Currency Unions
Lessons from the US

Fixed exchange rate regimes give rise to difficulties in general, but apparently not within certain groups of countries or within some countries with diverse regions such as the US. The `irrevocably fixed' exchange rate system within the US has functioned well, but both the gold standard and Bretton Woods collapsed. This may result from the presence in the US of a federal fiscal authority, which insures states against regional shocks by implicitly redistributing income from `favourably shocked' to `adversely shocked' regions so that tax and transfer policies mitigate the initial regional imbalances. There was no institution to perform such a role for the Bretton Woods or gold standard member countries.

In Discussion Paper No. 632, Research Fellow Xavier Sala-i-Martin and Jeffrey Sachs note that such an inter-regional public insurance scheme need not be `conscious': a combination of proportional income tax and acyclical expenditures and transfers will automatically help to defend fixed parities, while progressive income tax and countercyclical transfer systems will make the insured fraction of the shocks even larger and the defence of the parities more effective. This insurance scheme operates independently of the regions' initial wealth and of any other programme a Federal government may implement to reduce income inequality in the long run.
Sala-i-Martin and Sachs estimate the extent to which the US Federal government insures its member states against regional income shocks and find that a $1 reduction in a region's per capita personal income reduces Federal taxes by about 34 cents and raises Federal transfers by about 6 cents, producing a final reduction in disposable per capita income of around 60 cents. The Federal government thus absorbs between one-third and one-half of the initial shock, operating mainly through its income tax system, so that stabilization process is automatic rather than specifically implemented for each cyclical movement in income.

Many of those attributing the survival of fixed exchange rates within the US to its regional insurance scheme argue that EC policy-makers should seriously consider the creation (or expansion) of such a `fiscal federalist' system when they create the European Central Bank that will issue the single European currency. Creating the latter without such an insurance mechanism could endanger the monetary union. Under Europe's current tax system at Community level, a $1 shock to a member state's GDP reduces tax payments to the Commission by only half a cent; Europe has far to go to attain the level of insurance against idiosyncratic regional shocks already achieved by the US.

Fiscal Federalism and Optimum Currency Areas: Evidence for Europe from the United States
Xavier Sala-i-Martin and Jeffrey Sachs

Discussion Paper No. 632, March 1992 (IM)