Monetary Unions

Forrest Capie, Geoffrey E Wood

• Publisher: Routledge
• Year: 2003
• ISBN:
  9781134420247
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The Economic and Monetary Union (EMU) in which some members of the European Union have joined, has prompted much discussion of monetary union. Most of this discussion has focused on the immediate issues, such as prospects for the Euro and the possibility of expanding the Euro-zone. This book stands back and considers the relevant theory or what lessons might be drawn from other unions that have been formed in the past as well as looking at EMU directly.

1 Introduction

Forrest H. Capie and Geoffrey E. Wood

This book comprises the papers presented at a conference on monetary unions held at City University, London, in May 1999, along with the comments on them by their discussants at the conference. Monetary union was a much discussed subject at that time, of course prompted by the Economic and Monetary Union (EMU) in which some members of the European Union (EU) have joined, and has remained so since then. Most of the discussion, though, has been focused on that particular union. Few authors have stood back and considered either the relevant theory, whatever that might turn out to be, or what lessons might be drawn from other unions that have been formed, some durable, some not, in the past. It is the aim of four of the papers gathered together in this volume to address these issues; and although the fifth does look directly at EMU, it does so with the aid of analytical tools not previously used on that subject.

This short introductory essay provides a brief guide to the book, sets out the main points of each paper, and concludes by setting out the overall points to emerge from the conference as a whole.

The theory of monetary unions originated with a short but very well known paper by Robert Mundell (1961).¹ The paper draws attention to the problems of monetary union across a large, geographically diverse area (problems possibly exacerbated by an issue Mundell does not discuss, the area’s encompassing several languages). In his paper, the one which opens this volume and which concentrates on analytical issues, Bennett McCallum considers Mundell’s paper, as well as subsequent, but still pioneering, papers by McKinnon (1963) and Kenen (1969). McCallum also touches on the theory of currency crises, and an aspect of the connection between fiscal and monetary policy.

What emerges very strikingly is how little that is operational economic theory has to say on this subject. That certainly does not mean that it has no contribution to offer – only that it cannot be directly applied to answer, for example, whether a particular country should join EMU (or of course any other monetary union). What it very clearly can do is provide guidance on the questions to address to past episodes of monetary union. That is exactly how it is used in the papers by Michael Bordo and Lars Jonung, Hugh Rockoff and Marc Flandreau. One of these unions, the USA (studied by Hugh Rockoff) was certainly a success — at least by one criterion, which is discussed in the comment (on McCallum’s paper) by Wood, and used by Anna Schwartz in her remarks on the Rockoff paper. Bordo and Jonung seek to draw lessons for EMU from the study of a wide range of unions, and Flandreau from the experiences of a particular (pre-1914) union. Only Roland Vaubel looks directly at EMU, and, applying public choice analysis, makes predictions for its future inflation and business cycle behaviour, and considers the consequences of various still prospective members actually joining. His very striking results are discussed in a little more detail below.

We now move on to the papers, following in our discussion the order in which they appear in the book (and were presented at the conference).

The first paper in the volume, by Bennett McCallum, deals with some theoretical aspects of monetary union. As is well known, the most obvious and fundamental tool to use in this area, optimum currency area theory, has so far proved non-operational. In his paper, McCallum reviews this theory and concludes that it is still in that position. The original article, by Mundell (1961), and the subsequent additions by McKinnon (1963) and Kenen (1969) have provided a list of factors relevant when deciding whether an area is optimal, but have got no further. Later work by Bayoumi and Eichengreen (1996, 1997) has gone some way beyond this, but only by producing rankings of suitability for membership of a particular union; they do not provide any way of deciding on the optimality of a union.

McCallum also discusses the history of the subject, and provides an explanation for its developing only in the 1960s; his explanation turns largely on the existence of a consensus in favour of a worldwide fixed rate system until the attack on that consensus by Milton Friedman in 1953.

In view of the comparatively limited guidance optimum currency area theory can give, what other tools of economic analysis are useful in the area?

McCallum proposes two. He considers the comparatively recently developed theory of currency crises. (He notes that this, too, dated really from Milton Friedman’s 1953 paper on flexible exchange rates.) This theory is relevant because it shows that a ‘fixed but adjustable’ exchange rate regime, such as the EU had for some years before going to EMU, is not viable in the long term. The reason is straightforward; so long as governments wish to retain the freedom to change their exchange rates, they by implication wish on some occasions to subordinate defending the rate to some other policy objective. Knowing this is in itself sufficient to expose the currency to attack. European countries, then, had to move from the ERM (exchange rate mechanism). (In which direction they moved, fixed or floating, was of course not preordained by that body of theory.)

The paper concludes with a brief appraisal of the fiscal theory of inflation — the theory which says that price level behaviour is determined by the stock of government bonds, quite independently of whatever the money supply is doing. McCallum rejects this theory, and thereby raises questions about the purpose of fiscal rules in EMU (or any other monetary union).

Bordo and Jonung look specifically at past experience for lessons that might be learned from previous unions for European monetary union. They first survey the experience of national monetary unions — that is, those involved in nation building – looking at three specifically: the United States, Italy and Germany. They then consider multinational monetary unions: the Latin Monetary Union and the Scandinavian Monetary Union. Some others that are noted are those that existed informally between Britain and some of its colonies in the nineteenth century. And then there are some close approximations to monetary union found in certain currency boards. These latter have become more common again recently, having been a popular institution in the nineteenth century. (The East Caribbean Currency Area is currently a multinational monetary union with a single monetary authority. Where formerly there was a currency board for the seven territories there is now a currency union.)

The strongest element in the formation of monetary unions in the past has been political. In the main they have been formed to facilitate political unification or in some cases the rationalisation of different currencies after political unification. Economic reasons can obviously play a part. Equally, the principal cause of the break-up of monetary unions (Soviet Union, Czechoslovakia, etc.) can also be found in political developments. It can be that within a political entity economic strains can develop between certain regions which can then result in the break-up of the political union.

From this survey of historical experience Bordo and Jonung draw some strong and important conclusions. The main one concerns whether or not EMU will be a national or multinational union. According to one view monetary union is being used to promote political union. Bordo and Jonung list a number of defects in EMU as it stands. These include the lack of a number of features normally found in a modern monetary system, such as lender of last resort, a central supervisory body, an accountable central bank and co-ordinated fiscal policies, and inconsistent requirements in monetary policy. They add that Europe is quite clearly not an optimum currency area. They judge, however, that EMU will move towards being a national monetary union. The likelihood is that when one region suffers a shock this will simply stimulate the moves for a larger central authority to carry out the necessary fiscal transfers to smooth the adjustment process. Their guess is that EMU will hold together and that based on historical experience it takes rather extreme circumstances such as war to break unions up.

That EMU is a political agenda rather than the economic agenda that is often presented has become more and more widely accepted. One discussant, Charles Goodhart both noted this, and was not so sanguine as Bordo and Jonung that the union would survive adverse shocks.

A major part of the economic analysis of monetary unions is concerned with whether or not the territories covered make, in the jargon, an optimum currency area. As noted in the opening paper this is not an easy concept to make operational. It is straightforward to list the basic requirements such as price flexibility, labour mobility, capital mobility and so on, but much more difficult to say at what stage the combined factors have defined an optimum currency area. The originator of the concept, Robert Mundell, has in fact come out in support of the idea that the different European states would certainly become an optimum currency area even if they are not one at present. There can perhaps be no denying that; but the questions would then be, how long would that take and might there be unacceptable costs to some parts of the territory along the way. This in fact is the question that Hugh Rockoff addresses in relation to the United States. The United States was a political union from an early date, and that would no doubt have smoothed the monetary experience. Nevertheless, the question can still be put — might some parts of the United States have been better off with their own currencies floating against the US dollar?

Rockoff traces US experience from the origins of the monetary union, which dates from the ratification of the constitution in 1788. Prior to that, currency varied among the different colonies. The central question that he puts is, might the United States have been better off if some of the regions had had their own currency? He shows that there were bitter disputes over the 150 years after ratification. Typically what happened was that one region would experience a shock — commonly a fall in demand for an agricultural product — and the local banking system would suffer, leading in turn to falling money supply and real income.

In the Civil War there were effectively three monetary regions: the East and the mid-West used greenbacks; the South had a confederate dollar; and the Pacific coast stayed on gold. But after the war there was a long struggle towards acceptance of reunification. Rockoff shows too that in terms of optimum currency area criteria some regions differed highly from others, and that in many ways they were separable currency areas.

The most extreme experience was the great depression of 1929–32. While the whole country suffered there were big differences. It was at that point, argues Rockoff, that important institutional changes were made such as the development of federally funded transfer programmes which ‘redistributed reserves lost through interregional payments deficits’. These and the increasing integration of the labour market helped to bring the United States closer to an optimum currency area. But the answer to the question ‘How long did it take the United States to become a optimum currency area?’ is roughly 150 years.

Marc Flandreau is perhaps best known for his work on bimetallism and the working of the French monetary system in the middle of the nineteenth century; and that of course included the relationship with the Latin Monetary Union. He raises here the question as to how useful the study of historical experience can be for guidance on the sustainability of modern monetary unions. He points out, correctly in our view, that most of the arrangements that went under the name of ‘monetary unions’ can be found in the nineteenth century when most countries adhered to some form of metallic monetary standard. So unions such as the Latin Monetary Union or the Scandinavian Monetary Union turn out on closer examination not to be monetary unions of the kind we currently have in mind but, rather, simply currency unions. The countries involved simply agreed to accept each others’ currency. Given that these were coins with specified metal content there was little to get excited about and much of the activity was already taking place without any formal agreement. These unions had no common monetary policy and no common central bank. There were other monetary unions. There were those of the Swiss states, the Italian Kingdoms and the German States. But these were of course essentially attempts at political union. The driving force was political union; and different currencies had to be rationalised in order to facilitate political union or as a sensible practice after political union was achieved, or some combination of both of these. Insofar as the European monetary union is supposed to be about separate states and not political union, these latter examples should be of little interest to us. And yet, as Charles Goodhart at this conference stressed, European monetary union is a political agenda and has been carried along with ‘devilish cleverness by a politically astute clique intent on achieving their own ends’.

Be that as it may, Flandreau tried instead to find an experience which might fit our purposes more closely — a monetary union between separate independent states; this is found in the alliance between Austria and Hungary. This was an arrangement whereby both countries surrendered monetary sovereignty to a common central bank but retained fiscal sovereignty. The Habsburg monarchy operated without the kind of agreement that exists in Europe today to keep public expenditure within certain limits. There were great pressures to raise public spending in the nineteenth century to promote economic development and it was left to the capital market to discipline the fiscal authorities. The ‘compromise of 1867’ was the agreement struck between the two countries for a period of ten years and reviewed regularly until 1917. Flandreau traces the monetary and fiscal experience of this union. He shows how the two states were continuously concerned about their reputation in the market. There was some competition over reputation and as they standardised their debt instruments the market could better read the price signals.

This is an extremely interesting use of history which escapes from many of the limitations that apply to studies of other monetary unions.

In his penetrating paper (updated to June 2002) Roland Vaubel applies public choice analysis – in particular the median voter theorem, the theory of the political business cycle and the economic theory of bureaucracy – to various institutional aspects of EMU. He is concerned with the behaviour of EMU institutions rather than directly with EMU itself, although, of course, the behaviour of the institutions clearly has implications for EMU. The institutions he focuses on are the European Central Bank (ECB) and the EU’s Council of Ministers. The results (to which Vaubel attaches a reminder that they are the mid-point of a confidence interval and not a precise forecast — a warning which of course all econometric work should carry) are striking. Whatever methods he uses produce significantly higher inflation than the current ECB target — the predicted rates all exceed 5 per cent pa. There will, as a result of the timing of elections, very likely be a boom between 2002 and 2004. The effects of the Euro on unemployment are ambiguous in sign but certainly distributed very unevenly across the area.

And what of EMU (and, of course, EU) enlargement? Vaubel considers both Eastern prospective members of the EU, and existing non-EMU countries in the EU. Here too the results are fascinating. Of the Eastern countries, only Slovenia and Hungary are well suited to EMU membership; and of all the current EU countries, the UK is the least suitable for membership. There are many more results in this fascinating paper. The two discussants express some reservations — as does Vaubel, who points out that ‘The analysis of this article — like most empirical research — is merely suggestive’. Doubts are raised both about aspects of the econometrics and about the relevance of certain parts of public choice analysis. Nevertheless the paper is important, and remains so even should every one of its predictions be falsified. Its fundamental importance lies in showing how the tools of a particular, and very specialised, area of economics can be applied, and in showing how very important they are. For the rigour of the analysis demonstrates persuasively that simply hoping or asserting that matters will work out well for some institutional design is insufficient. Supporters of the design must argue their case before putting the model they have designed into operation. Faith, hope and trusting that men of goodwill will always produce good results is not enough. Quoting from the conclusion of this paper gives a striking and important example of the dangers lying in that ‘blind optimism’ approach. ‘It is easy to agree on an inflation target and leave open how it might be attained. If it is not attained it might be attributed to factors other than monetary policy. After all, failure to attain the target will not be sanctioned.’

Conclusion

The papers that we have reviewed contain a great deal that is both interesting and enlightening on the subject of monetary unions. But the main general focus seems to be that there is as yet no body of analysis which can give guidance on the optimality of prospective unions. The theory is still, very much like the theory of customs unions, a collection of useful points and particular cases. Nevertheless, there is one point that runs through all the papers: the importance of the political dimension. The economic analysis of monetary unions, actual or prospective, is important; but carrying it out without consideration of political pressures and institutions would provide at best a partial and quite easily a misleading view.

Note

1 Mundell is sometimes hailed as the ‘father of EMU’. But he surely receives this title not on the basis of the above cited paper, but on the result of a much less well known one, ‘Some uncommon arguments for common currencies’, published in 1973. This subsequent paper, which focused on the possibility that with flexible exchange rates uncertainty about the future course of rates could disrupt the international capital market, has suffered neglect (compared at least to his 1961 paper) and has yet to be followed up.

References

Bayoumi, T. and Eichengreen, B. (1996). ‘Operationalising the Theory of Optimum Currency Areas’, CEPR Discussion paper 1484.

Bayoumi, T. and Eichengreen, B. (1997). ‘Exchange Market Pressure and Exchange Rate Management: Perspectives from the Theory of Optimum Currency Areas’ in Blejer, M. I. Et al., eds, Optimum Currency Areas: New Analytical and Policy Developments. IMF, Washington, DC.

Friedman, M. (1953). Essays in Positive Economics. University of Chicago Press, Chicago.

Kenen, Peter B. (1969). ‘The Theory of Optimum Currency Areas: An Eclectic View’ in Mundell, R. A. and Swoboda, A. K., eds, Monetary Problems of the International Economy, Proceedings of the Conference on International Monetary Problems held September 1966. University of Chicago Press, Chicago.

McKinnon, Ronald (1963). ‘Optimum Currency Areas’, American Economic Review, 53.

Mundell, R. A. (1961). ‘A Theory of Optimum Currency Areas’, American Economic Review 51.

Mundell, R. A. (1973) ‘Some Uncommon Arguments for Common Currencies’ in Johnson, H. G. and Swoboda, A. K., eds, The Economics of Common Currencies. Allen and Unwin, London.

2 Theoretical issues pertaining to monetary unions

Bennett T. McCallum

Introduction

The purpose of this paper is to review the economic theory relevant to the subject of monetary unions, in principle to provide a background for the remainder of the conference. This is a difficult assignment, for there is only a small bit of theory that is directly and strongly relevant to the topic, whereas the amount of theory that is of possibly significant relevance is huge – too large to cover in a single paper of moderate length. Accordingly, I have had to make some difficult and debatable choices regarding content.

The one theoretical topic that is of clear and direct relevance is the theory of optimal currency areas, since the basic purpose of that analysis is to specify conditions under which it is (or is not) economically advantageous ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Contributors
• Acknowledgements
• 1 Introduction
• 2 Theoretical issues pertaining to monetary unions
• 3 The future of EMU
• 4 How long did it take the United States to become an optimal currency area?
• 5 The bank, the states, and the market: an Austro-Hungarian tale for Euroland, 1867–1914
• 6 The future of the euro