The latest turmoil on global currency and stock markets centres on the future of the European Union.  It is no exaggeration to say that there are growing concerns as to the long-term sustainability of the Euro as the common currency for 17 of the 27 member states of the European Union.

Despite the arguably strong economic case for a common trading area with similar tax, policy and standards protocols, the political case for union remains strained. This strain shows through at times of economic tension, and clearly underlies the muddled approach of the authorities to the risks of sovereign default.

In a nutshell, if an economic system wishes to retain a single currency, then monetary and exchange rate policies within the area must be sufficiently harmonised for imbalances not to emerge. Where such imbalances are inevitable, then forces other than exchange rates and monetary policy must be available to reduce the imbalances.

In both the United States and the European Union, sluggish domestic recoveries are exacerbating the effects of the underlying issue of unsustainable fiscal deficits. The largest difference between these two is that while the US has one federal government deciding fiscal tax and expenditure policies, the EU has many. The significance of this difference is increased when 17 of the 27 members of the EU share one currency.

For the EU there are essentially two options facing the17 members who wish to sustain their allegiance to the one currency. Either they align their fiscal policies, forcing member countries to adhere to previously agreed rules to keep fiscal deficits within a certain proportion of GDP, or the surplus members agree to continue to transfer funds and resources (i.e. lend/subsidise) to the deficit members. These are the options in the absence of an exchange rate mechanism to rectify such imbalances. Unfortunately neither of these options are palatable in an economic sense or in the political dimension.

In the former option, forcing an adherence to fiscal rules (euphemistically labelled ‘austerity’ measures) is likely to lead to significant unemployment and associated social hardship in some member countries, if not unrest. Further, the latter option is now becoming increasingly politically charged with taxpayers in the member surplus countries no longer keen to continue funding the deficit countries. Of course, the blame for the flouting of the rules in the early half of the previous decade should not be laid all on the deficit countries. The surplus countries themselves were complicit in allowing such unsustainable borrowing to occur.

Attempts now continue to focus on avoiding default. If successful, this will then set the scene for an (hopefully) orderly writedown of the assets held by the surplus countries (in their banks and financial institutions). This reinforces the point that it is not just in the debtor nations that adjustments are required.

Recall, if you owe a couple of million dollars to the bank, then it is you who is in trouble. But, if you owe the bank a couple of billion dollars, then it is the bank who is also likely to be quite worried.

Addressing these imbalances will no doubt lead to significant hardship for many people in these countries. Consequently, the governments of these areas are unable (or unwilling) to make sufficient adjustments to convince finance markets that their imbalances are under control. Hence there are increasing political tensions as some areas grow uncomfortable with the level of assistance that others require – especially if those other areas are perceived as not abiding by earlier agreed rules.

In such a situation, other countries within the common currency area are forced to ‘step-in’; that is, if they wish to protect the sustainability of their currency. This is relatively straight forward in the case where there is one federal government. However, the European Union clearly does not fit this case.

These heightened tensions were reflected recently when Netherlands Prime Minister Rutte called for more powers for the EU to enforce budget rules on member countries. He went so far as to suggest a new EU “Commissioner for Budgetary Discipline” who would have the ultimate sanction and be able to force countries to leave the Euro if they do not submit to the agreed rules. These comments follow calls by French President Sarkozy and German Chancellor Merkel for “true economic governance” across the Euro zone countries. Reading between the lines, some are now asking is a single currency worth it?

In the economic world, this political uncertainty is reflected in volatility. And this volatility is not restricted to Europe. For, if there is one thing that finance and currency markets do not like, it is political uncertainty.

The last couple of months have seen the major stock market indices gyrate daily, as brokers and investors respond to any morsel of information (whether rumour or real) and act in a seemingly knee-jerk manner. This behaviour is typical of an uncertain environment.

Associated with the uncertainty is a move towards assets and investments that are perceived to be relatively ‘safe’. Consequently, the price of precious metals has soared, as has the value of the Swiss Franc. The latter has led to Swiss authorities taking action to stem the appreciation in its currency because of its negative impact on Swiss exporters.

With their currency seen to be a ‘safe haven’, reflected in the unprecedented (and contrary to all economic textbooks) feature of short-term nominal interest rates turning negative, Swiss authorities have been compelled to take action. This has seen a move to put a ceiling on the Swiss Franc in order to protect the competitiveness of their export sector, with an extraordinary pledge from the Swiss National Bank that it is “... prepared to purchase foreign exchange in unlimited quantities”, and will enforce its exchange rate ceiling “...with the utmost determination”. It further states that “... doing nothing would almost certainly inflict tremendous long-term damage on our economy. With today’s measure, the Swiss National Bank is acting in the interest of the country as a whole.”

For New Zealand, our key policy question should not be when to raise interest rates, but why? The appropriateness of an inflation-target foundation to our macro policy framework may have been a no brainer two decades ago following two decades of double-digit annual average rates of inflation. But, in today’s world, where concerns over inflation seem minor compared with the finance, monetary, and debt issues that have already been responsible for the Global Financial Crisis.

Yes, the world has changed, and the sooner we realise this the sooner we will be able to make the necessary adjustments.