The euro: too hard an act to follow?
by Kathleen Lucia, EAU Vice-President

Outside Europe, the idea of monetary union has been slow to catch on. It is now nearly 50 years since the Nobel prize-winning economist, Robert Mundell, popularly known as the father of the euro, launched on the world his concept of Optimum Currency Areas. It was to be 40 years before the eurozone came into being and, so far, more than 10 years on, it remains the only such currency bloc. Mundell’s concept, though elegantly simple, is much less simple to implement.

Furthermore, monetary union has had a bad press lately. The economic shocks of the past two years and the recession that continues to bite around the world, have exposed painful rigidities inherent in the binding together of Europe’s 16 eurozone members with one common currency at one common fixed exchange rate. There is the risk of serious social dislocation in Greece. Similar strains threaten social distress in Portugal, Spain, Italy and Ireland. And the richer, stabler eurozone members further north are far from stress free, faced with the prospect of having to shore up the euro by underwriting the debts of Greece and, possibly, other stricken neighbors. North European voters are, largely, disgruntled by the likelihood of seeing their tax money spent on those they consider profligate.

Even so, despite the political as well as the economic fallout from the global recession, three large territories, one in the Middle East, two in Africa, are pressing ahead with their own monetary union projects, albeit slowly and painfully. Why?

In a report on the Gulf Co-operation Council’s plans for monetary union, published recently by The Bank for International Settlements, researchers for the Saudi Arabian Monetary Agency set out the following list of reasons based on Robert Mundell’s expectations:

·         Elimination of transaction and accounting costs

·         Removal of foreign exchange risk

·         Greater pricing transparency

·         Internationally more credible monetary policy

·         Less vulnerability to speculative attacks on the currency.

The council’s six member countries, Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates, have been working towards monetary union since 1981- an achingly slow process. But all see their dependence on oil and industries based on its derivatives as a problem in the long term and see monetary union as a way of encouraging more intra-country trade in non-oil goods and services and as a means to achieve better bargaining power with other economic blocs. The council has long targeted 2010 as the launch date of monetary union, but the project’s complexities have dashed this hope. Oman dropped out of the scheme some years ago; Kuwait de-pegged from the US dollar in 2007 in favor of a dollar dominated basket of currencies and then, last year, the United Arab Emirates dropped out of the project. Nevertheless Bahrain, Qatar, Kuwait and Saudi Arabia are continuing to pursue monetary union plans.

The Southern African Development Community (SADC) would endorse GCC’s list of potential benefits. For them, monetary union points the way out of poverty for the community’s15 members (Angola, Botswana, Republic of Congo, Lesotho, Malawi, Madagascar, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia and Zimbabwe). SADC plan to achieve a customs union this year and full monetary union by 2018. It still remains, though, for this large group to build a credible common statistical base on which to found economic analysis and prediction. They recognize that common markets and monetary unions simply cannot operate without timely, reliable data, or at least taxonomies on which everyone agrees. It seems a basic practical issue, but it is profoundly complex and time consuming. The eurozone, despite relatively well organized data collection, has had plenty of problems on that score and huge information gaps still confront the SADC. There is every likelihood that their monetary union timetable, like the GCC’s, will slip.

Similarly, the five members of the East African Community Partner States see monetary union as essential to the region’s economic future and have been working on their monetary union project since achieving a customs union in 2005. It is proving to be a hard slog, but in an address to a workshop on union earlier this year, Governor of the Bank of Uganda, Professor Emmanuel Tumuslime-Mutebile, delivered a clear exposition of the case in favor of it.

He could almost have been quoting Robert Mundell directly when he said: “The primary rationale for the monetary union is to reduce the costs and risks of transacting business across the national boundaries of those countries which comprise the members of the monetary union...Monetary union removes the costs of having to transact in different currencies and the risk of adverse exchange rate movements for trade within East Africa. Monetary Union will, therefore, deepen the integration of East African economies and in doing so enhance the benefits which can be derived from the East African common market. A well functioning common market in East Africa will stimulate competition and help domestic firms to realize economies of scale, thereby raising productivity, which will strengthen our competitiveness on world markets and raise living standards”.

Most significantly, Professor Tumuslime-Mutebile went on to say: “The 21st century global economy will be characterized by the emergence of major regional economic blocs, groups of countries whose economies are closely integrated, alongside the largest economies, such as those of China and the United States. Multilateral relationships between states and regional economic blocs will play a key role in shaping the institutional rules which will affect multilateral institutions such as the World Trade Organization and international fora. The recent global economic crisis has vividly demonstrated the importance of multilateral solutions to economic problems which have a global dimension. Small economies will find it very difficult to make their voice heard and ensure that their interests are taken into account... unless they are prepared to join together and present a common front”.

The professor’s straightforward statement of the geopolitics of optimum currency areas, again consistent with Mundell’s view, explains why so many individual nation states are prepared to go through so much pain, then to surrender their autonomy. But is it really that good a deal? Another Nobel prize-winning economist, the late Milton Friedman, would almost certainly say ‘not necessarily’ now, just as he did when the euro was still in its infancy.

In 2001, five years before his death, Friedman debated directly with Mundell the virtues and vices of currency blocs and fixed exchange rates. Their discussion was published in full by the French language Canadian magazine, Options Politiques and it remains fresh and relevant today.

What is surprising is that what seems mostly to separate them is as much an attitude of mind as intellectual disagreement. Both agree on the importance of price flexibility: that exchange rate flexibility can never be a substitute for the vast number of changes in individual prices that have to be made in an efficient market. Both agree on and strongly support the view that policies about trade and finance should be directed to securing the maximum possible free trade in goods and services and the free movement of capital. They also agree that the eurozone offers potential political benefits for Europe, but that the political benefits will accrue only if the euro is also an economic success. On this score, Mundell is an optimist and Friedman a pessimist.

On the euro, Mundell says: “The biggest issue between Milton and me lies in the quality of the monetary policy. I believe that every country in Europe is getting a better monetary policy than it had before. My own view about the politics of the euro is that it will provide a catalyst for increased political integration in Europe, which, after two centuries of a Franco-German rivalry that has periodically engulfed the entire world, is highly desirable. On economic grounds alone I believe the case for the euro is overwhelming. I also believe that every country in the euro area is now getting a better money than they had before. First of all, the size of the euro area is vastly larger than the size of any of the national currency areas and that affords to each country a better insulation against shocks”.

“The possibility of exchange rate changes has deflected the attention of policy makers from the vastly more important subject of flexibility in all individual markets. I believe that flexibility of individual prices will be fostered by the euro area and that, with exchange rate changes ruled out, policy makers will increasingly turn to deregulation and fewer controls.

“Most the 175-odd currencies in the world should be classified as junk currencies, sources of instability rather than anchors of stability. Europe has been the pioneer in the process of forming a larger currency area, and I believe it is an example that will be increasingly imitated in the rest of the world”.

Friedman argues: “Creating, perhaps, a number of currency blocs consisting of a major country and number of much smaller countries with close economic ties to the major country may well occur and be a good thing. The one really new development is the euro, a transnational central bank issuing a common currency for its members. There is no historical precedent for such an arrangement. It involves each country’s giving up power over its internal monetary policy to an entity not under its political control.

“Such a system has economic advantages and disadvantages, but I believe that its real Achilles heel will prove to be political; that a system under which the political and currency boundaries do not match is bound to prove unstable. In any event, I do not believe the euro will be imitated until it has a chance to demonstrate its viability.

“I believe we also agree that {the euro’s} attainment was driven by political, not economic considerations; by the belief that it would contribute to greater political integration – the much heralded United States of Europe – that would in turn render impossible the kind of wars which Europe has suffered so much. If achieved, political integration would render the monetary and political areas coterminous, the historical norm.

“Will the euro contribute to political unity? Only, I believe, if it is economically successful; otherwise, it is more likely to engender political strife than political unity. The euro encompasses politically independent countries, differing in culture, resources and economic development and subject to divergent influences. There are bound to develop among them differences about appropriate monetary, fiscal and other policies. Flexible exchange rates offered a way of adjusting to such differences through the market without political conflict. The euro closes that possibility. Bob (Mundell) is confident that other adjustment mechanisms will rapidly develop –greater internal flexibility in prices, regulation and the like. I hope he is right, but I fear he may not be. If he turns out not to be, the euro will generate more political conflict, not political unity”.

Friedman warns: “I have long believed, to paraphrase Clemenceau’s famous remark about war that money is far too serious to be left to central bankers. Is it tolerable in a democracy to have so much power concentrated in a body free from any kind of direct effective political control?

“On those grounds, national central banks, whether called independent or not, are always subject to ultimate political control. That is the fundamental reason why the monetary area has historically been coterminous with the political area. The euro is unique in its multi-country character. I believe that is a basic flaw and is likely sooner or later to convert economic differences into irresolvable political differences”.

So who is right, the optimist or the pessimist? In its first 10 years the eurozone has wrestled with myriad obstacles to cross border trade, endless frustration over common regulation and policymaking and there has been no shortage of political conflict. On the other hand, the euro continues to survive and the eurozone remains intact –so far. But some would say that, over the past decade economic conditions for the eurozone have been benign. They no longer are and, therefore, the jury is still out.

Nevertheless, the eurozone does inform those who would also set up a currency bloc. Robert Mundell, who continues in post as Professor of economics at Columbia University, USA, says that the euro offers a useful template for others in forming currency areas, if they can agree on a common inflation rate and co-ordinate monetary policy. It may be a big “if”, but: “Other things equal, including inflation rates, large currency areas are more stable and more resistant to shocks than small currency areas. In a monetary union or fixed exchange rate arrangement between a large and an small country, most of the gains go to the small country”.

Mundell defines fixed exchange rates as a process in which a central bank fixes the price of foreign exchange and lets the money supply move in a way that keeps the balance of payments in equilibrium. He argues:” The choice between fixed and flexible exchange rates is an oxymoron. The alternatives are incomparable. A fixed exchange rate system is a monetary rule. A flexible exchange rate is the absence of that particular monetary rule and is consistent with price stability or anything at all, including hyperinflation. The real choice is between a fixed exchange rate monetary rule and alternative monetary rules, such as inflation targeting or monetary targeting.

“Equilibrium under fixed exchange rates means that the country’s money supply is directed by its balance of payments. When the balance is in surplus, the money supple expands and that increases expenditure on goods and securities and that corrects its surplus. When the balance of payments is in deficit the money supply contracts and that decreases expenditure on goods and services and corrects its deficit. The country will then get the inflation rate of the currency area it is joining”.

Milton Friedman leaves the architects of new currency blocs the following legacy of questions about the economic factors country A should consider in deciding whether to unify its currency with country B. They are:

·         How extensive is trade between A and B? (The more extensive the trade the larger the gain from the unified currency in savings in transaction costs and the smaller the cost of adjustment to monetary changes in B. This item is not as simple as it may appear, though. The adoption of a unified currency may have a major effect on the amount of trade between A and B.

·         How flexible are wages and prices in A?

·         How mobile are workers within A and between A and B?

·         How mobile is capital within A and between A and B? (The more flexible are wages and prices the more mobile are workers and capital, the easier it will be for country A to adapt to factors that under a flexible rate would lead to changes in the exchange rate, usually described asynchronous shocks that affect A and B differently).

·         How good is monetary policy in A; in B and how good is it likely to be? (An inevitably political question. In practice, this is often the most important question. Experience suggests that in a small developing country an independent internal monetary policy is likely to be highly unstable with occasional episodes of high inflation).

·         Another inevitably political question: what is the political relation between A and B?

Friedman’s cost-benefit analysis is as follows: “Hard-fixed rates reduce transaction costs of international trade and finance and thereby facilitate international trade and investment. However, a country that enters into a hard fixed rate bears an economic cost. The cost is discarding a means, a flexible exchange rate, of adjusting to external forces that impinge on it differently than on the other country or countries whose currency it shares. Adjusting to such external forces with a hard fixed rate requires adjustment in many individual prices and wages that could be avoided if it could change the exchange rate. It is far simpler to allow one price to change, namely the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure. What flexible rates do is to make it possible for a country to have a good internal monetary policy, regardless of the policies followed by other countries.

“I believe that, 20 years from now, as now, there will be a variety of independent currencies in the world linked by flexible exchange rates. Whether more or fewer will probably depend on how successful the euro proves to be. But it also may depend on a major wild card that we have not considered at all: the Internet and the emergence of one or more varieties of e-money”.

Now, that is another story.