(PDF Version)
I am very pleased to be a
participant in this ECB Central Bank Conference on the tenth anniversary of the
creation of the euro and of the European Economic and Monetary Union (EMU).
While it is difficult to specify the conditions for an optimal currency area,
it is clear that the eurozone has been a very successful currency area. The
euro was launched without serious problems and the ECB has succeeded in
achieving the low inflation rate that is its single policy mandate. The desire
of other countries to join the eurozone is further evidence that it is doing
something right. Rather than trying to
define an optimal currency area or to state the conditions for an optimal
currency area, I think it is better to ask the question: When is it in the
interest of an outsider to join an existing currency union? And when is it in
the interest of the existing members to add that outsider? Of course, this can
be applied to the initial decision of any two or more countries to form a
currency union. I will begin by reviewing
the advantages of a currency union from the point of view of the potential
entrant and of the receiving group. I will then discuss two negative aspects of
a currency union and examine the economic conditions that affect the
seriousness of these negative aspects. Traditional Advantages of a Currency
Union Since this session is
subtitled An Academic View, I will begin with the three standard textbook
advantages of a monetary union. Currency
convenience. A traveler in the eurozone does not have to carry a
different currency for each county that he will visit. This is an advantage to
potential joiners, to the receiving group, and to outsiders like myself. The
importance of this is not large in todays world of credit cards and ATMs. Price comparability. With a single
currency, a shopper in one country can easily compare the price of a particular
good in different places, thereby minimizing the cost of purchase and
strengthening the efficiency of the market. This too is a potential gain both to
the joiner and to the existing group. But I have never understood why this is
considered significant. The housewife in Madrid cannot shop for her daily bread
in Frankfurt while the wholesale buyer has always been able to compare the
prices of steel that were stated in Spanish pesetas and German marks with the
help of a pocket calculator. Cross border
investment. A single currency eliminates the direct
exchange rate risk of cross-border investment within the currency union. This
also is a potential gain to both the joiner and the existing group. Each can
invest in the other without worrying about the potential loss if the exchange
rate changes adversely. To the extent that this causes cross-border investment
to occur that would not otherwise have happened, it presumably increases the
efficiency of the international allocation of capital. But the amount of this
gain is reduced to the extent that firms would otherwise hedge that currency
risk by borrowing in the host country to finance their cross-border fixed
investment and would use currency futures to hedge the currency risk of
cross-border portfolio investment. Transition Gains The academic literature on monetary
unions focuses on the continuing
advantages and disadvantages of membership. In practice the creation of the
European Monetary Union demonstrated that there can be significant transition
gains for some of the joining countries. Before they joined the EMU, several
countries had high inflation rates and correspondingly high rates of interest.
The requirement to reduce inflation and interest rates as conditions of
membership gave these countries the political ability to make these healthy
changes. Once in the EMU, the lack of independent national monetary policies
preserved the low inflation. The EMU membership criteria imposed
on those who would join the EMU also included a reduction in the fiscal deficit
and in the national debt. Although not all applicants satisfied these standards
at the time of entry, their attempts to do so did initially help to reduce
government spending and to limit fiscal deficits. Five Additional Persistent Gains for
Joiners As I look at the EMU experience I see
five additional ongoing gains that accrue to those who join. Inflation
Discipline. Although not every monetary union has a commitment to low
inflation, the EMU has had one from the beginning with the ECBs single goal of
price stability. Countries with a tradition of high inflation, often driven by
union wage demands, benefited from the discipline imposed by EMU membership.
Unions recognized that wage increases in excess of productivity gains could not
be absorbed by an exchange rate adjustment but would lead to a loss of
competitiveness and reductions in employment. This gain to the joiners who had
previously had high inflation rates did bring with it a risk to the low
inflation members. Since monetary policy in the EMU is set by a consensus of
all member countries, there was the danger that an increase in the number of
countries with a history of high inflation could lead to a more inflationary
monetary policy for the union as a whole. Fortunately that has not happened in
the EMU. Exchange Rate
Discipline. Any monetary union automatically prevents member countries
from seeking to gain competitive advantage by currency devaluations or to
offset excess wage increases in this way. This is closely related to the
inflation discipline but goes beyond it since it is implicit in any monetary
union. It is a gain to those countries that had a history of devaluations but
a risk to those existing member countries to the extent that there comes to be
increased pressure to devalue the common currency. Lender of Last
Resort. Commercial banks always have the potential need for a lender
of last resort when they experience a liquidity problem. Under those
circumstances, central banks do provide liquidity against illiquid collateral.
In this age of global banking, the needs of a domestic bank or of a group of
domestic banks may exceed the appropriate lending ability of the national
central bank and the fiscal capacity of the national government. This is an
even greater problem if the commercial bank needs foreign exchange. Shifting
from the resources of a single national bank to the resources of the central
bank of the monetary union provides a more powerful lender of last resort.
This is an advantage to any country that joins but is a potential risk to the
existing members if the resulting lending is against overvalued collateral. Expertise. Although some small
countries have a rich supply of wise economists and skilled bankers, not all of
them do. The complex decisions of monetary policy and banking supervision can
benefit from the larger pool of talent that can serve on the monetary policy
board of a multi-country union and on the supervisory and research staffs of
the central bank. Political Union. A monetary union need
not be a precursor of a political union. But the EMU and the euro were seen by
many in Europe as ways of strengthening the European union and developing
support for a stronger political union. If individuals carry euros in their
pockets instead of French francs or Italian lira, they would be more likely to
think of themselves as Europeans. If they saw the power of the central banks
shift from their own national capitals to Frankfurt, they would see the
European Union as a more significant political force. For those who favored
this transition to a stronger political union, the creation of the monetary
union and the single currency were advantages. Disadvantages of a Currency Union The currency union implies a single
monetary policy and a single exchange rate for all member countries. A country
that joins a currency union therefore gives up the opportunity to select a
monetary policy that it regards as optimal for its own circumstances.
Similarly, the countrys exchange rate cannot respond to the market forces by
which changes in technology, taste, and the behavior of other countries affect
its international competitiveness. A country that considers joining a
currency union must weigh these disadvantages against the advantages that I
have described in the earlier part of these remarks. This balancing
will differ from country to country. Each country must consider the extent to
which it can expect to gain from those advantages and the extent to which it
would be disadvantaged by the single monetary policy and single exchange rate. The adverse effect of the single
monetary policy and single exchange rate will depend primarily on four
conditions. Industrial
similarity. If all of the countries in the currency union had the same
industrial composition and were subject to the same shocks to technology and
demand, the lack of individualized monetary policy and differential exchange
rate movements would be irrelevant. A country that considers joining should
evaluate the extent to which a monetary policy designed for the currency union
as a whole would be the best one for itself. We see in the EMU substantial
differences among countries in the distribution of industries that are
reflected in differences in unemployment rates and in trade balances. Labor Mobility. A fall in demand in a
particular country or region will lead to less unemployment if the labor force
is geographically mobile and can shift to other areas where demand is stronger.
This is one way in which the United States has been able to cope with cyclical
and structural changes in demand. The ability to achieve such labor mobility
in a currency union depends on several features. The variety of languages
clearly inhibits labor mobility within the euro area. Labor regulations, union
restrictions, and licensing rules may also impede such geographic mobility. Fiscal Structure. Fiscal policy is important
in two ways: the role of the central fiscal authority and the freedom of the
individual national fiscal authorities. In the United States, the central
government collects about two thirds of all taxes and an even larger part of
cyclically sensitive income and profits taxes. When demand falls in a
particular part of the country, the amount of taxes paid from that region to
the central government falls. This automatic fiscal policy dampens the local
decline in net income and therefore stimulates demand relative to what it would
otherwise be. That helps to compensate for the lack of an independent monetary
authority for the region. In a currency union with a very small central fiscal
authority, like the EMU, there is no such fiscal counterbalance to local swings
in domestic demand. Members of the currency union can of
course vary national taxes and spending to provide a local stimulus to offset
declines in demand. But this ability to run deficits creates a problem for the
currency union as a whole. Because there is a single currency, large fiscal
deficits in any single country do not create the market feedback in the form of
higher interest rates or a weaker currency as it would if the deficit country
had its own currency. Although there are some relatively small differences in
national interest rates, the primary effect of any countrys fiscal deficit is
diluted and spread over the entire currency union, causing the common interest
rate to rise and the overall currency to decline. While this is an advantage for the
country that alters its domestic policy, it is a disadvantage for the currency
union as a whole. That led to the Stability and Growth Pact that, in
principle, limits the extent of any countrys fiscal deficit. Some rule of
that type is a necessary feature of any currency union in which fiscal actions
remain decentralized among the member governments. That limit on each countrys
fiscal policy is a further disadvantage for countries that consider joining a
currency union. Willingness to
Sacrifice. The potential success of a currency union depends on the
willingness of the member countries to accept what the monetary authority
regards to be best for the group of countries as a whole. At times, that will
mean a policy that is directly counter to the interest of specific countries
within the currency union. The willingness of those countries and of their
voting publics to support a common policy that is clearly against their
interest is a critical feature that will govern the long-term success and
survival of any currency union. The Current Challenge The first decade of the EMU has been
a clear success. But it is about to be challenged by more difficult
conditions: a financial crisis and sharply declining economic activity on a
scale that exceeds anything that Europe experienced in the past decade. Not all EMU countries will be
affected equally by the evolution of the European economy or by the policies of
the ECB. Some governments or political parties within countries will wish that
they had more control over their monetary policy or more ability to pursue a
very aggressive fiscal policy. Because of a limited willingness to
make sacrifices for the benefit of other EMU nations or for the EMU as a
system, some of those governments or politicians may seek to exit the EMU or
may threaten that they will do so unless policies are changed. In short, the next few years will be
a very challenging time for the ECB and for the European political process. Cambridge, MA November 2008 *
Professor of Economics, Harvard University. These remarks were delivered at the
ECBs Fifth Central Banking Conference on November 14, 2008 in Frankfurt.