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C.D.

Howe Institute
Institut C.D. Howe Communiqué
Embargo: For release Tuesday, June 22, 1999, at 10:00 a.m.

Canada should pursue


North American currency union,
economists say
Canada’s floating exchange rate is not serving the country’s economic interests well, and the
solution could be to work toward establishing a North American currency union, say two of
Canada’s most distinguished economists in a study released today by the C.D. Howe Institute.
The study, From Fixing to Monetary Union: Options for North American Currency Integration,
was written by Thomas J. Courchene of Queen’s University and Richard G. Harris of Simon
Fraser University.
The authors argue that Canada’s experience with a floating exchange rate for the dollar
has been disappointing. Floating rates make real exchange rates more volatile, do not appear to
offer effective buffers against external shocks, and can result in prolonged currency misalign-
ments, as the current period of pronounced weakness relative to the US dollar demonstrates.
Such weakness and volatility may tend to discourage productivity improvements in Canadian
firms that export or compete with imports; bias investment toward US locations and thus away
from Canadian ones; and discourage the development of human-capital-intensive industries
in Canada.
Courchene and Harris argue that, as the Canadian economy becomes more open to trade
and investment flows and as those flows become more focused on the United States, the cost-
benefit calculation is growing in favor of greater exchange rate fixity with the US dollar. Such
an arrangement, the authors say, would encourage wage and price flexibility in Canada as
firms and workers became more conscious of their competitive positions in North America;
stabilize prices for Canadian financial and real assets; and reduce currency conversion and
other transaction costs on crossborder trade and investment.
Courchene and Harris explain that the options for greater exchange rate fixity run the
gamut from exchange rate targets, through adjustable pegs, a fixed exchange rate fully backed
by both the central bank and federal and provincial fiscal policies, a currency board, “dollariza-
tion” — whether “market dollarization” (the move by private sector agents to adopt the US
dollar for a range of purposes) or “policy dollarization” (an official decision by the policy
authorities to proclaim the US dollar as legal tender) — all the way to a formal North American
Monetary Union (NAMU). Courchene and Harris argue that, of the single-currency options, a
currency union would be far preferable to dollarization.
C.D. Howe Institute / Institut C.D Howe Communiqué / 2

Responding to fears that moving to a fixed exchange rate monetary regime or currency
union would involve a loss of sovereignty for Canada, Courchene and Harris say that such a
loss would be more apparent than real. They point out that it was during the fixed rate period
of the 1960s that Canada developed its comprehensive social policy infrastructure.
As a final argument, Courchene and Harris note that, in any case, events elsewhere in the
Americas are forcing the issue. There is already a trend toward dollarization both in free trade
partner Mexico and in Argentina, which may serve to constrain the potential for a North
American currency union. Canada needs to be part of any public debate on the evolution of
North American currency arrangements, the authors argue, to ensure that the NAMU option
remains on the table.

*****

The C.D. Howe Institute is Canada’s leading independent, nonpartisan, nonprofit economic policy research
institution. Its individual and corporate members are drawn from business, labor, agriculture, universities,
and the professions.

— 30 —

For further information, contact: Thomas J. Courchene (613) 533-6555;


Richard G. Harris (604) 291-3795;
Shannon Spencer (media relations), C.D. Howe Institute
phone: (416) 865-1904; fax: (416) 865-1866;
e-mail: cdhowe@cdhowe.org; Internet: www.cdhowe.org

From Fixing to Monetary Union: Options for North American Currency Integration, C.D. Howe Institute
Commentary 127, by Thomas J. Courchene and Richard G. Harris (C.D. Howe Institute, Toronto, June 1999).
28 pp.; $9.00 (prepaid, plus postage & handling and GST — please contact the Institute for details).
ISBN 0-88806-459-6.

Copies are available from: Renouf Publishing Company Limited, 5369 Canotek Road, Ottawa, Ontario K1J
9J3 (stores: 71½ Sparks Street, Ottawa, Ontario; 12 Adelaide Street West, Toronto, Ontario); or directly from
the C.D. Howe Institute, 125 Adelaide Street East, Toronto, Ontario M5C 1L7. The full text of this publication
will also be available on the Internet.
C.D. Howe Institute
Institut C.D. Howe Communiqué
Embargo : à diffuser le mardi 22 juin 1999 à 10 h

Le Canada devrait rechercher


une union monétaire en Amérique du Nord,
affirment des économistes
Le taux de change flottant du Canada n’aide pas les intérêts économiques du pays et la solution
pourrait consister à établir une union monétaire nord-américaine. C’est du moins ce qu’affir-
ment deux des économistes les plus éminents au pays, dans le cadre d’une étude publiée au-
jourd’hui par l’Institut C.D. Howe.
Intitulée From Fixing to Monetary Union: Options for North American Currency Integration
(Du taux de change fixe à l’union monétaire : choix de l’intégration monétaire en Amérique du Nord),
l’étude est rédigée par Thomas J. Courchene de l’Université Queen’s et Richard G. Harris de
l’Université Simon Fraser.
Les auteurs soutiennent que l’expérience qu’a faite le Canada du taux de change flottant
pour le dollar s’est avérée décevante. Un taux flottant entraîne une instabilité des taux de
change réels, ne semble pas offrir un tampon efficace contre les chocs externes et peut se solder
par un mauvais alignement prolongé des devises, ainsi qu’en témoigne la période actuelle de
faiblesse prononcée de la devise canadienne par rapport au dollar américain. Une faiblesse et
une instabilité telles auraient tendance à dissuader les entreprises canadiennes qui sont expor-
tatrices ou qui font concurrence aux importations d’effectuer des améliorations de la produc-
tivité, elles pourraient encourager les investissements vers les emplacements américains au
détriment des emplacements canadiens et elles pourraient décourager l’essor des industries
aux besoins élevés en capital humain au pays.
Selon MM. Courchene et Harris, au fur et à mesure que l’économie canadienne s’ouvre da-
vantage au commerce et aux flux d’investissement et que ces flux se concentrent davantage sur
les États-Unis, le calcul coûts-avantages croît en faveur d’une fixité accrue du taux de change
par rapport au dollar américain. De telles dispositions, ajoutent les auteurs, stimuleraient la
souplesse en matière de prix et de salaires au Canada, car les entreprises et les travailleurs se-
raient plus conscients de leur position concurrentielle en Amérique du Nord; elles permet-
traient également une stabilisation des prix pour les biens financiers et immobiliers, et elles
réduiraient la conversion monétaire et les autres frais de transaction du commerce et de l’in-
vestissement transfrontaliers.
MM. Courchene et Harris expliquent que les choix d’une fixité accrue du taux de change
sont vastes, qu’il s’agisse d’objectifs de taux de change, d’un système de parité ajustable, d’un
C.D. Howe Institute / Institut C.D. Howe Communiqué / 2

taux de change fixe entièrement soutenu par la banque centrale, et les politiques budgétaires
des gouvernements fédéral et provinciaux, d’un conseil de la devise, d’une « dollarisation » —
consistant en une « dollarisation du marché » (l’adoption par les agents du secteur privé du
dollar américain dans divers secteurs) ou en une « dollarisation politique » (une décision offi-
cielle par les responsables politiques de proclamer le dollar américain comme monnaie légale)
— ou encore d’une union monétaire nord-américaine en bonne et due forme. Les auteurs souti-
ennent que parmi les choix de monnaie unique, c’est celui de l’union monétaire qui serait de
loin préférable à celui de la dollarisation.
Face aux craintes que l’adoption d’un régime monétaire à taux de change fixe ou d’une
union monétaire n’entraîne une perte de souveraineté pour le Canada, les auteurs affirment
que cette perte serait plus apparente que réelle. Ils soulignent également que c’est au cours des
années 60, durant lesquelles le Canada avait adopté un taux de change fixe, que le pays a pu
élaborer son infrastructure détaillée de politiques sociales.
En conclusion, MM. Courchene et Harris font la remarque que de toute manière, les évé-
nements qui se déroulent ailleurs en Amérique imposent une décision. Il se manifeste déjà une
tendance à la dollarisation non seulement dans un pays membre du libre-échange, le Mexique,
mais également en Argentine, et cette situation pourrait restreindre les possibilités d’une un-
ion monétaire nord-américaine. Selon les auteurs, le Canada doit participer à tout débat public
sur l’évolution des dispositions monétaires en Amérique du Nord pour veiller à ce que l’option
d’une union monétaire nord-américaine demeure une possibilité.
*****
L’Institut C.D. Howe est un organisme indépendant, non-partisan et à but non lucratif, qui joue un rôle
prépondérant au Canada en matière de recherche sur la politique économique. Ses membres, individuels et
sociétaires, proviennent du milieu des affaires, syndical, agricole, universitaire et professionnel.
— 30 —
Renseignements : Thomas J. Courchene 613 533-6555;
Richard G. Harris 604 291-3795;
Shannon Spencer (relations avec les médias), Institut C.D. Howe
téléphone : 416 865-1904, télécopieur : 416 865-1866;
courriel : cdhowe@cdhowe.org, Internet : www.cdhowe.org

From Fixing to Monetary Union: Options for North American Currency Integration, Commentaire no 127 de
l’Institut C.D. Howe, par Thomas J. Courchene et Richard G. Harris, Toronto, Institut C.D. Howe, juin 1999,
28 p., 9,00 $ (les commandes sont payables d’avance, et doivent comprendre les frais d’envoi, ainsi que la TPS
— prière de communiquer avec l’Institut à cet effet). ISBN 0-88806-459-6.

On peut se procurer des exemplaires de cet ouvrage auprès des : Éditions Renouf ltée, 5369, chemin Canotek,
Ottawa ON K1J 9J3 (librairies : 71½, rue Sparks, Ottawa ON, et 12, rue Adelaide Ouest, Toronto ON) ou
encore en s’adressant directement à l’Institut C. D. Howe, 125, rue Adelaide Est, Toronto (Ontario) M5C 1L7.
On peut également consulter le texte intégral de cet ouvrage dans le site Web de l’Institut.
Monetary Policy

From Fixing to Monetary Union:


Options for North American
Currency Integration

by
Thomas J. Courchene
and
Richard G. Harris

Canada’s experience with a floating spontaneous use of the US dollar by the


exchange rate for its dollar has been private sector in Canada, a NAMU would
disappointing. The floating dollar has been offer important benefits for macroeconomic
prone to major misalignments, as its current stability and financial integration.
weakness demonstrates, that put Canada at With interest in using the US dollar
a disadvantage in the North American growing elsewhere in the Americas, delay
competition for physical and human capital on Canada’s part in embracing this option
investment. As the Canadian economy could prove costly. US cooperation in
becomes more open to trade and establishing the new currency and in
investment flows, and as those flows providing central banking services to
become more focused on the United States, Canadian financial institutions would be
the benefits of greater exchange rate fixity valuable, but if other countries adopted the
with the US dollar are growing. US dollar without such concessions,
There are many options for greater Canada’s chances of obtaining them would
exchange rate fixity, running from exchange diminish. For that reason, Canada should
rate targets through a formal North make haste in investigating the possibility of
American Monetary Union (NAMU). establishing a monetary union in
Particularly in comparison with growing cooperation with the United States.
Main Findings of the Commentary
• Canada’s experience with flexible exchange rates for its dollar has been disappointing.
Floating rates make real exchange rates more volatile, do not appear to offer effective buff-
ers against external shocks, and can result in prolonged currency misalignments, such as
the recent period of pronounced weakness in the Canadian dollar.
• Prolonged misalignments, or overshoots, in the value of the Canadian dollar raise several
risks. Periods of weakness, such as the present, may discourage productivity improve-
ments in Canadian firms that export or compete with imports. More generally, a volatile ex-
change rate will tend to bias investment toward US locations and thus away from Canadian
ones, and to discourage the development of human-capital-intensive industries in Canada.
• Canada's growing openness to international trade and investment, and the concentration
of those trade and investment flows on the United States, are tipping the cost-benefit calcu-
lation in favor of greater exchange rate fixity with the US dollar. Such an arrangement
would encourage wage and price flexibility in Canada as firms and workers became more
conscious of their competitive positions in North America; stabilize prices for Canadian fi-
nancial and real assets; and reduce currency conversion and other transaction costs on
crossborder trade and investment.
• Options for greater exchange rate fixity run the gamut from exchange rate targets, through
adjustable pegs, a fixed exchange rate fully backed by both the central bank and federal and
provincial fiscal policies, a currency board, “dollarization” with or without government
backing, and a formal North American Monetary Union (NAMU). In terms of single cur-
rency options, a currency union would be far preferable to dollarization.
• The loss of sovereignty involved in a fixed rate regime would be more apparent than real. It
was during the fixed rate period of the 1960s that Canada developed its comprehensive so-
cial policy infrastructure.
• Events elsewhere in the Americas are forcing the issue. The apparent trend toward dollariza-
tion in both Mexico and Argentina may serve to constrain the potential for a North Ameri-
can currency union. Canada needs to be part of any public debate on the evolution of North
American currency arrangements to ensure that the NAMU option remains on the table.
T
he introduction of the euro in January cent of its trade with the 15 nations of the
1999 represents a watershed in the an- European Union.
nals of economic and monetary history.
At one level, the advent of the euro sig-
For its part, Canada’s exports are even more
nals the denationalization of national mone-
dependent on the US market (more than
tary regimes; at another, it signals that, in a
80 percent of our exports go there) than Swit-
progressively integrated global economy, cur-
zerland’s are on the EU. This enhanced degree
rency arrangements are a supranational public
of North American integration features promi-
good, one that is arguably consistent with a
nently in the analysis in this Commentary,
twenty-first-century vision of what constitutes
which aims to make the case for greater fixity
national sovereignty. Understandably, perhaps,
in the Canadian/US dollar exchange rate, the
Canadian officials responsible for macro- ultimate goal being a North American
economic policy do not share this view. As Monetary Union (NAMU) with many elements
Bank of Canada Governor Gordon Thiessen along euro lines.
noted in a recent speech, “the euro is not a Governor Thiessen’s preference for main-
blueprint for a North American monetary taining Canada’s flexible exchange rate regime
union. The political objectives that motivated is based primarily on the premise that the float-
monetary union in Europe do not have a paral- ing rate is serving the country well:
lel in North America” (1999, 123).
Granted, the North American Free Trade Canada has a very useful economic safety
Agreement (NAFTA) is largely a trade and valve in its floating exchange rate. Because
economic blueprint, whereas integration in the movements in the Canadian dollar reflect
European Union (EU) incorporates, in addi- external shocks as well as any domestic
tion, aspects of a confederal or federal over- economic difficulties we may face, there is
arching structure. But to link the euro solely to sometimes a tendency in Canada to blame
Europe’s political evolution is to ignore the such movements as the cause of our prob-
compelling economic rationales for a suprana- lems. In fact, these currency movements are
a consequence, not a cause. Exchange rate
tional currency: it is highly unlikely, for exam-
flexibility has served us well over time. Why
ple, that the British would ever buy into the
would we want to give it up? (1999, 123.)
overarching European political project, but they
are highly likely to embrace the euro. Even in Our view, however, is that a floating exchange
Switzerland, which is not a member of the EU, rate is not, in fact, serving Canada well within
private sector agents appear to be embracing the progressively integrated NAFTA environ-
“market euroization” — that is, adopting the ment; that there are persuasive arguments for
euro for a range of purposes, such as transac- greater exchange rate fixity; and that the
tions and as a unit of account; in the North longer-term objective of greater exchange rate
American context, this is called “dollarization.”1 fixity should be a common North American
As Tagliabue notes: currency. The purpose of this Commentary is to
examine these propositions and to look at
The reasons for this [Swiss] enthusiasm for some of the alternative approaches along the
the euro are clear. Switzerland, with just continuum from floating rates to monetary un-
seven million people and an area a little ion, including pegged rates, fixed rates, cur-
larger than Maryland’s, is surrounded by rency boards, and dollarization.
four euro nations — Germany, France, Italy While a NAMU is not on the immediate
and Austria — and conducts about 70 per- horizon, there is nonetheless an urgent need to

C.D. Howe Institute Commentary / 3


place the currency union issue on the public a wide range of international experience with
policy agenda. Policy developments within the respect to exchange rate regimes, both fixed
NAFTA and elsewhere in the Americas appear and floating.
to be moving quickly in the direction of dollari- (As an important aside, since Canada be-
zation. Since widespread dollarization could gan its floating rate regime as long ago as 1970,
preclude the emergence of a NAMU by reduc- few decisionmakers in government, the bu-
ing the advantages the United States would reaucracy, business, or labor know, or remem-
garner from it and since, as we argue below, a ber, how an economy functions under fixed
NAMU would be preferable to dollarization rates. Hence, the Canadian historical experi-
from a Canadian perspective, Canada must be- ence under flexible rates is, at best, an imper-
come engaged on this issue with its NAFTA fect lens through which to examine the adjust-
and hemispheric partners — and sooner rather ment requisites and dynamics under a fixed
than later. rate regime, especially since such a system im-
One final introductory note is in order. plies a wholesale transformation in the way an
One of the by-products of Canada’s pursuit of economy responds to various shocks, whether
monetary independence is that the exchange external or policy induced.)
rate has been a market-determined variable, What, then, does this international experi-
and in this sense there is a close link between ence tell us about flexible versus fixed rates?
monetary policy and exchange rate policy. The Clearly, from the perspective of the 1960s and
purpose of this Commentary is to assess Cana- 1970s, flexible rates have not operated as
da’s exchange rate options: it is not intended as economists had imagined they would. In 1953,
a criticism of Bank of Canada monetary policy. Milton Friedman’s case for flexible exchange
In our view, the same debate on currency and rates included the proposition that
exchange rate issues would be under way
whether the Bank was targeting inflation or instability of [flexible] exchange rates is a
unemployment or the growth rates of mone- symptom of instability in the underlying
tary aggregates.2 economic structure...a flexible exchange rate
need not be an unstable exchange rate. If it
is, it is primarily because there is underly-
The Economics of
ing instability in the economic conditions.
Exchange Rate Fixity (Quoted in Flood and Rose 1998, 2.)
One can make a number of broad characteriza-
tions about the behavior of economies operat- This has turned out not to be the case, however.
ing under differing exchange rate regimes. Rather, the evidence points to three basic
Beginning with what economists think they propositions.3
know about how economies work under float- First, over any period of time short enough
ing versus fixed regimes, we start with a look to be interesting, real exchange rates4 are sub-
at the implications of the exchange rate regime stantially more volatile under a flexible rate re-
for living standards, productivity, currency gime than under a fixed one, and almost all of
confidence, and a number of subsidiary issues. this volatility is due to movements in the nomi-
nal exchange rate. The Canadian-US bilateral
What Economists Know real exchange rate can appreciate either be-
about Exchange Rate Regimes cause the Canadian dollar appreciates relative
to the US dollar or because prices rise in Can-
Since the demise of the Bretton Woods interna- ada relative to those in the United States. It is
tional monetary system in 1971, there has been important to recognize that real exchange rates

4 / C.D. Howe Institute Commentary


move all the time and that they will adjust even value of the US dollar in the early 1980s, which
if the nominal exchange rate is completely fixed, ultimately led to the coordinated intervention
but at a much slower rate, in line with move- of five large industrialized countries in 1985 in
ments in the general level of prices. Eliminat- an attempt to bring it down. Canada has had
ing volatility in the nominal exchange rate will two serious periods of misalignment in the
eliminate most of the short- and medium-term past decade: the late 1980s, when the dollar
volatility in the real exchange rate.5 reached 89 US cents, and the recent period, in
Second, macroeconomic fundamentals can- which the dollar has approached 63 US cents.
not explain short- to medium-term exchange Identifying misalignment under flexible ex-
rate movements. More important, there is no change rates is an imperfect and judgmental
systematic difference in macroeconomic sta- process. In the short run, the exchange rate
bility between fixed and flexible exchange rate
responds primarily to capital movements,
regimes. As Flood and Rose note:
which, in turn, are induced by real or fi-
nancial market shocks. A misalignment is
Simply put, to a first approximation, coun-
judged to occur when, for long periods, these
tries with fixed exchange rates have less
volatile exchange rates than floating coun-
shocks seem to unlink exchange rates from
tries, but macro-economies that are equally economic fundamentals.
volatile....By choosing the exchange rate Economists have proposed a number of
regime, policy thus has an important effect methods to identify misalignment. The princi-
on exchange rate variability, but not on the pal method has always been calculations of
volatility of traditional macro-economic purchasing power parity (PPP), which adjust
fundamentals. (1998, 2–3.) for relative price-level changes across coun-
tries. While PPP theory is notoriously poor in
An important corollary of this observation explaining exchange rates over short periods,
(Bank of Canada Governor Thiessen’s views it does seem to have long-run predictive power.
notwithstanding) is that the benefits of either Long-term exchange rate trends are relatively
fixed or flexible rates as shock absorbers should well characterized by slow reversion to PPP
not be overstated. As economists discovered in values and, after any substantial departure,
the 1970s, neither flexible nor fixed rates can
convergence appears to take between four and
prevent the rapid international transmission
six years.
of inflation nor, as economists learned in the
Another way to benchmark fundamental-
1980s, can they prevent a large number of coun-
based exchange rates is to use the notion of a
tries (including Canada) from pursing unsus-
fundamental equilibrium exchange rate (FEER)
tainable fiscal policies. Poor economic policies
(Williamson 1994), which corrects for longer-
(whether micro- or macroeconomic) lead to
undesirable economic consequences, whatever term structural factors, including current ac-
the exchange rate regime. The process by which count imbalances, terms of trade shocks, and
the policy mistake is transmitted can differ, but foreign debt servicing. However, the concept
the ultimate consequences are similar. of a FEER also has a number of problems, not
Third, nominal exchange rates can wander the least of which is that the economy can ad-
from important long-term-trend fundamentals just to current account imbalances and stocks
for significant periods of time, often two years of net foreign debt through channels other
or longer. This is referred to as the “misalign- than the exchange rate. In any case, whether
ment problem.” The most infamous global mis- using PPP or FEER benchmarking, exchange
alignment was that of the soaring relative rate misalignment is a recurring problem.

C.D. Howe Institute Commentary / 5


From a policy perspective, the choice of cans. This trend is reflected in the movement of
a monetary regime would be much easier if young, well-educated people to the United
exchange rates reacted predictably to macro- States, increasingly attracted by employment
economic events and if one regime was clearly opportunities in that country — especially on
superior to the other in its ability to act as a the basis of after-tax comparisons — and in the
shock absorber. The evidence on mac- growing number of Canadian business execu-
roeconomic volatility suggests, however, tives who demand to be located in the United
that this is not the case. Much of the impetus States or remunerated closer to US levels.
on the part of smaller countries for moving to Under a fixed exchange rate regime, it
a fixed rate relates to volatile exchange rates might have been possible to isolate the sources
and periods of severe misalignment and the of the relative decline of Canadian living stan-
consequences of these problems for the econ- dards and so to identify the more likely policy
omy. The larger the portion of the economy repairs. Under flexible rates, however, policy-
exposed to international trade and invest- makers are uncertain as to whether the decline
ment, the more serious these consequences is permanent or the consequence of a mis-
become. A major reason Canada should move aligned dollar, which may be self correcting.
toward the fixed end of the spectrum of al- It is important to emphasize that a falling
ternative currency arrangements is to avoid nominal exchange rate does not necessarily in-
these costs. We develop these arguments fur- dicate a falling standard of living (and neither
ther below. does a rising exchange rate indicate the oppo-
site). A falling standard of living is associated
with shifts in trend productivity growth that
Living Standards ultimately must be reflected in real wages or
and Exchange Rates profits. A nation can have a falling rate of pro-
ductivity growth relative to its trading part-
During the 1960s, the Canadian dollar was tied ners’ average, while experiencing almost any
to the US dollar at a rate of 92½ US cents. pattern of nominal exchange rate movement,
Thanks to substantial upward pressure on the depending on developments in nominal wage
dollar, Canada floated its currency in 1970. By and price levels. We take up the productivity
1973 or so, the Canadian dollar traded at issue in more detail below.
roughly 104 US cents. Twenty-five years later,
the dollar was in the mid-60s-US-cents range,
dipping as low as 63½ cents during the sum- Rationalizing the Recent
mer 1998 currency crisis. Decline of the Canadian Dollar
A substantial part of the Canadian dollar’s
depreciation from 1973 to the mid-1980s can be One can, of course, attempt to rationalize the
attributed to inflation differentials between the relative decline of the Canadian dollar by ap-
two countries. By 1988, a PPP calculation sug- peal to fundamentals, as McCallum (1998) and
gested the long-run appropriate value of the Orr (1999) have done. For example, Canada’s
Canadian dollar was in the 80-US-cents range. proclivity to rely on external sources of capital
Since that time, pre-tax personal income per meant that interest payments to foreigners in-
capita in Canada has fallen relative to that in creased from $15.2 billion in 1987 to $26.5 bil-
the United States, magnified by Canadian ex- lion by 1990 and to a peak of $30.3 billion in
change rate depreciation, which suggests there 1995 (Bank of Canada Review, Autumn 1998, ta-
has been a significant fall in Canadians’ aver- ble J1). These increases might be interpreted as
age standard of living relative to that of Ameri- requiring an increasingly large merchandise

6 / C.D. Howe Institute Commentary


trade surplus in order to equilibrate the overall Moreover, as Harris (1993), Fortin (1994), and
current account balance and, therefore, a pro- others have argued, the exchange rate appre-
gressively lower exchange rate.6 ciation over that period could not be justified
Yet many economists, particularly those in by the real fundamentals in the economy. Since
the neoclassical tradition, discount calculations then, as Orr notes,
of the equilibrium value of the dollar using the
current account balance as a benchmark — as commodity prices in US dollars weighted
Harris (1992), Chandler and Laidler (1995), by Canadian exports rose significantly and
steadily by 30% over the 1992-1996 period.
and McCallum (1998), for example, have done
At the same time the Canadian dollar fell
— pointing out that the balance of payments is
sharply and steadily from 89 cents in 1991
an identity, and a current account deficit is the
to 73 cents in 1996. (1999, 5.)
necessary counterpart to an excess of national
investment over national savings. In fact, a real
The appropriate measure of the relevant exter-
exchange rate adjustment is only one of many
nal price shocks over this period is the change
influences on each item that make up the
in Canada’s terms of trade, which, using the
identity. Moreover, there are good reasons on Bank of Canada’s export and import price in-
fundamental grounds why aggregate savings dexes, declined by 3 percent from the first
might be less than aggregate investment for quarter of 1991 to the fourth quarter of 1998.
very long periods, as is the case in the United Thus, Canada’s terms of trade have generally
States. Thus, from this perspective, the recent been relatively stable in the 1990s and reveal
dramatic improvement in the fiscal situations no serious long-term negative trend. In fact,
of the federal government and most provinces falling commodity prices have been matched
should remove some of the downward pres- by improvements in the prices of other manu-
sure on the Canadian dollar. factured exports and by reductions in the prices
The Bank of Canada’s (and McCallum’s) of imported consumer and capital goods.
preferred explanation for the decline in the Whether or not there is a correlation over a
relative value of the Canadian dollar is that the longer time frame between commodity prices
exchange rate is simply tracking global com- and the value of the dollar, the buffer argu-
modity prices. Indeed, over the 1973–99 peri- ment adds little to an understanding of the
od, there has been a close relationship between dollar’s movements over the past decade, and
the decline in commodity prices and the ex- should add little to Canadians’ enthusiasm for
change rate. And, over the past year, the Bank a floating currency. The recent depreciation
has put a positive spin on the dollar ’s fall, appears to look increasingly like an overshoot,
arguing that it is serving as a buffer to offset one that is having negative consequences on
falling commodity prices and ensuring that real resource allocation and investment and,
Canada’s level of economic activity is likewise ultimately, on confidence in the economy.
buffered. But the buffering argument can ac- One explanation for the dollar’s relative
count for only a small part of the exchange rate decline that has not been given enough atten-
movements of the past decade or so. tion is the economic boom that has taken place
The run-up in the exchange rate from 1988 in the United States over the past seven years,
to 1991 to 89 US cents during Canada’s acces- particularly the extraordinary stock market
sion to the Canada-US Free Trade Agreement boom. Many market commentators have sug-
(FTA), for example, was induced by tight mone- gested that this may be a stock market bubble
tary policy, and did nothing to help Canada with valuations that cannot be sustained — US
cope with the external shock of free trade. Federal Reserve chairman Alan Greenspan has

C.D. Howe Institute Commentary / 7


famously called it “irrational exuberance.” In- bly delayed appropriate productivity-
deed, the extraordinary returns in the US mar- improving investments in our manufactur-
ket relative to the Canadian market may have ing industry until much later in the decade.
driven down the demand for Canadian dollar John McCallum has raised the same issue with
assets as foreign and Canadian investors shift respect to the current depreciation:
into high-yielding US equities. At the global
level, this asset boom has important conse- Canada’s plummeting relative manufac-
quences for the US dollar relative to both the turing productivity is a puzzle, especially
yen and the euro, and the undervalued Cana- when productivity was supposed to rise
dian dollar may well be a reflection of an over- following free trade with the United States
valued US dollar. and when broader productivity measures
Empirically, it is hard to “prove” with cer- have not shown a similar relative decline.
tainty which of these explanations might be The idea that a weak currency induces “lazi-
correct; they might all be so in part. None, how- ness” on the part of the manufacturing sec-
ever, contradicts the fact that the Canadian dol- tor is not one that appeals to this author,
lar is currently far below any value justified by but it seems to be broadly consistent with
the data, [which] suggests a “double dip”
fundamental benchmarks, and the downward
in Canada’s relative manufacturing pro-
trend has now been intact since 1992.
ductivity for the first half of the 1980s and
then in the period 1994–97. Both of these
Depreciation and Productivity periods correspond roughly to times of
weak currency. Indeed, there is a positive
and significant correlation (R = .45) be-
Perhaps the most visible argument in media
tween the Canada-minus-US productivity
discussion of the dollar’s relative decline is the
growth gap and the lagged value of Cana-
possible relationship between the exchange rate dian unit labour costs in manufacturing
and a slower rate of productivity growth in the relative to the United States (expressed in
manufacturing sector. Admittedly, in the short the same currency). So it may be that a
term, a falling dollar does allow Canadian ex- weak currency has been a cause rather than
ports to further penetrate the US market. But a consequence of poor productivity growth
the other side of the low-exchange-rate coin is in our manufacturing sector. (1998, 3–4;
that it provides a cost disincentive in terms of emphasis added.)
productivity improvements: a 10 percent fall
in the dollar means a 10 percent rise in the price McCallum offers more recent evidence
of competing goods from abroad, as well as in (1999) that a 10 percent reduction in the rela-
the price of US capital equipment (or equip- tive value of the Canadian dollar is associated,
ment priced in US dollars) for productivity en- two years later, with a 7 percent reduction in
hancements. This issue is not new in the the ratio of Canadian to US productivity in
Canadian context — the Canadian dollar was manufacturing. Since Canadians’ future living
low and productivity performance poor in the standards depend on productivity growth, this
1980s. As Harris (1993, 36) notes, finding is ominous indeed. Given the federal
[o]ne consequence of an undervalued ex- government’s recently announced policy shift
change rate is that it protects inefficient op- toward productivity issues, this relationship
erations from otherwise appropriate between exchange rate misalignment and pro-
market signals. In the Canadian case, the ductivity clearly merits attention.
robust demand growth in the [mid-1980s’] One might characterize what has been
recovery plus the low exchange rate proba- happening in the following way. An underval-

8 / C.D. Howe Institute Commentary


ued Canadian dollar, coupled with low infla- provements. Moreover, the FTA presented Ca-
tion, leads to a productivity slowdown relative nadian firms and subsidiaries with an option
to the United States, which is forging ahead on other than lowering costs or shutting down: they
the strength of a boom in high-technology could move to a US location, and a number of
sectors. This tends to convert the originally un- highly publicized moves did occur. No doubt
dervalued dollar to an equilibrium of sorts. In some of these relocations were made in the
turn, this puts pressure on the Canadian expectation that the overvalued exchange rate
authorities to accommodate a further drop in was permanent. The general point is that, with
the dollar to restore Canada’s erstwhile misalignment of this degree, downsizing,
competitive advantage. But this becomes a moving offshore, and exiting become attrac-
self-fulfilling process — allowing the exchange
tive avenues of adjustment for firms.
rate, rather than productivity, to drive com-
This misalignment problem has even
petitive and comparative advantage.
greater significance when recast in the context
This may be a tempting picture to paint,
of Canada’s shift away from a resource-based
given Canada’s recent experience, but it is much
economy toward one increasingly driven by
more in the nature of a hypothesis meriting
human capital and technology — what Harris
further research than a conclusion. In particu-
lar, the hypothesis needs squaring with the (1993) has called a fundamental shift in their
standard view of firms as profit maximizers, “wealth-generation processes.” From 1989, the
which should be expected to seek whatever ef- first year of the FTA, until 1997, the export sec-
ficiency gains are accessible, regardless of the tors that saw the greatest increases (as a per-
exchange rate or the regime by which it is de- centage of gross domestic product, GDP) were,
termined. Nonetheless, given that Canadians’ in order, transport equipment (including autos),
living standards ultimately depend on produc- machinery and equipment, electrical and com-
tivity, this is an issue with which defenders of munication products, lumber and wood, and
Canada’s flexible rate must come to grips. chemical and chemical products, followed by
several services categories. The export groups
that contracted the most (again, as a percent-
The Costs of Misalignment age of GDP) were, in order, grains, utilities,
metallic ores and concentrates, nonmetallic min-
Closely related to, although more general than,
erals, and petroleum and coal products (Grady
the undervaluation-productivity argument is
and Macmillan 1998). Only one of the former
the longer-run response of the structure of the
group falls into the commodities category,
economy to both under- and overvaluation of
whereas all five of the latter group do.
exchange rates for extended periods. These ar-
In a resource-based economy, floating rates
guments hinge on the mobility of firms and
highly skilled individuals across the Canada- are a smaller problem, since organized com-
US border. modity spot markets mean that most resource
In the case of an overvaluation, firms can exports are already priced in US dollars and
take defensive measures by cost cutting and hedging is relatively straightforward. In non-
absorbing cost increases through decreased resource areas, where less easily hedgible long-
profits. But the 1986–92 overshoot,7 which, term bilateral contracts are important and
from trough to peak, increased Canadian unit where the economy has a significant import-
labor costs by nearly 40 percent (measured in competing manufacturing sector, movements
a common currency), generated a degree of over- in the exchange rate are bound to be problem-
valuation that swamped any productivity im- atic. From the perspective of the firm:

C.D. Howe Institute Commentary / 9


The problem arises because free trade re- for their skilled workers or follow them to the
quires stable and predictable rates of inter- United States.
national exchange and cost calculations to Do new firms not enter or expand during
support the volumes of trade and degree of periods of undervaluation? There is some evi-
specialization associated with it. This pre-
dence this does occur in traditional sectors. For
dictability becomes more important the
firms whose business is based on skilled labor,
larger the volumes of trade, the more inter-
national exchange on a long-term bilateral the difficulty is that, during periods of ex-
basis [because it is difficult to hedge ex- change rate undervaluation, skilled labor mar-
change rate risk from contracts upward of kets become very tight. New entry, based on a
a year or so] and the lower the degree of en- cost advantage due to an undervalued exchange
try barriers to an industry. Unfortunately, rate or on wages that might be temporarily low
floating exchange rates provide inherently in domestic currency, is very risky. The net im-
volatile and unpredictable cost structures pact is that firms may exit in periods of over-
....Students of international business ob- valuation, and workers may exit in periods of
serve that major determinants of direct
undervaluation. For a smaller country, build-
international investment decisions have been
ing comparative advantage in human-capital-
exchange rate volatility and anticipated
protectionist actions in the markets of the intensive industries becomes quite difficult if
major industrial countries. The argument both firms and highly skilled labor are mobile
is made that flexible exchange rates have between the two countries. The irony is that re-
induced a pattern of location based on cri- peated periods of exchange rate misalignment
teria other than comparative or competi- are likely to result in the shift of Canadian com-
tive advantage, thus undoing many of the parative advantage toward industries that are
benefits achievable through free interna- resource and/or capital intensive, and in an
tional trade in a world of known structures
employment base that is both less diversified
and flexible prices. (Harris 1993, 39–40.)
and less human capital intensive than would
be the case with exchange rate stability.9
The dynamics of the response to a particu- In our view, then, the costs of exchange
lar misalignment vary significantly with the rate misalignment (or the benefits of greater
human capital intensity of the sector in ques- exchange rate fixity) can be summarized as
follows:
tion. In the case of overvaluation, firm exit (or
relocation) is the ultimate response. With a se-
• The benefits of exchange rate fixity increase
rious undervaluation, such as Canada is now
with the degree of international openness,
experiencing, the process works quite differ-
especially when this openness incorporates
ently.8 The immediate effect of the deprecia-
such a high degree of export integration
tion is to shift income in Canada from wages to with a currency and economic superpower
profits. With real wages in the United States (80 percent, in the case of Canada in rela-
rising relative to those in Canada, skilled labor tion to the United States).
begins to migrate. Many firms will resist rais- • Fixed exchange rates give Canada a better
ing wages in the short run, and would rather chance of getting its fair share of North
use the depreciation to cut prices and build American investment based on the com-
market share. If the low exchange rate persists, petitive advantage of its firms and in-
most firms will ultimately come to realize that dustries (in contrast to location decisions
the situation is unsustainable in the longer made on the size of the market in order to
term: they will either have to raise real wages isolate firms from exchange rate volatility).

10 / C.D. Howe Institute Commentary


• Canada's ability to generate and sustain running at roughly the same level as its in-
high-wage jobs depends on sustaining ternational exports (and imports) in 1980.
human-capital-intensive, but otherwise By 1996, however, the province’s interna-
highly mobile, industry within the North tional exports were roughly two and a half
America market. Repeated periods of ex- times its interprovincial exports and grow-
change rate misalignment severely ham- ing nearly a magnitude faster. More recent
per the development and growth of those data indicate that about 90 percent of On-
industries and firms in Canada and pro- tario’s international exports are destined
mote excessive specialization in capital- for the US market. Indeed, nearly 44 per-
and resource-intensive industries. cent of Ontario’s GDP is now exported to
the United States.

The analytical and empirical evidence is


such that free trade and currency stability Compare these integration data with those
should go hand in hand in North America: pertaining to the 15 countries of the EU. On av-
free trade and flexible rates are inherently in- erage, 62.9 percent these countries’ exports go
consistent (Harris 1993, 59). The time has come to other EU members (Courchene forthcom-
for Canadians to contemplate a wholesale ing), representing 16 percent of the combined
rethinking of their currency arrangements in GDP of the EU (Canadian exports to the
North America. United States are 30 percent of GDP). To be
sure, these aggregate data mask important dif-
ferences across EU members. Nonetheless, at
North-South Integration the aggregate level, Canada is integrated with
the United States to a greater degree with re-
Now that we have broached the issue of North
spect to trade than the average EU member is
American integration, it is important to high-
to the EU. Hence, on economic integration
light selected recent developments. Drawing
grounds, the argument for a common currency
from Courchene and Telmer (1998, chap. 9),
is at least as compelling from Canada’s van-
the following aspects of the increasing north-
tage point as that for the average EU member.
south integration appear particularly relevant:

• In 1996, all but two provinces exported


A Regional Perspective
more to the rest of the world (international
on Asymmetric Shocks
exports) than they did to other provinces
(interprovincial exports). To this trend toward sharply increased north-
• For each dollar of interprovincial exports south trade integration one should add that
in 1996, international exports were run- Canada’s regions appear to march to quite dif-
ning at $1.83. In the early 1980s, the oppo- ferent cyclical forces. For example, the 1980s’
site was the case: interprovincial exports recession was short lived in central Canada,
ran above international exports.10 which latched onto a US recovery triggered
• Since more than 80 percent of Canada’s by the rebound in the North American auto in-
international exports are destined for the dustry and the Reagan administration’s eco-
United States, north-south trade clearly ex- nomic stimulus. The economy in the rest of the
ceeds east-west trade in the aggregate. country languished, however, as a result of a
• In the interesting case of Ontario, its in- collapse in commodity prices. The 1990s’ re-
terprovincial exports (and imports) were cession was quite different: British Columbia

C.D. Howe Institute Commentary / 11


skated through it largely unscathed, whereas Table 1: Regional Economic Cycles in
the impact on central Canada was severe. North America, 1966–86
(correlation between eastern and western
Even prior to the FTA and the shifts that it Canada and other North American regions
subsequently induced, eastern and western in the timing of supply shocks)a
Canada displayed cyclical patterns that dif-
Eastern Canada Western Canada
fered markedly from one another and from
other regions of the continent. When one elimi- Eastern Canada — 0.30
nates common demand shocks due to similar Western Canada 0.30 —
United States
fiscal and monetary policies, the inherent
New England states 0.11 0.01
asymmetry in the supply shocks that hit east-
Mid-Atlantic states 0.15 – 0.26
ern and western Canada and the relatively Great Lakes states 0.06 – 0.07
strong correlations between western Canada Plains states 0.37 – 0.10
and the southern and western regions of the Southeastern states – 0.03 – 0.52
United States and Mexico become apparent Southwestern states – 0.05 0.54
California 0.23 0.14
(see Table 1).
Northwestern states 0.05 0.52
In tandem, north-south integration and the Mexico 0.14 0.57
nonsynchronization of east-west business cy-
a
The closer the number is to 1.00, the greater the similarity of
cles raise the central issue of whether or not experience in one region and another.
Canada is an “optimal currency area.” To be Source: Bayoumi and Eichengreen 1994, table 11.
sure, this is not a novel issue, since it was at the
core of Mundell’s influential 1961 essay on op-
timal currency areas, which argued that North shocks, Canada is appropriately viewed less as
America (or at least the United States and Can- a single east-west economy and more as a se-
ada) would be better served by a western dol-
ries of regional, crossborder economies. In this
lar and an eastern dollar than by a Canadian
context, suppose British Columbia were to align
dollar and a US dollar.
its policies to become competitive in the US
At base, the key question is whether the
northwest and the Pacific rim. Likewise, sup-
asymmetric external shocks that affect Canada
pose Alberta were to set its domestic cost and
tend to be north-south or east-west. If they are
tax parameters so that they were on par with
the former, Canada would constitute an opti-
its competitors in the Gulf of Mexico, Ontario
mal currency area.11 This is central to the argu-
ment that Canada needs the macroeconomic and Quebec were to gear their economic
instrument of a flexible exchange rate to buffer policies to match those of the US Great Lakes
these asymmetric north-south shocks. Since states, and so on, so that each province or re-
resources account for a larger component of gion aligns itself to be competitive with its
Canadian GDP (relative to US GDP), this is cross-border counterpart.
prima facie evidence in support of a stand-alone Now, in the event of a commodity price
currency. Or is it? Prior to addressing this view boom, BC lumber (for example) would be af-
of the exchange rate as a macroeconomic buff- fected in the same way as northeast US lumber,
ering instrument, it is instructive to come at Alberta oil would face the same price change
this asymmetric-shock issue from a regional, as oil from the Gulf of Mexico, auto manufac-
rather than a national, perspective. turers in Oshawa and Windsor would remain
Consider the following thought experiment. in step with their counterparts in Detroit, and
As a result of enhanced north-south integra- so on. But if Canada were to respond to the
tion and the nonsynchronization of regional commodity price shock by appreciating the

12 / C.D. Howe Institute Commentary


exchange rate vis-à-vis the US dollar, then all of higher under flexible exchange rate regimes
Canada’s provincial/regional economies would than under fixed exchange rate regimes. In the
be offside with respect to their US counterparts. Canadian context, the real commodity price is
This is questionable policy, especially if the ex- the price of commodities relative to the costs of
change rate were to exhibit the volatility of the the manufacturing sector. This, for all intents
past 15 or so years. Arguably, each Canadian trad- and purposes, is also the price of exports in the
ing region would prefer to maintain exchange west relative to that in the east. Cuddington
rate and transactions certainty with both east- and Liang’s results imply, consistent with both
west and north-south trading partners. The only the Courchene and Mundell hypotheses, that
way to do this would be to fix the Canadian dollar the flexible exchange rate regime may actually
to the US dollar and to rely on other policies to ac- have destabilized the internal regional price
commodate the differing impacts of the terms of ratio relative to what would have occurred
trade shock on the two national economies. Bay- with fixed rates. There are a number of reasons
oumi and Eichengreen (1994) strongly suggest this may occur, but one simple explanation is
that this is the way things worked in the past, par- overshooting on part of the foreign exchange
ticularly for western Canada. They find less evi- market in response to a commodity price shock.
dence of a link between eastern Canada and But the task at hand is how to address the
eastern US states, but their data are now quite macro implications arising from a commodity
dated.12 price shock.
But even if one accepts this region-by-
region view of shocks — that is, that the asym-
metry at the regional level runs east-west, not Macroeconomic Adjustment
north-south — one must still take account of
what we refer to as the “macro shock” of the How do Canada’s regions, and the Canadian
larger role that resources play in the Canadian economy as a whole, adjust to macroeconomic
economy. Thus, even if Canada’s regions were shocks, as defined above? The current policy
affected by external price shocks in ways simi- response is to use the floating exchange rate.
lar to their crossborder counterparts, there But this is unlikely to buffer the shock, as the
would still be asymmetric macro implications analysis above suggests, whereas a fixed ex-
for the Canada and US economies. change rate might reduce macro volatility.
Since this issue of adjusting to asymmetric Suppose the Canadian/US dollar exchange
macro shocks plays a critical role in the argu- rate were fixed, what adjustment mechanisms
ments for a floating exchange rate, additional would be in place to accommodate potentially
perspective is warranted on the role of the ex- asymmetric shocks?
change rate as a shock absorber. Cross-country There would, in fact, be at least three such
evidence, in fact, challenges this role. mechanisms. The first operates through the
Cuddington and Liang (1998), in a cross- internal adjustment of prices. This is not, how-
country study of commodity exporters and ex- ever, as significant a challenge as one might at
change rate regimes, document an important first imagine because terms-of-trade shocks
stylized fact regarding commodity prices us- affect regional economies on both sides of the
ing alternative data sets covering the 1880– border in a similar fashion — that is, it is the ex-
1996 period. They find that the volatility of real change rate response, not the terms-of-trade
commodity prices — defined as nominal com- change, that triggers crossborder disequilibrium
modity prices deflated by the manufacturing for Canada’s regional economies. Phrased dif-
unit value-added index — is systematically ferently, Ontario and Michigan (and Alberta

C.D. Howe Institute Commentary / 13


and Texas, and so on) would be allowed to assumption, could not otherwise occur. Many
adapt in the same way. economists now regard this analytical frame-
The second mechanism is fiscal policy, work as empirically indefensible, given the
which would have to come to the rescue in the well-documented studies of both price and
event of an external shock such as an oil price wage adjustment mechanisms in modern in-
hike. But this has always been an integral part dustrial economies.
of the philosophy underpinning fixed rates. From this perspective, one of the major
Moreover, it is probably important that indi- criticisms of Mundell’s approach was that it
vidual provinces or regions become involved ignored the regime-specific dependence of
in the fiscal stabilization of the exchange rate. price-setting institutions. Flexible and volatile
As Courchene (1990) argues, one would expect exchange rates encourage price setters to delay
that regions that experience a favorable terms- changing prices or renegotiating nominal con-
of-trade shock would use their fiscal levers to tracts in the face of a real shock. In labor mar-
temper their booms. Had Canada been under a kets, wage negotiations can be hampered by
fixed exchange rate system in the late 1980s, the inability to make firm cost comparisons be-
for example, the pressure on Ontario to tem- tween similar industries in different countries.
per, rather than fuel, its boom with fiscal policy The ability of small, highly open economies
would have been more explicit and intense, such as Ireland and Finland to operate success-
since everyone would have understood the fully under fixed rates suggests that, even
implications for the fixed exchange rate. though these countries faced differential
The third accommodating mechanism, and shocks relative to “core Europe” (the region to
arguably the most important, is the set of auto- which they are fixed), the mechanisms and in-
matic stabilizers — including the national tax stitutions that determine prices and wages in
and transfer system, employment insurance, the economy evolved toward greater flexibil-
the equalization program, and Canada’s high ity in response to the change in the exchange
degree of internal migration — already in place rate regime.
to deal with region-specific shocks or Canada- A second criticism of flexible exchange rates
wide terms-of-trade shocks, whether positive as a buffer mechanism relates to a different
or negative. type of exchange rate nonneutrality — one that
Thus, there are mechanisms for accommo- operates through asset markets and that is
dating regional and macroeconomic shocks un- stressed in modern accounts of the monetary
der fixed rates. At the very least, further re- transmission mechanism: changes in nominal
search is warranted on the nature of these exchange rates affect the foreign currency
shocks. It is also important, however, to recog- values of assets and liabilities. This means, for
nize that the presumed buffering qualities of example, that Canadian assets priced in Cana-
flexible rates are overestimated. dian dollars become cheaper as the Canadian
At an analytical level, it is instructive to dollar depreciates, which then has a series of
note that Mundell’s 1961 analysis of optimal wealth effects on the economy:
currency areas was rooted firmly in the 1960s’
Keynesian tradition, which treated nominal • foreign firms are able to acquire Canadian
price and wage adjustment as infeasible. In- firms, whose assets are priced in Canadian
deed, these short-term nominal inflexibilities dollars, at bargain prices (a kind of fire-sale
constituted the primary rationale for a flexible foreign direct investment);
exchange rate between two regions, as it al- • Canadian firms seeking to enter the US
lowed for relative price adjustments that, by market face higher acquisition costs;

14 / C.D. Howe Institute Commentary


• to the extent that Canadian and US equity tional to attribute confidence to countries that
markets are integrated, Canadian firms’ have a low inflation rate and a stable fiscal po-
balance sheets deteriorate in US dollars, sition. But confidence goes beyond that. As re-
limiting their ability to raise new capital in cent events have proven, currencies can decline
US markets; and precipitously even if economic fundamentals
• firms with US-dollar-denominated liabili- are sound on both the inflation and fiscal fronts.
ties suffer from a deteriorating balance Canada’s current exchange rate regime has
sheet when the exchange rate depreciates. delivered low inflation but, from time to time,
bouts of appreciation and depreciation. A sus-
tained and largely unanticipated currency de-
There are at least two implications of these
preciation in a period of close to zero inflation
observations for Canada-US exchange rate
is something that should be treated with great
arrangements. First, one can expect that Cana-
concern. The reason has to do with the central
dian wage- and price-setting institutions
issue of this Commentary. Arguably, interna-
would also change if the exchange rate were
tional markets were abandoning Canadian-
removed as a nominal adjustment mechanism
dollar-denominated assets and, therefore, the
between the two economies. In particular,
Canadian dollar. More important, Canadian
commodity risks would be more usefully di-
macro authorities’ initial indifference to the
versified through capital markets and other
fall in the dollar may have prompted Canadi-
risk management tools, rather than accommo-
ans to sell off assets denominated in Canadian
dated through an aggregate adjustment in all
dollars. Through this “market dollarization”
relative prices between the two economies,
process, the US dollar is embraced for a range
which an exchange rate change induces.
of purposes, such as transactions and as a unit
Second, one must recognize that an ex-
of account, and as a way to flee the uncertainty
change rate accommodation to an asymmetric
and volatility of the Canadian dollar.
shock, even if justified in the short run by
The fact is that, as a small country heavily
nominal price rigidities, almost certainly car-
integrated with the world’s largest economy,
ries with it other, less beneficial asset price ef-
Canada does not have a lot of maneuvering
fects that can be detrimental both to longer-run
room on the currency issue. And it seems ap-
growth and to the ability of individuals and
parent, from a societal vantage point, that mar-
firms to make the necessary longer-run adjust-
ket dollarization, as the private sector seeks
ments to the initial shock.
greater protection from exchange rate move-
By way of summary, therefore, not only do
ments, is an unfortunate outcome. Moreover,
fixed exchange rates possess important accom-
we suspect that further depreciation will give
modating mechanisms for external shocks, but
the supposed buffering qualities of flexible rise to both dollarization and demands by
rates are at the same time less effective and Canadians for currency integration with the
more problematic than is typically assumed. United States. One way to restore confidence
in the Canadian dollar would be for the cur-
rency to enjoy a period of sustained exchange
The Confidence Issue
rate stability, and perhaps some appreciation,
One important, but inherently nonquantifiable, together with an official acknowledgment by
aspect of a internationally traded currency is Ottawa that it is not indifferent to the value of
the confidence that individuals (meaning the dollar.13
workers, firms, and investors, both domestic Ultimately, however, what is called for is a
and foreign) have in that currency. It is tradi- “hard” Canadian dollar. Practically speaking,

C.D. Howe Institute Commentary / 15


that means a currency that is stable against the • Canadian issuers of new equity offerings
major international reserve currency, the US would find a larger market in the absence
dollar. Fortunately, this is also the currency of exchange rate risk.
that optimal currency theory dictates Canada • In product markets, price discrimination
fix against.14 by national market would be less preva-
lent, given better price comparison infor-
Fixed Rates and mation on the part of consumers.
Transaction Costs

We conclude the case for exchange rate fixity Alternative Approaches


by focusing on transaction or efficiency gains. to Exchange Rate Fixity
To be sure, the extent of such gains will depend
on the nature of the exchange rate fix, with Assuming our argument in favor of exchange
greater gains arising in the context of a com- rate fixity has merit, we now turn to the
mon currency where, by definition, there is no
question of how a more formal link between
exchange rate. While currency conversion costs
the Canadian and US dollars might be pur-
are usually estimated to be small — a few
sued. Table 2 presents a capsule summary re-
tenths of a percentage point of GDP — such
narrow estimates do not include the broader lating to the various options.
range of transaction costs that now exist as a We readily admit that there is considerable
consequence of the Canada-US border and the skepticism in academic and policy circles
use of two currencies that fluctuate in value about the durability of fixed exchange rate
against each other. For example: regimes. The prevailing view, as reflected in
Crow (1996) and elsewhere, is that a floating
• Canadian firms operating in the North exchange rate is viable for Canada and so are
American market could eliminate the ac- the single-currency options (namely, dollari-
counting costs that arise from using two zation and a NAMU), but nothing in between.
currencies. From our perspective, however, this is highly
• Companies that currently hedge exchange problematical because the macro authorities
rate risk would no longer find it necessary could assert that dollarization is unacceptable
to do so, and most of the costs associated and that a NAMU is unattainable, so that flexi-
with providing exchange-rate-related de- ble rates become, by default, the only optimal
rivatives would no longer be necessary. currency arrangement. But the entire analysis
• Menu costs associated with providing in the previous section was directed to the
price information and invoicing in two proposition that flexible rates are far from opti-
currencies would be eliminated, which mal. Our view is that such a position inappro-
might prove particularly important to the priately discards the analytical case for, and
development of electronic commerce (e- the historical experience with, fixed exchange
commerce) in Canada. rates. Accordingly, in what follows we attempt
• Capital markets would be deeper and in- to resurrect the case for intermediate options
terest rate spreads on government and cor- and, in particular, for fixed exchange rate re-
porate debt would be reduced, thereby gimes. Readers not inclined to be persuaded
improving the efficiency of financial inter- by this line of analysis may prefer to go directly
mediation and reducing borrowing costs to the discussion of our preferred endpoint, a
in Canada. single-currency option.

16 / C.D. Howe Institute Commentary


Exchange Rate Targets Exchange Rate Pegs

The first, and least constraining, policy option In his analysis of alternative exchange rate ar-
rangements for Canada, former Bank of Can-
in the direction of exchange rate stability is the
ada governor John Crow notes that the me-
unilateral one of an exchange rate target. The
chanics of fixing the exchange rate are straight-
target can be informal or formal and can be
forward: “[I]n Canada, all that is needed is a
stated as either a specific parity or a band. One government declaration that its Exchange
variant would adjust the target for underlying Fund Account will intervene in unlimited
differences in inflation rates (crawling targets). amounts to defend a given exchange rate”
The intermediate instruments of monetary (1996, 14). Typically, the exchange rate is al-
control are short-term interest rates, which are lowed to fluctuate within a narrow band (plus
raised or lowered in light of exchange market or minus 1 percent or perhaps 2 percent) of the
outcomes. The central bank might intervene in par value. If this is all that is contemplated, we
the foreign exchange markets, but only to would refer to this as a “pegged exchange
maintain an orderly market, much as the Bank rate.” We agree with Crow that a “pegged re-
of Canada does now. Exchange rate targeting gime invites attack and is demonstrably brittle
cannot eliminate short-term volatility, but it under pressure” (ibid, 13). Indeed, the pres-
sure could well come from within, since, under
has been practiced with some success as a
our definition of a pegged rate, there is no con-
means of reducing misalignment. Its major
certed effort on the part of overall macro policy
advantages are that it does not require the
to defend the peg. While pegged exchange
maintenance of large foreign exchange reserves rates can prove valuable as temporary stop-
and that it allows for temporary departures gaps, this is not what we have in mind in terms
from the targets in the event of unusual exter- of a fixed exchange rate.
nal circumstances.
As in the case of any exchange rate regime
short of a currency union, the central bank’s Fixed Exchange Rates
success hinges on its credibility and on the
Unlike a pegged rate, a full-blown fixed rate
government’s commitment to the exchange
regime would perforce require as an integral
rate target. Specifically, the macro authorities
component the full coordination of fiscal pol-
must occasionally be willing to impose higher
icy, both federal and provincial. As Courchene
interest rates to defend the target, even if this is (1990) notes, what is involved here is a policy
inconsistent with short-term inflation, growth, paradigm shift. Conducting overall macro pol-
or employment goals. This task may be com- icy is quite different under a fixed rate system
plicated by high levels of domestic or foreign than under a floating rate system. Govern-
debt, but the recent experience of industrial ments with booming economies, for example,
countries with strongly integrated and deep temper their booms via their fiscal stance, if
capital markets suggests that it is manageable maintaining the exchange rate fix required
— indeed, it may be easier with fixed rates, them to do so.
since flexible rates can intensify capital flows, It is, of course, still possible that fixed rate
with each movement generating an expecta- regimes can get caught in one-way bets on in-
tion of further movements in the same direc- ternational capital markets. Indeed, Crow’s
tion, prompting more capital flows in search of earlier quote to the effect that a pegged ex-
short-term gains.15 change rate would “invite attack” and is “de-

C.D. Howe Institute Commentary / 17


Table 2: Assessing Alternative Approaches
to Exchange Rate Fixitya

Canadian Bank of Canada Exchange Rate Policy


Option Dollar Remains? Seigniorage? Remains? Variability Flexibility

Fixed exchange rates Yes Yes Yes Fixed, within a narrow Partial, subject to
band gearing policy to
maintaining the
fixed rate

Currency board Yes Yes, but offset by Yes, but under Fixed at one-to-oneb; Less; Bank of
cost of carrying currency board no band Canada is a
foreign currency rules passive actor;
government
deficits can be
financed only by
borrowing

Common Canada-US Maybe; depends Yes Yes, but under None (common Depends on
currency on arrangements the euro currency) arrangements for
arrangement Canadian input
into US Federal
Reserve policy

Market dollarization Yes, but much Yes, but much less Yes As great or greater Reduced
reduced scale of because of reduced than now, with relevance of Bank
use scale of Canadian reduced scale of of Canada policy
dollar use Canadian dollar use for Canadian
households and
businesses

Policy dollarization No No No None (no Canadian Minimal, and


dollar) Canada could be
drawn into US
policy orbit

monstrably brittle” was actually in reference strong support for the political goal of
to a fixed rate regime. Yet there are several European Union. Austria and Belgium are
fixed exchange rate success stories — Austria/ close to being in the same camp as the
Germany and Netherlands/Germany, for ex- Netherlands because of their overriding
ample. However, Crow views these as special political commitment to shadowing the
mark. (1996, 17, n12.)
cases:

Crow thus unveils the secret to a successful


The Netherlands guilder, which might seem
fixed rate regime — namely, that Canada’s at-
an exception since it shadows the German
mark within an explicit tight band, is to all tachment to the US dollar would have to be a
practical intents fixed, rather than adjust- keystone of the country’s national economic
able. This is because successive Dutch policy within the broader North American
governments have made attachment to the framework. Indeed, a comprehensive policy
mark the keystone of national economic commitment to shadow the US dollar, backed
policy within the broader framework of up by a full understanding of what this means

18 / C.D. Howe Institute Commentary


Table 2 - continued

Implementation Implementation Access to US Maintain Financial


Costs Time Clearings Reversible? Capital Markets Sector Policy?

Minimal; need to select One to three Status quo plus Yes Enhanced access vis-à- Yes
“entry point” years; need to smaller transactions vis flexible rate status
establish costs for US quo
credibility clearings

Could require internal Several years, More integration Yes, but, Larger still Yes, but with
revaluation of prices presumably with US clearings expectation must more US banks
and a new currencyb preceded by systems be that it will not operating in
fixed exchange be reversed Canada
ratesb

Internal revaluation of Probably a National clearings Yes, but only Full Yes, but may be
prices and a new decade, as in the and then full under greater
currency euro process integration into exceptional harmonization
Canada-US clearings circumstances over time with
(presumably along and with large integration of
the lines of the euro costs clearing systems
target scheme)

Parallel currencies and Variable, Progressively Unlikely, once High for those using Will likely be
a depreciating depends on integrated into US private sector the US dollar drawn more into
Canadian dollar; large private sector clearings systems operating on US- US financial
wealth transfers from agents dollar basis policies
Canadian-dollar asset
holders to Canadian-
dollar liability holders

Moderate to large Variable, Progressively Not without Full Will likely be


depending on currency depends on integrated into US major problems drawn more into
replacement proced- private sector clearings systems (no central bank, US financial
ures and revaluation of agents no separate policies
existing Canadian currency)
dollar contractual
arrangements

a For all options, the Canadian price level would be tied to the US price level, and Canada would follow the US business cycle more than
under the status quo.
b
This need not be the case. If a currency board were implemented at, say, 75 US cents to the Canadian dollar, this would not require the
issuing of a new currency; the implementation time would also be much reduced.

on the fiscal front and in the context of already question of how one gets to a fixed rate. As the
high and increasing north-south trade integra- Dutch experience indicates, a country cannot
tion could make a fixed Canada-US rate one of go into a permanent fix without first demon-
the most stable and viable such regimes any- strating some commitment to more exchange
where. This does not mean that it could not be rate stability. That is, the monetary authorities
unsettled by unforeseen events; what it should must first demonstrate their willingness to use
mean is that international capital markets monetary policy to deliver on exchange rate
would come to view the Canadian dollar as goals in the form of a target band for the ex-
fully integrated into the US dollar area and, change rate, rather than simply intervene in
therefore, a near-substitute for the US dollar. the foreign exchange rate market.
While we regard a fixed rate regime as a Once this credibility is established, foreign
feasible option for Canada, a number of transi- exchange speculation would become stabiliz-
tion issues deserve mention. First, there is the ing and interest rates between the two coun-

C.D. Howe Institute Commentary / 19


tries should tend to converge. Over time, the as such. In addition, under a currency board
exchange target band could be narrowed, and regime, there is no lender of last resort — al-
the need for central bank intervention would though, in Hong Kong, which has a currency
diminish — this is the shadow policy to which board, the fact that reserves were well in excess
Crow refers. In short, credibility has to be of 100 percent did allow some flexibility; see
earned and, therefore, it would be unwise to Williamson 1997, 7–8).
move suddenly to a fixed exchange rate. How Currency boards have attracted a lot of at-
long would such a transition take? No one can tention, especially in light of Hong Kong’s suc-
know for sure, but it took the Netherlands cessful defense of its currency during the Asia
about three years from its initial shift to fixed crisis and Argentina’s holding of its currency
rates before it achieved interest rate conver- value in the wake of both the Mexican peso
gence with Germany. crisis and, more recently, the 40 percent de-
The second issue relates to Quebec. If there valuation of Brazil’s currency. Currency boards
is one event that could undo an otherwise suc- have also proven useful for emerging market
cessful fix it would surely be the anticipation economies with fiscal credibility problems and
by markets of a Quebec separation: the mas- a history of inflationary finance. Hanke and
sive resulting uncertainty would very likely Schuler (1993, 20) canvass the pros and cons
lead to an immediate loss of substantial for- of currency boards and conclude that “for the
eign exchange reserves under a fixed rate re- Americas, the currency-board system offers a
gime.16 Quebec independence would create means to establish sound money in a region”
enormous problems for any exchange rate re- and facilitates “the region’s natural tendency
gime and, indeed, would force a rethinking of to evolve toward a common currency area.”
currency arrangements in the upper half of Whether or not a currency board is a rele-
North America. Thus, moving to a fixed ex- vant option for Canada, it serves as a useful
change rate regime in the context of substantial benchmark. If Argentina, with its continuing
domestic political uncertainty is probably a fiscal problems, can hold its one-to-one peso/
nonstarter. dollar exchange rate in the face of repeated
This caveat aside, we believe fixed ex- crises involving other Latin American curren-
change rates are preferable to the flexible rate cies in recent years, surely Canada’s macro
status quo. And, over the longer term, the es- authorities could maintain international credi-
tablishment of a NAMU, which may be the bility under an exchange rate fix to the US
most attractive option of all, would require dollar.
some interim variant of a fixed exchange rate
regime.
Dollarization

Currency Boards In line with our assumption that there will be


further currency integration in the Americas,
Currency boards, which back domestic cur- in this section we focus briefly on the implica-
rency issue with identical values of foreign tions of Canada’s formally adopting the US
currency, provide institutional cement for a dollar as its currency. As a prelude, however,
fixed exchange rate regime. The conversion we address the likely implications of “market
rate is fixed precisely and the currency board dollarization” — namely, a scenario in which
stands ready to buy and sell at this dedicated private sector agents increasingly conduct
rate. In effect, there is no scope for domestic their affairs in US dollars.17 Such behavior
monetary policy since there is no central bank could be triggered by a variety of causes; for

20 / C.D. Howe Institute Commentary


example, the US dollar could become the cur- dundant and disappear, but Canada’s finan-
rency of choice in e-commerce, or high-level cial institutional and regulatory system would
management in Canadian corporations could be drawn inexorably under US influence and
increasingly insist on being remunerated ac- design. Indeed, it is likely that banking and
cording to US pay scales, or the rest of the finance would become integrated north-south
Americas could move toward dollarization, along the lines of Canada’s crossborder re-
leaving Canada with little choice but to follow gional economies. In turn, this would likely be-
suit. The second-to-last row of Table 2 summa- gin to impinge on Canadian policymaking
across a wide range of fronts extending well
rizes the implications of market dollarization.
beyond the monetary and financial sector. So,
While market dollarization would leave
although dollarization would solve the
intact the existing monetary institutional
framework, Canadian monetary policy influ- exchange rate problem, it would create a po-
ence would be considerably diminished be- tentially more serious set of challenges, even-
cause of the reduced range of Canadian dollar tually extending to sovereignty issues.
activity. Generating a given monetary policy Policy dollarization is presumably a non-
outcome would then require larger changes in starter, except as a last resort. But, as noted ear-
interest rates and exchange rates. But this lier, market dollarization is already alive and
would be problematic because volatility in Ca- well and, arguably, on the increase. Indeed,
nadian public policy parameters would surely market dollarization has “slippery slope”
trigger further market dollarization. characteristics: the more extensive it becomes,
Thus, it seems likely that such a scenario the more volatile is the exchange rate and the
would lead to exchange rate fixity. Although less effective is Canadian monetary policy.
that situation ultimately might be unstable, the One could argue, of course, that a degree of
longer-term equilibrium need not be “policy dollarization has long been characteristic of
dollarization” — it could also lead to fixed ex- the Canadian economy and something that
change rates or a currency board arrangement. Canada has been able to accommodate. Ac-
The general point is that market dollarization cording to this view, further shifts toward dol-
would tend to be self-reinforcing and to lead to larization (for example, the use of US-dollar-
unpredictable political dynamics, with the Ca- denominated credit cards for e-commerce)
nadian monetray authorities placed in an in- presumably would represent changes only in
creasingly defensive position. degree, not in the substance of dollarization.
Policy dollarization is, in a sense, the ulti- We are not so sure that this is the case, how-
mate fix: Canada would simply abandon the ever, and it will be interesting to keep a close
Canadian dollar and adopt the US dollar as le- eye on developments in Europe — particularly
gal tender. This would generate the full range in Switzerland, where market euroization is
of transactions and efficiency gains alluded to taking place even though that country (unlike
earlier. It would also address the challenges Britain) does not have the politically viable op-
arising from exchange rate variability since tion of joining the common currency area..
there would no longer be a Canada-US ex- In any event, in terms of our analysis, two
change rate. Dollarization would certainly general observations are warranted. First, it
grease the wheels of North American com- would be a major mistake on the part of Cana-
merce and integration. da’s monetary authorities to assign a zero
But dollarization would do much more probability to a dollarization scenario. Second,
than this. As the last row of Table 2 indicates, assuming that further currency integration in
not only would the Bank of Canada become re- North America is likely, there is a much prefer-

C.D. Howe Institute Commentary / 21


able alternative to policy dollarization — The Bank of Canada would still have a role
namely, a NAMU, to which we now turn. to play in the larger NAMU institutional struc-
ture, but it would be roughly similar to, say, the
Bank of France’s role within the new European
Central Banks structure. As Table 2 indicates,
A Common Currency
Canada would maintain its own financial in-
stitution regulatory system, its own clearing
The key distinguishing feature of a NAMU is system, and so on. The critical difference is that
that, unlike the other options discussed so far, there would no longer be a Canada-US ex-
Canada cannot opt for it unilaterally — the change rate.
United States obviously would have to partici- Should Canadians be in favor of a NAMU?
pate fully in any such arrangement. But does a Or, more properly, since further currency inte-
NAMU hold any interest for Canada in the gration in the NAFTA is likely, should Canadi-
first place? ans prefer a common North American
The easiest way to broach the notion of a currency to dollarization? To us, the answer is
NAMU is to view it as the North American clear, and positive.
equivalent of the European Monetary Union
(EMU) and, by extension, the euro. This would
mean a supranational central bank with a Transition to a NAMU
board of directors drawn in part from the cen-
tral banks of the participating nations. Many difficult issues would have to be dealt
Whether Canada would be content to partici- with in the transition to a NAMU. One of the
pate on the basis of, say, a one-thirteenth role most important would be the pace of the tran-
(its share in the combined Canadian-US GDP) sition. The European Monetary System (EMS),
on this board of directors is beyond our ability for example, operated from 1979 until last year.
to assess. If the mandate of this North Ameri- It was a complex and formal set of arrange-
can central bank were framed largely in terms ments that, with one major exception, reduced
of pursuing price stability, the actual voting nominal exchange rate volatility among the
share might matter less. countries involved, and may have done the
Since the US dollar is already the world’s same with respect to real exchange rates. The
premier reserve currency, there is no question relative success of the EMS certainly condi-
that a NAMU currency would bear the same tioned the ultimate decision to go ahead with
name; indeed, the United States would insist the EMU. It is an open question whether a
that its dollar continue to exist. The euro’s ad- NAMU could emerge without the experience
vent has shown, however, that the continued of something initially less than full monetary
existence of the US dollar would not be incon- union, but involving cooperation between the
sistent with parallel and perfectly substitut- countries involved.
able national currencies — until the eleventh Another transition issue for Canada would
hour, the design of euro coins and paper was to be the appropriate conversion rate. One could,
have been identical on one side in all EU coun- of course, opt for the existing exchange rate of
tries, but the other side could have been embla- about 69 US cents for a Canadian dollar, which
zoned with country-specific symbolism (as would set in motion a process of adjustment
will still be the case for 1 and 2 euro coins). that would make 69 US cents an equilibrium
Hence, the Canadian component of the com- rate. But what if this rate were inappropriately
mon NAMU currency could embody national low? Within a currency union, the problem of
symbolism. choosing an appropriate entry parity becomes

22 / C.D. Howe Institute Commentary


a multilateral regional problem. Canada, and ated challenges for the United States, which
any other country that chose to enter the suddenly finds that it no longer has a monop-
NAMU, would have to arrive at some jointly oly on the global reserve currency. The euro’s
determined criteria by which entry points are effective currency area has already spread be-
chosen. yond the 11 participating EU members, and
One approach, modeled in part on the many former communist countries of central
European convergence, would be for Canada and eastern Europe are likely to link their cur-
to use the transition to a NAMU to gear down rencies to it. Moreover, euroization may well
its debt-to-GDP ratio to that of the United spread in the private sector in Britain even if
States, so that there would be comparable fis- that country does not formally join the club.
cal flexibility. From the perspective of a FEER Thus, the euro, as it takes on an ever more
approach to exchange rate equilibrium, this important role in international portfolios, will
implies that the equilibrium entry point would become a serious rival to the US dollar as
rise as Canada made progress on the debt-to- the global reserve currency. Henceforth, the
GDP-ratio front. In any event, European expe- United States will find it increasingly difficult
rience suggests that, provided inflation is low to finance its balance of payments deficits. In
and the transition period has been sufficiently response, the Americans may well wish to ex-
lengthy, the entry-point problem should be pand the reach of the dollar area.
minimal. Another reason for potential US interest in
Other transition issues would also have to a NAMU is that the endless currency instabil-
be addressed, although space does not permit ity in the Americas, often involving US bail-
us to do so here. They would, however, include outs, cannot be in its best economic interests.
the types of cooperative arrangements that And the case for ensuring currency stability in,
would be necessary as NAMU members say, Mexico is not unlike the geopolitical real-
groped toward the ultimate union, and the cri- ity that led to the United States’ supporting the
teria, if any, that would be imposed on those NAFTA initiative.
joining with respect to macro indicators such
as inflation rates and debt levels.
Sovereignty and Symbolism
What’s in a NAMU That a NAMU would mean the end of sover-
for the United States? eignty in Canadian monetary policy is clear.
Most obviously, it would mean abandoning a
It is frequently asserted that, since there is ap- made-in-Canada inflation rate for a US or
parently nothing in a NAMU for the United NAMU inflation rate. But what are the impli-
States, the whole concept is a nonstarter. But cations of exchange rate fixity on the broader
the same might have been said about the possi- economic or cultural sovereignty front? Can
bility of Canada-US free trade. Fortunately, Canadians remain socio-economically distinct
Canadian economists had done their home- in the face of a common North American cur-
work, and Canada was ready when the oppor- rency? We do not claim to know the full an-
tunity presented itself. The same approach is swers to these critical questions. We can, how-
now called for on the currency-unification ever, offer some observations drawn from
front. Canada’s social and economic history.
In any case, it is not all that evident that the First, Canada embarked on the develop-
United States would oppose a NAMU initia- ment of a much more generous interregional
tive. The successful launch of the euro has cre- and interpersonal transfer system or social

C.D. Howe Institute Commentary / 23


contract than that of the United States even as currency issues out of the way, as it were, the
its trade became increasingly integrated into policy agenda would then be free to focus on
the broader North American economy. the issues that really matter in further fostering
Second, in the post-FTA, post-NAFTA era, a distinctly Canadian identity in the twenty-
it is true that a further intensification of north- first century.
south integration has coincided with an un- Fifth, although it is often claimed that po-
winding of key aspects of Canada’s social en- litical unity is underpinning the euro, this has
velope. Our view, however, is that the yet to be proven. We do not believe for a mo-
proximate cause of this was not enhanced inte- ment that the French view the birth of the euro
gration, but measures introduced (largely in as a threat to their national identity or sover-
the 1995 federal budget) to bring Canada’s fis- eignty. The reality is that currency arrange-
cal house under control. Now that Canadian ments are one of those policy areas that,
governments are entering a period in which following the dictates of subsidiarity, might
surpluses, rather than deficits, may become involve improved social welfare if passed up-
the norm, some of these social program cuts ward to the supranational level. It will be in-
may be restored. Indeed, with the recent social teresting to watch developments in Britain,
union framework agreement and the 1999 fed- where prices are already being quoted in euros
eral budget, most of the earlier cuts to the Can- as well as pounds; our guess is that British citi-
ada Health and Social Transfer have already zens and businesses alike will hold more and
been restored and the path cleared for future more euro accounts in British banks. The fact is
fiscal expansion. that currency arrangements are increasingly
Third, it is nonetheless the case that the becoming a supranational public good. This
NAFTA, globalization, and the information means that the overall costs of remaining out-
revolution are having an impact on Canada’s side these supranational currency arrangements
sovereignty and policy maneuverability. But will increasingly dominate the benefits of
these challenges need not influence the goals maintaining an independent currency regime.
Canadians set for themselves. True, they will This brings us to the sixth point, which re-
influence the choice of instruments Canadians lates Canadian sovereignty to the country’s
use to achieve those goals, but this constraint bargaining position with respect to the United
on instrument choice applies to all nations. In- States. If either policy or market dollarization
deed, our entire analysis is, in a sense, an exer- proceed apace in the rest of the Americas with-
cise in instrument choice: a fixed exchange rate out Canadian influence, Canada’s negotiating
regime rate simply may now be a more appro- stance will be permanently weakened. This
priate instrument than a flexible rate. bears on practical matters, such as the degree
The fourth point relates more directly to of representation outside parties might hope
the exchange rate fixity issue. Many of the so- to achieve vis-à-vis the US Federal Reserve. If a
cial programs that Canadians hold near and pan-American currency area were to develop
dear are a product of the Pearson era of the without Canada’s participation, the United
1960s, a period in which Canada had a fixed States would derive fewer marginal benefits
exchange rate with the United States. Quite ob- from adding Canada to the arrangement and
viously, the Pearson government did not view be less inclined to trade influence (or seignior-
a fixed exchange rate as an impediment to as- age) in exchange for Canada’s later accession.
serting Canada’s identity in terms of a compre- This militates for speedy Canadian action in
hensive social policy infrastructure. It may enunciating a coherent policy stance on multi-
now be time to make the opposite case: with lateral currency arrangements.

24 / C.D. Howe Institute Commentary


Conclusion
C.D. Howe Institute Commentary© is a periodic
analysis of, and commentary on, current public
Our aim in this paper was threefold: to argue policy issues.
that Canada’s floating and volatile currency is Thomas J. Courchene is Jarislowsky-
Deutsch Professor of Economic and Financial
not serving the country’s economic interests
Policy, School of Policy Studies, and Director,
well; to make the case that a progressively inte- John Deutsch Institute for the Study of Eco-
grated North America requires exchange rate nomic Policy, Queen’s University; he is also
fixity; and to propose that Canada pursue Senior Fellow of the C.D. Howe Institute.
greater fixity with a view to ultimately estab- Richard G. Harris is BC Telephone Professor
lishing a North American currency union. of Economics, Simon Fraser University, and
Even though the lead time for actually im- Fellow of the Canadian Institute of Advanced
Research. The text was copy edited and pre-
plementing a NAMU would likely be more
pared for publication by Barry A. Norris.
than a decade, the march of events elsewhere As with all Institute publications, the views
in the Americas is such that a degree of ur- expressed here are those of the authors, and
gency attaches to this issue. Argentina’s Presi- do not necessarily reflect the opinions of the
dent Carlos Menem recently proposed that his Institute’s members or Board of Directors.
country move from its currency board ar- To order this publication, contact: Renouf
rangement to full dollarization. More impor- Publishing Co. Ltd, 5369 Canotek Rd., Unit 1,
Ottawa K1J 9J3 (tel.: 613-745-2665; fax: 613-
tant, in January 1999, the head of the Mexican
745-7660), Renouf’s stores at 71½ Sparks St.,
bankers’ association called for the spread of Ottawa (tel.: 613-238-8985) and 12 Adelaide St.
the US dollar area to Mexico. And in March W., Toronto (tel.: 416-363-3171), or the
1999, Mexico’s most influential business lobby C.D. Howe Institute, 125 Adelaide St. E., To-
group called for full dollarization of the Mexi- ronto M5C 1L7 (tel.: 416-865-1904; fax: 416-865-
can economy. 1866; e-mail: cdhowe@cdhowe.org). We also in-
Intriguingly, US economist Robert Barro vite you to visit the Institute’s Internet web site
at: www.cdhowe.org.
(1999) suggests that the United States could
Quotation with proper credit is permissible.
(and should) find creative ways to support
these dollarization initiatives. Barro suggests, $9.00; ISBN 0-88806-459-4

for example, that the US Federal Reserve give


the Argentine central bank a one-time allot-
ment of $16 billion in newly issued US cur-
United States could simply take over as lender
rency, in exchange for $16 billion worth of non-
of last resort for its dollar-zone clients. Barro
interest-bearing pesos (the peso and the US
even suggests that the United States take the
dollar already exchange on a one-to-one basis)
lead in promoting this monetary integration.
that the Fed would hold as collateral. This
To be sure, the US government does not
would provide Argentina with the required
amount of US currency to embark on full dol- necessarily share Barro’s views. But discussion
larization, and the transfer would cost nothing of dollarization is still at an early stage in the
(except paper and ink); over the longer term, United States, and it is possible that growing
the United States would garner the seignior- awareness of its advantages for that country
age arising from an expanding supply of US will persuade US officials to explore ways of
dollars in Argentina. making some central banking services avail-
Barro further notes that, although dollari- able to countries adopting the US dollar.
zation would remove the lender-of-last-resort Our concern with all of this is the emphasis
facility of other countries’ central banks, the on dollarization, rather than on a NAMU. What

C.D. Howe Institute Commentary / 25


are the prospects for a NAMU if Mexico, let nomic integration that are vital to sustaining
alone the rest of central and South America, Canadians’ living standards in a competitive
were fully dollarized? Would the United States global economy.
simply take the view that Canada could follow The cost of monetary independence is be-
the rest of the Americas and use the US dollar, coming increasingly apparent as Canada shifts
with the Americans pocketing the resulting into human-capital-led growth and deeper
seigniorage? If Canada wants to keep the economic integration with the rest of North
NAMU option alive, it must become a party to America. The policy implications of this shift
these discussions and any resulting delibera- are profound and in many ways parallel the
tions. Canada’s involvement should include signal from the introduction of the euro. For-
not just academics but, more important, key mal monetary integration in North America is
business associations. It would be most unfor- an idea whose time may well be nigh; it is
tunate if, having finally realized the virtues of worth thinking seriously as to how it might
a NAMU, Canadians were to discover that this come to fruition.
avenue was no longer open because dollariza- The transition to a single North American
tion had already spread to the rest of the currency will be slow in coming and will ap-
Americas. propriately entail a great deal of research, de-
In summary, we have argued that exchange bate, and negotiation. In the interim, however,
rate stability relative to the US dollar is impor- we believe there is a more immediate need for
tant in sustaining and enhancing Canada’s exchange rate stability between the Canadian
long-term economic potential. The current and US dollars, even if unilateral action were
flexible exchange rate regime, while necessary the only course open. A rethinking of Canada’s
if Canada wants to pursue a different inflation options on this account is long overdue.
rate than the United States, is increasingly at
odds with both the economic stability and eco-

Notes
We wish to acknowledge Ted Carmichael, John Crow, 2 See, however, Courchene (forthcoming), who extends
John Murray, Finn Poschmann, Bill Robson, and Dan- the analysis to incorporate aspects of the Bank of
iel Schwanen for providing valuable comments on an Canada’s conduct of monetary policy.
earlier draft. Since not all of the above agree with the 3 In fixed versus flexible regimes, there is a whole set of
thrust of our analysis, it is more important than usual issues having to do with small, inflation-prone coun-
to attribute what follows solely to the authors. tries that attempt to achieve “credibility” on the infla-
1 In commenting on an earlier draft of this paper, Ted tion front by fixing their currency to that of a large
Carmichael suggested that we distinguish between country with a low inflation rate. This argument does
“market dollarization” and “policy dollarization.” The not have much relevance in the Canadian-US case.
former, as described in the text, relates to the move by 4 The real exchange rate is the nominal exchange rate
private sector agents to adopt the US dollar for a range corrected for differences in the price levels of two
of purposes, while the latter refers to an official deci- economies. From a macroeconomic perspective, the
sion by the policy authorities to proclaim the dollar as real exchange rate is one of the two key relative prices
legal tender. The reference to “market euroization” is in the economy, the other being the real interest rate.
to be interpreted in this light. Fortin (1996) and others argue that, for much of the

26 / C.D. Howe Institute Commentary


1990s, real interest rates have also been misaligned as 10 More recent data (Grady and Macmillan 1998) suggest
a result of Canada’s attempt to run an inflation target that, from 1989 to 1997, interprovincial exports slid
lower than that of the US Federal Reserve. from 22.7 percent to 19.7 percent of GDP. At the same
time, international exports grew from 26.1 percent to
5 Economists have long used a balloon analogy in talk-
40.2 percent of GDP.
ing about exchange rate volatility: if one removes the
volatility from the exchange rate, it just appears else- 11 Mundell (1990) argues that east-west shocks domi-
where in the economy. Flood and Rose (1998) present nate north-south shocks, which, among other issues,
evidence that this analogy is inappropriate. leads him to favor Canada-US exchange rate fixity.
6 From the point of view of a system change, one can ar- 12 Moreover, their “Canada East” region includes the At-
gue that abandonment of the Bretton Woods fixed ex- lantic provinces, which tends to blur some of the
change rate system led to a loss of fiscal discipline (see north-south results.
McKinnon 1997). There is substantial evidence, how- 13 Ironically, many of the Bank of Canada’s arguments in
ever, that some smaller countries on fixed rates — for favor of the importance of low inflation were based on
example, Belgium and the Netherlands — also had se- the idea that maintaining confidence in the value of
rious fiscal discipline problems in the 1980s. money was an important policy objective. The Bank
7 Note that this 40 percent overshoot measures the ac- had the objective right — it just got the instrument
tual deterioration in unit labor costs (in a common cur- wrong.
rency) over this period. Measured from a PPP bench- 14 For a country with a wide portfolio of trade partners,
mark, the overshoot would be less since the exchange such as New Zealand, the confidence argument could
rate was, initially, below PPP. justify pegging against a basket of major currencies.
8 Readers will note, as did a referee on a earlier draft, 15 A useful example of a country that currently uses ex-
that we are trying to have it both ways as it were: over- change rate targeting is Norway, which officially
valuation generates costs, but so does undervalua- adopted a policy of targeting the exchange rate be-
tion. Are these costs reversible? Some probably are, tween the krone and the deutschmark (it now targets
but many are not. In short, volatility generates irre- the euro). The country has had relative exchange rate
versibilities! Firms that choose to exit in a period of stability since then, although discussions of external
overvaluation and human capital that leaves in a peri- versus domestic objectives continue. Norway is a con-
od of undervaluation are not likely to reverse their de- structive example for Canada because, as a major oil
cisions quickly, if at all, as the exchange rate returns to exporter, it experiences shifts in oil prices that consti-
equilibrium. tute a major asymmetric supply shock relative to the
9 Grubel (forthcoming) comes at this comparative ad- euro zone (Nicolaisen and Quigstad 1998).
vantage issue from a different angle. He notes that al- 16 Readers wishing more detail on the potential financial
lowing the dollar to mirror commodity prices “has re- and exchange rate implications of a political breakup
tarded the move of labor and capital out of commod- can consult Laidler and Robson (1998) or Courchene
ity producing and into high-tech industries because it and Laberge (forthcoming).
signaled the wrong price trends to producers,” with
the result being a tilting of resource allocation in per- 17 We are indebted to Bill Robson for his suggestion that
verse directions. we expand the discussion of dollarization to include
market dollarization.

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