When tomorrow's historians look back at the recent financial crises and subsequent efforts to reform global finance, they will reach two conclusions. First, the grand rhetoric of creating a new global architecture yielded few concrete results. Second, we failed to foresee the most profound consequence of the turmoil: regional currency unions. By 2030 the world will have two major currency zones -- one European, the other American. The euro will be used from Brest to Bucharest, and the dollar from Alaska to Argentina -- perhaps even in Asia. These regional currencies will form the bedrock of the next century's financial stability.

That claim may seem bold, even outlandish. The concept of regionalism, whether financial, military, or commercial, hardly enjoys an auspicious reputation. Free-trade enthusiasts fret that regional trade arrangements divert more trade than they create. Europe's single market was long portrayed as "Fortress Europe" by outsiders. European aspirations for an independent defense initiative raise some eyebrows in Washington. Japan's proposal to create an Asian monetary fund in 1997 was quickly squashed by the Americans. In each case, opponents fear that regional approaches are exclusionary, protectionist, or destabilizing. But in finance, that prejudice is misplaced. Regional currencies will prove the best route to reconciling the economic imperatives of increasing international capital mobility with the political realities of the nation-state.

To understand why regional currency zones are in the cards, start by considering why the status quo is untenable. Over the past five years, financial turmoil has shattered the semi-fixed exchange-rate regimes that much of the developing world once favored. One after the other, countries with pegged (but ultimately adjustable) exchange rates had to devalue in the face of massive capital outflows. The recent crises have taught emerging economies a lesson that rich countries first learned through the collapse of the Bretton Woods system in the early 1970s, later reinforced by the 1993 collapse of the European exchange-rate mechanism: in a world of increasingly mobile capital, countries can either allow their currencies to float or fix them irrevocably, for instance through currency boards. They can even go further and attempt currency union. But the muddled middle ground, so popular in the years when capital was less mobile, has been wiped out by technological innovation and policy liberalization.

So much for the status quo. What might the future offer? Conventional wisdom among elites holds that most countries should opt for floating rates. By allowing their currency to float, the argument goes, emerging economies can maintain an independent monetary policy while insulating themselves from the vicissitudes of global capital flows. This view has gained even more credence in the past few months as Brazil's decision to float its currency, the real, did not produce the high inflation that many observers had feared. Nonetheless, most countries will find that advice sorely mistaken, for the second lesson of the emerging-market turmoil is that floating exchange rates tend not to protect a country from volatility. Indeed, they may even increase financial turbulence.

By rich-country standards most emerging economies have puny financial sectors. In a typical emerging market, the entire banking system is about the same size as a regional American bank. When financial sectors are small and capital is mobile, floating exchange rates spell massive currency volatility. When a lot of foreign capital flows in, a freely floating exchange rate rises sharply, wreaking havoc for domestic banks and exporters alike. This instability is a permanent phenomenon. To prevent it, many emerging economies with floating exchange rates will have to curb capital flows, particularly the short-term kind. That means that if floating exchange rates became the norm among emerging economies, capital-market integration would inevitably slow down.

That option is a high price to pay. Developing countries have much to gain from capital mobility: the ability to tap external sources of finance, greater financial efficiency from deeper stock and bond markets, and technology transfer and know-how from foreign direct investment. We must therefore consider the other alternative to today's discredited semi-pegged regimes: a shift to hard pegs or even currency union.

FROM THEORY TO PRACTICE

Farsighted academics have long argued that global capital mobility will eventually demand broader currency zones. In 1984, Richard Cooper made the case in these pages for an eventual common currency in industrial economies. In a 1994 Brookings Institution study on international monetary arrangements for the next century, Barry Eichengreen predicted the rise of regional currency zones. In each case, such advocates portrayed currency unions as a distant possibility -- one that might occur generations hence. For the here and now, most academics and politicians favor floating exchange rates. That is because they cling to conventional arguments that systematically overstate the political and economic costs of exchange-rate unions while understating their benefits.

The most popular economic argument against currency union is that it implies the loss of an independent monetary policy. Countless articles skeptical of European Economic and Monetary Union begin by pointing out that EMU members can no longer reduce interest rates in response to domestic recession. If they are hit by an external shock -- say a rise in oil prices or a fall in exports -- they cannot loosen monetary policy. Instead, the real economy must bear the shock: that is, domestic wages and prices must fall. Since this is politically painful, economists argue that only countries likely to suffer similar outside shocks should share a currency. Countries that -- in economic jargon -- do not form such an "optimal currency area" should therefore forfeit their monetary independence only under extreme circumstances.

This emphasis on "optimal currency areas" is a holdover from the days of limited capital mobility, when the biggest external shocks a country was likely to face came from export or import prices. In those days, it made sense for policymakers to reserve the option of devaluation. Today, the biggest shocks for emerging economies are far more likely to be sudden shifts in capital flows, which destabilize because they threaten sudden and unwanted currency depreciation. Not all such shifts result from macroeconomic fundamentals. The optimal policy for many emerging economies, therefore, has changed. Whereas a floating exchange rate was once the best way to deal with shocks, now fixed rates seem wiser.

Contrary to popular belief, a floating exchange rate does not necessarily allow a capital-dependent emerging economy to run an independent monetary policy. When investors shed an emerging economy's assets, a purely floating currency will likely succumb to an exchange-rate collapse. To stop this, even countries with floating currencies have to raise interest rates. Indeed, their interest rates may even need to be higher than in countries with rigid exchange rates.

Compare the respective responses of Mexico and Argentina to Russia's financial collapse in August 1998 and the subsequent investor stampede away from all risky assets. Mexico has a floating exchange rate; Argentina has a rigidly fixed currency board. You would think that Mexico could have absorbed the Russian shock by allowing its currency to weaken, while Argentina would have taken the full brunt through higher interest rates. Mexico's peso did fall -- by more than ten percent in the month after Russia's debacle. Yet real interest rates were much higher in Mexico than they were in Argentina. In the short term, Mexico paid a high price to convince international investors that it would not let its currency totally collapse.

It may be a mistake to read too much into this one episode, particularly as Mexico's interest rates have subsequently fallen. But more systematic analysis leads to similar conclusions. Recent research by the Inter-American Development Bank suggests that real interest rates in Latin America have been significantly lower when countries have had fixed, rather than flexible, exchange-rate regimes. Contrary to popular wisdom, there is no evidence that countries with fixed exchange rates have had to raise interest rates more during a recession than those with floating currencies; if anything, the opposite is true. What is more, countries with flexible rates have responded more sensitively to changes in foreign interest rates. At the very least, these results suggest that it is time to question how much monetary independence a floating currency really provides for emerging economies.

LAST RESORT

The other popular argument against currency unions centers on the loss of a domestic lender of last resort. When a country irrevocably ties its exchange rate or gives up its currency, the central bank can no longer print money as needed to shore up the domestic banking system. Many skeptics claim that this leaves emerging economies with weak banking systems extremely vulnerable. Here again, conventional wisdom overstates the benefits of unpegged rates. Just as emerging economies cannot simply reduce interest rates when foreigners flee their assets, they cannot print domestic money freely without precipitating hyperinflation and a currency collapse. This is the big difference between developed and emerging economies. If there were a bank panic in the United States, the Federal Reserve could simply print more dollars, which people would willingly hold. But if there is a bank panic in an emerging market, investors want safe assets. Generally, that does not include the country's domestic currency. People rush to a safe haven, such as dollars, and the domestic currency collapses. Hence, a country's potential to be a lender of last resort is limited even with a floating currency.

More important, an emerging economy does not need to be able to print money to have a lender of last resort. To assume this role, a central bank must simply be able to provide secure money to stem panic in the banking system. A country without its own currency can do that; it just cannot get the resources by printing money. Bulgaria, a country with a currency board, has a specific pot of money in reserve to deal with banking panics. Argentina has set up contingency lines of credit with major international banks. In the event of a liquidity shock, it gains access to cash in return for collateral.

The argument for fixed exchange rates applies equally to currency unions and currency boards, which make the exchange-rate peg credible by demanding that all domestic currency in circulation be backed with foreign reserves. But currency union offers an additional advantage. It makes the commitment to stability that much more credible. Currency boards always run the risk that a new government might decide to change the system, so investors demand a higher premium to balance that risk. Argentine peso debt, for instance, yields several percentage points more than Argentine dollar debt. Giving up a national currency altogether is a much harder step to reverse. Hence, going for full currency union is likely to yield lower interest rates.

All the same, currency union raises suspicions that go well beyond economics. Skeptics argue that a national currency is a basic symbol of sovereignty that countries choose to forfeit only under extraordinary circumstances. They point out that although currency unions existed in the nineteenth century, the main twentieth-century examples have either been former colonialist regimes (the western and central African monetary unions) or EMU, the latest and most ambitious phase of Europe's postwar political integration. If Europe took two generations to reach the point where currency union became possible, argue the doubters, what is the possibility of currency union in the Americas, let alone Asia -- a region riven with deep historical and political suspicions?

The first answer is that enthusiasm for currency union in emerging economies is on the rise. In 1983, Israel's finance minister, Yoram Aridor, was forced to resign days after suggesting dollarization as a solution to the country's inflation problem. Today, the subject is widely discussed. Argentina's president, Carlos Menem, has suggested dollarization for Argentina as a first step toward currency union in the Americas. El Salvador is also actively considering dollarization, while Mexican business groups speak loudly in favor of it. An opinion poll in late 1998 suggested nine out of ten Mexicans support adopting the dollar. In Asia, the head of Hong Kong's Monetary Authority has spoken in favor of Asian monetary union as a long-term project. And as the euro becomes more established, the political acceptability of currency unions will surely increase.

The second answer is that Europe's experience is sui generis. The euro is indeed part of a larger project of political integration that is not easily replicable. But EMU also represents only one type of currency union: a highly egalitarian pooling of sovereignty. Regional currency zones could easily occur in other, more hegemonic ways. Countries can simply adopt another country's currency. Panama, for instance, uses the U.S. dollar, although the Federal Reserve has no responsibilities toward that country whatsoever.

More ambitiously, countries might negotiate limited mutual responsibilities with the central bank whose currency they adopt. Argentina's central bank, for instance, has an ingenious idea for dollarization along these lines. America could return to Argentina its share of seignorage revenue, the profit that a central bank makes when people use its currency. This money, about $750 million a year in Argentina's case, could provide the collateral for private-sector liquidity in case of a bank panic in Argentina. America would thereby substantially boost regional stability at no cost -- since it would not have had this income at all had Argentina not dollarized. The notion of reciprocal responsibilities would also help address potential political opposition to currency union.

Such a "limited-responsibility" currency union would not appeal to everyone. Developed countries with deep financial sectors and the commensurate level of monetary independence are unlikely to accept it. Canada, for instance, would not dollarize on this basis. It would demand some say in the conduct of American monetary policy, an altogether more complicated matter. But for emerging economies -- big and small -- this option would offer more benefits than costs.

RISKY BUT RIGHT

Admittedly, there are risks involved in a regional route. But these are not overwhelming. It is true, for example, that Asia does not fit obviously into any currency zone. Although Asia's highly trade-oriented economies would benefit enormously from currency stability, there is no obvious regional hegemon to take the lead. The yen is the leading Asian currency, but Japan's heavy regulation has long stifled its international use. More fundamentally, historic rivalries between China and Japan mean that neither would accept the other as regional currency hegemon. And yet the regional currency idea may still prove relevant to Asia if some countries there choose to adopt the U.S. dollar.

It is also true that the emergence of currency unions brings some risk of the negative aspects of regionalism. Monetary blocks could potentially fuel protectionist trade tendencies, especially if exchange rates between regional blocs, such as the euro and the dollar, fluctuate wildly. But that danger already exists even now, since the dollar and the euro account for the bulk of world trade. By fostering greater stability within regions, currency unions may well act as a bulwark against protectionist pressure.

The greatest danger of a regional route is the potential for two-tiered globalization. Emerging economies will divide into those that are integrated into regional blocks and global capital markets and those with floating exchange rates and little capital integration. The former will receive the lion's share of foreign investment, leaving the latter lagging dangerously behind. In a roundabout way, however, this risk illustrates the benefits of regional currency regimes. It is surely better that part of the emerging world enjoy the benefits of financial integration than none of it.

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