Monetary Union Mechanics and Related Issues

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Monetary Union Mechanics and related issuesBy Katarzyna Cielak, BA

To understand the workings of a monetary union there is no other method but view its

costs and benefits, then draw conclusions from its operation. A monetary union is complex

with factors that function on many levels. Nations that choose to band together in such a way

do nothing but reason what they will gain or lose when they integrate their economies into a

collective. This analysis is based heavily on Paul de Grauwes bookEconomics of Monetary

Union which clearly displays the various dynamics necessary to understand the functioning of

monetary unions in the world today.

1.1 Economic Integration

Through all of mankinds existence there has always been a pull to unite and function

as an entity, a group, to be more than one. Countless examples of history illustrate this.

Nations with diverging economic, fiscal and monetary policies unite to form a trade block

with a common objective. There are varying degrees of sacrifice necessary for this behavior,

all of which depend on the level of economic integration that the group of nations chooses to

approach.

There are four levels of economic integration. The higher levels build upon that which

is allowed under the lower levels. The chief goal of economic integration is to ease the flow

of trade among member states. There are many barriers that inhibit the trade and the removal

of these restrictions will aid this problem. As mentioned before there are four levels of

economic integration1:

!"Free trade areas

!"Customs union

!"Common market

!"Economic Union

The first type of regional economic arrangements are free trade areas. In this setup a

group of nations works to remove tariffs on one anothers products. Depending on the

agreement at hand, the tariffs may be removed for all products or just a few of them. As for

1 D. Appleyard, A. Field: International Economics Trade Theory and Policy, Irwin McGraw-Hill, Singapore,

1998, pg. 355


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trade policies for non member states each member country can set up their own individual

policy. An example of a free trade area is NAFTA or the North American Free Trade

Agreement whose members are the United States, Canada and Mexico.

The next level of economic integration are customs unions. In this case there are no

tariffs whatsoever between member states. Additionally, they adopt a common external

commercial policy toward nonmembers2. The trade agreements that are made between

members and nonmembers are same for all those part of the customs union.

A customs union is the foundation for which the subsequent degree of integration is

built upon. This is a common market. In this stage everything is the same as with a customs

union but the movement of labor and capital is fluid meaning that there are no barriers. With

this increased level of trust and lowered borders the member states lose more control of their

individual countries as they act more as a collective now.

The final level of integration is an economic union. This stage is built upon what is

part of the common market. There are additional ramifications which include a unification of

economic institutions and the coordination of economic policy throughout all member

countries3. There are institutions that are above national borders and their decisions are

binding. The key issue with this point of integration is that the member state must give up a

great deal of independence. The moment an economic union accepts a common currency it

becomes a monetary union. The costs and benefits of a monetary union will be examined

further within this paper.

1.2 Optimum Currency Areas

The theory of optimum currency areas was pioneered by Robert Mundell in 1961. His

theory came at a time when the post-WWII world was at ease with the notion of fixed

exchange rates and was just starting to debate floating exchange rate dynamics. The idea of

flexible exchange rates was a new notion and the world of economics was slowly accepting

the idea. An optimum currency area is a geographic area within which the benefits of a single

currency outweigh the costs when coping with an asymmetric shock using domestic monetary

policy4. In Mundells first notion of an OCA he noted that labor mobility, and wage flexibility

will help nations return to the previous held balance. His 1961 article was used for the debate

2

Appleyard, Field, pg. 3553Appleyard, Field, pg. 355

4M. Bordo, H. James; One World, One Money, Then and Now www.nber.org/papers/w12189 07.09.06


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spending with the final cost being a slump in output9. Grauwe finally states that in the long

run the exchange rate devaluation will not fix the issues that are within the goods market.

1.4 The Benefits of a Monetary Union

1.4.1 Transaction Costs Elimination

This is perhaps the most obvious gain from forming a monetary union. Since there is

one currency there is obviously no need for changing currencies and paying transaction costs.

These transaction costs, which have been defined more thoroughly in chapter 1, are seen as

deadweight costs10. Thus their elimination is a loss of a source of income for banks. The fact

that transaction costs in terms of currency exchange no longer pay a role has a less obvious

benefit to the monetary union community.

Consumers of a monetary union are granted price transparency meaning they can

shop around11. For the bargain hunter this is ideal. All prices are in the same currency all

across the union. Grauwe notes that there is significant price discrimination across the EMU

even price discrimination within the same countrys borders. He moves further to state the

very existence of borders affects prices even though the so called primary source, transaction

costs, is gone. Great price convergence, according to Grauwe, may happen with the advent of

a single currency on account of the movement to greater integration in all areas of the union.

This will lead to further integration in terms of legal, financial, and political parameters.

1.4.2 Price mechanism efficiency

The price mechanism is a source of information for economic agents. This is a simple

definition. This mechanism can become distorted and less efficient in communicating

information to those that seek it due to exchange rate uncertainty. Grauwe states that

uncertainty comes about because the exchange rate changes do not reflect price changes12.

If a currency appreciates or depreciates the effect on prices is not depicted by the exchange

9Grauwe, pg. 37

10

Grauwe, pg. 6111 Grauwe, pg. 6112

Grauwe, pg. 66


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rate. This can cause huge problems. In general exchange rate uncertainty can lead investors

astray where they will wrongfully invest in countries where the exchange rate did not

correctly forecast future gains or costs.

Grauwe moves further to investigate the other effects of exchange rate uncertainty on

the price mechanism. He notes that the issue of moral hazard is a prevalent one. There is risk

involved with any transaction tied to exchange rates, along with risk there is price uncertainty

and as a result there needs to be a greater return on the endeavor in order to compensate for

the greater probability of loss. This return we can note as the interest rate. Moral hazard

comes into play when investors or speculators choose to on purpose to take the more risky

projects because the return is higher. The problem is such that when the project fails, the

investor has to pay only his equity share and the bank has to face the other losses, however

when the project is successful the investor retains his earnings. Exchange rate uncertainty can

lead to very disadvantageous effects tied with speculation like the South East Asia currency

crisis but this is a very dramatic scenario.

Exchange rate uncertainty leads to information uncertainty and does not allow for a

clear perception of the price mechanism. When a monetary union is in place there is no need

to fret over uncertainty caused by an exchange rate since all the countries will have a single

currency. This will allow for the price mechanism to communicate adequate information and

will stimulate trade.

1.4.3 Trade Growth

Taking into account the last two sections it would be beneficial to find whether or not

these gains from the advent of a monetary union actually do stimulate trade. To find whether

there is a correlation between trade flows and monetary integration a number of econometric

studies were conducted. Andy Rose in 2000 found in his studies that trade flows between

countries that are part of a monetary union are 100% higher than those among countries that

are not part of a monetary union13. Rose was the first to find that a monetary union does

positively affect trade flows.

In terms of exchange rate uncertainty, monetary unions eliminate this issue and as a

result the interest rate is slowed which stimulates trade. However this benefit of trade growth

is not so easily quantifiable because since the interest rate is reduced the expected future

13Grauwe, pg. 73


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profits of firms are as well14. Grauwe notes that there is an ambiguous effect on economic

growth because of this decreased level of risk. To better understand this, one can draw from

the laws of physics where matter cannot be created nor destroyed, the same can be assigned to

risk. Although there is no risk with exchange rates in a monetary union, risk is placed

elsewhere.

1.4.4 International Currency

An international currency is such that is seen as a vehicle for international

transactions15. In terms of international trade it is a currency in which is simply pays off to

use because of transaction costs. Traders, investors pay and sell their goods/services using thiscurrency. The country of origin of this currency has to have a large GDP and an open

economy to facilitate international trade. The U.S. dollar is one such international currency.

The United States has the largest GDP and capital markets in the world16. However, the Euro

and Yen are next in line in terms of the title of international currency.

The chief benefit for the issuer of an international currency is the additional revenue17.

This revenue can be used to finance the governments spending which might allow for

lowering taxes, the uses are endless. Another gain is that domestic financial markets become

more attractive for foreigners who want to invest with the use of the international currency.

Domestic financial institutions benefit and this in turn spurns a greater sense of welfare for

citizens. Grauwe draws upon the example of the U.K. to caution against any overzealous

reactions. London is a city that has become a pivotal center for financial markets worldwide

even though it has not adopted the Euro. There are, as with anything, exceptions to the rule.

1.5 Costs of Operating a Monetary Union

1.5.1 Varying Preferences in Inflation and Unemployment

When countries choose to band together as a monetary union they are relinquishing

control over their exchange rate since it will be an instrument that will no longer exist. Each

14 Grauwe, pg. 74

15http://www.ecb.int/press/key/date/2003/html/sp030227.en.html 06.09.0616

http://www.ecb.int/press/key/date/2003/html/sp030227.en.html 06.09.0617

Grauwe, pg. 75


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country is different, very different yet what matters most for this analysis is that each state has

a different approach to inflation and unemployment. Some nations like Italy like inflation,

while other like Germany are allergic to any rise in it. Grauwe illustrated inflation and

unemployment on a Phillips curve. In general the analysis he follows is such when two

countries like Italy and Germany form a monetary union together they will have to set the

same inflation rate for one another. Each country had a different inflation rate beforehand and

now much accept either having more or less inflation than they are normally use to 18. There is

a tradeoff here: the lower the inflation, the higher the unemployment and vice versa. 19 This

illustration of what the Phillips curve implies as an economic model has been debunked by

Milton Friedman in 1976. It is a very comfortable illustration that may not have real life

applications.

These policy preference differences can lead to political agenda issues since those

countries that have to lower their inflation rate will face an increase in unemployment. This is

a huge cost for joining a monetary union. In time the unemployment rate will go down.

1.5.2 Labor market institutions and supply shocks

The analysis in terms of the costs of joining a monetary union tends to be exhibited in

terms how a country can rescue itself after an asymmetric shock. This type of illustration aids

in understanding that face alone a country with its exchange rate is really not better off than if

it was lacking that instrument and was part of a monetary union. Grauwe states that supply

shocks have a completely different effect in each country since the centralization of wage

bargaining is different20.

Bruno and Sachs developed a macroeconomic theory upon which Grauwe bases his

observations. The two noted that when wage bargaining is centralized the inflationary effect

of wage increases is taken into account by labor unions. Countries with such a structure are

said to be corporatist21. Labor unions are aware that their claims will only lead to higher

inflation and real wages will not increase in the end. However, in countries where wage

bargaining is decentralized, labor unions represent a small fraction the total work force and as

a result their claims will not effect the aggregate price level too much. However, the issue

18Grauwe, pg. 14

19

Grauwe, pg. 3820Grauwe, pg. 15

21Grauwe, pg. 15


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with a decentralized wage bargaining system is that how union is willing to let go of their

claims after they have brought them about. This is an issue after a supply shock and wage

moderation is difficult to attain. No union wants to be the first to step down since it could lose

out to others. This is a simple psychological process pertaining to cooperation. This scenario,

however, was further analyzed by Calmfors and Driffill who found that there is no simple

relationship between wage moderation and the centralization of wage bargaining. They found

that a highly decentralized system which is at the firm level will exhibit a great deal of wage

constrain since the greater the claims the more likely chance of unemployment22.

In terms of the difference in labor market institutions in countries willing to join a

monetary union it can be a cost. After a supply shock the wages and prices in each country

will be different depending on how centralized wage bargaining is and how organized the

labor unions are. The consequences of the supply shock after all the countries are in a

monetary union will be difficult to adjust since the exchange rate will be gone as a monetary

instrument. The key is wage moderation yet all unions want more money for their members

while firm managers want to limit their labor costs. This is no doubt a constant battle that

should end in compromise especially in light of a supply shock which is difficult for the

country to adapt afterwards.

1.5.3 Differences in Legal Systems

There is a very noticeable divide between continental and English law. The English

like to be different and this is another aspect of their uniqueness. This aspect can been seen in

terms of mortgage loans which are very different regulation in every country. Differences in

terms of collateral and fixed or floating interest rates do matter. In the case of the E.U. should

the European Central Bank choose to raise the interest rate, this shock will be absorbed

differently in each of the member countries23.

In terms of where firms find their investment there are different sources as well that

are also divided by continental and English lines. In the U.K. capital markets are the primary

source of finance for investments and they are very well developed. Continental Europe,

however, is not so well off. Firms must turn to banks for loans in order to finance the projects

they wish to pursue. This is very problematic as with the example, the ECB may raise the

22Grauwe, pg. 16

23Grauwe, pg. 18


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interest rate and the effects will be very different for the U.K. and the rest of Europe. An

increase in the interest rate in Continental Europe will affect consumer spending via the bank

channel24 where in the U.K. the increase will cause the prices of stocks and bonds to fall

which will have large wealth effects for stock market players.

The above mentioned differences in legal systems is an issue for countries within a

monetary union since a shock will lead to different macroeconomic effects which will be

difficult to handle with no exchange rate.

1.5.4 Differences in Growth

It may appear the entire process for joining a monetary union is to stimulate trade andeconomic growth. Each has a different rate of growth. This can lead to additional costs when

countries with such differences join together. The problem is such that when a fast growing

country is with countries that are not as quickly developing it will face trade balance

problems; imports will grow faster than exports25. In order to have their imports equal exports

the fast growing country needs to make their own products more attractive. To do this the

country can depreciate its currency or it can lower the rate of domestic price increases as

compared to the slower growing countries26. As part of a monetary union, the option of

depreciation is not possible. The only possibility for the fast growing country is to follow

deflationary policies which will, in turn, stifle economic growth. This is very unfortunate and

will come at a heavy cost for nations that stand out in terms of their growth rate.

1.5.5. Different fiscal systems

There is a difference in how governments raise revenue for themselves. They can

either do this through taxes or by seigniorage. The latter is the issuing of new currency which

in turn raises inflation. Some countries may have an underdeveloped tax system and choose to

go through the seigniorage channel. This preference becomes a problem when such countries

form a monetary union with countries that have a well developed tax system. The problem is

such that their inflation rate will need to be lowered to at least the level of the other more

24

Grauwe, pg. 1825Grauwe, pg. 19

26Grauwe, pg. 19


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developed members. In order to do this they will need to face the decision of raising taxes 27.

This is a very difficult decision and certainty will be faced with a great deal of resentment

since many citizens feel that a monetary union should bring them prosperity and growth- not

higher taxes. Unfortunately, the process of aligning economic markers at the same level with

other nations comes at a cost.

27Grauwe, pg. 20

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Monetary Union Mechanics and Related Issues