Currency Union: Overview, History, Criticisms

What Is a Currency Union?

A currency union is when two or more economies (usually sovereign countries) share a common currency or mutually decide to peg their exchange rates to the same reference currency to keep the value of their monies similar. One goal of forming a currency union is to coordinate economic activity and monetary policy across member states. A currency union is often referred to as a "monetary union."

Understanding Currency Unions

A currency union is when a group of countries (or regions) use a common currency. For example, eight European nations created the European Monetary System in 1979. This system consisted of mutually fixed exchange rates between member countries. In 2002, twelve European countries agreed to a common monetary policy, thus forming the European Economic and Monetary Union. One reason why countries form these systems is to lower transaction costs of cross-border trade.

A currency union or monetary union is distinguished from a full-fledged economic and monetary union, in that they involve the sharing of a common currency but without further integration between participating countries. Further integration may include the adoption of a single market in order to facilitate cross-border trade, which entails the elimination of physical and fiscal barriers between countries to free the movement of capital, labor, goods, and services in order to strengthen overall economies. Current examples of currency unions include the Euro and the CFA Franc, among others.

Another way countries unite their currency is by use of a peg. Countries commonly peg their money to the currencies of others—typically to the U.S. dollar, the euro, or sometimes the price of gold. Currency pegs create stability between trading partners and can remain in place for decades. The Hong Kong dollar has been pegged at a rate of HK$7.8 to the U.S. dollar since 1983. The Bahamian dollar has been pegged at parity with the greenback since 1973.

In addition to a peg, some countries actually adopt a foreign currency. For example, the U.S. dollar is the official currency in El Salvador and Ecuador, along with the Caribbean island nations of Bonaire, Sint Eustatius and Saba. The Swiss franc is the official currency in both Switzerland and Lichtenstein. 

There are more than 20 official currency unions, the largest of which is the euro, which is used by 19 of the 28 members of the European Union. Another is the CFA franc, backed by the French treasury and pegged to the euro, which is used in 14 Central and West African in addition to Comoros. The Eastern Caribbean Dollar is the official currency for Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts and Nevis, Saint Lucia, and Saint Vincent and the Grenadines.

History of Currency Unions

In the past, countries have entered into currency unions to facilitate trade and strengthen their economies, and to also unify previously divided states. In the 19th century, Germany's former customs union helped to unify the disparate states of the German Confederation with the aim of increasing trade. More states joined beginning in 1818, sparking a series of acts to standardize the value of coins transacted in the area. The system was a success and led to the political unification of Germany in 1871, followed by the creation of the Reichsbank in 1876 and the Reichsmark as the national currency.

In 1865, France spearheaded the Latin Monetary Union, which encompassed France, Belgium, Greece, Italy, and Switzerland. Gold and silver coins were standardized and made legal tender, and freely exchanged across borders to increase trade. The currency union was successful and other countries joined. However, it was formally disbanded in 1927 amid political and economic turmoil during the early part of the century. Other historical currency unions include the Scandinavian Monetary Union of the 1870s based on a common gold currency.

Evolution of the European Currency Union

The history of the European currency union in its contemporary form begins with economic unification strategies pursued throughout the latter half of the 20th century. The Bretton Woods Agreement, adopted by Europe in 1944, focused on a fixed exchange rate policy to prevent the wild market speculations that caused the Great Depression. Other agreements reinforced European economic unity, such as the 1951 Treaty of Paris establishing the European Steel and Coal Community, which was later consolidated into the European Economic Community in 1957. However, the global economic hardships of the 1970s prevented further European economic integration until efforts were renewed in the late 1980s.

The eventual formation of the European Economic and Monetary Union was made possible by the signing of the 1992 Maastricht Treaty. Thus, the European Central Bank was created in 1998, with fixed conversion and exchange rates established between member states.

In 2002, twelve member states of the European Union adopted the euro as a single European currency. As of 2020, nineteen countries use the euro for their currency.

Criticism of the European Monetary System

Under the European Monetary System, exchange rates can only be changed if both member countries and the European Commission agree. This unprecedented move attracted a lot of criticism. Significant problems in the foundational policies of European Monetary System became evident following the Great Recession.

Certain member states—Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus—experienced high national deficits that developed into a European sovereign debt crisis. Because they did not control their own monetary policy, these countries could not resort to currency devaluation to boost exports and thus their economies. Nor did rules permit them to run budget deficits to reduce unemployment rates.

From the beginning, the European Monetary System policy intentionally prohibited bailouts to ailing economies in the eurozone. Amid vocal reluctance from EU members with stronger economies, the European Economic and Monetary Union finally established bailout measures to provide relief to struggling peripheral members.