New Zealand Herald 07.05.2002

Keywords: Globalisation & Trade; Macroeconomics & Money

Should New Zealand form a currency union with Australia, just as until recently Argentina did with the United States dollar? A fixed exchange rate between two markets is clearly advantageous to the exporter, whose one ambition is to sell to Australia. But more than 80 per cent of exporters and 90 per cent of the economy have other ambitions.

To argue the case for a currency union we need to go back to fundamentals. Consider the basic weakness of the economic model which the advocates used. It is a one-price model – the only price it has is between money and aggregate production. If relative prices between the various components of production and expenditure do not change, or do not change quickly, the one-price model works reasonably well. But sometimes those prices change rapidly. The Argentinian crisis was precipitated by the US dollar rising relative to other currencies, which hurt exporters who sold outside the dollar zone and import substitutors who competed against imports from non-US sources. For a number of reasons Argentina was not a well-run economy and we could easily get bogged down in the details of its failure.

So consider an example of another country in a common currency which slumped into economic and social turmoil when there was a significant relative price shift. New Zealand up to the early-1930s had a common currency with sterling. When New Zealand export prices relative to import prices crashed as a result of the world depression, much of the policy of the time was focused on how to restructure the domestic price levels. A part of that restructuring was the devaluation of the New Zealand currency against sterling – in effect, the busting of the common currency union we had with Britain.

In the 70 years since, New Zealand has never re-entered a common currency union. Nothing has happened to suggest it will work a second time if we get a major relative price shock, which the Argentine experience shows remains a real threat in the volatile international system. Why, then, advocate a currency union with Australia when at most only 10 per cent of the economy may benefit?

Unfortunately, those who use the exceptionally simple one-price model (the model used by monetarists) are not going to see the treacherous prospects for a real economy with many prices. But there is a deeper issue. A group of New Zealanders suffer from the colonial cringe – an inferiority complex about the prospects for New Zealand. They do not have that sturdy faith in the country being a success that is common in Australia today.

Instead, they believe that New Zealand cannot survive on its own and needs to hook up with some bigger economy. Australia is an obvious candidate. But if New Zealand is too small to go it alone, the likelihood is that Australia is too small, too. Its economy is only six times bigger than New Zealand. The two countries combined would be but 2 per cent of the OECD. A currency union between them solves nothing, and exacerbates everything.

By ignoring the complexity of a real economy, the single-price economic model does not require any policy instrument to deal with an external shock from changes in relative export prices or international exchange rate relativities. The economy would still adjust to such shocks. In the case of a terms of trade collapse, it would go into a long period of disinflation, depression, unemployment and stagnation. As Gordon Coates judged in the 1930s, it is better to change the exchange rate and get expansion under way. (If export prices rise sharply, the economy is likely to experience sharply rising inflation.) Even were there never any such shocks (New Zealand gets a major one about once a decade), the strategy would be wrong, because it sees New Zealand’s economic destiny with Australia, even though we send but a fifth of our export merchandise there.

To get too close to the Australians, as the limited-vision, little New Zealanders want us to do, diverts us from the big project on which New Zealand’s survival depends – engaging with the whole world.

Listener columns which explore some other aspects of the ideas in this article include:
DONT CRY FOR US ARGENTINA February 9, 2002.
WALTZING WITH MATILDA September 15, 2001.