United We Stand:
The Pros and Cons of Currency Union
by Don Brash
Click here for PDF version

The volatility and plummeting value of both the Australian and New Zealand dollars has renewed interest in the idea of a joint currency. Most of the costs and benefits fall on New Zealand as the smaller country in such a union.

There has been a huge increase in interest in exchange rate regimes in recent years, with eleven European countries abandoning their own currencies and forming a currency union. Closer to home, Sir Frank Holmes and Dr Arthur Grimes, two highly regarded economists, released a study earlier this year entitled An ANZAC Dollar? (Grimes, Holmes & Bowden 2000), which has further intensified public and political interest in the subject (see previous article in this issue).

It seems clear from the survey conducted for the Holmes/Grimes study by the National Bank of New Zealand that a substantial majority of the New Zealand business communityÑor at least a substantial majority of those who responded to the surveyÑare in favour of a currency union with Australia.

The study also suggested that a currency union with Australia (involving a new central bank for both countries, and a new currency) could have some useful benefits for New Zealand. However, the authors proposed a currency union rather than New ZealandÕs adoption of the Australian dollar, largely for reasons of political acceptability in New Zealand.

Whether such an approach would meet the political acceptability test in Australia is an open question. Preliminary comments from Australia suggest no interest whatsoever in abandoning the Australian dollar in favour of a new trans-Tasman currency. Moreover, any decision to abandon a national currency is fundamentally a political issue. Currency unions are generally formed as part of a larger strategic push for integration, often in combination with free trade agreements, harmonisation of legal standards and liberalised migration laws.

Viewed in this way, entering a currency union is a major foreign policy decision, and thus a matter for elected politicians. It is not a matter on which a central banker should express an overall opinion. But the choice of currency regime does have important economic implications, which need to be carefully assessed. Before weighing up the pros and cons, however, a number of myths about currency union need to be dispelled.

Myth 1: The Reserve Bank of New Zealand is opposed to currency union. If we ÔdollarisedÕ, using either the Australian dollar or the US dollar, there would be no need for anybody to be employed by the Reserve Bank of New Zealand and those now employed by the Bank would lose their jobs. If we went into a currency union, presumably with Australia, it is also likely that many existing Reserve Bank staff would lose their jobs.

However, the Reserve Bank is not opposed to currency union. Nor is it promoting currency union. The BankÕs responsibility is to advise Ministers about the economic pros and cons of currency union, and to foster informed public discussion on the issue.

Myth 2: Small countries are just too vulnerable to have their own currencies in the modern world. There are some extremely successful small countries with their own currenciesÑSingapore and Switzerland spring immediately to mind. And, contrary to popular mythology, the New Zealand dollar is not a particularly volatile currency. The big exchange rate swings experienced by the New Zealand dollar during the 1990s were not in the least unusual by the standards of other currencies (Brash 2000).

This suggests that while currency union would eliminate nominal exchange rate uncertainty for New Zealand traders within the currency union, there is no currency that we could adopt which would eliminate big exchange rate swings against countries outside the currency union. And since New ZealandÕs trade with Australia amounts to little more than 20% of the total, a currency union with Australia would still leave most of our exporters facing currency uncertainty.

In other words, currency union with Australia would buy nominal exchange rate certainty for those handling little more than 20% of our trade (especially those in the manufacturing sector), leaving those handling the other 80% of our trade still facing such uncertainty.

Currency union would certainly not buy anybody real exchange rate certainty, or in other words, certainty of a constant exchange rate after inflation has been taken into account.

Hong Kong has discovered this over the years. Although its currency has been tightly tied to the US dollar since the early 1980s, its real or inflation-adjusted exchange rate has appreciated quite strongly, both because the US dollar has appreciated against most other currencies and because Hong KongÕs inflation rate has been markedly higher than that in the United States. This has led to the steady erosion of the competitive position of Hong KongÕs manufacturing sector, and has been one of the factors leading to a move of manufacturing out of Hong Kong into southern China.

Myth 3: Currency union with Australia would greatly increase competition in the New Zealand banking sector. New Zealand already has an open and contestable banking sector. There are few regulatory obstacles to foreign banks entering New Zealand, provided they meet certain minimum qualitative criteria. Thus, it is clearly not necessary to enter a currency union in order to derive the benefits of foreign competition in the banking sector.

Myth 4. Currency union with Australia would make New Zealanders instantly richer. It is nonsense that currency union would somehow suddenly enable the New Zealand economy to grow as quickly as the Australian economy.

The fundamental driver of living standards in New Zealand is the rate at which we can improve productivity. This in turn depends on the quality of our education system, the quality of New Zealand management, the incentives provided by the tax and benefit system to work and acquire skills, attitudes to work and leisure, the pace of innovation, and so on. Currency union would have little effect on these matters.

Currency union within Australia itself has certainly not guaranteed that economic growth in Tasmania and South Australia will match that in Queensland. And PanamaÕs adoption of the US dollar in 1904 has not enabled Panama to perform as well as the US economy. Other factors and other policies are much more important for our long term growth than whether we are part of a currency union.

Myth 5: Because other countries are forming currency unions or dollarising, New Zealand should do the same. The reasons why other countries are forming currency unions or dollarising have very little relevance to New Zealand.

In Europe, currency union was simply one part of a wider agenda of political, economic and regulatory integration. Some Latin American countries have locked themselves to the US dollar, and some are thinking of full US dollarisation, but only because of decades of extremely poor money management and hyperinflation. Neither of these situations has any relevance to New Zealand.

Moreover, in the last few years a large number of countries, particularly but not exclusively in Asia, have moved away from tying their currencies tightly to some other currency, in favour of a floating exchange rate. Certainly, there has not been a generalised international move towards currency union or dollarisation.

The real economic pros and cons of currency union

Despite the myths, there are some valid arguments as to why a currency union might have economic advantages.

At this point, however, it should be noted that there are some differences between Ôcurrency unionÕ (implying a new central bank and a new currency, as in the case of European Monetary Union) and ÔdollarisationÕ (implying the simple adoption of the currency of another country, whether in New ZealandÕs case that be the Australian dollar or the United States dollar).

The major difference between dollarisation and currency union is whether New Zealand would play any part in decisions about the monetary policy that would affect it. In a currency union, all the countries included in the union have a sayÑin principleÑin forming monetary policy for the area covered by the union. That is, all countries have a voice at the table, even if that is only a single voice among many. In the case of dollarisation, however, only the country whose currency is adopted makes the decisions about monetary policy.

The case for currency union

A currency union seems certain to reduce the transaction costs incurred now by traders and travellers exchanging New Zealand dollars for other currencies. This would probably not produce a huge saving in a currency union with Australia, although there would be worthwhile benefits for tourists in both directions. However, because so much international trade is conducted in US dollars, the savings would be considerably greater if we were to adopt the US dollar as our own currency.

Second, a currency union with Australia might reduce average New Zealand interest rates a little. By adopting either the Australian dollar or the US dollar, we would avoid the need to pay the currency risk premium that savers currently demand for holding New Zealand dollar assets.

But it is also the case that a currency union would remove any chance of New Zealand interest rates falling below those in Australia (or the United States, if it was the US dollar we adopted). It is worth recalling that New ZealandÕs long-term interest rates were somewhat lower than those in Australia through the first half of the 1990s and slightly lower than those in the United States for a time in 1994.

If New Zealand continues to keep inflation well under control, and continues to maintain the confidence of financial markets by following a prudent fiscal policy, it seems entirely reasonable to expect that in time New Zealand interest rates could fall below those in both Australia and the United States. However, in forming a currency union we would in effect be betting that, no matter with whom we formed that currency union, their policy performance would be better than our own could have been for the indefinite future.

Third, while currency union with Australia or any other single country would not eliminate the exchange rate uncertainty that New Zealand exporters face, it would clearly eliminate the nominal exchange rate uncertainty for trade with the country or countries forming part of the currency union (and probably reduce the real exchange rate uncertainty also).

As a result of this reduction in exchange rate uncertainty within the currency union, it seems very likely that currency union would stimulate trade with other parts of the currency union. However, empirical research on the effects of currency uncertainty on trade is, unfortunately, not very conclusive.

My view is that a currency union would indeed increase trade between New Zealand and other parts of the union, and that seems to be the view of the business community also. If correct, then a currency union with Australia or the United States would stimulate trade within the currency union. To that extent, it could produce some worthwhile productivity gains, as New Zealand producers moved into areas of greatest comparative advantage.

The case against currency union

On the other side of the ledger, there would be one potentially major and one more minor disadvantage of a currency union.

The potentially major disadvantage would be the loss of an independent monetary policyÑin other words, the loss of a very important way of moderating demand shocks and the loss of any ability to influence our own inflation rate. This loss would seem to apply whether the currency union was with Australia or the United States, and whether it involved the creation of a new central bank (possible in the case of Australia) or simply dollarisation.

Clearly, if New Zealand enters a formal currency union with Australia, involving a new central bank with representatives from both countries and a new currency, New Zealand would have some say in the formulation of monetary policy. But realistically, that say could only ever be a small voice alongside the much larger voice of the Australian economy.

Views will differ on how important this loss of monetary independence would be. But we can see from recent international experience that such a loss can have very substantial and sometimes very adverse implications.

For instance, there is little doubt that Argentina has had a more prolonged recession over the last few years, compared with some of the other major countries of Latin America, because Argentina has been tightly tied to the United States dollar through its currency board arrangement. As a consequence, the Argentine currency has been pushed upwards, along with the US dollar, against the currencies of many of ArgentinaÕs trading partners.

Similarly, Hong Kong seems to have had a more prolonged recession than many other Asian economies for the same sort of reason. Interestingly, during the 1990s the trade-weighted real appreciation of the Hong Kong dollar, tied tightly to the US dollar, was much greater than the maximum appreciation of the New Zealand dollar during the 1990s.

Conversely, it seems clear that within the European Monetary Union some of the smaller economies such as Ireland have been overheating rather dramatically recently, with monetary policy determined by the new European Central Bank in the interests of the whole currency union almost certainly too easy for those smaller economies. While it may create prosperity in the short term, it may also create considerable difficulties down the road.

Were New Zealand to join Australia in a currency union, our interest rates and the exchange rate we faced would be influenced by the common central bank (in the case of a genuine currency union), or by the Reserve Bank of Australia (in the case of Australian dollarisation). In practice, it would be the needs of the Australian economy that would dominate the monetary policy decisions in either case. And, of course, adopting the US dollar would mean accepting whatever monetary policy seemed appropriate for the US economy.

This would probably tend to increase the magnitude of New Zealand business cycles and the variability of New ZealandÕs inflation rate. With no ability to use New Zealand monetary policy to deal with these cycles, it would be necessary to use fiscal policy more actively, and to encourage more flexibility, both up and down, in prices and wages, to moderate these cycles.

The minor disadvantage of dollarising would be the loss of what central bankers call seigniorage income. This is the interest income generated when central banks issue currency. In New Zealand it amounts to about $130 million each year.

If we were to join a currency union modelled on the European Monetary Union, we would retain a share of the seigniorage income appropriate to our relative size in the new currency union. But if we were simply to adopt the Australian dollar or the US dollar, it is likely that we would lose the benefit of that income to the country whose currency we adopted. Not a huge loss perhaps, but $130 million each year, growing gradually, should not be given away without some thought!

Conclusion

Clearly, joining a currency union or adopting the currency of another country has potentially important implications that go well beyond economic issues. It is sobering to note that Canada, a country doing almost 80% of its trade with the United States, has nevertheless chosen to retain its own currency. In fact, a recent article by a senior economist at the Bank of Canada argued that, given the way in which CanadaÕs terms of trade behave relative to those of the United States, having a separate Canadian currency was very much in CanadaÕs national interest (Murray 1999).

It may well be appropriate to widen the range of options somewhat before we reach any conclusions at all. For example, it might be possible to negotiate a comprehensive free trade agreement with the United States as part of a package involving our adoption of the US dollar and surrender of the relevant seigniorage income. Losing the seigniorage income might well be a worthwhile concession in return for a free trade agreement with the US.

Clearly, there are lots of potential options. For this reason, there can be little doubt that this issue will be a matter for public discussion and debate for a considerable time to come. But it is crystal clear that currency union is not a magic path to substantially faster New Zealand growth. It is no substitute for domestic policies that promote stronger productivity growth. And is not an issue which should be decided in haste.

References

Brash, Don. 2000, ÔThe Pros and Cons of Currency Union: A Reserve Bank PerspectiveÕ, Address to the Auckland Rotary Club, New Zealand, 22 May, URL: http://www.rbnz.govt.
nz/SPEECHES/sp000522.htm.

Grimes Arthur, Frank Holmes, and Roger Bowden 2000, An ANZAC Dollar? Currency Union and Business Development, Institute of Policy Studies, Wellington.

Murray, John. 1999, ÔWhy Canada Needs a Flexible Exchange RateÕ, Bank of Canada Working Paper: 99-12, Bank of Canada, Ottawa, URL: http://www.bankofcanada.ca/en/
res/wp99-12.htm.

About the Author
Don Brash is Governor, Reserve Bank of New Zealand. This is an extract of a speech delivered by Dr Brash to the Auckland Rotary Club, 22 May 2000.

Policy is the quarterly review of The Centre for Independent Studies. For more information on subscribing to Policy, click HERE

If you are interested in the Centre's activities and publications, why not subscribe to e-PreCIS, our regular email update on the latest news and events.

(e-PreCIS requires html capable email facilities, such as Microsoft Outlook Express or Netscape Messenger)