Ethnic Politics and Fiscal Dominance: Implications for Currency Union Formation in Sub-Saharan Africa

Abstract

Numerous currency unions have been proposed in Africa over the past 50 years, but none have succeeded. This paper asserts ethnic favouritism is a crucial yet often overlooked feature that strongly influences an African government’s willingness to join a currency union. We use a Barro and Gordon(1983) style model that incorporates fiscal dominance, political business cycles and ethnic favouritism to assess the benefits and costs to African households and governments of joining a currency union. Our results show that ethnic alignment between the head of state and central bank governor amplifies fiscal dominance, which reduces an African government’s desire to surrender monetary autonomy. A currency union is more beneficial to African households if the common central bank is free from political influence of its member countries and more beneficial to African governments if fiscal dominance persists. Both African households and governments will gain utility from joining a monetary union if the trade benefits are strong enough to overcome the costs of belonging to the union. Given the prevalence of fiscal dominance and modest trade among neighbouring countries, it is easy to understand why Africa has made little progress toward implementing currency unions in recent years.