With talk of a Greek exit from the Euro now being treated seriously it can be informative to consider past experiences with monetary union. The normal fate for currency unions has been eventual failure and dissolution, and the history books are full of examples of such failures. By and large having some pre-existing form of centralised political union in place appears to greatly improve the chances of a monetary union succeeding. Classic examples of resilient monetary unions include the USA, the UK and in some respects even the former USSR.
Nineteenth century Europe had the Latin Monetary Union (LMU) based on the French franc and centred on France, Belgium, Switzerland and Italy, as well as the Scandinavian Monetary Union (SMU) between Sweden, Denmark and Norway. Both the LMU and the SMU broke apart because there was no central institution to enforce common monetary policy and because of divergent fiscal policies motivated by domestic concerns.
Perhaps the most famous example of a de facto currency union was the gold standard which developed internationally from 1870 onwards. The gold standard was a system of fixed exchange rates based on convertibility to gold at set prices. The system came under severe pressure following the stock market crash in 1929 and finally came unravelled in the early 1930s when virtually all countries abandoned gold convertibility.
The outlines of a new international monetary system based on the convertibility of certain national currencies into United States dollars was agreed in July 1944 at Bretton Woods. The US dollar was itself backed by convertibility into gold, and this meant all participating currencies were indirectly pegged to gold and therefore to each other. Under the Bretton Woods system countries could devalue their currencies under certain agreed conditions. The Bretton Woods system began to fray in the late 1960s as the United States became increasingly unable and unwilling to sustain the dollar’s exchange rate with gold. Eventually dollar convertibility was terminated by the United States in 1971.
The currency instability of the 1970s prompted a series of attempts to stabilise exchange rates in the European Economic Community (EEC). The first of these was the ‘Snake in the Tunnel’ system designed to peg the EEC currencies to one another within narrow bands. The Snake in the Tunnel system had broken down by the mid 1970s. The next major attempt at monetary coordination was made in 1979 with the launch of the European Monetary System (EMS). The EMS was based on a system of narrowly fluctuating exchange rates known as the Exchange Rate Mechanism (ERM). In practice the Deutsche Mark quickly became the anchor currency of the EMS and the system was characterised by repeated devaluations by member states.
Post-reunification expansionary fiscal policy designed to support the rebuilding of the former East Germany, combined with the Bundesbank’s ultra-tight monetary policy, forced other countries to keep interest rates at extremely high levels to support their currencies and prevent capital outflow to Germany. A number of European currencies came under speculative attack and Sterling’s membership of the ERM was suspended by the British Government in September 1992. Italy withdrew the following day and the ERM was effectively dismantled in 1993 when the fluctuation band for national currencies was extended to 15 per cent. As with previous failed attempts at fixing exchange rates, the system was undermined by conflicting policy goals in the different countries and by the inability of member countries to harmonise monetary and fiscal policies.
Despite these setbacks, the push for monetary union continued as it was claimed that unpredictable exchange rate fluctuations were incompatible with the EU’s fully open and competitive internal market. This perspective drove European Monetary Union (EMU) and policies aimed at convergence between the various EU economies in areas such as inflation and fiscal discipline. These policies were intended to create the conditions for a viable currency union. One lesson drawn from the ERM experience was that systems of fixed exchange rates will eventually buckle under the strain of divergent domestic policies and objectives. Thus, in preference to yet another system of fixed exchange rates, the decision was made to pursue a single currency as well as a single monetary policy under the control of an independent central institution. Eleven national currencies were made convertible to the Euro at established rates in 1998 and the Euro was officially launched the next year, with monetary policy and enforcement falling under the authority of the independent European Central Bank (ECB).
It remains to be seen whether this latest experiment in monetary union will succeed. It is now clear that EMU has major fundamental design flaws and if history is a guide then the odds of success do not look great. On the other hand, Europe’s persistence with the idea of monetary union suggests that mistakes will be learned and the attempt renewed.
The real question is whether the mistakes will be learned in time to prevent the currency union from imploding.
This column was first published by Progressive Economy @ TASC