A New Theory on Monetary Union

Noting the 20th anniversary of the advent of the euro, Patrick Bolton, the Barbara and David Zalaznick Professor of Business, remembers what it was like to travel in Europe in the time of francs and marks.

“I would go from France to Belgium to Germany and you had to have all the different currencies,” recalls Bolton, who teaches in the Finance Division. “You had a really thick wallet.”

While traveling through the Eurozone countries has by all counts become more convenient since the euro's introduction—it launched on January 1, 1999; banknotes and coins followed in 2002—the currency has had a fraught two decades. Its difficulties peaked beginning about a decade ago with the great financial crisis and the subsequent euro sovereign debt crisis.

“The euro is not a good model for monetary union, but I think it is here to stay,” Bolton says.

Bolton uses the troubled recent history of the euro as a key component in his new theory of Optimum Currency Areas (OCA), which he developed in a 2018 working paper, “Money, Sovereignty, and Optimal Currency Areas,” co-written with Haizhou Huang of the China International Capital Corporation.

Bolton and Huang base their theory on the scholarship of Columbia University Professor Emeritus of Economics Robert Mundell, who won the Nobel Prize in 1999 for his work on OCAs. Mundell provided much of the intellectual backing that led to the formation of the euro and European Central Bank.

“Mundell's view on monetary union was that it makes trade efficient,” Bolton says. “It lowers the cost because instead of having to change currencies every time you trade across countries, you have one single currency.”

While Mundell focused solely on the positives—the lower transaction costs— Bolton and Huang's theory takes into account the fact that OCAs come with tradeoffs. Yes, there are lower transaction costs, but in return, countries give up a certain amount of sovereignty.

Bolton and Huang's research indicates that while a monetary union can control inflation, the loss of each country's individual currency eliminates the ability for them to issue money to service debt obligations in times of financial upheaval. Bolton says that fiat money, or legal tender, for nations operates like equity for companies.

“When you have two companies that merge, the acquired company essentially loses the right to issue stock,” explains Bolton. “Similarly, with a monetary union, each country gives up independence with its currency; it no longer has the ability to issue debt denominated in its own currency.”

The research also advocates for the benefits of merging a monetary union with a fiscal union, so the same body that decides interest rates, for example, is the same one that controls tax policy and government spending. Currently, the Eurozone countries share a currency and a central bank, but each constituent nation sets its own fiscal policies, which Bolton says creates problems.

“You don't have fiscal and monetary coordination in Europe,” he explains. “The central bank has to coordinate with every single member and say, 'What are you going to do about your fiscal policy?' It is a fundamental weakness.”

That flaw in the euro must be seen, Bolton explains, in the context of European history, as the single currency is as much a political project as it is an economic venture.

“I think that is where the euro backfired,” Bolton said. “It was a big miscalculation that you could have a political union happening quickly after monetary union.”

Bolton says the enlargement of the European Union in 2004 and 2007, which saw the addition of several former Soviet bloc nations, combined with the fact that some of those states opted out of the euro, made it more difficult to achieve a closer political union.

“That's a weakness and when the financial crisis hit, that became visible,” Bolton says.

As for the future of both Europe and the euro, Bolton is encouraged by the cohesion the EU-member states have shown in negotiating Britain's exit from the union, which could bode well for further policy discussions.

“I think the political will is there to have a single market, with a single currency, with a more federal Europe,” Bolton said. “I think the big priority is some form of fiscal union. We have to get there.”