Breaking up Currency Unions

Wobbly euro or not, monetary integration is quite a fashion around the world. Ecuador dumped its currency in favour of the US dollar, twelve European countries kissed their familiar notes and coins good-bye and embraced the euro, fifteen African countries use the CFA franc, seven Caribbean ones make up the Eastern Caribbean Currency Area and so on. All in all, a whopping two thirds of the sovereign countries in the world are either considering abandoning their national currency or have already done so.

But, like any marriage, these unions can turn sour and end in one or more partners renouncing their vows and walking away. What makes a monetary union fall apart, and what ensures that it remain intact? Volker Nitsch, of the Free University Berlin, dissected 245 country pairs that use or have used a common currency between 1948 and 1997 in order to understand what instigates currency union divorces and published his findings in CESifo Working Paper No. 1113.

With marriages, the reasons for taking the vow are well known: a strong chemical interaction between the partners, family considerations, pecuniary considerations, social considerations, clock-ticking considerations. And love, sure, that too. But with monetary unions, where taking the step means giving up a cherished symbol of nationhood?

Mr Nitsch lists several motivations for taking such a step. Top on the list is the credibility of these arrangements. In contrast to other hard currency pegs (such as fixed exchange rates or currency boards), the abandonment of a country’s own currency is often assumed to be permanent. Commitment also plays a role: with the use of a common currency, Europeans signal a degree of integration that goes far beyond the elimination of exchange rate volatility. For dollarised countries, the adoption of another country’s currency means that monetary policy is delegated to a foreign authority deemed to be more competent that the local brand.

Still, from 1948 through 1997 there were far more dissolutions than establishments of currency unions. Why a country should leave a currency union is, however, less well understood. The author used an extremely comprehensive data set compiled by Reuven Glick and Andrew Rose covering 217 countries, territories, colonies and dependencies from 1948 through 1997, in addition to data from such standard sources as the World Bank’s World Development Indicators and the IMF’s International Financial Statistics. Pairing countries that shared a currency left him with a set of 245 country pairs.

His extensive analysis of the data on these country pairs led the author to conclude that a large inflation differential between currency union members is consistently associated with a high likelihood of currency union dissolution. This differential tends to increase in the run-up to the break-up.

Termination of a political union also leads usually to severing the currency union ties. This can take the form of one of the partners undergoing a significant change in political status.

Openness to trade also plays a role. If one of the countries is closed to international trade and trade flows dry up, the death knell for the currency union is close at hand.

Surprisingly, neither asymmetries in output nor fiscal variables matter for a typical break of a currency union.

A cursory glance at the euro area countries with regard to these pointers does not suggest an imminent break-up. Unfortunately, the author does not delve into the prospects of this particular union. But in another paper written jointly with Helge Berger, a former IMF economist now at the Free University Berlin, the authors demonstrate that the euro, contrary to expectations and hype, has not contributed to increased trade among the euro member countries. Would that add up to the current disenchantment with the euro that appears to be making the rounds? And could that eventually lead to a currency divorce in the euro area? Well, watch this space.

Volker Nitsch: Have a Break, Have a ... National Currency: When Do Monetary Unions Fall Apart?, CESifo Working Paper No.1113

• Other CESifo Working Papers dealing with the currency unions
• Other CESifo Working Papers by Volker Nitsch
• CESifo Working Papers published in the past three months