1. Continue with high unemployment in the periphery countries until wages and prices have fallen enough to restore the loss in competitiveness. Since the full-employment trade deficits of these countries are still significant, further reductions will be painful to achieve. Unemployment is already at very high levels in these countries. In small countries, for which a floating exchange rate may seem too risky, such a route may be the only option.

2. Create a period of high inflation in Germany and other countries in surplus, while restraining wages and prices in the periphery, to eliminate the differences in competitiveness between north and south. That would require a marked fall in the euro for a long period, which would be unpopular in both Germany, whose savers would earn an even lower return on their assets than at present, and the rest of the world, which would interpret the fall as a hostile move.

3. Abandon the attempt to restore competitiveness within the euro area, and accept the need for indefinite and explicit transfers from the north to the south to finance the full-employment trade deficits in the periphery countries and to service external debt. Such transfers could well exceed 5 per cent of the GDP of the countries in the north, and would require significant conditions to be imposed on the periphery countries to limit the extent of those transfers.28 Moreover, there is no popular support for transfers on such a scale in either donor or recipient countries.

4. Accept a partial or total break-up of the euro area.

I shall return to the prospects for these alternative ways of dealing with the problem in Chapter 9. When confronted with such a range of unpalatable choices, the leaders of Europe react by saying, ‘We don’t like any of them.’ So they have responded by muddling through and adopting the coping strategy of Mr Micawber (in Charles Dickens’ David Copperfield), waiting for something to turn up. Since the future is wholly unpredictable, it is certainly possible that something might turn up. But it is hard to believe that it would be an improvement on facing up to the problem and providing a sustainable economic basis for monetary union. The euro is no longer a means to an end, but the end itself. Given the strength of their political commitment to the project, one can sympathise with the dilemma in which those leaders find themselves. They are essentially following the views of John Maynard Keynes who, when confronted with the prospect of war in the 1930s, wrote:

We do not know what the future will bring, except that it will be quite different from anything we could predict. I have said in another context that it is a disadvantage of ‘the long run’ that in the long run we are all dead. But I could have said equally well that it is a great advantage of ‘the short run’ that in the short run we are all alive. Life and history are made up of short runs. If we are at peace in the short run that is something. The best we can do is put off disaster, if only in the hope, which is not necessarily a remote one, that something will turn up.29

The problem with the Mr Micawber strategy, however, is that whatever else may turn up, it is unlikely to be the economy.

For perfectly understandable reasons, Germany is unwilling to sign up to permanent, or at least indefinite, transfers of the kind that characterise most existing monetary unions (say between northern and southern Italy, or between different states of the United States). It is equally unenthusiastic about either higher inflation or a break-up of the monetary union. Yet trying to restore competitiveness by continued depression does not seem likely to succeed - it didn’t in the 1920s after the return to the gold standard. Many commentators seem to believe in the ‘progress through crisis’ doctrine for Europe. Fred Bergsten, who served as Assistant Secretary for International Affairs during the Carter administration, argued the case when he said in 2014 that ‘Germany would pay whatever was necessary, repeat whatever was necessary, to preserve the euro’.30 That proposition is yet to be tested. But if other member countries come to believe it, then any semblance of fiscal discipline will be lost unless Germany takes control of their economies.

Policies dictated by Brussels and Frankfurt, and supported by policy-makers in Washington, have imposed enormous costs on citizens throughout Europe. The inability of governments to prevent high unemployment and avoid reductions in living standards has led to disillusionment. It was predictable that many voters would seek salvation in parties outside the mainstream. The European elections in 2014 and the Greek elections of 2015 were testimony enough. Putting the cart before the horse - setting up a monetary union before a political union - has forced the ECB to behave like a supranational fiscal authority. But neither it nor governments have a mandate to create a transfer or political union - voters do not want it. The bond market may be powerful, but the belief that a monetary crisis will provoke rapid steps to political union is pie in the sky.

Some German economists would like to return to the original idea of monetary union - with a strict implementation of the no-bailout clause in the European Treaty and the Stability and Growth Pact (SGP), which is a set of rules governing the fiscal policies of member countries of the European Union adopted in 1998-9. Among them is the man who more than anyone else made a success of the European Central Bank, Otmar Issing, its first Chief Economist. As he wrote in 2015, ‘Economically and politically, relaxing the no bail-out clause would open the door for a massive violation of the principle of no taxation without representation, creating strong movement toward a transfer union without democratic legitimacy.’31 But politicians in Europe seem immune to such powerful arguments. The treaty was ignored in the past, and would be again. The reason is that European monetary union is a political, not a constitutional project. As in many instances of nation-building, constitutions play an important role. They legitimise and popularise the essential strands of political ideology that bind people into their ‘nation’. The European Treaty contains a number of provisions relating to monetary and fiscal policy to support the monetary union, including a prohibition on the direct financing of governments (Article 123), the no-bailout clause, which makes it illegal for one member to assume the debts of another (Article 125), limits on government deficits and debt (Article 126), and the SGP to enforce the limits on deficits and debt (secondary legislation based on Articles 121 and 126). Although those provisions had the appearance of binding treaty commitments, in times of crisis the treaty was simply ignored or reinterpreted according to the political needs of the moment. For example, in 2003 France and Germany ignored the constraints of the SGP and neither ministers nor the European institutions took any action. A similar reaction occurred in 2014-15 when the economic problems facing France and Italy demanded a relaxation of the constraints of the SGP. After 2010, the no bailout clause was quietly forgotten in the need to restructure Greek debt. The treaty seems to mean whatever the politicians in the big countries want it to mean.

People around Europe quite like the idea of the euro - but they don’t like what it is doing to them. As someone once said to me, he wouldn’t mind if the UK adopted the euro provided that we could keep our own interest rate. Misunderstanding of the economics of a monetary union is widespread. Just as the internal imbalances between spending and saving within major economies remain, as I discussed in Chapter 1, so do the external imbalances between economies. The sharp fall in demand and output across the world in 2008-9 did lower external surpluses and deficits. But full employment surpluses and deficits remain. Germany’s trade surplus is approaching 8 per cent of GDP. To argue, as the German finance minister did, that this is helpful to the euro area as a whole because the German surplus offsets deficits elsewhere is to misunderstand the economic consequences of monetary union.32 Germany’s surplus and the deficits in the periphery countries are two sides of the same coin, and can be managed only by adopting one or more of the four solutions set out above.

The European experience over the past fifteen years or so suggests three main lessons for the relationship between nations and monetary unions. First, it is sensible to ensure that all partners in a monetary union have fully converged on the same underlying rates of wage and price inflation before they are permitted to join. Although this was the intention of the monetary union in Europe, political pressures led to the admission of countries where inflation rates had not fully converged. Second, once a union has been created, it is important to monitor and prevent the emergence of divergences in wage and price inflation before they lead to losses of competitiveness, which can be reversed only by long periods of mass unemployment. To its credit, the European Central Bank issued many warnings about this, but they were ignored. Third, future economic shocks are inherently unpredictable and monetary union will come under great strain unless there is a high degree of mutual trust and willingness to make transfers to countries that have suffered major shocks. That requires a degree of political integration that is absent in Europe today. Substantial powers have been transferred to European institutions, but democratic legitimacy remains in the hands of national governments.

The crisis of European Monetary Union will drag on, and it cannot be resolved without confronting either the supranational ambitions of the European Union or the democratic nature of sovereign national governments. One or other will have to give way. Muddling through may continue for some while, but eventually the choice between a return to national monies and democratic control, or a clear and abrupt transfer of political sovereignty to a European government cannot be avoided.33 European leaders, including the British, have for many years failed to make clear the nature of this choice to their peoples, for fear of being seen to rock the boat and thereby lose influence. The leaders of the smaller countries, in particular, have been cowed by threats from the centre, on the one hand, and by the prospect of jobs in European institutions when they stand down from national office on the other. Voters in a growing number of countries have turned away from centre-left and centre-right parties towards more extreme parties that still respect national sovereignty. There is a limit to the economic pain that can be imposed in the pursuit of a federal Europe without a political counter-reaction.

Iraq between the Gulf Wars

The second example illustrating the complex relationship between money and nations is the remarkable story of currency arrangements in Iraq between the First and Second Gulf Wars. It is the unusual story of one country with two currencies, or, perhaps more accurately, a country divided into two halves, one of which had a government and a badly run currency and the other, which had no government but a stable currency.

At the time of the First Gulf War in 1991, the Iraqi currency was the dinar. Following the war, Iraq was divided into two parts that were politically, militarily and economically separate from each other: southern Iraq was under the control of Saddam Hussein, and northern Iraq, protected by a no-fly zone north of the 36th Parallel, became a de facto Kurdish protectorate. In the south, Saddam’s regime struggled to cope with UN sanctions, and resorted to printing money to finance growing budget deficits. Unable to import notes printed abroad because of sanctions, the official Iraqi government started to print new notes that bore Saddam’s image. These were known as ‘Saddam’ dinars. Citizens had three weeks to exchange old notes for new. So many notes were eventually printed that the face value of cash in circulation jumped from 22 billion dinars at the end of 1991 to 584 billion only four years later. Inflation soared to an average of about 250 per cent a year over the same period.

In the north, however, people were given no opportunity to exchange their banknotes. So the new Saddam dinar did not circulate in the north, and people continued to use the old dinar notes. These were known as the ‘Swiss’ dinar - so-called because although the notes had been printed by the British company De La Rue, the plates had been manufactured in Switzerland. The Swiss dinar developed a life of its own and in effect became the new currency in the north - a successful coping strategy. No Swiss dinar notes were issued after 1989, and since the region had no issuing authority there was at most a fixed, and probably a declining money stock in the north. As a result, the Saddam and Swiss dinars developed into two separate currencies.

For ten years, therefore, until the invasion in 2003 by the United States and its coalition partners, Iraq had two currencies. In the south the Saddam dinar was issued by the official government of Iraq. In the north the Swiss dinar circulated, even though backed by no formal government or central bank, nor any law of legal tender. For a fiat currency this was an unusual situation. Whatever gave the Swiss dinar its value did not derive from the official Iraqi government, nor indeed from any other government.34

Although there was little or no trade between northern and southern Iraq, both the Swiss and Saddam dinars were traded against the US dollar. After 1993, the implied cross-exchange rate between Swiss and Saddam dinars rose in value from parity to around 300 Saddam dinars to each Swiss dinar by the time Saddam was deposed in 2003.35 The appreciation of the Swiss dinar was clearly a consequence of the evolution of the actual and expected money supplies in the two territories: the supply of Saddam dinars rose rapidly, whereas the supply of Swiss dinars was fixed.

What is less obvious is the interesting behaviour of the Swiss dinar against the US dollar. After fluctuating in the 1990s, the Swiss dinar rose sharply against the US dollar from the middle of 2002 as the prospect of an end to the Saddam regime increased. It rose from around eighteen to the dollar in May 2002 to about six to the dollar by the beginning of May 2003, when the war ended. That appreciation reflected expectations about two factors: first, the durability of the political and military separation of Kurdish from Saddam-controlled Iraq and, second, the likelihood that a new institution would be established governing monetary policy in Iraq as a whole and would retrospectively back the value of the Swiss dinar. The political complexion of northern Iraq led to the assumption that the currency used there would have value once regime change had occurred. In other words, the value of the Swiss dinar had everything to do with politics and nothing to do with the economic policies of the government issuing the Swiss dinar, because no such government existed.

The crucial role of the political regime is illustrated by the behaviour of the exchange rate in the light of beliefs about a likely invasion and its consequences. At the time, financial market traders could, believe it or not, buy and sell futures contracts related to the fate of Saddam Hussein. One such contract paid out $1 if Saddam was deposed by the end of June 2003 and nothing otherwise. The price of the contract, which lay between $1 and zero, was a measure of how expectations about the political order in Iraq were evolving, and traders could bet on the outcome by buying or selling as many contracts as the market would bear. As the chance of Saddam’s regime being deposed (and the price of the contract) increased, the Swiss dinar appreciated against the dollar. Later, another futures contract paid $1 if Saddam was captured by the end of December 2003, and nothing otherwise. As the chance of this happening (and the price of the contract) fell during 2003, with Saddam still missing, the Swiss dinar fell against the dollar. It rose again just before Saddam’s capture on 13 December 2003.

After American and other coalition forces assumed control of Iraq in July 2003, the head of the Coalition Provisional Authority, Paul Bremer, announced that a new Iraqi dinar would be printed and exchanged for the two existing currencies at a rate that implied that one Swiss dinar was worth 150 Saddam dinars. The exchange was to take place over the period from October to the following January. The new dinars, like the Swiss, were printed by De La Rue in a very short space of time using plants in Britain and several other countries, and were flown into Iraq on twenty-two flights using Boeing 747s and other aeroplanes. The 150-dinar parity was barely half the rate the Swiss dinar reached at its peak. But it was above both the average rate that had prevailed over the previous six years, and the rate that would equalise the purchasing power of the two currencies. For example, around the time when the new conversion rate was being determined, it was estimated that 128 Saddam dinars to the Swiss dinar would equalise the wages of an engineer in the two parts of Iraq, 100 would equate the price of the shoes he wore to work, and 133 the price of his suit.36 The new Iraqi dinar has remained fixed against the US dollar since, with the exception of the period between December 2006 and December 2008, when the Central Bank of Iraq steadily revalued the currency to prevent a rise in inflation, so that after two years it had appreciated by around 20 per cent.

The circulation of Swiss dinars in Kurdish-controlled Iraq during the 1990s was a market solution to the problem of devising a medium of exchange in the absence of a government with the power to issue currency. Changes in the relative price of Swiss and Saddam dinars show that the value of money depends on beliefs about the probability of survival of the institutions that define the state itself, and not just the policies pursued by the current government. The recent monetary history of Iraq is a telling example of the importance of political stability and the consequences of its absence.

Interestingly, a similar issue arose during the Second World War in the French overseas territories, which were divided between Vichy France and the Free French under Charles de Gaulle. In French Equatorial Africa, Cameroon and other French territories in sub-Saharan Africa, the right to issue banknotes had been vested in the Banque de l’Afrique Occidentale (BAO), which was under Vichy control until 1943. But as Free France began to acquire Vichy territory, it operated a different currency policy - namely, an exchange rate fixed to the pound sterling. So ‘francs’ meant different things in the two sets of territories, even though the notes were at first indistinguishable. Naturally, this created opportunities for making money by exchanging franc notes into foreign currency in one region and then reversing the exchange in the other. To prevent such activity, in 1941 Free France set up the Caisse Centrale de la France, operating from the Bank of England, as the issuer of its own banknotes and coins.37 Notes issued by the BAO were exchanged at par for those of the Caisse Centrale in the summer of 1942, and were no longer legal tender. The Free French notes advertised their origin by incorporating in their design a phoenix and the ‘Marianne de Londres’ as symbols of freedom.

In the very different circumstances of both Iraq and the French overseas territories, the value of the currency depended very much on beliefs about the future political arrangements of the ‘nation’ that would stand behind it. There is clearly much more to the value of money than the economic issues that dominate the financial pages in the press.

An independent Scotland

The third example of the relationship between money and statehood concerns a country considering a divorce from its partner and the end of a long-standing monetary union. On 18 September 2014, the people of Scotland were asked in a referendum, ‘Should Scotland be an independent country?’ With a high turnout of 85 per cent, they rejected the proposition by 55 per cent to 45. Much of the referendum campaign centred on the choice of currency arrangements for a newly independent Scotland. The Yes campaign was reluctant to spell out a clear answer to the question of which currency would be used in the event of independence; the No campaign made a series of unsubstantiated claims about the difficulty of finding a satisfactory solution to the question. In fact there was a simple answer which, interestingly, neither side was prepared to spell out, each for its own reasons.

The original vision of the Scottish nationalists, put forward before the crisis, was of an arc of prosperity encompassing Ireland, Iceland and Scotland, within the euro, and with a large and successful banking sector in all three countries. After the crisis hit in 2008, it became clear that the vision was an illusion: Iceland and Ireland were overwhelmed by the cost of supporting a banking sector that had grown far too big for any small country to support, the euro was struggling to survive, and the two British banks that required substantial recapitalisation by the state (Royal Bank of Scotland and Halifax Bank of Scotland, the latter of which became part of Lloyds), and so by taxpayers in the UK as a whole, were both Scottish. Joining the euro was no longer a credible option. Nor was a new Scottish currency that would have floated against sterling and the euro in what had become turbulent monetary waters. With such a large proportion of trade and economic activity taking place with the rest of the UK, the next option was to peg a new Scottish currency to the pound sterling through a currency board. That would have required potentially unlimited reserves of sterling to convince markets that there was no risk to the peg. And that in turn would have meant a large borrowing programme in sterling - not an attractive prospect for a newly independent country trying to convince markets of its fiscal prudence.

So, by the time of the referendum, the Yes campaign proposed that in the event of independence there should be a formal monetary union with the residual United Kingdom, maintaining existing arrangements but with additional representation for Scotland in decision-making on monetary policy at the Bank of England. The No campaign flatly rejected this arrangement and ruled out any possibility of a monetary union, citing the experience of monetary union in Europe, which had shown the need for fiscal rules governing the newly independent country that would undermine the case for independence. The Yes campaign responded by pointing out that, whatever had been said during the campaign, the morning after a vote in favour of independence would be a new situation in which negotiating positions would change. Because the referendum was lost, this was never put to the test. But a formal monetary union cannot occur without the explicit agreement of both Scotland and the residual United Kingdom, and, given the demands of the former and the opposition of the latter, it seems most unlikely that this would have been forthcoming.

When the referendum took place, the currency question remained unresolved. But there was an answer. The simple and straightforward solution was ‘sterlingisation’. Following a ‘yes’ vote, the Scottish government could have announced the next day that an independent Scotland had no intention of issuing its own currency and that all contracts denominated in sterling would always be legally honoured in sterling. There would be no formal currency union. Scotland would simply go on using sterling. Nothing would change. The Yes campaign could not, however, openly advocate such a solution, because it would have made clear that independence would give Scotland no real say over its monetary arrangements - they would be borrowed from England, exactly as they are today, because the relative size of the two economies means that interest rates are largely unaffected by conditions in Scotland. Politically, sterlingisation would have provided an answer to the currency question, but it would have taken the edge off the case for an independent Scotland.

The No campaign was also misleading. To admit that there was a simple and straightforward answer to the currency question would have undermined its argument that independence would be an economic disaster. That proposition was always implausible. There are many small and successful countries in the world, and there is no reason why Scotland could not have joined them. The case for and against the Union is more to do with identity than economics, the political costs of breaking up a three-hundred-year partnership, and whether Scotland needs full independence to manage its own domestic affairs when it already has substantial devolved powers. After the referendum, the Westminster Parliament moved rapidly to grant further powers to the Scottish Parliament.

Sterlingisation is a perfectly reasonable policy for a country that is happy to accept the economic consequences of a fixed exchange rate with sterling, but does not have the option of joining a formal monetary union with the UK. The attraction to Scotland of such a solution is that nothing significant would need to change. Many banknotes issued by banks in Scotland already have distinctive national designs, and the same could occur with coins if another symbol of Scottish identity was desired, as in Ireland following independence.38

Dollarisation has worked well for countries looking for a safe haven in stormy monetary conditions - including Cambodia, Ecuador and Panama - and sterlingisation would work for Scotland.39 It would be the right solution because Scotland has successfully lived in a currency union with England and Wales for three hundred years. Current expectations of inflation and wage settlements are consistent with an enduring exchange rate link. Scotland would not be joining, as were the members of European Monetary Union, a new currency arrangement. Scotland has less need than in the past for subsidies from England to offset adverse shocks specific to Scotland because changes in the industrial structure of both Scotland and England, with the decline of heavy manufacturing and mining and the decreasing contribution from North Sea oil, mean that the two economies tend to move together. Nor would Scotland be faced with a substantial burden in the event of another banking failure. It is true that under sterlingisation major banks in an independent Scotland would have to unscrew the brass plates at their legal headquarters in Edinburgh and move them to London. Effectively, Scotland would have only foreign banks. As a consequence, Scotland would need no ability to act as a lender of last resort to those banks. That role would continue to be performed by the Bank of England, just as it does today for UK banks, such as Barclays, with overseas banking operations. But there is no reason to suppose that there would be any significant change in the number or location of jobs in banks in Scotland - the economic incentives to locate jobs in different places would be unchanged.40

Of course, it is always possible that over decades the economic links between the two former partners could diminish. But that is for the distant future; in the short term, sterlingisation is a perfectly feasible solution. In brief, despite the positions of the two sides, the currency question does not need to be at the centre of the debate on the future of Scotland. Independence was, and remains, a question about political identity. Until that issue is resolved, and this writer would be extremely sad to see Scotland choose to leave the Union, the fate of the United Kingdom will remain uncertain. In the General Election of 2015, the Scottish Nationalists won fifty-six out of fifty-nine seats in Scotland. So independence will remain a live issue. If, for example, the UK as a whole were in the future to vote to leave the European Union, while in Scotland a majority voted to remain a member, the clamour for independence would be even more difficult to resist than in 2014.

What do these three examples tell us about the relationship between nations and monies? As we saw in Chapter 2, the key role of governments is to supply the right amount of money in good times in order to avoid the extremes of hyperinflation on the one hand, and depression on the other, and to create emergency money in bad times. In both cases that involves political judgements in the face of radical uncertainty. In good times, monetary policy combines an inflation target, whether implicit or explicit, with a policy for how quickly to react to temporary disturbances to inflation and growth. Judgements about the desirable long-term inflation rate, and the trade-offs between inflation and output in the short term, are inherently political. In bad times, decisions about how much emergency money to create and to whom it should be distributed are highly political, as the popular anger following the financial bailout of banks in the crisis revealed. Institutions, whether national or supranational, are important ways of embodying these political judgements so that monetary management, in good times and bad, can be effective. Moreover, trust in government is a crucial component of successful monetary arrangements.

Traditional economic arguments about ‘optimum currency areas’ - trading off the loss of flexibility in adjusting to shocks from having your own currency against the greater trade intensity that stems from an integrated monetary area - played only a minor role in shaping monetary arrangements in Europe, Iraq and Scotland. Monetary integration in Europe was driven by a political agenda, and in some cases a belief that economic problems flowing from the common currency would force faster political integration. In Iraq, market prices revealed the importance of political institutions in determining the value of a currency. And in the debate leading up to the Scottish referendum, neither side was prepared to embrace the obvious economic solution to the currency question for fear that it would undermine their political case. In both Iraq and Scotland the immediate questions have been answered. But in the euro area the fight for survival has become a battle between politicians and arithmetic. Although the future outcome is unknowable, history is on the side of arithmetic. The tragedy of monetary union in Europe is not that it might collapse but that, given the degree of political commitment among the leaders of Europe, it might continue, bringing economic stagnation to the largest currency bloc in the world and holding back recovery of the wider world economy. It is at the heart of the disequilibrium in the world today.

The French ambition to curtail the economic power of Germany, and especially its central bank the Bundesbank, by drawing it into a monetary union that would be controlled by French civil servants has failed. The French economy is weaker than that of Germany, and monetary union has increased, not reduced, Germany’s political dominance. Responsibility for the economic conditions in other member states will be laid at the door of Germany. The idea of a federal union was intended to represent the birth of a new Europe, born out of the common experience of defeat and occupation during the Second World War among all the original members of the European Economic Community. Attempts to recreate the Holy Roman Empire have often appealed to a European elite, but have foundered on the resistance of its peoples. The relationship between nations and their money reflects politics more than economics. And the same applies to the relationship between nations and their banks.