The Political Economy of a Diverse Monetary Union

We analyze the political economy of monetary unification among countries with different quality of institutions. Countries with stronger institutions have lower public spending and better productive incentives, even under a stronger currency. Governments under weaker institutions spend more and must occasionally devalue. In a diverse monetary union prices and flows adjust quickly while institutional differences persist, so the common exchange rate has large redistributive effects. Public spending in the weaker country is less constrained and may rise, so productive incentives are reduced by both a fiscal and common exchange rate effect. A weak country government may agree to a common currency that reduces productive capacity as it enables more public spending. Strong country production benefits from a weaker currency, but in a crisis the survival of the monetary union may require fiscal transfers, justified by the implicit gains. Even when a diverse monetary union is on aggregate beneficial to all countries, firms in weaker countries and savers in stronger countries lose.