Currency union (monetary union)
A currency union, also known as a monetary union, is a financial arrangement where two or more entities, typically countries, adopt a single currency as legal tender across all member jurisdictions. This can also include fixed exchange rate systems, where a country ties its currency's value to that of another, often referred to as "pegging." A prominent example of a currency union is the Eurozone, where 19 of the 28 European Union member states utilize the euro, managed by the European Central Bank.
Historically, the concept of currency unions emerged in 19th-century Europe, with early examples such as the Latin Monetary Union and the Scandinavian Monetary Union aimed at standardizing currencies to facilitate trade. While currency unions can reduce transaction costs, enhance price comparisons, and support economic stability, they also pose challenges. Member countries may relinquish control over their individual economic policies, leading to difficulties in addressing localized economic downturns, as seen during Greece's debt crisis.
Currently, there are other active currency unions, such as the CFA franc in West Africa and the East Caribbean dollar, with proposals for future unions in regions including South America and East Africa. The dynamics of currency unions can lead to both positive and negative economic effects, influenced by the varying health of member economies.
On this Page
Currency union (monetary union)
In finance, a currency union is a situation in which two or more entities, usually countries, adopt a single, common currency that serves as legal tender in all involved jurisdictions. Alternately, a currency union can also occur when an entity adopts a fixed exchange rate, tying the value of its currency to the currency of an external country. This practice is informally referred to as "pegging" the exchange rate. For example, in 2001, Bahrain pegged its currency, the dinar, to the US dollar at a rate of 0.376 dinars to one dollar. This exchange rate remains fixed, even if the US dollar rises or falls in value relative to other currencies traded on the global foreign exchange market.
The European Union (EU) provides the best-known example of a common currency union. In twenty of twenty-seven EU member states, the euro serves as the common currency. Together, these countries are known as the Eurozone. They are financially united by the European Central Bank, which also sets key interest rates used by all member countries.
Background
The modern history of currency unions can be traced back to nineteenth-century Europe, when early forms of the concept were introduced in Germany, France, and Scandinavia. Prior to 1871, Germany was a loose confederation of states, each of which used monetary units with differing relative values. In an effort to make it easier for states to conduct trade with one another, the German Confederation adopted a system that created standardized values for the various coin denominations used throughout the region. In 1865, France led the creation of the Latin Monetary Union (1865 -1926), which initially consisted of France, Belgium, Switzerland, and Italy. Under the terms of the union's treaty, standardized gold and silver coins were minted and used as legal tender in all participating regions. The Latin Monetary Union eventually grew to include numerous French colonies and other European nations but was abandoned in the 1920s in the aftermath of World War I (1914–1918). In 1873, Denmark and Sweden joined the Scandinavian Monetary Union (1873 to 1921), creating a common currency system that used gold coins. These early financial unions were mostly successful and set an early precedent for the later development of the EU system during the twentieth century.
In 1958, several of Europe's leading steel and coal industries formed an economic union that later became the European Economic Community (EEC; later renamed the European Community [EC], which disbanded in 2009). Although further European financial unification was delayed by the economic difficulties of the 1970s, the topic was revisited in the 1980s, resulting in the Maastricht Treaty of 1992. This treaty formed the European Economic and Monetary Union (EMU), and the European Central Bank (ECB) followed in 1998. The common euro currency was then introduced in EU member countries, becoming a virtual unit used for the settlement of bank transactions in 1999. Euro banknotes and coins became legal tender in the Eurozone on January 1, 2002.
The gold standard also merits mention in this context. Although it was not, strictly speaking, a currency union, the gold standard did create a system of fixed exchange rates that pegged the value of various international currencies to gold. This brought much-needed stability to international trade but fell out of favor during the twentieth century. The United Kingdom abandoned the gold standard in 1931, and the United States did the same in 1971.
Overview
Currency unions come with advantages as well as drawbacks, and the EU's adoption of the euro has largely served as the standard model for evaluating their impacts. Currency unions make it easier for international shoppers to compare prices in participating countries and regions, and they reduce banking costs by eliminating the need to exchange the various currencies of member entities during transactions. On a macro level, currency unions also make it easier for businesses to predict costs, which, in turn, encourages them to make more investments. This can lead to sustained economic growth. Monetary unions also help control inflation, or sharp rises in the prices of goods and services. Some economists also believe that currency unions support higher levels of trade between participating countries and contribute to job creation.
However, these benefits are checked by numerous disadvantages. In the EU, participating countries lose much of their ability to create and enforce their own economic policies. Instead, the system must operate by consensus and, in practice, that consensus is typically driven by the agendas of larger nations with more financial might.
Currency unions also make it difficult for countries that are hit particularly hard by economic downturns to create internal economic controls that might help them regain financial stability. For example, Greece and several other European countries suffered a debt crisis beginning in 2009, forcing the other EU member states to deliver a bailout package that prevented their financial collapse. This had negative effects in Greece and in other countries in the EU, raising questions about the Eurozone's long-term viability.
Such events can also have the reverse effect, such as when a sector of a particular region's economy experiences growth that is not shared throughout all parts of the monetary union. For example, Hong Kong was once an overseas territory of the United Kingdom, which had been leased to the UK by China and was set to return to Chinese control in 1997. However, before China regained control of Hong Kong, a large number of the city's residents immigrated to the UK. This, in turn, created a sharp increase in demand for British housing, particularly in London. Real estate values in London and other parts of the UK began to rise at rates that far outpaced other parts of the EU. These events, whether they have a negative or positive regional impact, are known as asymmetric shocks, and they can have unpredictable economic effects.
Several other currency unions operate around the world, with monetary units that include the CFA (Communauté financière d'Afrique, meaning "African Financial Community") franc and the East Caribbean dollar. The CFA franc is a legal tender that is pegged to the Euro and backed by the French Treasury. The currency is divided into the Central African CFA franc (XAF), the West African CFA franc (XOF), and the Comorian franc (KMF), which are used interchangeably in fourteen West and Central African countries. While the CFA franc remained the commonly used name for the currency, it was announced in 2019 that France would reduce its role in the region's currency in the coming years, and the newly established currency would adopt the name Eco. The East Caribbean dollar is used in eight polities in the Caribbean region under the Eastern Caribbean Currency Union (ECCU). All Eastern Caribbean nations use this currency except the British Virgin Islands, which uses the US dollar.
Additional currency unions have been proposed. For example, in 1999, economics scholar and professor Herbert Grubel proposed an EU-style monetary union between the United States, Canada, and Mexico, which would use the currency "Amero." However, this plan never gained popularity.
Bibliography
Bergin, Paul. "Monetary Union." Library of Economics and Liberty: The Concise Encyclopedia of Economics, www.econlib.org/library/Enc/MonetaryUnion.html. Accessed 9 Jan. 2025.
Bolton, Sally. "A History of Currency Unions." The Guardian, 10 Dec. 2001, www.theguardian.com/world/2001/dec/10/euro.eu. Accessed 9 Jan. 2025.
Chen, James. "Currency Union: Overview, History, Criticisms." Investopedia, 30 Sept. 2022, www.investopedia.com/terms/c/currency-union.asp. Accessed 9 Jan. 2025.
"The Euro." European Union, european-union.europa.eu/institutions-law-budget/euro‗en. Accessed 9 Jan. 2025.
Grubel, Herbert. "The Case for Amero." Fraser Institute, 1999, www.fraserinstitute.org/sites/default/files/CasefortheAmero.pdf. Accessed 9 Jan. 2025.
Helleiner, Eric. Towards North American Monetary Union? The Politics and History of Canada's Exchange Rate Regime. McGill-Queen's Press, 2014.
Heshmati, Almas. Economic Integration, Currency Union, and Sustainable and Inclusive Growth in East Africa. Springer Publishing, 2016.
Lanzavecchia, Alberto, et al. "How Euro Shrinks Democracy: Insights from the Greek Crisis." Journal of Governance and Regulation, vol. 4, no. 4, 2015, pp. 135–46.
"Monetary Cooperation between Africa and France: The Cfa Franc." Ministry for Europe and Foreign Affairs, 24 Mar. 2023, ambafrance.org/Monetary-cooperation-between-Africa-and-France-the-CFA-franc. Accessed 9 Jan. 2025.
Rochon, Louis-Philipe. The Encyclopedia of Central Banking. Edward Elgar Publishing, 2015, pp. 160–65.
Wallace, Helen, et al. Policy-Making in the European Union. 8th ed., Oxford UP, 2020.