One continent, one currency? Varieties of common currency experience in Europe and Latin America

Abstract

Currency unions have been promoted as a means to increase trade, investment and growth. A crucial issue in giving up the domestic currency is the loss of a mechanism to absorb real external shocks. High real exchange volatility between countries considering such a policy would suggest that a currency union could be quite costly in terms of large, persistent misalignment and thus balance of payments imbalances. Von Hagen and Neumann (1994) assessed the readiness of nine European countries for Euro-zone membership by examining real exchange rate variability. In this paper we analyze their predictions, and find them to be quite accurate for Europe. All of the nations which appeared ready for the Euro have joined. Of the three which did not appear prepared, two have retained their own currency, and the third has experienced real appreciation and stagnant exports. Given the prescience of this method, we apply it to nine Latin American nations. A number of countries in this region have begun to form a currency union by unilaterally adopting the U.S. dollar. The Von Hagen-Neumann method finds very high real exchange rate variability between the U.S. and the Latin American nations-indeed much higher than that between Germany and the countries which would later adopt the Euro-so adopting the dollar could cause very painful adjustment in Latin America.