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What Makes a Successful Currency Union?

Jamus Lim's picture

Market movers and shakers are beginning to seriously consider the possibility of a eurozone breakup (or, at the least, a Greek exit). Up till now, the voices arrayed against the euro have typically been euro-skeptics from the start---voices such as the four German professors who took the German government to court over its entry into the eurozone, euro perma-bear Marty Feldstein, and, most famously, Milton Friedman, who ventured that the euro would not survive its first crisis. The price of the euro---along with expected future prices---have responded accordingly (see figure).

Source: J.P. Morgan.

Notes: Exchange rate is spot rate for the EUR/USD and forward premium is the futures-implied 3-month forward premium.

Many commentators have adopted a "told-you-so" attitude to their analysis, raising the familiar refrain that the eurozone does not satisfy the classic conditions necessary for a successful monetary union: In particular, that Europe does not have sufficiently flexible labor markets (especially due to language and cultural differences), and that direct fiscal transfers between member states are undeveloped and, hence, unavailable for offsetting the inevitable growth differentials.[*] Without these policies, it is argued, the eurozone cannot continue (at least in its present form).

It is useful, then, to think about just how important these supposed sustainability mechanisms are. At some level, this question is somewhat rhetorical: Of course having such systems in place would enhance the stability of a monetary union that is not quite yet political. At another level, however, it is useful to know whether implementing an intra-EMU system of fiscal transfers, or introducing additional economic incentives to encourage intra-union labor mobility---both of which are likely to entail significant economic, political, and cultural costs---is necessary or sufficient for a successful common currency area.

Here we draw on the experience of another durable currency union: the Communauté Financière Africaine franc zone, a 65 year-old, 12-country currency union that has proved largely stable and durable (with the last countries having left the zone in 1974). However, the CFA zone is a much looser political union as compared to the EMU. As a consquence, the CFA, like the EMU, does not have an inter-governmental system of direct fiscal transfers. Nor does it possess a unified labor market within it; not only is free labor movement within the zone much more limited than Shengen, and member states such as Benin, Cote d'Ivoire, and Cameroon, all have distinct languages (although they share French as an official language, their common vernaculars differ), cultures, religious beliefs (on occasion), and levels of economic and political development. Through its history, the CFA franc zone has never undergone the same crisis of legitimacy that the eurozone is currently suffered through.

This comparison undoubtedly vastly simplifies matters for the sake of expositional convenience.[] Still, it appears that neither a system of fiscal transfers or an integrated labor market is necessary for a successful currency union.

What may account for the ability of CFA zone countries to appear to better be able to navigate asymmetric economic shocks to their economies? As developed economies, the public sectors of the troubled Euro Periphery countries (Portugal, Ireland, Greece, Spain, and, to a much lesser extent, Italy) are generally large, and social transfers of one form or another typically constitute a significant share of public expenditures, which are often funded by external debt. It is this large element of social insurance, along with the ability to borrow cheaply from international markets in order to fund such expenditures, that perhaps distinguishes the EMU countries from those in the CFA zone.

Ironically, then, it is precisely the relative maturity of the eurozone periphery economies---and the expectations that such maturity entails for their populace---coupled with the ostensible economic stability provided by a common currency that has made countries such as Greece and Portugal vulnerable to a runup in debt-financed public expenditures. This option is generally unavailable to developing economies, since global markets would generally not even extend credit to them in the first place.

Was participating in the EMU uniformly bad, then? This may be easy to claim on hindsight, when it is evident that it enabled a debt-fuelled binge that may not have been possible in the absence of such a union. But recent research does show that small countries with strong trading ties with larger partners---a circumstance that arguably could describe the pre-euro situation of Greece, Ireland, and Portugal---may benefit from giving up their currencies and joining a union. Similarly, other benefits to being a part of a currency union---such as increased credibility, macroeconomic stabilization, and enhanced trade---all certainly did accrue to the Euro Periphery countries. Balancing the two is the kind of question that policymakers will need to confront when they contemplate participation in a currency union---whether they are a developed economy, or a developing one.

*. It should not be forgotten, however, that indirect mechanisms for enabling such transfers do exist; the most (in)famous being the Common Agricultural Policy (CAP) of the EU, a systemwide structure of agricultural cross-subsidies. To the extent that, in any given country, agricultural production is procyclical, the CAP serves as a systemic automatic stabilizer.

. For starters, the CFA franc zone is not even a single union or currency, but two (the XOF and XAF unions) that are freely convertible against the euro but not against each other. The EMU is a far more complex economic area, which a much richer set of underlying institutional and legal frameworks, than the CFA area. As a pegged currency, both francs' values are not freely determined in global foreign exchange markets, unlike the euro. And perhaps most importantly, the currencies are both guaranteed by the French treasury, which lends a certain level of credibility. Still, economic adjustment within the member countries of the zone are subject to the same challenges as that of any monetary union.

Update: An earlier version of this post incorrectly claimed that Cape Verde and Ghana were both part of the zone. Cape Verde is pegged independently to the euro, while Ghana is leading a charge for a common currency for West Africa, but are definitively not members of the CFA zone. Thanks to commenters for pointing our this error.

Update 2: Sanou Mbaye has a far more dour take on the relative success of the CFA franc zone, and makes a strong case that the common currency has not only been a net negative for growth for zone economies, but has also promoted chronic structural deficits.


Submitted by Anonymous on
"not only is free labor movement within the zone much more limited than Shengen, and member states such as Cape Verde, Cote d'Ivoire, and Ghana, all have distinct languages, cultures, and levels of economic and political development." Especially since Ghana and Cabo Verde aren't CFA members.....

The EURO Single Currency union sits atop a Single Market, which is probably the underlying imbalances. Growing bilateral trade deficits showed that some of the smaller members countries did not necessarily benefit form the Single Market and the Single Currency. Gaping current account deficits, even after considering large Cohesion and Structural Funds transfers, represented warning signs that were largely ignored thanks to the easy credit recycling funds from surplus countries, on the mistaken belief that a currency union had done away with Balance of Payments considerations and rating and bond yield differentials. But the Balance of Payments external constraint has been come roaring back to bite us. Single Currency woes reflect Single Market imbalances, can't tackle one without the other.

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