Anzac spirit

By Donal Curtin

Monday 1st March 2004

The Kiwi dollar is having one of its bipolar episodes - down in the dumps below 40 cents one moment, bouncing towards 70 cents the next. Currently it's dancing to music only it can hear, its pupils the size of pins.

At times like these, it's not surprising that people are beginning to ask, is there A Better Way? Do we need all this volatility, or would we be better off with some other, more stable, exchange rate arrangement? One in particular shimmers into half focus: what if we had a common currency with Australia?

This sounds, at first blush, like one of those metaphysical debates economists like to have, where there's no possibility of a clear-cut answer. In fact, the economics of the thing aren't that complex. Back in 1965, a Canadian economist, Robert Mundell, got the ball rolling as follows. In one sense, the argument goes, a separate currency is a good thing - if you've got a problem particular to your economy, you've got your own exchange rate to manipulate as one of the policy levers to pull. But from another viewpoint, it's a damn nuisance - all those transaction costs of switching between currencies, plus (a bigger issue) all those business deals that don't take place because people are scared off doing them by the exchange rate variability.

Mundell got to the idea of an "optimum currency area": if there were regions similar enough, they wouldn't each need their own currency. Because they're alike, the one exchange rate would do for all of them. And how would you know if they were alike enough to meet the test? Because you'd observe that resources - people, money, businesses - move freely between them.

Mundell's analysis was the frame of reference used by almost everyone when the euro hove into view: unsurprisingly, the 11 countries of the common euro zone were widely judged to fail the "alike enough" test (what's the likelihood of a Sicilian peasant moving to Sligo?). And, as it transpired, an interest rate low enough to help the sluggish French and German economies helped to generate the mother of all house price inflations in Ireland. That wouldn't have happened if Irish folk were in the habit of moving to new jobs (and bargain housing) in Palermo, or if the Palermo spec builders were used to getting on a plane and building houses in Galway.

On the other hand, the prima facie case for Australia and New Zealand being an optimum currency area looks pretty strong. Resources can and do move freely between the two, and residual barriers are, by and large, being chipped away. As a result, the chance that an exchange rate and interest rates suitable for Australia would be wildly unsuitable for New Zealand isn't very high.

Note the bundling of exchange rate and interest rates, though: they come as a package deal. Fix your currency permanently to someone else's, or use someone else's, and you also get their interest rates (and their monetary policy and their inflation rate). That's more than just theoretical economics: it's exactly what happened in practice with the Irish pound. It had 150 years of a fixed parity with sterling, and over that time Dublin interest rates and Irish inflation were virtually indistinguishable from London interest rates and British inflation. When the Irish peeled off and joined the euro, Irish interest rates became those set by the European Central Bank.

Part of the deal, in short, would be signing up for the Reserve Bank of Australia's processes and policy stance. Again, that doesn't look too bad: the RBA's inflation target is 2-3% inflation on average over the business cycle, and it has delivered credibly on that. We'd be giving up a bit on the deal - our Reserve Bank is more independent than the RBA, and there's greater transparency in its decisionmaking - but it wouldn't be the end of the world if we swapped.

One other benefit is that it would be an easier story to tell to would-be overseas investors into New Zealand. We're well behind in the contest for overseas direct investment projects - it must surely help the investors' decisionmaking if they've got one less variable to factor in.

Granted, some sort of currency union or link with the Aussie dollar wouldn't be an exchange rate panacea. You'd be removing volatility between the Kiwi and Aussie dollars, but you'd still have volatility between the new unit and the rest of the world (especially against the US dollar, which has been the source of most of the recent gyrations). Even so, you'd have one less currency risk to worry about.

Not that I'm expecting any immediate progress: the political interest isn't there (the Aussies have less than zero interest thus far, and it's nobody's priority here), and irrespective of what the economic benefits may look like, it would obviously require a political decision for them to be bagged. But it can be done: the politicians of the Irish Free State in the 1920s handled some of the sensibilities by having Irish notes and coins made with Irish designs, while maintaining the one-for-one parity with sterling (British notes were widely used in Ireland, but Irish notes weren't accepted in Britain, which says something about both countries). The euro experience also shows that people can be persuaded.

In all probability, if we're ever going to see a common "Anzac" currency, or a fixed rate between the Aussie and Kiwi dollars, it's going to have to wait till there's a big set-piece discussion on closer economic integration more generally.

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