Friday, July 4, 2014

How Long Did It Take the United States to Become an Optimal Currency Area?

This is a great question to consider as we celebrate Independence Day here in the United States. It is also a great question for Europeans who have learned the hard way that the Eurozone is not an optimal currency area. Fortunately, economic historian Hugh Rockoff has already worked on this question and concluded it took only 150 years. Yep, that means the Eurozone project needs another 135 years or so before it works. I can hardly wait.

Here is the NBER summary of Rockoff's paper:
In 1788, Congress was given the exclusive right to "coin money" and "regulate the value thereof." Since then, Americans have spent and invested within the immense area of this country without ever having to worry about different exchange rates. The only exception to the monetary union occurred during the Civil War, when the nation was divided into three monetary regions.

In How Long Did It Take the United States to Become an Optimal Currency Area? (NBER Working Paper No. H124), NBER Research Associate Hugh Rockoff explores the costs and benefits of the monetary union. He notes that "the survival of the U.S. monetary union is at best muted evidence that the net effects have been positive."

The incentive for a region to join a monetary union is the minimizing of transaction costs. But the costs of uniting include giving up the exchange rate and changes in the money stock as policy tools. Whether a specific area composes an optimal currency area, or whether it would be better off as a segment of a larger monetary union, depends on the net sum of the costs and benefits. During the first 150 years of the U.S. monetary union, regional battles over monetary policy and institutions were widespread. Simply put, what was beneficial monetary policy for one region was not necessarily beneficial for another.

Rockoff finds numerous examples of regional shocks magnified by monetary reactions. The typical scenario involves a shock in financial or agricultural markets which would hit one region particularly hard. The banking system in the region would lose reserves resulting in a monetary contraction. A political battle would often erupt, and the regions that had experienced the contraction would demand a reform of the monetary system. The resulting uncertainty about the future of existing monetary institutions would further intensify the initial contraction.

In the 1930s institutional changes, such as the adoption of interregional fiscal transfers and bank deposit insurance, overcame the problem of regional banking shocks. Federally funded transfer programs, such as unemployment insurance, Social Security, and agricultural price supports, cushioned regional shocks and pumped high-powered money into regions losing reserves. Deposit insurance tended to reduce regional banking problems that characterized recessions.

So, how long did it take the United States to become an optimal currency area? Rockoff concludes that a reasonable minimum may be 150 years. It was not until the 1930s that all regions in the country could be said to be components of a single optimal currency area, the United States. Thus for a country debating whether to join a monetary union, it would be wise to examine the U.S. history first.
Great news for the Eurozone! 

Krugman, Mankiw, and the US as an OCA
The Three Monetary Regimes During the US Civil War


  1. In the US, most spoke using a common language, allowing for easy migration between the states. This is not true of the Eurozone.

  2. The term "optimal" suggests a very high standard for a currency zone to meet. Is an optimal currency zone one that could not be divided *in any fashion* that would produce benefits exceeding the extra transaction costs (in the long run)? And won't it be very hard to prove that any currency zone is *optimal*, since the actual zone would have to be compared with all of the infinitely many ways of dividing it up (all of which are merely hypothetical)?

  3. Well, another way of looking at it is that this is in fact good news for the Euro Zone: evidently, you can be a non-optimal currency area and still have strong growth (if punctuated by crises) and hold together as a political entity.

    Richard A: Actually, you had large parts of the country speaking non-English languages. FOr instance, German used to be very widely spoken in large parts of the country. 1870s labour organizers in Chicago found themselves obliged to print pamphlets & posters in German as well as English.

  4. I'm still not convinced the U.S. is an optimal currency area. Particularly once you consider American Samoa, Puerto Rico, and other U.S. territories which have to use the dollar.