To commemorate its founding 25 years ago, PS will be republishing over the coming months a selection of commentaries written since 1994. In the following commentary, published two years before the introduction of the euro in 1999, the Nobel laureate economist Milton Friedman offered a concise but comprehensive explanation of why the European Union would be ill-suited for a single currency. Though the currency has survived, many of his warnings proved prescient.
SAN FRANCISCO – A common currency is an excellent monetary arrangement under some circumstances, a poor monetary arrangement under others. Whether it is good or bad depends primarily on the adjustment mechanisms that are available to absorb the economic shocks and dislocations that impinge on the various entities that are considering a common currency. Flexible exchange rates are a powerful adjustment mechanism for managing shocks that affect the entities differently. It is worth dispensing with this mechanism to gain the advantage of lower transaction costs and external discipline only if there are adequate alternative adjustment mechanisms.
The United States is an example of a situation that is favorable to a common currency. Though composed of 50 states, its residents overwhelmingly speak the same language, listen to the same television programs, see the same movies, and can and do move freely from one part of the country to another. Moreover, goods and capital move freely from state to state; wages and prices are moderately flexible; and the national government raises in taxes and spends roughly twice as much as state and local governments. Fiscal policies differ from state to state, but the differences are minor compared to the common national policy.
Unexpected shocks may well affect one part of the US more than others, as the Middle East oil embargo did in the 1970s. That event increased the demand for labor and created boom conditions in some states, such as Texas, but led to unemployment and depressed conditions in others, such as the oil-importing states of the industrial Midwest. The different short-run effects were soon mediated by movements of people and goods, financial flows from the national to the state and local governments, and wage and price adjustments.
By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nation states, whose residents speak different languages, have different customs, and have far greater loyalty and attachment to their own country than to the common market or to the idea of “Europe.”
Despite the European Union being a free-trade area, goods move less freely there than in the US, and so does capital. The European Commission spends a small fraction of what EU member-state governments spend in total. The latter, not the EU’s bureaucracies, are the important political entities. Moreover, regulation of industrial and employment practices is more extensive in the EU than in the US, and differs far more from country to country than it does between US states. As a result, wages and prices in Europe are more rigid, and labor is less mobile.
In these circumstances, flexible exchange rates provide an extremely useful adjustment mechanism. If one country is affected by negative shocks that call for, say, lower wages relative to other countries, that can be achieved by a change in one price – the exchange rate – rather than by requiring changes in thousands upon thousands of separate wage rates, or the emigration of labor. The hardships imposed on France by its “franc fort” policy illustrate the cost of a politically inspired determination not to use the exchange rate to adjust to the impact of German reunification. Britain’s economic growth after it abandoned the European Exchange Rate Mechanism a few years ago (in order to refloat the pound) illustrates the effectiveness of the exchange rate as an adjustment mechanism.
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Proponents of the “euro” often cite the gold-standard era from 1879 to 1914 as demonstrating the benefits of a common currency. But the gold standard also had its costs. The period was characterized by declining prices from 1879 to 1896, rising prices thereafter, and sharp fluctuations within each period; these were especially severe in the 1890s. The gold standard was viable only because governments were small (spending in the neighborhood of 10% of the national income rather than 50% or more, as now), prices and wages were highly flexible, and the public was willing to tolerate – or had no way to moderate – wide swings in output and employment. Take away the rose-colored glasses, and it was hardly a period or a system to emulate.
As of today, a subgroup of the EU – the Benelux countries (Belgium, the Netherlands, Luxembourg), Austria, and perhaps Germany – come closer to satisfying the conditions favorable to a common currency than does the EU as a whole. But they already have the equivalent of a common currency. Austria and the Benelux three have, for all intents and purposes, linked their currencies to the Deutschmark. However, these countries still retain their central banks, and hence can break the link at will. Any country that wishes to link to the Deutschmark more firmly can do so on its own, simply by replacing its central bank with a currency board, as some countries (such as Estonia) outside the EU have done.
The drive for the euro has been motivated by politics, not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.
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SAN FRANCISCO – A common currency is an excellent monetary arrangement under some circumstances, a poor monetary arrangement under others. Whether it is good or bad depends primarily on the adjustment mechanisms that are available to absorb the economic shocks and dislocations that impinge on the various entities that are considering a common currency. Flexible exchange rates are a powerful adjustment mechanism for managing shocks that affect the entities differently. It is worth dispensing with this mechanism to gain the advantage of lower transaction costs and external discipline only if there are adequate alternative adjustment mechanisms.
The United States is an example of a situation that is favorable to a common currency. Though composed of 50 states, its residents overwhelmingly speak the same language, listen to the same television programs, see the same movies, and can and do move freely from one part of the country to another. Moreover, goods and capital move freely from state to state; wages and prices are moderately flexible; and the national government raises in taxes and spends roughly twice as much as state and local governments. Fiscal policies differ from state to state, but the differences are minor compared to the common national policy.
Unexpected shocks may well affect one part of the US more than others, as the Middle East oil embargo did in the 1970s. That event increased the demand for labor and created boom conditions in some states, such as Texas, but led to unemployment and depressed conditions in others, such as the oil-importing states of the industrial Midwest. The different short-run effects were soon mediated by movements of people and goods, financial flows from the national to the state and local governments, and wage and price adjustments.
By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nation states, whose residents speak different languages, have different customs, and have far greater loyalty and attachment to their own country than to the common market or to the idea of “Europe.”
Despite the European Union being a free-trade area, goods move less freely there than in the US, and so does capital. The European Commission spends a small fraction of what EU member-state governments spend in total. The latter, not the EU’s bureaucracies, are the important political entities. Moreover, regulation of industrial and employment practices is more extensive in the EU than in the US, and differs far more from country to country than it does between US states. As a result, wages and prices in Europe are more rigid, and labor is less mobile.
In these circumstances, flexible exchange rates provide an extremely useful adjustment mechanism. If one country is affected by negative shocks that call for, say, lower wages relative to other countries, that can be achieved by a change in one price – the exchange rate – rather than by requiring changes in thousands upon thousands of separate wage rates, or the emigration of labor. The hardships imposed on France by its “franc fort” policy illustrate the cost of a politically inspired determination not to use the exchange rate to adjust to the impact of German reunification. Britain’s economic growth after it abandoned the European Exchange Rate Mechanism a few years ago (in order to refloat the pound) illustrates the effectiveness of the exchange rate as an adjustment mechanism.
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Proponents of the “euro” often cite the gold-standard era from 1879 to 1914 as demonstrating the benefits of a common currency. But the gold standard also had its costs. The period was characterized by declining prices from 1879 to 1896, rising prices thereafter, and sharp fluctuations within each period; these were especially severe in the 1890s. The gold standard was viable only because governments were small (spending in the neighborhood of 10% of the national income rather than 50% or more, as now), prices and wages were highly flexible, and the public was willing to tolerate – or had no way to moderate – wide swings in output and employment. Take away the rose-colored glasses, and it was hardly a period or a system to emulate.
As of today, a subgroup of the EU – the Benelux countries (Belgium, the Netherlands, Luxembourg), Austria, and perhaps Germany – come closer to satisfying the conditions favorable to a common currency than does the EU as a whole. But they already have the equivalent of a common currency. Austria and the Benelux three have, for all intents and purposes, linked their currencies to the Deutschmark. However, these countries still retain their central banks, and hence can break the link at will. Any country that wishes to link to the Deutschmark more firmly can do so on its own, simply by replacing its central bank with a currency board, as some countries (such as Estonia) outside the EU have done.
The drive for the euro has been motivated by politics, not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.