This is not a post about organized crime in Mexico, although I will be returning to the topic shortly. This post asks simply: given all the things that can go wrong with a fixed exchange rate, let alone a currency union, why do so many countries continue to return to them? After all, when they go wrong, they can go very wrong. You can get horrible explosions like Mexico in 1994 or the Asian currency crashes in 1998, or you can slow grinding meltdowns like the depressions in Argentina around the turn of the century or the Baltic States today.
Yet countries continue to do it. All the West Indies save Jamaica fix to the dollar. Ecuador, El Salvador, and Panama have dollarized. The Baltic States have already been mentioned. Denmark fixes to the euro. The euro itself has no shortage of suitors, even now. In fact, even with the Eurozone’s problems, countries want to form currency unions. East Africa wants to form a currency union. Why?
Well, history is a big reason. The CFA franc, for example, exists and is linked to the euro because of the French non-empire also known as Françafrique. A similar thing can be said about the West Indian links to the dollar. These historical links make it very hard to figure out the effects of a currency link. Maybe countries link to countries with which they trade. Or countries trade more and link with countries with whom they have special political links. All that would make it hard to tell whether exchange rate certainty has a big effect on trade, because causality could run both ways. That didn’t stop Andy Rose from trying, but the results were still highly contested.
Jeffrey Frankel came up with a neat natural experiment. In his own words:
“The long-time link of CFA currencies to the French franc has clearly always had a political motivation. So CFA trade with France could not in the past reliably be attributed to the currency link, perhaps even after controlling for common language, former colonial status, etc. But in January 1999, 14 CFA countries woke up in the morning and suddenly found themselves with the same currency link to Germany, Austria, Finland, Portugal, etc., as they had with France. There was no economic/political motivation on the part of the African countries that led them to an arrangement whereby they were tied to these other European currencies. Thus if CFA trade with these other European countries has risen, that suggests a euro effect that we can declare causal. The dummy variable representing whether one partner is a CFA country and the other a euro country has a highly significant coefficient of .57. Taking the exponent, the point estimate is that the euro boosted bilateral trade between the relevant African and European countries by 76%. It is not doubling, and the timing is not perfect. But it does suggest that the effect on trade among small countries is very substantial even after correcting for endogeneity.”
It is true that the CFA franc is in a fixed exchange rate with the Eurozone, not a currency union. Still, as fixed exchange rates go, this one is very strong. It’s supported by the French treasury and not just the governments of the countries in question. Moreover, these countries are dependent on France in umpteen ways, and their governments would find it very difficult to leave the zone without risking economic and political collapse. So there doesn’t seem to be a strong institutional reason to reject the results. It isn’t quite a currency union, but it is close. So what happened in 1999 between the CFA countries and the Eurozone wasn’t quite an accidental currency union, but it was close. And even if it isn’t a real currency zone, the experiment can shed a lot of light on fixed exchange rates.
So fixed exchange rates promote trade! Great news for those of us with strong intuitions that fixed exchange rates and currency unions should be good things for small countries. Problem is, the quantitative results are a little odd:
First, the effect starts in 1997, not 1999. It is possible that expectations of the fixed rate with the rest of Euroland caused the trade boom, but that seems a little ad hoc. Second, the effect seems to have faded out by 2006. Neither result lets one say with confidence that dollarization (or even fixing to a bigger currency) is a good thing for poor countries. Either the result from the CFA-Eurozone experiment is stronger than it looks (maybe 2005-06 were just bad years, or the authors failed to correct for some important factor), or fixed exchange rates only have brief and transitory effects.
We still have a mystery. Thoughts?