When Things Go Bump: Is Monetary Union a Help or a Hindrance?

Listener 5 June 1999

Keywords: Macroeconomics & Money;

The Cook Islands lost 13 percent of its population in the last two years, about the same as New Zealand losing Christchurch. The economy suffered some severe external shocks – mainly from New Zealand – which contracted the economy. The government tried to spend its way out of the crisis, ran out of foreign currency, and the consequential cuts plunged the economy into depression and unemployment.

Given the severity of the shocks, the Cooks were bound to face economic difficulties. But different policy responses can moderate the impact to different degrees. Because they were in a kind of monetary union with New Zealand – the Cook Island dollar is at parity and freely exchangeable with the New Zealand one – they were unable to change their exchange rate. Instead there was a reduction in national spending and a rise in unemployment was one. Because the Cooks are in a labour market union with New Zealand – the Islanders may readily come here – a major adjustment was through emigration.

New Zealand regions experience similar external shocks to the Cooks. But the local government in, say, Christchurch, in monetary union with the rest of New Zealand, knows it cannot spend its way out of a contraction. However the region is also in a nation wide fiscal union, paying taxes and receiving government spending. When its businesses close, the workers go onto the unemployment benefit and the tax drain lessens. The Christchurch contraction would not be as severe for the same shock as the Cook Islands’.

The recent rhetoric advocating monetary union has paid little attention to external shocks or how to adjust to them. Over the last thirty years New Zealand has had major ones (good and bad) in 1971-2, 1973-4, 1979, 1981, 1984, 1986, 1987, 1991, 1993, and 1997-8, including export price collapses, oil price shocks, the international world business cycle, and world financial chaos. I have probably overlooked some, but the record is an average of one every three years or less. If New Zealand’s economy is a ship buffeted by stormy seas, many of the arguments for monetary union assume that the sea is calm. As Keynes said “economists set themselves too easy a task if in tempestuous seasons they can only tell us when the storm is long past the ocean is flat again.”

Forming a monetary union with Australia or the US (or Pantagonia, for the advocates seem not to care with whom), would mean give up the ability to use monetary and exchange rate policies to assist the adjustment with the external shocks. But there would be no fiscal union, and there is no labour market union with the US. We would be better off by being a state of either country. It is true there is not full fiscal union in the European Union (there is labour market union) but there is a supranational political system and there are central funds. If, for instance, there was a disease which destroyed the olive crop of its Mediterranean members (equivalent to foot and mouth disease here), the European Union would switch its funding to help the devastated regions adjust.

If there can be no emigration and no fiscal inflow, monetary union forces a region to adjust by reducing its domestic price level. We simply do not know how to induce deflation on top of an already contracting economy without causing a depression. I am not saying that with independent monetary and exchange rate policies, a country can avoid the pain from a large detrimental external shock. The Cook Island’s are bound to suffer a major and painful adjustment. But not having available the full range of policy instruments is like turning up to fight a big fire with a fireman or two short.

Whatever the nationalist reasons for monetary independence – for having one’s own currency – if there were significant gains to be made from monetary union, the task would be to redefine our nationhood in terms of a country without its own money. Its a challenge many European nations and sub-nations are facing. But monetary union without full economic union makes the ship easier to manage in calm waters. The concern is its seaworthiness in storms. That probably means sailing under its own flag.