The Quebec election and the perceived likelihood of a majority Parti Québécois government has provoked much talk of the prospect of another referendum on independence. So far, the only firm promise that Pauline Marois has made is to produce a white paper on the topic of an independent Quebec. This initiative will almost certainly follow the paths laid out by previous exercises, but there’s one topic where the project needs a fundamental rethink: what currency would an independent Quebec use?
In retrospect, the discussion of monetary policy during the 1995 referendum campaign was alarmingly superficial. Debate revolved almost exclusively around whether or not the Rest of Canada could or would prevent an independent Quebec from carrying out the Yes campaign’s promise to continue to use the Canadian dollar.
These questions are beside the point. Firstly, there is almost nothing that Canada can do to prevent another country from using its currency. Secondly, there’s little reason to try. If anything, the rest of Canada would stand to gain: it could extract a (small) seigniorage tax from Quebec.
The real question is why Quebec would want to use the Canadian dollar in the first place. The government of an independent Quebec could be expected to assume a share of the federal debt roughly equal to its share of the population. When the existing provincial debt is added, it would produce a total of roughly 90% of Quebec’s GDP—all denominated in a currency it did not control. By not adopting its own currency, an independent Quebec would be depriving itself of a lender of last resort. If the federal government were to find itself unable to borrow, the Bank of Canada can and would step in to buy its debt. The Bank of Canada would be under no such obligation to do the same for the government of another country. Not only would Quebec have high debt levels, it would face higher borrowing costs as investors demand higher returns to compensate for the risk of default.
From Quebec’s point of view, the best scenario has traditionally been a monetary union. In 1995, it was easy enough to point to Europe: the Maastricht Treaty and its commitment to create the euro had demonstrated that it was possible for different countries to agree to a monetary union. But thanks to the euro experiment, we know a lot more about how monetary unions work—and we also know what happens when countries barge ahead with poorly-thought-out monetary unions.
One of the problems with the euro project was that unlike the Bank of Canada and other national central banks, the European Central Bank was not given the authority to act as a lender of last resort. This was a deliberate omission: Germany did not want to use a currency whose value could be inflated away by a bailout of a more profligate country. Instead of setting up a lender of last resort, the Maastricht Treaty’s conditions on government debt and deficits were designed to make one unnecessary.
As we all know, this structure did not survive its first test. Even before the recession, the Maastricht limits were discarded when they became inconvenient to France and Germany. More recently, the hardest-hit countries of Southern Europe lurched from debt crisis to debt crisis until the ECB finally decided to act as a de facto lender of last resort.
With a debt-GDP ratio comparable to that of pre-crisis Italy, an independent Quebec could scarcely afford the luxury of doing without a lender of last resort. But it is extremely unlikely that the rest of Canada would agree to enter a monetary union in which the Bank of Canada played that role for both countries. The relatively large size of the Quebec economy compared to the rest of Canada’s would mean that a Quebec debt crisis could have significant inflationary consequences for the RoC.
More generally, a RoC-Quebec monetary union is unlikely to satisfy the conditions for an optimal currency area. (It’s arguable that the current Canadian monetary union doesn’t satisfy them, either.) For example, one criterion is the existence of system that transfers income from areas that are doing relatively well to other regions. In Canada, this involves more than government-to-government payments: it includes unemployment benefits and salaries paid to federal workers. In 2012, these amounted to a net transfer of $16 billion from the ROC to Quebec – 4.3 per cent of its GDP (pdf - Table 4.2 on page 46). Transfers of this size are still unthinkable in Europe, just as they would be for a RoC-Quebec monetary union.
Of course, just because a monetary union is poorly-designed doesn’t mean that it will collapse. The euro continues to survive, even though the recent recession would have very likely been far less harsh if it had never been adopted in the first place. The members of the eurozone see the common currency as a step towards a deeper political union, and they are evidently willing to accept a high economic cost in order to advance that goal.
There would be no such political support to sustain an eventual RoC-Quebec monetary union. There is a world of difference between viewing a monetary union as a step towards a stronger political union and seeing it as a transition to political disintegration.