What Is a Currency Union?

A currency union occurs when two or more groups (usually sovereign countries) share a common currency or decide in unison to peg their exchange rates to the same reference currency to keep the value of their monies similar. One of the goals 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."

Key Takeaways

  • A currency union is where more than one country or area shares an officially currency.
  • A currency union may also refer to one or more countries adopting a peg against another currency, such as the U.S. dollar.
  • The largest currency union active presently is among the Eurozone which share the euro as their currency across 19 member states, as of 2020.

What Causes Drastic Currency Changes?

Understanding Currency Unions

A group of countries (or regions) using a common currency. For example, in 1979, eight European nations created the European Monetary System (EMS). This system consisted of mutually fixed exchange rates between these countries. In 2002, 12 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 the transaction costs of cross-border trade.

A currency union or monetary union is distinguished from a full-fledged economic and monetary union in that it involves the sharing of a common currency between two or more countries, 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 that countries unite their currency is by use of a peg. Countries commonly peg their money to the currencies of others, typically, the U.S. dollar, the euro, or sometimes to the price of gold. Currency pegs create stability between trading partners and can remain in place for decades. For example, the Hong Kong dollar has been pegged to the U.S. dollar beginning in 1983, as is the Bahamian dollar. In addition to a peg, where one currency is given a fixed exchange rate for another, some countries actually adopt the foreign currency - for instance, the U.S. dollar is the official currency in the U.S., Puerto Rico, El Salvador, Ecuador and other small nations in the region.; and the Swiss franc that is official in both Switzerland and Lichtenstein. 

Today, there are more than twenty official currency unions. The most-used being 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 West African countries. Yet another is the Eastern Caribbean Dollar, the official currency for eight island countries: Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts and Nevis, Saint Lucia, and Saint Vincent and the Grenadines.

History of Currency Unions

Currency unions have often been adopted in the past with the goal of facilitating trade and strengthening economies, while also helping to 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. Beginning in 1818, more states subsequently joined, sparking a series of acts to standardize coin values used in the area. The system was a success and helped secure the political unification of Germany in 1871, followed by the creation of the Reichsbank in 1876 and the national currency the Reichsmark.

Similarly, 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 eventually disbanded in the 1920s with the stresses of war and other political and economic hardships.

Other historical currency unions include the Scandinavian Monetary Union of the 1870s based on a common gold currency, and the eventual adoption of a national currency by the United States in 1863.

Evolution of the European Currency Union

The European currency union in its contemporary form can be traced through various economic unification strategies 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. Various other agreements reinforced further European economic unity such as the 1951 Treaty of Paris establishing the European Steel and Coal Community (ECSC), later consolidated into the European Economic Community (EEC) in 1958. However, the global economic hardships of the 1970s prevented further European economic integration until efforts were undertaken in the late 1980s.

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

In 2002, the adoption of the euro, a single European currency, was implemented by 12 member states of the EU. As of the year 2020, 19 countries use the euro for their currency.

Criticism of the European Monetary System

Under the European Monetary System (EMS), exchange rates could only be changed if both member countries and the European Commission were in agreement. This was an unprecedented move that attracted a lot of criticism.

With the global economic crisis of 2008-2009 and the ensuing economic aftermath, significant problems in the foundational European Monetary System (EMS) policy became evident.

Certain member states; Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus, experienced high national deficits that went on to become the European sovereign debt crisis. These countries could not resort to devaluation and were not allowed to spend to offset unemployment rates.

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