Optimal Currency Areas: An Analysis of Inflation, Trade, and Currency Unions, Apuntes de Administración de Empresas

¡Descarga Optimal Currency Areas: An Analysis of Inflation, Trade, and Currency Unions y más Apuntes en PDF de Administración de Empresas solo en Docsity! This PDF is a selection from a published volume from the National Bureau of Economic Research Volume Title: NBER Macroeconomics Annual 2002, Volume 17 Volume Author/Editor: Mark Gertler and Kenneth Rogoff, editors Volume Publisher: MIT Press Volume ISBN: 0-262-07246-7 Volume URL: http://www.nber.org/books/gert03-1 Conference Date: April 5-6, 2002 Publication Date: January 2003 Title: Optimal Currency Areas Author: Alberto Alesina, Robert J. Barro, Silvana Tenreyro URL: http://www.nber.org/chapters/c11077 Alberto Alesina, Robert J. Barro, and Silvana Tenreyro HARVARD UNIVERSITY, NBER, AND CPER; HARVARD UNIVERSITY, HOOVER INSTITUTION, AND NBER; AND FEDERAL RESERVE BANK OF BOSTON Optimal Currency Areas 1. Introduction Is a country by definition an optimal currency area? If the optimal number of currencies is less than the number of existing countries, which countries should form currency areas? This question, analyzed in the pioneering work of Mundell (1961) and extended in Alesina and Barro (2002), has jumped to the center stage of the current policy debate, for several reasons. First, the large increase in the number of independent countries in the world led, until recently, to a roughly one-for-one increase in the number of currencies. This prolifera- tion of currencies occurred despite the growing integration of the world economy. On its own, the growth of international trade in goods and assets should have raised the transactions benefits from common curren- cies and led, thereby, to a decline in the number of independent moneys. Second, the memory of the inflationary decades of the seventies and eight- ies encouraged inflation control, thereby generating consideration of ir- revocably fixed exchange rates as a possible instrument to achieve price stability. Adopting another country's currency or maintaining a currency board were seen as more credible commitment devices than a simple fix- ing of the exchange rate. Third, recent episodes of financial turbulence have promoted discussions about "new financial architectures." Although this dialogue is often vague and inconclusive, one of its interesting facets We are grateful to Rudi Dombusch, Mark Gertler, Kenneth Rogoff, Andy Rose, Jeffrey Wurgler, and several conference participants for very useful comments. Gustavo Suarez provided excellent research assistance. We thank the NSF for financial support through a grant with the National Bureau of Economic Research. 304 ? ALESINA, BARRO, & TENREYRO ~I -^~i b1-0661 [I~~ x ^~- ~6-S861 I9 ttr ,-0861 ?< | ^ ^ [0 6-SL61 t -OL61 Fb>?~~~~~~ | 6-S961 Cr | b-0961 t):?~~~~~'' 6-SS61 U tb-0561 X 6-St61 0 17-O661 r.z i -6-561 <?I 1-0?61 _ 6-SZ61 : I _ b-OZ61 O _6-161 Ecd 17-0161 6-S061 ="-0061 6-S681 <?~~~~~~~~ I-~~~~~~~ b~1V-0681 U E _ 6-S881 t-0881 Z. U 'I 6-SL81 O < b-OL81 sI I ....--t I I I qI .-- cH VN 0o 0S o J 0o J o 0o (^ f S- N i , bO *, s.lXunoDjo ]oqumN Optimal Currency Areas ? 305 were virtually frozen. In contrast, after the end of World War II, the num- ber of countries almost tripled, and the volume of international trade and financial transactions expanded dramatically. We view these two devel- opments as interrelated. First, small countries are economically viable when their market is the world, in a free-trade environment. Second, small countries have an interest in maintaining open borders. Therefore, one should expect an inverse correlation between average country size and the degree of trade openness and financial integration. Figure 2, also taken from Alesina, Spolaore, and Wacziarg (2000), shows a strong positive correlation over the last 150 years between the detrended number of countries in the world and a detrended measure of the volume of international trade. These authors show that this correlation does not just reflect the relabeling of interregional trade as international trade when countries split. In fact, a similar pattern of correlation holds if one mea- sures world trade integration by the volume of international trade among countries that did not change their borders. Alesina and Spolaore (2002) discuss these issues in detail and present current and historical evidence on the relationship between country formation and international trade. The number of independent currencies has increased substantially, un- til recently almost at the same pace as the number of independent coun- tries. In 1947, there were 65 currencies in circulation, whereas in 2001 there were 169. Between 1947 and 2001, the ratio of the number of currencies to the number of countries remained roughly constant at about 85%. Twelve of these currencies, in Europe, have now been replaced by the euro, so we now have 158 currencies. The increase in the number of countries and the deepening of economic integration should generate a tendency to create multicountry currency areas, unless one believes that a country always defines the optimal cur- rency area. One implication of Mundell's analysis is that political borders and currency boundaries should not always coincide. In fact, as discussed in Alesina and Spolaore (2002), small countries can prosper in a world of free trade and open financial markets. Nevertheless, these small countries may lack the size needed to provide effectively some public goods that are subject to large economies of scale or to substantial externalities. A currency may be one of these goods: a small country may be too small for an independent money to be efficient. To put it differently, an ethnic, linguistic, or culturally different group can enjoy political independence by creating its own country. At the same time, this separate country can avoid part of the costs of being economically small by using other coun- tries to provide some public goods, such as a currency. A country constitutes, by definition, an optimal currency area only if one views a national money as a critical symbol of national pride and identity. Number of Countries 1 o ( -- 4 01 -o - o I I I I I I I I o ? - ? ?? 3 i I 0 0 2 P P I 1 -" 1 O i CAo 0 g "\ 3 p o p 0n 01 0 mtl m 0 U) r, tI 0 0 CO Trade to GDP Ratio OU,AXNHNII ~2 'OavaV 'VNISSIV * 90E 1870 1873 1876 1879 1882 1885 1888 1891 1894 1897 1900 1903 1906 1909 1912 1915 1918 1921 1924 1927 1933 1936 1939 1942 1945 1951 1957 1975 1978 1981 1987 1993 1996 s I' , i, I ' 41 41 ) _ I I I I o o o o o & Mj CO :0. Optimal Currency Areas ? 309 anchor plus the change (positive or negative) in its price level relative to that of the anchor. In other words, if the inflation rate in the United States is 2%, then in Panama it will be 2% plus the change in relative prices between Panama and the United States. Therefore, even if the anchor maintains domestic price stability, linkage to the anchor does not guaran- tee full price stability for a client country. The most likely anchors are large relative to the clients. In theory, a small but very committed country could be a perfectly good anchor. How- ever, ex post, a small anchor may be subject to political pressure from the large client to abandon the committed policy. From an ex ante perspec- tive, this consideration disqualifies the small country as a credible anchor. In summary: The countries that stand to gain the most from giving up their currencies are those that have a history of high and volatile inflation. This kind of history is a symptom of a lack of internal discipline for mone- tary policy. Hence, to the extent that this lack of discipline tends to persist, such countries would benefit the most from the introduction of external discipline. Linkage to another currency is also more attractive if, under the linked system, relative price levels between the countries would be relatively stable. 3.3 STABILIZATION POLICIES The abandonment of a separate currency implies the loss of an indepen- dent monetary policy. To the extent that monetary policy would have contributed to business-cycle stabilization, the loss of monetary indepen- dence implies costs in the form of wider cyclical fluctuations of output. The costs of giving up monetary independence are lower the higher the association of shocks between the client and the anchor. The more the shocks are related, the more the policy selected by the anchor will be appropriate for the client as well. What turns out to matter is not the correlation of shocks per se, but rather the variance of the client country's output expressed as a ratio to the anchor country's output. This variance depends partly on the correlation of output (and, hence, of underlying shocks) and partly on the individual variances of outputs. For example, a small country's output may be highly correlated with that in the United States. But, if the small country's variance of output is much greater than that of the United States, then the U.S. monetary policy will still be inap- propriate for the client. In particular, the magnitude of countercyclical monetary policy chosen by the United States will be too small from the client's perspective. The costs implied by the loss of an independent money depend also on the explicit or implicit contract that can be arranged between the an- chor and its clients. We can think of two cases. In one, the anchor does 310 * ALESINA, BARRO, & TENREYRO not change its monetary policy regardless of the composition and experi- ence of its clients. Thus, clients that have more shocks in common with the anchor stand to lose less from abandoning their independent policy but have no influence on the monetary policy chosen by the anchor coun- try. In the other case, the clients can compensate the anchor to motivate the selection of a policy that takes into account the clients' interests, which will reflect the shocks that they experience. The ability to enter into such contracts makes currency unions more attractive. However, even when these agreements are feasible, the greater the association of shocks be- tween clients and anchor, the easier it is to form a currency union. Spe- cifically, it is cheaper for a client to buy accommodation from an anchor that faces shocks that are similar to those faced by the clients.9 The alloca- tion of seignorage arising from the client's use of the anchor's currency can be made part of the compensation schemes. The European Monetary Union is similar to this arrangement with com- pensation, because the monetary policy of the union is not targeted to a specific country (say Germany), but rather to a weighted average of each country's shocks, that is, to aggregate euro-area shocks. In the discussion leading up to the formation of the European Monetary Union, concerns about the degree of association among business cycles across potential members were critical. In practice, the institutional arrangements within the European Union are much more complex than a compensation scheme, but the point is that the ECB does not target the shocks of any particular country, but rather the average European shocks.10 In the case of developing countries, the costs of abandoning an indepen- dent monetary policy may not be that high, because stabilization policies are typically not well used when exchange rates are flexible. Recent work by Calvo and Reinhart (2002) and Hausmann, Panizza, and Stein (1999) suggests that developing countries tend to follow procyclical monetary policies; specifically, they tend to raise interest rates in times of distress to defend the value of their currency.1 To the extent that monetary policy is not properly used as a stabilization device, the loss of monetary in- dependence is not a substantial cost (and may actually be a benefit) for 9. Note that, in theory, a small country could be an ideal anchor because it is cheaper to compensate such an anchor for the provision of monetary services that are tailored to the interests of clients. However, as discussed before, a small anchor may lack credibility. 10. The European Union also has specific prescriptions about the allocation of seignorage. The amounts are divided according to the share of GDP of the various member countries. For a discussion of the European Central Bank policy objectives and how this policy relates to individual country shocks, see Alesina et al. (2001). 11. A literature on Latin America, prompted mostly by a paper by Gavin and Perotti (1997), has also shown that fiscal policy has the wrong cyclical properties. That is, surpluses tend to appear during recessions, and deficits during expansions. Optimal Currency Areas * 311 developing countries. However, recent work by Broda (2001) shows that countries with floating-exchange-rate systems show superior perfor- mance in the face of terms-of-trade shocks. This pattern may reflect the benefits from independent monetary policies. To summarize, the countries that have the largest comovements of out- puts and prices with potential anchors are those with the lowest costs of abandoning monetary independence. 3.4 TRADE, GEOGRAPHY, AND COMOVEMENTS Countries that trade more can benefit more from currency unions for the reasons already discussed. Increased trade may also raise the comove- ments of outputs and prices. In this case, there is a second reason why countries that trade more would have a greater net benefit from adopting a currency union. An established literature on the gravity model of trade shows that bilat- eral trade volumes are well explained by a set of geographical and eco- nomic variables, such as the distance between the countries and the sizes and incomes of the countries. Note that the term "distance" has to be interpreted broadly to include not only literal geographical distance, but also whether the countries share a common language, legal system, and so on. In addition, some geographical variables may influence comove- ments of outputs and prices beyond their effects through trade. For exam- ple, locational proximity and weather patterns may relate to the nature of underlying shocks, which in turn influence the comovements. Whether more trade always means more comovements of outputs and prices is not a settled issue. On the theoretical side, the answer depends largely on whether trade is interindustry or intraindustry. In the latter case, more trade likely leads to more comovements. However, in the for- mer case, increased trade may stimulate sectoral specialization across countries. This heightened specialization likely lowers the comovements of outputs and prices, because industry-specific shocks become country- specific shocks.12 The type of trade between two countries is also likely influenced by the levels of per capita GDP; for example, intraindustry trade tends to be much more important for rich countries. In summary, geographical or gravity variables affect bilateral trade and, as a result, the costs and benefits of currency unions. Some geographical variables may have an effect on the attractiveness of currency unions be- yond those operating through the trade channel. 12. See Frankel and Rose (1998) for the argument that more trade favors more correlated business cycles. See Krugman (1993) for the opposite argument. For an extensive theoret- ical and empirical discussion of these issues, see Ozcan, Sorensen, and Yosha (2001, 2002) and Imbs (2000). 314 - ALESINA, BARRO, & TENREYRO 5. Which Currency Areas? In this section, we sketch "natural" currency areas, based on the criteria discussed above. For anchor currencies, we consider the U.S. dollar, the euro, and the yen. We are not assuming that all countries have to belong to one of the unions centered around these three currencies. In fact, many countries turn out not to be good clients for any of the anchors and seem to be better off keeping their own currency. Therefore, we are addressing the question of which countries would be better served by joining some currency union, as well as the question of which anchor should be chosen if one is needed. 5.1 INFLATION, TRADE, AND COMOVEMENTS We begin in Table 1 by showing the average inflation rate, using the GDP deflator, for selected countries and groups in our sample from 1970 to 1990. We stopped at 1990 because in the 1990s several countries adopted currency arrangements, such as the EMS, that contributed to reduced in- flation. We are interested here mostly in capturing inflation rates that would arise in the absence of a monetary anchor. We take the 1970s and 1980s (that is, after Bretton Woods and before the recent emphasis on nominal anchors) as a period with few true monetary anchors. We show the 20 countries with the highest average inflation rates, along with the averages for industrialized countries and for regional groups of devel- oping countries. The top average rates of inflation are all Latin American countries, and 7 Latin American countries are in the top 11. The top 5 countries had an average annual inflation rate above 280%. Despite its poor economic performance in other dimensions, Africa does not have a very high aver- age inflation rate. While there are 6 African countries in the top 20, the average for the continent is brought down by the countries in the CFA franc zone, which have relatively low inflation records. The Middle East is the second highest inflation group, with two countries, Israel and Leba- non, in the top 13 with inflation rates of 78% and 44%, respectively. In the euro zone, Greece and Italy lead in the rankings, with inflation rates of 16% and 13%, respectively. Overall, 11 countries had an average an- nual inflation rate above 50%, 30 countries above 20%, and 72 countries above 10%. Table 2 shows inflation variability and is organized in the same way as Table 1. Since average inflation and inflation variability are strongly positively correlated, 16 of the top 20 countries in Table 1 are also in the top 20 of Table 2. However, in some cases, such as Chile, the high average inflation rate (107%) reflected one episode of hyperinflation followed by relative stability. In others, such as Colombia, the fairly high average in- Optimal Currency Areas ? 315 Table 1 MEAN ANNUAL INFLATION RATE 1970-1990a Region Rate (%/yr) High-Inflation Countriesb Nicaragua 1168 Bolivia 702 Peru 531 Argentina 431 Brazil 288 Vietnam 213 Uganda 107 Chile 107 Cambodia 80 Israel 78 Uruguay 62 Congo, Dem. Rep. 49 Lebanon 44 Lao PDR 42 Mexico 41 Mozambique 41 Somalia 40 Turkey 39 Ghana 39 Sierra Leone 34 All Industrial Countriesc Developing Countriesc Africa Asia Europe Middle East Western Hemisphere 9.8 16.3 17.4 6.9 19.6 98.6 aBased on GDP deflators. Source: WDI 2001. b This group includes only countries with 1997 population above 500,000. Ranked by inflation rate. c Unweighted means. flation rate (22%) resulted from a long period of moderate, double-digit inflation. Tables 3, 4, and 5 list for selected countries and groups the average trade-to-GDP ratios16 over 1960-1997 with three potential anchors for cur- rency areas: the United States, the euro area (based on the twelve mem- 16. The trade measure is equivalent to the average of imports and exports. Glick and Rose's (2002) values come from averaging four measures of bilateral trade (as reported for im- ports and exports by the partners on each side of both transactions). 316 * ALESINA, BARRO, & TENREYRO Table 2 INFLATION-RATE VARIABILITY 1970-1990a Region Variability (%/yr) Countries with High Inflation Variabilityb Nicaragua 3197 Bolivia 2684 Peru 1575 Argentina 749 Brazil 589 Chile 170 Vietnam 160 Israel 95 Cambodia 63 Uganda 63 Mozambique 52 Somalia 50 Oman 46 Lebanon 41 Kuwait 38 Uruguay 38 Guinea-Bissau 37 Mexico 37 Guyana 36 Congo, Dem. Rep 36 Industrial Countriesc All 4.6 Developing Countriesc Africa 13.9 Asia 14.0 Europe 6.6 Middle East 28.4 Western Hemisphere 251.2 a Standard deviation of annual inflation rates, based on GDP deflators. Source: WDI 2001. b This group includes only countries with 1997 population above 500,000. Ranked by standard deviation of inflation. c Unweighted means. Optimal Currency Areas ? 319 Table 5 AVERAGE TRADE-TO-GDP RATIO WITH JAPAN, 1960-1997a Region Ratio (%) High-Trade-Ratio Countriesb Oman 16.0 United Arab Emirates 15.7 Panama 14.1 Singapore 12.8 Kuwait 9.5 Malaysia 9.5 Papua New Guinea 9.2 Bahrain 8.4 Saudi Arabia 8.0 Hong Kong, China 7.9 Indonesia 7.8 Swaziland 6.5 Thailand 5.6 Gambia, The 5.5 Mauritania 5.4 Iran, Islamic Rep. 5.4 Philippines 4.8 Korea, Rep. 4.1 Nicaragua 3.9 Fiji 3.7 Industrial Countriesc All 0.8 Developing Countriesc Africa 1.4 Asia 5.5 Europe 0.3 Middle East 6.1 Western Hemisphere 2.0 a Trade is the average of imports and exports. (Im- ports is the average of the values reported by the importer and the exporter. Idem for exports.) Av- erages are for 1960-1997 (when GDP data are not available, the average corresponds to the period of availability). Source: Glick and Rose (trade values); WDI 2001 (GDP). bThis group includes only countries with 1997 population above 500,000. c Unweigted means. 320 * ALESINA, BARRO, & TENREYRO bers), and Japan. The GDP value in the denominator of these ratios refers to the country paired with the potential anchor. The tables show that Japan is an economy that is relatively closed; moreover, in comparison with the United States and the euro region, Ja- pan's trade is more dispersed across partners. Hence, few countries ex- hibit a high trade-to-GDP ratio with Japan. Notably, industrial countries' average trade share with Japan is below 1%. Among developing coun- tries, oil exporters have a high trade share with Japan, but still below that with the Euro 12. Singapore, Malaysia, Hong Kong, and Indonesia exhibit relatively high trade-to-GDP ratios with Japan (above 7%), but Singapore and Hong Kong trade even more with the United States. For the United States, aside from Hong Kong and Singapore, a good portion of Latin America has a high ratio of trade to GDP. Canada is notable for trading almost exclusively with the United States; its trade ratio is 18%, compared with 1.7% for the Euro 12 and 1.4% for Japan. African countries, broadly speaking, trade significantly more with Europe, but some of them, such as Angola and Nigeria, are also closely linked with the United States. Tables 6, 7, and 8 report our measures of the comovements of prices for selected countries with the United States, the Euro 12 area, and Japan.17 Remember that a larger number means less comovement. Panama and Puerto Rico, which use the U.S. dollar, have the highest comovements of prices with the United States. These two are followed by Canada and El Salvador, which has recently dollarized. Members of the OECD have fairly high price comovements with all three of the potential anchors (which are themselves members of the OECD). For Japan, the countries that are most closely related in terms of price comovements lack a clear geographical distribution. For the Euro 12, the euro members and other western European countries have a high degree of price comovement. African countries also have relatively high price comovements with the Euro 12, higher than that with the United States. Tables 9, 10, and 11 report our measures of the comovements of outputs (per capita GDPs) for selected countries with the United States, the Euro 12 area, and Japan.18 The general picture is reasonably similar to that for prices. Note that all of the OECD countries have relatively high output comovements with the three anchors, particularly with the Euro 12. Ja- pan's business cycle seems to be somewhat less associated with the rest of the world: even developing countries in Asia tend to exhibit, on aver- age, higher output comovements with the Euro 12. The regional patterns 17. Recall that we compute comovements only for pairs of countries for which we have at least 20 annual observations. 18. As for prices, we consider only pairs of countries for which we have at least 20 observations. Optimal Currency Areas ? 321 Table 6 COMOVEMENT OF PRICES WITH THE UNITED STATES, 1960-1997a Region VP High-Comovement Countriesb Puerto Rico 0.0193 Panama 0.0244 Canada 0.0335 El Salvador 0.0340 Singapore 0.0444 Thailand 0.0529 Guinea 0.0545 Bahrain 0.0563 Hong Kong, China 0.0566 Honduras 0.0571 Malaysia 0.0609 Saudi Arabia 0.0646 Australia 0.0664 Fiji 0.0666 Hungary 0.0673 Egypt, Arab Rep. 0.0681 Cyprus 0.0687 Tunisia 0.0689 New Zealand 0.0691 Norway 0.0671 Industrial Countriesc All 0.0830 Developing Countriesc Africa 0.1445 Asia 0.0913 Europe 0.1107 Middle East 0.1348 Western Hemisphere 0.1040 a The table shows the value VP, the standard error of the residual for the AR(2) regression for the log of the real exchange rate. In some cases, the sample differs from 1960-1997. bThis group includes only countries with 1997 population above 500,000. c Unweighted means. 324 * ALESINA, BARRO, & TENREYRO Table 9 COMOVEMENT OF OUTPUTS WITH THE UNITED STATES, 1960-1997a Region VY High-Comovement Countriesb Canada 0.0135 United Kingdom 0.0150 Australia 0.0175 Germany 0.0196 Netherlands 0.0197 France 0.0200 Colombia 0.0205 Puerto Rico 0.0216 Denmark 0.0217 Norway 0.0224 Italy 0.0230 Spain 0.0238 Honduras 0.0251 Belgium 0.0253 Sweden 0.0254 Switzerland 0.0256 Costa Rica 0.0258 Austria 0.0261 Japan 0.0265 Guatemala 0.0265 Industrial Countriesc All 0.0251 Developing Countriesc Africa 0.0591 Asia 0.0524 Europe 0.0449 Middle East 0.0749 Western Hemisphere 0.0442 The table shows the value of VY, the standard er- ror of the residual for the AR(2) regression for the log of the ratio of real per capita GDPs. In some cases, the sample differs from 1960-1997. b This group includes only countries with 1997 population above 500,000. c Unweighted means. Optimal Currency Areas * 325 Table 10 COMOVEMENT OF OUTPUTS WITH THE EURO 12, 1960-1997a Region VY High-Comovement Countriesb France 0.0094 Belgium 0.0108 Netherlands 0.0116 Austria 0.0131 Colombia 0.0145 Italy 0.0154 Germany 0.0154 Sweden 0.0165 Spain 0.0165 Switzerland 0.0168 United Kingdom 0.0170 Denmark 0.0177 United States 0.0185 Canada 0.0187 Japan 0.0202 Puerto Rico 0.0205 Norway 0.0210 Guatemala 0.0220 Australia 0.0222 Cyprus 0.0227 Industrial Countriesc All Developing Countriesc 0.0198 Africa 0.0557 Asia 0.0500 Europe 0.0421 Middle East 0.0713 Western Hemisphere 0.0426 a The table shows the value of VY, the standard er- ror of the residual for the AR(2) regression for the log of the ratio of real per capita GDPs. In some cases, the sample differs from 1960-1997. For a member of the Euro 12, the comovement is in rela- tion to the other 11 countries. bThis group includes only countries with 1997 population above 500,000. c Unweighted means. 326 * ALESINA, BARRO, & TENREYRO Table 11 COMOVEMENT OF OUTPUTS WITH JAPAN, 1960-1997a Region VY High-Comovement Countriesb France 0.0214 United Kingdom 0.0217 Germany 0.0229 Austria 0.0234 Netherlands 0.0235 Italy 0.0236 Belgium 0.0243 Colombia 0.0252 Australia 0.0254 Sweden 0.0256 Greece 0.0260 Switzerland 0.0262 Puerto Rico 0.0262 Denmark 0.0265 United States 0.0265 Sri Lanka 0.0271 Spain 0.0272 Thailand 0.0282 Cyprus 0.0286 Canada 0.0296 All Industrial Countriesc Developing Countriesc 0.0282 Africa 0.0596 Asia 0.0541 Europe 0.0443 Middle East 0.0748 Western Hemisphere 0.0463 a The table shows the value of VY, the standard er- ror of the residual for the AR(2) regression for the log of the ratio of real per capita GDPs. In some cases, the sample differs from 1960-1997. bThis group includes only countries with 1997 population above 500,000. c Unweighted means. Sierra Leone Guinea-Bissau Ecuador Colombia Guyana Costa Rica Venezuela, RB Paraguay Nigeria Jamaica Portugal Iran, Islamic Rep. Oman Greece Dominican Republic Indonesia 34 30 25 23 22 20 18 18 18 17 16 16 16 16 15 15 0.049 0.123 0.025 0.207 0.014 0.275 0.018 0.156 0.099 0.043 0.017 0.072 0.045 0.027 0.006 0.071 0.230 0.094 0.035 0.117 0.113 0.049 0.013 0.109 0.117 0.040 0.010 0.112 0.024 0.034 0.008 0.109 0.150 0.228 0.025 0.160 0.194 0.031 0.011 0.113 0.011 0.077 0.003 0.083 0.031 0.123 0.054 0.479 0.036 0.177 0.160 0.125 0.008 0.061 0.006 0.075 0.168 0.031 0.011 0.096 0.040 0.028 0.078 0.122 a Only countries with population above 500,000 are considered. For Euro 12 members, comovements are computed in relation to the other 11 countries. High- inflation countries with no data on VY or VP are not reported in the table. 0.254 0.142 0.114 0.098 0.155 0.110 0.144 0.119 0.195 0.135 0.048 0.467 0.145 0.051 0.114 0.148 0.249 0.174 0.113 0.116 0.151 0.141 0.147 0.125 0.213 0.145 0.096 0.497 0.162 0.097 0.134 0.151 0.058 0.063 0.042 0.020 0.058 0.026 0.044 0.037 0.082 0.050 0.035 0.073 0.120 0.029 0.057 0.031 0.050 0.063 0.040 0.014 0.058 0.029 0.040 0.034 0.070 0.046 0.028 0.066 0.118 0.024 0.053 0.030 0.056 0.062 0.041 0.025 0.062 0.040 0.043 0.040 0.079 0.044 0.030 0.069 0.112 0.026 0.056 0.033 330 * ALESINA, BARRO, & TENREYRO Table 13 HIGH-INFLATION COUNTRIES: BEST ANCHOR BASED ON THE THREE CRITERIA Mean annual inflation rate Country (%) Trade VP VY Nicaragua 1168.4 U.S. U.S. Euro Bolivia 702.4 U.S. U.S. U.S. Peru 530.7 U.S. Euro Euro Argentina 430.8 Euro Euro Euro Brazil 288.4 U.S. U.S. Euro Chile 106.9 Euro U.S. U.S. Israel 78.2 Euro U.S. Euro Uruguay 62.2 Euro Euro U.S. / Euro Congo, Dem. Rep. 48.7 Euro Euro Euro Mexico 41.0 U.S. U.S. Euro / Japan Turkey 39.4 Euro Euro U.S. Ghana 38.7 Euro U.S. Euro Sierra Leone 34.2 Euro U.S. Euro Guinea-Bissau 30.5 Euro Euro Japan Ecuador 25.0 U.S. U.S. Euro Colombia 22.7 U.S. U.S. Euro Guyana 22.3 U.S. U.S. Euro Costa Rica 20.0 U.S. U.S. U.S. Venezuela 18.5 U.S. U.S. Euro Paraguay 17.8 Euro U.S. Euro Nigeria 17.5 Euro U.S. Euro Jamaica 16.6 U.S. U.S. Japan Portugal 16.2 Euro Euro Euro Iran 16.1 Euro Euro Euro Oman 16.0 Euro U.S. Japan Greece 15.6 Euro Euro Euro Dominican Republic 15.1 U.S. U.S. Euro Indonesia 15.0 Japan U.S. Euro The table excludes countries with 1997 population below 500,000 and countries for which VP or VY is not available. Bold values apply if (1) highest trade share less second-highest trade exceeds 0.04, (2) magnitude of difference between lowest VP and next-lowest VP exceeds 0.025, or (3) magnitude of difference between lowest VY and next-lowest VY exceeds 0.005. Table 13 summarizes the information from Table 12 by listing for each of the three criteria (trade, price comovement, and output comovement) which of the three anchors is best. A boldface entry means that the chosen anchor is much superior to the other two; a lightface entry means that the difference from at least one other anchor is small. More specifically, a bold entry in the trade column means that the highest trade share with one of the three potential anchors is more than 4 percentage points higher Optimal Currency Areas * 331 than that of the second of the three. In the case of price comovements, a bold entry means that the absolute value of the difference between the most associated of the three and the second one is larger that 0.025. For the output comovement, the same definition applies with a cutoff of 0.005. These cutoff choices are arbitrary, but the reader, using the data reported in Table 12, can calculate another cutoff. These criteria emphasize the choice among potential anchors, rather than the choice of whether to re- tain an independent currency. Several interesting observations emerge from Table 13. First, Japan is not an attractive anchor for virtually any of the high-inflation countries. Out of 96 entries in the table, only 8 (which includes one tie) are for Japan. No case has more than one of the criteria in favor of Japan. Second, high-inflation Latin American countries are by no means a clear dollarization bloc. In fact, Brazil might be better served by adopting the euro. (Although there is no clear superiority in terms of trade or price comovements, the euro performs better in terms of comovement of out- put.) The case of Argentina is interesting: having one of the highest infla- tion rates, this country seems to be one of the best examples of a place with a high demand for an external currency anchor. However, as shown in Table 12, Argentina has been largely closed to international trade, and its output and price comovements are not high with any of the three po- tential anchors. So, other than its lack of commitment ability, Argentina does not appear to be an obvious member of a currency union with the euro or the U.S. dollar. In contrast, Mexico and Ecuador look much closer to the U.S. dollar than to the euro. The same conclusion applies to the Dominican Republic. Nicaragua has low comovements with all three an- chors, but its exports go mostly to Europe. Hence, the euro might be a better choice than the U.S. dollar. Chile and Uruguay have higher exports to Europe, but they have larger comovements with the United States. Third, looking at countries at the geographical boundaries of Europe, in some cases their natural anchor is the euro: this conclusion applies to Greece (which has joined the euro zone) and Turkey. Israel might be a good candidate for the euro, although it could also be well served by the U.S. dollar. As for Africa, trade shares are much higher with Europe. Comovements are, however, just as high with the United States. Ghana, Guinea-Bissau, and Sierra Leone seem to be natural euro clients, but other African countries are less clear. We have measured lack of ability to commit according to past inflation experience. One could also look at institutional measures of potential commitment, such as the degree of central-bank independence. However, although this measure has some explanatory power for inflation perfor- 334 * ALESINA, BARRO, & TENREYRO Table 14 CONTINUED Best anchor Country Tradea VPb VYb Sierra Leone Euro U.S. Euro Singapore U.S. /Japan U.S. Euro Sweden Euro Euro Euro Switzerland Euro Euro Euro Syrian Arab Republic Euro U.S. Euro Togo Euro Euro Euro Trinidad and Tobago U.S. U.S. Euro Tunisia Euro Euro Euro United Arab Emirates Japan / Euro U.S. Euro Venezuela, RB U.S. U.S. Euro a The table excludes countries with 1997 population below 500,000 and countries for which VP or VY is not available. The best anchor according to the trade criterion is shown only when the trade share exceeds 9%. When there is more than one anchor country for which the trade share exceeds 9%, we list the anchors in descending order of the trade shares. b Bold values apply if the magnitude of the difference between the lowest VP and the next-lowest VP exceeds 0.025 or the magnitude of the difference between the lowest VY and the next-lowest VY exceeds 0.005. any anchor is her history of high inflation. (3) There does not seem to be any clear yen area. (4) There are several countries that do not appear in Tables 12-14. These are countries with low inflation that do not trade much with any of the three potential anchors. Primary examples are India, Australia, and New Zealand. It is worthwhile to compare our results briefly with those of Ghosh and Wolf (1994), who use a different approach to assess the pros and cons for regions and countries to form currency unions. They argue that optimal currency areas are typically formed by countries that are geographically disconnected. For example, they conclude that Europe and the states of the United States are not optimal currency areas. We have not examined the U.S. states, but Europe does present a good case for a currency union based on our examination of the patterns of trade and comovements of prices and outputs. More generally, despite some exceptions, geographi- cal proximity typically fits well with our criteria for currency unions. The differences between our findings and those of Ghosh and Wolf seem to arise because they do not emphasize the link between currency unions and trade and because they assume a very high cost from imperfect syn- chronization of business cycles. Ideally, we would go beyond the simple criteria thus far advanced to evaluate the relative costs and benefits of the trade-off leading to the choice of currency adoption. For example, should a country such as Optimal Currency Areas ? 335 Argentina with high inflation but low comovements with the United States and the euro zone remain autonomous or use the dollar or the euro? How much can trade benefits of a currency union compensate for the loss of monetary autonomy? To answer these questions, we need more quantitative information than we have yet generated. 6. What Changes with Currency Adoption? Thus far, we have discussed the possible configuration of currency areas based on the behavior of inflation, trade, and the comovements of prices and outputs that prevail (in most cases) before the creation of a currency union. In choosing whether to join a monetary area, a potential entrant would have to estimate the values of trade and comovements that would apply after the entry. In practice, this calculation is difficult-for the po- tential entrant and also for the econometrician.22 In the next section, we discuss estimates of effects from joining a currency union on international trade flows. Then we discuss some new estimates of effects of currency union on trade and on comovements of prices and outputs. 6.1 CURRENCY UNIONS AND INTERNATIONAL TRADE: THE AVAILABLE EVIDENCE Most of the existing empirical work on the effects of currency unions on trade flows has been framed in the context of the standard gravity model. According to this approach, the bilateral trade between a pair of countries is increasing in their GDPs and is inversely related to their distance, broadly construed to include all factors that create "trade resistance." The gravity equation is then augmented with a dummy variable indicating whether or not the countries share the same currency. The estimate of the coefficient on this dummy is interpreted as the currency-union effect. In the seminal paper in this area, Rose (2000) reports that bilateral trade be- tween two countries that use the same currency is, controlling for other effects, over 200% larger than bilateral trade between countries that use different currencies. The apparently large effect of currency unions on trade is surprising, because estimates of the effect of reduced exchange-rate volatility on trade are small [see, for example, De Grauwe and Skudelny (2000), Frankel and Wei (1992), and Eichengreen and Irwin (1995)]. Moreover, fees on cur- rency conversion are typically a small percentage of total transaction 22. Issing (2001) argues that one should expect that prices and outputs will move more closely together in the European Union after the adoption of the euro. 336 ? ALESINA, BARRO, & TENREYRO Table 15 EMPIRICAL STUDIES OF THE EFFECT OF CURRENCY UNION ON TRADE Point estimate of increased trade from Authors Significancea currency union Rose (2000) s 240% Frankel and Rose (1998) s = 290% Engel and Rose (2002) s - 240% Persson (2001) ns - 40% Tenreyro (2001) ns 60% Pakko and Wall (2001) ns ~ -55% Glick and Rose (2002) s - 100% Rose and van Wincoop (2001) s = 140% Rose (2002) ns, s -68% to +708% Lopez-Cordova and Meissner (2001) s - 100% Levy (2001) s = 50% Nitsch (2002) s = 85% Flandreau and Maurel (2001) s - 220% Klein (2002) s ~ 50% a = statistically significantly different from zero, ns = not significant. costs.23 On the other hand, as already discussed, border effects on trade are large, and perhaps these large effects can be explained by the necessity to use different currencies on the two sides of a border. Numerous empirical studies, summarized in Table 15, have examined and extended Rose's research. Pakko and Wall (2001) focus on time-series variation, which involves cases in which currency union is either imple- mented or abandoned. Their findings reveal a negative, though insignifi- cant, effect of currency union on trade. However, Glick and Rose (2002) use an expanded panel data set that includes more episodes of regime switching. With this set, they find large and positive estimates from the time-series variation. Rose (2002) provides new estimates of the effect of currency unions on trade, making use of the time-series as well as cross-sectional variation in the data. This study reports a wide range of estimates, using different samples and techniques. Point estimates range from a negative, though insignificant, effect of -68%, using fixed effects in the original sample, to a 708% effect using a matching sample technique and a much broader database. Rose and van Wincoop (2001), Nitsch (2002), Melitz (2001), Klein (2002), 23. The argument that currency conversion fees are low may not apply to trade in capital, where the currency turnover is extremely high and hence small proportionate costs can translate into large disbursements. Optimal Currency Areas - 339 Table 16 PROPENSITY TO ADOPT THE CURRENCY OF MAIN ANCHORS Marginal Std. effect at Statistic Coefficient error mean min(log per capita GDP in pair) -0.1586* 0.061 -0.0015 max(log per capita GDP in pair) 1.7167* 0.385 0.0163 min(log population in pair) -0.1352* 0.048 -0.0013 max(log population in pair) 0.2372 0.127 0.0023 min(log area in pair) -0.0546 0.046 -0.0005 max(log area in pair) 0.2181* 0.072 0.0021 Regional-trade-agreement dummy -0.8864* 0.277 -0.0032 log distance (km) -0.8766* 0.143 -0.0083 Border contiguity dummy -1.2398* 0.619 -0.0033 Landlocked-client dummy -0.1522 0.242 -0.0013 One-island-in-pair dummy 0.0226 0.240 0.0002 Two-islands-in-pair dummy 1.1880* 0.437 0.0512 Common-language dummy 0.7487* 0.216 0.0124 Ex-colony-colonizer dummy 1.8799* 0.285 0.1369 Current-colony (or territory) dummy 0.8491* 0.239 0.0253 Pseudo R2 0.473 Number of observations 29,564 Dependent variable: currency-union dummy. The sample consists of country pairs that include the four candidate anchors: Australia, France, the United Kingdom and the United States. The equations are for annual data from 1960 to 1997, include year effects, and allow for clustering over time for country pairs. The definition of currency union treats the CFA franc countries as linked to France and treats the ECCA countries as linked to the United States since 1976 and to the United Kingdom before 1976. The mean of the currency-union dummy for this is 0.051. For the sample that regards the CFA countries as unlinked to France and the ECCA countries as unlinked to the United States or the United Kingdom, the mean is 0.024. The last column shows the marginal effect, evaluated at the sample mean, of each explanatory variable on the estimated probability of a currency union. For dummy variables, the effect refers to a shift from zero to one. * Statistically significant at 1% level. ables) also enter directly into the determinants of bilateral trading volume. Hence, Tenreyro (2002) adopts an indirect approach. Consider any potential client country, i, which is evaluating the adop- tion of a currency with one of the four anchors considered, denoted by k = 1, 2, 3, 4. The probit regression determines the estimated probability, p(i, k), of the currency adoption. This probability depends on the distance between i and k and the other variables mentioned above. If the countries take their currency-union decisions independently, then the joint proba- bility that i and j use the currency of anchor k will be given by Jk(i j) = p(i, k)p(j, k). Note that Jk(i, j) will be high if countries i and j are both close to potential anchor k. The idea, for example, is that Ecuador and El Salvador currently 340 * ALESINA, BARRO, & TENREYRO share a common money (the U.S. dollar) not because they are close to each other, but rather because each is close to the United States, and hence each was independently motivated to adopt the U.S. dollar. The joint probability that i and j use the same foreign currency (among the four candidates considered) will then be given by the sum of the joint probabilities over the support of potential anchors k:26 4 4 (i, j) = >Jk(i, j) = >p(i, k)p( j, k) k=l k=l One can then use the variable J(i, j) as an instrument for the currency- union dummy, for example, in equations for bilateral trade between coun- tries i and j. The underlying assumption for the validity of this instrument is that the bilateral trade between countries i and j depends on bilateral gravity variables for i and j but not on gravity variables involving third countries, notably those associated with the potential anchor countries k. These gravity variables involving third countries affect the propensity of countries i and j to be part of the same currency zone and thereby influ- ence bilateral trade between i and j through that channel. However, these variables do not (by assumption) directly influence the bilateral trade be- tween i and j. Tenreyro (2002) uses the new instrument for the currency-union dummy to estimate relations for pairs of countries for trading volume, comovement of prices, and comovement of outputs. We present some of these results in Table 17, which, for brevity, reports only the estimated coefficients of the currency-union variable. For bilateral trade, the results use annual data from 1960 to 1997 for all pairs of countries. Taking account of data availability, this system com- prises over 300,000 observations (when we include the roughly half of the sample that has zeros for bilateral trade). The dependent variable is measured as log(trade + positive constant), where the presence of the positive constant allows us to include the zero-trade observations in the regressions. For the results shown in Table 17, the constant is set to 100 1995 U.S. dollars. The system includes as independent variables a set of usual gravity measures-log of geographical distance, membership in a regional trade agreement, common language, former and current colonial relationship, common colonizer, common border, and island and land- locked status-along with the logs of GDP per capita, population, and 26. For a pair of anchors, say, k1 and k2, the probability is J(kl, k2) = p(k2, k2)[1 - p(kl, k3) p(k1, k4)] + p(ki, k2)[l - p(k2, k3) - p(k, k,)] + =3 p(kl, k3)p(k2, k3). Optimal Currency Areas * 341 Table 17 ESTIMATED COEFFICIENTS OF CURRENCY-UNION DUMMY IN VARIOUS SYSTEMS Coefficient (standard error) OLS with IV with System OLS country effects IV country effects log(bilateral trade + 100), 0.75 0.91 1.56 2.70 N = 348,295 (0.20) (0.18) (0.44) (0.44) Comovement of prices, 0.0690 0.0456 0.2433 0.0874 mean = -0.16, (0.0058) (0.0028) (0.0243) (0.0080) N = 9027 Comovement of outputs, 0.0029 0.0000 0.0119 -0.0020 means = -0.07, (0.0026) (0.0011) (0.0061) (0.0022) N = 7610 The equations for bilateral trade use annual data from 1960 to 1997, include year effects, and allow for clustering of the error terms over time for country pairs. The dependent variable is log(trade + 100), where trade is measured in 1995 U.S. dollars. The value 100 is close to the maximum-likelood estimate of the constant in the expression log(trade + constant). The explanatory variables included, aside from the currency-union dummy, are log(distance); dummy variables for contiguity, common language, colonial relationships, landlocked, and island; and the values for each country in the pair of log(per capita GDP), log(population), and log(area). The definition of currency union treats the CFA franc countries as linked to France and treats the ECCA countries as linked to the United States since 1976 and to the United Kingdom before 1976. Country effects refer to each member of the pair (not to a country pair). The instrumental variable (IV) systems include as an instrument for the currency-union dummy the variable described in the text. The equations for comovement include only one observation for each pair, corre- sponding to the period 1960-1997. The explanatory variables then refer to averages over time. Standard errors are in parentheses. area for each country in a pair.27 The OLS estimates of the gravity variables are typically significant.28 Table 17 shows that the estimated coefficient on the currency-union dummy variable is 0.75 (s.e. = 0.20) when country fixed effects are ex- cluded, and 0.91 (0.18) when country fixed effects (not country-pair ef- fects) are included. These results accord reasonably well with those presented by Rose (2000), despite two major differences in the ap- proaches. First, since he used log(trade) as the dependent variable, he discarded all of the zero-trade observations (which, as mentioned, consti- tute roughly half of the sample). Second, we defined the currency-union dummy more liberally than Rose, in that we treated the CFA franc coun- tries as in a union with the French franc and the ECCA countries as in a union with the U.S. dollar or the British pound (depending on the period). 27. 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Economic Policy, April: 7-46. . (2002). The effect of common currencies on international trade: A meta- analysis. Berkeley: University of California. Unpublished. , and E. van Wincoop. (2001). National money as a barrier to international trade: The real case for currency union. American Economic Review, May, 386- 390. Tenreyro, S. (2001). On the causes and consequences of currency unions. Harvard University. Unpublished. . (2002). Economic effects of currency unions. Harvard University. Unpub- lished. Thom, R., and B. Walsh. (2002). The effect of a currency union on trade: Lessons from the Irish experience, European Economic Review, June, 1111-1123. Comment RUDI DORNBUSCH Massachusetts Institute of Technology This is a very very aggressive paper, and accordingly, a great pleasure to discuss. Andy called me and asked: "How about I discuss the empirical issues and you focus on the rest?" Little did I know that the little bugger had read the paper and I hadn't. But let me stand by our agreement. This paper says Iraq is part of a U.S. currency union, and it pays a lot of attention to the Comoro Islands, wherever they are. I think this is like 346 DORNBUSCH looking under the light for the keys. You focus on trade because you have the trade data, and all other considerations must take second place. But the authors are not shy about assigning countries to currency unions. So I want to ask how sturdy those results might be if you looked at a few extra considerations. But before getting there they have acerbic remarks about nationalism. They say there are 100 extra countries and why the hell do they need a money? They ought to have a soccer team-or, even more expensive, an Olympic team-but why a money? I think they should go further and ask, why should we have these countries? Once we have these countries, don't be surprised they have a money, and a flag, and all the junk that goes with it. I think it's a reality that people who are very poor attach an unusual importance to nationalism. They have nothing else. So I would say, once you have the countries, take for granted that there has to be a compelling reason for them to give up their money-either many humili- ating experiences with trying to manage their own, or the total ascen- dancy of bureaucrats. I say that because the paper ambitiously says that Mexico is actively considering a monetary union or currency union with the United States. I don't think anyone in Mexico is actively thinking about that. They say it would be a really good idea, but forget about it, simply because of this nationalism issue. And I think the same is true in Peru. I was part of putting Peru on the dollar once, for three and a half hours. We had it there, and dessert was served and I had to go to the airport, and in the morning, it hadn't happened. I think that's sort of the likelihood of Peru, Mexico, and many others soon being on the dollar, after the Argentine example takes away the powerful credibility of dol- larization and gives nationalism the upper hand. So on the remarks about nationalism, I agree that countries don't need their own money, but be sure that nationalism is an enormously powerful argument, and will stand. A more technical concern I have with their allocation of countries is, let's say Poland doesn't belong in the euro zone. Now do the experiment, a slightly different experiment, and have the seven accession countries joining the euro zone. And in that experiment, what would happen? Well, my guess is that Poland would shift over and belong in the euro zone, because we go from the bilateral to the cross effects of all the countries who have more of a trade integration with Europe than Poland does. I think this is an interesting question to ask with this model in hand. What happens if you look at a group of three or four countries contemplating where they belong? Then the cross effects between them will matter, and Poland-once the effects of Hungary, the Czech Republic, and God knows what are included-will be much more Europe-oriented, and on Comment - 349 in the end we are really looking at retail prices, and that stuff isn't happen- ing. Do it for automobiles, and you will find that the problem is anti- competitive practices. The issue isn't borders per se, but rather that borders are a hook on which to hang anticompetitive practices, and I think that is an important difference. Let me ask four questions to finish, maybe three. Since the authors are happy to go forward and make currency unions out of the past correla- tions, let's go backward and ask, was the sterling area an optimal currency area? I think that's easy to do, it's interesting to do, and I don't really know what to believe. The second question is, poor Korea. I see those islands, the Comoro Islands prominently. I don't see Korea. And Korea searches its soul to know where it belongs. Does it belong in NAFTA? Does it belong in the Japanese monetary area that is actively being dis- cussed, actively being promoted, a north Asia monetary union? And the paper doesn't really get to that. I think that is the interesting question: the yen story. It involves China and Korea; it doesn't really have much to do with Indonesia. So that would be an interesting direction to look. Lastly, Canada is supposed to be in the dollar area, but Canada is very happy not to be, and people like Chretien get up every morning and say that it is really wonderful that they are not on the dollar because they get the extra cushion that a commodity currency needs of having some movements in the exchange rate. Switzerland every morning wakes up and says thanks be to God we are not in the European monetary union because we would have one percent higher interest rates if we were in and everybody would go bankrupt. So I think that finance is really three-quarters of the story, the terms of trade are ten percent, and the past correlations are sort of the residual. I think the paper is very challenging, and I think it is a good exercise to piece the world together and find out that 60 percent of the extra 100 countries are orphans, don't belong anywhere on the criterion we have, and are therefore an unsolved problem for international financial architecture. Comment ANDREW K. ROSE University of California at Berkeley and NBER 1. What's Here Currency unions are all the rage in international policy circles these days. But suppose a country-say Argentina (the crisis du jour)-decides that 350 ROSE it needs to adopt a foreign currency. Which one should it pick? Alesina, Barro, and Tenreyro provide the methodology, or at least most of it, to answer this important and interesting question. Their methodology is reasonable in a number of aspects. First, it is based on solid, standard theory. Second, it seems to yield mostly sensible results in practice. And third, the authors deal with the endogeneity issue carefully; that is, the potential ex post effect of currency union itself on the criteria used to judge the ex ante desirability of currency union. They focus on three key issues: (1) the benefits from enhanced international trade that currency unions bring; (2) the low inflation that clients get from joining a currency union with a low-inflation anchor; and (3) the potential effects of currency union on price and output comovements, which repre- sent the cost of more imperfectly stabilized business cycles. All this I find eminently plausible and valuable. 2. What's Not All modeling relies on abstraction, and this paper is no exception. There are some omissions which have been made deliberately but which may affect the results in practice. In particular, there are at least four poten- tially important issues that are absent from the analysis of Alesina, Barro, and Tenreyro. Least important is the fact that the authors do not consider the issue of factor mobility. Labor mobility in practice is glacial, both within country and across countries, for most of the world. Thus it is generally not considered as a response to the sorts of business-cycle shocks that monetary policy might handle (outside a currency union, that is). Still, homage to Mundell's original idea is appropriate for a paper with this title. A slightly more important consideration is the fact that monetary sover- eignty is the fiscal policy of last resort. Any country with its own currency retains the option of monetizing its national debt. This issue has not at- tracted much attention in the literature, but is clearly important for a number of the Latin-American countries that the authors are most inter- ested in. A more important omission is the issue of insurance. Regions (whether countries or areas within countries) may be insulated from idiosyncratic productivity shocks with an appropriate insurance system. At least two are widely considered to be important: a federal system of taxes and trans- fers of the type that we usually see within countries; and the private ex- change of financial claims. Growing international financial integration may alleviate the costs of national business cycles, especially if currency union spurs financial integration. I expect this issue to grow in importance over time, and I encourage the authors to pursue it. Comment * 351 The most striking issue is the intentional avoidance of financial issues such as liquidity, bailouts, moral hazard, corporate finance and banking issues, and the lender of last resort. As the authors show, there is no clear reason why Argentina and Brazil are part of the dollar bloc, if one does not consider the level of financial integration. Yet these countries are clearly members of the dollar zone, presumably because of their strong financial ties with the United States. Indeed, these issues have obsessed much of the recent literature on currency unions, mostly on a theoretical basis only. I would be more comfortable with the generality of the results here if they had considered financial issues. 3. What's the Question The results are mostly quite sensible. Using the criteria of inflation, trade, and price and output comovements, the authors find well-defined dollar and euro areas, although a few countries fall through the cracks. Their most striking result is that there is little evidence of any yen zone. Fine. But at least two issues arise immediately. The first is that there is no obvi- ous way to weigh the various criteria when they disagree about which currency union to join. What should be done when the criteria give con- flicting signals, as they do in certain important cases such as Brazil? Even more important is the question itself. Usually the issue is not which currency union to join but whether to join. Countries like Denmark, Swe- den, and the United Kingdom know that the issue is whether or not to join EMU. Similarly for Argentina, Canada, and Mexico, which are (at least vaguely) considering dollarization. The big payoff in this literature will be a methodology which allows a country to decide in practice, on the basis of quantitative economic criteria, when it makes sense for a coun- try to join. Alesina et al. have certainly made progress on this issue, but the work has not yet been finished. 4. What's Up While I believe most of the results in this paper, some are more plausible than others. The authors find larger effects than others (like me) have found in the nexus of price comovements, and smaller than those of others on business-cycle comovements. Fair enough; they use a new methodol- ogy and a better dependent variable. Their results become the new target. But speaking of targets, I cannot resist emphasizing the estimated ef- fects of currency union on trade that the authors tabulate in Table 17. These are large compared to those in the literature (summarized in Table 15). But mostly they are just large-enormous, in fact. The (preferred) instrumental-variable estimates are 1.56 (without country effects) and 2.70 354 * DISCUSSION cies, might be better provided on a larger scale, and speculated that na- tionalist sentiment about currencies might be changing. Ken Rogoff asked Alberto Alesina which public goods he thought of as most subject to substantial economies of scale. He was particularly curi- ous about the ranking of currency on the list. Alesina replied that there is a trade-off between economies of scale and sharing policy with people with different preferences. The point of the paper is to try to measure the exact trade-off between the two forces as regards monetary policy. Greg Mankiw asked how large countries with federal governments can be distinguished from small countries with shared public goods provided by supranational organizations. Alesina replied that decentralization can be thought of as a continuum, with a menu of policies that might be de- cided at different levels of aggregation. Bob Hall remarked on this point that California had its own currency for a long period of time. A number of participants voiced concern about endogeneity and the Lucas critique. Pointing to the instability of the coefficient on GDP co- movements in Table 17, Alan Stockman said he was particularly con- cerned that output comovements might be substantially affected by domestic monetary policy, and also that other domestic policies might be correlated with membership of a currency union. He noted that, ideally for the empirical strategy, one would like comovements to be generated by factors such as movements in international commodity prices. On this point, Eric van Wincoop responded that he did not think that endogeneity due to monetary policy is likely to be very serious. He said that the evidence points towards regions within countries comoving much more than countries not because of monetary policy, but because of the greater extent of trade within countries than across countries. Jonathan Parker took up Alan Stockman's concern about endogeneity. He asked whether the EU is unique in the extensive legal and regulatory changes that took place at the same time as EMU. He remarked that simul- taneous important changes in many spheres would make identification difficult. Pierre-Olivier Gourinchas remarked that the EU is one of the few places where economic reasons rather than historical accident drove the move towards a currency union. Silvana Tenreyro responded that, on the con- trary, there are other examples, such as Guinea-Bissau, which joined the CFA in 1987 in order to reduce inflation. Ken Rogoff raised the question of the irreversibility of currency unions. He noted that although in the past currency boards had been seen as irreversible, it had been proven that this is not the case. On a related point, Mark Gertler suggested that the output and price Discussion 355 comovement variables used by the authors might look very different if they were calculated over the period 1980-2000 instead of 1960-1997. In particular, he was worried that among OECD countries, comovements in the 1970s might have been driven mainly by oil shocks, and he also cited Stock and Watson's evidence of declining volatility in output and prices over the sample period. Alberto Alesina responded that comovements calculated over 1975-1997 do not differ much from those calculated over 1958-1997. He agreed that as a further robustness check, it might be inter- esting to look at comovements in the more recent past. He also noted that client-anchor comovements are the crucial variable in the paper, so the evidence on the OECD is not necessarily relevant. Gian-Maria Milesi-Ferretti commented that the fact that the data on bilateral trade are mainly on trade in goods, and do not include trade in services, could be affecting the results. He speculated that the tendency of some small countries to have large service exports in tourism and fi- nancial services could be biasing the results in one direction or another. He suggested that it might be possible to check this using better-quality data from industrial countries. Rudi Dornbusch raised the possibility of "special effects" currency unions, giving the example of a potential union of commodity currencies such as those of Australia, New Zealand, and Canada. He noted that the benefits of such a union would be more on the financial side than on the trade side. He commented that this is another way to think about coun- tries facing common shocks sharing a currency. Pierre-Olivier Gourinchas asked what is the evidence on trade diver- sion in the literature with regard to the effects of currency unions on bilat- eral trade. Silvana Tenreyro replied that Frankel and Rose had tested for trade diversion and found no evidence that it was present. Andy Rose responded that even if there were trade diversion, it would not have nega- tive welfare consequences, as the loss of transactions costs within a cur- rency union would result in efficiency gains. Takero Doi wondered whether Japan should join the dollar zone rather than create its own currency union. Alberto Alesina answered that the authors had not considered Japan as a client in search of an anchor. He noted that although Europe, the United States, and Japan have business cycles that are fairly highly correlated, the authors do not find plausible the idea that they would form a currency union. Lars Svensson was curious about the organization of central banks and the goals of monetary policy in small currency unions. Andy Rose said that it depends on the currency union, but that the ECCA and the CFA have multilateral central banks, similar to the European Central Bank. 356 * DISCUSSION Silvana Tenreyro responded that as regards goals, small currency unions such as the ECCA and the CFA tend to peg their exchange rates rather than float. Finally, the authors responded to comments made by the discussants and other participants. Robert Barro addressed in particular the com- ments of Andy Rose. He agreed that currency unions without major an- chors are possible, and indeed being proposed in Southern Africa, the Gulf states, and Australia and New Zealand. But he disagreed that the CFA zone and the ECCA should be thought of as being without an anchor. He felt that the fact that they are linked to a major currency is central to their continued existence. He remarked that the methodology for analyz- ing currency unions without anchors would be similar to that used in the paper, although more difficult to implement. Barro also responded to Rose's comment that monetary policy is a fiscal instrument that govern- ments might like to retain control of. He said that there are good reasons for precluding governments from using monetary policy as a fiscal instru- ment. In response to Rudi Dombusch on the question of whether joining a currency union requires agreement from both sides, he said that while agreement might be favorable, it is not necessary, and that unilateral join- ing has occurred. On the issue of Japan, Alberto Alesina said that the authors agree with Andy Rose that the data do not support the existence of a natural yen zone, but disagree with Dornbusch on the matter. He said that Korea's low inflation means that it is not in search of an anchor country, rather than it being a country with no anchor to turn to.