01:00 AM EDT on Wednesday, October 12, 2005

WELLESLEY, Mass.

THE BENEFITS of joining a currency union and the costs associated with withdrawing from one can be enormous. There are two recent illustrations of the importance of computing the net benefits of currency unions and making sure that all the costs and benefits are considered.

In 2004, 10 nations (the "accession countries") joined the European Union. These nations had applied for E.U. membership years ago, and worked to make their laws and institutions consistent with E.U. guidelines. The accession countries also set their sights on becoming members of the European Monetary Union (EMU), and are on track to adopt the euro. As a result, these nations have already captured many of the benefits associated with full-fledged currency-union membership.

The second illustration is a proposal, which fortunately has not been implemented. After the French and Dutch votes against the European constitution this summer, two Italian cabinet ministers suggested that Italy hold a referendum on withdrawing from the European Monetary Union and reissuing the Italian lira. They obviously felt that having an independent central bank would be advantageous to Italy. It is unclear whether they considered the enormous potential losses in wealth that would occur.

One of the most important, but largely ignored, benefits of joining a currency union is the dramatic increase in wealth that accrues to the new member. It results from the rapid and significant reduction in new members' nominal interest rates, which occurs when these nations replace their profligate central banks with a responsible supranational one.

Capital markets reward prudent central banks by lowering the risk premiums and expected inflation premiums that are built into nominal interest rates. To get an idea of how large these gains in wealth can be, consider this example.

If the fixed interest rate on a 10-year government bond fell from 12 percent to 4 percent, the bond's value, and therefore the wealth accruing to its owners, would rise almost 65 percent. Likewise, increases in nominal interest rates would significantly reduce investors' wealth.

Using published statistics and a familiar formula for determining the value of assets earning fixed-income streams (e.g., capital stock, real estate, incorporated businesses, unincorporated businesses, and intellectual property), we estimate that, between 1993 and 2003, the 10 accession countries' efforts to become E.U. and EMU members increased investors' wealth between5 trillion and11 trillion euros.

Our estimates also show that if Italy abandoned the EMU, and its interest premiums relative to the euro returned to pre-Maastricht Treaty levels relative to the German mark, investors in interest-sensitive Italian assets would suffer losses in wealth between 4 trillion euros (about $4.8 trillion) and69 trillion euros.

If our estimate ranges seem wide, it is because of the assumptions we have to make about the future growth rate of member nations' future income streams. Our lowest estimate assumes zero future growth, which is probably (we hope) too low. Our most aggressive estimate assumes that future growth will be 4 percent.

For the 10 accession countries, this 4-percent assumption may also be on the low side -- especially in view of their greater-than-7-percent-a-year gross-domestic-product growth rates between 1998 and 2003.

As a result of the accession countries' efforts to join the E.U. and EMU, there has been an enormous increase in wealth accruing to the owners of interest-sensitive assets denominated in these nations' domestic currencies, and the gains are not done. Even more staggering would be the potential losses to owners of interest-sensitive Italian assets if Italy were to withdraw from the EMU.

The massive gains and potential losses associated with currency-union membership are much like the proverbial elephant in the living room. Despite their size, they are rarely discussed.

According to our estimates, if the wealth-related economic benefits of currency unions were considered alongside flow-related effects -- such as the elimination of foreign-exchange uncertainty, greater specialization in trade and finance, economies of scale, increased competition, rationalization, and reduced transaction costs -- the scales would be tipped substantially in favor of currency-union membership.

John C. Edmunds and John E. Marthinsen are, respectively, Babson College professors of economics and of finance.