TCS Daily

The Dangerous Allure of Currency Unions

By Desmond Lachman - May 23, 2007 12:00 AM

On observing the renewed interest in the supposed advantages of regional currency unions in both Asia and Latin America, one has to be reminded of Sir Dennis Robertson's view of fashion in economic ideas. He thought that fashion in economic ideas was much like going to the greyhound races. If one stood still for long enough, the dogs would come around again.

And at least as far as the support for regional currency unions might be concerned, the dogs do seem to be coming around again. In Asia, primarily in response to the humiliating experience of the Asian currency crisis in the late 1990s, steps are being taken that could be see as laying the groundwork for an eventual Asian currency union. Countries as diverse as China, Indonesia, Japan, Korea, Philippines, and Thailand have recently agreed to pool part of their international reserves. They have also agreed to set up a new currency crisis management system.

Motivated more by political than by economic considerations, several Latin American countries are now also toying with the idea of a Latin American currency union. They hope that the establishment of such a union will set them free of the tutelage of the United States-dominated multilateral lending agencies. While much of the impetus for a Latin American currency union is coming from Venezuela's Hugo Chavez, the idea does seem to be resonating in the capitals of Argentina, Bolivia, Brazil, and Ecuador.

A distressing aspect of Asia and Latin America's flirtation with the currency union idea is that is that it flies in the face of what economic theory would suggest is appropriate for those countries. Of even more concern is that it seems to overlook the serious strains now building up in the euro area, from whose mistakes one might have hoped that Asia and Latin America would learn.

An extensive economic literature on optimum currency areas suggests that a number of conditions need to be met for the individual countries to function successfully under the stringent discipline of a currency union. Among the more important of these conditions is the requirement that the individual member countries have similar economic structures, since the more similar were those economies, the less vulnerable would they be to being hit by asymmetric external shocks.

If the countries joining the currency union were not to have similar structures, one would hope that they both enjoyed considerable labor and product market flexibility and had considerable scope for inter-area labor market mobility. Such flexibility would allow the individual member countries to better cope with shocks to their economy in a world where their currency union membership deprived them of an independent interest rate or exchange rate policy.

Looking at economies as diverse as China and Japan or Korea and the Philippines, one could hardly arrive at the conclusion that the potential Asian candidates for a currency union had similar economic structures. It would also be a large stretch to say that those countries enjoyed either the labor market flexibility or the inter-area labor market mobility that would allow them to cope with the rigors of a single currency.

If the Asian countries do not seem to meet the required standards of a currency union, the same would appear to be all the more true in the case of the more diverse and rigid economies of the Latin American region. One only need compare the more developed economies of Argentina and Brazil with the highly commodity-dependent economies of Bolivia, Ecuador, and Venezuela, to arrive at that conclusion.

A reason for hope that Asia and Latin America will in the end not go down the misguided currency union path is that they might learn from the present economic challenges being posed within the euro area. Greece, Italy, Portugal, and Spain are all being seriously squeezed by a rising euro, given the erosion that has already occurred in their relative wage and price competitiveness positions over the last few years. Since 1999, when the euro was launched, these countries have lost anywhere between 33 and 45 percent in competitiveness with respect to Germany.

Within the constraints of a currency union, the euro's Mediterranean countries can no longer resort to currency devaluation to restore competitiveness. Nor can they use interest rate policy to stimulate domestic demand. Instead, the rules of the currency union require them to endure deflation or to increase productivity as the only means of restoring their eroded competitiveness.

Over the past year, increased dissatisfaction with the constraints of the euro was vociferously expressed in both the Italian and French election campaigns. How much more so will the political noise rise when the Mediterranean member countries are condemned to prolonged periods of slow or negative growth for want of international competitiveness? And what happens to a country like Spain when its present international competitiveness problem is compounded by the bursting of its outsized housing market bubble?

The growing strains in the euro area are an unfortunate development for the euro's individual member countries. It would be doubly unfortunate, if the Asian and Latin American were to fail to draw the lesson that, while politically attractive, a currency union can exact a heavy economic toll.

The author is Resident Fellow, American Enterprise Institute.


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