A COMMON MONETARY STANDARD OR A COMMON CURRENCY FOR EUROPE? FISCAL LESSONS FROM THE UNITED STATES†
| Author | Ronald I. McKinnon |
| DOI | http://doi.org/10.1111/j.1467-9485.1994.tb01132.x |
| Published date | 01 November 1994 |
| Date | 01 November 1994 |
Scorrish
Journal oJPolilicaI
Economy,
Vol.
41,
No.
4.
November
1994
0
Scottish Economic Sociely
1994.
Published by Blackwcll Publishers,
108
Cowley
Road.
Oxford
OX4
IJF.
UK
and
238
Main Street. Cambridge.
MA
02142,
USA
A
COMMON MONETARY STANDARD
OR
A
COMMON CURRENCY
FOR
EUROPE?
FISCAL
LESSONS
FROM
THE
UNITED
STATES?
Ronald
I.
McKinnon
*
I
INTRODUCTION
Consider an economically integrated group of countries that form an optimum
currency area: the need for exchange stability is paramount.' As in the
European Union (EU), political integration has progressed to the point where
a
federal system consisting
of
a central government and lower-level national or
state governments has emerged. Under what fiscal circumstances should partici-
pating countries prefer
a
common currency to
a
common monetary standard?
Once made, how does this choice constrain, or fail to constrain, each govern-
ment's fiscal policies in the federal system?
Under
a
common monetary standard, national currencies remain in circu-
lation. But member countries agree on
a
common monetary policy consistent
with fixing exchange rates within narrow bands-say,
2%.
Without disrupting
trade or investment, these minor variations in exchange rates are sufficient to
separate the domain
of
each national currency from the others, and the clearing
of international payments typically devolves from central banks to commercial
banks (McKinnon,
1979).
A common monetary standard can encompass
a
wide
range
of
countries. The international gold standard from
1879
to
1914,
and the
fixed rate dollar standard from
1950
to
1970,
were virtually worldwide in scope.
Among the more closely integrated Western European economies, whether
or not to dispense with exchange rate bands altogether and adopt
a
single
currency is (was) the immediate concern.
To
the negotiators
of
the Single
European Act
of
1986
leading to the Maastricht Agreement in
1991,
moving
from a nascent common monetary standard to a common currency seemed
a
natural forward step to more complete financial and commodity market inte-
gration. Money changing costs irritating tourists at airports-which are gener-
ally
over
5%
of the gross transaction value-would
be
eliminated.2 In addition,
'The old literature
on
optimum currency areas (Mundell. 1961; McKinnon, 1963) did not
distinguish the case for fixed exchange rates from that for a common currency. The new litera-
ture (DeGrauwe, 1992; Tavlas, 1993) covers new theoretical arguments which,
on
net balance,
increase the size of 'optimum' currency areas. But it still does
not
resolve the issue of a
common currency versus a common monetary standard.
'1n contrast, the money changing costs of the vastly greater flow
of
commercial trans-
actions by business firms are tiny by comparison-typically much less than
one
quarter of one
per cent
of
the gross value of the transactions. However, firms face additional hedging costs
and exchange risk (which hedging can't fully eliminate) when they contract forward.
tThis paper was presented as the twenty ninth Annual Lecture of the Scottish Economic
Society, at the Heriot Watt University,
on
7
April, 1994.
Stanford University and Visiting Heriot-Watt University
331
338
RONALD
1.
McKlNNON
fixed exchange rates would, seemingly, be better secured if national monies
were completely withdrawn from circulation. The American monetary union
with but one currency successfully circulating throughout the
50
states was
the
model.
But the right currency model for Europe is elusive.
To
prepare for full mon-
etary integration in the late
199Os,
the authorities in
1987
removed their
remaining capital controls while pledging to keep exchange rates fixed hence-
forth-rather than leaving them adjustable. This proved
to
be
‘a
bridge
too
far’. Speculative attacks against the exchange rate pegs in
1992
and
1993
forced
some members out of the European Exchange Rate Mechanism (ERM)-while
others had to accept dramatically wider exchange-rate bands. The momentum
for further integration in the EU was severely weakened. In
1994,
once-burned
European central bankers are loathe even to discuss the mutual stabilization of
exchange rates-let alone discuss (re)establishing
a
common monetary standard
with narrow bands
(Financial
Times,
11
April,
1994,
p.
3).
11
THE
IMPOSSIBILITY
OF
FIXED
EXCHANGE
RATES
BETWEEN NATIONAL
CURRENCIES
WITH
FREE
CAPITAL MOBILITY?
All too easily, one could draw the wrong lessons from these unfortunate epi-
sodes. Several writers, most particularly Barry Eichengreen
(1993),
now argue
that fixed exchange rates can only be secured by complete monetary unification
under
a
common currency. Richard Portes
(1993
p.
2)
puts this now prevailing
view most strongly:
‘
“Permanently” fixed exchange rates is an oxymoron’. In
the absence of capital controls, official par values for exchange rates between
national currencies will invite speculative attackfs) that eventually undermine
the currency pegs themselves. The only viable alternatives are floating without
meaningful par values or complete monetary unification,
i
e.,
a
common
currency without an exit option (Obstfeld,
1992).
The failure of the EU countries to secure their exchange rates against specu-
lative attack in
1992-93
seemed
to
vindicate this new wisdom. And, going one
step further, Eichengreen
(1993)
argues that the gains from having
a
common
currency aren’t that great anyway. Among other things, the ‘lower’ level
national governments would be inhibited from taking counter-cyclical action
against region-specific downturns; while the taxes and expenditures by the EU
central government remain too small to provide automatic regional stabiliza-
tion.
In
contrast, the US Federal Government’s much larger flow of revenues
and expenditures substantially cushions downturns in American regional
incomes. (Sala-i-Martin and Sachs,
1992).
Thus Eichengreen concludes:
There is no technical reason why
a
single currency is required to reap the
benefits
of
a single market. In principle, factor- and product-market inte-
’
Eichengreen also criticizes the Maastricht agreement
for
not specifying how the putative
European Central Bank’s open-market and discounting operations would be conducted, i.e.,
which financial instruments would be chosen
to
avoid discriminating against one country
or
another. Responsibility for the prudential supervision
for
community-wide banking institu-
tions also seems
to
have been left in limbo.
0
Scottish Economic
Society
1994
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