The pattern of one country one currency was reinforced with the decline of empires. Some former colonies were reluctant to discard shared currencies, but after a brief time lag, currencies became national. An example fromthe 1990s is the rapid introduction of national currencies following the dissolution of Yugoslavia, the USSR, and Czechoslovakia. The 12 Commonwealth of Independent States successors to the USSR recognized the increased transaction costs that would result from abandoning the common currency, but after less than two years the ruble zone had collapsed.
Most currencies are national, where Nm is the number ofmonies andNc is the number of countries:
Nm ≈ Nc (1)
In practice, however, the one country one currency rule is not always the case and sometimes Nm
Carrots and Ministates
The principal examples of currency union driven by carrots (i.e., incentives offered by an interested party) are the CFA franc zone in central and West Africa and the rand zone in southern Africa.The French Treasury, which acts as a guarantor of the fixed exchanger ate, manages the CFA franc zone’s reserves and settles the regional central banks’ payments and receipts. The zone has existed for more than a half a century because of preferential French aid to zone members and balance of payments (BOP) support. In the rand zone, South Africa has formal arrangements to share seigniorage (i.e., the real resources obtained from printing money which can be spent on goods and services) with the countries in which the rand is legal tender (Lesotho and Namibia), and the South African central bank is prepared to act as lender of last resort in these countries. Similar carrots encouraged retention of the ruble zone in 1992 93, but Russia objected to the size of transfers to other members while some members opposed the political use of the levers. Ultimately, lack of agreement on monetary policy institutions made the ruble zone unstable. In the both the CFA franc zone and the rand zone, by contrast,members accept the institutions imposed by a dominant economic power. Even so, the membership of the CFA franc zone and the rand zone has not been entirely stable. Mali withdrew from the CFA franc zone in 1962 and rejoined in 1984; Mauritania withdrew in 1973; Equatorial Guinea, a former Spanish colony, joined in 1985; and Guinea-Bissau, a former Portuguese colony, joined in 1997. Botswana withdrew from the rand zone in 1976.
Other countries that lack independent currencies or those that participate in a shared currency arrangement are small and oftenspecial cases, known as ministates. Between 1970 and 1990, according to Rose (2000, 41), 82 countries were involved in currency unions, 15 of which were in the CFA zone and three in the rand zone. The remaining 64 countries were small economies using the currency of a neighboring or quasi-colonial power or ceding monetary policy control to a larger country. The Eastern Caribbean Currency Area (consisting of eight small island economies), the British Virgin Islands, Bahamas, Barbados, and Belize have tied their currencies’ value to the U.S. dollar since 1976. Ireland- UK (pre-1979), Luxembourg-Belgium (preeuro), and Brunei-Singapore are often described as currency unions, but the second-named country in each pair had total control overmonetary policy.The remainder of the 82 currency union members used another country’smoney for all or part of the twentyyear period.Most of these are tiny economies, such as Svalbard, Isle of Man, and Norfolk Island. The largest, Liberia, ceased using the U.S. dollar in the 1980s when a new government started issuing first coins and then paper currency. The next largest, Panama, has had a special status with the United States since itwas created prior to construction of the Panama Canal.
Historically, some colonies have had separate currencies, although this typically involved large colonies of a kind that no longer exists. The status of some territories is not clear cut, because the ruler, occupier, or guardian is sensitive to the term colony, but territories such as Guam (and Panama, to a lesser extent), Northern Cyprus, or Western Sahara have a quasi-colonial relationship with the country whose currency they use. Other currency union members are integral parts of the larger nation. Scotland, for example, is part of the United Kingdom, not a member of a currency union, just asChristmas Island is part of Australia.
Apart from the CFA countries, Lesotho, Namibia, Swaziland, Ireland, Luxembourg, Brunei, Liberia, and Panama, all currency union members identified from 1970 to 1990 were small islands or territories without full sovereign status. An updated version of this list would include another exception: the eurozone. The euro, however, is a unique example of independent nation-states agreeing to use a common currency whose monetary policy is determined by a common institution.
Explaining Currency Domains
The theoretical approach to explaining the use of a common currency has been dominated by the optimumcurrency area (OCA) literature initiated by the economists RobertMundell and Ronald McKinnon in the early 1960s and continuing to Alberto Alesina and Robert Barro (2002). OCA theory, which emphasizes the trade-off between the macropolicy benefits of an independent currency and the microeconomic benefits from a common currency, is appealing in principle but has a poor record of explaining the composition of existing currency areas or predicting changes in currency domains.
Independent countries want their own currency because they want to set their own monetary policy. Economic stability is not always a primary concern. Ukraine left the ruble zone in 1992, for example, so that the government could print money to support inefficient producers. In many newly independent countries in all eras, monetary policy independence enabledrulerstofinanceexpenditures.Fixedexchange rate arrangements and currency unions both involve some level of constraint on independent monetary policy, but all exchange rate regimes involve an important element of choice (over instrument and peg) and leave an option of reversal. Fixed exchange rate systems enable countries to make their own macroeconomic policy choices, while a currency union definitively cedes control over monetary policy.
OCA theory takes the position that very small nations, or microstates, cannot afford to have a national currency because the transaction costs would be too high. The threshold for such transaction costs is not so high as to prohibit small countries likeMalta or Iceland from having independent currencies, however. Neither are transaction costs the reason for membership in the CFA franc zone and rand zone; these members use common currencies because France and South Africa provide carrots for them to do so, and even then the carrots were insufficient to keepMauritania in the franc zone or Botswana in the rand zone.
What explains the use of a common currency by independent countries, and especially the case of the euro? The OCA theory does not explain the timing or composition of the euro because it ignores the importanceof a commoncurrency forpublicfinance. For governments, seigniorage is a benefit of anational currency, but the benefit tends to be small, especially as cash declines in significance.More important is the need tohave a common unit of account for the public finances; the concept of legal tender allows the government to set tax rates, approve expenditures, and similar functions. The use of multiple currencies within one country would undermine political agreement over the allocation of the central budget. Internal exchange rate changes would reduce the tax burden and increase the relative value of expenditures for the users of one currency over another.
The Adoption of the Euro
The emergence of single-currency areas paralleled the consolidation of the nation-state. The major currency unions of the second half of the nineteenth century, including those inGermany, Italy, andCanada,were associated with political unions. In 1990, German monetary union accompanied the reunification of the country. Although debates took place at the time over acceptance of the deutschmark in the former East Germany and the rate at which old Ostmarks would be exchanged, a common budget in common units played a key role inGerman reunification. The euro, first adopted for noncash transactions in the late 1990s before it became a cash currency, is a 21stcentury example of public finance driving adoption of a common currency.
The adoption of the euro was preceded by a lengthy transition period during the existence of the European Monetary System, which began in 1979, and especially after the Maastricht agreement of the early 1990s. The process did not follow the predictions of the OCA theory. Although the EU did become more integrated with more open national economies and greater movement of labor and capital across national borders, the pace of monetary integration did not follow these trends, and in the end, restrictions on capital movements were abolished as a step toward monetary union rather than monetary union being driven by greater factor (e.g., labor or capital) mobility.
How to explain these outcomes? The European Monetary System began operation in 1979, and an important driving force was the difficulty of managing the Common Agricultural Policy based on agreed common prices when exchange rates were market-driven (Pomfret 1991; Basevi and Grassi 1993). The problems of the EU’s agricultural policy may be reduced by reform, but any common policies based on political negotiations about financial contributions and monetary benefits will be undermined by changes in bilateral exchange rates. The more far-reaching the EU’s common policies and the larger the EU’s common budget became, the more severe the problems associated with lack of a common currency. Meanwhile, the desire for independent monetary policies was moderated by growing agreement on the primacy of price stability and on the desirability of central bank independence. In the 1990s, the crucial issues behind adoption of a common currency concerned who determines the conduct of monetary and fiscal policy, rather than the emphasis in OCA theory on private sector transaction costs and on whether macropolicy will be effective or not.
If the EU is becoming a territorial unit as Germany or Italy or Canada did in the 19th century, and this was a significant motive behind the introduction of the euro, then the euro as a common currency is sui generis in the current world economy. Apart from the euro, the only current examples of common currencies are the special cases of the CFA franc zone and the rand zone, where carrots encourage membership, and the extreme cases of ministates. See also Bretton Woods system; dominant currency; euro; European Monetary Union; exchange rate regimes; impossible trinity; multiple currencies; optimum currency area (OCA) theory