Euroland May Expand Too Far

Currency unions like EMU that let in new members on the basis of a majority vote have a built-in tendency to grow beyond their optimal size. That is the central finding of new research by John Maloney and Malcolm Macmillen published in the latest issue of the Economic Journal. As enlargement negotiations with up to a dozen potential new EU members get underway – all with the prospective right to join the currency union as soon as they meet the Maastricht criteria – the study strongly suggests the need to examine the future costs to EMU of excessive enlargement.

The researchers note that as a single currency area grows, the drawbacks for existing members – a communal exchange rate and an interest rate even further removed from their particular needs – begin to overhaul the advantages – reduced exchange rate uncertainty and fewer currency conversion costs. At any one time, some currency union members will have a net gain and some a net loss if new countries join.

Yet according to these researchers, losers lose more on average than gainers gain. The significance of this is that a system of admission by majority voting, as is the case in Euroland, will inflict large aggregate losses on the union as a whole. At the same time, a membership approval system based on unanimity would lead to under-expansion. The research suggests that a majority rule of about 5/6 – that is, an 83% majority is needed to admit new members – would result in the currency union settling down at its optimal size.

Why are there always gainers and losers when a currency union expands? The main disadvantage of a single currency area is that its members have divergent industrial structures. Hence, events affect them asymmetrically: after a switch in demand from coal to cars, for example, a carproducing country might like a higher exchange rate – it can then sell the cars for more but still have a satisfactory trade position – whereas a coal-mining country would want its exchange rate to fall in order to cut the price of its coal and restore demand.

With a common currency, it is impossible for both countries to get their way. So how a country feels about another joining will depend on whether the candidate is industrially similar to them – in which case its interests will be strengthened by a friendly voice as exchange rate and interest rate policies are decided. But if the new member is industrially very different, then it is taking on board a potential adversary.

The optimal size for a currency area can be defined as the point where the last country to join results in a net gain for the currency area as a whole but the next one will do the reverse. Assuming that countries all vote for their own economic interests, then under a system of majority voting, the currency area will settle at the point where there is one more gaining country than losing country. Initially, this would seem to result in a net gain for the currency area, as the summation of the gaining countries'' benefits will more than offset the losses of the losing countries.

But this logic rests on the idea that the average loss/gain is the same for both losing and gaining countries. According to the study, this idea is false: the average size of the loss for losing countries is greater than the average size of the gain for gaining countries and, under a system of majority voting, this will result in the currency area growing above its optimal size.

The solution to this problem is to increase the voting rights of the losing countries. In practical terms, this can be achieved by increasing the size of the majority needed to admit new countries. The study argues that the majority should be increased from 51% to 83% in order to achieve an optimal currency area.

EU entry negotiations are already underway with the Czech Republic, Cyprus, Estonia, Hungary, Poland and Slovenia; and the European Commission has recommended that these talks be extended to include Bulgaria, Latvia, Lithuania, Malta, Romania and Slovakia. Once they become members of the EU, these countries will be guaranteed EMU membership as soon as they fulfil the Maastricht criteria. Maloney and Macmillen''s results suggest that decisions about EU enlargement should not be taken without consideration of its future costs to EMU.

What about the interests of those countries left outside the currency union? The researchers find that single currency areas do more harm than good to countries excluded from them. If members of a union no longer have exchange rates that they can vary against one other when appropriate, it must follow that rates will become misaligned against outsiders too. Some of this cost will fall on the outsiders, which will have little compensation in the form of reduced conversion costs. It is therefore likely that the UK will suffer from the existence of Euroland if it does not join.

''Do Currency Unions Grow Too Large for their Own Good'' by John Maloney and Malcolm Macmillen is published in the October 1999 issue of the Economic Journal. Maloney and Macmillen are at the University of Exeter.