The Experiences Of Monetary Union

Listener 30 September, 2000.

Keywords: Macroeconomics & Money;

It is extraordinary how much economic debate in New Zealand is oblivious to any evidence. Recent advocates of the New Zealand economy going into monetary union with Australia or the US seem quite unaware that it has spent over half of the time since 1840 in one, and is currently in one. We can learn from both experiences, but the lesson is not what the advocates want us to hear.

Here is an example of what happened in the early 1930s. The story is told by Bernard Ashwin, later Secretary and founder of the modern Treasury, although here he is only a Treasury officer.

“I recollect quite vividly one day my door in the Treasury opening. [Gordon] Coates [then Deputy Prime Minister] came in and said ‘come on. Get your hat. We are going to take the Bank on.’ By that he meant the Bank of New Zealand, of which the government at the time owned about one third of the shares. So we went to meet the Board of the Bank, which at that time was known as the ‘Kelly Gang’. And our argument was long and fierce.”

Ashwin then describes Coates’ request that the trading banks should ease the monetary pressures, and goes on:

“Coates, of course, took the ring and I was more or less in the position of holding the towel and being his second. However, they would not shift. Mr Buckleton [the BNZ board chairman] dominated the discussion and he would not budge at all. So on the way back in the car, Mr Coates said to me, ‘well, where do we go now?’

I replied ‘there is only one answer. We must found a Reserve Bank and take the right of note issue and control of credit away from them.’

‘All right,’ he said, in his direct manner, ‘you see [the Minister of Finance] in the morning and go to it.’

At the time New Zealand was in a monetary union with Britain which set monetary policy for those countries whose trading banks held their reserves in sterling (the British currency) and had no Reserve Bank. The exchange rate was fixed, and there were no exchange controls. Coates wanted New Zealand to run a different monetary policy from Britain. That made sense at the time because the Great Depression impacted on us rather differently from Britain (because we were so dependent on pastoral exports). However he was unable to, because that required the New Zealand government to get agreement from the trading banks, and they refused. Whether it was because they were conservative or because they were controlled by British monetary policy hardly matters. The lesson is that in a monetary union with a larger economy, New Zealand would have to adopt their monetary policy, and would lose the freedom to run a different one.

We are also currently in a monetary union. Don’t laugh: it is with the Cook Islands. Look it from the perspective of the smaller partner. It the 1990s, the Cooks suffered from a severe external stock basically they suffered more than New Zealand from the economic policies we were running at the time. They tried to run an independent monetary and fiscal policy, but to cut a long story short, the trading bank that acted as the Islands’ banker forced them to change, causing government layoffs, unemployment, hardship, and depopulation.

As it happens, I do not agree with the policy the Cooks tried to run. But the policy I would have in their circumstances, which would have included addressing the external shock by an exchange rate change, was precluded because in a monetary union the Cooks’ exchange rate is fixed rigidly to the New Zealand dollar.

This repeats the first lesson. In a monetary union the smaller partner has much less freedom of policy manoeuvre. Note that both cases involve major shocks. When things are going fine the economy may not need an independent monetary policy. Arguing for a monetary union while ignoring shocks is like advocating abolishing the fire service because our houses are not usually on fire. We tend to have a significant external shock about once every three years and a major one about once a decade a higher rate than the chances of your house burning down.

Space precludes my detailing the problem of fixing the exchange rate in a monetary union. The experience of the British pound in the early 1990s has some relevance here. Joining in a preliminary monetary union with the rest of the European Union, they chose the wrong rate, and suffered a currency disaster. When Britain chose the wrong rate in the 1920s, it had a decade of depression as a result. Fixing an exchange rate is a bit like trying to land a plane in a fog on an aircraft carrier in a ranging sea. Better stay floating in the air than crashed rigid on the deck.

Keynes said that he did not ‘know which makes a man more conservative – to know nothing but the present, or nothing but the past.’ Some of our commentators seem to nothing about either.