1. Introduction This assignment will examine whether two countries canshare the same currency and both prosper. In order to find out, arguments bothin favour and in opposition to the research question will be discussed andevaluated. Finally, a conclusion will be drawn.
Before starting a detailed discussion, it is vital to establishprecise definitions of the terms “sharing a currency” and “prosper”. For thepurpose of this paper, “sharing a currency” is defined as being a member of amonetary union. According to Bergin (2008), a monetary union, also referred toas a currency union, is an association of at least two sovereign states whichgive up their national currencies to adopt a new shared currency. The authorfurther states that by doing so, the member countries surrender their controlover money supply as well as monetary policy to a shared authority, a newcentral bank. There are multiple currency unions all over the world, which iswhy, to apply this broad definition, this paper will use the Economic andMonetary Union (EMU) as an example.
This specific monetary union was chosen dueto its global uniqueness because, as Siklos (2009) notes, the EMU was the firstcurrency union with both a shared currency and monetary policy but differentnational fiscal policies. The European Commission (What is the Economic andMonetary Union? (EMU), 2018) explains that the EMU was established in 1992 withthe goal of increased growth and employment figures as well as overall enhancedeconomic stability. The common currency, the euro, launched at the beginning of2002 and is used by 19 countries today (Euro area 1999 – 2015, 2018). Out ofthese 19, Germany and France will be analysed in this paper.
These twocountries were chosen because they are the two largest economies in the EMU,which should allow for some interesting examination (Share of Member States inEU GDP, 2017). The second important term, “prosper”, is a little moredifficult 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 thelevel of “economic development and material welfare”. Thus, if this levelincreases, prosperity in a state also does. Fritz and Koch (2016) argue thatthe higher the economic development in a country, the higher its individual andsocial prosperity.
In order to gauge the level of prosperity of a state, anumber of indicators are very useful. One of the most important indicators for prosperity isthe Gross Domestic Product (GDP) of a country. According to the Organisationfor Economic Co-operation and Development (OECD) (Gross domestic product (GDP),2016), the GDP indicates “the expenditure offinal goods and services minus imports”. In addition to the GDP, the level oftrade is an important indicator for a nation’s prosperity. As explained by theWorld Bank (Exports of goods and services (% of GDP), 2017), it is determined bythe exports of both goods and services as a share of the respective country’sGDP. 2. Maindiscussion Generally, there is much debate about the advantagesand disadvantages of joining a currency union1.
Most of them build on the most famous academic theory regarding this matter, the1961 theory of optimum currency areas (OCAs) by Robert Mundell, for which he wasawarded a Nobel Prize. His theory states that potential benefits arising fromthe membership in a monetary union, such as enhanced price transparency andlower transaction costs, have to outweigh potential detriments, such as givingup flexible exchange rates and sovereign monetary policy. In the following, theseadvantages and detriments will be discussed and evaluated.
The first argument in favour of prosperity as a resultof a monetary union is the reduction of the transaction costs which arise fromthe exchange of currencies associated with the trade between different nationalcurrencies. This argument is brought forward by Brash (2000), Ca’Zorzi, DeSantis, and Zampolli (2011) and Mundell (1961). Mundell especially stresses theimportance of this argument, stating that the existence of a vast number ofdifferent national currencies results in the constant need to converse them. Hebelieves that the high transaction costs resulting from these constantconversions of currencies essentially reduce the usefulness of money. Thus, Mundellconcludes that by joining currency unions, the number of national currencies and,therefore, the transaction costs are reduced. According to the Commission of theEuropean Communities (1990, p. 21), the savings made from lower transactioncosts, in turn, reduce the “damaging impact on efficient resource allocation”.Additionally, the savings can be utilised for otherpurposes, which is not only economically advantageous for businesses but alsofor governments and individual households.
It is, however, extremely hard tomeasure the amount of these savings for France and Germany due to their differentuses. Hence, the positive impact on prosperity of this argument cannot be quantified.Nonetheless, it is interesting to note that before the establishment of theEMU, the Commission of the European Communities (1990) conservatively estimatedthat the overall transaction costs of the European Community2amounted to approximately 13 to 19 billion euro per annum. Given the significanceof this amount and the above mentioned position of France and Germany as thetwo largest economies in the EMU, it is obvious that their trade levels are equallylarge. Consequently, they enjoy great transaction cost savings as a result of theirparticipation in the monetary union, leading to increased prosperity. A second major argument in favour of the researchquestion is that participation in a currency union increases trade levels. Brash(2000) argues that by joining a monetary union, the exchange rate uncertainty arisingfrom trade with different countries is eliminated. Accordingly, he finds that amonetary union stimulates internal trade between the members and yields prosperityin the form of productivity gains.
This conclusion is shared by Ca’Zorzi, DeSantis, and Zampolli (2011), who agree that a currency union substantiallyimproves trade between its member states. Rose (2000, p. 31) delivers solidempirical evidence for this argument, calculating that countries in monetaryunion trade “over three times as much as countries not sharing a commoncurrency”. Baldwin et al.
(2008, p. 9) confirm that this more than 200% tradeincrease is the result of robust calculations and apply the so-called “Roseeffect” to the case of the EMU. They prove how the euro, only six years afterits launch, led to a significant increase of trade of approximately 5% amongthe countries using it as their shared currency. Following these findings thata currency union leads to prosperity through increased trade levels, Frankeland Rose (1998) add that states with close trade links and high trade volumes benefitmore from joining a monetary union.
According to the authors (1998, p. 1009), itmakes these states “more likely to be members of an optimum currency area”. Alesina, Barro and Tenreyro (2002) take into account sensibleprevalent expectations regarding substitution and elasticity between differentgoods and agree with Frankel and Rose (1998) that nations which already tradegreat volumes with each other also stand to gain a great amount from sharing acommon currency. In his context, Brash (2000) notes that upon foundation of theEMU, intra-union trade between the future monetary union members already accountedfor a very high proportion in most of these countries. This included France andGermany, which, therefore, were in an excellent position to receive the prosperitygains from the increase in trade mentioned above.
According to Rose (2000),these gains from trade are a result of the increase of competitive pressuresand they can be considered as quite substantial. This assumption is confirmedby empirical results from Frankel and Romer (1999), who conclude that tradeindeed raises income. The authors (1999, p. 394) find that “a rise of onepercentage point in the ratio of trade to GDP” results in a 0.5% to 2% increaseof the income per person.
Adding up the 200% trade increase and the at least0.5% income increase per one percentage point trade increase, it becomes clearthat the establishment of a monetary union leads to enormous prosperity gainsfor its participants, including France and Germany. A third argument in favour of prosperity as a resultof sharing a currency is the abolishment of flexible exchange rates. Accordingto Bean (1992), the pre-EMU system of slightly flexible exchange rates for allcurrencies within the European Community was not viable in the long termperspective. In his opinion, inevitable economic or political tensions wouldhave had destructive influences and, thus, the only feasible long termalternative 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 exchangerates lead to instability.
The authors argue that the removal of said flexiblerates through participation in a monetary union leads to greater stability andthe elimination of currency risk. They believe that this, in turn, leads to enhancedfinancial integration, which may reduce financing costs of businesses, againleading to enhanced prosperity. Altogether, lower transaction costs, increased tradeand enhanced financial integration all contribute to increased long term prosperityof the countries sharing a currency in the form of a monetary union.
Following these positive arguments, however, there area number of arguments stating that sharing a currency is an obstacle forprosperity. According to Brash (2000), the first major drawbackregarding participation in a monetary union is the loss of the sovereignnational monetary policy. As Bergin (2008) states, this is due to the fusion ofthe participating states’ sovereign central banks into one common system. Heexplains that in the case of the EMU, this system is the European System ofCentral Banks, led by the European Central Bank (ECB), which is responsible forthe union’s money supply and overall monetary policy. While this system, inprinciple, gives all members of the currency union a say in the formation of ashared monetary policy, Brash (2000) argues that each member state only has onesole voice amid many others. In this context, Bergin (2008) notes that ceding controlof the national money supply entails a number of restrictions on decisionsregarding sovereign economic policies and, thus, national prosperity. Accordingto the author, this is due to the fact that changes in the national moneysupply largely affect how national government budgets are financed. In additionto this, Brash (2000) as well as Ca’Zorzi, De Santis and Zampolli (2011) argue thatthe loss of monetary policy decision-making power causes further instability.
Brash(2000) criticises the associated omission of an important method to influencenational inflation rates and to moderate any potential demand shocks. Ca’Zorzi,De Santis, and Zampolli (2011) mention another vital stabilising tool which isgiven up, namely the option of utilising national monetary policy to regulatefluctuations of business cycles. In consequence, the authors state how therespective national fiscal policy gains in importance in order to address thesecycles. As mentioned above, all members in a currency union haveto 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 notthe same for all member states, as Bergin (2008) notes. He finds that itdepends largely on the similarity of the countries involved, therefore basinghis view on the theory of Mundell (1961), who finds that the less similarparticipants in a monetary union are, the less likely will it be a success.
Opposing butsame argBergin (2008) thus states that if two countries tendto 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 toprosperity for both of these countries simultaneously. This is the case forFrance and Germany, both of which XXX The second main argument against the thesis thatsharing a currency leads to prosperity for the participating countries is theinability to adjust the rigid exchange rate which is prevalent within amonetary union. While the same argument is brought forward by supporters ofmonetary unions, this inflexibility of the exchange rate can also have negativeeffects 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 theloss of the sovereign policy of flexible exchange rates equals the forfeit of thepossibility of national macroeconomic adjustments. According to Durevall,Newfarmer and Söderbom (2011), this increases the exposure of the monetaryunion’s members to adverse asymmetric shocks, which, as a result, poses aserious threat to production and employment in the member countries.
In thecase of the EMU, however, the Commission of the European Communities (1990)warns that this threat should not be overstated because the exchange rates ofthe EMU in relation to non-EMU countries will still be flexible. Moreover, theCommission states that the EMU itself will reduce the occurrence ofcountry-specific shocks and argues that, on top of that, the EMU would havealso been able to absorb all of the past two decades’ major economic shocks withoutany great disturbances. This shows that, contrary to its initial appearance, inflexibleexchange rates do not represent an obstacle to prosperity.
Altogether 3. Conclusion In conclusion, I believe two countries can share a currencyand both prosper, as can be seen from the example of the Economic and MonetaryUnion in Europe. In my opinion, the above discussed gains from a monetary unionsignificantly outweigh the detriments presented in this paper.
The dataregarding the gains from trade and the increase of income show how prosperityis achieved by participation in a currency union. This is more convincing to methan the drawbacks of giving up sovereign monetary policy and flexible exchangerates. Nonetheless, it is clear that membership in a currency union is not a guaranteefor an immediate increase in growth and prosperity. In order for this to workout, the underlying policy framework has to be adequate.1 SeeMcKinnon (1963); Kenen (1969); Alesina, Barro and Tenreyro (2002)2 Memberstates 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)