Today, we’re fortunate to have a guest contribution by Jeffry Frieden, Stanfield Professor of International Peace at Harvard University, and author of the newly published Currency Politics: The Political Economy of Exchange Rate Policy (Princeton University Press, 2015). This post is based upon a portion of that book.
As the Eurozone struggles through its eighth year of stagnation and limping recovery, many Euro-skeptics are rubbing their hands with “I told you so” glee. The ongoing crisis in the Eurozone demonstrates the weaknesses of a currency union among countries with substantial macroeconomic divergences, separate financial regulations, uncoordinated fiscal policies, and an inability to credibly commit not to bail out member states in trouble. All of the gaps in the design of the euro that were pointed to in the 1990s seem to have come together to demonstrate the foolishness of Economic and Monetary Union in Europe.
Yet the member states of the Eurozone seem committed to maintaining the monetary union, and in fact countries continue to join. Seven nations have adopted the euro since 2001, six of them since the crisis began. It seems hard to square the continued attraction of the currency union to members and (some) non-members alike with the manifest problems that beset it.
The euro project’s strength is puzzling for those who focus on traditional economic reasons for a currency union. The standard approach is to explore Optimal Currency Area criteria: Are the countries subject to similar exogenous shocks? Do factors of production (especially labor) move freely among them? Is their industrial structure similar? These criteria largely evaluate the costs of giving up a national monetary policy. If these criteria are met, then sharing a currency will impose few costs: independent national monetary policies would either be unnecessary or impossible.
These evaluations have two problems: they focus on costs rather than benefits, and they are purely economic. On the first front, the OCA literature largely took for granted that there are welfare gains to a common currency, without developing any good metric for evaluating them. On the second, just as monetary policy is made subject to political-economy constraints, so too is the decision to create a monetary union. On both counts, EMU and the euro may seem more defensible than the standard story allows.
The first point is that the potential benefits may be larger than commonly supposed. It is striking that both popular and policy discussion of EMU focused on the purported value of a common currency in encouraging broader European economic integration. Economic analyses tended to downplay this, finding only very minor gains in the reduction of transaction costs. After all, currency markets are very well-developed and currencies are easily hedged, so the efficiency gains are likely to be small.
From early days, policymakers seemed to believe that a common currency would lead to a substantial increase in the level of cross-border trade and investment. And there is some scholarly evidence to support this view. Andy Rose’s early empirical estimate that being in a currency union increased trade by 300 percent was not widely believed, and it may be an over-estimate. But subsequent work tends to reinforce the view that a common currency does increase trade quite substantially. For example, Lopez-Cordova and Meissner used ample historical data and found that being on the gold standard increased trade among countries by 30 percent. On a related front, the work of Roberto Rigobon and his colleagues in their Billion Prices Project has demonstrated that within a currency union prices are much more similar even than among countries with strong nominal currency pegs.
The euro is seen by many in Europe as a means to an end, with the end being the more complete integration of markets for goods and capital (and perhaps even labor). Indeed, in public opinion polls, political support for the common currency is closely related to support for closer economic ties among the members of the EU. So one source of support for the euro is simply the view – for which there is some empirical evidence – that a common currency will speed the process of economic integration.
The second point is that there are strong political-economy considerations that militate for a currency union. Among countries that trade freely with each other, currency movements remain the principal policy that can affect the competitive position of national producers. A ten percent depreciation is the equivalent of a ten percent tariff plus a ten percent export subsidy. However, among commercially integrated economies this sort of policy is widely seen as predatory, and whatever its ethical standing it is almost certain to give rise to political protests.
In this context, it is not clear that a functioning single market can be sustained if countries are free to manipulate their exchange rates. This was in fact one of the main lessons many Europeans took away from the crisis of the European Monetary System in 1992-1993. The crisis led to the devaluation of many of the region’s currencies against the Deutsche mark (and other northern European currencies). The result was a flood of cheapened imports into the strong-currency countries, and an upsurge in protectionist pressures in those countries, including even some threats to impose emergency protectionist measures.
As I wrote in Currency Politics, “there was an increasing sense that if the single market were to survive, monetary integration might be essential. Member states that had eschewed all trade barriers could hardly be expected to welcome attempts by other member states to promote exports and reduce imports by depreciating their currencies….Otherwise there would be powerful incentives to engage in competitive depreciations, which could reliably be expected to give rise to strong protectionist pressures in response – thus calling into question the very nature of the single market itself.” (page 150)
This dilemma is in fact common among countries pursuing trade integration. Mercosur, the common market of several South American countries centered on Brazil and Argentina, got off to a strong start in 1994 – at a time when both the Brazilian real and the Argentine peso were pegged to the dollar (at 1:1:1 parities, in fact). Trade between the two countries grew very rapidly. However, early in 1999 Brazil devalued the real, flooding Argentina with imports and hindering the sale of Argentine products in Brazil. Argentine producers complained bitterly, the government threatened trade barriers, and eventually the Brazilians agreed to restrain some of their exports. In 2001-2002 it was the turn of the Argentine peso to devalue. Other factors contributed to the stagnation of the region’s plans for commercial integration, but the currency fluctuations certainly helped make Mercosur largely a dead letter.
The broader point is that currency movements can cause substantial political conflict among trading partners, feeding protectionist pressures and threatening their commercial relations. This is true even of countries that are not linked by a customs union or a single market, as ongoing friction between the United States and China demonstrates. It is all the more important for countries that have resolved to create a true single market. Indeed, there are some in Europe who believe that without movement toward a single currency, the single market itself might not have held together.
The problems the Eurozone faces currently are enormous. But these problems should not let us lose sight of the fact that there are reasons the members states have been moving toward some form of monetary unification for over forty years, ever since the collapse of the Bretton Woods system. Those reasons are neither purely economic nor purely political, but they are nonetheless powerful.
This post written by Jeffry Frieden.