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Pascal Lachance
Student #2100204
Academic Supervisor
Dr. Saktinil Roy
4/28/2010
Universal Currency: Potentials and Pitfalls
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Abstract It has been argued by some researchers and observers that a universal currency might bring greater prosperity and stability for the world economy and community. These claims are being made in the foreground of an ever globalizing world where common languages, processes and systems are facilitating interactions across the globe. Currencies and the financial systems play an important role in such international transactions. However, the thought that a common currency would facilitate and promote trade amongst world countries is mainly intuitive in nature. This paper reviews this proposition, identifies the potential advantages and disadvantages of a global currency, and offers recommendations based on those findings.
Starting with a literature review of the current and past research on the nature of money, monetary unions, and global trade, I examine four major areas: i) the optimum currency area theory and trade volume; ii) propagation of financial shocks; iii) creation of money and the related impact on sovereignty; iv) the societal benefits. A numerical analysis is performed on the impact of the European Monetary Union on the growth rates of real GDP per capita and of average productivity of the member countries. As a baseline test, a comparison is made to the corresponding growth rates of four non-member countries.
Mundell’s “optimum currency area” theory is reviewed in the context of a future global currency. The potential benefits from greater trade volumes and lower transaction costs are examined. The validity and impact of the “border effect”, the “impossible trinity” problem, and the related supply and demand issues are also discussed and examined.
Since it has been proposed by a number of researchers that a global currency will reduce the risk of a financial crisis, I review the nature and causes of the historical financial crises with particular reference to the impacts of foreign reserves and currency trading. The relationship and impact of interest rates and inflation rates on financial shocks are discussed in relation to a universal currency system.
The probable rules and regulations in the creation of money for a global monetary system are also explored. In this context special reference is made to the potential impact which the centralization of the process of money creation will have on a state’s sovereignty. This includes money creation by a central bank, money multipliers, and bank reserve requirements.
Finally, I examine the potential direct and indirect benefits of a universal currency to our daily lives in light of the experiences in Europe in specific periods before and after the establishment of the European Monetary Union. For this purpose, two indicators are considered: i) growth rate of real GDP per capita; ii) growth rate of average productivity.
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It is found that a common currency could potentially be a powerful tool for countries that already share strong common attributes. However, the political and fiscal divergences would make the introduction of a global currency a rather thorny issue. It is recommended that countries wanting to be part of a monetary union continue to strengthen their economic and political collaboration at the continent level with the aim of possibly creating continental monetary unions. A universal currency and a global monetary system may not be a viable alternative in the near future.
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Table of Contents
Abstract ........................................................................................................................... 2
Section 1: Introduction ..................................................................................................... 6
Section 2: Research Purpose and Research Questions ................................................ 7
2.1. Interest Rates ........................................................................................................ 7
2.2 Exchange Rates ..................................................................................................... 8
2.3 Inflation Rates ........................................................................................................ 8
2.4 National Surpluses and Deficits ............................................................................. 8
2.5 Transaction Costs .................................................................................................. 8
2.6 Money Creation Authority ....................................................................................... 8
2.7 Credit Leverage Ratios .......................................................................................... 8
2.8 Central Governance and Monitoring ...................................................................... 9
2.9 International Capital Movements ............................................................................ 9
2.10 Currency Trading ................................................................................................. 9
2.11 Spread and Absorption of Financial Shocks ........................................................ 9
2.12 Special Drawing Rights ........................................................................................ 9
Section 3: Literature Review ......................................................................................... 10
3.1 Optimum Currency Area & Trade Volume ............................................................... 10
3.1.1 General Facts ................................................................................................... 10
3.1.2. Optimum Currency Area Theory ...................................................................... 11
3.1.3. Trade Volume and Transaction Cost ................................................................ 12
3.1.4 Border Effect ..................................................................................................... 13
3.1.5 Impossible Trinity .............................................................................................. 14
3.1.6 Supply and Demand.......................................................................................... 14
3.1.7 Possible Effects of a Universal Currency .......................................................... 15
3.2 Spread of Financial Shocks ..................................................................................... 16
3.2.1 Past Financial Crises ........................................................................................ 18
Subprime Crisis ...................................................................................................... 18
Russian Currency and Banking Crises ................................................................... 18
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Asian Financial Crisis ............................................................................................. 19
Mexican Economic Crisis ........................................................................................ 19
3.2.2 Foreign Reserves .............................................................................................. 19
3.2.3 Currency Trading .............................................................................................. 20
3.2.4 Interest Rates .................................................................................................... 20
3.2.5 Inflation Rates ................................................................................................... 22
3.2.6 Spreading of Shocks ......................................................................................... 23
3.3 Creation of Money & Impact on Sovereignty ........................................................... 24
3.3.1 Money Creation ................................................................................................. 24
3.3.2 Money Multiplier and Reserve Requirement ..................................................... 25
3.3.3 Global Monetary Governance ........................................................................... 25
3.3.4 Impact on Sovereignty ...................................................................................... 27
3.3.5 Global Currency Implementations ..................................................................... 28
3.3.6 Summary ........................................................................................................... 29
3.4 Welfare Benefits ...................................................................................................... 29
3.4.1 Direct Benefit to Individuals ............................................................................... 29
3.4.2 Indirect Benefits ................................................................................................ 30
3.4.3 Trade Volume – Welfare Benefit ....................................................................... 31
3.4.4 Capital Flows and Salary Levels ....................................................................... 32
3.4.5 Summary ........................................................................................................... 33
Section 4: Results ......................................................................................................... 33
4.1 Real Per Capita GDP Growth Analysis for Euro Countries .................................. 33
4.2 Real Per Person Employed GDP Growth Analysis for Euro Countries ................ 35
4.3 Research Questions............................................................................................. 36
Section 5: Analysis ........................................................................................................ 39
Section 6: Recommendations ....................................................................................... 40
Section 7: Conclusion .................................................................................................... 40
Bibliography .................................................................................................................. 42
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Section 1: Introduction A universal currency that would be used across the globe is currently a topic of discussion amongst the highest levels of national governments. The issue has recently been raised by many countries including China and Russia as well as organizations such as the United Nations and the International Monetary Fund. The main arguments for such a global federation are the desire to reduce transaction costs, eliminate currency risk, and to promote overall economic stability. The proof of any benefits of a potential global currency union is theoretical and the loss of control over monetary policy, as well as the encroachment on fiscal policy it would bring about, is a concern for some. The largest economic experiment on this front is the European Monetary Union (EMU) - one that will undoubtedly provide economists with valuable lessons in building a universal currency system, should world leaders agree to such a project. Discussions on this topic are likely to be precipitated by the erosion of the world reserve currency status of the United States dollar as it continues to lose value due to the country’s low economic performance and large budgetary deficit.
The aim of this research project is to identify the advantages and disadvantages of a unique global currency. Advantages will be defined as measures, policies and processes having a positive impact on gross domestic product, trade, and overall quality of life. Disadvantages, on the other hand, will be measures, policies and processes having a negative impact on gross domestic product, trade and overall quality of life. Economists generally agree that increases in gross domestic product or trade, which often occur in unison, lead to a higher quality of life. Other items such as low inflation rates, and the cessation of financial shocks will be examined in concert with the “quality of life” criteria.
Whether a centralized currency or a balance of centralized and decentralized currencies would be more advantageous as an impetus towards trade growth and quality of life improvement is the intent of this examination. Of interest is to determine what implementations of a global currency would work, what wouldn’t succeed, and which factors could mitigate the negative effects of a singular global currency.
Research will be based on a review of the current economic research, models, theories, regulations and initiatives employed by countries and organizations such as the United Nations, the World Bank, the International Monetary Fund and the World Trade Organization. This will be extremely useful in interpreting the current research and climate of opinion concerning the creation and implementation of a global currency system. The research will facilitate further exploration and research into the various areas identified above, in relation to the main objective of the project. The issue of global finances and currencies is quite relevant, considering the growing number of
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appeals globally to confront the issues associated with the current global or reserve currency system.
The topics covered in the research begin with the exploration of the concept of an optimum currency area and trade volume. The spread of financial shocks in a global currency setting is then investigated. This leads into a review of the creation of money and its impact on national sovereignty, with the last section being a review of the welfare benefits arising from the adoption of a universal currency. An analysis of gross domestic product and productivity data from key European Union countries is performed to compare the economic growth of countries prior to and following the launch of the European Monetary Union. It has been found that the potential key benefits from a universal currency would be born of the stability brought on by the fiscal, trade and governmental integration requirements of a monetary union. The need to agree on compromises to many sovereign issues would predispose a successful monetary union to nations which are already close in relations. Hence, a focus on continental monetary unions is suggested.
The rest of the paper is organized as follows. In section 2, I discuss the main purpose of the research project and outline the specific research questions associated with it. In section 3, I review the literature on the optimum currency area theory and trade volume, financial shocks, money creation and welfare benefits. Section 4 presents an analysis of growth of per capita real gross domestic product and of average productivity for post and pre European Monetary Union. The answers to the research questions are also discussed in this section. The results are analyzed in section 5 and recommendations are made in section 6. Section 7 concludes.
Section 2: Research Purpose and Research Questions In order to determine whether a global currency would be good or bad for the world economy and community, we must first make a decision on the metrics used to measure the potential merits and demerits of such a concept. Increases or decreases in trade, stability and welfare should be regarded respectively as positive or negative consequences. For gauging the extent or magnitude of the impacts, the following issues will be examined:
2.1. Interest Rates Why are interest rates so important, and why is there a long-term interest rate criterion for countries to join the European Union (Euro convergence criteria, 2009)? This conundrum will be explored using the available literature concerning interest rate variations and the background of this criterion. This approach will shed light on the issue of a global currency and its possible relationship to interest rates.
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2.2 Exchange Rates Here, other than the obvious role of converting to and from different valuations, I will explore the role floating exchange rates play in the dissipation or amplification of financial shocks as they spread through multiple countries.
Starr (2006) points out that some favor national currencies and floating interest rates, in contrast to a global currency, for developing countries by stating that a global currency is too restrictive for their needs, which require greater flexibility in order to respond to different business cycles and financial shocks.
2.3 Inflation Rates As part of the Maastricht criteria, countries endeavoring to join the EU must have inflation rates at no more than 1.5 percentage points above the average rate for the three member states with the lowest inflation rates (Euro convergence criteria, 2009). The dynamics of inflation rates in integrating diverse economies will be analyzed through a review of the literature and work behind the agreements currently in place for the European Union.
2.4 National Surpluses and Deficits As Keynes proposed penalties for countries maintaining a deficit or surplus in an integrated financial system (UNCTAD, 2009), I will review the research relating to this proposition as well as the effects deficits and surpluses might cause on a globally integrated system. Discerning if the problem of deficits and surpluses solves itself in a world with a universal currency will be analyzed.
2.5 Transaction Costs Lower transaction costs are cited by Starr (2006) as one of the primary reasons of the dollarization of countries. Further literature review will examine this proposition.
2.6 Money Creation Authority The authority to create money can be a thorny political issue although in a central system this authority would lie with a central board, expropriating this power from the member states. Similar to the restrictions imposed on a state by a gold standard, or gold-based currency, removal of money creating authority would limit the ability of a member state to independently create money to stimulate its economy. The current agreements and mechanics in place within the European Union will be reviewed as the basis for delving into the issue of where the authority to create money should lie.
2.7 Credit Leverage Ratios The ability of banks to leverage their deposits into larger loans is currently regulated at the state level in the United States. This is a means of creating money that might have to be regulated at the global level in a universal currency framework. High credit
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leverage ratios in the United States are being blamed for the current economic crisis (UNCTAD, 2009). A means of identifying ‘real’ money versus ‘leveraged,’ or virtual, money might also have to be devised.
2.8 Central Governance and Monitoring A review of the governing framework for the now 10-year-old European Monetary Union provides an ideal opportunity to identify the potential strengths, weaknesses, and key areas of concern involved in such an endeavor.
2.9 International Capital Movements It is believed that a universal currency would remove most of the barriers to the free flow of capital. A literature review with respect to the consequences of free capital movement will performed to discover the impact this has on trade growth and economic stability.
2.10 Currency Trading The practice of trading currency for profit distorts the value of a state’s money, due to the influences of speculative manipulation on the supply and demand of a country’s currency. This leads to the question: would removing this function help or hamper trade growth and global stability? This question, along with others, will be explored in this work.
2.11 Spread and Absorption of Financial Shocks Does the existence of multiple individual currencies help to attenuate or amplify financial shocks as they propagate from one country to another? Would having one universal currency ameliorate this issue, or would it expedite the spread of such financial shocks?
2.12 Special Drawing Rights The introduction of Special Drawing Rights (SDRs) from the International Monetary Fund, along with the European Monetary Union, could be the empirical front that would bring us closer to an understanding of the dynamics of a global currency. Although not as strong and liquid as the euro, SDRs are being considered as a potential global trading currency outside of the North American and European Union trading arenas (Fox, 2009). The experience to date and planning of SDRs will be researched, through literature review, to compare, contrast and supplement the research concerning the euro, as well as the previously asked questions.
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Section 3: Literature Review
3.1 Optimum Currency Area & Trade Volume
3.1.1 General Facts When two individuals meet face-to-face to perform a transaction, they can quickly agree on a value for the goods and carry out an exchange. In the example of someone wanting to trade eggs for a loaf of bread, the transaction involves two individuals who will meet and conduct the exchange. The goods can be physically inspected by both parties before changing hands. In this situation, there is no cost fluctuation or risk premium associated with the purchase and delivery of the goods, the nature of the goods, how the exchange occurs or the parties carrying out the trade.
In today’s world, with its fully integrated financial networks, this type of trade does not occur often. However, today’s exchanges include trade risks due to the elements of time and distance. The point in time at which goods are purchased will impact the purchase price based on the value of the good or commodity being traded and the relative value of the currencies used at that moment. The further the transaction is in terms of geographical distance, the greater the exposure is to different government regulations. These perfunctory interactions can vary drastically from what the originating party is accustomed to, thus potentially impacting the costs and risks associated with the transaction. As the distance between the source and destination increases, the goods being purchased and the vendor can also become suspect with regard to credibility and quality. Recourses for a defective lot purchased down the road, versus half-way around the globe, can be quite different in nature and costs. Additionally, the delivery means of purchased goods can also affect the purchase price directly or through the addition of increased shipping and insurance costs.
We can infer that trade costs and risks increase with distance. The increase is expected to follow a linear growth along distance, with spikes occurring when certain boundaries are encountered. These boundaries can include national, geographical, political, language and religious borders.
If one were to consider dollars to be electrons, we could postulate that trading circles, like any other type of energy flow will funnel through the path of least resistance to get to their destination. With this example, instead of the positive trying to cancel out the negative in the circuit, we have the buyer meeting the seller, or supply meeting demand. Different obstacles and resistances are in the way of these dollars, and at each encounter they lose a bit of their charge or value. The resulting path becomes a business trading network based on local demand and supply.
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Trade in the modern marketplace is as simple as using the Internet - where a myriad of websites will allow a consumer to compare prices around the world for the products being sought. All this is available in a few keystrokes and mouse clicks. Some online companies go as far as completing a purchase, including shipment, directly to one’s home through a single mouse click. This is the case with Amazon’s “One-Click purchase” patent. Such price transparency has been shown to increase competitive pressures and result in more trade, based on lower prices (Artis, 2006).
With today’s low energy and shipping costs, certain purchases from the other side of the globe have become less expensive. Distances have been conquered in such a way to make geography irrelevant for such transactions.
In the case of personal purchases, a transaction billed in a different currency is usually handled by a credit card company or converted automatically in the customer’s local currency by the seller’s online store. This means the customer does not have to be concerned about anything other than a) shipping costs, b) import or export duties, and c) laws concerning consumer protection and refunds. The transaction is immediate and the currency conversion done automatically.
The risk of exchange rate fluctuations between the customer’s currency and the vendor’s currency, while the purchase is en route, is removed since the transaction has already been settled. Should the customer’s currency double in value between the time the shipment was sent and the time it was received, the amount liable for duties and taxes could very well be doubled, as they are calculated based on the local value of the package.
Listed below are some of the main risks that international commercial buyers face on a daily basis:
a) Currency fluctuations between the time of purchase and time of payment for a contract;
b) Currency fluctuations on foreign accounts or reserves held by the buyer; c) Contract laws being different in the two countries; d) Delivery risks.
For this reason, purchases are likely to be done within a certain area. Buyers reduce their risk by doing business in their own country, in a common currency, and with laws that are familiar. Purchasing from an established international company with an office, or even their headquarters, in the buyer’s country can also be relatively risk free.
3.1.2. Optimum Currency Area Theory The discussion so far suggests that certain trading areas will generally develop inside political and geopolitical boundaries. This brings us to the Optimum Currency Area
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(OCA) theory (Mundell, 1961). An optimum currency area is defined as a geographical region in which, if the entire region shared a single currency, economic efficiency would be maximized.
Frankel (1998) summarizes the four main relationships involved in Optimum Currency Area models and calculations as amount of trade, business cycle similarity, labor mobility and risk-sharing systems. He indicates that a higher rating in any of these categories imply a higher suitability for a common currency.
We can also look at the world area to cover not just geographical space, but also other shared-contour attributes which could present, or remove, resistance to financial flow. Rose & Wincoop (2001) added the following attributes to the standard gravity model that is used to determine trade interactions: whether the countries were landlocked, used a common language, shared a common border as well as whether the countries were colonized by a common third country. Rose & Wincoop (2001) also make the assumption that nations who are geographically closer will trade more exclusively and that richer and larger nations will have higher trade amongst themselves as well. Through this we can infer that the usage of different currencies would inhibit trade between countries in the same region, depending on the ease of convertibility between the currencies involved. Following this vein of thought brings us to the issue of trade volume.
3.1.3. Trade Volume and Transaction Cost Rose & Wincoop (2001) indicate that “National money seems to be a significant trade barrier” and state the statistical impact of membership in a currency union on trade volume at an amazing 230% trade growth. They question, however, the ranking of lower transaction costs as the primary driver for this trade increase. The majority of the literature reviewed is in agreement with the fact that a monetary union will result in a lower transaction cost in concert with the loss of independent monetary policy (Frankel & Rose, 1998; Kollman, 2004; Starr, 2006). Another benefit quoted is the elimination of any risks due to exchange rate fluctuations (Kollman, 2004).
The majority of monetary unions and global currency proponents state the reduction of trade costs as a major benefit and reason for monetary unions (Barro & Tenreyro, 2007; Rose, 2004). The reasoning behind this thinking is that lowering trade costs and complexities will increase the amount of money available, thereby increasing overall trade. In turn, reductions in the perceived risks of delivery and price fluctuations will ease the minds of traders doing business with other states. Although not a monetary union, this was one of the major goals behind the formation of the Zollverein Customs Union in 1834 (Anderson, 1931; Henderson, 1934) - an alliance that removed the majority of custom tariffs between the various German states.
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What seems to be left out of this equation is the assertion that, although a monetary union results in lower transaction costs, it is questionable whether overall economic activity is stimulated by the lowering of these fees. The transaction costs in question were someone else’s profit that was spent or invested somewhere else in the world. The value provided by transactions fees is one area that could be studied further. Although transaction fees are clearly a trade inhibitor, their economic value does not disappear from the system. The profits from these transaction fees could possibly be deposited into longer term investments and therefore their contribution to the GDP, or the velocity of money, in the economic ecosystem is not as noticeable. The reduction of transaction fees however is clearly a positive factor in the growth of trade between countries, which has a positive overall contribution to the welfare of the states participating in trading activities.
It is also shown in the literature that the benefits will be lower for countries with banking systems that are more efficient and already incur lower transaction costs (EC, 1990). As an example, the benefit of joining the European Monetary Union was estimated to be between only 0.1% and 0.2% of GDP for the United Kingdom (EC, 1990). Though there may be a wide range of variance in the benefits of these two factors, lower trade volume and higher transaction cost share a common contributor: the border effect
3.1.4 Border Effect The border effect is defined as the difference in price of a good traded on one side of a border versus the price for the identical good on the other side of the border.
The border effect results in supply and demand rules being bent to accommodate different currencies, trade complexities and national identification. A theoretical example of the border effect would be to infer that the amount of trade between companies in the Canadian province of Ontario and companies in the Canadian province of British Columbia is higher than with companies in the American state of Washington. While British Columbia and Washington State are practically the same distance from Ontario, the fact that Washington State is across a national border could hamper trade with Ontario based companies.
Hence the adoption of a monetary union does not imply that goods and services will flow freely through national borders. A global currency will diminish the impact of this effect, but not totally remove it. Issing (2006) contends that in Europe “border effects have been reduced to 20% of pre-EMU levels”. Here again, we can assume that overall economic activity has remained more or less unchanged and that some level of domestic trade has been replaced by cross-border trade. The border effect reduction brought about by a monetary union will also have an impact on cross border capital flows as explained through the ‘impossible trinity’ problem.
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3.1.5 Impossible Trinity Mundell’s “impossible trinity” states that in choosing a currency arrangement a country can only realize two out of the three following objectives: a stable exchange rate, free capital mobility or a strong domestic monetary policy. In the setting of a potential global currency, the choice would be clear; a stable exchange rate and free capital mobility is selected over the ability to maintain a strong domestic monetary policy. On the other hand, the loss of leverage over monetary policies does not imply a total loss of response to regional economic issues. Fiscal policy is still available, and the government of a state can respond with spending programs targeted towards depressed economic areas. These local economic depressions would also be addressed by the system-wide balancing effect of proper labor flow to the unaffected areas. Problems and imbalances can, however, start to develop if markets are not allowed to operate freely where supply and demand are distorted.
3.1.6 Supply and Demand Occasionally obstacles appear, restricting the free and efficient workings of markets. Countries, organizations and companies can manipulate supply and demand for either financial or national strategic advantages. This can result in the short-circuiting of basic theoretical assumptions about economics. Restriction or manipulation of the flow of energy, basic commodities or labor can result in disequilibrium across any trading network. Although joining a currency union can remove a country’s ability to use monetary policy to affect its economy, policies on the domestic and trade fronts are still available for use. A country, or corporation, can severely limit or withhold the supply of key commodities with the aim of driving up prices and engendering higher profits. This would effectively drive up inflation in other countries that rely on imports of these commodities for regular operations.
Currently, there are several examples of this type of manipulation in the news media. The Organization of Petroleum Exporting Countries (OPEC) regularly sets production quotas for its member countries to keep the price of a barrel of crude oil within a certain price range. As an obvious proof of this fact, the Saudi oil minister stated that “At between $70 and $80, everyone is happy” (Webb & Luanda, 2009) in referring to the price of a barrel of oil. Fully-laden oil tankers are also asked to postpone unloading until such a time when prices are higher (BBC, 2009). In fact, at one point in 2009 more than 50 tankers were anchored around the British Isles waiting for the price of crude oil to rise (Derbyshire, Levy, and Massey, 2009). China has also been considering the limitation of the export of rare earth metals, which are essential elements in the burgeoning “green” technology industry and several high technology systems. The country currently holds 95 percent of the global supply of these minerals (Lewis, 2009).
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As of December 18th, 2009, the European Commission is involved in 37 World Trade Organization disputes (EC, 2010). These disputes range from banana imports, to poultry exports, to taxes on imported wines in India. These trade manipulations have a similar effect to currency manipulation, however in the EMU implementation everything is quoted in euros and there are no trade tariffs within the euro area. With all of this in mind, we now need to consider the potential effects of a global monetary union.
3.1.7 Possible Effects of a Universal Currency Starting with the question raised by Keynes on whether the world economy would be better off with a global currency, it is shown that in most parts it would. Unfortunately, due to politics and self interest, getting there will be a lengthy process. Starr (2006) shows that smaller economies will agglomerate towards the larger ones based on regional proximity and political affiliation. The smaller, emerging economies have much to gain in terms of trade growth with the affiliation to a larger currency system and trading block, such as the European Union.
The article concludes that the world is heading in the direction of fewer, but better, currencies and that this will have a positive impact on global trade and global integration by removing fluctuations in intermediary economic activities supporting global trade (Starr, 2006).
Helliwell and Schembri (2005) point out in the conclusion of their paper that “borders and separate national currencies represent significant barriers to trade” echoing the findings of Rose and Wincoop (2001). However, this observation may need better explanation in terms of more data and further analysis. In particular, this leaves many questions unanswered; such as how much a sense of nationality factors into a citizen’s decision to purchase locally versus internationally, how much a common currency would impact trade, and what are the underlying variables contributing to these barriers?
Another front on the vocalization of the need for a global currency comes from the current precarious situation of the US dollar, which is the de facto global reserve currency. The value of the US dollar has been declining over past years, the United States government has posted a budget deficit for 2009 of 1.4 trillion dollars (White House, 2010), and the US economy has yet to recover from the subprime mortgage crisis. Understandably, the budget deficit can be alarming to external investors as it jumped 308 percent from 2008’s level of $459 billion dollars, and is predicted to remain in the vicinity of 2009 levels for the next two years (White House, 2010). In expanding the reach of a currency through a global monetary union, we would be opening up the global financial system to the economic influences and shocks emanating from all member countries.
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3.2 Spread of Financial Shocks It is at this point that we need to consider the potential impact a monetary union, or global currency, would have on the velocity, reach and intensity of the spread of financial shocks.
The reach is defined as the distance a financial shock travels, from its originating point to other countries, financial systems or monetary unions. The velocity is the measurement of how quickly it gets there, and the intensity is the determination of whether there is any amplification or attenuation of the original financial shock.
The optimal result of this monetary union would be a reduction in all three of these financial shock attributes. That is, the overall effect of a global currency would be to restrain the area of impact, reduce the velocity of the spread and attenuate the force of a financial shock. Duration must also be considered as an attribute - best studied within the realm of macro-economics. The assumption taken is that equalization will happen after a certain period of time. The worst effect resulting from a global currency would be the accelerated spreading of an intensified financial shock.
A financial shock is defined as an unexpected event with a large effect on an economy or the markets, where events are seen as negative or positive. The latter, positive shocks are simply labeled as productivity gains, bubbles and general economic growth.
Does the fact that we currently have multiple currencies help to alleviate or amplify financial shocks as they propagate from one country to another? Would the use of only one global currency mitigate the immediate expansion of a financial shock, or would it expedite the propagation of such an occurrence? Are the numerous existing currencies ultimately a better system, where each currency system acts as mini shock absorber?
It was observed that financial shocks propagate extremely rapidly in our current world of highly-integrated financial systems (UNCTAD, 2009), indicating that in a well integrated financial market, and what would be proposed under a global currency, financial crises could quickly spread to the interconnected economies. The report also infers that there might be some attenuating properties of an integrated system with variable exchange rates. The capacity of the various national exchange rates to absorb a certain amount of pressure at every degree of expansion could explain this. The precarious element in this relation is that if a certain member of the integrated set is able to absorb a larger portion of the stress, it ultimately might cause its direct neighbours a great deal of calamity when this accumulation releases into the overall regional economy.
The countries which were quick to abandon the gold parity from their currencies and allow them to fluctuate were plagued with smaller recessions, but were quicker to recover than those countries that adhered to the gold standard (The Economist, 2009).
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Without the constraint of maintaining the gold-price parity they were able to lower interest rates and thus, stimulate spending locally. In reference to the case of the political inability of European Union member countries to manipulate interest rates independently of the European Central Bank, a global currency framework would present the same problem.
An important consideration in the formation of a monetary union is to have a structure wherein underlying economic drivers have the freedom to react to and absorb stresses that would typically be dissipated through changes in the relative value of individual currencies. Hence, the movement of labor and capital across the borders of states participating in a monetary union must be considered. The question of labor movement was thoroughly covered in the European Union, where citizens are allowed the freedom to work in any EU member country without the need for a work permit or visa (CEC, 2002). With no restrictions on labor movements, a workforce could relocate to where economic activity is stronger and employment is available. The inflationary and deflationary dynamics caused by this movement then ensure the leveling of economic activity across the different areas in question. Off-shoring and outsourcing to countries with lower labor costs is a similar concept, where instead of the labor moving to a location where employment is available, the work is relocated to where labor is available.
Let us consider a hypothetical scenario taking place in the European Union, where a company is looking at the construction of an industrial facility. The decision on the location of the new plant would take into consideration several key factors - factors such as construction costs, future labor costs, operating costs, output quality levels, availability of expertise, accessibility to raw materials, and shipping costs. The current levels of local labor costs would also have an impact on the decision, but if the facility is actually constructed it is expected that the influx of labor would come from areas of the European Union with lower economic activity levels.
Similarly, capital can flow through national jurisdictions to reach a destination where it is in demand. Capital flow occurs far more rapidly, and with less legal obstacles, than labor flow. At the press of a few keys billions of dollars can go half-way across the globe, to be deposited in a different country in a different currency. The large and sudden flow of capital has been associated as a major contributor to financial crises and their spread.
In this context, I will discuss some financial crisis episodes as they relate to global currency.
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3.2.1 Past Financial Crises Past financial crises include the subprime mortgage crisis (2008), the Russian debt crisis (1998), the Asian financial crisis (1997), and the Mexican peso crisis (1994).
Each of these four will be reviewed and analyzed within the context of a global currency.
Subprime Crisis The most recent of these is the subprime mortgage crisis which originated in the United States. It was triggered by rising mortgage defaults and foreclosures. The effect of these defaults trickled back up to securities that were backed by the subprime mortgages, thus quickly reducing the values of these securities. Since the majority of banks were holding mortgage-backed securities as part of their capital base, the reduction of their value created huge losses and also greatly reduced the amount of credit the banks were able to offer as loans (Gorton, 2009).
In the creation phase of the crisis, a somewhat recursive pattern occurred, as banks were able to sell the mortgages to investors. Through this process the banks replenished their funds, which gave them the ability to create more loans, generate fees, and repeat the process (Sherman and Tana, 2008).
In the years just prior to the crisis, the US banks moved more than 5 trillion dollars of assets and liabilities off the balance sheet into exotic financial instruments. This allowed them to ignore the financial regulation regarding minimum capital ratios (Reilly, 2009).
The result of this crisis, which is still being felt today, was that the credit markets froze up and that the financial services, real estate and home construction industries were dealt a very hard economic blow.
Russian Currency and Banking Crises The Russian financial crisis resulted from two causes: the country’s heavy reliance on oil exports and the drop in commodity prices triggered by the Asian financial crisis. The main reason for the Russian crisis was the unsustainable interest on public debt, and the inflated real exchange rate (Ellman and Scharrenborg, 1998). This of course could not have happened in a global currency setting, as there would be no opportunity to sustain an overinflated exchange rate. There would still be the possibility of an individual state offering higher interest rates than its counterparts to attract a higher amount of capital. In turn, this might still cause imbalances that would have to be addressed through some type of corrective measure. The implementation of a higher interest rate would increase the capital inflow and take this capital away from the other nations, potentially putting downward pressure on their economic growth. Inflation would also increase in the country with the higher interest rates, as the new capital got spent in the local economy. This measure could balance out the issue as rising prices
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reduce the profitability of projects undertaken with funds procured at higher interest rates.
Asian Financial Crisis The Asian financial crisis started in Thailand in July of 1997 and quickly spread to many other Asian countries. Although most Asian countries were affected in one way or another, the countries most affected were Thailand, Indonesia and South Korea, and to a lower degree Hong Kong, Malaysia, Laos and the Philippines. A Thai baht, which had been tied to the US dollar, helped the economy of Thailand grow at an average rate of more than 9% per year from 1985 to 1996. The baht came under speculative attack in 1997 and, after some effort by the government to maintain the link to the US dollar, the pressure to float the baht became too strong. The currency devalued quickly and the Thai stock market lost 75% of its value (Asian financial crisis, 2009). Surrounding countries were mostly affected by foreign investors pulling their money out of Asia and subsequently refusing to lend money to developing countries.
Mexican Economic Crisis In a similar economic situation, Mexico’s peso lost investor confidence when the government was unable to hold its peg against the US dollar. The peso floated in the currency market and crashed to an exchange rate of 7.2 pesos to the dollar from its original value of 4 pesos to the dollar within a week (Economic crisis in Mexico, 2009). The United States then intervened and bought pesos on the open market to help stabilize the Mexican economy; it also provided $50 billion in loan guarantees to further calm the financial markets. The assertion that a country’s foreign currency reserves play an important role in its ability to maintain a stable currency will now be reviewed.
3.2.2 Foreign Reserves Foreign reserves can be an important instrument in the fight against speculative attacks on a currency. Conversely, if a number of countries decide to start selling their reserves of the same currency, they can bring about the beginning of a financial crisis that could lead to the eventual devaluation of the currency in question.
China is currently known to have up to 70 percent of its $1.95 trillion currency reserves in US dollars (Brown, 2009). The quick movement of this money would have a dramatic impact on the value of the US dollar and on the welfare of millions, if not billions, of people. If this amount of reserve capital were in a global currency there would be no real possibility of movement and, therefore, a much reduced probability of economic fluctuation attributed to this surplus. The financial equation would then become more focused on the supply and newly-created demand for the goods that the savers are interested in purchasing.
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The Chinese government has recently been transferring large amounts of capital from its holdings of US debt into commodities like mines in Canada (Hoffman, 2010) and South Africa (Macharia, 2010). Oil developments in South America (Mouawad, 2010) and farm operations in Australia (Callick, 2008) have also become the targets of Chinese investments, as China seeks to diversify its reserve holdings with commodities that are more likely to retain their value than the declining US dollar. As shown in the above examples, currency attacks and speculative currency trading can put enormous stress on a country’s foreign reserves.
3.2.3 Currency Trading Currency trading distorts the true value of money due to the influences of supply and demand, based on speculation and manipulation. As a result of the implementation of universal currency, the trading of currencies would simply disappear. This would remove the possibility of localized devaluations as every country would be utilizing the global currency in play.
Although the global value of this new currency would remain constant, its purchasing power could still vary between different regions and countries. This is described in the work of Ashenfelter and Jurajda (2001) where the equivalent US dollar cost of a McDonald’s Big Mac in Belgium, France and Germany were $2.61, $2.62 and $2.36, respectively, in August of 2000. These three countries are all members of the original eleven countries which adopted the euro currency in 1999. Although the difference in Big Mac prices for Belgium and France is minimal, there is nearly a ten percent difference in price between France and Germany - two adjacent countries that share a common border of over 450 kilometers.
As discussed in previous sections, the variability of a currency can play a significantly large role in helping to trigger a financial crisis. Also discussed was the statement that a stable currency is beneficial to trade and welfare. A Tobin tax, which is a tax on currency trades, or similar tax on short-term speculative foreign exchange transactions, would potentially reduce the number of speculative trades on a currency as the profitability of such operations would diminish considerably. The implementation of a global currency would remove any such speculative trades or attack as there would be only one currency in play: one whose value is guaranteed by a lender of last resort (Calvo, 2009). Another determinant of where money moves to and from is the rate of interest paid on savings and loans.
3.2.4 Interest Rates Interest, being the fee paid for the borrowing of money over time, is an integral part of our financial and money creation system. In our global setting, where large amounts of capital can flow freely and quickly across national boundaries, high interest rates on low risk investments can be a magnet for this capital. This has been recognized and
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structured into the architecture of the European Monetary Union through a long-term interest rate criterion that must be met by any country hoping to join the European Union monetary union and adopt the euro as its currency. It requires that the nominal long-term interest rate of the interested country be lower than 2 percentage points above the average inflation rate of the three countries with the lowest current rates in the European Union (Euro convergence criteria, 2009).
High interest rates in a national economy are documented to decrease economic activity by promoting the saving of money. Low interest rates do not promote high levels of savings, but rather higher levels of borrowing. New money is injected into the economy through forms of business or personal loans and will be consumed, thereby stimulating the economy. Knowledge of the correlation between interest rates and economic activity transforms the setting of interest rates into a crucial tool of monetary policy. In the context of the euro, this tool has been centralized in the European Central Bank, which issues directives for the member state banks to follow. The European Central Bank’s primary objective is to keep inflation low in order to maintain price stability in regions where the euro is used as the base currency (European Central Bank, 2004).
Although a global currency setting would not dictate the disappearance of this tool, it would undoubtedly change some of its core dynamics and implications. In the European Union framework, the European Central Bank is in charge of setting an interest rate, which is then reflected by the banks in the member countries. In lieu of having unique interest rates in different locations across the globe, interest rates could be set individually for loans, depending on their applications, to stimulate different areas or industries. A similar method has recently been employed in Venezuela, where the Venezuelan government is attempting to stimulate exports by introducing two different official exchange rates for the Bolivar (Cancel, 2010).
As a monetary union removes the risk of shocks associated with uncovered interest rate parity (UIP) conditions (Kollman, 2004), the monetary union characteristics of a global currency would also inherit this benefit.
It is argued by some that there is no evidence for a general relationship between interest rates and exchange rates (Hnatkovska, Lahiri and Vegh, 2008; Calvo and Reinhart, 2002) and that most models don’t explain exchange rate movements (Frankel and Meese, 1987). However, as capital flows from one currency to another with the objective of accessing higher interest rates, there will be an impact on exchange rates as demand for the currency being purchased increases, while the demand for the currency being sold decreases.
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Platt’s (2007) second claim of similar interest rates across regions utilizing a common currency is also negated by the fact that interest rates across Canada are different, based on factors such as banking institution, region, credit terms, credit risk, type of loan required, and type of bank account. Interest rate variations will not be necessarily minimized through usage of a global currency. As an example, today’s 5-year fixed rate on a mortgage in Canada was set by the Canadian Imperial Bank of Commerce to a rate of 5.49%, while Toronto Dominion’s 5-year rate mortgage was set at 4.3%, and that of Westminster Savings Credit Union at 3.9%. Though interest rates might be the engine driving the global banking machine, their value can be greatly reduced by fluctuating inflation rates.
3.2.5 Inflation Rates Inflation is defined as the increase of the price of products and services over time. The short-term effects of inflation seem to be upward pressure on wages and prices. In the long term, the effect is from the increase in the money supply - where more dollars start chasing fewer goods, which brings about reduced purchasing power of the currency (Inflation, 2009).
Honohan and Lane (2003), and Lane (2006) state that the European Central Bank has had success in setting the medium-term inflation rate in the euro area at approximately 2 percent. This is in accordance with the 1992 Maastricht Treaty requiring countries joining the European Union to have an inflation rate no higher than 1.5 percentage points above the average of the three lowest European Union member countries. The authors also submit that countries with higher medium-term inflation will benefit from lower, real interest rates, as demand is stimulated in countries where credit and housing markets grow stronger than in other countries. This will result in increased prices and over time, the different economic areas will equalize.
Lane (2006) observed that “inflation differentials can be attributed to equilibrating forces.” This means that although the inflation rates have been varying across the member states of the EU this is a temporary phenomena while other factors adjust themselves for potential convergence. Optimistically, this will result in some level of economic equilibrium across the euro area, which is one of the major goals of the European Monetary Union.
Issing (2006) suggests that because the euro-area countries have a greater uniformity and lower levels of specialization, they are less exposed than the various areas of the United States to asymmetric shocks. This indicates a potential welfare problem as other research has shown that the adoption of a monetary union amongst a group of countries will generate an increase in localized specialization. This specialization hypothesis speculates that states will concentrate and will, in due time, specialize in areas where they have a competitive edge (Krugman and Veneables, 1995).
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An increase in the risk of financial shocks due to specialization becomes apparent, since it requires more time to retrain labor and convert to either commodity production, or another type of specialized production. For the individual, if the demand for the products and services in their area of specialization disappears they will be forced to retrain for a move into a different occupational sector and potentially a new location, or move into a more generalized and commoditized occupation.
As a theoretical example; if a small country specialized entirely in the production of a particular type of bananas, and it was discovered that the product had a negative health impact, demand would to drop to nil. The residents would have to either relocate or quickly familiarize themselves with a different product. If the industry is heavily capitalized towards banana production it could potentially take years to reinvent itself. Hence, a high degree of specialization is undesirable and somehow, the implementation of a global currency would have to take this into account for the protection of the welfare of the member states and their residents. A certain minimum threshold of localized basic food production or housing production capacity would ideally be enforced to provide a buffer for the potential economic shocks tied to specialization.
Lane (2006) states that in the euro area larger differences exist in services than in goods. He also reasons that services cannot be repackaged and resold as easily as tangible products, thus limiting their reach and tradability. The fact that you can’t realistically package a service and ship it across borders in the same manner as tangibles is a point that also needs to be considered in relation to labor movements. This has interesting implications for service-based economies. The United States is continually moving towards the direction of a service economy, and could potentially see a higher level of inflation as a result of this specialization.
Platt’s (2007) claim that if we were utilizing a universal currency, such as the United States’ dollar, the inflation rate and interest rate would be similar everywhere is difficult to imagine. Monthly inflation statistics published by the government of Canada show that provinces in this country, which are using the Canadian dollar, have inflation rates that vary considerably between the provinces. As an example, the inflation rates between January 2006 and January 2007 in Ontario and Prince Edward Island were 1.4% and 5.9% respectively (Inflation, 2010). This evidence, and the fact that inflation varies across countries, regions within a country, and by the type of goods and services purchased, bring doubt to the claim of stability and growth resulting from common levels of inflation and interest derived from the utilization of a global currency system. With this understanding we can now examine the overall spread of financial shocks.
3.2.6 Spreading of Shocks A global currency would definitively remove any risk of currency crisis. However, financial crisis could still occur through the overstimulation of the economy in different
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sectors or areas. The removal of differences in basic economic drivers such as inflation rates, interest rates and public debts across the euro area will dramatically hamper the creation and spread of financial crises as well.
Issing (2006) states that an advantage of flexible exchange rates is that they can absorb shocks as they try to cross national borders; and that the movements of nominal exchange rates due to temporary shocks can offset the shock`s effects. In a universal currency world, financial shocks and their propagation would be greatly reduced, mainly due to the fact that there would be no opportunity for a differential force to build between two different currencies. Like the European Monetary Union, any global currency agreement would have to include convergence criteria on basic economic drivers. One of the most basic of these is the actual creation of money. Our next point of focus in this discussion is where the authority to create money will lie once a global currency has been established.
3.3 Creation of Money & Impact on Sovereignty
3.3.1 Money Creation The authority to create money can be a thorny political issue. In a centralized system this authority would lie with a central board. By taking away the power from the member states, the creation of money is then left to an independent third party with no affiliations to any country, e.g. IMF, WTO, and UN. This removes the ability for countries to 'print' money as a means of correcting an economic problem without addressing the problem’s underlying causes. This could be compared with the gold standard, where currencies tied to gold required physical gold reserves. The fact that the amount of gold is limited and cannot be created, and is used as currency and backing of currency, disallows countries from printing money to inflate their way out of a problem.
One of the basic tenets of current monetary policy practice is to lubricate an economy by increasing the money supply as GDP increases. Quantitative easing is a similar, but different, practice in monetary policy that is employed to create money and stimulate the economy to increase the GDP.
This concept was reflected in the Latin Monetary Union of 1848, where each member state was only allowed to mint 6 franc coins per capita (Einaudi, 2000). Although this was a voluntary restriction, its existence was rooted in an assumption that all things being equal, GDP would increase linearly proportional to population count. This is logical in that each individual has a certain capacity for work and production, and has a certain basic quantity of needs for nourishment and shelter. These factors, combined with any other averaged consumption of the times, would give a reasonable estimate of the basic strata of economic activity in a simple economy. Ensuring that there is
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enough money in circulation to accommodate the population’s basic needs, plus a certain level of discretionary spending, is certainly a sound economic plan, effectively preventing high levels of inflation and deflation.
One of the main considerations in establishing a global currency would be the determination of the rules and rights of printing money. The manner in which new money is created and introduced into the financial system would have to be agreed upon by all founding parties and be based on rules and mechanisms that have been orchestrated to maintain financial stability across member states. A centrally-based and mutually agreed-to mechanism for the creation of new money would also prevent any member states from using monetary policy to create more money and inflate their way out of an economic problem to the detriment of the other states and their general economic stability. This restriction is also one of the primary reasons for the independence of central banks from the main governmental body of a country. This arrangement provides a safeguard against potential currency manipulation by the government. Another form of money creation is performed by the banks through the use of the money multiplier.
3.3.2 Money Multiplier and Reserve Requirement Banks are required to have a reserve of capital in order to create loans on this capital. The Basel accord sets the amount of leverage a bank can have at 15:1 (Basel Accords, 2009). One of the issues relating to the subprime crisis of 2008 was this credit leverage ratio. Some banks’ ratios were reported to be as low as 1 to 40 (Coffee, 2008).
In a fractional banking environment the money multiplier is an important factor which literally allows bank to create money, in the form of new loans, based on the amount of capital they have in deposits. The ability of banks to leverage their deposits into larger loans is currently regulated at the state level in the United States. This is a means of creating money that would likely be regulated at the global level in a universal currency framework. High credit leverage ratios in the United States are being blamed for the current economic crisis (UNCTAD, 2009). A means of identifying ‘real’ money versus ‘leveraged’, or ‘virtual’, money may also have to be devised. The tracking and regulation of real and leveraged money is a task that would require coordination by the member countries of a global monetary union. This global monetary governance would require the proper framework and authority to function properly,
3.3.3 Global Monetary Governance The central bank of a monetary union will, in all likelihood, not be deeply concerned about local problems, but rather be focused on the aggregate of local problems. This begets the question of how one is to react at the local level and to wonder what tools would be available. This brings about the impetus for increased movement of capital and labor.
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Issing (2006) states that the enforcement of the rules relating to the Stability and Growth Pact for the euro area is problematic. Excessive deficits of some European Union member countries are pushing those countries outside of the prescribed ranges. The ability to dismiss a country from the European Union or to force it to restrict its spending, does not seem realistic. This is of course, a problem as individual states are encouraged to take on more risk because it can be absorbed by the overall group, hence reducing their risk exposure. If there is a negative impact as a result of an imprudent action, the augmented risk is absorbed and cushioned by the whole. Under a global currency countries would be unable to expand their money supply directly through monetary policy but could increase it by securing loans. The European Union example of a centralized European currency fosters a different type of exposure to national loan defaults, since the national currency itself would be impacted. Unbalanced budgets and lack of debt servicing gives rise to currency devaluation. For the European Union this impact would spread to the rest of the member states with the depth of the impact increasing along with the size of the defaulting country. Although the euro currency would be impacted proportionally to the economic size of the defaulting country, the main result would be that the country in question would itself face higher interest rates and find it more difficult to borrow funds from external capital sources. In the case of a global currency higher interest loans would be the only resulting impact, and obviously, no currency depreciation would occur, because in theory there would be nothing else to depreciate against.
A sound case for a global central bank (Garten, 2009), without the direct implementation of a global currency, can be the logical first step in bringing countries into alignment with global currency flows and fostering stability in the world’s economies. The point made is that a global central bank would oversee the more than two dozen existing financial institutions large enough to cause problems on the global economic stage. The recommendations include devising a number of national regulatory approaches, the oversight of large global financial institutions, and setting standard debt-to-equity ratios for lending institutions. Such a global central bank could engage in pre-emptive simulations and models to proactively probe weak global economic points or linkages. The article acknowledges that one of the main obstacles with a global central bank is that each country wants to give their institutions competitive advantages over the others.
This could be where, as a global entity, we start moving away from competition and into cooperation in regards to our international economic infrastructure. At that point, questions of ambition, alignment and trust are brought forward, and a paradox arises: Would a global currency help advance these, or are they first necessary for the establishment of a unique international monetary system?
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Other authors advocate that we do not need to convince everyone at the onset. Smaller groups, such as the European Union, can gain economic momentum and, at certain point, acquire a critical mass that entices neighboring nations to join in for the obvious benefits of being involved in the trade group.
A global central bank would keep the economy running smoothly once everyone agrees on the rules for the creation of money. There is a conviction that the state cannot be trusted to maintain a stable currency due to political pressures (Bordo and James, 2006). The term ‘tying hands’ applies to and indicates the beneficial characteristic of central banks to adhere to economic principles rather than capitulate to political pressure in the process of money creation. New rules will have to be developed for localized responses and application of monetary policy.
In his observations, John Law saw that the problems of Scotland arose from a shortage of money which caused an underutilization of resources (Murphy, 1991). Hence the question becomes one concerning the means of properly applying local capital injections with the goal of stimulating local portions of the economy. This will be a major concern within the construct of a global currency system. A centralized monetary policy will greatly erode state sovereignty, requiring concessions from some member states, as many rules and regulations will have to be harmonized.
3.3.4 Impact on Sovereignty One of the costs of converting to a common currency would be the loss of the stabilizing benefit of applying monetary policy locally to smooth out financial shocks (Artis, 2006). This will obviously erode the popularity of local politicians as they will be seen to have no control over the economic situation of their constituents. A current example of this situation is taking place in the euro zone with the financial crisis facing the Greek government. Greek citizens are witnessing external politics dictate the parameters within which their government can enact fiscal policy.
Most certainly, this will be viewed by most as a negative impact, since local politicians will no longer have the wherewithal to effectively and quickly respond to local economic issues. The residents of these regions or localities will neither see, nor understand the benefits to the greater good of a more stable economic system when they are experiencing local problems. In his paper ‘The Case for the Amero’ Grubel (1999), reviews the notion that Canada and the United States could implement a fixed exchange rate to circumvent the political issues around a common currency. He however rejects the idea, based on the fact that future governments could simply abandon the fixed rate as needed.
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A current, but limited, implementation of a universal currency that floats on the average of the relative currency values of its member countries is the International Monetary Fund’s introduction of Special Drawing Rights.
3.3.5 Global Currency Implementations The introduction of Special Drawing Rights (SDRs) from the International Monetary Fund, along with the euro, could be the empirical front which upon which we gain a better understanding of the dynamics of a global currency implementation. Although not as strong and liquid as the euro, SDRs are being considered as a potential global trading currency outside of the North America and the European Union (Fox, 2009).
Special Drawing Rights (SDRs) are portrayed as a potential replacement to the US dollar as a reserve currency, and potentially a global currency. Fox (2009) identifies situations where the usage of SDRs would have been beneficial during past experiences. He suggests that the current financial crisis could have been triggered by the US dollar’s special status on the world stage, augmenting the United States’ ability to accumulate a federal deficit close to 2 trillion dollars without any counter balancing action (Fox, 2009).
Although these policies would most certainly create an imbalance, a direct cause and effect relationship between the current global financial crisis and the United States’ federal debt is not apparent. In contrast, the fact that a greater sum of money was generated internally within the US through the leveraging of deposits to loans at a ratio of 1 to 35 points (Fox, 2009), calls attention to a greater danger. It is evident that the United States needs even more money to be created than what we see revealed as official debt and current account figures. This scenario, if explored through modeling, could expose that money is being created “out of thin air”, through the steep leveraging of bank deposits. This “phantom” capital is then transferred across borders in exchange for hard goods. The accumulation of such transfers would create a financial bubble which must burst at some point. This conviction leads me to believe that the federal deficit of the United States has an impact on the health of global finances, but more as a secondary driver than a primary influence. Its main impact is directly from the US economy which, when it slows down, affects the global economy. The solution to the deficit that has been created lies in fiscal belt tightening measures aimed at reducing the escalating gap between income and expenses.
In 2009 the G-20 agreed to allow the International Monetary Fund (IMF) create an additional $250 billion in Special Drawing Rights (SDRs) (Allocation of SDRs, 2009). This was a major step forward from the total of $31.9 billion in SDRs initially created by the IMF in 1981. At the same time, China is supporting the usage of SDRs as a global currency. The tracking of SDRs as they flow through different countries will give rise to a study of the potential dynamics of a global currency.
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3.3.6 Summary Monetary policy is an indispensible tool that can be used by states to stabilize their economy. By removing this instrument and placing it in the hands of a centralized body might cause tremendous political friction between the governments and citizens of the affected member states.
Conversely, the removal of the control over national monetary policy will deflect political blame away from local politicians who will, in turn, be able to better focus on strategic issues in place instead of dealing with the short term, economy-related financial and political issues.
Although this should not be the norm, any global currency could get sidestepped by a commodity possessing a certain level of liquidity, like gold, oil or food, for either large or local transactions. If a commodity is in sufficient demand, a market for the commodity should develop, with trades taking place using the global currency, assuming there is no currency shortage.
The short term stability gained from the removal of monetary power from the member states would be a benefit to the overall stability of the group, as no one member state would be able to ‘inflate its way’ out of a problem and consequently cause inflation across the entire union. Barring any financial manipulation, the market should behave properly and adjust prices based on supply and demand. Should there be no demand for a product of a certain type, or from a certain locality, the population would have to change their production focus or change their location. This circumstance would be no different in the presence of a global currency, than what it is with a local currency. Ultimately, the global financial system is an infrastructure that is meant to facilitate and empower our daily activities. Let us explore some of the benefits which a universal currency could bring us.
3.4 Welfare Benefits A currency system, much like any other tool, machine, process or structure is created to fulfill a purpose. One of the main purposes of currency is liquidity, where its value can be quickly and widely used for transactions. In defining a potential world currency with worldwide acceptance and ease of use, we must first consider whether this in itself would bear direct benefits. Deeper insight into this question can be gained from a review of personal activities that could be impacted by a global monetary union.
3.4.1 Direct Benefit to Individuals In reviewing my routine personal purchasing activities over the past few months, I would be hard pressed to find an example of a situation in which a common currency would have impacted me directly in any beneficial way. My purchases of food, gasoline,
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clothing, books and other items are all based in dollars and I would receive no direct benefit if the items were priced in euros, or if the Canadian dollar was accepted in China. Insurance, rent, mortgage payments and utilities are all debited automatically from my bank account and here, as well, would have no direct benefit from a common currency. In a purchase of a product from Greece through the online trading site EBay the quoted price was automatically converted into dollars – a transaction as easy as if it would have been carried out with a global currency. The only issues of concern were the customs tariffs and shipping costs, on which a global currency would not have had any impact. This simple example infers that a global currency would have little direct benefit to the average citizen’s daily transactions across the world. My belief is that financial and political integration would bring about many more direct beneficial changes to an individual’s daily life than a global monetary alliance. After finding a lack of substantial direct benefits we now examine the potential indirect benefits of a global currency.
3.4.2 Indirect Benefits In extending this thinking to the material that has been covered thus far in this paper, and looking at the indirect consequences a global currency would produce, the question that arises is whether we can point to any tangible benefits beyond the lowering of cross border transaction costs and the minimization of currency fluctuation risks.
Platt (2007) puts forward an estimate of potential yearly savings of $400 billion in foreign exchange transaction costs. Platt fails to consider however, the fact that this $400 billion was also someone’s profit and actually stimulated the overall economy as well. Hence the net gain from saving the costs of currency exchange transactions could very well be close to zero.
Mundell's (1961) 'impossible trinity' gives us a choice of two out of the following three possible benefits: stable exchange rate, free capital mobility, and strong domestic monetary policy. Joining a global monetary union and foregoing a strong domestic monetary policy causes a country to strive for a stable exchange rate and free capital mobility. A stable exchange rate, as well as the influx of capital into a region or economy, can be viewed as beneficial. However, there are instances in which a country might prefer to retain capital for the economic stimulation of a region.
An additional, potential benefit of economic stability is the reduction of financial shocks caused by the reduced potential for differentials in inflation and exchange rates to build up to a size which could cause shocks. For this to happen, the creation of money must be restrained and controlled by a central source to prevent local governments and politicians from inflating their way out of an economic problem. This can be a disadvantage though, when localized creation of money would be exactly the right remedy for a temporary economic downturn. Currently, the mayor of Lansing, Michigan,
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who is also running for the post of Governor of the State of Michigan, is proposing the creation of a state-owned bank to offer loans at low interest rates to local businesses and students (Hoffman, 2010). Mayor Bernero states that Michigan’s economy is being suppressed by the fact that hundreds of job-creating projects by Michigan-based enterprises are being denied financing by the banks. This sentiment is also echoed by lawmakers from the states of Maryland, Massachusetts, Minnesota, and New Mexico, who want to transfer more money to smaller financial institutions in their states, thereby giving them the ability to issue more loans to businesses and individuals (Simon, 2010). Would this be akin to pouring fuel on the fire, as the main purpose of a central bank being autonomous from the government is to restrict government officials from printing money to get out of difficult situations? Many American states that have been considering state-owned banks point to the 90-year-old Bank of North Dakota as a success story. The bank holds $3.9 billion in assets and has provided $351 million in profits to the North Dakota treasury since 1997 (Simon, 2010). North Dakota has an impressive record for staving off the current economic crisis and recession; in 2008 its economy had the largest percentage growth of all US states, and it kept unemployment down to 4.2% (Rappeport and Bullock, 2009).
Kollman (2004) states that “It has long been recognized that a potential key benefit of a Monetary Union is the elimination of exchange risk, while a “cost” of MU is the loss of monetary policy autonomy.” Both of these results can have a positive or negative impact on trade and state welfare. While the removal of exchange risk is an advantage that will grow in consequence and impact over the long term, the loss of localized monetary autonomy can hamper the state’s short-term reaction to localized crises.
Greece is now facing a similar problem, in which its central bank is unable increase the money supply due to restrictions and conditions imposed by the central European bank, and it is also facing difficult borrowing conditions from the bond markets and foreign countries (Granitsas, 2010). Given these examples, we can now look at trade volume and its welfare impacts in the context of a universal currency.
3.4.3 Trade Volume – Welfare Benefit A main argument used for the implementation of a global currency is the relationship between trade volume and welfare benefits Rose and Wincoop (2001). This point has its weaknesses. Kollmann (2004) states that the impact of a monetary union on state welfare is greater in high-trade areas where the reduction of shocks minimizes the number of trade flow disruptions and hence facilitates a larger amount of trade. This is in comparison to low-trade areas where, even when there are fluctuations in trade flows, the overall effect is much smaller.
Based on sustainability arguments, it can be argued that there isn’t a linear relationship between trade volume and welfare. A finite set of natural resources will act as an
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environmental damper on economic growth and reduce the increase in growth to near zero, and potentially even negative, to reach a sustainable state. This is in contrast to studies which have pointed out that there is such a relationship. Another area to review in regards to welfare benefits is the equalization effect of opening borders to capital and labor flows.
3.4.4 Capital Flows and Salary Levels Friedman (2005) states that the flow of capital between two countries, such as in the case of an American company moving a factory to India, results in the narrowing of global inequalities. This is done by increasing the number and wages of Indian workers, while decreasing the number and lowering the wages of American workers. The concept of economic equalization, which has been alarming to the North American worker, works on a weighted average basis. As a gross mathematical example, if we take the population of the United States versus the population of India, we compare a population of 304 million against one of 1,147 million. This comparison gives us an approximate ratio of 1:4, or 25 percent. In theory, the flow of capital towards an economic model of equilibrium would require that the average salary of an American worker drop by four dollars per hour to increase the average salary of an Indian worker by one dollar per hour.
The United States Department of Labor’s 2008 Occupational Employment Statistics published an average wage of $42,270 per year, or $20.32 per hour, for American workers. We can also assume a $10,000 per year, or $5 per hour, average for Indian workers. Using this available information, a rough calculation determines that the hypothetical equilibrium point is a salary of $16,000 a year, or $8 per hour.
In such an equilibrium equation, due to the larger population of India, the American workers’ salary must drop by 64% to afford a 60% salary increase for the Indian workers. The issue here is not that the American worker’s salary would have to drop by about half to increase the Indian worker’s salary, but rather what that decrease signifies to the American worker. The quality of life of the American worker would have to be greatly reduced to yield equilibrium. This would be of grave concern to the American population, with the result being pressure for politicians to enact protectionist measures.
This brings up a number of key questions: would the use of a global currency accelerate the flow of capital investments between countries? Would these transfers be beneficial to G20 nations? Would they be solely beneficial to the recipient countries? Most importantly, would a unique currency be a benefit to the aggregate global economy?
Although we have not seen a reduction in the income of this magnitude for American workers due to globalization, we cannot dismiss the likelihood of arriving at the same
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point over a longer period of time through the lack of growth in real income. Simulation models capturing these parameters would be worthwhile to explore.
Friedman (2005) points out that the amelioration of the poverty level is an effect of international trade. This introduces two points that need to be researched. The first is whether a universal currency would help increase international trade, and the second is whether the factors behind such betterment are still valid in current times and in the current context of globalization. He points out that this betterment of the poverty level allows families to keep their children in school longer; and encourages the reduction of child labor in affected regions. This would be a widespread net benefit, locally and globally.
3.4.5 Summary The two main positive associations of a global currency to a better welfare are first, higher levels of trade, which bring about better welfare through income on the side of the seller, and affordability on the side of the buyer. Secondly, the reduction of risk and the spreading of financial shocks give rise to greater stability in trade, income and purchasing power.
Despite the apparent evidence, monetary policy, or monetary integration, does not seem to be the main agent in bringing about any great level of welfare betterment on these fronts. Rather, fiscal and political integration, which is brought upon participating states, seems to be the real foundation upon which these benefits are supported. This supposition is becoming evident in the issues faced by EU member countries, such as with the Greek debt crisis. As such, we can envision monetary unions as only a step in the right direction toward better overall global welfare.
Section 4: Results The topics covered in the literature involved in this research project ranged from basic microeconomic concepts to macroeconomic data as well as the philosophical and political concepts of a sovereign state. These different concepts need to be positioned and associated in order to begin answering the global questions about a global monetary union. The literature review executed in the research framework has yielded some interesting facts on a few areas of consideration for the topic. Also included is a numerical analysis of per capita GDP growth data for the original European Monetary Union members to see if the benefits of the union would be directly reflected in higher economic growth.
4.1 Real Per Capita GDP Growth Analysis for Euro Countries The euro was introduced in 1995, and officially adopted as an accounting currency across member countries on January 1st, 1999. The real per capita GDP growth data in
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these tables show an analysis of two 5-year periods: the first spanning the years from 1995 to 1999 and the second from 2001 to 2005.
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The results indicate an average real per capita GDP growth rate for European Union countries of 3.30% for the years 1995 to 1999, versus 1.53% for the years 2001 to 2005. This is a drop of over 50% in real per capita GDP growth rate for the period after the introduction of the European Monetary Union. The results can be contrasted to 2.76% and 1.90% for the same periods for average real per capita GDP growth rates for the four non European Union countries used as a comparison. This translates into a drop of 31.2% for the non-EU countries in contrast to the 53.6% drop for European Union countries.
This is a sub-par performance, which could be explained by the initial costs related to the introduction of the euro. However, this data clearly does not demonstrate any per capita GDP growth advantages related to the European Monetary Union. A similar analysis can now be performed on productivity.
4.2 Real Per Person Employed GDP Growth Analysis for Euro Countries The real per person employed GDP growth data in these tables show an analysis of two 5-year periods: the first spanning the years from 1995 to 1999 and the second from 2001 to 2005.
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As can be seen from these two tables, the first set of data, which represents real per person employed GDP growth from 1995 to 1999, gives us an average yearly growth of 1.53% for EU member countries, versus 2.08% for the non-EU countries. The 5 years following 2000, represented by the 2001 to 2005 data, shows an average per capita GDP growth of 0.84% for the EU members, versus 1.58% for the non-EU countries. This infers that the real per person employed GDP growth in the European Union countries dropped by 45.1% after the introduction of the euro, while the non-European Union countries represented in this chart dropped by only 24%. As in the case of the drop in real GDP per capita growth for the same period for EU countries, this is close to twice the drop of the other countries compared. This could also be explained by the initial costs involved in introducing the euro. Next, I turn to the findings related to my specific research questions.
4.3 Research Questions Interest, Exchange, Inflation Rates and the Spread and Absorption of Financial Shocks
Interest rates have been shown to be important for the impact they have on saving, borrowing and inflation. It is important to have similar interest rates for the different member countries of a monetary union to ensure an economic balance. Although interest rates can be lowered to stimulate the economy, and brought higher to encourage savings, this is usually coordinated at the national level.
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While preventing the flow of capital from one euro region to another, the requirement to keep interest rates for European Union member countries within a certain band could be relaxed, with the effect of stimulating or slowing down the economy in different euro regions.
Exchange rates have had a buffering effect on the spreading of economic shocks across national boundaries. The worldwide integration of our financial systems has facilitated the spread of financial shocks across countries (UNCTAD, 2009). With various stock exchanges being interconnected throughout the world and the exchange of currencies almost instantaneous through the markets, a common global currency would, on one side, facilitate such spread of shocks but conversely, would also negate the shock concept, as all currencies would be the same and would have no capacity to endure or dissipate stress.
The initial requirement for similarity in inflation rates for countries wanting to join the European Union was set to prevent any disturbing economic force from impacting the other countries in a negative way. Once part of the European Union, inflationary dynamics allow economies to balance out fundamental economic drivers such as labor, commodities, capital and interest rates.
National Surpluses and Deficits
This seems to be one of the most destabilizing factors facing an integrated economic system. Keynes also considered this as a potentially major problem (UNCTAD, 2009) and wanted to impose fees or fines on countries having a surplus or deficit. In the end, imbalances on this front will rectify themselves, but the economic and social costs can be enormous and long-lasting.
We are currently witnessing such an adjustment in the case of Greece as part of the European Union. The end result will most likely be a higher cost of borrowing, and government budget cuts reducing the benefits and services to Greek citizens. As Greece can no longer simply print money to help itself out of this situation, its appetite for budget deficits will be curbed dramatically, since it will no longer be able to afford the rates on new loans. In the European Union the concern with Greece is that the higher risk and rates could start spreading to other countries within the Union and subsequently, drive up the cost of borrowing for everyone.
A similar situation is developing in the United States with its nearly 1.5 trillion dollar budget deficit. The major difference between the Greek and American situations is that the US dollar is already considered the world’s reserve currency. The impact this increased borrowing and lack of savings will have on the global economy is not well understood. The Chinese government has already stated that it doesn’t have the capacity to absorb the new debt even if it wanted to, as the US recession is also hitting
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Chinese exports. In fact, China has expressed serious concerns about the safety of its dollar-linked assets and has been asking for re-assurances that the United States will not print its way out of the recession (Evans-Pritchard, 2009). This would severely impact the real value of Chinese holdings of assets linked to the US dollar.
Transaction Costs
Although the topic of transaction costs seem to be one of the major reasons for the adoption of a common currency, estimates of the GDP gain on this range from minimal to astronomical. The United Kingdom decided against the euro as a common currency partly due to the benefits potentially being only 0.1% of GDP (EC, 1990). Transaction costs that disappear from transactions also disappear from the economy until these savings are used against a new purchase. This argument has not been found to be of any great impact.
Money Creation Authority
The inability to create money, and inflate its way out of an economic problem, will be a major readjustment for any country joining a monetary union. This is currently being demonstrated through the Greek debt crisis. This is an erosion of what was considered a sovereign right by countries, and now in the European Union there is movement towards a European economic government, or a governance group, which will have some level of oversight over the finances of member countries. This shows that monetary and fiscal policies are intertwined and need to be closely monitored.
Credit Leverage Ratios
This is an area where economic fundamentals can be further distorted. Potentially bypassing the creation of ‘real money’, the creation of credit could act against policy to restrict monetary intervention. As shown, the creation and accounting of credit was a major contributor to the subprime mortgage crisis in the United States. Credit creation and credit leverage ratios are as important as money creation; however, the creation of credit doesn’t seem to have the same level of governance and regulation.
International Capital Movements
In maintaining an average economic landscape across its member countries, the European Union is hoping to minimize any disruptive flow of capital from one member country to another. If return and risk is equivalent across member states, capital should then flow from one region to another based on different criteria.
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Special Drawing Rights
The concept of Special Drawing Rights (SDRs) is one in which the spread of risk across many different countries and economies could potentially lead to a currency with a more stable value. This is in contrast to the US dollar being used as the global reserve currency, when the United States is currently going through a recession and the value of the US dollar is suffering. Klaffenbock (2008), in his research paper on reforming the global financial architecture, states that we should abandon the notion that any single nation’s currency be used as the global reserve currency, based on the current situation with the US dollar. The SDRs are currently limited in scope and size, and can only be traded by governments. The amount of SDRs has recently been increased and there is talk of allowing companies to start using SDRs in international transactions.
Section 5: Analysis The issue of a global currency remains a complex one. An analysis of GDP growth data for European Union member countries did not show an important positive growth difference between the years before and after the adoption of the euro as an accounting currency in member states. In the short term this detracts from the benefit of stronger economic growth brought on by a potential global currency. This is somewhat confirmed by the ease of currency conversion in today’s digital age and the study showing very minimal potential benefits from the United Kingdom’s usage of the euro as a common currency (EC, 1990).
Impacts on border effects of a common currency would lead to more inter-national trade. However any considerable external trade gains are realized, they are likely to come at the expense of internal trade, hence nullifying any overall economic growth.
If not growth, then perhaps stability could make the case for a global currency. The requirement of member countries to converge on key economic drivers does the majority of the work towards this stability requirement. In a global setting, however, could we really discriminate between those who have gained access to a global currency and those who have not? In this case, countries with the highest GDP levels would have to agree to convergence as a cornerstone of any global currency plans. Smaller economies, whose economic fundamentals may not yet be in line with the rest of the union, could then join without having a large impact on the group. In joining, some of these countries would have to absorb significant financial shocks and change, as is the case with Greece today. It is improbable that a global currency would be utilized by all countries of the planet, as the economies of developing countries have very different needs and dynamics than those of the G8 member countries.
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In a truly global currency environment capital would be held in one bank and would be allocated to both corporations and countries alike. This would bring higher economic stability by removing potential oscillations in capital flow but would also bring about centralized control of capital allocation. A global economy must find the right balance between centralization and decentralization. A universal currency would remove some level of decentralized management as the functions associated with the nationality of a currency would disappear. This process is currently in development with the European Union’s economic governance project. This will bring about a sovereignty and identity crisis for European Union member countries. The countries of the world are much more diverse than the countries represented in the European Union. A global currency, and its framework, would be dramatically stressed if a worldwide implementation was undertaken at this point in time.
Section 6: Recommendations The creation and usage of a global currency would bring about a multitude of issues to solve in the short term, but would, in the long term, result in a more stable global economic landscape. For this to happen, the various political and social agendas around the world would have to start converging. Otherwise, a global currency would not survive and alternate means of trade would be developed at the national or local levels.
For this reason, individual countries should keep working towards currency alignment and financial integration at the continental level where the Optimum Currency Area criteria (Mundell 1961) such as proximity, language and culture, have a stronger correlation. The European Union has already formed a currency union for Europe. Other groups and agreements such as the North American Free Trade Agreement (NAFTA), the Organization of Petroleum Exporting Countries (OPEC) and the African Union could be the stepping stones leading toward new currency unions.
For these reasons, this paper recommends that countries work towards continental monetary unions, as opposed to a global currency union.
Section 7: Conclusion This research paper reviewed the literature related to monetary unions and global financial networks. The main areas covered in relation to a universal monetary union were: the concept of an optimum currency area and trade volume, the spread of financial shocks, the creation of money and its impact on sovereignty, and welfare implications. A numerical analysis of the differences in the growth of the per capita Gross Domestic Product (GDP) and of the productivity of key European Union member countries before and after the introduction of the euro was also conducted.
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It was found that within a universal monetary union, currency shocks would be eliminated. They would, however, be replaced by financial shocks in which capital would move from one region to another based on economic or speculative pressure. Local currencies would no longer exist to buffer the local economies from this movement. National surpluses and deficits would still remain a potential problem in a global currency world, but the increasing influence of other countries on a nation’s economic affairs will most likely have a dampening effect on the damages caused by these. The savings associated with lower international transaction costs has been found to not be a strong argument for a universal currency as they are minimal, and do not contribute to additional economic activity. The loss of monetary policy associated with participation in a global monetary union will also lead to the erosion of fiscal policy, as other countries will now have a louder voice in the affairs of the state.
This will also bring about some loss in sovereignty. Credit leverage ratios and the creation of credit-based money have been found to be as important as the creation of physical currency and should be regulated just as closely; otherwise, it could lead to further erosion of sovereignty and financial crises. The harmonization of the economic landscape across the European Union is beneficial in that it should prevent uneven capital flows. This would be the same in a global currency setting should similar rules be applied. The most advanced, and mature, instrument available today which could be utilized as a potential universal currency is the concept of Special Drawing Rights (SDRs), as utilized by the International Monetary Fund (IMF). They currently act as a global currency for member states of the International Monetary Fund and have the benefit of being valued based on the average of multiple currencies and to be independent of any foreign state.
In conclusion, a currency is simply an instrument of commerce, and not a replacement for sound economic and budgetary policy. The main benefit of a global currency would be the balance and stabilization of fiscal policy which would be effectuated through slow, but sure, financial, political and regional integration. With the considerable differences amongst countries of the world, continental monetary unions have a higher probability of success due to the higher level of similarities of countries on the same continents.
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