1. Introduction

 

This assignment will examine whether two countries can
share the same currency and both prosper. In order to find out, arguments both
in favour and in opposition to the research question will be discussed and
evaluated. Finally, a conclusion will be drawn.

 

Before starting a detailed discussion, it is vital to establish
precise definitions of the terms “sharing a currency” and “prosper”. For the
purpose of this paper, “sharing a currency” is defined as being a member of a
monetary union. According to Bergin (2008), a monetary union, also referred to
as a currency union, is an association of at least two sovereign states which
give up their national currencies to adopt a new shared currency. The author
further states that by doing so, the member countries surrender their control
over money supply as well as monetary policy to a shared authority, a new
central bank. There are multiple currency unions all over the world, which is
why, to apply this broad definition, this paper will use the Economic and
Monetary Union (EMU) as an example. This specific monetary union was chosen due
to its global uniqueness because, as Siklos (2009) notes, the EMU was the first
currency union with both a shared currency and monetary policy but different
national fiscal policies. The European Commission (What is the Economic and
Monetary Union? (EMU), 2018) explains that the EMU was established in 1992 with
the goal of increased growth and employment figures as well as overall enhanced
economic stability. The common currency, the euro, launched at the beginning of
2002 and is used by 19 countries today (Euro area 1999 – 2015, 2018). Out of
these 19, Germany and France will be analysed in this paper. These two
countries were chosen because they are the two largest economies in the EMU,
which should allow for some interesting examination (Share of Member States in
EU GDP, 2017).

 

The second important term, “prosper”, is a little more
difficult to define as there is a vast number of possible prosperity indicators,
such as the unemployment rate or the wage level. For the purpose of this paper,
“prosperity” is defined in accordance with Fritz and Koch (2016, p. 41) as the
level of “economic development and material welfare”. Thus, if this level
increases, prosperity in a state also does. Fritz and Koch (2016) argue that
the higher the economic development in a country, the higher its individual and
social prosperity. In order to gauge the level of prosperity of a state, a
number of indicators are very useful.

 

One of the most important indicators for prosperity is
the Gross Domestic Product (GDP) of a country. According to the Organisation
for Economic Co-operation and Development (OECD) (Gross domestic product (GDP),
2016), the GDP indicates “the expenditure of
final goods and services minus imports”. In addition to the GDP, the level of
trade is an important indicator for a nation’s prosperity. As explained by the
World Bank (Exports of goods and services (% of GDP), 2017), it is determined by
the exports of both goods and services as a share of the respective country’s
GDP.

 

 

 

2. Main
discussion

 

Generally, there is much debate about the advantages
and disadvantages of joining a currency union1.
Most of them build on the most famous academic theory regarding this matter, the
1961 theory of optimum currency areas (OCAs) by Robert Mundell, for which he was
awarded a Nobel Prize. His theory states that potential benefits arising from
the membership in a monetary union, such as enhanced price transparency and
lower transaction costs, have to outweigh potential detriments, such as giving
up flexible exchange rates and sovereign monetary policy. In the following, these
advantages and detriments will be discussed and evaluated.

 

The first argument in favour of prosperity as a result
of a monetary union is the reduction of the transaction costs which arise from
the exchange of currencies associated with the trade between different national
currencies. This argument is brought forward by Brash (2000), Ca’Zorzi, De
Santis, and Zampolli (2011) and Mundell (1961). Mundell especially stresses the
importance of this argument, stating that the existence of a vast number of
different national currencies results in the constant need to converse them. He
believes that the high transaction costs resulting from these constant
conversions of currencies essentially reduce the usefulness of money. Thus, Mundell
concludes that by joining currency unions, the number of national currencies and,
therefore, the transaction costs are reduced. According to the Commission of the
European Communities (1990, p. 21), the savings made from lower transaction
costs, in turn, reduce the “damaging impact on efficient resource allocation”.

Additionally, the savings can be utilised for other
purposes, which is not only economically advantageous for businesses but also
for governments and individual households. It is, however, extremely hard to
measure the amount of these savings for France and Germany due to their different
uses. Hence, the positive impact on prosperity of this argument cannot be quantified.
Nonetheless, it is interesting to note that before the establishment of the
EMU, the Commission of the European Communities (1990) conservatively estimated
that the overall transaction costs of the European Community2
amounted to approximately 13 to 19 billion euro per annum. Given the significance
of this amount and the above mentioned position of France and Germany as the
two largest economies in the EMU, it is obvious that their trade levels are equally
large. Consequently, they enjoy great transaction cost savings as a result of their
participation in the monetary union, leading to increased prosperity.

 

A second major argument in favour of the research
question is that participation in a currency union increases trade levels. Brash
(2000) argues that by joining a monetary union, the exchange rate uncertainty arising
from trade with different countries is eliminated. Accordingly, he finds that a
monetary union stimulates internal trade between the members and yields prosperity
in the form of productivity gains. This conclusion is shared by Ca’Zorzi, De
Santis, and Zampolli (2011), who agree that a currency union substantially
improves trade between its member states. Rose (2000, p. 31) delivers solid
empirical evidence for this argument, calculating that countries in monetary
union trade “over three times as much as countries not sharing a common
currency”. Baldwin et al. (2008, p. 9) confirm that this more than 200% trade
increase is the result of robust calculations and apply the so-called “Rose
effect” to the case of the EMU. They prove how the euro, only six years after
its launch, led to a significant increase of trade of approximately 5% among
the countries using it as their shared currency. Following these findings that
a currency union leads to prosperity through increased trade levels, Frankel
and Rose (1998) add that states with close trade links and high trade volumes benefit
more from joining a monetary union. According to the authors (1998, p. 1009), it
makes these states “more likely to be members of an optimum currency area”.

 

Alesina, Barro and Tenreyro (2002) take into account sensible
prevalent expectations regarding substitution and elasticity between different
goods and agree with Frankel and Rose (1998) that nations which already trade
great volumes with each other also stand to gain a great amount from sharing a
common currency. In his context, Brash (2000) notes that upon foundation of the
EMU, intra-union trade between the future monetary union members already accounted
for a very high proportion in most of these countries. This included France and
Germany, which, therefore, were in an excellent position to receive the prosperity
gains from the increase in trade mentioned above. According to Rose (2000),
these gains from trade are a result of the increase of competitive pressures
and they can be considered as quite substantial. This assumption is confirmed
by empirical results from Frankel and Romer (1999), who conclude that trade
indeed raises income. The authors (1999, p. 394) find that “a rise of one
percentage point in the ratio of trade to GDP” results in a 0.5% to 2% increase
of the income per person. Adding up the 200% trade increase and the at least
0.5% income increase per one percentage point trade increase, it becomes clear
that the establishment of a monetary union leads to enormous prosperity gains
for its participants, including France and Germany.

 

A third argument in favour of prosperity as a result
of sharing a currency is the abolishment of flexible exchange rates. According
to Bean (1992), the pre-EMU system of slightly flexible exchange rates for all
currencies within the European Community was not viable in the long term
perspective. In his opinion, inevitable economic or political tensions would
have had destructive influences and, thus, the only feasible long term
alternative was the establishment of a currency union with a single currency. Ca’Zorzi,
De Santis, and Zampolli (2011) share this view and agree that flexible exchange
rates lead to instability. The authors argue that the removal of said flexible
rates through participation in a monetary union leads to greater stability and
the elimination of currency risk. They believe that this, in turn, leads to enhanced
financial integration, which may reduce financing costs of businesses, again
leading to enhanced prosperity.

 

Altogether, lower transaction costs, increased trade
and enhanced financial integration all contribute to increased long term prosperity
of the countries sharing a currency in the form of a monetary union.

 

 

Following these positive arguments, however, there are
a number of arguments stating that sharing a currency is an obstacle for
prosperity.

 

According to Brash (2000), the first major drawback
regarding participation in a monetary union is the loss of the sovereign
national monetary policy. As Bergin (2008) states, this is due to the fusion of
the participating states’ sovereign central banks into one common system. He
explains that in the case of the EMU, this system is the European System of
Central Banks, led by the European Central Bank (ECB), which is responsible for
the union’s money supply and overall monetary policy. While this system, in
principle, gives all members of the currency union a say in the formation of a
shared monetary policy, Brash (2000) argues that each member state only has one
sole voice amid many others. In this context, Bergin (2008) notes that ceding control
of the national money supply entails a number of restrictions on decisions
regarding sovereign economic policies and, thus, national prosperity. According
to the author, this is due to the fact that changes in the national money
supply largely affect how national government budgets are financed. In addition
to this, Brash (2000) as well as Ca’Zorzi, De Santis and Zampolli (2011) argue that
the loss of monetary policy decision-making power causes further instability. Brash
(2000) criticises the associated omission of an important method to influence
national inflation rates and to moderate any potential demand shocks. Ca’Zorzi,
De Santis, and Zampolli (2011) mention another vital stabilising tool which is
given up, namely the option of utilising national monetary policy to regulate
fluctuations of business cycles. In consequence, the authors state how the
respective national fiscal policy gains in importance in order to address these
cycles.

As mentioned above, all members in a currency union have
to agree on one monetary policy to deal with multiple countries’ business cycles.
In the EMU, the gravity of the loss of sovereign decision-making power is not
the same for all member states, as Bergin (2008) notes. He finds that it
depends largely on the similarity of the countries involved, therefore basing
his view on the theory of Mundell (1961), who finds that the less similar
participants in a monetary union are, the less likely will it be a success.

Opposing but
same arg

Bergin (2008) thus states that if two countries tend
to have similar business cycles and experience recessions at the same time,
they are far more likely to agree on a single monetary policy which leads to
prosperity for both of these countries simultaneously. This is the case for
France and Germany, both of which XXX

 

 

The second main argument against the thesis that
sharing a currency leads to prosperity for the participating countries is the
inability to adjust the rigid exchange rate which is prevalent within a
monetary union. While the same argument is brought forward by supporters of
monetary unions, this inflexibility of the exchange rate can also have negative
effects on a country’s prosperity. The Commission of the European Communities (1990)
also brings this argument forward as the main cost of the EMU. They note that the
loss of the sovereign policy of flexible exchange rates equals the forfeit of the
possibility of national macroeconomic adjustments. According to Durevall,
Newfarmer and Söderbom (2011), this increases the exposure of the monetary
union’s members to adverse asymmetric shocks, which, as a result, poses a
serious threat to production and employment in the member countries. In the
case of the EMU, however, the Commission of the European Communities (1990)
warns that this threat should not be overstated because the exchange rates of
the EMU in relation to non-EMU countries will still be flexible. Moreover, the
Commission states that the EMU itself will reduce the occurrence of
country-specific shocks and argues that, on top of that, the EMU would have
also been able to absorb all of the past two decades’ major economic shocks without
any great disturbances. This shows that, contrary to its initial appearance, inflexible
exchange rates do not represent an obstacle to prosperity.

 

Altogether

 

 

 

3. Conclusion

 

In conclusion, I believe two countries can share a currency
and both prosper, as can be seen from the example of the Economic and Monetary
Union in Europe. In my opinion, the above discussed gains from a monetary union
significantly outweigh the detriments presented in this paper. The data
regarding the gains from trade and the increase of income show how prosperity
is achieved by participation in a currency union. This is more convincing to me
than the drawbacks of giving up sovereign monetary policy and flexible exchange
rates. Nonetheless, it is clear that membership in a currency union is not a guarantee
for an immediate increase in growth and prosperity. In order for this to work
out, the underlying policy framework has to be adequate.

1 See
McKinnon (1963); Kenen (1969); Alesina, Barro and Tenreyro (2002)

2 Member
states of the European Community (now European Union) in 1990: Germany, France,
Italy, the Netherlands, Belgium, Luxembourg, Denmark, Ireland, United Kingdom,
Greece, Spain and Portugal (Europe without frontiers, 2018)

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