On the Inflationary Bias of Common Currencies: the Latin Union Puzzle

The prospect of imminent monetary unification in Europe has directedattention to the importance of the institutional setting that would beappropriate for efficient management of a common currency. The supportersof a ‘EuroFed' often use a popular argument that stresses the superiority of acentral bank as compared to a regime where sovereign countries can print acommon currency [see e.g. Emerson (1992, p. 35)]. It is said that in the lattercase, there is an incentive for each country to ‘free-ride' by ‘over-issuing' thecommon currency. since while the cost of inflation is shared, the benefit ofseigniorage accrues to the country that prints the money. The problem wasfirst formalized by Casella and Feinstein (1989) in a two-country model.They concluded that - due to ‘pervasive free-rider problems' - the success ofa common currency depends crucially on the organization of a jointlycontrolled central bank (...).