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MONDAY JULY 20 1998 

ROBERT CHOTE: Lessons from the past
History suggests that successful currency unions depend on political objectives

As the launch date of the euro on January 1 1999 draws ever nearer, it is a sobering thought that as many currency unions have collapsed during the 20th century as have been created.

The Austro-Hungarian empire, Czechoslovakia, Yugoslavia and the Soviet Union have all seen political disintegration accompanied by monetary dismemberment. Only five significant currency or exchange rate unions have been created, of which four survive (the Belgium-Luxembourg monetary union, the CFA zone in francophone Africa, the Common Monetary Area in southern Africa and the East Caribbean Currency Area) and one has collapsed (the East African Community).

Using historical parallels to assess the prospects for European monetary union is not easy because there is no precedent for the creation of a cross-border monetary alliance on anything like this scale. But there are some lessons from the ways in which nation states have asserted, shared or surrendered monetary sovereignty in the past that remain relevant.

Michael Mussa, economic counsellor at the International Monetary Fund, expresses the conventional view of monetary sovereignty thus: "Virtually all the world's nations assert and express their sovereign authority by maintaining a distinct national money and protecting its use within their respective jurisdictions. Money is like a flag; each country has to have its own."

But although money has been used since the dawn of modern civilisation, it was not until the 19th century that western governments first claimed the right to monopolise control over its issue and management. Until then foreign coins could enter a country and circulate without particular restriction.

The experience of the US was typical. As late as 1830 almost one-quarter of the coins circulating in the country were Mexican pesos. Gold coins from Britain, France, Portugal and Brazil also circulated widely, enjoying explicit protection from Federal legislation. During the 1850s new US silver and copper coins were introduced and shortly afterwards the dollar became the country's sole legal tender.

Fully fledged national currencies emerged in Europe and Japan at around the same time. In the wave of decolonisation that followed the second world war it was taken for granted that each nation would want its own central bank and currency.

More recently, the Baltic states of Estonia, Latvia and Lithuania saw the creation of new currencies as a natural complement to their new- found independence when the Soviet Union dissolved in late 1991. The other republics tried to maintain the rouble zone, but it collapsed as they scrambled to appropriate real resources with money in effect printed unwillingly in Moscow.

Benjamin Cohen, at the University of California (Santa Barbara), says nation states gain from monetary monopolies in four ways.*

First, as in the Baltic states, political symbolism. Second, seignorage - the difference between what a currency costs a government to produce and the resources it can command from the private sector. Of value even in normal times, Charles Goodhart, a professor at the London School of Economics, calls seignorage the "revenue of last resort". Third, the scope to influence economic activity by changing interest rates and the exchange rate. Fourth, insulation from foreign influence. For example, Panama's use of the dollar allowed the US to cripple its economy while trying to displace General Manuel Noriega in 1988.

Entering a monetary alliance, such as a single currency, dilutes all these gains. But there are benefits too.

For one thing, political symbolism works both ways.

It is conventional wisdom that progress towards monetary union in Europe is driven as much by the desire to promote political union as by an assessment of economic pros and cons. The repeated efforts to forge a workable monetary union in the German "Zollverein" customs union last century had a similar motivation.

Another gain is an improved power position in relation to the outside world. The D-Mark lags behind the dollar in most dimensions that determine a currency's international attractiveness. Monetary union will make it a closer fight, although not as quickly as some might like.

Economists argue that monetary sovereignty should be pooled if the micro-economic benefits of reduced transaction costs, greater price transparency, industrial specialisation and increased trade and investment flows outweigh the macroeconomic flexibility that has to be sacrificed. This depends on many variables, including wage flexibility, fiscal arrangements and the external disturbances an economy faces.

But as Paul de Grauwe, at the Catholic University of Louvain, says: "Not a single monetary union in the past came about because of a recognition of economic benefits of the union. In all cases the integration was driven by political objectives."

Professor Cohen argues that political factors also determine whether currency unions survive. Two characteristics matter. First, is there a a dominant state (or hegemon) willing to keep the arrangement functioning effectively on terms acceptable to all? Second, is there a genuine sense of community that will override the temptation for a participant to exploit its fellows or exit?

"Where both are present, they are a sufficient condition for success," he argues. "Where neither is present, unions erode or fail." The Belgium-Luxembourg monetary union typifies the former; the East African Community typifies the latter.

What of Emu? One of the arguments for the single currency is that it waters down the hegemonic role Germany played in the European exchange rate mechanism. As for a sense of community, it has been strong enough to drive the process so far.

But it is here that economics surely enters the equation again. Europe's sense of community is far stronger among its political elites than its electorates. If Emu delivers a poor economic outcome, the political glue may not be strong enough to withstand popular dissent.

*The Geography of Money, by Benjamin J Cohen, Cornell University Press 1998.

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