Tuesday, August 28, 2012
Milton Friedman's prophetic article written 15 years ago: "The Euro: Monetary Unity To Political Disunity?"
August 28, 1997
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 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 fifty states, its residents overwhelmingly speak the same language, listen to the same television programs, see the same movies, can and do move freely from one part of the country to another; 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 United States more than others -- as, for example, the Middle East embargo on oil did in the 1970s, creating an increased demand for labor and boom conditions in some states, such as Texas, and 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, by offsetting financial flows from the national to the state and local governments, and by adjustments in prices and wages.
By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nations, 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 being a free trade area, goods move less freely than in the United States, and so does capital.