In 1961, the economist Robert Mundell published a paper laying out, per the title, “A Theory of Optimum Currency Areas.” In it, he inquired about the appropriate geographic extent of a shared unit of money. Was it the world? A country? Part of a country? A border-spanning region of, say, the western parts of the United States and Canada, with a separate currency circulating in the eastern parts of the two countries?
“It might seem at first that the question is purely academic,” he wrote, “since it hardly seems within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement.” But it was worth considering anyway, in part because “certain parts of the world are undergoing processes of economic integration and disintegration,” and an idea of what an “optimum currency area” would look like could help “clarify the meaning of these experiments.”
Mundell’s paper was published four years after the establishment in 1957 of the European Economic Community, which aimed to more closely integrate European countries economically and politically, and laid the groundwork for a common market that would enable the free movement of goods and people across the region’s borders. Sixteen years ago, in 1999, the euro was adopted as the common currency of 11 European countries; the same year, Mundell won a Nobel Prize in economics in part for his work on optimum currency areas. Fourteen years ago, Greece joined the currency union. Five years ago came the first hints that a debt crisis might force Greece to leave. Today, 19 countries share the euro, but the dominant headlines are more about disintegration than integration, with Greece’s finance minister confirming that the country will miss Tuesday’s deadline to repay a roughly $1.8 billion loan to the International Monetary Fund. Greece’s banks are now closed as it heads into a Sunday referendum on further government spending cuts and tax increases that may determine whether the nation stays in the euro zone. Whatever else the question of optimum currency areas is, it’s not just academic.
Mundell noted that a previous generation of economists had “generally favored a world currency.” John Stuart Mill, for example, wrote in Principles of Political Economy, first published in 1848, that it was due to “barbarism … in the transactions of most civilised nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and that of their neighbours, a peculiar currency of their own.” In 1869, Walter Bagehot, then the editor of The Economist, conceived of a kind of trans-Atlantic currency union between Britain and the United States “as a step towards a universal money.” Observing the French-led formation of “a great coinage league”—the Latin Monetary Union, which established fixed exchange rates among a membership that grew to include 11 countries before it fell apart during World War I—Bagehot warned that “Before long, all Europe will have one money, and England will be left outstanding with another money.” Mundell wrote:
Mill, like Bagehot and others, was concerned with the costs of valuation and money-changing ... 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. ... (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.
The mid-19th century was a time “of monetary chaos around the world,” Kathleen McNamara, an associate professor of government and foreign service at Georgetown University, told me. That chaos extended to the United States, where until the Civil War a number of different currencies circulated. The Industrial Revolution had provided incentives “to integrate markets and trade across areas,” she said, “but they had these chaotic, very local monetary systems, where the transaction costs were huge, because you have to kind of figure out what the different exchanges are.”
Given all the costs associated with multiple currencies, why not just establish a world currency? McNamara said there are two main takeaways from the literature on optimal currency areas. “One is the notion that currency changes help economies adjust.” If a country lets its currency depreciate, or lose value, for example, its exports become cheaper and thereby more in demand relative to other goods on the world market, helping ease unemployment. “So if you take that away, if you in fact create one large currency area, then you have to make sure that that currency area has other ways of adjusting” to shocks like inflation or rising unemployment, she said. “And the easiest way of adjusting is to move factors of production, so labor moves. So for example, say there’s unemployment in one part of the currency area, labor has to be able to move easily to other parts of the currency area.”
“The second thing is this ‘asymmetric shock’ idea,” McNamara said. For example, if one part of an economic region is booming and another is facing a slowdown—as was the case with Ireland and Germany, respectively, in 2002—they require different kinds of policies to adjust. “The more alike a region is, the more likely they’ll need the same kinds of economic prescriptions in the case of a shock.”
In that sense, the United States itself might not have been an optimal currency union for much of its history. In a 2000 paper for the National Bureau of Economic Research, Hugh Rockoff argued that until the 1930s, “the United States might well have been better off if each region had had its own currency,” since shocks to agricultural or financial markets hit different regions and their banks differently. “Often, an interregional debate over monetary institutions would follow,” he wrote. “The uncertainty created by the debate would further aggravate the contraction.”
Asymmetric shocks like these persist in the modern U.S. economy. Florida, for example, can experience a housing bust even as the timber markets of the Pacific Northwest remain relatively robust. Florida can’t devalue its currency to stimulate exports, and yet nobody was talking about the threat to the dollar zone from a potential Florexit back in 2010.
McNamara maintains that the difference is less technical than political. “People think about the United States as a nation-state,” she said. “People don’t know how to think about the [European Union]. … Throughout the entire euro zone crisis, traders, financial actors, have been kind of casting around to figure out, ‘How tightly bound together is the EU as a political entity? Can we really count on the other members bailing out Greece?’”
As of Tuesday, the answer seemed to be no—but that uncertainty has lingered for five years as voters in the euro zone’s richer core, most notably in Germany, have signaled an unwillingness to help Greece pay its debts. The United States, by contrast, has since the 1930s developed institutions to make those kinds of transfers automatically, as Paul Krugman explained three years ago in regard to Florida:
America may have a small welfare state by European standards, but it’s still pretty big, with large spending in particular on Social Security and Medicare—obviously both a big deal in Florida. These programs are, however, paid for at a national level. What this means is that if Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.
“For all of the United States’ problems, we still are a federal nation-state. … Nobody doubts that,” McNamara said. The European Union is not a nation-state, and the anxiety surrounding Greece has revealed that markets—and even the euro zone’s constituent nations—still aren’t quite sure what the EU is.
“It’s this innovative, emergent kind of governance form,” McNamara explained. In that sense, the current crisis is bigger than Greece’s 2-percent share in the European Union’s GDP; it tests the very meaning of EU membership. It’s an experiment that’s ongoing as Greece runs out of money, and it won’t be settled anytime soon whether or not Greece remains in the union. Rockoff estimated that it took a minimum of 150 years for the United States to become an optimal currency area.
For now, the result of the EU’s identity crisis is turmoil. As McNamara noted, “Markets hate uncertainty.”