Journal Issue

Currency Unions—Pro and Con

International Monetary Fund. External Relations Dept.
Published Date:
June 1966
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J. V. Mládek

THE ISSUE of a common currency—or a currency union—appears on the agenda in three continents: Europe, America, and Africa. It figures in the program of the European Economic Community, although there are few signs that it is considered urgent. In Central America, it is being discussed within the framework of proposed economic integration, toward which some steps have already been taken.

Africa is the only continent which can boast real live currency unions: the West African (CFA franc), the Equatorial African (CFA franc), and the East African (shilling) currency unions. Of these, the last is preparing for liquidation, following the example of three other unions which expired at about the time of their members’ accession to independence. Africa can therefore offer some lessons based on practical experience with currency unions, which may be of interest to developing areas.

Currency Union and Economic Integration

A currency union in practice is either an instrument of economic integration or a feature of an already existing economic union; in recent history there has been no instance of a currency union whose members have not at the same time observed the rules of a common market. This is true of both the West African and the Equatorial African currency union, and it is still largely true of the East African currency union. Nor is there any plan for a future currency union which would not be accompanied by a common market, thus forming an economic union.

Plans for economic integration in Europe and in Central America recognize that a currency union cannot be envisaged until integration is well advanced, although a unified currency may be expected to stimulate integration. The degree of economic cooperation required in order to achieve a currency union makes it a waste of time to discuss plans for common currencies in vast areas where individual countries have not taken the first steps toward bringing their economies any closer together—and perhaps could not do so if they tried.

What advantages does a currency union offer to its members? Its main merit can be appreciated only on the basis that amalgamation of small economic units into large ones is desirable.

Economic Integration: Advantages and Drawbacks

If the desirability of such amalgamation is accepted, two further questions may be asked: First, what are the benefits of having an economic union? Second, what are the advantages of a full economic union—including a common currency—over a less complete form of union, such as a common market?

The basic claim of the partisans of economic integration is easy to understand. The stepped-up competition resulting from the abolition of protective restrictions leads to increased specialization, efficiency, and productivity. The factors of production—labor and, particularly, capital—are used more efficiently, and the enlarged markets make possible the application of modern technology, which often depends on the so-called economy of scale, that is, on plants whose optimum size is relatively large. When these claims are made good, a common market has already achieved considerable success.

What does a common currency add to such an achievement? In theory, a common market establishes freedom of movement for products and factors of production across member countries’ borders, thus unleashing the forces of competition. In practice, however, it is possible for any common market to have many imperfections, so that it stops short of complete freedom for products and factors, as illustrated by the European Economic Community. Under one currency, some of these imperfections could not survive, and others would be subject to new pressures. The very first consequence of having a single currency is, of course, that it allows complete freedom of payment by any one place to any other place in the union; thus a currency union gives complete liberty to capital movements, which under a common market may still be restricted. To an investor, besides providing him with freedom to move his money as he thinks best, the currency union brings another gift: guarantee against a devaluation loss. Even under full interconvertibility of currencies of countries in the common market, a change in par values remains a real possibility, a threat which is finally removed only by the unification of the currencies. This is indeed the great advantage of a currency union over a monetary union.

TERMINOLOGY used by different authors in this field varies; the present author offers his own definitions without claiming universal validity for them. All the definitions are of ideal concepts; in existing arrangements there are many exceptions to rules.

A currency union is an arrangement between two or more sovereign states to share the same currency and responsibility for its management. (A country may use another country’s currency without participating in its management, but that is not a currency union.)

A further distinction should be made between currency unions and what used to be termed monetary unions in the nineteenth century. All member countries in a currency union use one single currency. Countries in a monetary union—such as the short-lived Latin Monetary Union and the Scandinavian Monetary Union of the nineteenth century—use separate currencies that are freely interchangeable at fixed rates. As long as the rules of a monetary union are observed, the difference between the currency union and the monetary union appears, at least in theory, to be slight. In practice, however, there is a difference.

A customs union is an agreement between countries to remove customs tariffs on trade between members and to create a common customs barrier vis-à-vis the rest of the world.

A common market means a free market for the goods and services produced by its members and also for the factors of production, that is, capital and labor. There are no quantitative restrictions or multiple rates of exchange and no customs barriers, the rules of a customs union being part of the whole structure.

An economic union is a combination of a common market and a currency union. There are no restrictions on the movement of products or factors and there is one currency.

What applies to capital is equally true of the earnings and savings of labor and should encourage migration across national borders. Payments within a union would become swifter as exchange controls were shed.

The happy expectations of benefits which economic integration may bring are not, however, equally shared in all quarters. There has been considerable controversy about the extent to which the benefits are offset by switching from less expensive foreign markets to the more expensive (because less efficient) suppliers within a union. Furthermore, an economic union, or a common market, may over-protect its area and thereby tend to create unsound industries. Essentially, these are arguments against excessive protectiveness, but it is true that the very process of integration, through the elimination of internal barriers and the maintenance of external ones, involves some losses which have to be subtracted from the benefits.

Some critics of integration plans, while not attacking the theory, argue that local circumstances often prevent the plans from working. They say, for instance, that migration of labor will not act as an equilibrating factor in payments between member countries because tradition, language, and religion will discourage it. Other critics, while not doubting that the integrating process will work, are disturbed by some of the results that they expect from it. Thus, mobility of capital may be harmful if it results in capital being attracted to more developed areas rather than to the neglected ones which need it most. So integration may actually increase the uneven geographic distribution of incomes and wealth.

Yet often, opponents of integration—especially if their opposition is political—take their stand on other grounds and stress the loss of freedom of action which integration would entail for national governments. This argument, politically sensitive and therefore of consequence, deserves analysis.

Integration and Sovereignty

The simplest way of describing what happens to governmental prerogatives in the process of economic integration is to list the weapons that a sovereign government possesses for the defense of its balance of payments and to show which of these weapons the country has to give up when it enters an economic union.

The government of a fully independent country that experiences an upset in its balance of payments can take any number of measures to set it right. It can cut down outlays on imports by applying import restrictions, imposing import taxes, or raising tariffs. On the receipt side of the balance of payments, it may attempt to boost exports by providing subsidies or by introducing a specially favorable exchange rate for exports. Finally, if the trouble is persistent, it may devalue its currency. With the exception of devaluation, external measures usually appear easier than attacking the root of the problem through internal action, which is directly felt and resented by the population, or at any rate by the business community. If it is assumed, for instance, that the cause of the balance of payments disequilibrium is a too ambitious development program, the correct remedial action would be to slow down the pace of investment or possibly to review the program and supervise spending more closely. More likely than not, the lowering of aims will be unpopular; a decline in the volume of public works may easily affect working opportunities for labor, and the resulting reduction in consumption may be resented in business circles. Faced with the possibility of political trouble, authorities often tend to delay the unpleasant moment and to rely for the time being on external expedients.

All such external measures are barred to a country in an economic union. Even a common market considerably reduces a member country’s arsenal of defenses. While the government would maintain the right to devalue its currency and might retain some freedom to regulate capital outflow, it would be unable to impose any form of restriction on its imports and current payments without explicit authority from its fellow members of the common market. The country in our example could not raise its external tariffs above the common tariff level, and it might find that restrictions on imports from third countries were ineffective unless internal controls were reimposed on the movement of goods within the market. Short of going from one devaluation to another, our country would discover that its development policy, and for that matter its employment policy, must be coordinated with the policies of other member countries.

Should the common market graduate to a full economic union because its members have signed a treaty establishing a common currency, the country in question would have to give up its last external instruments of defense. It would be unable to devalue, and it could not impose any restrictions on capital movements.

What freedom of economic policy is left to member countries on the internal front? If they have free banking and free mobility of funds, only limited differences in credit policy are conceivable. Differences in taxation are possible, provided, however, that they are not so big as to drive labor or capital to the areas of lighter taxation. Even a country’s budgetary policies become a legitimate interest to its fellow members in the union. As a matter of course, deficit financing in one country, whether by the banking system or the central bank, would be watched with attention by all other members of the union. Monetary expansion in one country alone would increase that country’s share in the union’s products and resources. It would be tolerated only up to a point, beyond which it would be challenged by the other members. In practice, precautions would almost certainly have been taken at the outset to prevent such a contingency by centralizing credit policies in a central monetary authority and possibly by setting a fairly strict limit on the credits which the common central bank could grant each member government.

A country’s inability to escape from economic difficulties by settling its own policies may sometimes be a real privation. A monetary policy which is right for most of the union may be wrong for one particular country or area. Such a situation can arise even within a country, where the interests of one region may clash with those of others. But it is far more dramatic in a union of sovereign states where the remedies, such as migration, are less easy to put into motion. In sovereign states, too, social discontent can easily take on nationalistic overtones. The answer to this problem seems to lie mainly in intermember arrangements for relief action, which in developing countries would usually be connected with machinery for stabilizing incomes.

Requirement of Discipline

The requirement of a thorough coordination of policies, the transfer of so many prerogatives of sovereignty from member governments to central organs, is a price that some consider forbidding. Yet it may be asked whether the discipline and restraint which an economic union imposes on its members is really an entirely negative aspect of integration, especially for the new countries. In “Why a Central Bank?” (Finance and Development, Vol. II, No. 3), J. Keith Horsefield called attention to countries’ experiences with central banks over the last 40 years. In 1920, the international financial conference at Brussels recommended that every country should set up its own central bank. The recommendation was made on the assumption that national central banks would be able to restrain their governments from unwise policies.

But this hope has not been entirely fulfilled since then. While the restraining influence of central banks has often been exercised, the banks’ powerful credit instruments have frequently been misused and have tended not to counteract, but to accentuate, the bad effects of government policies. The existence of a central bank, with its limitless power of creating money, often seems to encourage government laxity about deficits, and this arouses doubts whether national central banks in the hands of inexperienced, irresponsible, or weak governments are much of a blessing.

Experience shows that governments seldom resort deliberately to inflation, but that, although aware of the perils involved, they are unable to resist political pressures and that they would actually be helped by a constitutional stop sign. Some countries have such a stop sign in the form of central bank laws banning certain policies or limiting the government’s borrowing powers. In other countries, however, where inflationary deficits have become something of a habit, the national monetary authorities no longer have such signs. It is clear that, as a restraining influence, a multinational central bank is in a considerably stronger position to take an anti-inflationary stand against one or several governments than is a national institution that has to face its one and only government. It is not easy for an individual country to disregard a warning from a multinational bank that it must not damage the common currency by allowing excessive expansion in a part of the territory. A government that is eager to avoid inflation, but fearful of taking alone the full responsibility for refusing excessive demands, may actually find relief in the firm policy of a multinational central bank and possibly in the statutory limits on the central bank’s credit to the government. Furthermore, in such situations a government, in answering its critics, would also be able to use to some advantage the weight of public opinion in other countries. Undoubtedly, a violent disagreement between governments on budgetary and monetary policies might bring about a breakup of, or secession from, the union at any time. On the other hand, if the members of the union manage to avoid harsh actions over the years, a tradition of reasonableness may grow up and tend to eliminate crises.

Institutional Cost

Partisans of economic integration often mention among its favorable consequences the reduced duplication, and hence the reduced cost, of centralized agencies. While the saving on the cost of public administration is a minor consideration in the developed countries, it is of considerable consequence in the developing countries, most of which lack skilled personnel as well as funds. The Common Services Organization in East Africa is an example of efficient and inexpensive administration in several countries of tax and customs collection, transport and mail, and some other services. The central banks in West and Equatorial Africa are other examples of efficient, very inexpensive organizations, which, far from being reduced to the basic essentials of central banking, provide for their member countries valuable statistical and research services.


Does economic integration help economic development? It has been pointed out by many that, unlike the countries of Western Europe, most developing countries pondering the possibilities of economic integration have little mutual trade and little industry. Free trade within these areas would not, it must be admitted, bring their production under the purifying flame of competition with industries in developed countries. The most obvious favorable consequence of integration would be the creation of markets large enough for modern industrial enterprises and of the modern infrastructure needed for economic growth. Yet an economic union, while creating more favorable conditions for new industries, does not in itself make redundant the efforts of governments to carry out purposeful development policies. Even in an economic union it is possible to live insouciantly, especially under the umbrella of foreign aid, or jealously and waste-fully to duplicate a neighbor’s projects.

The problem of capital movements may be a serious one for developers in an integrated economy. If directed exclusively by investors’ choice, such movements may result in the further accumulation of the means of production in more developed regions and perhaps in stagnation or even backsliding in less favored areas. This anxiety was in fact one of the main causes underlying the dismantling of one important economic union in Africa. It appears unlikely that the process of industrialization could be left entirely to investors’ decisions. It may be hoped that an acceptable distribution of resources can be achieved through agreements between member governments on such means of channeling investments as are not likely to discourage capital.

Thus, in the last analysis, promise of full and balanced growth is to be weighed against the hardships of economic discipline and the need for uniformity in policies. Economic union is possible only for countries that think alike on political and economic questions. Discipline, while strong, must also be flexible, which seems to be possible only in an atmosphere of mutual sympathy.

Although the form of the future political organization of Europe is now, more than ever, clouded by conflicting views, there is little doubt that the founders of the movement for European unity were moved not only by economic considerations but also by the desire to cement inter-European relations and to restore Europe to its position of influence among the world powers. In Central America, there is a memory of a common past, political kinship, and a community of language and culture between the countries. In Africa, where the unions have come into life not through a long effort of integration but by accepting and modifying a heritage from preindependence times, the success and survival of the remaining economic unions will be determined in the first place by their ability to develop among their members a strong feeling of common loyalty.

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