Introduction

In the literature on optimum currency areas (OCAs), theory has always run ahead of empirics. The classic contributions of Mundell (1961), McKinnon (1964) and Kenen (1969) were essentially theoretical. Beyond some casual observations – Mundell's to the effect that Western Canada and the Western United States were subject to many of the same disturbances, McKinnon's that Canada was more open and tradedependent than its neighbour to the south, Kenen's that the US economy was more sectorally diversified and less susceptible to idiosyncratic national shocks – little was done to fill the analytical framework with empirical content. This is not a criticism of the founding fathers of the theory of OCAs; the real puzzle is that so little systematic empirical work seeking to operationalise this literature has been undertaken over the course of the succeeding quarter-century.

In this respect, the debate over European monetary unification provoked by the Delors Report and the Maastricht Treaty has served as a healthy corrective. Recent years have seen a wave of empirical studies attempting to operationalise the theory of OCAs as a way of marshalling evidence on EMU's costs and benefits. It is that empirical literature that we seek to survey in this chapter. The fact that recent empirical work is itself a product of the debate over EMU necessarily lends our discussion a European cast.

There exist a number of recent surveys of the theory of OCAs, including several which take into their compass both theoretical and empirical studies. Our purpose here is different: we focus on empirical work, examining the success with which theory has been operationalised.

This is an interesting paper about an important topic, namely, the effects of globalization on developing countries. It first highlights some “neglected” details about TNCs and FDI. The rest of the paper is then spent discussing how developing country governments should respond to these new challenges, concluding that they should continue to try and use industrial policies to restrain the forces of globalization, largely by controlling the amount of technological transfer that such investment provides. The exposition is certainly clear but, at the end of the day, I must confess that I remain largely unconvinced by the arguments.

“The facts, ma'am, the facts.” The author focuses on several “neglected” details about foreign direct investment. First, most FDI occurs across industrial countries, and is thus not much of a benefit to developing countries. Second, a few favored countries have been receiving the bulk of recent FDI flows. Finally, FDI was not very important in investment and development even in these countries. The overall argument is that FDI's role in development has been overstated.

It is certainly true that most FDI occurs across developed countries, but the issue is considerably more complex than this. The text never mentions the words “greenfield” or “acquisitions,” the two categories into which FDI is generally divided because of their different implications for “real” behavior. Greenfield investment occurs when a company comes in and builds a new plant in a country – in other words, its financial investment in a country is supported by physical investment, as measured in the national accounts.

Introduction

One of the limitations of the literature on optimum currency areas, a topic to which Peter Kenen so importantly contributed, has always been the difficulty of confronting theory with evidence. We have at best limited information on the symmetry of shocks, the sectoral distribution of employment, the mobility of labor, the volume of interregional trade, and the other variables assumed to drive the decision of whether to form a monetary union (Mundell 1961; McKinnon 1963; Kenen 1969). Precisely because they are monetary unions, few national states gather data with which to test the predictions of optimum currency area (OCA) theory. It is not hard to see why: one can imagine the political problems that would arise were it discovered, for example, that New York runs a trade deficit with the rest of the United States.

If the theory of optimum currency areas does in fact possess significant explanatory power, then the same factors that influence monetary arrangements within countries should also govern arrangements between them. In the same way that two regions should form a monetary union if they experience similar disturbances, factors of production flow freely between them, and they trade heavily with one another, we should expect to see two countries that maintain separate currencies follow different exchange-rate-management practices depending on whether these conditions are or are not met.

Introduction

Despite the attention lavished on it by generations of scholars, the question of why the pre-1914 gold standard operated so smoothly for so long remains stubbornly unresolved. Under the gold standard, the exchange rates of the major industrial countries were firmly pegged within narrow bands (“the gold points”) in an environment free of significant restrictions on international flows of financial capital. This is precisely the sort of international monetary arrangement that recent experience suggests should be fragile, precarious and difficult to maintain. The breakdown of the Bretton Woods System following the liberalization of international capital markets in the 1960s and the collapse of the narrow-band European Monetary System (EMS) on the heels of the removal of Europe's residual capital controls in the 1980s illustrate the point. How the pre-1914 gold standard managed to avoid the same fate constitutes an analytical mystery and an important policy question.

The literature on this subject can be separated into two strands concerned with the policy regime and with the structure of markets, respectively. The former focuses on the stabilizing nature of the policy rules followed by central banks and governments during the gold standard years. Eichengreen (1992), for example, focuses on credibility and cooperation as the dual pillars of the policy regime. At the core of the system – in Britain, France and Germany – there was no doubt, barring the most exceptional circumstances, that whatever steps were needed would be taken to defend the central bank's gold reserves and the exchange rate peg.

Economic liberalism is back in style. Around the world governments are opening their economies to trade, privatizing government enterprises, and deregulating markets. These changes have already had profound effects in many areas of the world. Some of the most dramatic changes that have occurred to date are in international capital markets, where transactions between countries in the developed world are now essentially free of government regulation. By contrast, as little as two decades ago the vast majority of industrial countries maintained a wide array of capital controls.

The liberalization of international capital markets has provided benefits to the world economy through improved financial intermediation. However, the new system has not been without costs. Increasing capital mobility is often seen as one of the underlying causes of the break-up of the Bretton Woods fixed exchange rate system in the early 1970s. More recently, abrupt changes in market sentiment have generated capital flows which have disrupted efforts to peg exchange rates between national currencies. Speculative crises forced the members of the Exchange Rate Mechanism (ERM) in Europe to abandon their 21/4 percent currency bands in 1993 in favor of more permissive 15 percent bands, and forced the United Kingdom and Italy to suspend membership in the Mechanism the previous year. Similar market pressures have also forced countries operating unilateral fixed exchange rate banks, such as Finland, Sweden, and Chile, to widen their exchange rate bands or abandon them entirely.

Introduction

From all appearances the process of European monetary unification continues to gather momentum. Nearly four years have passed since the last significant realignment of exchange rates of members within the European monetary system (EMS). All significant controls on capital movements among member countries have been removed. Discussions of the establishment of a European central bank and a single currency are proceeding apace. If the current timetable is observed the transition will have been completed by the end of the decade.

At the same time there remain serious questions about the advisability of a European Monetary Union (EMU) voiced, in the most recent round of discussions, by the governments of the United Kingdom and Spain. By definition, EMU involves a sacrifice of monetary autonomy. In response to country-specific shocks, governments will no longer have the option of adopting a monetary policy which differs from that of the union as a whole. Insofar as monetary policy is useful for facilitating adjustment to disturbances, adjustment problems may grow more persistent and difficult to resolve.

These concerns are reinforced to the extent that it is believed that completion of the internal market will place new limits on the use of fiscal policy. Not only will individual governments have lost autonomy over the use of seigniorage to finance budget deficits but, insofar as the 1992 process renders factors of production increasingly mobile, constraints will be placed on their ability to impose tax rates significantly different from those of their neighbours.

Introduction

One of the features of most currency unions is that they contain an integrated national capital market, which can be used by private individuals to borrow and lend capital across regions within the union. In addition to allowing capital to be transferred across regions, the existence of an integrated capital market also allows individuals to insure themselves against region-specific risk by holding a diverse portfolio of assets. The extent to which individuals actually use capital markets in these ways is the focus of this chapter.

Regional data for the United States of America are used to estimate the importance of these two factors. The United States is an obvious candidate for such an investigation, since it is a large, well-integrated currency area with freely functioning capital markets. Examining behavior within the United States sheds light on the importance of private capital markets in economic adjustment within market economies in general. It also gives pointers as to the probable impact of more open international capital markets on behavior across countries, particularly in Europe where the progress toward Economic and Monetary Union (EMU) is rapidly creating an integrated capital market.

We begin by examining regional data from the United States on product and income for evidence of intertemporal trade among the regions of the United States. The regional data are collected on a basis similar to that under which components of the national data on gross national product (GNP) and gross domestic product (GDP) are calculated, so that these data allow rough calculations of the magnitude of inter-regional net factor payments.