The EuroAmerican Single Currency Free Trade Area
Back in 1998 before the Euro replaced twelve currencies and could soon replace another dozen, I made a proposal that the Euro and the Dollar should be linked at par with one another to create a “Eurodollar”, providing a single currency for both Europe and the United States. This response to this bold proposal has been less than overwhelming, even though the logic of the proposal remains as valid in 2003 as it did in 1998.
Now that five years have passed since this suggestion, it is time to move to the next level—not only should Europe and the United States link their currencies together, but they should also eliminate all trade barriers between the United States and the European Economic Community. The result would be a Single Currency Free Trade Area (SCFTA) that would be shared between the United States and Europe.
We believe that history and economics all point toward the benefit of moving toward a EuroAmerican SCFTA; however, there has been virtually no discussion of this, nor has there been any effort to achieve this goal. Unfortunately, in the past four years since the Euro was introduced, international economic integration has not been at the top of anyone’s agenda. Economists learned long ago that politics and not economic logic determine the timing of monumental economic changes, and no politician has seen any benefit from pursuing this goal.
Of course, this is nothing new. As Austin and Vidal-Naquet noted concerning ancient Greece, “In the history of Greek cities coinage was always first and foremost a civic emblem. To strike coins with the badge of the city was to proclaim one’s political independence.” (Austin and Vidal-Naquet, Economic and Social History of Ancient Greece, London: 1977, p. 57)
Of course, Adam Smith argued in favor of free trade back in 1776, and economists have been arguing in favor of free trade ever since. Yet, despite the fact that millions of people in every country on the planet have taken economics courses and discovered the benefits of free trade in their classroom, not a single country on the planet has eliminated all of its trade barriers. Certainly, there are multilateral agreements such as the World Trade Organization that fight for free trade, while NAFTA and the European Community promote free trade within their own economic areas, but NAFTA and the EEC maintain trade barriers with the rest of the world.
Today, there is not a single country on the planet that allows trade barriers to be set up within its own boundaries, or allows several currencies to compete within its borders. It should naturally follow that if an SCFTA makes sense within each nation, why shouldn’t it make sense in the entire world? The German Zollverein in the 1800s was created to eliminate internal barriers to trade and the Mark was created to eliminate different currencies within Germany, just as the European Economic Community has eliminated trade barriers and competing currencies within Europe. Why not move on to the rest of the world.
Do the 25 countries that will soon make up the EEC make a natural SCFTA? By the end of this decade, the European Economic Community will encompass 25 countries which will share free trade and a common currency in almost every member country. Could you imagine a more diverse set of economies ranging from Latvia to Greece to Germany to Portugal to Slovenia to France to Maltato Finland and another dozen countries in between. Similarly, are the Chinese and Indian economies integrated well enough to create a SCFTA within those countries. Why should the Soviet Union have one currency, but the CIS have 15 currencies?
The answer to these questions is simple. Politics determines economics, and not vice versa. Although, as we hope to show here, there are strong economic arguments for creating an SCFTA between the United States and Europe, until politicians find it in their economic interest to promote such an agreement, it is unlikely to happen.
If over two centuries after Adam Smith wrote The Wealth of Nations, every nation in the world still maintains barriers to trade, it isnot because The Wealth of Nations has been banned as indecent literature, but because every interest group that would be adversely affected by free trade has fought tooth and nail to maintain protection in their own industry while supporting free trade in other industries. Farmers provide the best example of this truth. About 40% of the European budget is devoted to its Common Agricultural Policy that benefits less than 5% of the population.
This article will review the idea of introducing a EuroAmerican SCFTA. We first provide a brief economic single currencies and free trade areas, showing that whenever it has been politically and economically feasible, nations have moved toward not only a single currency, but free trade as well. Yet free trade still does not exist and currencies multiplied like rabbits during the 21st Century. This is because economics remains subservient to politics. So the real question is how can economics convince politics of the benefits of a EuroAmerican SCFTA?
And to continue the economic argument to its logical conclusion, if a EuroAmerican SCFTA is economically beneficial, why not have a global SCFTA?Unfortunately, convincing the non-economic world of the logic of a EuroAmerican or even global SCFTA, may be even more difficult than convincing the world that the earth revolves around the sun and not vice versa. We hope that time will prove us wrong.
The Economics of Single Currency Free Trade Areas
Every introductory Economics class discusses the benefits of free trade, but almost none of them extend the logic of that argument to analyzing the benefits of an SCFTA. For this reason, we will briefly review the arguments in favor of free trade, then move on to look in more detail at the benefits of an SCFTA.
Adam Smith’s The Wealth of Nations is an argument against government intervention in the economy, both in international and internal economic affairs. The Wealth of Nations was written, in part, to attack Mercantilist ideas against free trade. David Ricardo followed in Smith’s footsteps, using the ideas of comparative advantage to provide a more rigorous underpinning to the benefits of free trade. In his case, David Ricardo argued in favor of repealing the Corn Laws that had been introduced during the Napoleonic Wars.
The basic argument in favor of free trade is simple. Society as a whole is better off with free trade than without. Barriers to trade reduce economic efficiency and lower the level of output that an economy is capable of producing, and thus lowers the level of per capital income within each country. Free trade also increases the variety of products that consumers have to choose from, introduces new ideas, promotes competition, and enhances productivity.
But as always, there are tradeoffs. Consumers benefit by gaining access to goods that would not be produced in their own country, and from goods that are cheaper to import than to produce domestically. On the other hand, if foreign consumers are willing to pay more for a domestically produced good, the cost of that good will rise when trade is introduced. Similarly, producers benefit from free trade by being able to export goods at higher prices to foreign consumers, but they may also be hurt by competition from cheap imports.
Moreover, the historical evidence is clear. Countries that promote free trade with other countries have higher rates of growth, and ultimately a higher standard of living, than countries that pursue protectionist policies that limit trade. The General Agreement on Tariffs and Trade (GATT), which later became the World Trade Organization (WTO), was founded to prevent the protectionist policies of the 1930s that had helped to keep the world in a Global Depression.
The political problem is that some producers and their employees are hurt by free trade. They seek protection from competition through government subsidies, tariffs, quotas and non-tariff barriers that cost taxpayers and consumers billions of dollars every year. However, because the benefits of the protection are concentrated among a small percent of the population, such as farmers, while the costs are spread out among the entire population, the interest group that benefits from the protectionism is able to successfully lobby politicians to insulate them from free trade.
Inflation or Disinflation? Who Cares. It’s Exchange Rates Stupid.
Though every freshman learns about the benefits of free trade, there is almost no discussion about the benefits of a single currency area. When Robert Mundell won the Nobel Prize in Economics for his work on optimum currency areas, he stated that he believed the world was an optimum currency area, implying that there should be one global currency. Despite this, one wonders how relevant the theory of optimum currency areas is to today’s world.
Since 1960 when Mundell introduced his theory, he lived in a world where capital controls were more common than they are today, tariffs were higher, labor was less mobile, and trade was more constrained. Since then, restrictions on the movement of capital, goods and labor have all been freed at different rates. Capital controls have been virtually eliminated. Capital is free to flow from one country to another and as a result, over $1 trillion is traded in currencies every day. The World Trade Organization has substantially reduced tariffs and other trade barriers affecting manufactured goods allowing world trade to grow dramatically. Still, there are substantially greater barriers to trade than there are barriers to capital. Finally, labor remains fairly restricted in its ability to move from country to another. Consequently, corporations bring factories to labor in other countries rather than moving labor to their factories.
The result of this is that financial flows, and not trade flows, drive exchange rates between countries today. Trade is at the mercy of monetary policy. This can be seen in the behavior of the exchange rate between the United States and Europe since the Euro was introduced. In 1999, the United States’ stronger economy and higher interest rates led to a gradual appreciation of the US Dollar from $1.18 when the Euro was introduced to $0.85 at the low point in 2001. As US interest rates fell and the American economy and stock market weakened, the US Dollar fell, returning to the $1.18 level it had been at on January 1, 1999. Within less than 5 years, the US Dollar had appreciated against the Euro by 30%, then depreciated by an equal amount.
First, these are large swings in relative exchange rates within short periods of time. Businesses in the United States and Europe could benefit or suffer from the currency swings, but exchange rates are not offsetting differences in the supply and demand for goods in Europe and the United States, but to differences in the demand and supply for financial assets between the two regions.
What is surprising is that the greatest debate in monetary circles is about inflation and deflation when the great problem is with fluctuating exchange rates. During the past 10 years, inflation in the Untied States has fluctuated between 1.5% and 3.3%, between -2.9% and 1.8% in Japan, and between 0.8% and 3.8% in Europe. Inflation has not been a problem in any of the world’s major economies for a decade. Even within Japan where deflation is seen as being a problem, the deflation is probably more of a symptom of the problem than a cause.
At the same time, swings in exchange rates have been quite large between the United States in Europe. For example, in 1999, both short-term and long-term interest rates in the United States were higher than rates in Europe. At the same time, the US stock market was in the final phases of its bubble with the NASDAQ Composite rising by 85% in 1999. In 2001, the Fed lowered US short-term interest rates substantially, and a weakening stock market and falling long-term yields reduced the demand for US financial assets.
It is the fluctuations in the returns on financial assets that have generated the 30% swings in the values of the US Dollar and Euro, not relative growth rates between the two regions. Although the theory of Optimum Currency Areas says that the purpose of exchange rates is to allow adjustments between different currency areas, in practice this is not possible because it is the relative demand for financial assets that drives exchange rates, not the demand for imports and exports.
Does the Fed Control Interest Rates or do Interest Rates Control the Fed?
A second fallacy of current though on monetary policy is the importance of the independence of the Central Bank. At the beginning of the twentieth century, very few countries had Central Banks. Today, Central Banks are seen as being part and parcel of political independence.
However, how much influence Central Banks really have over the economy is debatable. Financial innovations have eliminated Central Banks’ ability to influence the money supply. Reserve requirements have been made virtually irrelevant by the multiplication in the sources for funds that banks have access to.
The level of trading in foreign exchange markets prevents central banks from influencing exchange rtes. Any attempts by Central Banks to control exchange rates inevitably only lose taxpayers money and make currency traders richer. Government bond markets are too large for central banks to control. The Federal Reserve and ECB make no pretense to being able to control yields on long-term government bonds. And central banks have never made any pretense of being able to control stock markets. They may complain about their irrational exuberance, but other than complain, there is nothing they can do.
The only thing left that the Federal Reserve and ECB make any pretense of influencing is short-term interest rates. The Fed’s control over short-term rates in the United States can be seen in 2001 when the Fed lowered the Fed Funds rate from 6.5% at the beginning of 2001 to 1.75% by the end of 2001. But one wonders how much of a difference there would have been between interest rates if there were no Fed and the actual course of interest rates that existed.
The movements in Fed Fund futures and in Treasury Bill yields try to anticipate future changes in the Fed Funds rate and thus short-term interest rates. This is true in both Europe and in the United States. How different would the behavior of the US and European economies have been if interest rates had followed a slightly different path in the United States and in Europe? GDP growth and unemployment would have been different, but how different?
But you can’t only look at how the Fed and ECB’s interest rate policies affected GDP growth and unemployment in the United States and Europe, but you have to look at the cost of these policies as well. The primary cost has been a wildly fluctuating exchange rate between the United States and Europe, swinging up and down within a 30% range.
One way that economics attacks problems is to think counterintuitively. What if in January 2000 when the Euro and US Dollar were at par with each other, the United States and Europe had decided to coordinate exchange rate and interest rate policies between the two currency areas to maintain the Euro and US Dollar at part with one another. This would have required the Fed and ECB to coordinate their short-term interest rates together in order to maintain the link between the two currencies.
Under these circumstances, instead of the US Dollar rising to $0.84 before the end of 2000, fluctuating around the $0.90 level for the next 18 months before gradually declining to $1.18, what would have happened if instead the Euro and US Dollar had remained at par with one another?
One rule of thumb is that a 5% appreciation in a country’s currency is equivalent to raising interest rates by 1%. By this rule, the 30% increase in the value of the Euro between the beginning of 2002 and mid-2003 is equivalent to raising interest rates in Europe by 6%! On the other hand, the spread between the US Fed Funds Rate and the Repo Rate in Europe has never been greater than 2%. If this rule of thumb is correct, by pursuing independent monetary policies, Europe and the United States have created greater economic instability than if they had coordinated their monetary policies.
A History of SCFTAs
Whenever economic and political stability have enabled international trade to expand, attempts have been made to eliminate barriers to trade and introduce a universal currency that meets the demands of trade. Because of the political benefits of introducing a universal currency, a single monetary standard has usually followed the expansion of political power. The Roman Empire, the Chinese Empire, and the British Empire all established a single currency standard for the regions over which they ruled. Although there are economic reasons for having a universal currency, history suggests that politics, and not economics, has been the chief determinant of currency areas and the presence of trade barriers in the past and today.