National, International, or City-wide Currencies?

Anyone who has traveled in Europe before and after the introduction of the euro can appreciate how easy tourism is made by the common currency (haggling with the guys in money change booths was never my idea of vacation). But a recent paper by Benn Steil in Foreign Affairs goes even further, arguing that the adoption of regional or multi-state currencies is better for economic development than the cornucopia of national currencies used in the world today.

Time was, Steil recalls, it was said that three things were necessary in order to be a "real country": an airline, a stock exchange, and a national currency. The Euro-zone has over the past several years seen airline mergers, stock exchange mergers, and above all the currency merger, all without losing country-cred on the international stage. Given that national currencies often pose more problems for developing countries than they solve, Steil recommends that countries unilaterally adopt either the dollar or the euro as their national currency, or in some cases that neighbors join in forming multi-country currencies of their own.

For Steil, the genesis of the cycles of currency crisis we see today was the separation of money from a universally acknowledged store of value, gold. When Nixon formally signed the US off the gold standard, monies around the world ceased to be based on anything more than the country's promise of their worth. With nothing tying down the currency, governments were free to issue money at will, and globalization as we know it is carried out in various denominations of fiat monies. Herein lies the problem, according to Steil:

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.

Traditionally, governments in the developing world exercised strict control over interest rates, loan maturities, and even the beneficiaries of credit -- all of which required severing financial and monetary links with the rest of the world and tightly controlling international capital flows. As a result, such flows occurred mainly to settle trade imbalances or fund direct investments, and local financial systems remained weak and underdeveloped. But growth today depends more and more on investment decisions funded and funneled through the global financial system. (Borrowing in low-cost yen to finance investments in Europe while hedging against the yen's rise on a U.S. futures exchange is no longer exotic.) Thus, unrestricted and efficient access to this global system -- rather than the ability of governments to manipulate parochial monetary policies -- has become essential for future economic development.

But because foreigners are often unwilling to hold the currencies of developing countries, those countries' local financial systems end up being largely isolated from the global system. Their interest rates tend to be much higher than those in the international markets and their lending operations extremely short -- not longer than a few months in most cases. As a result, many developing countries are dependent on U.S. dollars for long-term credit. This is what makes capital flows, however necessary, dangerous: in a developing country, both locals and foreigners will sell off the local currency en masse at the earliest whiff of devaluation, since devaluation makes it more difficult for the country to pay its foreign debts -- hence the dangerous instability of today's international financial system...

Why has the problem of serial currency crises become so severe in recent decades? It is only since 1971, when President Richard Nixon formally untethered the dollar from gold, that monies flowing around the globe have ceased to be claims on anything real. All the world's currencies are now pure manifestations of sovereignty conjured by governments. And the vast majority of such monies are unwanted: people are unwilling to hold them as wealth, something that will buy in the future at least what it did in the past. Governments can force their citizens to hold national money by requiring its use in transactions with the state, but foreigners, who are not thus compelled, will choose not to do so. And in a world in which people will only willingly hold dollars (and a handful of other currencies) in lieu of gold money, the mythology tying money to sovereignty is a costly and sometimes dangerous one. Monetary nationalism is simply incompatible with globalization. It has always been, even if this has only become apparent since the 1970s, when all the world's governments rendered their currencies intrinsically worthless.

The solution? Steil advocates adoption of only a few global currencies (the dollar, the euro, other pan-regional currencies such as a future pan-Asian currency) which are managed with the goal of targeting low, stable inflation. He takes the example of Ecuador, a country plagued with both political and economic problems until dollarization occured in 2000. The political problems remain, but economically the country is quite stable, which makes it nearly impossible for any politician campaigning on a platform of de-dollarization to get elected. This policy would make capital flows easier, and remove the problematic cycles of devaluation and currency crisis.

Adopting a foreign currency as the national currency removes monetary policy from the governmental toolkit. Since it's often bad governmental policy that causes currency crises rather than anything intrisically wrong with national currencies, this might be a good thing. As Steil says:

Of course, dollarizing countries must give up independent monetary policy as a tool of government macroeconomic management. But since the Holy Grail of monetary policy is to get interest rates down to the lowest level consistent with low and stable inflation, an argument against dollarization on this ground is, for most of the world, frivolous. How many Latin American countries can cut interest rates below those in the United States? The average inflation-adjusted lending rate in Latin America is about 20 percent. One must therefore ask what possible boon to the national economy developing-country central banks can hope to achieve from the ability to guide nominal local rates up and down on a discretionary basis. It is like choosing a Hyundai with manual transmission over a Lexus with automatic: the former gives the driver more control but at the cost of inferior performance under any condition.

Of course, all of this is contingent on the US getting its own finances under control. WIth the budget and current account as abysmal as they are, it's not a given that international faith in the dollar as a store of value will remain unshaken. Steps will need to be taken in the direction of long-term fiscal discipline in order to preserve the dollar's position as global currency-of-account.

I am not a monetary economist, but I'm intrigued by this question. What do you think? Are we headed toward a world monied by only a few stable, widely-accepted currencies? Or possibly even a single, global currency? Does all this even matter given the speed with which we're converging to an "electronic economy"?

Funnily enough, NPR covered this paper with an interview with Steil himself, and followed it up with a story on local community currencies, which seem to be popping up in various places in the US. Communities are offering local monies that exchange one-to-one with the dollar and are only redeemable at locally-owned businesses. The goal is to promote local businesses and help them compete with big box retailers that come in. So far, I don't think there has been much success, which I can understand. I lived for a while in Switzerland (on the Swiss franc) but bought groceries in France (euro), and carrying around two currencies at once is a royal pain in the ass. If the dollar's good enough for Ecuador, it's good enough for me.

Thanks to Jake for the heads-up on this piece.