“I’m living on a one-way, dead-end street. I don’t know how I ever got there.”
— Comedian Steven Wright
When the members of the European Common Market agreed to form a monetary union in 1999, with the euro as its common currency, the continent was forced upon a one-way street, with no turning back. As the eurozone credit crisis drags on into its third year, many suggest that this one-way street is nearing a dead-end. Since, the thinking goes, the monetary union is not backed by by a fiscal union, nor is it enforced by a military union, the monetary union is rife with moral hazard.
I disagree about the dead-end. I see a fork in the road, but it remains unclear whether eurozone members have the wherewithal to make the turn in time. The question must be asked, though, why they are in this position to begin with? Is the euro really preferable to pegged or banded currencies? And, given the eurozone turmoil, why are Australia and New Zealand considering the single currency idea?
The answer to the last question is easy – economies of scale, and increased efficiency and productivity from the elimination of cross-border transaction costs. Of course, these are the same arguments that were presented to create the euro, and are the same arguments used every day for corporate mega-mergers. But, as we have all learned over the past few years, dangers are hidden beneath the surface, and cracks tend to form, grow, and manifest themselves at the most inopportune time.
Granted, tying currencies together into a bloc sends a powerful signal to the world. Just like the ancient Chinese saying, “break the kettles and sink the boats,” a formal bloc signals full commitment. In the case of the eurozone, however, it appears that they have passed the point of no return, and are now working on gaining universal commitment from the rank-and-file. There is no fiscal authority to back up the monetary imbalances, and no executive (military) authority to enforce compliance. Peripheral countries such as Greece and Spain have no exchange rate flexibility to fall back upon, but the populace sees no net benefit to accepting the punitive austerity measures contingent in further bailout. (Did we have to sink all the boats?)
Given the current eurozone impasse, is the euro bloc truly preferable to the European Rate Mechanism, which seemed to work fine for decades? Granted, when Great Britain dropped out in 1992 amid severe rate pressures, it certainly made for some volatile markets (and some painfully expensive lessons learned by yours truly). Overall, however, the market worked as it was supposed to work. There was a readjustment period, followed by a lengthy period of calm. Now, however, if Greece were to drop out of the eurozone, all hell would break loose, even though Greece’s GDP is about one sixth the size of the U.K. Go figure.
Switzerland provides a good example of how a currency can be successfully pegged to another with no loss in credibility. When the Swiss National Bank announced the EUR/CHF floor of 1.20 on September 6 of last year, they did so in powerful fashion, saying the central bank was prepared to defend the level “for as long as it is necessary and will defend it with utmost determination.” The floor has held for over seven months, with only two minor breaches, the latest one coming last week as the euro tanked on a Spanish fears.
The Chinese provide another modern example of how a central bank can manage currency pegs and/or bands without resorting to a full-commitment bloc. The People’s Bank of China announced over the weekend that it would widen the yuan’s trading band to one percent from 0.5 percent. This sent the signal of price stability and an end to the “managed appreciation” of the currency over the past few years. While the jury is certainly still out on yuan stability, the PBoC has earned kudos for its methodical transition to a free market.
In a fiat money scheme, the lack of an asset-backed standard often necessitates an alternative “value reference point” such as another, more stable reserve currency. Pegs and bands, if managed properly, can offer price stability, but keep the option open for flexibility. Forming a bloc may have its advantages, but full commitment is necessary, with “full” being defined as fiscal and military unity in addition to monetary unity.
Australia and New Zealand should think long and hard about whether they would like to travel down that road.