Greece learning flipside of using euro, writes Andrew Gawith.
The choice between a floating and a fixed exchange rate has prompted a lot of technocratic discussion about their relative merits.
A fixed exchange rate, or the more irreversible currency union, offers certainty to exporters; a floating exchange rate provides the economy with an automatic stabiliser.
But the day-to-day benefits of either pale before the question of how that decision will cope, or survive, in the face of a crisis.
The euro is surely the boldest modern currency union. And it is facing is toughest test now, in the aftermath of the credit crisis, as markets question whether the weaker euro-zone governments can hope to pay back the mountains of debt they have accumulated as the result of recession and stimulus and bailout expenditure.
The crisis facing Europe's fiscal delinquents is largely of their own making. The credit crisis exposed the vulnerability of their governments' deficit spending, but the decision to borrow recklessly was made in calmer times.
But for Greece, and perhaps soon for Portugal, Spain and others, their fiscal situation is being exacerbated by the straitjacket of the European Monetary Union.
It is this arrangement that has fanned the flames of crisis, while countries like the United Kingdom remain largely unaffected, despite also possessing massive fiscal deficits and mountains of debt.
Adopting the euro allowed Greece to piggy-back on the currency stability and monetary policy credibility of the larger and better-performing EU countries.
That brought initial benefits - principally, the ability to utilise that credibility to borrow at much lower interest rates.
Unfortunately, too many of the smaller EU currencies have taken those lower interest rates as an opportunity to borrow profligately and prop up an unsustainable standard of living (with the treaty designed to restrict EU member deficits to 3 per cent of GDP proving unenforceable).
Now Greece is faced with the costs of the monetary union. Lacking its own exchange rate, it can't devalue to restore competitiveness to its export sector. Lacking independent monetary policy, it can't inflate debt away.
Reducing its fiscal deficit has to come through adjustments in real variables - ie cutting wages to restore competitiveness. Needless to say, this is a hard ask, and one that has seen the Greek unions marching in the streets.
The mathematics of sustainable fiscal positions involve both the stock and the flow of debt.
Large, temporary deficits are okay if you don't have too much debt, and large amounts of debt are okay if you can meet the interest repayments without excessive deficits. Normal economic growth also goes a long way to helping to keep the ratio of debt to GDP under control.
So a country with debt of 100 per cent of GDP, and 5 per cent nominal GDP growth rate (fairly standard) can keep the debt-to-GDP ratio steady with a deficit of less than 5 per cent of GDP a year. At a 5 per cent interest rate on that debt, a government could simply borrow to repay its debt, and keep the debt ratio stable, providing the rest of its budget was in balance.
But these dynamics are potentially very unstable. If interest rates rise from 5 per cent to 10 per cent, suddenly the government must improve the budget position by 5 per cent of GDP.
Most government sectors make up about 40 per cent of GDP, implying that to do so entirely on the expenditure side requires a 13 per cent across-the-board cut (assume that public sector wages can't be reduced and those numbers get even less manageable).
To make matters worse, standard Keynesian economics implies that fiscal contraction tends to shrink the real economy, making it even harder to stabilise that debt.
From this example, it is easy to see how increases in the deficit or increases in interest rates can see countries spiral off a sustainable pathway, especially once creditors start to doubt a country's ability to repay.
Greece is in that situation now, with debt of 115 per cent of GDP, a deficit of 13.6 per cent of GDP, and borrowing costs of 10.2 per cent on its bonds (compared to 4.6 per cent six months ago).
The Greeks have been living well beyond their means, so it is hard to feel a great deal of sympathy for the painful fiscal austerity plan they're now attempting to enact. But are New Zealanders in any position to judge?
Although New Zealand's public debt position is fairly sound, our total net debt to foreigners is 94 per cent of GDP.
With a current account deficit of 5 per cent of GDP (about average for the last 20 years), that is currently a stable position. Nevertheless, it is clear the same mathematics apply - higher borrowing costs could see that ratio explode dangerously.
The test of NZ's financial stability came during the credit crisis, and this time around we passed the stress-test. The free-floating New Zealand dollar initially fell 31 per cent to buffer the shock. And the current account deficit was cut back from 9 per cent of GDP to 3 per cent in the space of the year.
That adjustment was not easy - wages stagnated, belts were tightened, and jobs lost. But it was still a degree of magnitude easier than the adjustment facing Greece.
Of course, the fact that New Zealand avoided the banking crises infecting the rest of the world was an immense help. William Buiter, Citigroup's chief economist, has argued that small floating currencies are basically unsustainable in combination with an internationalised banking sector. Iceland was the prominent casualty of this mixture during the credit crisis.
The long-term viability of an independent New Zealand dollar remains an open question.
Conceivably, NZ's fiscal discipline would make it a more suitable candidate for a monetary union than Greece. But looking at the recent fates of the two countries, it is hard to downplay the value of a flexible exchange rate.
* Andrew Gawith is a director of Gareth Morgan Investments.
