A Europe-Wide Currency Makes No Economic Sense

PAUL R. KRUGMAN <i> is professor of economics at Massachusetts Institute of Technology. </i>

The idea of European unity--the transmutation of the European Community from a free trade area to a full-fledged economic union and eventually to a federal political system--has become virtually unstoppable, even in Britain.

Prime Minister Margaret Thatcher wanted to stop the process with trade; she has been an ardent opponent of British entry into the so-called exchange rate mechanism of the European Monetary System, which stabilizes exchange rates within Europe. But she has effectively lost that struggle; Britain is now expected to join the exchange rate mechanism in the very near future.

And this is a more pregnant move than a decision to join five years ago would have been, because the European Monetary System has clearly become a way station on the route to a common European currency. And as the Germans have just reminded us, a currency union is not much different from a political union.


What is ironic is that Thatcher, who gained a reputation for leadership by putting her economy through incredible punishment in the 1980s, now looks weak, foolish and silly for clinging to a position that makes considerable economic sense. On purely economic grounds, the case against a common European currency is actually quite strong.

Why should one ever want to have separate national currencies? Because sometimes it is very helpful to be able to change the value of one currency relative to another.

Suppose, for example, there is a sharp drop in worldwide demand for goods made in Britain. To cope with such a shock, Britain must both make its goods cheaper and attract new industries to replace the shrunken old ones. The only quick way to do this is to reduce British wages, to make its labor more competitive.

But how can all British wages be reduced quickly? In the face of sustained high unemployment, workers might be persuaded to accept lower wages, and the whole wage structure could gradually be squeezed down to a competitive level. But the economic and social cost of reducing wages by, say, 15% would be huge. In contrast, a 15% devaluation of the pound on foreign exchange markets would accomplish the same thing instantly and almost painlessly.

Conversely, imagine a surge in demand for British products. This would bid up the prices of British goods and services, possibly building an inflationary momentum that would later prove hard to stop--unless Britain accommodated the surge by allowing the pound, instead of the price level, to rise.

The point is that it can be very convenient to change the value of your currency rather than experience painful inflation and deflation. Once Britain has accepted a common European currency, as it may well do this century, that option will be gone.


Of course the argument is not that one-sided. If it were, then not only should every country have its own currency, so should each region within a country. Why not a Southern California dollar, or even a San Diego dollar? There must be some kind of trade-off. And there is. Having your own currency brings costs as well as benefits.

Most importantly, it is more difficult to do business when the contracting partners keep their books and pay their workers in different currencies. So keeping your own currency acts as a barrier to potentially beneficial international trade and investment.

The economic theory of the “optimum currency area” says this trade-off gets less and less favorable as the size of the economic unit shrinks. An independent currency for San Diego would not make sense. On one side, residents of San Diego do so much business with other Americans that the costs of keeping track of a separate currency would be huge.

On the other side, changing the value of a local San Diego currency would probably be ineffective as a way of cutting or raising wages because workers in such a tiny currency area would almost surely want to index their wages to some outside standard. So it only makes sense to have an independent currency for an economic unit large enough to do most of its business with itself, and to have some prospect of an independent wage- and price-setting process.

But how large is this optimum unit? Nobody knows--and it is not at all crazy to imagine that Europe might be better off economically with four or five regional currencies than with only one.

For example, it is all too likely that in the next several years Germany will be a boom economy, as it gets most of the business from the reconstruction of Eastern Europe. To fight inflation, the German central bank will keep interest rates high; these high interest rates will depress other European economies, notably Britain’s. There will be a clear economic case for devaluation of Britain’s currency against the German mark. Yet this will be difficult under the European monetary system and impossible once a common currency has been established.


Against this one might use the example of the United States--260 million people living with only one currency. We’re doing fine, aren’t we? Not necessarily. During the first half of the 1980s, when the United States was fighting inflation with high unemployment, the harshest burden of that unemployment was concentrated in the Midwestern industrial heartland. Had there been a separate Midwestern currency, it is arguable that inflation might have been controlled at significantly lower cost. Right now, as the economy of the Northeast fights a serious slump, one wonders whether we wouldn’t all be better off if Mario Cuomo could devalue a regional currency.

But of course the idea of separate currencies within the United States is unthinkable, for the same reason that a common European currency is now inevitable. Whatever the strict economies of currency union, a common currency is a potent political instrument: a symbol of unity.

And this symbol may be most important when it makes the least economic sense. In terms of economic geography, Canada makes no sense as a currency area: each province’s natural business linkages are with the U.S. regions to its south, not with fellow Canadians. Yet Canada needs an independent, unified currency to exist as a nation. (In the long run, it may cease to exist anyway; but, as John Maynard Keynes said, in the long run we are all dead.)

As the 20th Century nears its end, the idea of European unity has finally become real, and to symbolize that idea, Europe must have a unified currency. The common currency may not do much economic good; it may even do some harm, but that is beside the point.