8
$\begingroup$

What would happen if all countries suddenly stopped using local currencies and adopted a global currency (like the Euro, but for everyone)?

$\endgroup$
  • 4
    $\begingroup$ "What would happen" is so broad, it cannot be answered. Please narrow down your focus, otherwise this will likely be closed. Meanwhile you can have a first taste about the possible economic reasons why many currencies should exist, by reading about Optimal Currency Areas, en.wikipedia.org/wiki/Optimum_currency_area $\endgroup$ – Alecos Papadopoulos Apr 6 '15 at 1:23
13
$\begingroup$

The Euro was always conceived by most Economists as a political goal, not an economic one.

Prologue: There is the theory of Optimum Currency Areas (OCA) which characterizes properties that a larger area would need to have if it were to operate on a single unit of currency. Since the announcement of the Euro around 1990, there were many papers that looked into whether the European Area actually satisfied the broader range of these criteria, and they mostly agreed that it did not.

Ex-post, we can now see this playing out as the ECB has a hard time setting up an inflation rate that is improving conditions of countries that are hit very badly by the crisis such as Greece and Spain, and countries which are not, such as France and Germany.

Intuition behind OCA

Basically, a country gives up the tool of monetary policy when it subordinates into such a currency union. In order to properly use monetary policy for a set of different economies (countries), you need these to be very similar in nature: If all countries react similarly to a housing bubble / oil shock / etc, you can easily improve outcomes for all countries with the same monetary tool. If the countries respond differently, it is much harder to do so.

Single currency for non-OCA

To the extent that all countries in the world are very different in nature, your experiment is similar to the gold standard (see Bretton Woods system). We think about that system mostly as a failure. While there is no hard data on the causal relationship, countries that abandoned the gold standard earlier tended to do better. We observed similar trends for countries that abandoned the dollar standard earlier. As a short intuition, among other explanations, when you abandon monetary policy and fix your exchange rate, you make yourself more vulnerable to inflation/deflation of other regions.

$\endgroup$
  • $\begingroup$ Thanks a lot. Can you think of an example of a detrimental effect we might have seen happen with a single global currency? $\endgroup$ – oyvind Apr 5 '15 at 20:20
  • 2
    $\begingroup$ @oyvind I'd suggest you to read into the history of latin american countries that fixed their currencies against the US dollar. Typically, as soon as the US Fed increased interest rates to fight inflation, these countries imported their low inflation, which was detrimental for growth. Also, the likelihood of them keeping up with their fixed exchange rate went down, so a lot of speculation against their fixed exchange rate depleted their USD reserves rather quickly. $\endgroup$ – FooBar Apr 5 '15 at 20:34
3
$\begingroup$

After a period of time they would switch back.

Why?

The monetary systems of each country are based on fractional reserve banking, which creates a leveraged relationship between currency and deposits within the banking system. Both forms of money are used interchangeably for purchases, although in practice the use of bank deposits dominates in modern systems.

The underlying problem posed by a single currency is that for a variety of reasons, every single country is expanding their bank deposits at different rates. In floating regimes, currency exchange values change over time to adjust for this, but in a single currency regime this can't happen. As a consequence goods become relatively more expensive in countries whose banking systems are expanding quickly, and less expensive in those which aren't - without this necessarily reflecting any underlying economic realities vis-à-vis production. Eventually (over decades - it's a slow system) the discrepancies become so extreme, that economic reality in the form of arbitrage intervenes in a way that invariably causes the destruction of the currency union.

Examples of this process can currently be seen in the Euro zone, it is left as an exercise for the reader to work out which countries are expanding faster than others.

$\endgroup$
  • $\begingroup$ Cool. Am I right in assuming that this would not be a problem if trade between countries was completely free? $\endgroup$ – oyvind May 5 '15 at 5:07
  • $\begingroup$ No it would still be a big problem.It's a consequence of embedding the monetary system in the banking system, and the banking system has this rather strange property of linking lending to the money supply. The same process also occurs within countries, interestingly - it's why properties in cities like New York and London are so much more expensive than their regions, but it's easier to compensate for it internally with government spending. $\endgroup$ – Lumi May 5 '15 at 13:29
  • $\begingroup$ But in an open economy, would not the lower prices in one area cause more demand for its products, increasing the price to parity? If Poland oranges are cheaper than Germany oranges, why would my local supermarket not stock Poland oranges? If labor in Bulgaria was cheaper than in Britain, why would I not locate my factory in Bulgaria? Pushing all prices and salaries to parity (relative to the worth of natural resources in each area). $\endgroup$ – Jonathon Aug 24 '16 at 18:50
  • $\begingroup$ This explanation makes no sense. The idea that differential inflation rates are a result of fractional reserve banking is quite far fetched. I would say it's pretty much a consensus in policy circles and academia that this does indeed cause big problems in currency unions, but is largely caused by differences in productivity and wage growth of member countries. See for example Germany and Greece. @JonathonWisnoski is right that the mechanism suggested in the above answer would break down with free trade in goods and services. $\endgroup$ – Tobias Jan 11 '17 at 10:34
  • 1
    $\begingroup$ It's a little more complicated than purely a fractional reserve issue - but the problem of variable rates of expansion is very real, and does not break down with trade. Bear in mind currently while people quote "consensus in policy circles" there is also a consensus that the theories that this consensus is based on are badly broken. At any rate, I suggest you explore the data for the EU banking systems and calculated the differential rates of expansion over the last 20 years for yourself. The data on the old Scandinavian currency union is also quite interesting. $\endgroup$ – Lumi Jan 11 '17 at 17:39

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.