The End of National Currency

Benn Steil

From Foreign Affairs, May/June 2007

Summary:  Global financial instability has sparked a surge in "monetary nationalism" -- the idea that countries must make and control their own currencies. But globalization and monetary nationalism are a dangerous combination, a cause of financial crises and geopolitical tension. The world needs to abandon unwanted currencies, replacing them with dollars, euros, and multinational currencies as yet unborn.

Benn Steil is Director of International Economics at the Council on Foreign Relations and a co-author of Financial Statecraft.

The political mythology associating the creation and control of money with national sovereignty finds its economic counterpart in the metamorphosis of the famous theory of "optimum currency areas" (OCA). Fathered in 1961 by Robert Mundell, a Nobel Prize-winning economist who has long been a prolific advocate of shrinking the number of national currencies, it became over the subsequent decades a quasi-scientific foundation for monetary nationalism.

Mundell, like most macroeconomists of the early 1960s, had a now largely discredited postwar Keynesian mindset that put great faith in the ability of policymakers to fine-tune national demand in the face of what economists call "shocks" to supply and demand. His seminal article, "A Theory of Optimum Currency Areas," asks the question, "What is the appropriate domain of the currency area?" "It might seem at first that the question is purely academic," he observes, "since it hardly appears within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement."

Mundell goes on to argue for flexible exchange rates between regions of the world, each with its own multinational currency, rather than between nations. The economics profession, however, latched on to Mundell's analysis of the merits of flexible exchange rates in dealing with economic shocks affecting different "regions or countries" differently; they saw it as a rationale for treating existing nations as natural currency areas. Monetary nationalism thereby acquired a rational scientific mooring. And from then on, much of the mainstream economics profession came to see deviations from "one nation, one currency" as misguided, at least in the absence of prior political integration.

The link between money and nationhood having been established by economists (much in the way that Aristotle and Jesus were reconciled by medieval scholastics), governments adopted OCA theory as the primary intellectual defense of monetary nationalism. Brazilian central bankers have even defended the country's monetary independence by publicly appealing to OCA theory -- against Mundell himself, who spoke out on the economic damage that sky-high interest rates (the result of maintaining unstable national monies that no one wants to hold) impose on Latin American countries. Indeed, much of Latin America has already experienced "spontaneous dollarization": despite restrictions in many countries, U.S. dollars represent over 50 percent of bank deposits. (In Uruguay, the figure is 90 percent, reflecting the appeal of Uruguay's lack of currency restrictions and its famed bank secrecy.) This increasingly global phenomenon of people rejecting national monies as a store of wealth has no place in OCA theory.

NO TURNING BACK

Just a few decades ago, vital foreign investment in developing countries was driven by two main motivations: to extract raw materials for export and to gain access to local markets heavily protected against competition from imports. Attracting the first kind of investment was simple for countries endowed with the right natural resources. (Companies readily went into war zones to extract oil, for example.) Governments pulled in the second kind of investment by erecting tariff and other barriers to competition so as to compensate foreigners for an otherwise unappealing business climate. Foreign investors brought money and know-how in return for monopolies in the domestic market.

This cozy scenario was undermined by the advent of globalization. Trade liberalization has opened up most developing countries to imports (in return for export access to developed countries), and huge declines in the costs of communication and transport have revolutionized the economics of global production and distribution. Accordingly, the reasons for foreign companies to invest in developing countries have changed. The desire to extract commodities remains, but companies generally no longer need to invest for the sake of gaining access to domestic markets. It is generally not necessary today to produce in a country in order to sell in it (except in large economies such as Brazil and China).

At the same time, globalization has produced a compelling new reason to invest in developing countries: to take advantage of lower production costs by integrating local facilities into global chains of production and distribution. Now that markets are global rather than local, countries compete with others for investment, and the factors defining an attractive investment climate have changed dramatically. Countries can no longer attract investors by protecting them against competition; now, since protection increases the prices of goods that foreign investors need as production inputs, it actually reduces global competitiveness.

In a globalizing economy, monetary stability and access to sophisticated financial services are essential components of an attractive local investment climate. And in this regard, developing countries are especially poorly positioned.