Bitcoin and optimum currency areas

18 April 2021

Robert Mundell, a Nobel Laureate in Economics, passed away on 4 April 2021. Of his many critical contributions, one of his most famous is the optimum currency area theory where he argues basically that national currencies are not optimal and that currency areas should not be defined by political but by economic boundaries. The emergence of bitcoin and other private currencies seems to affirm that currency areas could be formed irrespective of countries. This has attracted some incipient comments to explain the advantages of private currencies and as an extension of currency competition. Mundell's theory, reviewed here only in its broadest terms, may offer a robust framework to explain why the proliferation of private currencies would be rational.

Mundell’s 1961 article, A theory of optimum currency areas, outlines that a currency area should be defined by factor mobility. His argument rests on stabilisation, that is, “a flexible exchange rate is a device where a depreciation can take the place of unemployment when the external balance is in deficit and an appreciation can replace inflation when it is in surplus.” He then contends that “if labour and capital are insufficiently mobile within a country then flexibility of the external price of the national currency cannot be expected to perform the stabilisation function attributed to it and one could expect varying rates of unemployment or inflation in the different regions.” Mundell then concludes that “if the world can be divided into regions within each of which there is factor mobility and between which there is factor immobility, then each of these regions should have a separate currency.”

Mundell thus argues that “the optimum currency area is the region.” He stipulates that a region is an optimum currency area when the exchange rate can accommodate an external shock such that neither inflation nor unemployment arises. Similarly, if regions shared a common currency or adhered to a fixed exchange rate regime, then an adverse shock arising in one region would be transmitted to the other region. Mundell therefore emphasises that the case for flexible exchange rates is based on regional currencies not national currencies; “if regions cut across national boundaries or if countries are multiregional then the argument for flexible exchange rates is only valid if currencies are reorganized on a regional basis.”

The reorganisation, Mundell writes, on the basis of currencies would be feasible only where the "political organisation is in a state of flux” such as “ex-colonial areas and in Western Europe” since “it hardly appears within the realm of political feasibility that national currencies would ever be abandoned.”

Private currencies could serve as currencies irrespective of national territories and be guided strictly by economic criteria and circulate in parallel to national currencies. Currency areas could be commercial, social or otherwise defined networks. In principle, the relative homogeneity of corporations and social networks could make them more likely to constitute an optimum currency area than a country while there would have to be some intolerance to unemployment and inflation which may differ of any public policy consideration.

Private currencies will have to demonstrate they can constitute effective payment mediums. Many national currencies have not. The adoption of fixed exchange rate regimes for private currencies, often associated with the concept of stable coins, could help build sufficient confidence in the short to medium term as central banks have done for decades. Some mechanism would have to be adopted to ensure adequate liquidity of the private currency on the basis of a transparent issuance framework. Private currency issuer may have to communicate their issuance policy clearly similar to central banks to support adoption. The critical advantage that central banks normally issue legal tender may not be available to a private currency.

The adoption of private currencies would follow criteria similar to national currencies. For issuers, a common currency of a given corporation could bring the advantages of a monetary union to reduce transaction costs and support financial and economic integration while serving as an instrument to stabilise output. For users, the adoption of private currencies would rest on considerations like “dollarization;” users would assess whether they are better off to float vis-à-vis the national currency and fix to the private currency or vice versa.

Currencies like other products and services depend on brand recognition. Strong brands should benefit disproportionately favouring trusted established financial and non-financial actors. Bigtech, other well-known non-bank corporations, credit card issuers and international banks seem particularly well positioned to issue their own currencies.

Bitcoin and others may offer the international economy a new dimension of “flux” as currency areas could form independently of national territories. The difficulty is to define the domain of the currency area. There is a priori no reason why a private currency could not serve as effective payment medium. Naturally, there would be limits to the proliferation of private currencies amid strong network effects currencies normally are dependent on. While Mundell undoubtedly had an important influence on the formation of the euro, he may prove far more consequential for the adoption of private currencies.