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Will the euro be Europe's last monetary union?

Not to bore you with history, but Europe has dealt with failed currency unions before. Since the 14th century, Europe has seen more than 10 monetary unions come and go. It's probably even more, when you consider that such alliances stretch back to at least to the 2nd century BC when Greek city states shared a common currency. Yet there's one failed union that economic historians cite as a precedent for the potential demise of the euro.

Unlike Germany and Great Britain, France was on a bimetallic monetary system during the 19th century, where both silver and gold coins were accepted as legal tender. Because France had a large economy, its gold and silver coins circulated in border nations such as Belgium, Italy, and Switzerland.


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France and these three countries eventually formed the Latin Monetary Union (LMU) in 1865. France considered the alliance a means to enhance its influence in Europe. The other countries joined because a closer relationship with France would lead to more trade and access to capital. The LMU didn't restrict its members from issuing their own currencies but established a uniform standard for coinage based on the French franc.

And then…Greece joined the LMU in 1867. Greek officials knew that as a poor nation, it would benefit by allying with the rich LMU countries, according to a Bank of Greece economist. But because Greece was economically unstable, LMU countries were initially reluctant to approve its membership. "Greece was a useless appendage to the monetary league," writes one economic historian. In the end, France saw Greece's admission as a means to expand its monetary system.

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The LMU disbanded in 1923 for two reasons. First, Gresham's Law. In the late 19th century, the price of silver cratered, so foreigners brought their silver coins to LMU nations, where the price was fixed, and sold them at a profit. People hoarded gold coins, which became scarce. To retain gold coins, LMU countries competed with each other, over issuing silver coins and not honoring each other's coins. It was a union divided.

The second fatal flaw was decentralization. For example, Italy issued paper money in the late 1860s to cover its expenses, which led to spending and inflation. Italy's money was supposed to have a fixed value and be accepted by other LMU members. Yet Italy repaid its debts with its depreciated currency, creating a "free rider" problem among the LMU nations. There was no central power, not even France, which could enforce the LMU agreement on others. Though it lasted fifty-eight years, the LMU was a weak alliance, as members eventually adopted policies that better served their national interests.

Unlike the European Monetary Union (EMU), the LMU didn't have a shared parliament, central bank, stabilization fund, or for that matter, currency. So exiting the LMU wasn't as economically perilous as the prospect of leaving the EMU.

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But the demise of the LMU illustrates how a shock can obliterate a currency union. When silver prices slumped, the alliance splintered. Regarding the EMU, the sovereign debt crisis has shocked Greece into possibly leaving and setting a damaging precedent. When the next shock happens, another "free-riding" country may leave too, especially if Greece's economy recovers post departure. To limit the effects of a shock, the EMU should be more disciplined in its application of the Stability and Growth Pact, during the entire economic cycle.

An enduring monetary union requires a strong political one. Sure, monetary unions have the political will when times are good. However, like the LMU, the EMU's weak political union has been exposed by the Greek crisis. Policy makers in Brussels and Frankfurt aren't accountable to Greek voters – and Greek officials are merely representing their people. For the EMU to last, European countries must forge a common identity, establishing a fiscal and eventually political union.

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If there's not a strong political union, the EMU will be the LMU: Last Monetary Union. At least for a while.

Commentary by Kabir Sehgal, author of the New York Times best seller "Coined: The Rich Life of Money And How Its History Has Shaped Us." He is a former vice president at JPMorgan and Grammy-winning producer. Follow him on Twitter @HiKabir.