People
felt the need to create a uniform medium of exchange as early as in
Ancient Greece and Medieval Europe. Those proto-unions did not have a
central monetary authority or monetary policy, yet they functioned
surprisingly well in the uncomplicated economies of the time.
I. The History of Monetary Unions
"Before long, all Europe, save England, will have one money". This was
written by William Bagehot, the Editor of "The Economist", the renowned
British magazine, 120 years ago when Britain, even then, was heatedly
debating whether to adopt a single European Currency or not.
A century later, the euro is finally here (though without British
participation). Having braved numerous doomsayers and Cassandras, the
currency - though much depreciated against the dollar and reviled in
certain quarters (especially in Britain) - is now in use in both the
eurozone and in eastern and southeastern Europe (the Balkan). In most
countries in transition, it has already replaced its much sought-after
predecessor, the Deutschmark. The euro still feels like a novelty - but
it is not. It was preceded by quite a few monetary unions in both
Europe and outside it.
What lessons does history teach us? What pitfalls should we avoid and what features should we embrace?
People felt the need to create a uniform medium of exchange as early as
in Ancient Greece and Medieval Europe. Those proto-unions did not have
a central monetary authority or monetary policy, yet they functioned
surprisingly well in the uncomplicated economies of the time.
The first truly modern example would be the monetary union of Colonial New England.
The four kinds of paper money printed by the New England colonies
(Connecticut, Massachusetts Bay, New Hampshire and Rhode Island) were
legal tender in all four until 1750. The governments of the colonies
even accepted them for tax payments. Massachusetts - by far the
dominant economy of the quartet - sustained this arrangement for almost
a century. The other colonies became so envious that they began to
print additional notes outside the union. Massachusetts - facing a
threat of devaluation and inflation - redeemed for silver its share of
the paper money in 1751. It then retired from the union, instituted its
own, silver-standard (mono-metallic), currency and never looked back.
A far more important attempt was the Latin Monetary Union (LMU). It was
dreamt up by the French, obsessed, as usual, by their declining
geopolitical fortunes and monetary prowess. Belgium already adopted the
French franc when it became independent in 1830. The LMU was a natural
extension of this franc zone and, as the two teamed up with Switzerland
in 1848, they encouraged others to join them. Italy followed suit in
1861. When Greece and Bulgaria acceded in 1867, the members established
a currency union based on a bimetallic (silver and gold) standard.
The LMU was considered sufficiently serious to be able to flirt with
Austria and Spain when its Foundation Treaty was officially signed in
1865 in Paris. This despite the fact that its French-inspired rules
seemed often to sacrifice the economic to the politically expedient, or
to the grandiose.
The LMU was an official subset of an unofficial "franc area" (monetary
union based on the French franc). This is similar to the use of the US
dollar or the euro in many countries today. At its peak, eighteen
countries adopted the Gold franc as their legal tender (or peg). Four
of them (the founding members of the LMU: France, Belgium, Italy and
Switzerland) agreed on a gold to silver conversion rate and minted gold
and silver coins which were legal tender in all of them. They
voluntarily limited their money supply by adopting a rule which forbade
them to print more than 6 franc coins per capita.
Europe (especially Germany and the United Kingdom) was gradually
switching at the time to the gold standard. But the members of the
Latin Monetary Union paid no attention to its emergence. They printed
ever increasing quantities of gold and silver coins, which constituted
legal tender across the Union. Smaller denomination (token) silver
coins, minted in limited quantity, were legal tender only in the
issuing country (because they had a lower silver content than the Union
coins).
The LMU had no single currency (akin to the euro). The national
currencies of its member countries were at parity with each other. The
cost of conversion was limited to an exchange commission of 1.25%.
Government offices and municipalities were obliged to accept up to 100
Francs of non-convertible and low intrinsic value tokens per
transaction. People lined to convert low metal content silver coins
(100 Francs per transaction each time) to buy higher metal content ones.
With the exception of the above-mentioned per capita coinage
restriction, the LMU had no uniform money supply policies or
management. The amount of money in circulation was determined by the
markets. The central banks of the member countries pledged to freely
convert gold and silver to coins and, thus, were forced to maintain a
fixed exchange rate between the two metals (15 to 1) ignoring
fluctuating market prices.
Even at its apex, the LMU was unable to move the world prices of these
metals. When silver became overvalued, it was exported (at times
smuggled) within the Union, in violation of its rules. The Union had to
suspend silver convertibility and thus accept a humiliating de facto
gold standard. Silver coins and tokens remained legal tender, though.
The unprecedented financing needs of the Union members - a result of
the First World War - delivered the coup de grace. The LMU was
officially dismantled in 1926 - but expired long before that.
The LMU had a common currency but this did not guarantee its survival.
It lacked a common monetary policy monitored and enforced by a common
Central Bank - and these deficiencies proved fatal.
In 1867, twenty countries debated the introduction of a global currency
in the International Monetary Conference. They decided to adopt the
gold standard (already used by Britain and the USA) following a period
of transition. They came up with an ingenious scheme. They selected
three "hard" currencies, with equal gold content so as to render them
interchangeable, as their legal tender. Regrettably for students of the
dismal science, the plan came to naught.
Another failed experiment was the Scandinavian Monetary Union (SMU),
formed by Sweden (1873), Denmark (1873) and Norway (1875). It was a
by-now familiar scheme. All three recognized each others' gold coinage
as well as token coins as legal tender. The daring innovation was to
accept the members' banknotes (1900) as well.
As Scandinavian schemes go, this one worked too perfectly. No one
wanted to convert one currency to another. Between 1905 and 1924, no
exchange rates among the three currencies were available. When Norway
became independent, the irate Swedes dismantled the moribund Union in
an act of monetary tit-for-tat.
The SMU had an unofficial central bank with pooled reserves. It
extended credit lines to each of the three member countries. As long as
gold supply was limited, the Scandinavian Kronor held its ground. Then
governments started to finance their deficits by dumping gold during
World War I (and thus erode their debts by fostering inflation through
a string of inane devaluations). In an unparalleled act of arbitrage,
central banks then turned around and used the depreciated currencies to
scoop up gold at official (cheap) rates.
When Sweden refused to continue to sell its gold at the officially
fixed price - the other members declared effective economic war. They
forced Sweden to purchase enormous quantities of their token coins. The
proceeds were used to buy the much stronger Swedish currency at an ever
cheaper price (as the price of gold collapsed). Sweden found itself
subsidizing an arbitrage against its own economy. It inevitably reacted
by ending the import of other members' tokens. The Union thus ended.
The price of gold was no longer fixed and token coins were no more
convertible.
The East African Currency Area is a fairly recent debacle. An
equivalent experiment, involving the CFA franc, is still going on in
the Francophile part of Africa.
The parts of East Africa ruled by the British (Kenya, Uganda and
Tanganyika and, in 1936, Zanzibar) adopted in 1922 a single common
currency, the East African shilling. The newly independent countries of
East Africa remained part of the Sterling Area (i.e., the local
currencies were fully and freely convertible into British Pounds).
Misplaced imperial pride coupled with outmoded strategic thinking led
the British to infuse these emerging economies with inordinate amounts
of money. Despite all this, the resulting monetary union was
surprisingly resilient. It easily absorbed the new currencies of Kenya,
Uganda and Tanzania in 1966, making them legal tender in all three and
convertible to Pounds.
Ironically, it was the Pound which gave way. Its relentless
depreciation in the late 60s and early 70s, led to the disintegration
of the Sterling Area in 1972. The strict monetary discipline which
characterized the union - evaporated. The currencies diverged - a
result of a divergence of inflation targets and interest rates. The
East African Currency Area was formally ended in 1977.
Not all monetary unions ended so tragically. Arguably, the most famous
of the successful ones is the Zollverein (German Customs Union).
The nascent German Federation was composed, at the beginning of the
19th century, of 39 independent political units. They all busily minted
coins (gold, silver) and had their own - distinct - standard weights
and measures. The decisions of the much lauded Congress of Vienna
(1815) did wonders for labour mobility in Europe but not so for trade.
The baffling number of (mostly non-convertible) different currencies
did not help.
The German principalities formed a customs union as early as 1818. The
three regional groupings (the Northern, Central and Southern) were
united in 1833. In 1828, Prussia harmonized its customs tariffs with
the other members of the Federation, making it possible to pay duties
in gold or silver. Some members hesitantly experimented with new fixed
exchange rate convertible currencies. But, in practice, the union
already had a single currency: the Vereinsmunze.
The Zollverein (Customs Union) was established in 1834 to facilitate
trade by reducing its costs. This was done by compelling most of the
members to choose between two monetary standards (the Thaler and the
Gulden) in 1838. Much as the Bundesbank was to Europe in the second
half of the twentieth century, the Prussian central bank became the
effective Central Bank of the Federation from 1847 on. Prussia was by
far the dominant member of the union, as it comprised 70% of the
population and land mass of the future Germany.
The North German Thaler was fixed at 1.75 to the South German Gulden
and, in 1856 (when Austria became informally associated with the
Union), at 1.5 Austrian Florins. This last collaboration was to be a
short lived affair, Prussia and Austria having declared war on each
other in 1866.
Bismarck (Prussia) united Germany (Bavarian objections notwithstanding)
in 1871. He founded the Reichsbank in 1875 and charged it with issuing
the crisp new Reichsmark. Bismarck forced the Germans to accept the new
currency as the only legal tender throughout the first German Reich.
Germany's new single currency was in effect a monetary union. It
survived two World Wars, a devastating bout of inflation in 1923, and a
monetary meltdown after the Second World War. The stolid and
trustworthy Bundesbank succeeded the Reichsmark and the Union was
finally vanquished only by the bureaucracy in Brussels and its euro.
This is the only case in history of a successful monetary union not
preceded by a political one. But it is hardly representative. Prussia
was the regional bully and never shied away from enforcing strict
compliance on the other members of the Federation. It understood the
paramount importance of a stable currency and sought to preserve it by
introducing various consistent metallic standards. Politically
motivated inflation and devaluation were ruled out, for the first time.
Modern monetary management was born.
Another, perhaps equally successful, and still on-going union - is the CFA franc Zone.
The CFA (stands for French African Community in French) franc has been
in use in the French colonies of West and Central Africa (and,
curiously, in one formerly Spanish colony) since 1945. It is pegged to
the French franc. The French Treasury explicitly guarantees its
conversion to the French franc (65% of the reserves of the member
states are kept in the safes of the French Central Bank). France often
openly imposes monetary discipline (that it sometimes lacks at home!)
directly and through its generous financial assistance. Foreign
reserves must always equal 20% of short term deposits in commercial
banks. All this made the CFA an attractive option in the colonies even
after they attained independence.
The CFA franc zone is remarkably diverse ethnically, lingually,
culturally, politically, and economically. The currency survived
devaluations (as large as 100% vis a vis the French Franc), changes of
regimes (from colonial to independent), the existence of two groups of
members, each with its own central bank (the West African Economic and
Monetary Union and the Central African Economic and Monetary
Community), controls of trade and capital flows - not to mention a host
of natural and man made catastrophes.
The euro has indirectly affected the CFA as well. "The Economist"
reported recently a shortage of small denomination CFA franc notes.
"Recently the printer (of CFA francs) has been too busy producing euros
for the market back home" - complained the West African central bank in
Dakar. But this is the minor problem. The CFA franc is at risk due to
internal imbalances among the economies of the zone. Their growth rates
differ markedly. There are mounting pressures by some members to
devalue the common currency. Others sternly resist it.
"The Economist" reports that the Economic Community of West African
States (ECOWAS) - eight CFA countries plus Nigeria, Ghana, Guinea, the
Gambia, Cape Verde, Sierra Leone, and Liberia - is considering its own
monetary union. Many of the prospective members of this union fancy the
CFA franc even less than the EU fancies their capricious and
graft-ridden economies. But an ECOWAS monetary union could constitute a
serious - and more economically coherent - alternative to the CFA franc
zone.
A neglected monetary union is the one between Belgium and Luxembourg.
Both maintain their idiosyncratic currencies - but these are at parity
and serve as legal tender in both countries since 1921. The monetary
policy of both countries is dictated by the Belgian Central Bank and
exchange regulations are overseen by a joint agency. The two were close
to dismantling the union at least twice (in 1982 and 1993) - but
relented.
II. The Lessons
Europe has had more than its share of botched and of successful
currency unions. The Snake, the EMS, the ERM, on the one hand - and the
British Pound, the Deutschmark, and the ECU, on the other.
The currency unions which made it have all survived because they relied
on a single monetary authority for managing the currency.
Counter-intuitively, single currencies are often associated with
complex political entities which occupy vast swathes of land and
incorporate previously distinct -and often politically, socially, and
economically disparate - units. The USA is a monetary union, as was the
late USSR.
All single currencies encountered opposition on both ideological and pragmatic grounds when they were first introduced.
The American constitution, for instance, did not provide for a central
bank. Many of the Founding Fathers (e.g., Madison and Jefferson)
refused to countenance one. It took the nascent USA two decades to come
up with a semblance of a central monetary institution in 1791. It was
modeled after the successful Bank of England. When Madison became
President, he purposefully let its concession expire in 1811. In the
forthcoming half century, it revived (for instance, in 1816) and
expired a few times.
The United States became a monetary union only following its traumatic
Civil War. Similarly, Europe's monetary union is a belated outcome of
two European civil wars (the two World Wars). America instituted bank
regulation and supervision only in 1863 and, for the first time, banks
were classified as either national or state-level.
This classification was necessary because by the end of the Civil War,
notes - legal and illegal tender - were being issued by no less than
1562 private banks - up from only 25 in 1800. A similar process
occurred in the principalities which were later to constitute Germany.
In the decade between 1847 and 1857, twenty five private banks were
established there for the express purpose of printing banknotes to
circulate as legal tender. Seventy (!) different types of currency
(mostly foreign) were being used in the Rhineland alone in 1816.
The Federal Reserve System was founded only following a tidal wave of
banking crises in 1908. Not until 1960 did it gain a full monopoly of
nation-wide money printing. The monetary union in the USA - the US
dollar as a single legal tender printed exclusively by a central
monetary authority - is, therefore, a fairly recent thing, not much
older than the euro.
It is common to confuse the logistics of a monetary union with its
underpinnings. European bigwigs gloated over the smooth introduction of
the physical notes and coins of their new currency. But having a single
currency with free and guaranteed convertibility is only the
manifestation of a monetary union - not one of its economic pillars.
History teaches us that for a monetary union to succeed, the exchange
rate of the single currency must be realistic (for instance, reflect
the purchasing power parity) and, thus, not susceptible to speculative
attacks. Additionally, the members of the union must adhere to one
monetary policy.
Surprisingly, history demonstrates that a monetary union is not
necessarily predicated on the existence of a single currency. A
monetary union could incorporate "several currencies, fully and
permanently convertible into one another at irrevocably fixed exchange
rates". This would be like having a single currency with various
denominations, each printed by another member of the Union.
What really matters are the economic inter-relationships and power
plays among union members and between the union and other currency
zones and currencies (as expressed through the exchange rate).
Usually the single currency of the Union is convertible at given
(though floating) exchange rates subject to a uniform exchange rate
policy. This applies to all the territory of the single currency. It is
intended to prevent arbitrage (buying the single currency in one place
and selling it in another). Rampant arbitrage - ask anyone in Asia -
often leads to the need to impose exchange controls, thus eliminating
convertibility and inducing panic.
Monetary unions in the past failed because they allowed variable
exchange rates, (often depending on where - in which part of the
monetary union - the conversion took place).
A uniform exchange rate policy is only one of the concessions members
of a monetary union must make. Joining always means giving up
independent monetary policy and, with it, a sizeable slice of national
sovereignty. Members relegate the regulation of their money supply,
inflation, interest rates, and foreign exchange rates to a central
monetary authority (e.g., the European Central Bank in the eurozone).
The need for central monetary management arises because, in economic
theory, a currency is never just a currency. It is thought of as a
transmission mechanism of economic signals (information) and
expectations (often through monetary policy and its outcomes).
It is often argued that a single fiscal policy is not only unnecessary,
but potentially harmful. A monetary union means the surrender of
sovereign monetary policy instruments. It may be advisable to let the
members of the union apply fiscal policy instruments autonomously in
order to counter the business cycle, or cope with asymmetric shocks,
goes the argument. As long as there is no implicit or explicit
guarantee of the whole union for the indebtedness of its members -
profligate individual states are likely to be punished by the market,
discriminately.
But, in a monetary union with mutual guarantees among the members (even
if it is only implicit as is the case in the eurozone), fiscal
profligacy, even of one or two large players, may force the central
monetary authority to raise interest rates in order to pre-empt
inflationary pressures.
Interest rates have to be raised because the effects of one member's
fiscal decisions are communicated to other members through the common
currency. The currency is the medium of exchange of information
regarding the present and future health of the economies involved.
Hence the notorious "EU Stability Pact", recently so flagrantly
abandoned in the face of German budget deficits.
Monetary unions which did not follow the path of fiscal rectitude are no longer with us.
In an article I published in 1997 ("The History of Previous European
Currency Unions"), I identified five paramount lessons from the short
and brutish life of previous - now invariably defunct - monetary unions:
To prevail, a monetary union must be founded by one or two economically
dominant countries ("economic locomotives"). Such driving forces must
be geopolitically important, maintain political solidarity with other
members, be willing to exercise their clout, and be economically
involved in (or even dependent on) the economies of the other members.
Central institutions must be set up to monitor and enforce monetary,
fiscal, and other economic policies, to coordinate activities of the
member states, to implement political and technical decisions, to
control the money aggregates and seigniorage (i.e., rents accruing due
to money printing), to determine the legal tender and the rules
governing the issuance of money.
It is better if a monetary union is preceded by a political one
(consider the examples of the USA, the USSR, the UK, and Germany).
Wage and price flexibility are sine qua non. Their absence is a threat
to the continued existence of any union. Unilateral transfers from rich
areas to poor are a partial and short-lived remedy. Transfers also call
for a clear and consistent fiscal policy regarding taxation and
expenditures. Problems like unemployment and collapses in demand often
plague rigid monetary unions. The works of Mundell and McKinnon
(optimal currency areas) prove it decisively (and separately).
Clear convergence criteria and monetary convergence targets.
The current European Monetary Union is far from heeding the lessons of
its ill fated predecessors. Europe's labour and capital markets, though
recently marginally liberalized, are still more rigid than 150 years
ago. The euro was not preceded by an "ever closer (political or
constitutional) union". It relies too heavily on fiscal redistribution
without the benefit of either a coherent monetary or a consistent
fiscal area-wide policy. The euro is not built to cope either with
asymmetrical economic shocks (affecting only some members, but not
others), or with the vicissitudes of the business cycle.
This does not bode well. This union might well become yet another footnote in the annals of economic history.
