Guest commentary by Steven Englander, global head of G10 FX Strategy at CitiFX
Many, and in some places most, marriages end in divorce, but people still find the institution attractive, even if the odds are not overwhelmingly in its favour and the costs of break-up are often extremely large. Moreover, not all marriages that survive can be viewed as happy ones. Many marriages that start in love (or lust) end as marriages of convenience, but they still remain marriages.
So it is with currency unions. History is littered with failed and faltering currency unions and writing about them has a strong appeal to some economists. As might be expected, economists are much more aware of the costs of currency unions than of their value. Nevertheless currency unions seem to have a strong appeal and not just in the last decade. I would argue that the better question is what the persistent appeal of monetary union is, despite the odds against their success, not why they fall apart.
In a world of capital mobility the cost of monetary instability is extremely high and the benefits in reducing risk premia are similarly high
To be sure, a variety of monetary unions have come and gone. The Latin Monetary Union existed for almost 60 years, the Scandinavian Monetary Union some 40 years, the German monetary union through the middle-part of the 19th Century to name a few1. While the tabulation of monetary union failures is on the surface distressing, many of those most frequently cited were ended by war, the Great Depression or similar extreme shocks.
The most famous monetary union, and certainly the broadest, was the gold standard which lasted from late in the 19th century to the Great Depression. There was no common fiscal authority to discipline the members, no global central bank to determine monetary policy and even ratings agencies were in their relative infancy. Many countries dropped it under pressure of World War I, but there was a longing to have it restored immediately after. Adherence was never perfect, but the surprise is how long and how strong adherence was, not how poor. And if there had been some agreement early in the Great Depression to have a general depreciation against gold (rather than have countries fall off one by one) it might have lasted even longer.
The counter argument is that those are exactly the shocks that monetary unions are meant to withstand, just as the US monetary union and other countries with control over their own monetary policy did. However there is a risk that the bar is not being set at the same level in determining failure of monetary unions and failure of the alternatives monetary framework. Many countries with no constraints on their monetary framework in the 19th and 20th centuries ended up with inflation, default and depression, sometimes through several episodes, without the ‘help’ of a monetary union.
Just as countries learned that crunching the money supply during depression did not work, members of monetary unions have learned not to have bimetallic standards (with their inherent contradictions) and not go to war with each other or be near bystanders to other people’s wars. The (lack of) political commitment is frequently cited as underlying the failure of monetary unions, but through much of history the countries that entered into currency unions were far from being best friends forever.
The current euro zone, hard as it is to believe, ranks relatively high on the scale of amity. It also seems to have learned relatively quickly that some degree of central supervision of fiscal plans is needed, and some fiscal solidarity is needed in crisis.
Given the political issues in many previous monetary unions and within many countries the question again may be why monetary unions are formed and survive, rather than why some fail. The answer may be that there is a belief that longer term economic and investment efficiency is impeded by currency volatility. Revealed preference suggests that the economies of scale in production complementary to stabilised monetary arrangements. Some small countries have succeeded in achieving remarkable economic gains, but most have seen benefit in being closely linked to a major currency zone. In a world of capital mobility the cost of monetary instability is extremely high and the benefits in reducing risk premia are similarly high.
The degree of integration of euro zone financial systems and economies is high. Even if it is not a perfect marriage, a marriage based on self-interest can be equally strong, as reading celebrity news frequently tells us. Even one country leaving would introduce an extended period of pseudo-currency risk premia reflected in rate spreads, asset pressures, and capital outflow for most of the countries that remain.
We see pressure on the euro in coming months from ongoing uncertainty about how the fiscal and financial problems will be resolved. We do not see the catastrophic decline that speculation on break-up or dropout would bring. Longer term US fiscal pressures match or exceed those of the euro and we would not extrapolate the euro’s pressures of the last six months into the future, even if they have not yet fully run their course.
Writer’s note: I would like to thank my colleague Jessica James with whom I have had extensive discussion on currency unions and who introduced me to the subject (but who is probably much less sympathetic to them than I am.)
1See Cohen, Benjamin. Monetary Unions. EH.Net Encyclopedia, edited by Robert Whaples. February 10, 2008. http://eh.net/encyclopedia/article/cohen.monetary.unions and the articles he cites.
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