OPTIMUM CURRENCY AREAS
Robert A. Mundell
Columbia University
http://www.columbia.edu/~ram15/eOCATAviv4.html
Extended version of a luncheon speech presented at the "Conference on Optimum Currency Areas," Tel-Aviv University, December 5, 1997
It is a great satisfaction to be the recipient of so much kindness occasioned by my 1961 article on optimum currency areas. I would like to tell you a little about how the article came about, what my intentions were when I wrote it, and then comment on its relevance today.
Genesis of the Article
The beginnings of the idea first occurred to me in the academic year 1955-6 when I was writing my dissertation under James Meade for MIT at the London School of Economics. My dissertation for MIT, titled "Essays on the Theory of Capital Movements" was entirely devoted to the real side of the subject--the transfer problem, stability conditions, welfare implications, factor mobility, transport costs, and so forth; it had nothing to do with flexible or fixed exchange rates. Meade, however, was an ardent advocate of flexible exchange rates and it was a hot subject at LSE. He had suggested that the signers of the Treaty of Rome achieve balance of payments equilibrium by letting exchange rates float. At that time I had an open mind on the subject but I could not see why countries that were in the process of forming a common market should saddle themselves with a new barrier to trade in the form of uncertainty about exchange rates.
In the next academic year, 1956-57, I was a post-doctoral fellow in political economy at the University of Chicago. Friedman, as you know, like Meade, championed flexible exchange rates. Their reasons were very different. Meade, the liberal socialist, saw flexible exchange rates as a device for achieving external balance while freeing policy tools for the implementation of national planning objectives. Friedman, the libertarian conservative, saw flexible exchange rates as way of getting rid of exchange and trade controls. Both economists saw flexible exchange rates as a means of altering real wages when money wage rigidities would otherwise cause unemployment. The analogy frequently used was that it was easier to put the clocks back than to change people's habits.
As at LSE, flexible exchange rates was a hot subject at Chicago, and it was billed as a free market alternative to fixed exchange rates. It occurred to me here that if the case for flexible exchange rates held for the United States or Canada, it should also hold for any of the regions in those multi-regional countries. But to have flexible exchange rates between regions of the same country, it would be necessary to have more than one currency. Were there not costs associated with the creation of additional currencies? Milton's answer to my queries on that subject were that if the argument for regional currencies was correct within a particular country, it was a problem that was probably becoming less important as the national economy became more integrated. The upshot however was that I began thinking seriously about the relation between "regions" and "countries" in the context of monetary systems.
Students of trade theory are of the criticism that John H. Williams had made of the classical model of trade, which was based on the supposition that factors of production were mobile internally but immobile internationally. Williams argued that factors were by no means completely mobile inside countries, nor were they completely immobile between countries. Once said, this is obvious, as any glance at history will confirm. But, despite the work of Bertil Ohlin and especially Carl Iversen, who took explicit account of factor movements, the theory of trade typically identified regions with countries. I now began to see that the same criticism that Williams had made of real trade theory may be applicable to international monetary theory and the theory of exchange rates.
In 1957-58, I returned to Canada to teach at the University of British Columbia. In the fall of that year, I presented a paper at a faculty seminar on flexible exchange rates and regional problems, in which I introduced the idea that, if the theory of flexible exchange rates endorsed by James Meade and Milton Friedman were valid, it would apply to British Columbia and the other individual regions in Canada rather than to Canada itself. The Canadian dollar, which, uniquely among the G-10 countries was then floating, had not helped Canada to escape the US business cycle and in any case was addressed to the stability of the heartland economy of Ontario and lower Quebec and not to the peripheral regions in the west, the north and the Maritimes. I also noted that Canadian labor unions were not independent of US labor unions so that even though the Canadian dollar had appreciated against the US dollar, wage expansion was no slower in Canada than wage expansion in the United States. I should make it clear, however, that I was not proposing an independent currency for British Columbia; I was rather beginning to think of the argument as a qualification, if not a refutation, of the argument for flexible exchange rates.
The next academic year, 1958-59, was spent at Stanford University. By this time I had developed what would become known as the "Mundell-Fleming model." At Stanford I presented a paper at a faculty seminar with a title something like "The Theory of International Adjustment and Optimum Currency Units." This was the first public presentation of my external-internal balance dynamic model (QJE, May 1960) and I was flattered to have in my audience, not just Lorie Tarshis, Ed Shaw, Ken Arrow, Bernard Haley and Mel Reder and others from Stanford, but also Abba Lerner and Tibor Scitovsky, who had come up from Berkeley. Most of my time in the seminar was taken up explaining the dynamic model and the adjustment mechanism under fixed and flexible exchange rates. After the seminar, Lerner chided me for not having talked enough about optimum currency areas, but, with his great intellect, it was easy for him to grasp my basic idea to him in a few sentences. After--or was it before?--that seminar, I submitted a long paper to Roy Harrod, the editor of the Economic Journal, including in it not only the model of monetary and exchange rate dynamics, but also the theory of international disequilibrium, the appropriate mix of monetary and fiscal policy for internal and external balance, the principle of effective market classification, and the theory of optimum currency areas.
When Harrod rejected it, I was naturally disappointed, but, in retrospect, he did me a favor. When I got to know him well a few years later, he told me that at the time he had been in a state of distress over a controversy raging in the Journal between Harry Johnson and Don Patinkin; soon after, he resigned the editorship. The rejection taught me not to overload an article with too many ideas. The Tinbergenian principle is a good rule of thumb here as in economic policy: one target, one instrument; one idea, one paper!
I spent the next two years, 1959-61, at the Bologna Center of The Johns Hopkins School of Advanced International Studies. It was there I put the finishing touches on my Optimum Currency Area paper. I remember a precocious student there, Helmuth Mayer (who went on to a fine career at the BIS and became an outstanding expert on the Eurodollar market), helping me to make up my mind whether to title the paper "Optimum Currency Units" or "Optimum Currency Areas." The next question was to decide where to send it. I had already published two articles in the AER (Mundell, 1957, 1960), another in the QJE, (Mundell 1960), another two in the Canadian (Mundell 1957, 1961), so I sent this article it to Economica. That journal had already rejected two of papers so I was not surprised when the OCA paper was also rejected! I sent it to the AEA, where that wonderful friend and great editor, Bernard Haley, enthusiastically accepted it. It came out in September 1961.
Doubts About Flexible Exchange Rates
So much for the five-year history of the article. The story of the idea did not end with the article. My own views evolved and it became a subject of discussion in the literature. The article presented a qualification to the case for flexible exchange rates, which, provided the basic argument was valid, works best when currency areas are regions. My next two years, 1961-63, were spent at the IMF. During those years I was mainly involved with the theory of the policy mix, the theory of inflation and the monetary approach to the balance of payments. There was not much to report on optimum currency areas, except that I tried--unsuccessfully as it turned out--to get the Fund to address the optimum currency area issue in the case against flexible exchange rates that the staff was preparing for its 1962 Annual Report.
At this point I was skeptical about the applicability of flexible exchange rates in many situations but not opposed as a matter of principle. If you read my testimony to the Joint Economic Committee in 1963 (Mundell 1963), you will see that at that time I am still rather sympathetic to the use of exchange rates as a mechanism of adjustment. But my main interest was in getting the arguments right. Starting in 1964, I took part in the Bellagio-Princeton Study Group on International Monetary Reform, organized by Fritz Machlup, Robert Triffin and William Fellner. This group, you may remember, distinguished four main options for the international monetary system: the gold standard; flexible exchange rates; a new international reserve facility; and a world central bank.
A follow-up of those discussions was the circulation of a petition in 1966 urging the generalized adoption of flexible exchange rates. When I did not respond, Willy Fellner called to ask whether my failure to respond indicated an objection to it. I told him, yes, that I had arrived at the conclusion that a movement to generalized flexible exchange rates would be a step backward for the international monetary system. I had crossed the Rubicon. It was with great regret that I felt compelled to distance myself on this basic policy issue from teachers and good friends like James Meade, Milton Friedman, Harry Johnson, Gottfried Haberler, Fritz Machlup, Lloyd Metzler and Arnold Harberger and others who supported flexible exchange rates. I found myself among such diverse company as Lord Robbins, Sir Roy Harrod, Jacques Rueff, Edward Bernstein, Robert Triffin, Otmar Emminger, Rinaldo Ossola, Charles Kindleberger, Guido Carli and Robert Roosa--and some of them would later become defectors. Of course I was happy to be in the company of all the great economists of the past who, with the possible exceptions of Fisher and Keynes, were vigorously opposed to flexible exchange rates between countries with inconvertible currencies.
Like the tariff and bimetallic controversies of the late 19th century, the flexible exchange rate controversy was complicated by considerations that went far beyond economics as it was normally conceived. From a theoretical point of view, I had come to have strong doubts about the validity of the basic argument for flexible exchange rates as an adjustment mechanism, and became more appreciative of the adjustment mechanism under fixed exchange rates. It was not that I had forgotten the Mundell-Fleming model, but that I had gone beyond it.
At the outset it should be noted that the choice between fixed and flexible exchange rates is a false and biased way of posing the issue. It presents the false suggestion that flexibility of the exchange rate provides an extra degree of freedom. In a general equilibrium system, there is one degree of freedom. How this is used characterizes the system. A country has a choice to stabilize such possible targets as the price level, the money supply, the exchange rate, the price of gold or the wage rate. In other words, it can have a commodity standard, a monetary standard, a foreign currency standard, a gold standard or a wage standard. In the international monetary system of the 1960s the price of gold was fixed by the United States and the price of the dollar was fixed by foreign countries. Moving toward flexible exchange rates (and a flexible price of gold for the United States) shifts the burden of stabilization policy onto a monetary standard (a là Friedman), or a commodity standard (a là Thomas Attwood or Irving Fisher or Frank Graham) or a wage standard. Four main possibilities are the following:
"STANDARD"
FIXED TARGET
VARIABLE
VARIABLE
VARIABLE
Commodity
price level
exchange rate
money supply
gold price
Monetary
money supply
exchange rate
price level
gold price
Foreign Currency
exchange rate
money supply
price level
gold price
Gold
gold price
money supply
exchange rate
price level
When the issue is posed in this way, one variable is fixed and three are flexible; there is no extra degree of freedom in a framework of a stable system. Of course, it is possible for the authorities not to fix any single variable but instead a weighted average of the price level, the money supply, the exchange rate and the price of gold. Even in this case, however, there is no extra degree of freedom.
My objections to flexible exchange rates make an exception for two very different types of cases. Very unstable countries--usually the result of large budget deficits that are being financed by the banking system--cannot have fixed exchange rates; in general, a country that is inflating relative to its currency-area partner cannot maintain fixed exchange rates. Nor do the objections apply to a very large country in a world where there is no established international monetary system. The largest economy in the world--the United States--does not have the option of fixing exchange rates unilaterally.
Initial conditions matter. In the 1960s, of course, there was a coherent international monetary system even if it had developed problems arising from the undervaluation of gold. There were definite costs to abandoning the system. Apart from that, I had come to have strong doubts about the basic arguments for flexible exchange rates. First, I had come to doubt the validity of the money-illusion argument for flexible exchange rates. Already in my OCA paper, I had argued that exchange flexibility would not work in small open currency areas because its effectiveness would require a degree of money illusion that was unrealistic. Moreover, money illusion is affected by experience. The more inflation a country experiences, the more it is built into expectations, and the more unions try to insert inflation premiums into wage demands. The first devaluation may work without too much inflation; the second, invites a wage response; and the third, provokes compensation demands. Keynes hit it on the nose (for his time and country) when he said that employment might be governed by a monetary policy conducted by the trade unions instead of the banking system!
One can understand why a generation of economists brought up in the great depression could believe in money illusion. In the early 1930s, the public of most countries (with the important exception of those countries that had experienced hyperinflation in the post-war period) had come to expect deflation, or at least price stability. With mass unemployment, and a history of gold-standard stability or deflation, people would not worry too much about inflation which, in any case, was thought of in some quarters as a way of bailing out debtors and an antidote to the depression. But three decades after the great depression, a full generation had grown up that knew only inflation. It took some time before the real-world lesson of inflation set in--students take their biases as well as their models from their teachers--but eventually new premises spring forward; as Paul Samuelson, paraphrasing Max Planck, once put it, science progresses funeral by funeral.
Second, my continued study of the adjustment mechanism made me more optimistic about the ease of adjustment under fixed exchange rates. Remember Taussig's astonishment when he reviewed the evidence of his students--Jacob Viner, John Williams, Harry Dexter White, et. al.--on the transfer problem. He was stunned by how quickly and easily current accounts adjusted to capital movements; even if the terms of trade or relative price levels change in the direction predicted by the classical theory, these changes were too small to have been responsible for the recorded shifts in trade balances. Taussig's objectivity opened the way to the rediscovery by Bertil Ohlin of expenditure effects--rediscovery because a host of early writers, including Gervaise, Thornton, Ricardo, Bastable and Wicksell, were aware of them--which greatly expedited the transfer process. In addition, the classical constant-purchasing-power model needed to be supplemented by money-induced expenditure effects. When both these effects are incorporated into the Mundell-Fleming model, international adjustment of the balance of payments becomes much smoother without the necessity of troublesome changes in relative prices, wages or employment. Inter-regional adjustment of the current account to capital flows occurs without dramatic problems between regions of the same monetary area: why should it be any different between countries under firmly-fixed exchange rates?
Of course one can construct models where a transfer can have an effect on the terms of trade or real exchange rate, and history is replete with exchange rate crises. It is a mistake, however, to blame fixed the exchange rate mechanism for these crises. There is an asymmetry between the pain of adjusting upward and downward. Few countries have problems generating a current account deficit in response to a capital inflow; it is the opposite adjustment that creates the problem. I do not believe now--nor did I in the 1960s--that devaluation is a good way of easing the pain; except for possible employment stimulus, no new resources are added by devaluation. As Mexico's experience after 1976 or 1994 undoubtedly shows, devaluation starts the inflation cycle all over again.
Third, I had come to the conclusion that for many countries fixed rates (with its automatic monetary adjustment) was a more effective barrier against inflation than alternatives involving flexible exchange rates. One of the problems is that policy makers choose flexible rates over fixed rates without substituting an alternative stabilization procedure. It is one thing to substitute price-level or money-supply targeting for exchange rate targeting; it is quite another to abandon fixed rates without replacing it with an alternative brake.
Fourth, there are several types of economies of scale in the formation of currency areas. First, there is an economy in policy formation. When a small country fixes its currency to that of a larger country with an acceptable inflation rate, it sets the course for the rest of its macroeconomic policies (an accommodating monetary policy as well as budget discipline is required); thus when, in the 1970s, Milton Friedman advised Yugoslavia to fix the dinar to the mark, he made the blunt remark that Germany had a better monetary policy than Yugoslavia (See Friedman, 1973). Second, there is an economy in size from the standpoint of insulation against shocks; the more countries join a currency area, the smaller the proportion to its output of any internal or external disturbance. Third, because money is a unit of account, there are economies of information and convenience in fixed exchange rates, compared to flexible exchange rates, and to currency unions compared to currency areas. The more countries that join a currency area, the more efficient it will be. Indeed, it is these economies-of-scale factors that led to the emergence of one or two precious metals as the base of historical international monetary systems. From the standpoint of these factors, the optimum currency area is the world.
A fifth reason for my doubts about flexible exchange rates ws that I became convinced me that there was a fundamental asymmetry in the adjustment of big and small countries. I studied the impact of size in three papers in the 1960s. The first (Mundell 1964) was an elaboration of the Mundell-Fleming model to a two-country world; this model showed, inter alia, that the multiplier was different for large and small countries. The second (Mundell 1965) demonstrated that under both classical and Keynesian assumptions the distribution of the burden of adjustment varied inversely with the size of the country. The third (Mundell 1968), entitled "Gold and the Gulliver Problem," analyzed international monetary conditions when the world configuration of countries included a superpower, a few "oligops" and many ministates. In this paper I argued that the oligops would be restive under a dollar standard and seek to challenge it by a currency alliance of their own, but that this outcome was inferior to that which would be result if the superpower were willing to accept a world currency. I had now come to the conclusion, as I argued (Mundell 1968) at the Joint Economic Committee, that a world currency was the theoretical optimum and that as we backtrack from the drafting board toward second-best feasible solutions, we should be aware of the nature of the costs incurred.
That size matters in the field of international adjustment should come as no surprise to economists aware of the literature on optimum tariffs and retaliation, which shows how large countries can dominate small countries even if the latter retaliate. That this prospect also holds in the monetary adjustment literature demonstrates clearly enough that the prospects of small and large countries will be very different in the world oligopoly, and that an international monetary system was needed to protect the weak from the strong.
I have long believed that the interdependence of exchange rates and balances of payments in the world economy could best be managed multilaterally. It is true that the rest of the world needs an international monetary system much more than the United States. In the absence of an international monetary system, the superpower dominates and bilateral bashing replaces multilateral rules. Although superpower pre-eminence will be apparent even in an international monetary system, there is at least a set of rules that apply equally and a multilateral framework for resolving disputes. The biggest casualty of the breakup of the international monetary system was the plan for European Monetary Union put into motion at the Hague Summit in 1969. European economies were better integrated around the dollar than in the two decades that followed. When the dollar was taken off gold, the legal basis for the position of the dollar at the center of the system ended, and the other major countries went off the dollar. The movement to flexible exchange rates in 1973 made a world of currency areas inevitable.
In December 1975 I presented a paper to the American Geographical Society entitled "The Geography of Inflation and Reform of the Gold Standard" (Mundell, 1976) in which I related the geography of inflation to currency areas:
"...The most important intellectual tool an economist can give a geographer on this subject is the currency area concept. If geographers seek iso-inflation zones they can do so by mapping currency areas. In the bimetallic and duo-metallic periods of the 19th century, they need only note shifts of the bimetallic ratio (the price of gold in terms of silver) and the independent inconvertible currencies. Inflation rates differ in the long run because of exchange rate changes. During the Bretton Woods era, the dollar area had a common rate of inflation except when a country abandoned the dollar by devaluation. The dollar area was almost world wide after 1949 and the US called the tune of world inflation. Exceptions of high inflation areas were always sections of the world where currencies had been devalued or were depreciating. With the breakdown in the international monetary system and more generalized floating exchange rates since 1973, each currency or currency area becomes its own inflation source. The world monetary economy ceased to act as a monetary unit when floating rates were introduced in 1973. Each country floating separately had an independent rate of inflation."
A currency-area map should therefore identify iso-inflation zones.
In the international jungle of independent currency areas, the superpower, as already noted, dominates. The dollar is the main unit for international price quotations, contracts, invoicing and currency reserves. Floating rates do not reduce the need for international reserves; today, foreign exchange reserves as a percentage of imports are higher, 17.4% at the end of 1995 as compared to 12.3% at the end of 1969; this increase in demand makes the United States the main beneficiary, and encourages it to effect a higher "optimal" rate of inflation (Mundell, 1971) than would otherwise be adopted. Because of the international demand for its currency, and subject to the constraint imposed by the threat of entry, the United States will have a higher optimal rate of inflation than it would in the absence of the international use of its currency.
The argument for the reserve country applying the inflation tax on the rest of the world should not be exaggerated. Demand for international reserves is not inelastic. If the superpower abuses its monopoly position, the rest of the world can form a defensive league against it, and take steps to find alternatives. When, in the late 1970s, the United States went on an irresponsible inflation binge, Europe was provoked into the creation of the European Monetary System (EMS).
An international monetary system is easier to destroy than to rebuild. It was easy enough for a few amateurs in a few hours to wreck the international monetary system in August 1971. Compare that to the protracted negotiations that went into the Bretton Woods Articles of Agreement. It is not that this agreement created an international monetary system. Rather, it merely devised the set of rules and procedures for making other countries comfortable with the existing system, the anchored dollar standard. The great significance of the agreement lay in its creation of a multilateral way of managing the international interdependence of exchange rates in a forum in which the interests of the smaller countries could be taken into account.
The Unit-of-Account Property of Money
In the last part of my OCA article, I address the issue of money serving as a unit of account, as well as a medium of exchange. We have already discussed the money illusion argument, which requires that currency areas be large; and the economies-of-scale factors that increase with the size of the currency area. There is also the problem of size with respect to the monopoly issue; with respect to the latter, I wrote: "...markets for foreign exchange must not be so thin that any single speculator can affect the market price; otherwise the speculation argument against flexible exchange rates would assume weighty dimensions." In a world of big international banks and multinational corporations, there is not much scope in practice for the monetary independence of any except a few large countries.
From the standpoint of the unit of account properties of money, the fewer the currencies the better. After quoting a passage from Mill that identifies national currencies with a form of barbarism, I wrote:
"Mill, like Bagehot and others, was concerned with the costs of valuation and money changing, not stabilization policy, and it is readily seen that these costs tend to increase with the number of currencies. Any given money qua numeraire, or unit of account, fulfills this function less adequately if the prices of foreign goods are expressed in terms of foreign currency and must then be translated into domestic currency prices. Similarly, money in its role of medium of exchange is less useful if there are many currencies; although the costs of currency conversion are always present, they loom exceptionally large under inconvertibility or flexible exchange rates. (Indeed, in a hypothetical world in which the number of currencies equaled the number of commodities, the usefulness of money in its roles of unit of account and medium of exchange would disappear, and trade might just as well be conducted in terms of pure barter.) Money is a convenience and this restricts the optimum number of currencies. In terms of this argument alone, the optimum currency area is the world, regardless of the number of regions of which it is composed."
The unit of account property of money has an ancient history in economics although one not well modeled. The idea of money as a unit of account was known to Aristotle, Plato and Oresme. But it did not become an important part of economics until late in the 17th century, when, during the great debate over recoinage in England in the 1690s, the role of the unit of account crystalized into two extreme views. As background for the debate it is necessary to know that the newly-formed Bank of England had just issued ,1,200,000 in bank notes to the government in return for a large public loan to finance "King Billy's War." An economist today, like David Hume 2 centuries earlier, would recognize that this new issue of notes to finance government spending would displace an almost equal amount of specie.
But which specie? Up to that time, coins had been accepted at face value, but now a distinction was suddenly made between full-valued and light coins, since they fetched a different price abroad. As Aristophanes and Thomas Gresham would know, the best coins were exported and the worst stayed at home. Coins thus fell toward their metallic value, the pound depreciated by about 25% against gold weight, and prices began to rise. It was now decided to organize a recoinage and the question was: should coins be put in circulation with a quarter less silver, but still be called a pound; or should coins with the old silver content be put in circulation in order to maintain the historical value of the pound? Enter now the protagonists: Lowndes, the Secretary of the Treasury, against John Locke, the philosopher, supported by Charles Montagu (later the Earl of Halifax), the Chancellor of the Exchequer. Newton also participated in the debate, but his position flip-flopped: he first advocated devaluation along the line of Lowndes; and then came out against it, on the side of Locke, Montagu and the metallists.
Lowndes, recognizing the unique role of money as a unit of account, had favored a devaluation to keep prices more or less where they were and to finance the recoinage. Locke countered with vigorous (if incorrect) logic that money was nothing more nor less than the metallic value of the silver of which it was composed. Thus began the train of thought and controversy between "metallists" and "cartalists."
From the standpoint of expediency in dealing with the problem, as well as insight into the nature of money as a token, Lowndes (and Newton in his initial position) was right; from the standpoint of protecting bondholders and attention to long-run stability, Locke (and Newton in his second position) was right. Lowndes had the insight of the future; knowing that money was also a unit of account, he recognized that it could have a value above its metallic content; it could be accepted ad talum rather than ad pesum. Nevertheless, logic won over insight, Locke won the argument (although he later regretted that he had ever entered the field!), and the newly-created heavy coins continued to be exported. But Locke's recipe for maintaining the standard held the day for over two centuries, resulting in Britain's deflationary restorations of the standard after the Napoleonic Wars, and after World War I.
Keynes took up the issue of the role of the unit of account in the 1930s. In the opening of the Treatise, he writes: "Money of account, namely that unit in which debts and prices are expressed, is the primary concept of the theory of money." Money's unit of account role is now embodied in the term "money illusion," which is the concept that money in and of itself takes on its own significance. Since Keynes wrote these words in 1930, the Lowndes-Keynes view emphasizing the short-run expediency of devaluation and inflation has come to dominate the thinking of policy makers and the international organizations.
Decisions about currency areas should not lose sight of the role of the unit of account. Purchasing power parity cannot be relied on in the short run between large currency areas. Firmly-fixed exchange rates are more conducive to the operation of the law of one price than flexible rates, and monetary unions are more conducive than merely fixed rates. The departure of relative prices from purchasing-power-parity norms should be a wake-up call for those who believe flexible exchange rates are efficient. From the standpoint of the unit of account factor, the optimum currency area is the world.
Fixed Rates and the Adjustment Mechanism
There is an important difference between a "fixed" exchange rate and a "pegged" exchange rate. The former, as I use the term, presupposes that the money supply is allowed to increase and decrease with balance of payments surpluses or deficits, while the latter allows monetary policy to finance budget deficits or to support an inflation rate incompatible with maintenance of the exchange rate. The pegged rate system deserves to be discredited as the worst of all systems, whereas the former will be, for many countries, the best of all systems. In the literature, however, much confusion arises because of the failure to distinguish between the two arrangements.
A currency board system has virtually nothing in common with a pegged exchange rate, but it can be looked upon as an extreme case of a fixed exchange rate system. Under a currency board system, the central bank buys and sells only foreign exchange, maintaining its reserves entirely in foreign exchange or liquid foreign exchange earning assets. It may maintain 100% reserves, or even a higher proportion if it sees fit to establish a supplementary fund to fulfil a role as lender-of-last resort to the commercial banks. The key element in a currency board system is that the exchange rate is kept fixed within narrow or zero margins and that the peg can be changed only by parliamentary or constitutional changes that can only be negotiated with considerable difficulty, thus generating confidence in the continuation of the system. I am very glad to see that the IMF is now supporting the idea of currency boards for some countries.
The most important element in any sound monetary system is that monetary policy be predictable. In a firmly fixed exchange rate system, the key element is that there is little if any expectation of a change in the exchange rate because the monetary policy of the country is automatically geared to making that exchange rate an equilibrium rate. A sufficient directive to central banks would be that the central bank deal only in foreign assets within the required margins of the par value. If applied strictly, the reserve base of the money supply could only increase as a result of a balance of payments surplus. (In a large and growing country, with sufficient reserves, some allowance could be made for fiduciary monetary expansion after the confidence of the public in the system has been earned).
In the modern world, we are poles away from the perceptions existing at the time of the Bretton Woods meeting when 44 nations gave their endorsement to a system of fixed exchange rates anchored through the dollar to gold; the alternative was rejected as a form of currency chaos, a throwback to the world of the 1930s to which no country wanted to return. The anchored dollar standard from 1936 to 1971 was by no means as effective an arrangement as the gold standard, but it was nevertheless a coherent system and the only one negotiable under the prevailing circumstances. Whatever its defects, it provided a satisfactory solution to the problem of inflation convergence, a high level of employment, balance of payments equilibrium and a tolerable rate of inflation in the world as a whole. To appreciate the strength of commitment of members of the IMF to the system, one need only read the attacks on the alternatives of flexible exchange rates in the IMF Annual Reports of 1950 and 1962.
The perception that world inflation could best be contained by a common approach within the context of an international monetary system completely changed in the 1970s. By that time, three successive secretaries of the Treasury harbored a bee in their bonnets: flexible-exchange-rate monetarism, and this view, championed by the vigorous logic of Milton Friedman, a protagonist just as effective as John Locke, led to the second amendment to the Articles of Agreement, endorsing "managed" flexible exchange rates. It is ironic that the two European Presidents who were partners in the scheme soon changed their mind and signed the agreement that led to the creation of a regional monetary system in Europe. It seems inevitable that the example of Europe will be followed elsewhere, particularly, but not exclusively, in Asia, as the disintegration of the international monetary system creates a new externality that can be internalized, as a second-best alternative to an international monetary system, by regional monetary arrangements. Why not a monetary system for each continent? Or civilization?
Not surprisingly, two decades of flexible exchange rates have been too much of a bad thing. Now both fixed and flexible exchange rates have been discredited! Fixed exchange rates have become confused with "pegged" rates. Monetary unions or currency boards, on the other hand, have become respectable. Here is a curious thing. Monetary unions and currency boards are eminently respectable, as are flexible exchange rates, but not so fixed exchange rates. The reason is that fixed exchange rates have become tarred with the same feather as "pegged rates" which usually, if not inevitably, leads to one-war speculation and currency crises.
Spectrum of Exchange Rate Arrangements
System
Monetary Policy
Par Value
Margins
clean float
independent
none
none
dirty float
independent
none
none
sliding-gliding parity or tablita
independent
variable
optional
pegged rates
independent
short-term
optional
fixed exchange rates
adaptive or automatic
long-term
narrow
currency board
adaptive or automatic
long-term
tiny
monetary union
automatic
forever
none
My own view, however, is that a parity system of fixed exchange rates is completely viable as long as the automatic adjustment mechanism is allowed to work itself out. This means no sterilization. We have thriving examples of fixed exchange rate regimes in Austria, Holland and Belgium (and indirectly Luxembourg), tied to the DM, and decades of examples of viable fixed exchange rates before the governors of the IMF shifted to flexible rates. The recent example of Argentina's fixed exchange rate system tied to the dollar is an encouraging sign that, if allowed to be successful, will help to refute the view that fixed exchange rates cannot work. These and other examples that include successful "currency board" arrangements eloquently refute the idea that fixed exchange rate systems cannot work without political integration. The gold standard was a way of organizing a fixed exchange rate system without the need for political integration.
This is not to say that there are not advantages to moving from a currency area to a monetary union. The former is a half-way house that confers many of the benefits of monetary union without a degree of political integration that, in the present world is unrealistic or at least premature. In any case, the best path toward monetary union is through irrevocably fixed exchange rates.
Case for and Against Joining an OCA?
Before I list some criteria justifying a country's fixing the exchange rate to a currency area or monetary union, allow me to list some of the circumstances under which a country might decide against joining a fixed exchange rate zone or a currency union:
(1) because the country wants a rate of inflation different from the currency area inflation rate;
(2) because the country wants to use the exchange rate as an instrument of employment policy to lower or raise wages;
(3) because the country wants to use the exchange rate as a beggar-thy-neighbor instrument to capture employment from other countries;
(4) because, as a large country, the country does not want an unfriendly country to benefit from the economies-of-size advantages of the large currency area, or else because it fears that the addition of another currency will make national macroeconomic policy more difficult;
(5) because the country wants to use the money-expansion or the "inflation tax" to finance government spending, and it would be prevented from doing so to the extent desired by the discipline of fixed exchange rates;
(6) because the country does not want to sacrifice seigniorage from the use of its money as an international means of payment; this applies especially to a large country;
(7) because the government of the country wants to use seigniorage as a source of hidden or off-budget funding for personal use by members of a corrupt dictatorship or naive democratic government;
(8) because a regime of fixed exchange rates could conflict with the required policies of a central bank that had a constitutional mandate to preserve price stability;
(9) because monetary integration with one or more other countries would remove a dimension of national sovereignty that is a vital symbol of national independence;
(10) because the country wants to optimize the currency denominations appropriate to its per capita incomes (this would be relevant only in the case of currency unions, not fixed exchange rates);
(11) because the country wants to maintain its monetary independence in order to use the money-expansion or inflation tax in the event of a war;
(12) because the country wants to protect the secrecy of its statistics, as in the case when the Soviet Union opted out of the IMF and forced its Eastern European satellites to leave the Fund;
(13) because there is no domestic political and economic leadership capable of maintaining a fixed exchange rate system in equilibrium;
(14) because the political authorities cannot achieve budget balance and/or establish confidence in the permanence of budgetary equilibrium or the viability of fixed exchange rates;
(15) because the partners in the prospective currency area are politically unstable or prone to invasion by aggressor countries;
(16) because the partner countries are poorer and will expect, aid, "equalization payments," or otherwise an unduly large proportion of the OCA's expenditures;
(17) because the country does not want to accept the degree of integration implied by the OCA agreement, such as common standards, immigration, labor or tax legislation.
So much for the case against joining an OCA. The following are some of the reasons why a country might instead choose to join an OCA:
(1) to gain the inflation rate of the OCA;
(2) to reduce transactions costs in its trade with a major partner;
(3) to eliminate the cost of printing and maintaining a separate national currency;
(4) to participate in a purchasing power parity area, which would be fostered by fixed exchange rates and even more by monetary union;
(5) to establish an anchor for policy, a fixed point around which expectations can be formulated and policies can revolve;
(6) to remove discretion from monetary and fiscal policy authorities;
(7) to keep the exchange rate from being kicked around as a political football by vested interests that want depreciation to increase profits, or to bail out debtors;
(8) to establish an automatic mechanism that will enforce monetary and fiscal discipline;
(9) to have a multinational cushion against shocks;
(10) to participate more fully and on more equal terms in the financial center and capital market of the union;
(11) to provide a catalyst for political alliance or integration;
(12) to establish a power bloc as a countervailing influence against domination of neighboring powers;
(13) to share in the political decision of determining the OCA's inflation rate;
(14) to establish a competing international currency as a rival to the dollar and earn, instead of pay, seigniorage;
(15) to reinforce or establish an economic power bloc that will have more clout in international economic discussions and have a greater power to improve, by its trade policy, its terms of trade;
(16) to delegate to a mechanism outside the domestic political process the enforcement of monetary and fiscal discipline;
(17) to participate in a restoration of a reformed international monetary system.
The Viability of EMU
With respect to the position I take with EMU, most of you will know that I have already put my cards on the table. I began thinking about this issue when I was at the Bologna Center in 1959-61, and I remember my complete agreement when Lionel Robbins, on one of his annual visits to the Center, told me that he had come to the conclusion that a European currency was both viable and desirable. In my booklet Mundell (1965), I analyzed a model of three currency areas--the dollar area, the sterling area, and a third bloc based on a European currency, what I called the "thaler" area. At that time there was not much enthusiasm for a European currency, but by the late 1960s things had changed. In 1969, I presented a paper (Mundell 1969) in New York called "The Case for a European Currency," which was widely reported in Europe. It contained my proposal for a European currency, which I dubbed the "europa." A revised version of this paper (Mundell 1973), entitled "A Plan for a European Currency," was presented at the "Conference on Optimum Currency Areas" in Madrid in March 1970. The 1969 paper led to an invitation to come to Brussels to prepare alternative plans for a European currency the following summer, which I was able to do en route to ECAFE in Addis Adaba to prepare a report on currency problems in Africa (Mundell 1970, 1972).
I see two recent changes in the winds regarding monetary union in Europe, one of which is less favorable to monetary union and the other is more favorable. The unfavorable factor is the strength of the dollar. EMU can be looked upon at least partly as a reaction against the seigniorage or money tax, which is more oppressive the weaker the dollar. The cycle of "eurofever" has risen and fallen with the weakness and strength of the dollar. Thus, with the deficits and gold conversion of the early 1960s, some early plans were made for monetary integration. These increased again in the late 1960s, the Hague Summit and the Werner Plan. The breakup of the system and Europe's inability to organize a joint float dampened eurofever in the early 1970s, but US inflation and depreciation in the late 1970s brought it again to the fore with the creation of the EMS. With Reaganomics and the soaring dollar, eurofever subsided, but with the weak dollar in the late 1980s, the Delors Report set the stage for EMU, all of which was accelerated by German unification and the peak of eurofever with the Maastricht Treaty. A strong dollar takes away one of the most powerful arguments for EMU.
The optimistic event is the unexpected success of a few countries in moving toward the achievement of the convergence criteria. A year ago it seemed unlikely that Italy, Spain and Portugal would be close to the needed 3% deficit figure. But a concerted effort by each country has brought them closer, and the markets have responded by narrowing greatly the gap between German and national interest rates.
Another factor is favorable to EMU. As you all know, budget deficits can be calculated in different ways. In its 1996 World Economic Outlook the IMF, relying on a study prepared by Sheetal Chand, underscored the importance of the inclusion of unfunded pension liabilities in calculating budget deficit. This factor is particularly important in the case of such core countries in the European Union as Germany and France. If you make an allowance for financing these future payments in the current deficit, the budget deficits of all countries will be higher, but the impact is very different between countries. It turns out Germany's and France's deficits are increased to a much larger extent than Britain's and Italy's for example. Britain could satisfy the Maastricht conditions relatively easily and its problem is that it may not want to enter. But Italy's position, is no longer as inferior to that of France and Germany as the official figures show.
The same argument holds with respect to Debt/GDP ratios. Taking into account the capitalized value of unfunded pension commitments, Britain is in a far better position than France or Germany. Italy is also in a far better relative position, taking into account the capitalized value of its unfunded pension liabilities. When or if these factors are taken into account at the Council Summit in early 1998, the position of the "Club Med" countries will be much improved relative to France and Germany. On these grounds, therefore, there is a better chance for the Club Med countries to go forward. If so, the Scandinavian countries may go ahead as well, as will Ireland--which makes the entry of 13 countries a distinct possibility.
Then what will Britain do? Many think Britain should stay out. But the issue is still open. I think that when Britain sees this bloc of 13 countries forming, some of its objections will be overcome, and it will see the costs of staying out as much higher. I would put the chances that Britain would enter as high as .5. Britain's joining would make EMU composed of all EU members except Greece. But Greece's position is not as hopeless as it has been made out. It does have a huge budget deficit--6 to 7 percent of GDP. One of Greece's difficulties is that it feels compelled to spend the highest proportion of its GDP on armaments. Despite this fact, Greece has the largest primary surplus, as a percent of GDP, in Europe. If Greece makes a real effort to put other elements of its economic house in order--which it has announced it wants to do--it could be accepted into the union as well. The huge international transfers that are now being made to countries like Greece and Portugal and Spain could be phased out more rapidly under monetary union than otherwise. Because of these considerations I would not rule out the possibility that all 15 countries enter the EMU.
More formally, I would put the probabilities of EMU as follows: that a core group including both Germany and France form a monetary union: 80%; that a monetary union is formed that includes Germany, France, Austria, Netherlands, Belgium, Luxembourg, Denmark, Ireland and Finland: 60%; that these countries join and are joined by Sweden, Portugal, Spain and Italy: 30%; that the above countries join and are joined by Britain: 15%; and that all countries, including Greece join: 10%.
Let me just conclude by saying that the Maastricht approach is not the only route to monetary union. Once countries have got control of their budget deficits, they will have the option of fixing exchange rates to the euro with very narrow margins, achieving many of the benefits of EMU without the ultimate sacrifice in monetary sovereignty. Indeed, this is the approach countries like the Club Med countries and Greece should follow even if the European Council at its 1998 meeting rejects their application for early admittance to EMU (Mundell and Sadun (1996)). The more countries that join the bloc the greater will be its chance of success. Failure to go forward would be an awesome disappointment to those who see European Monetary Unfication as the best catalyst for a stable economic and political order on the continent.
References
Friedman, Milton. "Contemporary Monetary Problems," Economic Notes, Vol. 2, No. 1. January-April 1973: 5-18. This article reproduces a lecture given at the National Bank of Yugoslavia, March 20, 1973, published in Serbo-Croatian translation in Jugoslovensko Bankrstvo, n. 6, 1973, the monthly periodical of the Yugoslav Banking Association.
Mundell, R. A. "International Trade and Factor Mobility," The American Economic Review, XLVII, No. 3, (June 1957), 321-335. (Reprinted in Readings in International Economics (eds. R. E. Caves and H. G. Johnson). Chicago: Irwin.1967); and Mundell (1968).
-----------------"Transport Costs in International Trade Theory," The Canadian Journal of Economics and Political Science, XXIII, No. 3, (August 1957), 331-348.
Reprinted in Mundell (1968).----------------"The Pure Theory of International Trade," The American Economic Review, L, No.1 (March 1960), 68-110.
Reprinted in Mundell (1968)----------------"The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates," The Quarterly Journal of Economics, LXXXIV, No. 2 (May 1960), 227-257. Reprinted in Mundell (1968).
-----------------"The International Disequilibrium System," Kyklos, XIV, Fisc.2, (1961), 154-172. Reprinted in Mundell (1968).
-----------------"Flexible Exchange Rates and Employment Policy," The Canadian Journal of Economics and Political Science, XXVII, No. 4, (November 1961) 509-517. Reprinted in Mundell (1968).
---------------------"A Theory of Optimum Currency Areas," The American Economic Review, LI, No. 4 (November 1961), 509-517. Reprinted in Mundell (1968)
---------------------- "The Gold Herring," U.S. Congress. Hearings on the U.S. Balance of Payments. Washington, DC: Joint Economic Committee. November 1963.
-----------------------"Capital Mobility and Size," The Canadian Journal of Economics and Political Science, XXX, No. 3 (August 1964), 421-431. Reprinted in Mundell (1968).
------------------------"The Proper Division of the Burden of the International Adjustment," The National Banking Review, 3, No. 1, (September 1965): 81-87.
------------------------The International Monetary System: Conflict and Reform. Montreal: Private Planning Association of Canada. 1965.
-------------------------"Gold and the Gulliver Problem." Lecture Presented at the University of Chicago. February 8, 1968.
------------------------- "A Plan for a World Currency." Joint Economic Committee. Hearings Before [Reuss] Subcommittee on International Exchange and payments. September 9, 1968.
-------------------------------
"The Case for a European Currency." Paper presented at a meeting of the American Management Association in New York. December 1969. Mimeo.--------------------------
"A Plan for a European Currency." Paper presented at the Optimum Currency Areas Conference in Madrid, March 1970. Reprinted in The Economics of Common Currencies (eds. H. Johnson and A. Swoboda). London: George Allen & Unwin Ltd. 1973: 143-173.----------------------------
"African Trade, Politics and Money." In Africa and Monetary Integration (ed. R. Tremblay). Montreal: Les Editions HRW. 1972: 11-67. Paper originally prepared for the United Nations Economic Commission for Africa (August 1970).------------------------------
"The Choice of Monetary Systems: African Currency Problems." In Africa and Monetary Integration (ed. R. Tremblay). Montreal: Les Editions HRW. 1972: 363-368.-----------------------
"The Optimum Balance of Payments Deficit and the Theory of Empires." In Stabilization Policies in Interdependent Economies, (eds. P. Salin and E. Claassen). Amsterdam: North Holland Press, 1971. 69-86.------------------------------
"The Geography of Inflation and the Reform of the Gold Standard." In Geographical Aspects of Inflation Processes. New York: American Geographical Society. 1976.Mundell, R.A. and Arrigo Sadun.
"Il Piano di parità lira-marco: entrare in Europa passando per Francoforte," Rivista di Politica Economica Anno LXXXVI-Serie III Fasciocolo VII-VIII (Luglio-Agosto) 1996: 121-41----------------------------------------
"The Lira-Mark Parity Plan" (with Arrigo Sadun) Rivista di Politica Economica (September-October 1996. English version of the above.
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