Common Currency Areas are a Disastrous Idea

In our March-April issue, Clyde Prestowitz has a deep look at the two potential trade deals currently on deck in Washington: the Trans-Pacific Partnership and the Transatlantic Free Trade Agreement. It's mostly good reporting, the details of which I am not equipped to adjudicate, but there is one particular aside worth mentioning. Here he suggests something remarkable:

None of this is to suggest that the United States couldn’t prosper from a deeper trading relationship with Asia if it were done on the right terms. Indeed, imagine if the U.S. went for the whole enchilada and proposed something like a trans-Pacific European Union? Take the advanced democratic economies of the Pacific—Canada, the U.S., Mexico, New Zealand, Australia, Japan, and Korea—and make them one integrated economy with a common antitrust regime, a common set of employment and environmental standards, one banking system, and eventually one currency—call it the Yollar or the Yelarso or the Denso. Make the union open to new entrants if and when they reform their economies enough to qualify for membership.

That entity would be the world’s biggest, richest economy. It would eliminate the structural impediments to U.S. exports in much of Asia, and bring most of the world economy under a true free trade standard. With this kind of a union there would be much less currency manipulation and much less (if any) need for “pivots” and more U.S. military in Asia. But, alas, Washington isn’t even thinking about anything like this, even though it would be a game-changing economic and geopolitical move.

With respect, this is a terrible idea. There are several technical reason transnational currency areas don't work. For starters, when a large currency zone is hit with non-synchronous shocks—like, say, a recession which hits Spain much harder than Germany—it is missing the most effective adjustment mechanism: the adjustment of the exchange rate. This is why the failure of the Eurozone was predicted beforehand by the likes of Milton Friedman, Paul Krugman, and Charles Calomiris.

But there are many bad ideas out there. What makes transnational currency zones one of the all times worst ones in history is that they have a certain surface plausibility to the public which hides their more awful characteristics. "Let's cede our budget power to a bunch of unelected technocrats who will inflict brutal recessions at will" would have never passed muster in any European country. But "let's join a common European currency," which has amounted to the same thing, did.