A COMMON CURRENCY FOR NORTH AMERICA by Thomas J. Courchene Jarislowsky-Deutsch Professor School of Policy Studies, Queen’s and Senior Scholar Institute

A COMMON CURRENCY FORNORTH AMERICA

by

Thomas J. Courchene

Jarislowsky-Deutsch Professor

School of Policy Studies, Queen’s

and

Senior Scholar

Institute for Research on Public Policy

Montreal

Significance of the Euro

• Former Governor Gordon G. Thiessen:The introduction of the Euro ushers in an exciting new era for the Europeans, and we should all wish them well. But the Euro is not a blueprint for a North American monetary union. The political objectives that motivated monetary union in Europe do not have a parallel in North America.

• This is true. However, once the Euro is launched, the focus is no longer on its origins, but on what it signals:•Common currency is a supra-national public good•Signals denationalization of independent national monetary regimes•Dramatic shift toward currency integration and consolidation

Common Currency: Introduction (1)

Re: Currency Consolidation:

When tomorrow’s historians look back at the recent financial crises and subsequent efforts to reform global finance, they will reach two conclusions. First, the grand rhetoric of creating a new global architecture yielded few results. Second, we failed to foresee the most profound consequence of the turmoil: regional currency unions. By 2030 the world will have two major currency zones – one European and the other American. The Euro will be used from Brest to Bucharest, and the dollar from Alaska to Argentina – perhaps even in Asia. These currencies will form the bedrock of next century’s financial stability.

(Zanny Minton Beddoes, “From EMU to AMU: The Case for Regional Currencies”, Foreign Affairs (July/August, 1999).



Outline of Presentation

•Problems with Canada’s floating exchange rate;

•Arguments for greater exchange rate fixity;

•Alternative approaches to fixed rates (currency boards, dollarization, NAMU);

•Nationalism, identity, sovereignty;

•Why might the US agree to a common currency or NAMU?

•Where to from here?

The Failings of Canada’s Float (1)

Need a floating rate if want to have independent monetary policy (i.e. if want to set an inflation rate different from that in the US).But: will show that it is too costly to do this.

The Bank of Canada is viewed as an excellent central bank – has earned a good deal of “credibility” in banking circles. But: issue is not the Bank, per se, but its policy.

Case for a common currency in Canada is not related to achieving a stable internal monetary environment, since Bank of Canada has achieved an inflation rate lower than that in US. Hence, reason for Canada to have a N.A. common currency is not the same reason for Mexico to prefer it.

First, the Case for a Floating Rate


In mid-1975, C$ was worth about 105 US cents; In 1991, worth 89 US cents; In 2001, worth just over 62 US cents.

Because:

Our nominal inflation is less than in US; Our productivity is lower than in US; Much of our 40% export share is priced in US dollars.

This has led to a dramatic fall in Canadian living standards relative to those in the US.

The Americans now spend more public money on health care than we do [evaluated at PPP at 78 cents].

Falling Living Standards


C$ has departed both upward and downward from underlying fundamentals for long periods of time.

This volatility is typically referred to as the “misalignment problem”.

When way overvalued (89-91), leads to downsizing, offshoring and exit.

When way undervalued, exports and profits do increase. But quality labour begins to move in response to high wages elsewhere (brain drain).

Result: bouts of misalignment lead to shifting our comparative advantage toward resource-based activities with an employment base that is less diversified and less human-capital intensive than if exchange rates were stable.

Volatility or Misalignment

Failings of Canada’s Float (5)

Probably the strongest argument for a floating rate is that it can act as a buffer against asymmetric shocks.

Bank argues that by allowing the exchange rate to fall as commodity prices fall, this shores up output and employment in commodity sectors.

But – result could well be a decline in productivity – the “lazy dollar” hypothesis. Producers take advantage of low dollar to increase exports but fall behind competitors in implementing productivity-enhancing equipment and technology.

John McCallum notes that at first blush it appears that a 10 percent reduction in the C$ is associated, two years later, with a 7% reduction in the ratio of Canadian to US productivity in manufacturing.

Buffering and Productivity (A)

Two “shocks” are occurring

a fall in commodity prices (i.e. a negative shock to the “old economy”)

emergence of a generous purpose technology (GPT) priced in US$ (a positive shock to the new economy).

Assume that the GPT increases productivity


Buffering and Productivity: A Theoretical Model

Failings of Canada’s Float (6) Cont’d

If we buffer (depreciate C$ as commodity prices fall) entice capital and labour to stay in old economy increase C$ price of GPT and, therefore, underinvest in new economy hence, new economy is smaller and less capitalized and our productivity falls relative to the US

If we have common currrency commodity price fall leads to a transfer of labour and capital out of old economy provides incentive to invest in GPT hence Canada adjusts to the shock in the same way as California adjusts. This will close the income gap.

At the 62 US cents per C$, Canada’s assets are at fire-sale prices.

On the resource side, if US buys the Canadian companies, the mining/forestry/oil activity still must take place in Canada.

Not so for manufacturing. The purchase of innovative high-tech firms typically means the transfer of the firm, jobs and people to the US.

Result: increase our reliance on resource-based production in a progressively human-capital era.

Major counter to those who argue that a common currency erodes sovereignty.


Fire-Sale Assets

Ontario’s trade has dramatically shifted north-south (see charts).

True for all provinces except NS and PEI.Thus, Canada is less and less a single east-west

economy and more and more a series of north-south, cross-border economies.

Enhances case for common currency.

The Case for Exchange Rate Fixity (1)

North-South Integration:

The Case for Exchange Rate Fixity: (2a)

The Case for Exchange Rate Fixity: (2b)The Case for Exchange Rate Fixity: (2b)

Major case for flexible rates is that exchange rate is a buffer against foreign shocks. But fixed rates can handle shocks too. Regional adjustment Assume that Ontario is in equilibrium with US Great Lakes states, Alberta is cost competitive with the Texas Gulf, BC is on-side with the Pacific Northwest, etc. Now comes a price shock, say an increase in raw material prices.Initially, this affects both sides of the cross-border regions similarly, i.e. Ontario is affected the same way as Michigan.But if we allow the exchange rate to appreciate, then all Canadian regions become vis-à-vis their US counterparts. Highly questionable policy – better to have fixed exchange rate.Real asymmetry is between Alberta and Ontario or Texas and Michigan --(not north-south).

The Case for the Exchange Rate Fixity (3)

Adjustment under Fixed Rates


• For the former, there is fiscal policy.

• For the latter, there is income taxation, equalization, EI and labour mobility.

Therefore, not true that we lack effective adjustment under fixed rates. Ontario would adjust more or less in the same way as Michigan.

National Adjustment

There is still a national problem because resources are a larger part of Canadian GNP than US GNP and there is also a Canadian interregional problem.

But we have policies to handle this


Previous adjustment focused on producers. What about consumers? Here, fixed rates have an advantage.

Again, assume a price shock (fall in commodity prices) which affects Canada more than the US. If the C$ falls in response, consumers assets denominated in C$ fall relative to US assets. This serves to focus the impact of the price fall within Canada.

Under common currency, we would hold assets in same currency as Americans. Fall in resource prices would not affect our generalized asset values vis-à-vis Americans.

This is an offset to the fall in price.

Fixed Rates as a Consumer Buffer


Remove exchange rate volatility. Cost certainty is increasingly important as we shift

from a resource base to a human capital base. Reduction in transaction costs (including costs for

hedging against currency shifts). Capital markets would be deeper and interest rate

spreads narrower, thereby increasing the efficiency of financial markets.

Evidence suggests that trade will increase dramatically

Other factors

Alternative Approaches to Fixity (1)

Bank of Canada and many mainstream analysts assert:

Fixed exchange rates are unsustainable, and a common currency is unattainable, therefore the real choice is between flexible rates and dollarization. Since dollarization is unacceptable, flexible rates rule!

This will not wash. Fixed rates can work – look at the Austrians and the Dutch. They held their fix to the D-Mark even through German unification. And Canada is as integrated to the US as they are to Germany.

We would have to make the fixed exchange rate the keystone of our national economic policy within NAFTA geo-economic space.

Alternative Approaches to Fixity (2)

Under a CB, the conversion rate is fixed precisely and the CB stands ready to buy and sell at this dedicated rate. There is no scope for domestic monetary policy because there is no central bank, as such.

Two lesson from Argentina’s experience:

1. Currency boards hold incredibly well.

2. Make sure that you anchor your currency to the currency of your major trading partner.

Currency Boards (CB)

North American Monetary Union (1)

Modelled along Euro lines. Supra-National central bank – Federal Reserve Bank of North

America (FRBNA). Bank of Canada would still exist, as does Bank of France under

the Euro. B of C would have a seat on the board of the FRBNA (but US

would maintain control – has 12 Federal Reserve Banks). US dollar would continue to be US currency. Why destroy

world’s foremost currency? We would issue a new Canadian currency, that would exchange

one-for-one with the US dollar. (Suppose that the conversion rate was 150 Canadian cents for each US dollar. Then 100 new Canadian dollars would exchange for 150 old Canadian dollars and items that formerly cost $150 dollars would now cost $100 of the new currency. Thus, we maintain existing price differences, i.e, no real change in real prices. This is the identical process that all Euro countries are going through.

Nature of NAMU

North American Monetary Union (2)

One side of the new currency, (say the $5 bill) would say that this is a North American $5 bill, identical to 5 US dollars. The other side could have a picture of the rockies, for example. Hence, Canadian symbolism could remain.

The B of C would issue the new currency, in the same way that the 12 US Federal Reserve Banks issue the currency in their own regions. Thus, we would keep the seigniorage.

We would enter into some version of the European EMS in order to move toward an appropriate currency conversion rate. This took nearly a decade in Europe.

We would maintain control over financial regulations. As an important aside, during this conversion process, we

should work down our debt/GDP ratio to the US level, to ensure that we have similar fiscal flexibility under NAMU, I.e. a variant of the Maastricht Guidelines under the Euro.

There would no longer be an exchange rate.

NAMU vs Dollarization

• Could do this unilaterally, whereas NAMU requires US cooperation.

• We eliminate the exchange rate and generate much of the benefits noted earlier.

However:

• We would lose seigniorage and lose currency symbolism.• The clearings system would likely become north-south by region,

rather than a national clearings system which is then reconciled internationally;

• Our financial institution regulation would begin to fall into the US orbit and ambit;

• There would be no rationale for maintaining the Bank of Canada (I.e. there is no fall-back position).

Why Not Simply Use US dollars?

The USA and NAMU (1)

Will the US ever agree to a NAMU? Perhaps not. But consider this. When the Euro coins and notes

arrive in 2002, they will be legal tender in the 12 Euro nations. They will presumably be an anchor currency (for fixed rates or CBs) or be a circulating currency for all of those countries soon to enter the EU and Euro. As important, the Euro will begin to circulate in Russia, former Soviet countries, and perhaps as far away as South Africa and Brazil.

And the Euro area has a large current account surplus while the US has a large current account deficit. Over the longer term, therefore, the odds are for a substantial appreciation of the Euro relative to the US dollar.

The US and NAMU (2)

Hence, the US may have a problem, because the Euro will compete with the dollar in major portfolios. At the very least it will lose significant seigniorage.

At some point, therefore, the Americans will presumably be interested in expanding the formal dollar area.

Initially, this will likely take the form of encouraging countries to dollarize – to declare the US$ legal tender. The US may even agree to share the resulting seigniorage with these countries, as Senator Connie Mack’s Bill proposes to do.

The US and NAMU (3)

But once countries dollarize, they will then want some influence over monetary policy. And as more countries dollarize, some power begins to shift to these countries.

Initially, the Federal Reserve will want to monitor and ameliorate any problems associated with spreading dollarization in the Americas. This can be addressed via informal meetings. These will then begin to evolve toward more formal contacts and this could trigger the beginnings of what could eventually become the Federal Reserve Bank of the Americas.[This is one way of conceiving how we might replicate the Euro in the Western Hemisphere].

Sovereignty and a Common Currency (1)

Naturally, a common currency means that we buy into US monetary policy.

Not obvious that we have much independence now:

Low dollar is resulting in an asset “fire-sale”, as noted earlier;We tend to follow the US monetary policy (interest rates) anyway;

Question: If we had fixed the dollar at 80 US cents at the time of the FTA, would we now have a softwood lumber problem? That is, is the US going to stand by in a recession knowing that the C$ depreciated from 89 cents to the low 60-cent range over the past decade?

Sovereignty and a Common Currency (2)

We Canadians are proud to have created a special place and space in the upper half of North America.

The Pearson years were initially important in creating a social vision that differed from that in the US – the CPP/QPP, the final version of Medicare, the Canada Assistance Plan, making the Equalization program comprehensive, and DREE, among others.

But the Pearson years represented the only post-war period where Canada was using US monetary policy – our exchange rate was fixed at 92.5 cents.

Thus, there is no evidence that a common currency would limit our ability to legislation in our own likeness and image across a broad range of policy areas. Quite the opposite!

Where to From Here? (1)

The Brits have, in some respects, a similar choice to make.They do not want political union with Europe.Their choices: keep the floating pound; fix the pound to the Euro; allow Euroization; or embrace the Euro and the ECB.

The British will have one vote of 13 on the Board of the ECB, and a lesser role as more countries join.

Yet, my guess is that the British will join the Euro. This will probably have an influence on Canadians.

Britain vs Canada

Where to From Here? (2)

NAMU, if possible at all, is still probably a decade away;

If Mexico dollarizes, this might tend to force some choices on Canada.

Happily, in the polls, Canadians now prefer a common currency to dollarization.

My guess is that any further push needs to come from the business sector.

Meantime, it is important that we engage in the necessary research so that we can make the appropriate choice when the time comes.

References

Thomas J. Courchene and Richard G. Harris (1999) From Fixing To Monetary Union: Options for North American Currency Integration, Commentary 127 (Toronto: C.D. Howe Institute).

Available at:

http://qsilver.queensu.ca/~courchen/papers.html

Documents

A COMMON CURRENCY FOR NORTH AMERICA by Thomas J. Courchene Jarislowsky-Deutsch Professor School of Policy Studies, Queen’s and Senior Scholar Institute