6 August 2019 0 Comments

Is ECOWAS an optimal currency area? The epilogue

“A common executive authority must follow”

This is the last of a series of three blogposts discussing the implications of a new common currency within the Economic Community of West African States (ECOWAS). The last two posts examined the economic benefits of a monetary union and the immediate effects of the adoption of the projected single currency. In this post, I will focus more on the economic costs of a mutualized monetary policy and the types of institutions and arrangements that have to be adopted to promote a long-lasting monetary union. Without deeping much into the wonkiness of economic theory, let’s first expose the political economy of a domestic currency.

Why does a country need its own currency?

Societies have been using different sorts of currencies for exchange as far back as humanity existed. Legal tenders and notes were mostly private and issued by businesses at some point in time. Public authorities took control of the medium of exchange essentially as a way to establish more control over the economy but also to collect taxes and finance public goods. A currency is needed primarily to facilitate exchanges both domestically and abroad. I know many like to believe that a currency is essentially a sovereignty device. I take issue with that philosophy and believe that a currency remains an exceptional economic policy tool that many countries have used on their way to economic prosperity. It is a remarkable “shock absorber” and can be used to increase the competitiveness of domestic producers on global markets.

In the face of adverse macroeconomic shocks, monetary authorities can devalue a currency to get an economy out of a slump. Suppose for instance that the price of cocoa dips significantly due to a reduction in global demand. Ivory Coast and Ghana would be affected by this development since both countries draw important resources from the exports of this commodity. But these countries could also devalue their currency to cushion part of the damage. If say, cocoa prices decreased by 50% but the (hypothetical) Ivory Coast Central Bank devalue its currency by 25%, then domestic farmers would only experience a 25% drop in real revenue. The same result could be achieved if domestic wages or prices are reduced by 25% in response to the commodity price fall. This is what economists refer to as “shock absorbers”.

In a technical Economics jargon, nominal devaluation (cutting down the nominal exchange rate) of a currency is known as “external devaluation” while the reduction of domestic wages and prices is generally referred to as “internal devaluation”. The former is easier to implement than the latter due to numerous rigidities such as labor market institutions (minimum wage, union bargaining, etc.) which limit the ability of policymakers to manipulate real wages. For these reasons, the legal tender i.e. currency is the privileged “shock absorber” for policymakers around the globe. Plus, even in the absence of negative macroeconomic shocks, the central bank could devalue its currency for domestic producers to become competitive (competitive devaluation) on the global stage.

What are the economic costs of a monetary union?

As discussed above, a currency is an important device in the toolkit of policymakers seeking to promote economic growth. When a country becomes part of a currency area, this leverage is lost and monetary policy is set at the union level. For instance, Ghana currently uses its own currency (The Cedi). If faced with an adverse external shock (for instance when cocoa prices plunge) monetary authorities in the country could devalue the Cedi to absorb part of the revenue loss to domestic agents. But, were the ECO currency to become legal tender in the ECOWAS union, this will not be possible specially if other commodities (Cotton, Oil, Uranium, etc.) are booming at the same time. The union as a whole might be expanding while Ghana is going through a recession. Therein lies the dichotomy of a common currency: it promotes trade and economic integration but takes away a developmental policy tool at the country level.

What makes up for a successful monetary union?

For a currency area to succeed, there has to be a redistributive mechanism under the authority of an executive body made up of elected officials. To emphasize this argument let’s compare the United States (the oldest monetary union in modern history) to the Eurozone which adopted a single currency in 2001. By most accounts, the U.S. have been a successful monetary union mainly because the federal government is somewhat effective at smoothing the business cycles across space. American states have different economic structures. California is predominantly agricultural, while oil extraction dominates in Texas and finance and services in New York. State business cycles do not always align and Texas could be in a recession when New York is experiencing a boom. But the federal government can redistribute revenue from the state at the high-end of a business cycle to the one at the low-end. Plus, Americans can move across states to take advantage of newly created job opportunities.

In contrast, the effectiveness of the Eurozone remains the subject of controversies. The debt crises that plagued several countries in the Union brought to light the economic costs of the common single currency. Some countries were forced to issue tremendous public debt to get out of the recession that followed the Great Recession of 2008. The common interest rate and nominal exchange rate was not tailored to the realities of countries such as Greece, Italy and Spain which underwent a deeper recession than the rest of Union. In the absence of a supranational executive body that could use fiscal policy to help out the aforementioned countries, the recession worsened and lasted much longer than necessary. Had these countries been in charge of their domestic monetary policy, external devaluation could have been used to move out of the slump quicker. One could also point out that labor mobility is not as high in Europe as it is in the U.S.

In sum, for a monetary union to be successful, there needs to be a powerful executive authority charged with the duty of transferring resources to parts of the union in need. This authority should not be composed of appointed figureheads (like the ECOWAS commission) but must include elected officials. The success of a currency area also requires some degree of fiscal federalism with taxes being levied in every country to finance the redistributive authority. This will also facilitate the fiscal integration necessary for a long-lasting monetary union.

Lessons for the planned ECO currency

For the ECO to be a successful currency, there is a number of institutions that should be enacted. These go beyond the convergence criteria related to inflation, deficit and debt norms which only serve to guarantee that economic fundamentals and fiscal discipline converge within the union. Below, I laid out a number of institutions and norms that must follow the inception of the common currency to avoid the above-mentioned low-hanging fruits.

(i) An ECOWAS Executive government: Like national governments, there must be an ECOWAS government with a head elected by citizens of union. The elected official will lead a cabinet charged with the task of conducting fiscal policy at the union level. Without getting into the nitty-gritty of its attributes, I will say that the supranational body’s prerogative is to redistribute resources and smooth out economic fortunes across the Union. A regional legislative body should also be put in place to oversee the executive.

(ii) Fiscal federalism: For the initiative to be beneficial for all country-members, the union must also adopt a fiscal federalism with taxes being collected at the National level to support the executive government. This requirement just highlights the mechanism through which the executive government is financed. This would cause significant disruptions in the current overarching scheme of public expenditures in the union.

(iii) Eliminate all barriers to labor mobility: There are few obstacles to the free movement of citizens across the ECOWAS as the Union abolished any visa for residents of country-members going back to the mid-1990s. But there still remains impediments to a fully integrated labor market. Differences in languages and cultures limit the ability of workers to search for hirings beyond their country limits. For the ECO currency to be effective at smoothing out economic conditions across countries, the Union should harmonize labor market regulations and rules and require businesses to advertise job openings in all countries of the Union. This implies that employment searches have to be made available in both French and English.

(iv) Create an (effective) common market: This proposition takes the previous one a step further. A common market is one in which there is no impediment to the free mobility of goods, capital, ideas and people. It also requires that regulations and rules be harmonized and firms be allowed to compete  regardless of where they are domiciled within the Union. The goal is to increase the size of the market and force businesses to become more efficient (due to a combination of increasing returns and competition). The current single market will have to be strengthened to further integrate the economies of the Union.

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