Monetary sovereignty is a seductive drug
Monday 13 February 1995
In fact, the idea that money and national sovereignty should inevitably be inter-linked is quite modern. Nation states existed for millennia while money was dug up from gold and silver mines, and for several hundred years while it was issued in paper form by goldsmiths or private banks. The development of central banking, with the nation in effect taking the monopoly power to issue banknotes, is a phenomenon only of the last 150 years.
In Britain, the Bank Charter Act of 1844 recognised the Bank of England as the central note-issuing authority, but it was not until the First World War that the Bank - still a private institution - issued large quantities of notes without the backing of gold. And only in the inter-war period did the central bank fully recognise its ability, through acting as a lender of the last resort, to manipulate the economy by altering interest rates.
So monetary policy as we understand it today is far too recent a flower to be called indispensible to nationhood. But seigniorage, a monopoly to print banknotes, is a seductive power once it has been recognised, and a difficult one to give up. For one thing, it enables a government to exchange pieces of paper for real goods and services. (In fact, the Bank of England was established in 1694 because the government wanted to use pieces of paper to finance a war in the Low Countries.)
Nowadays, the note issue is tiny compared to the total of government spending, so this direct form of seigniorage is not very important. But the power to issue banknotes still lies at the heart of the ability of the banking sector to create credit, and therefore to sustain inflation.
For any entity like the government, which issues vast quantities of debt, denominated in fixed nominal quantities (ie gilts), the power to inflate is extremely important. As Britain discovered in the mid-1970s, an unanticipated burst of inflation reduces (or "monetises") the real debt burden, and is therefore equivalent to an invisible increase in taxation.
It is the polite way to repudiate debt. Similarly, the power to control interest rates and economic activity, however haphazard, can be used to get the economy out of sticky corners. Policy mistakes, or private sector calamaties, which result in deep recessions and widespread bankruptcies, can be offset or minimised by reducing interest rates and increasing the availability of credit. This power was used in 1992-93 by many European countries after the break-up of the exchange rate mechanism, and it is chilling to think what might have happened in Sweden and Italy had it not been available.
Strangely enough, the trend across the world in the past decade has been voluntarily to restrict the use of these monetary powers. Like most seductive drugs, the manipulation of monetary control by the nation state has had adverse side-effects.
The private sector has come to recognise that governments can wield such powers, and has taken out insurance against their potential use by demanding much higher real interest rates on debt. And governments have discovered that it is more difficult and costly to control inflation if the private sector expects a counter-inflation policy to fail. Monetary credibility is a priceless asset.
As these points have sunk in, many governments have engaged in unilateral monetary disarmament by handing over their weapons to independent central banks. No one claims that this involves a fundamental loss of national sovereignty, since everyone knows that in extreme conditions governments would direct the central bank to inflate.
The safety valve therefore remains in national hands. The more independent the central bank, the higher the political hurdle which needs to be jumped before the government would resort to inflation, but the ultimate safety valve would still be there.
How does all this relate to EMU? Clearly, a decision to hand over monetary policy not just to an independent entity within the nation state, but to an independent entity outside it, is likely to be a more profound step. Two particular differences should be noted.
First, a European central bank would be unlikely to come to the rescue of an individual national economy which faced difficulties peculiar to itself, so the safety valve of inflation could only be used by leaving the monetary union and re-establishing national control over monetary policy. This could well prove to be a higher hurdle than wresting powers back from an independent central bank within any given nation state. Under most normal circumstances, this would probably increase the credibility of monetary policy, though it might also lead to severe instabilities of the type which occurred in 1992 when the ERM suddenly blew up.
Second, any member of a monetary union needs to be acutely aware of the problems that can arise from other members of the union, since they too would lose the safety valve of inflation. Stronger members of the union might face political demands for fiscal transfers from weaker members, such as Italy, Spain and Sweden, who would no longer be able to monetise their own excessive debt.
We should not enter a monetary union with economies which are inherently unsound - whether through excess government debt, or high rates of structural unemployment - since they are all too likely to require bursts of the inflationary drug to make their predicaments tolerable to their electorates. Once inside EMU, they may blame the union for their economic problems, and ask for compensation.
But Germany, France and the Benelux countries are no more likely to hit such problems than we are. When contemplating a monetary union with these countries - and for the foreseeable future we should certainly contemplate nothing wider - we do not need to worry about fiscal bail-outs. But we do need to consider the following questions.
First, how much additional monetary credibility would we gain by extending monetary disarmament beyond our own shores, rather than simply having an independent central bank in the UK? Second, how likely are we to need to use the safety valve of inflation at a time when the rest of the monetary union does not need to? Third, if we ever do need to use this safety valve, would it be possible in extreme conditions to wrest monetary control back to the UK? And fourth, if this were possible, how far would it undermine the entire credibility of the monetary union?
It is less than a century since nation states recognised the full powers which the lever marked "monetary policy" bestows upon them. It is about 20 years since they started to worry about the dangers of using these powers, and about 10 since they began voluntarily ceding them to other bodies. But no country has yet entirely ceded these powers to an untried foreign quango, which is what the Maastricht Treaty invites us to do.
My heart has always been with the pro-Europeans. But on this issue my head has more than a few nagging doubts, and these have become much greater since the ERM debacle. I did not expect that to happen, and cannot entirely shrug off the fact that it did.
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