By Paul Bergin
When economists such as robert mundell were theorizing about optimal monetary unions in the middle of the twentieth century, most people regarded the exercise as largely hypothetical. But since many European countries established a monetary union at the end of the century, the theory of monetary unions has become much more relevant to many more people.
Definitions and Background
The ability to issue money usable for transactions is a power usually reserved by a country’s central government, and it is often seen as a part of a nation’s sovereignty. A monetary union, also known as a currency union or common currency area, entails multiple countries ceding control over the supply of money to a common authority. Adjusting the money supply is a common tool for managing overall economic activity in a country (see monetary policy), and changes in the money supply also affect the financing of government budgets. So giving up control of a national money supply introduces new limitations on a country’s economic policies.
A monetary union in many ways resembles a fixed-exchange-rate regime, whereby countries retain distinct national currencies but agree to adjust the relative supply of these to maintain a desired rate of exchange. A monetary union is an extreme form of a fixed-exchange-rate regime, with at least two distinctions. First, because the countries switch to a new currency, the cost of abandoning the new system is much higher than for a typical fixed-exchange-rate regime, giving people more confidence that the system will last. Second, a monetary union eliminates the transactions costs people incur when they need to exchange currencies in carrying out international transactions. Fixed-exchange-rate regimes have been quite common throughout recent history. The United States participated in such a regime from the 1940s until 1973; numerous Europeans participated in one until the creation of the monetary union; and many small or poor countries (Belize, Bhutan, and Botswana, to name just a few) continue to fix their exchange rates to the currencies of major trading partners.
The precedents for monetary unions prior to the current European Monetary Union are rare. From 1865 until World War I, all four members of the Latin Monetary Union—France, Belgium, Italy, and Switzerland—allowed coins to circulate throughout the union. Luxembourg shared a currency with its larger neighbor Belgium from 1992 until the formation of the broader European Monetary Union. In addition, many former colonies such as the franc zone in western Africa or other small poor countries (Ecuador and Panama) adopted the currency of a large, wealthier trading partner. But the formation of the European Monetary Union by a group of large and wealthy countries is an unprecedented experiment in international monetary arrangements.
Optimal Currency Area Theory
Forming a monetary union carries benefits and costs. One benefit is that merchants no longer need worry about unexpected movements in the exchange rate. Suppose a seller of computers in Germany must decide between buying from a supplier in the United States at a price set in dollars and a supplier in France with a price in euros, payment on delivery. Even if the U.S. supplier’s price is lower once it is converted from dollars to euros at the going exchange rate, there is a risk that the dollar’s value will rise before the time of payment, raising the cost of the computers in euros, and hence lowering the merchant’s profits. Even if the merchant expects that the import price probably will be lower, he may decide it is not worth risking a mistake. A monetary union, like any fixed-exchange-rate regime, eliminates this risk. One effect is to promote international trade among members of the monetary union.
The same argument can be made for international investment. If a European investor is considering buying a computer manufacturing company in the United States, the value of profits converted from dollars to euros is uncertain. On the other hand, exchange-rate fluctuations could make international investment more appealing, in that they can be used strategically to lower production costs. For example, suppose the European investor above buys the computer manufacturing company in the United States, and suppose he already owns one in Europe. Then, when a dollar depreciation lowers relative production costs in the United States, he can shift production toward the U.S. facility; during times of dollar appreciation he can shift production toward the European facility. Although the overall theoretical effect on investment is unclear, international trade and investment are highly beneficial to society. To the degree that exchange-rate variability tends to discourage the volume of trade and investment, this can provide a rationale for stabilizing the exchange rate.
How strong is the effect of exchange-rate variability? Regarding trade, most empirical estimates are close enough to zero to question if there is any effect; regarding investment, estimates conflict as to whether the effect is positive or negative. The apparently small effect of exchange-rate uncertainty might be due to the fact that international financial markets provide people with opportunities to hedge against the risk of exchange-rate changes: they can buy or sell in the currency futures markets.
But recall that a monetary union goes beyond simply fixing the exchange rate, and it appears to offer additional benefits. For example, it also eliminates the need for merchants to exchange currencies and pay the associated transactions costs. Empirical evidence indicates that while simply reducing exchange-rate uncertainty may not noticeably affect trade, adopting a fully common currency can raise trade much more—approximately doubling it according to several estimates. It is not yet known whether these large effects directly reflect the reduction of transactions costs.
Balanced against the benefit of increased international trade is the cost of losing control over national monetary policy. Countries whose governments control their own money supply typically use monetary policy to influence the level of activity in the country’s economy. When, for example, the United States enters the downturn of a business cycle, growth slows and unemployment rises. The U.S. Federal Reserve increases the supply of money in circulation in order to reduce the interest rate. A lower interest rate, which lowers the cost of borrowing, stimulates consumption and investment spending, boosting production and counteracting the movement toward recession. Conversely, when the United States enters a boom of a business cycle, with high inflation, it pursues the opposite monetary policy. Because a monetary union has only one money, it must agree on a single monetary policy to address the business cycles of multiple countries.
How costly this loss is depends on institutional features of the particular countries involved. If Germany and Italy tend to have recessions at the same time, they can agree more often on a single monetary policy that accommodates the needs of both countries simultaneously. Even if Germany has a recession when Italy has a boom, this asymmetry can be accommodated if newly unemployed Germans move to Italy to take the newly vacant positions. Another way to mitigate this asymmetry is if Italy transfers income to help support unemployed Germans during Germany’s recessions, and vice versa during times of recession in Italy.
The European Case
Much of the theory of optimal currency areas is illustrated by the institutions of the U.S. economy, which might be viewed a type of monetary union in which fifty states have agreed to share a common currency. Although the severity of recessions in the United States can vary by region, there is significant labor mobility, with around 3 percent of the U.S. population moving from one state to another annually. Further, the federal fiscal system permits compensation across state lines. Economists have estimated that for every dollar lost in one region relative to another in a recent recession, up to thirty-five cents were transferred to the losing region from the rest of the country, in terms of lower income taxes paid to the federal government and extra unemployment benefits received.
By contrast, there is relatively little labor mobility between European countries. Only about 1 percent of Germans and Italians relocate annually between regions within their own countries, and even fewer move between the two countries. As yet, most taxes and fiscal expenditures are conducted at the national level, and so there is limited opportunity for cross-country compensation. Further, European countries have more distinct business cycles than those observed between U.S. regions.
Perhaps it is too soon to tell whether Europe satisfies the theoretical criteria for an optimal currency area. Now that the euro has been adopted, the euro-area economies may evolve to more closely match the criteria for an optimal currency area. It may be that business cycles will become more synchronized across Europe as trade linkages increase, or that labor mobility or fiscal federalism (EU transfers of wealth from one EU country to another) will develop over time. Further, it should be noted that much of the motivation for the monetary union in Europe was not economic, but political. Policymakers seem to value monetary union as a stepping-stone toward greater political integration, quite separate from its economic implications.
The development of monetary union in Europe was a gradual political process. Monetary union was a stated objective as early as 1969 (Werner Report), but it was not until 1989 that concrete steps were laid out for achieving this objective (Delors Commission). A controversial part of this process was the set of criteria for who could join the union, as set forth in the Maastricht Treaty of 1992. This included restrictions on the level of fiscal debts and deficits, as well as a requirement for exchange-rate stability and convergence of national inflation rates. The fiscal restrictions proved difficult for many of the participants and were loosely enforced. The monetary union formally began in 1999, though it was not until 2002 that the new currency began to circulate in physical form.
The European Monetary Union (EMU) has taken care in designing its institutions. The member countries’ national central banks have been fused together into the European System of Central Banks, with all money-supply decisions directed solely by the European Central Bank (ECB) in Frankfurt. A governing council with representatives from each member country decides monetary policy. The ECB’s charter states that controlling inflation, rather than smoothing business cycles, is its primary objective. The ECB is insulated from political pressure: the president is offered an eight-year term, and governing council members are prohibited from taking instructions from their home governments.
The European Monetary Union has experienced some bumps in the road, with an early change of president and disagreement on how strictly to enforce restrictions on the size of fiscal deficits of member countries. Depending on the experience in Europe, one might expect to see future proposals for the formation of monetary unions in other regions of the world.
Anthony de Jasay, For an Ever Closer Union, Econlib, October 2016
Nils Karlson, Public Choice and Statecraft in the Euro Crisis, Econlib, May 2021
Pedro Schwartz, Sound Money Through Monetary Competition, Econlib, May 2015
Lawrence H White on Monetary Constitutions, EconTalk podcast, March 2015
Tyler Cowen on the European Crisis, EconTalk podcast, December 2011