Optimal Currency Areas Scottish Economic Society/Royal Bank of Scotland Annual Lecture, 1999
| Published date | 01 August 2000 |
| Author | Willem H. Buiter |
| DOI | http://doi.org/10.1111/1467-9485.00161 |
| Date | 01 August 2000 |
{Journals}sjpe/47_3/x178/makeup/x178.3d
Scottish Journal of Political Economy, Vol. 47, No. 3, August 2000
#Scottish Economic Society 2000.Publ ishedby Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and
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OPTIMAL CURRENCY AREAS
SCOTTISH ECONOMIC SOCIETY=
ROYAL BANK OF SCOTLAND
ANNUAL LECTURE, 1999
Willem H. Buiter
ABSTRACT
Microeconomic efficiency and market transparency argue in favour of UK
membership in EMU and for Scotland's membership in the UK monetary union
and also in EMU. UK seigniorage (government revenues from money issuance)
would be boosted by EMU membership. Lender of last resort arrangements
would not be substantially affected by UK membership in EMU. The UK is too
small and too open to be an optimal currency area. The same point applies even
more emphatically to Scotland. The `one-size-fits-all', `asymmetric shocks' and
`cyclical divergence' objections to UK membership are based on the misapprehen-
sion that independent national monetary policy, and the associated nominal
exchange rate flexibility, can be used effectively to offset or even neutralise
asymmetric shocks. This `fine tuning delusion' is compounded by a failure to
understand that, under a high degree of international financial integration,
market-determined exchange rates are primarily a source of shocks and
instability. Instead, opponents of UK membership in EMU view exchange rate
flexibility as an effective buffer for adjusting to asymmetric shocks originating
elsewhere. I know of no evidence that supports such an optimistic reading of what
exchange rate flexibility can deliver under conditions of very high international
financial capital mobility. The economic arguments for immediate UK member-
ship in EMU, at an appropriate entry rate, are overwhelming. Monetary union
raises important constitutional and political issues. It involves a further surrender
of national sovereignty to a supranational institution, the ECB=ESCB. It is
essential that this transfer of national sovereignty be perceived as legitimate by
those affected by it. In addition, the citizens of the UK have become accustomed
to a high standard of openness and accountability of their central bank since it
gained operational independence in 1997. The ECB=ESCB must be held to the
same high standard, and, while there are grounds for optimism, there still is some
waytogothere.
213
University of Cambridge and Bank of England
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IINTRODUCTION
Should the UK join EMU? Would Scotland benefit from having its own
currency and monetary authority? Similar questions are being asked the world
over, in Canada, Iceland, Switzerland, Mexico, Argentina, Bulgaria and the
Ukraine.1It is an issue in political economy par excellence. Technical economic
and financial arguments are interlaced with political and constitutional
considerations.
In this lecture I illustrate the general question as to what determines a nation's
optimal currency regime, by focusing on the arguments for and against UK
membership in EMU. Along the road, the question of the optimal currency
arrangement for Scotland will, I hope, also be answered satisfactorily.
Why does the currency regime matter? In Sections II to V, I review the
technical economic arguments for and against a common currency, starting with
the microeconomic benefits of a common medium of exchange and the
microeconomic costs of the change-over. Next is the question of seigniorageÐ
the real resources appropriated by a national government through the issuance
of non-interest-bearing central bank liabilities. The third topic is systemic
financial stability and the role of the national central bank as the lender of last
resort. The final, and most controversial economic issue concerns the costs and
benefits of national monetary sovereignty and exchange rate flexibility from the
point of view of macroeconomic stabilisation policy. This is the venerable
subject of optimal currency area theory. It is here that conventional wisdom and
enlightened economic analysis part company most starkly. Section VI considers
some political and constitutional aspects of membership in a common currency
arrangement. This includes the substance and symbols of national sovereignty
and the issue of accountability of the monetary policy makers to the electorate.
Section VII concludes.
II THE MICROECONOMICS OF A COMMON CURRENCY
The transaction cost saving advantages of a common currency are familiar. A
medium of exchange or transactions medium is subject to a network externality
(Dowd and Greenaway, 1993). The usefulness to me of a medium of exchange is
increasing in the number of other economic agents likely to accept it in exchange
for goods, services and securities. By eliminating the need for the exchange of
one currency for another, monetary union saves real resources. From a
microeconomic efficiency point of view, if one were to design the world from
scratch, a single currency would be adopted.
If the status quo is a situation in which there are multiple national currencies,
the permanent flow of transaction cost savings from having a common currency
have to be balanced against the one-off, up-front switch over costs of moving to
a common currency. For the UK, if and when it joins EMU, the remaining
1See eg, Buiter (1999c, 1999d).
214 WILLEM H. BUITER
#Scottish Economic Society 2000
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switch over costs are likely to be lower than the total costs for the countries that
joined EMU in the first round, for three reasons.
First, in the wholesale financial markets the investment has already been
made. Second, the UK is unlikely to join much before 2003. This will be after the
date (1 July, 2002) on which the visible relics of the old national currencies will
have disappeared from the existing EMU area, through the issuance of euro
notes and coins and the demonetisation of the old national currencies. UK
businesses and consumers will therefore already be familiar with the euro in all
its manifestations, at the wholesale and retail levels.
Third, the microeconomic costs of giving up sterling and switching to the euro
depend on how widespread the use of the national currency is as a means of
payment or medium of exchange and as a nume
Âraire or unit of account and
invoicing currency. While at the retail level and in labour contracts the use of
sterling is likely to remain near-universal, contracts among larger international
businesses are likely to see a growing use of the euro. While one should not
overstate the scope and scale of this `creeping demonetisation of sterling', it will
make the final switch easier.
It is impossible to be precise and confident about the magnitude of the
resource savings involved. The spreads in the foreign exchange markets will
understate the true cost because it ignores the `in-house' costs incurred by the
non-bank parties in the foreign exchange transactions. It overestimates the true
costs to the extent that there are monopoly profits or X-inefficiency in the
foreign exchange markets.
In its report One market, one money (European Economy, 1990), the
Commission of the European Communities estimated the permanent flow of
exchange transaction costs savings at about 05% of GDP for the 15 member
Community as a whole. Of course, this exercise involved the thought experiment
of the abolition of 14 national currencies and their replacement by a single
currency. In the case of the UK joining EMU, there would only be the abolition
of a single national currency and its replacement by the euro. The foreign
exchange transaction costs savings should also be augmented by the transaction
costs saved in now redundant exchanges among instruments denominated in
national currencies motivated by exchange risk considerations. For example, a
switch from UK Treasury bills to German euro-denominated bills involves the
sale of the UK sterling bills, a purchase of euros and the purchase of the German
bills. There would be three transactions, and three sets of transaction costs.
Foreign exchange market transaction costs are just one of the three. One half of
one per cent of GDP (if that is a indeed a reasonable estimate) may not sound
like much, but it is twice the maximal estimate of the amount of seigniorage the
UK currently gets from note issuance (see Table 1).
The magnitude of the switching costs for the UK are even harder to estimate.
Competing estimates differ by one and sometimes two orders of magnitude. The
switching costs do not just involve the administrative, legal and hardware cost of
re-denominating all contracts, changing vending machines etc., but also the
psychological costs of having to compute prices with a new nume
Âraire. With
boundedly rational individuals, these costs will always be there, but they are
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