Currency Unions
By Alberto Alesina and Robert J Barro
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Currency Unions - Alberto Alesina
transition.
Introduction
Alberto Alesina
Robert J. Barro
During the post-World War II period, the number of independent countries more than doubled, to nearly two hundred today. Until recently, most countries had their own currencies. Hence, the expansion of the number of countries led to a proliferation of the number of currencies. More recently, however, the identification of currencies with countries has weakened, and the discussion has shifted toward one of desirable forms and sizes of currency unions.
The growing policy significance of currency unions motivated us to organize a conference at the Hoover Institution in May 2000. We brought together about two dozen economists who were experts on international monetary topics. The idea was to consider basic conceptual issues about currency unions and other monetary regimes, including flexible and fixed exchange rates. We sought also to assess the available empirical evidence on the performance of these alternative monetary systems. Finally, we hoped to reach some policy conclusions, notably on the desirability of currency unions for countries in various circumstances.
The conference included eight academic papers, many of which will likely appear in a special issue of Harvard University’s Quarterly Journal of Economics. The present volume includes nontechnical summaries of these papers, along with the text of a dinner address that was presented at the conference by Stan Fischer, the first deputy managing director of the International Monetary Fund.
Individual currencies are sometimes valued out of national pride, although one would have expected these feelings to be more intense for language than for money. Yet many countries willingly use the language of another country, typically the one of a former colonial ruler. Given this acceptance of transplanted language, it is surprising how often people reject currency unions—which sometimes involve the use of another country’s currency—simply on the grounds that important countries are supposed to have their own money.
From an economic standpoint, the strongest argument for individual money is that it allows a country to pursue its own monetary policy. In theory, if the country operates with a flexible exchange rate, the monetary authority can design a policy that responds optimally to its own economic disturbances. Typically, the desired policy will look countercyclical, that is, expansionary during recessions and contractionary in booms. In contrast, under a fixed exchange rate, monetary policy has to be subordinated to the maintenance of the exchange rate. Fixed exchange rate regimes include a peg to another currency—which may or may not be permanent—as well as the more serious commitment represented by a currency board or dollarization (by which we mean one country’s use of another country’s money).
Luis Céspedes, Roberto Chang, and Andrés Velasco make the traditional case for flexible exchange rates and countercyclical monetary policy in a modern theoretical framework that includes a detailed analysis of a country’s financial structure. They argue that an independent monetary policy and a flexible exchange rate can be useful even for developing countries that have substantial foreign currency debt. Maurice Obstfeld and Kenneth Rogoff also look at the workings of monetary policy under flexible exchange rates. They argue that this type of policy can work out well even if central banks determine their actions independently, rather than coordinating with the banks of other countries.
However, as Guillermo Calvo and Carmen Reinhart argue in their paper, many central banks in supposedly flexible exchange rate systems have been unable in practice to carry out policies that look desirable, much less optimal. Empirically, the typical monetary authority has a fear of floating
and, therefore, does not allow the exchange rate to move in a way that would permit a countercyclical monetary policy.
Two other papers in this volume reach somewhat different conclusions. Christian Broda argues empirically that countries that operate under flexible exchange rates have performed better than fixed rate countries in their responses to terms-of-trade shocks. Presumably, the better performance results from the extra freedom for monetary policy in the floating rate systems. Eduardo Borensztein and Jeromin Zettelmeyer carried out case studies for several countries and found that all monetary authorities are, to some extent, dependent on the interest rate policy set by the U.S. Federal Reserve. However, this dependence is much less for flexible rate countries than for those that commit to a fixed exchange rate by operating a currency board.
In our paper for this volume, we extend Robert Mundell’s classic and Nobel Prize-winning analysis of optimum currency areas to bring together the various elements that determine the optimal sizes of currency unions. We allow for a possible benefit from independent monetary policy, but we also argue that dollarization conveys a valuable commitment to price stability (assuming that the anchor currency, which could be the U.S. dollar or the euro, is properly managed). Under dollarization, sound monetary and exchange rate policies no longer depend on the intelligence and discipline of domestic policymakers. Their monetary policy becomes essentially the one followed by the anchor country (which could be the United States), and the exchange rate is fixed