Scottish Affairs CommitteeSupplementary written evidence submitted by Iain McLean, Professor of Politics, Oxford University

1. As promised during oral evidence on 7 March 2012, I am pleased to supply the Committee with a note on the short-lived Czech-Slovak currency union of 1993.

2. Czechoslovakia came into existence in 1918 largely due to the efforts of its first federal president Tomas Masaryk.

3. The Czech Lands (Bohemia and Moravia) had many features in common with Slovakia. Their languages are mutually comprehensible; their economies developed similarly in the democratic period of 1918–38.

4. However, they also had cultural differences. Both had been part of the Austro-Hungarian (Hapsburg) empire; however, the Czech lands had been governed from Austria, and Slovakia from Hungary. The Roman Catholic Church commanded more loyalty in Slovakia than in the Czech Lands.

5. During the Second World War, the Czech Lands, minus Sudetenland, became the Protectorate of Bohemia and Moravia, under direct German occupation. Slovakia was governed by a puppet clerical regime.

6. The reunited Czechoslovakia came fully under Communist control in 1948. The “Prague Spring” of 1968 was led by a Slovak, Alexander Dubček, but ended in the Warsaw Pact invasion of August 1968.

7. In the “Velvet Revolution” of 1989, Czechoslovakia became a federal parliamentary democracy. Its first elected President was one of the leaders of the Velvet Revolution, Vaclav Havel.

8. The parliamentary elections of 1992 revealed a complete disjunction between the parties gaining seats in the Czech Lands and those gaining seats in Slovakia. The dissolution of the federal state was agreed between the party leaders—Vaclav Klaus in the Czech Lands and Vladimir Meciar in Slovakia—without a referendum in either territory. President Havel resigned in protest at what has become known as the “velvet divorce”.

9. The agreed division of the country into the independent states of the Czech Republic and Slovakia took effect on 1 January 1993. One of the terms of the “divorce” was a continued currency union. However, the union lasted only about five weeks. It broke up in early February 1993.

10. The fiscal and monetary institutions set up by the divorcing parties are described as follows in an econometric study made available to the Committee1:

To mitigate the economic effects of the split, the Czech Republic and Slovakia retained a common currency, customs union and common labor market. While the customs union and freedom of movement of labor were intended to remain in place indefinitely, the monetary union was conceived as a temporary measure. Nevertheless, the two sides agreed to retain it at least for the first six months of 1993 and then consider further extensions. However, either side could withdraw from the union in case of the following developments: ¨ fiscal deficit of either republic exceeded 10% of budgeted revenues;—foreign exchange reserves of either republic fell below one month’s worth of its imports;—inter-republic capital transfers exceeded 5% of total bank deposits; and—Monetary Committee (see below) could not reach an agreement on fundamental monetary-policy issues. The State Bank of Czechoslovakia (SBCS) ceased to exist with the demise of the federation, and instead both republics established their own central banks. For the duration of monetary union, so-called Monetary Committee was charged with determining monetary policy. The governors as well as two senior officials from each central bank were members of the Committee and monetary policy was decided by simple majority vote. The policy was then to be implemented by both central banks in accord with the decisions of the Monetary Committee.

11. After the break-up of the currency union, in July 1993, the Slovak central bank devalued the Slovak crown by 10% from its starting parity with the Czech crown. Both countries were part of the central-European wave of accession to the EU in 2004. Slovakia joined the Euro in 2009. The Czech Republic has not. It appears neither to have a current intention to join nor to have been successfully coerced by the Eurozone countries into an early commitment to join.

12. The comprehensive econometric study made available to the Committee has established that in 1993 the Czech Republic and Slovakia met many of the conditions for an optimum currency area. These include: economic shocks in the two territories were positively correlated; high ratio of mutual trade to trade with the rest of the world; no barriers (including cultural or linguistic barriers) to inter-territory mobility; both territories were small open economies.

13. On the other hand, Slovakia had considerably higher unemployment than the Czech lands and had been more heavily industrialised in the Communist era. It therefore had a higher proportion of capital-goods industry that was not competitive in world markets. Although after 1989 there were no barriers to labour mobility, there was not much of it. The effects of these imbalances were mitigated by fiscal transfers from the Czech lands to Slovakia. Their drying-up in 1993 worsened the short-term relative position of Slovakia.

14. The imbalances mentioned in the last paragraph were sufficient to lead to immediate speculation about the likely collapse of the currency union and the relative decline of the Slovakian currency and Slovakian reserves. This became a self-fulfilling prophecy within days of the creation of the currency union. For instance, throughout January 1993, many Slovak firms and individuals transferred funds to Czech commercial banks in expectation of Slovak devaluation shortly after the split.

15. The break-up of the currency union was agreed by the parties on 2 February 1993 and implemented on 8 February after an imposed freeze on movement of funds from 4 to 7 February.

16. The relevant part of the study cited in paragraph 10 concludes:

It seems that political factors played crucial role in determining the break-up of Czechoslovakia. This view is consistent with the work of authors who stressed the preeminent role of political factors in creating and sustaining monetary unions. ... According to Machlup (1977, p.71), “What ultimately counts, however, is that all members are willing to give up their independence in matters of money, credit and interest. Pragmatically, therefore, an optimum currency area is a region no part of which insists on creating money and having a monetary policy of its own”.2

17. If there is a lesson for an independent Scotland, it seems to be that, even in an optimum currency area such as Scotland and the rest of the UK, markets would force any currency union apart unless the conditions specified by Machlup are met.

March 2012

1 J. Fidrmuc and J. Horvath, “Stability of Monetary Unions: Lessons from the Break-up of Czechoslovakia”, 1998. Later published in Journal of Comparative Economics 27: 4, 1999, pp. 753–781.

2 Fidrmuc and Horvath, p. 13, citing Machlup, Fritz (1977), A History of Thought on Economic Integration, New York: Columbia University Press.

Prepared 4th May 2012