We live in a globalized world where travel is more accessible than ever, global GDP per capita has never been higher, infant mortality is dropping every year, and life expectancy is up globally. This is a very different world from 50 years ago. There are a few major conflicts in the world today, particularly in Ukraine and Israel, but the trend of global deaths from armed conflict has been going down for decades, especially during the War on Terrorism which were the most peaceful years in history.
As the world has become more safe and interconnected, countries have to make choices about how we interact with each other. The first question is whether to join a customs union with similar countries, which is usually a pretty easy decision given the aggregate benefits. The next question is whether to form a travel area like Schengen or the Andean community given the costs and benefits of customs, the costs of customs between low-corruption democracies usually outweigh the benefits, so countries are forming free travel areas around the world.
These are easy questions with lots of upsides and few if any disadvantages.
Currency union
But then there is the question of a full blown currency union. Should you pursue it? What are the advantages and disadvantages?
The main reason countries pursue currency unions is perceived stability. They see the exchange rate staying the same with other countries, with less volatility with third parties, and this is perceived as a good thing. It is good for consumption if you have a valuable currency which makes imports cheaper. But if you are a net exporter in a country with lower productivity, it can actually be worse for your business by making your exports more expensive.
So in the case of Luxembourg and Germany I see no reason why these countries should not have a currency union. They are both highly educated countries with low corruption, leading to very similar economies. Luxembourg is very small, so tying their currency to a larger wealthy economy makes sense.
Currency fluctuations
But what about when it comes to Portugal? Portugal has a mean years of schooling of only 9.6 years versus 13.1 in Germany. Portugal’s GDP per capita is hence significantly lower, and their corruption perceptions index ranking is significantly lower than Finland. While every country in the Eurozone is highly developed, there are major fluctuations within it.
By adopting the Euro, Portugal’s exports are more expensive. This attracts fewer tourists, and makes it more difficult for Portuguese businesses to be cost-competitive globally when exporting. With a weaker currency they would see Portuguese businesses export more items, boosting national income. This is one major drawback of different economies adopting a currency union.
A second consideration is if there is a local recession, the currency usually will drop in value. This makes exports cheaper, boosting the economy so the recession is less severe. This doesn’t work if you are in a currency union, making it far more difficult to recover. It also makes it so you can’t borrow money from your central bank to do a fiscal stimulus to reduce the severity of the recession.
It’s also disadvantageous in good times. If your economy is booming wildly and you are in a currency union, you cannot raise interest rates to keep the economy at a less frantic pace. This can lead to faster inflation and bubbles.
A central tenet of modern economic theory is counter-cyclical policy. While there are some services the government always handles, like health care, education, and infrastructure, they increase and decrease their involvement based on the market cycle. If unemployment is low and inflation is high, they might put off that infrastructure project for a rainy day. In a recession with high unemployment and deflation the government will hire people on to build the backlog of infrastructure projects, keeping the economy moving and people employed.
But if you are in a currency union you lose this ability. You will not have the monetary independence which allows you to reduce interest rates and have the government borrow more money straight from the central bank in order to get the economy moving. You also are stuck with less volatile interest rates in good times, so you can’t increase interest rates faster in order to slow down an overheating economy.
So are currency unions worth it? It depends what you value.
If you value having a strong currency so when you travel abroad you have more purchasing power, currency unions can provide a short-term fix. This makes things look good to citizens, improving the popularity of politicians. This is why currency unions are so politically appealing.
But when recession strikes, currency unions can act as a further weight on your economy. Keeping your depressed economy in a high-interest rate environment with your government less able to borrow money to get people back to work and projects built. Businesses still have to deal with more expensive loans, reducing employment further.
So in my opinion I think the costs of a currency union outweigh the benefits. If you want to become wealthier, the only way to do it with little downside is to improve productivity. Productivity is measured by the value of work done per hour. You can’t hack your way to higher productivity by working longer hours, you can only do it by increasing education levels and adopting better technology.
If you improve your productivity, your GDP will go up by definition. Your quality of life increases as people make higher incomes. As people make more money, they will import more items from abroad. As your country increases its exports demand for your currency will go up, improving the value of your currency.
An easy way to think of this is in terms of net exports versus net imports between two currencies. The currency with net imports will see its value rise in that currency pair.
So let’s say the United States and Canadian dollars are hypothetically trading 1:1. If the value of American exports to Canada (software) is higher than Canadian exports to the United States (oil) the United States has a trade surplus with Canada. This trade surplus means there is more demand for USD than CAD. This will push the prices away from parity, to perhaps .99 USD for 1 CAD, or 1.01 CAD/USD.
In this scenario, where I would have gotten 1000 CAD for 1000 USD, I will now get 1,100 CAD for the same amount of USD. This means the next time we trade, Canadians will need to spend more CAD to buy the same amount of computers, pushing our trade back to parity. But it also will make Canadian oil cheaper, meaning Americans will buy more oil, bringing the exchange rate back to parity in the long run ceterus paribus.
Polish zloty
Poland has joined the European Union, but has maintained its own free floating currency. Being in the European Union and Schengen Area it has all the advantages of free trade that one could want to boost their economy, their education level is high, though corruption remains around the level of Italy, so way better than their neighbors Russia and Belarus, but with room for improvement.
This has led to massive growth in the Polish economy over the last twenty years. The zloty is far less valuable than the Euro, keeping Polish exports relatively cheap. This boost in exports helps bring money into Poland, improving their incomes, and their incomes have increased from $30k in 2014 to $44k in 2024. Almost 50% in 10 years!
I suspect if Poland had entered into the Euro their exports would have become more expensive, slowing their growth.
When Poland sells good to the rest of the European Union, this bring Euros into Poland which they can then turn around and purchase more factor inputs to further increase their productivity. This creates a virtuous cycle until their economy reaches the productivity of the other members of the bloc. If Poland were to hit a recession, the zloty would depreciate, Polish exports would become cheaper, and that would increase exports, boosting their economy in a counter-cyclical manner.
Portugal has no such advantage. If their economy hits a recession they are tied into the Euro so they have to use other methods.
So is it worth it?
Should countries join currency unions? My answer is no. As long as you keep increasing productivity you will see an improved quality of life. This will happen whether you are in a currency union or not. So during normal times, it won’t make that much of a difference.
But when the economy hits a recession in the future for whatever reason, it will not be felt equally across a large currency union. This will cause a conflict for monetary policy. Do they keep interest rates high for the countries less harmed, risking the recession regions falling further? Or do they reduce the interest rate and risk an inflationary cycle in the countries which are doing relatively well?
Exchanging currencies for goods is natural. The hassle of exchanging currencies is minimal in today’s technological era, the only issue you might have is increased price volatility.
But price volatility is not necessarily a bad thing. It means the market is working. You want prices to fluctuate to clear the market and facilitate trade. If prices are unable to change you will end up with shortages and surpluses. The advantages of price volatility outweigh the cons.
So countries should absolutely form customs unions and open border regimes, but keep their own currency.