1. Introduction
Should a country join a currency union or should it stick to the traditional one country-one currency practice? For most countries this is a non-issue. Most have no potential currency zone to join. Others, Britain . In Denmark .
Usually, the starting point of the debate on the pros and cons of joining a currency zone, is a country that has its own currency. Palestine .
It seems that Palestine . The main reason has little to do with economics and more to do with the fact that Palestine was forced into the currency union with Israel - initially, after the 1967 war, by the occupying force, and since the Oslo . De facto, Israel .
In Palestinian eyes, breaking this currency union is an act of liberation. Another step on the road to independence from the Israeli occupier.
This paper is an effort to discuss the currency issue mostly on economic grounds. Not “pure” economics the way most papers are written, but from a position that searches for the best possible solution to Palestine itself and other Middle East countries.
2. The “science” of currency unions
Even in modern economics currency areas, are a relatively new subject. Surprisingly, serious writing began only after Robert Mundell published his 1961 (1) an article that focused on the foreign exchange policy- i. e. fixed vs. floating rate. This is surprising due to the fact that the “Bretton- Woods Fixed Exchange Rate Regime” was enacted after World War II. This should have been an incentive to create currency areas. It did not.
Mundell described how fixed exchange rates could cause severe problems to countries and showed how a floating rate could reduce the negative consequences of a fixed rate regime.
However, he pointed out, if floating is the solution why not carry the “float” from the country unit to the region unit?! Why should Gaza
Mckinnon (2) tried to respond to some of these questions. He pointed out that the size of the “area” that deserves its own currency has a lot to do with the credibility of the regime that issues the currency. He also made a point of the price a country has to pay for having its own currency. Having a currency invariably, necessitates holding foreign currency reserves. These are needed for emergency imports, defending speculation against the currency and a host of other reasons. Holding such reserves is costly and reduces the amount of capital available for productive investments. Carrying this argument further, one reaches a conclusion that for small open economies, an independent currency is a luxury best avoided. An independent currency is suitable for large countries or areas that have relatively, less foreign trade.
While some economists claim to have found the formula for making a decision, the majority is skeptic. Leiderman (3) points out that when one looks at what actually happens in the world one finds a rather mixed bag. The USA and Canada . But this is not even discussed. The two countries do not coordinate between their currencies and enjoy large trade, low inflation and economic growth at least as good as countries which are part of currency areas. The Euro area seems to be growing faster economically since the currency was established in 1999, although the Euro has deteriorated vis-a vis other major currencies. Both theory and practice, says leiderman, leave the jury undecided.
What are the pros of a currency union?
a. Reducing costs of transactions. If the country in question has a large share of its GNP traded with one partner, opting for union reduces costs. This is especially true for small businesses for which currency transaction costs could be a big portion of the profit. When the Euro was established economists calculated that costs would be reduced by 0. 5-1 per cent of GNP.
b. Reducing price discrimination. The European union has found that in Britain . One of the explanations to this, is that British consumers are unaware of the possibilities of purchasing the same car at lower prices in nearby Holland . Using one currency gives consumers the ability to compare prices and know what is better for them.
c. Reducing uncertainties. An investor in a small country has to take into consideration the uncertainty of its currency. He will thus require a higher profit margin in order to reduce possible changes in the currency. Thus, ceteris paribus, the level of investment will be smaller relative to a situation in which such uncertainty does not exist.
d. Increasing economic growth. The smaller the country the higher is the risk premium demanded by investors. Thus in order to sell government bonds, an independent Palestine will have to convince investors by paying higher yields - that is higher interest rates. Higher interest rates, economists agree, reduces economic activity and growth. Being part of a currency area eliminates this currency risk factor.
e. Reducing costs of foreign currency reserves. With no own-currency a country that is part of a currency area does not have to hold foreign currency reserves. The rate of return on such reserves is noted to be far lower than non-financial alternatives. The necessity to hold such reserves reduces the available capital for investment in preferred areas such as education and infrastructure.
What are the cons of joining an economic area?
a. Losing revenues from printing money (seigniorage) . The printer of a currency enjoys a profit from this monopoly. People who hold currency refrain from purchasing a good. By printing money a government transfers resources from the citizens and the non-government sector to itself. This profit, seigniorage in economic lingo, could amount to 1-2% of GNP depending on the rate on inflation. However, with inflation being so unfashionable nowadays, this profit is minute.
b. Losing the “cushion” absorbing external shocks. When a country suffers, say, from higher energy prices and deterioration in its external finances - it has to pay a price. With a currency area the price is in the form of reducing real incomes, higher unemployment etc. With an independent currency this shock could be softened by devaluation.
c. No monetary policy. With no currency there is no independent monetary policy. Although this saves some resources devoted to carrying out such a policy, it has a price. At this stage, for example, Ireland . It can do little to reduce inflation. Since Germany is more concerned with unemployment than with inflation, the Euro central bank pursues a much milder anti inflationary policy that is suited to Ireland .
3. Features of Palestine .
income revenue financing
Million $, current prices
1994 456 1433 575 25 547
1999 740 3398 914 624 609
% change 62 137 59 2300 11
employment in Israel
1995 62,000
1999 136,000
% change
source: A. Arnon and J. Weinblatt (4)
These basic figures of Palestine . Almost a quarter of the labour force of Palestine was employed in Israel . True, the 1995 figures are low due to closures at the time. But with the normalization, which developed up to the breakdown of negotiations in the summer of 2000, the number of people employed increased considerably. In fact, the halving in the unemployment rate in Palestine from 24% in 1996 to about 11% in the second quarter of 2000 is explained by the increase in employment in Israel(*).
Another significant development of the last few years has to do with the finances of Palestine . Apart from donor countries contributions, Israel . This is the outcome of the customs union in which Israel .
(*) Employment figures of Palestine ’s labour force are quoted from the central bureau of statistics of Palestine . Israel . Israel compiles the number of Palestinians working in Israel .
Israel & Palestine prices
The price data points out to the magnitude of price convergence in the two economies. Palestine . By august 2000 the price level in both countries is almost identical. Such convergence is very rare. Although in all other respects the two economies differ considerably; and although the structure of the Consumer Price Index in the two areas is very different – the price level and its yearly change is almost identical.
All this is evidence to the closeness of the two economies. Or, to make this point more exact, to the dependence of Palestine ’s economy on Israel . It seems that the Oslo . In 1997-1999 Palestine’s economy increased by about 7% per year, far faster than Israel . But this significant change hardly dented the dependence. Looking at gross figures it seems that Palestine is closer to the average of Israel than the south of Israel itself – the Negev .
Interviewed by the Israeli daily Ha’aretz (5) following almost one month of clashes, Mohammed Shtaia, head of Pecdar, was quoted as saying: “unilateral separation (by Israel – g. e. ) will have catastrophic consequences to the economy of Palestine . The article goes on to quote a pecdar document calculating the economic losses to Palestine . Palestine .
4. To link or not to link?
Viewing the economic data it will be easy to conclude that separation is not only unwise - it is almost impossible. Shtaia as well as Arnon &Weinblatt (4) point out that this conclusion is politically dependent. If both governments agree to establish borders, thus changing the economic regime from a customs union to something different – the negative economic consequences of separation would be much smaller.
No doubt that an agreement between the sides will make everything easier. But an agreement may not be feasible in the near future. The clashes, war de facto could continue. Israel might resort to additional economic sanctions (at present the closure has prohibited workers from Palestine .
This article will not dwell on the monetary possibilities under a continued war situation. Assuming an agreement of some sort is reached what kind of monetary regime is most suitable for Palestine
During the failed Camp David negotiations of summer 2000 it seems that Israel . No longer does it insist on a customs union. It has agreed that a free trade area between the two countries, if so wished by Palestine . This is consistent with Israel ’s position that it is time to reach a final agreement which will define the borders between Israel and Palestine .
In this proposed economic regime Palestine . If it opts out of a tightly linked customs union with Israel to the less integrated free trade regime, it will be quite unlikely that Palestine . It is most likely that lessening the economic ties will go hand in hand with a separate currency.
The main reason for such as choice is political. Almost every country that gained independence, (and in the last decade similar cases involved states that broke with the USSR . There is, besides the political reasoning, also an economic one: none of these countries – and this is true also with the PA – had an honest currency area.
As in the European Central Bank, an honest regime is one in which all participants to the area share in costs, management and benefits. When Israel imposed a currency area on Palestine . It did not allocate Palestine . Cassella (6) points out that small partners in a currency area “deserve” a share even larger than their relative economic strength. Israel . It does not seem to offer one now.
Alesina & Barro (7) show that a precondition for a country to join a currency area is that the “anchor country accommodates to the interests of clients”. This has not been the case in the ME.
Both politics and institutional considerations draw us to the conclusion that the continuation of the present currency union is not feasible. This holds true although parameters such as trading costs, distance and monetary stability tend to favour such a union.
In the real world Palestine .
5. DIY
Going alone is the obvious way. Most countries do it, so why should Palestine
The main economic reason for DIY is that the government can implement its own monetary policy. The benefit of this is not only in the seigniorage. The economy of Palestine is vastly different than that of Israel . It makes sense for such a country to opt for independence. Clearly, the politics of creating a new state point to a similar route.
This could be extremely costly.
A. Although DIY would probably mean using a floating rate of exchange, even such a regime will have to be backed by foreign currency reserves held by the government/central bank. It is questionable how such reserves could be created without extremely tight fiscal and monetary policies. Palestine . This could be costly in terms of employment and investments.
B. In today’s world there is very little a country can do in terms of an independent monetary policy. Or, to put more accurately, a country is independent only to have a tighter monetary policy than a monetary policy inflicted on it by its partners to a monetary area.
Such a foreign exchange regime seems non-feasible nowadays. The policies of the past ended when Israel . This kind of policy could be criticized. But at present there is no real alternative.
What happens in Israel . Although this is not the official policy, the two – domestic prices and the price of the US dollar – are tightly linked. What is the interest rate that guarantees low inflation? The interest rate of the US . According to the bank of Israel . 4%. For Palestine .
This means that in order to maintain an inflation rate identical to that of the US . This is what is needed in order to please foreign investors.
The less stable a country is considered, the higher the risk premium. A country like Palestine .
This is true under “normal” conditions. Under a war situation the price of DIY could be far higher. This issue, extremely important when this paper is written, is not part of the current discussion. But it should be obvious that issuing a new currency under the present war situation could devastate the economy of Palestine .
Alesina and Barro make the following observation: “in a world of small and highly integrated countries, where the benefits of low and stable inflation are highly valued, one should observe a collapse of the
“one country- one currency” identity and a move toward a world with relatively few currencies”.
6. A currency union
Taking into account the situation in Palestine and the views of the economic profession and experience it seems that a. Palestine . And b. Preferably will opt for a non-independent currency.
Which?
There are basically two possible regimes: issuing a currency but linking it to a stable foreign currency. Or adopting a foreign currency.
The first is easier. One country does not need the approval of the other to form such a linkage. Israel linked its currency to the US dollar following the 1985 stabilization program without the need to gain US . Argentina . The same holds for Hong Kong , in 1983.
Such a linkage is considered worthy of countries that are in the process of stabilizing their economies. Having a currency, which is under pressure due to inflation, speculation and inadequate domestic policies, requires a strict monetary policy. Some countries have opted to add linkage to a strong currency as additional tool to obtain credibility. However, it seems that in some instances this is not enough. If domestic policies “invite” speculation, the formal linkage does not suffice. The country is then under a dilema: to stick to the linkage and risk its foreign currency reserves; or break the linkage. Brazil .
In an open economy with a tradeable currency, it all boils down to the question: to what extent and at what price will the government be trusted to credibly control the economy. Palestine .
7. the best of the worse.
Bringing this discussion to its logical end means choosing the last option: to “adopt” a foreign currency for domestic use. This is what israel imposed on palestine . This paper has tried to explain why the Sheqel is a non-option. Is there a different option?
The Jordanian Dinar is an obvious choice. It has been a legal tender in the West Bank since Jordan . For many years the dinar was relatively a “stronger” currency than the sheqel. It therefore was used as a “hoarding currency” and as a denominator for long term transactions, similar to the function of the US dollar in the Israeli economy. With the weakening of the economy of jordan .
The same political considerations that rule out the sheqel, also rule out the dinar. Jordan . It is also a rival in many facets we shall not go into her. Anyway, its economy is so weak, that it will be a bad anchor to be tied to.
Assuming that the currency issue will become relevant under a political agreement, it is safe to assume that foreign countries will be involved in forming and implementing that agreement. Notably the European Union.
Some politicians and economists dislike the Euro because when it was born in was valued at $1. 17 and now only $0. 85. But when one takes into consideration that the Euro zone had very high unemployemnt at its birth, this devaluation seems in place. When considered historically, and in comparison to the recent change in the dollar-yen ratio, the shift in value - is not wild.
If we consider the fact that Europe will be the main trading partner with Palestine and the fact the notion that a free trade agreemnt is in place – the choice of the Euro as the future currency of Palestine .
The use of the Euro could be a European contribution to an agreement reached between Palestine and Israel . In fact adopting the Euro could be a good option also for Israel .
If both countries opted for the Euro under an agreement with the European Union, it could minimize the costs Palestine . Clearly such a cost exists, and due to dependence of Palestine on Israel . If every Palestinian employed in Israel . The same is true for all transactions which amount to about $6 billion per year. The magintude of these costs is , in fact, considered the main factor in staying with the sheqel as Palestine .
But if both countries switch at the same time to the Euro, not only is monetary stability guranteed,but also these costs will not have to be incurred.
The Euro has additional merits. Since the Euro zone is very diverse in economic performance, it does not necessarily follow the needs of Germany . Its monetary policy takes into account the diversity of the different economies. Palestine and Israel could be at the same end as Portugal , Spain , Greece , and maybe Cyprus .
NOVEMBER 2000
Notes
(1) Mundell R, “A Theory Of Optimum Currency Areas”, American Economic Review, Vol. 51, September 1961, pp. 657-665.
(2) Mckinnon R, “Optimal Currency Areas”, American Economic Review, Vol. 59, pp. 717-724.
(3) ליאו ליידרמן, "האם אינטגרציה כלכלית מחייבת איחוד מוניטרי", הרבעון לכלכלה 94/1 עמ. 44-49.
(4) Arnon A. & Weinblatt J. , “Sovereignty and Economic Development The Case of Israel and Palestine .
(5) Ha’aretz 26. 10. 2000 p. C2.
(6) Cassella A. , “Participation in a Currency Union ”, American Economic Review, Vol. 82(4), September 1992, pp. 847-863.
(7) Alesina A. & Barro R. , “Currency Unions”, National Bureau of Economic Research, Working Paper 7927, September 2000.
