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C.D. Howe InstituteInstitut C.D. Howe Communiqué

Embargo: For release Tuesday, June 22, 1999, at 10:00 a.m.

Canada should pursueNorth American currency union,

economists sayCanada’s floating exchange rate is not serving the country’s economic interests well, and thesolution could be to work toward establishing a North American currency union, say two ofCanada’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 SimonFraser University.

The authors argue that Canada’s experience with a floating exchange rate for the dollarhas been disappointing. Floating rates make real exchange rates more volatile, do not appear tooffer 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 Canadianfirms that export or compete with imports; bias investment toward US locations and thus awayfrom Canadian ones; and discourage the development of human-capital-intensive industriesin Canada.

Courchene and Harris argue that, as the Canadian economy becomes more open to tradeand 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. Suchan arrangement, the authors say, would encourage wage and price flexibility in Canada asfirms and workers became more conscious of their competitive positions in North America;stabilize prices for Canadian financial and real assets; and reduce currency conversion andother transaction costs on crossborder trade and investment.

Courchene and Harris explain that the options for greater exchange rate fixity run thegamut from exchange rate targets, through adjustable pegs, a fixed exchange rate fully backedby 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 USdollar for a range of purposes) or “policy dollarization” (an official decision by the policyauthorities to proclaim the US dollar as legal tender) — all the way to a formal North AmericanMonetary Union (NAMU). Courchene and Harris argue that, of the single-currency options, acurrency union would be far preferable to dollarization.

Responding to fears that moving to a fixed exchange rate monetary regime or currencyunion would involve a loss of sovereignty for Canada, Courchene and Harris say that such aloss would be more apparent than real. They point out that it was during the fixed rate periodof 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 theAmericas are forcing the issue. There is already a trend toward dollarization both in free tradepartner Mexico and in Argentina, which may serve to constrain the potential for a NorthAmerican currency union. Canada needs to be part of any public debate on the evolution ofNorth American currency arrangements, the authors argue, to ensure that the NAMU optionremains on the table.

* * * * *

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

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For further information, contact: Thomas J. Courchene (613) 533-6555;Richard G. Harris (604) 291-3795;

Shannon Spencer (media relations), C.D. Howe Institutephone: (416) 865-1904; fax: (416) 865-1866;

e-mail: [email protected]; Internet: www.cdhowe.org

From Fixing to Monetary Union: Options for North American Currency Integration, C.D. Howe InstituteCommentary 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 K1J9J3 (stores: 71½ Sparks Street, Ottawa, Ontario; 12 Adelaide Street West, Toronto, Ontario); or directly fromthe C.D. Howe Institute, 125 Adelaide Street East, Toronto, Ontario M5C 1L7. The full text of this publicationwill also be available on the Internet.

C.D. Howe Institute / Institut C.D Howe Communiqué / 2

C.D. Howe InstituteInstitut C.D. Howe Communiqué

Embargo : à diffuser le mardi 22 juin 1999 à 10 h

Le Canada devrait rechercherune 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 solutionpourrait 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 del’Université Simon Fraser.

Les auteurs soutiennent que l’expérience qu’a faite le Canada du taux de change flottantpour le dollar s’est avérée décevante. Un taux flottant entraîne une instabilité des taux dechange réels, ne semble pas offrir un tampon efficace contre les chocs externes et peut se solderpar un mauvais alignement prolongé des devises, ainsi qu’en témoigne la période actuelle defaiblesse prononcée de la devise canadienne par rapport au dollar américain. Une faiblesse etune 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 audétriment des emplacements canadiens et elles pourraient décourager l’essor des industriesaux 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 surles États-Unis, le calcul coûts-avantages croît en faveur d’une fixité accrue du taux de changepar rapport au dollar américain. De telles dispositions, ajoutent les auteurs, stimuleraient lasouplesse 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 ellesréduiraient 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 changesont vastes, qu’il s’agisse d’objectifs de taux de change, d’un système de parité ajustable, d’un

taux de change fixe entièrement soutenu par la banque centrale, et les politiques budgétairesdes 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 dudollar 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 deloin préférable à celui de la dollarisation.

Face aux craintes que l’adoption d’un régime monétaire à taux de change fixe ou d’uneunion monétaire n’entraîne une perte de souveraineté pour le Canada, les auteurs affirmentque cette perte serait plus apparente que réelle. Ils soulignent également que c’est au cours desannées 60, durant lesquelles le Canada avait adopté un taux de change fixe, que le pays a puélaborer 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 unetendance 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 publicsur l’évolution des dispositions monétaires en Amérique du Nord pour veiller à ce que l’optiond’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 rôleprépondérant au Canada en matière de recherche sur la politique économique. Ses membres, individuels etsociétaires, proviennent du milieu des affaires, syndical, agricole, universitaire et professionnel.

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Renseignements : Thomas J. Courchene 613 533-6555;Richard G. Harris 604 291-3795;

Shannon Spencer (relations avec les médias), Institut C.D. Howetéléphone : 416 865-1904, télécopieur : 416 865-1866;

courriel : [email protected], Internet : www.cdhowe.org

From Fixing to Monetary Union: Options for North American Currency Integration, Commentaire no 127 del’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) ouencore 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.

C.D. Howe Institute / Institut C.D. Howe Communiqué / 2

Monetary Policy

From Fixing to Monetary Union:Options for North American

Currency Integration

by

Thomas J. Courcheneand

Richard G. Harris

Canada’s experience with a floatingexchange rate for its dollar has beendisappointing. The floating dollar has beenprone to major misalignments, as its currentweakness demonstrates, that put Canada ata disadvantage in the North Americancompetition for physical and human capitalinvestment. As the Canadian economybecomes more open to trade andinvestment flows, and as those flowsbecome more focused on the United States,the benefits of greater exchange rate fixitywith the US dollar are growing.

There are many options for greaterexchange rate fixity, running from exchangerate targets through a formal NorthAmerican Monetary Union (NAMU).Particularly in comparison with growing

spontaneous use of the US dollar by theprivate sector in Canada, a NAMU wouldoffer important benefits for macroeconomicstability and financial integration.

With interest in using the US dollargrowing elsewhere in the Americas, delayon Canada’s part in embracing this optioncould prove costly. US cooperation inestablishing the new currency and inproviding central banking services toCanadian financial institutions would bevaluable, but if other countries adopted theUS dollar without such concessions,Canada’s chances of obtaining them woulddiminish. For that reason, Canada shouldmake haste in investigating the possibility ofestablishing a monetary union incooperation 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 asthe recent period of pronounced weakness in the Canadian dollar.

• Prolonged misalignments, or overshoots, in the value of the Canadian dollar raise severalrisks. 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 Canadianones, and to discourage the development of human-capital-intensive industries in Canada.

• Canada's growing openness to international trade and investment, and the concentrationof 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 arrangementwould encourage wage and price flexibility in Canada as firms and workers became moreconscious of their competitive positions in North America; stabilize prices for Canadian fi-nancial and real assets; and reduce currency conversion and other transaction costs oncrossborder trade and investment.

• Options for greater exchange rate fixity run the gamut from exchange rate targets, throughadjustable pegs, a fixed exchange rate fully backed by both the central bank and federal andprovincial fiscal policies, a currency board, “dollarization” with or without governmentbacking, 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. Itwas 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 NorthAmerican currency arrangements to ensure that the NAMU option remains on the table.

T he introduction of the euro in January1999 represents a watershed in the an-nals of economic and monetary history.At one level, the advent of the euro sig-

nals the denationalization of national mone-tary regimes; at another, it signals that, in aprogressively integrated global economy, cur-rency arrangements are a supranational publicgood, one that is arguably consistent with atwenty-first-century vision of what constitutesnational sovereignty. Understandably, perhaps,Canadian officials responsible for macro-economic policy do not share this view. AsBank of Canada Governor Gordon Thiessennoted in a recent speech, “the euro is not ablueprint for a North American monetaryunion. The political objectives that motivatedmonetary union in Europe do not have a paral-lel in North America” (1999, 123).

Granted, the North American Free TradeAgreement (NAFTA) is largely a trade andeconomic blueprint, whereas integration in theEuropean Union (EU) incorporates, in addi-tion, aspects of a confederal or federal over-arching structure. But to link the euro solely toEurope’s political evolution is to ignore thecompelling economic rationales for a suprana-tional currency: it is highly unlikely, for exam-ple, that the British would ever buy into theoverarching European political project, but theyare highly likely to embrace the euro. Even inSwitzerland, which is not a member of the EU,private sector agents appear to be embracing“market euroization” — that is, adopting theeuro for a range of purposes, such as transac-tions and as a unit of account; in the NorthAmerican context, this is called “dollarization.”1

As Tagliabue notes:

The reasons for this [Swiss] enthusiasm forthe euro are clear. Switzerland, with justseven million people and an area a littlelarger than Maryland’s, is surrounded byfour euro nations — Germany, France, Italyand Austria — and conducts about 70 per-

cent of its trade with the 15 nations of theEuropean Union.

For its part, Canada’s exports are even moredependent on the US market (more than80 percent of our exports go there) than Swit-zerland’s are on the EU. This enhanced degreeof North American integration features promi-nently in the analysis in this Commentary,which aims to make the case for greater fixityin the Canadian/US dollar exchange rate, theultimate goal being a North AmericanMonetary Union (NAMU) with many elementsalong euro lines.

Governor Thiessen’s preference for main-taining Canada’s flexible exchange rate regimeis based primarily on the premise that the float-ing rate is serving the country well:

Canada has a very useful economic safetyvalve in its floating exchange rate. Becausemovements in the Canadian dollar reflectexternal shocks as well as any domesticeconomic difficulties we may face, there issometimes a tendency in Canada to blamesuch movements as the cause of our prob-lems. In fact, these currency movements area consequence, not a cause. Exchange rateflexibility has served us well over time. Whywould we want to give it up? (1999, 123.)

Our view, however, is that a floating exchangerate is not, in fact, serving Canada well withinthe progressively integrated NAFTA environ-ment; that there are persuasive arguments forgreater exchange rate fixity; and that thelonger-term objective of greater exchange ratefixity should be a common North Americancurrency. The purpose of this Commentary is toexamine these propositions and to look atsome of the alternative approaches along thecontinuum from floating rates to monetary un-ion, including pegged rates, fixed rates, cur-rency boards, and dollarization.

While a NAMU is not on the immediatehorizon, there is nonetheless an urgent need to

C.D. Howe Institute Commentary / 3

place the currency union issue on the publicpolicy agenda. Policy developments within theNAFTA and elsewhere in the Americas appearto be moving quickly in the direction of dollari-zation. Since widespread dollarization couldpreclude the emergence of a NAMU by reduc-ing the advantages the United States wouldgarner from it and since, as we argue below, aNAMU would be preferable to dollarizationfrom a Canadian perspective, Canada must be-come engaged on this issue with its NAFTAand hemispheric partners — and sooner ratherthan later.

One final introductory note is in order.One of the by-products of Canada’s pursuit ofmonetary independence is that the exchangerate has been a market-determined variable,and in this sense there is a close link betweenmonetary policy and exchange rate policy. Thepurpose of this Commentary is to assess Cana-da’s exchange rate options: it is not intended asa criticism of Bank of Canada monetary policy.In our view, the same debate on currency andexchange rate issues would be under waywhether the Bank was targeting inflation orunemployment or the growth rates of mone-tary aggregates.2

The Economics ofExchange Rate Fixity

One can make a number of broad characteriza-tions about the behavior of economies operat-ing under differing exchange rate regimes.Beginning with what economists think theyknow about how economies work under float-ing versus fixed regimes, we start with a lookat the implications of the exchange rate regimefor living standards, productivity, currencyconfidence, and a number of subsidiary issues.

What Economists Knowabout Exchange Rate Regimes

Since the demise of the Bretton Woods interna-tional monetary system in 1971, there has been

a wide range of international experience withrespect to exchange rate regimes, both fixedand floating.

(As an important aside, since Canada be-gan its floating rate regime as long ago as 1970,few decisionmakers in government, the bu-reaucracy, business, or labor know, or remem-ber, how an economy functions under fixedrates. Hence, the Canadian historical experi-ence under flexible rates is, at best, an imper-fect lens through which to examine the adjust-ment requisites and dynamics under a fixedrate regime, especially since such a system im-plies a wholesale transformation in the way aneconomy responds to various shocks, whetherexternal or policy induced.)

What, then, does this international experi-ence tell us about flexible versus fixed rates?Clearly, from the perspective of the 1960s and1970s, flexible rates have not operated aseconomists had imagined they would. In 1953,Milton Friedman’s case for flexible exchangerates included the proposition that

instability of [flexible] exchange rates is asymptom of instability in the underlyingeconomic structure...a flexible exchange rateneed not be an unstable exchange rate. If itis, it is primarily because there is underly-ing instability in the economic conditions.(Quoted in Flood and Rose 1998, 2.)

This has turned out not to be the case, however.Rather, the evidence points to three basicpropositions.3

First, over any period of time short enoughto be interesting, real exchange rates4 are sub-stantially more volatile under a flexible rate re-gime than under a fixed one, and almost all ofthis volatility is due to movements in the nomi-nal exchange rate. The Canadian-US bilateralreal exchange rate can appreciate either be-cause the Canadian dollar appreciates relativeto the US dollar or because prices rise in Can-ada relative to those in the United States. It isimportant to recognize that real exchange rates

4 / C.D. Howe Institute Commentary

move all the time and that they will adjust evenif the nominal exchange rate is completely fixed,but at a much slower rate, in line with move-ments in the general level of prices. Eliminat-ing volatility in the nominal exchange rate willeliminate most of the short- and medium-termvolatility in the real exchange rate.5

Second, macroeconomic fundamentals can-not explain short- to medium-term exchangerate movements. More important, there is nosystematic difference in macroeconomic sta-bility between fixed and flexible exchange rateregimes. As Flood and Rose note:

Simply put, to a first approximation, coun-tries with fixed exchange rates have lessvolatile exchange rates than floating coun-tries, but macro-economies that are equallyvolatile....By choosing the exchange rateregime, policy thus has an important effecton exchange rate variability, but not on thevolatility of traditional macro-economicfundamentals. (1998, 2–3.)

An important corollary of this observation(Bank of Canada Governor Thiessen’s viewsnotwithstanding) is that the benefits of eitherfixed or flexible rates as shock absorbers shouldnot be overstated. As economists discovered inthe 1970s, neither flexible nor fixed rates canprevent the rapid international transmissionof inflation nor, as economists learned in the1980s, can they prevent a large number of coun-tries (including Canada) from pursing unsus-tainable fiscal policies. Poor economic policies(whether micro- or macroeconomic) lead toundesirable economic consequences, whateverthe exchange rate regime. The process by whichthe policy mistake is transmitted can differ, butthe ultimate consequences are similar.

Third, nominal exchange rates can wanderfrom important long-term-trend fundamentalsfor significant periods of time, often two yearsor longer. This is referred to as the “misalign-ment problem.” The most infamous global mis-alignment was that of the soaring relative

value of the US dollar in the early 1980s, whichultimately led to the coordinated interventionof five large industrialized countries in 1985 inan attempt to bring it down. Canada has hadtwo serious periods of misalignment in thepast decade: the late 1980s, when the dollarreached 89 US cents, and the recent period, inwhich the dollar has approached 63 US cents.

Identifying misalignment under flexible ex-change rates is an imperfect and judgmentalprocess. In the short run, the exchange rateresponds primarily to capital movements,which, in turn, are induced by real or fi-nancial market shocks. A misalignment isjudged to occur when, for long periods, theseshocks seem to unlink exchange rates fromeconomic fundamentals.

Economists have proposed a number ofmethods to identify misalignment. The princi-pal method has always been calculations ofpurchasing power parity (PPP), which adjustfor relative price-level changes across coun-tries. While PPP theory is notoriously poor inexplaining exchange rates over short periods,it does seem to have long-run predictive power.Long-term exchange rate trends are relativelywell characterized by slow reversion to PPPvalues and, after any substantial departure,convergence appears to take between four andsix years.

Another way to benchmark fundamental-based exchange rates is to use the notion of afundamental equilibrium exchange rate (FEER)(Williamson 1994), which corrects for longer-term structural factors, including current ac-count imbalances, terms of trade shocks, andforeign debt servicing. However, the conceptof a FEER also has a number of problems, notthe least of which is that the economy can ad-just to current account imbalances and stocksof net foreign debt through channels otherthan the exchange rate. In any case, whetherusing PPP or FEER benchmarking, exchangerate misalignment is a recurring problem.


From a policy perspective, the choice ofa monetary regime would be much easier ifexchange rates reacted predictably to macro-economic events and if one regime was clearlysuperior to the other in its ability to act as ashock absorber. The evidence on mac-roeconomic volatility suggests, however,that this is not the case. Much of the impetuson the part of smaller countries for moving toa fixed rate relates to volatile exchange ratesand periods of severe misalignment and theconsequences of these problems for the econ-omy. The larger the portion of the economyexposed to international trade and invest-ment, the more serious these consequencesbecome. Amajor reason Canada should movetoward the fixed end of the spectrum of al-ternative currency arrangements is to avoidthese costs. We develop these arguments fur-ther below.

Living Standardsand Exchange Rates

During the 1960s, the Canadian dollar was tiedto the US dollar at a rate of 92½ US cents.Thanks to substantial upward pressure on thedollar, Canada floated its currency in 1970. By1973 or so, the Canadian dollar traded atroughly 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-mer 1998 currency crisis.

A substantial part of the Canadian dollar’sdepreciation from 1973 to the mid-1980s can beattributed to inflation differentials between thetwo countries. By 1988, a PPP calculation sug-gested the long-run appropriate value of theCanadian dollar was in the 80-US-cents range.Since that time, pre-tax personal income percapita in Canada has fallen relative to that inthe United States, magnified by Canadian ex-change rate depreciation, which suggests therehas been a significant fall in Canadians’ aver-age standard of living relative to that of Ameri-

cans. This trend is reflected in the movement ofyoung, well-educated people to the UnitedStates, increasingly attracted by employmentopportunities in that country — especially onthe basis of after-tax comparisons — and in thegrowing number of Canadian business execu-tives who demand to be located in the UnitedStates or remunerated closer to US levels.

Under a fixed exchange rate regime, itmight have been possible to isolate the sourcesof the relative decline of Canadian living stan-dards and so to identify the more likely policyrepairs. Under flexible rates, however, policy-makers are uncertain as to whether the declineis permanent or the consequence of a mis-aligned dollar, which may be self correcting.

It is important to emphasize that a fallingnominal exchange rate does not necessarily in-dicate a falling standard of living (and neitherdoes a rising exchange rate indicate the oppo-site). A falling standard of living is associatedwith shifts in trend productivity growth thatultimately must be reflected in real wages orprofits. A nation can have a falling rate of pro-ductivity growth relative to its trading part-ners’ average, while experiencing almost anypattern of nominal exchange rate movement,depending on developments in nominal wageand price levels. We take up the productivityissue in more detail below.

Rationalizing the RecentDecline of the Canadian Dollar

One can, of course, attempt to rationalize therelative decline of the Canadian dollar by ap-peal to fundamentals, as McCallum (1998) andOrr (1999) have done. For example, Canada’sproclivity to rely on external sources of capitalmeant that interest payments to foreigners in-creased from $15.2 billion in 1987 to $26.5 bil-lion by 1990 and to a peak of $30.3 billion in1995 (Bank of Canada Review, Autumn 1998, ta-ble J1). These increases might be interpreted asrequiring an increasingly large merchandise


trade surplus in order to equilibrate the overallcurrent account balance and, therefore, a pro-gressively lower exchange rate.6

Yet many economists, particularly those inthe neoclassical tradition, discount calculationsof the equilibrium value of the dollar using thecurrent account balance as a benchmark — asHarris (1992), Chandler and Laidler (1995),and McCallum (1998), for example, have done— pointing out that the balance of payments isan identity, and a current account deficit is thenecessary counterpart to an excess of nationalinvestment over national savings. In fact, a realexchange rate adjustment is only one of manyinfluences on each item that make up theidentity. Moreover, there are good reasons onfundamental grounds why aggregate savingsmight be less than aggregate investment forvery long periods, as is the case in the UnitedStates. Thus, from this perspective, the recentdramatic improvement in the fiscal situationsof the federal government and most provincesshould remove some of the downward pres-sure on the Canadian dollar.

The Bank of Canada’s (and McCallum’s)preferred explanation for the decline in therelative value of the Canadian dollar is that theexchange rate is simply tracking global com-modity prices. Indeed, over the 1973–99 peri-od, there has been a close relationship betweenthe decline in commodity prices and the ex-change rate. And, over the past year, the Bankhas put a positive spin on the dollar ’s fall,arguing that it is serving as a buffer to offsetfalling commodity prices and ensuring thatCanada’s level of economic activity is likewisebuffered. But the buffering argument can ac-count for only a small part of the exchange ratemovements of the past decade or so.

The run-up in the exchange rate from 1988to 1991 to 89 US cents during Canada’s acces-sion to the Canada-US Free Trade Agreement(FTA), for example, was induced by tight mone-tary policy, and did nothing to help Canadacope with the external shock of free trade.

Moreover, as Harris (1993), Fortin (1994), andothers have argued, the exchange rate appre-ciation over that period could not be justifiedby the real fundamentals in the economy. Sincethen, as Orr notes,

commodity prices in US dollars weightedby Canadian exports rose significantly andsteadily by 30% over the 1992-1996 period.At the same time the Canadian dollar fellsharply and steadily from 89 cents in 1991to 73 cents in 1996. (1999, 5.)

The appropriate measure of the relevant exter-nal price shocks over this period is the changein Canada’s terms of trade, which, using theBank of Canada’s export and import price in-dexes, declined by 3 percent from the firstquarter of 1991 to the fourth quarter of 1998.Thus, Canada’s terms of trade have generallybeen relatively stable in the 1990s and revealno serious long-term negative trend. In fact,falling commodity prices have been matchedby improvements in the prices of other manu-factured exports and by reductions in the pricesof imported consumer and capital goods.

Whether or not there is a correlation over alonger time frame between commodity pricesand the value of the dollar, the buffer argu-ment adds little to an understanding of thedollar’s movements over the past decade, andshould add little to Canadians’ enthusiasm fora floating currency. The recent depreciationappears to look increasingly like an overshoot,one that is having negative consequences onreal resource allocation and investment and,ultimately, on confidence in the economy.

One explanation for the dollar’s relativedecline that has not been given enough atten-tion is the economic boom that has taken placein the United States over the past seven years,particularly the extraordinary stock marketboom. Many market commentators have sug-gested that this may be a stock market bubblewith valuations that cannot be sustained — USFederal Reserve chairman Alan Greenspan has


famously called it “irrational exuberance.” In-deed, the extraordinary returns in the US mar-ket relative to the Canadian market may havedriven down the demand for Canadian dollarassets as foreign and Canadian investors shiftinto high-yielding US equities. At the globallevel, this asset boom has important conse-quences for the US dollar relative to both theyen and the euro, and the undervalued Cana-dian dollar may well be a reflection of an over-valued US dollar.

Empirically, it is hard to “prove” with cer-tainty which of these explanations might becorrect; they might all be so in part. None, how-ever, contradicts the fact that the Canadian dol-lar is currently far below any value justified byfundamental benchmarks, and the downwardtrend has now been intact since 1992.

Depreciation and Productivity

Perhaps the most visible argument in mediadiscussion of the dollar’s relative decline is thepossible relationship between the exchange rateand a slower rate of productivity growth in themanufacturing sector. Admittedly, in the shortterm, a falling dollar does allow Canadian ex-ports to further penetrate the US market. Butthe other side of the low-exchange-rate coin isthat it provides a cost disincentive in terms ofproductivity improvements: a 10 percent fallin the dollar means a 10 percent rise in the priceof competing goods from abroad, as well as inthe price of US capital equipment (or equip-ment priced in US dollars) for productivity en-hancements. This issue is not new in theCanadian context — the Canadian dollar waslow and productivity performance poor in the1980s. As Harris (1993, 36) notes,

[o]ne consequence of an undervalued ex-change rate is that it protects inefficient op-erations from otherwise appropriatemarket signals. In the Canadian case, therobust demand growth in the [mid-1980s’]recovery plus the low exchange rate proba-

bly delayed appropriate productivity-improving investments in our manufactur-ing industry until much later in the decade.

John McCallum has raised the same issue withrespect to the current depreciation:

Canada’s plummeting relative manufac-turing productivity is a puzzle, especiallywhen productivity was supposed to risefollowing free trade with the United Statesand when broader productivity measureshave not shown a similar relative decline.The idea that a weak currency induces “lazi-ness” on the part of the manufacturing sec-tor is not one that appeals to this author,but it seems to be broadly consistent withthe data, [which] suggests a “double dip”in Canada’s relative manufacturing pro-ductivity for the first half of the 1980s andthen in the period 1994–97. Both of theseperiods correspond roughly to times ofweak currency. Indeed, there is a positiveand significant correlation (R = .45) be-tween the Canada-minus-US productivitygrowth gap and the lagged value of Cana-dian unit labour costs in manufacturingrelative to the United States (expressed inthe same currency). So it may be that aweak currency has been a cause rather thana consequence of poor productivity growthin our manufacturing sector. (1998, 3–4;emphasis added.)

McCallum offers more recent evidence(1999) that a 10 percent reduction in the rela-tive value of the Canadian dollar is associated,two years later, with a 7 percent reduction inthe ratio of Canadian to US productivity inmanufacturing. Since Canadians’ future livingstandards depend on productivity growth, thisfinding is ominous indeed. Given the federalgovernment’s recently announced policy shifttoward productivity issues, this relationshipbetween exchange rate misalignment and pro-ductivity clearly merits attention.

One might characterize what has beenhappening in the following way. An underval-


ued Canadian dollar, coupled with low infla-tion, leads to a productivity slowdown relativeto the United States, which is forging ahead onthe strength of a boom in high-technologysectors. This tends to convert the originally un-dervalued dollar to an equilibrium of sorts. Inturn, this puts pressure on the Canadianauthorities to accommodate a further drop inthe dollar to restore Canada’s erstwhilecompetitive advantage. But this becomes aself-fulfilling process — allowing the exchangerate, rather than productivity, to drive com-petitive and comparative advantage.

This may be a tempting picture to paint,given Canada’s recent experience, but it is muchmore in the nature of a hypothesis meritingfurther research than a conclusion. In particu-lar, the hypothesis needs squaring with thestandard view of firms as profit maximizers,which should be expected to seek whatever ef-ficiency gains are accessible, regardless of theexchange rate or the regime by which it is de-termined. Nonetheless, given that Canadians’living standards ultimately depend on produc-tivity, this is an issue with which defenders ofCanada’s flexible rate must come to grips.

The Costs of Misalignment

Closely related to, although more general than,the undervaluation-productivity argument isthe longer-run response of the structure of theeconomy to both under- and overvaluation ofexchange rates for extended periods. These ar-guments hinge on the mobility of firms andhighly skilled individuals across the Canada-US border.

In the case of an overvaluation, firms cantake defensive measures by cost cutting andabsorbing cost increases through decreasedprofits. But the 1986–92 overshoot,7 which,from trough to peak, increased Canadian unitlabor costs by nearly 40 percent (measured ina common currency), generated a degree of over-valuation that swamped any productivity im-

provements. Moreover, the FTA presented Ca-nadian firms and subsidiaries with an optionother than lowering costs or shutting down: theycould move to a US location, and a number ofhighly publicized moves did occur. No doubtsome of these relocations were made in theexpectation that the overvalued exchange ratewas permanent. The general point is that, withmisalignment of this degree, downsizing,moving offshore, and exiting become attrac-tive avenues of adjustment for firms.

This misalignment problem has evengreater significance when recast in the contextof Canada’s shift away from a resource-basedeconomy toward one increasingly driven byhuman capital and technology — what Harris(1993) has called a fundamental shift in their“wealth-generation processes.” From 1989, thefirst year of the FTA, until 1997, the export sec-tors that saw the greatest increases (as a per-centage of gross domestic product, GDP) were,in order, transport equipment (including autos),machinery and equipment, electrical and com-munication products, lumber and wood, andchemical and chemical products, followed byseveral services categories. The export groupsthat contracted the most (again, as a percent-age of GDP) were, in order, grains, utilities,metallic ores and concentrates, nonmetallic min-erals, and petroleum and coal products (Gradyand Macmillan 1998). Only one of the formergroup falls into the commodities category,whereas all five of the latter group do.

In a resource-based economy, floating ratesare a smaller problem, since organized com-modity spot markets mean that most resourceexports are already priced in US dollars andhedging is relatively straightforward. In non-resource areas, where less easily hedgible long-term bilateral contracts are important andwhere the economy has a significant import-competing manufacturing sector, movementsin the exchange rate are bound to be problem-atic. From the perspective of the firm:


The problem arises because free trade re-quires stable and predictable rates of inter-national exchange and cost calculations tosupport the volumes of trade and degree ofspecialization associated with it. This pre-dictability becomes more important thelarger the volumes of trade, the more inter-national exchange on a long-term bilateralbasis [because it is difficult to hedge ex-change rate risk from contracts upward ofa year or so] and the lower the degree of en-try barriers to an industry. Unfortunately,floating exchange rates provide inherentlyvolatile and unpredictable cost structures....Students of international business ob-serve that major determinants of directinternational investment decisions have beenexchange rate volatility and anticipatedprotectionist actions in the markets of themajor industrial countries. The argumentis made that flexible exchange rates haveinduced a pattern of location based on cri-teria other than comparative or competi-tive advantage, thus undoing many of thebenefits achievable through free interna-tional trade in a world of known structuresand flexible prices. (Harris 1993, 39–40.)

The dynamics of the response to a particu-lar misalignment vary significantly with thehuman capital intensity of the sector in ques-tion. In the case of overvaluation, firm exit (orrelocation) is the ultimate response. With a se-rious undervaluation, such as Canada is nowexperiencing, the process works quite differ-ently.8 The immediate effect of the deprecia-tion is to shift income in Canada from wages toprofits. With real wages in the United Statesrising relative to those in Canada, skilled laborbegins to migrate. Many firms will resist rais-ing wages in the short run, and would ratheruse the depreciation to cut prices and buildmarket share. If the low exchange rate persists,most firms will ultimately come to realize thatthe situation is unsustainable in the longerterm: they will either have to raise real wages

for their skilled workers or follow them to theUnited States.

Do new firms not enter or expand duringperiods of undervaluation? There is some evi-dence this does occur in traditional sectors. Forfirms whose business is based on skilled labor,the difficulty is that, during periods of ex-change rate undervaluation, skilled labor mar-kets become very tight. New entry, based on acost advantage due to an undervalued exchangerate or on wages that might be temporarily lowin domestic currency, is very risky. The net im-pact is that firms may exit in periods of over-valuation, and workers may exit in periods ofundervaluation. For a smaller country, build-ing comparative advantage in human-capital-intensive industries becomes quite difficult ifboth firms and highly skilled labor are mobilebetween the two countries. The irony is that re-peated periods of exchange rate misalignmentare likely to result in the shift of Canadian com-parative advantage toward industries that areresource and/or capital intensive, and in anemployment base that is both less diversifiedand less human capital intensive than wouldbe the case with exchange rate stability.9

In our view, then, the costs of exchangerate misalignment (or the benefits of greaterexchange rate fixity) can be summarized asfollows:

• The benefits of exchange rate fixity increasewith the degree of international openness,especially when this openness incorporatessuch a high degree of export integrationwith a currency and economic superpower(80 percent, in the case of Canada in rela-tion to the United States).

• Fixed exchange rates give Canada a betterchance of getting its fair share of NorthAmerican investment based on the com-petitive advantage of its firms and in-dustries (in contrast to location decisionsmade on the size of the market in order toisolate firms from exchange rate volatility).


• Canada's ability to generate and sustainhigh-wage jobs depends on sustaininghuman-capital-intensive, but otherwisehighly mobile, industry within the NorthAmerica market. Repeated periods of ex-change rate misalignment severely ham-per the development and growth of thoseindustries and firms in Canada and pro-mote excessive specialization in capital-and resource-intensive industries.

The analytical and empirical evidence issuch that free trade and currency stabilityshould go hand in hand in North America:free trade and flexible rates are inherently in-consistent (Harris 1993, 59). The time has comefor Canadians to contemplate a wholesalerethinking of their currency arrangements inNorth America.

North-South Integration

Now that we have broached the issue of NorthAmerican integration, it is important to high-light selected recent developments. Drawingfrom Courchene and Telmer (1998, chap. 9),the following aspects of the increasing north-south integration appear particularly relevant:

• In 1996, all but two provinces exportedmore to the rest of the world (internationalexports) than they did to other provinces(interprovincial exports).

• For each dollar of interprovincial exportsin 1996, international exports were run-ning at $1.83. In the early 1980s, the oppo-site was the case: interprovincial exportsran above international exports.10

• Since more than 80 percent of Canada’sinternational exports are destined for theUnited States, north-south trade clearly ex-ceeds east-west trade in the aggregate.

• In the interesting case of Ontario, its in-terprovincial exports (and imports) were

running at roughly the same level as its in-ternational exports (and imports) in 1980.By 1996, however, the province’s interna-tional exports were roughly two and a halftimes its interprovincial exports and grow-ing nearly a magnitude faster. More recentdata indicate that about 90 percent of On-tario’s international exports are destinedfor the US market. Indeed, nearly 44 per-cent of Ontario’s GDP is now exported tothe United States.

Compare these integration data with thosepertaining to the 15 countries of the EU. On av-erage, 62.9 percent these countries’ exports goto other EU members (Courchene forthcom-ing), representing 16 percent of the combinedGDP of the EU (Canadian exports to theUnited States are 30 percent of GDP). To besure, these aggregate data mask important dif-ferences across EU members. Nonetheless, atthe aggregate level, Canada is integrated withthe United States to a greater degree with re-spect to trade than the average EU member isto the EU. Hence, on economic integrationgrounds, the argument for a common currencyis at least as compelling from Canada’s van-tage point as that for the average EU member.

A Regional Perspectiveon Asymmetric Shocks

To this trend toward sharply increased north-south trade integration one should add thatCanada’s regions appear to march to quite dif-ferent cyclical forces. For example, the 1980s’recession was short lived in central Canada,which latched onto a US recovery triggeredby the rebound in the North American auto in-dustry and the Reagan administration’s eco-nomic stimulus. The economy in the rest of thecountry languished, however, as a result of acollapse in commodity prices. The 1990s’ re-cession was quite different: British Columbia


skated through it largely unscathed, whereasthe impact on central Canada was severe.

Even prior to the FTA and the shifts that itsubsequently induced, eastern and westernCanada displayed cyclical patterns that dif-fered markedly from one another and fromother regions of the continent. When one elimi-nates common demand shocks due to similarfiscal and monetary policies, the inherentasymmetry in the supply shocks that hit east-ern and western Canada and the relativelystrong correlations between western Canadaand the southern and western regions of theUnited States and Mexico become apparent(see Table 1).

In tandem, north-south integration and thenonsynchronization of east-west business cy-cles raise the central issue of whether or notCanada is an “optimal currency area.” To besure, this is not a novel issue, since it was at thecore of Mundell’s influential 1961 essay on op-timal currency areas, which argued that NorthAmerica (or at least the United States and Can-ada) would be better served by a western dol-lar and an eastern dollar than by a Canadiandollar and a US dollar.

At base, the key question is whether theasymmetric external shocks that affect Canadatend to be north-south or east-west. If they arethe former, Canada would constitute an opti-mal currency area.11 This is central to the argu-ment that Canada needs the macroeconomicinstrument of a flexible exchange rate to bufferthese asymmetric north-south shocks. Sinceresources account for a larger component ofCanadian GDP (relative to US GDP), this isprima facie evidence in support of a stand-alonecurrency. Or is it? Prior to addressing this viewof the exchange rate as a macroeconomic buff-ering instrument, it is instructive to come atthis asymmetric-shock issue from a regional,rather than a national, perspective.

Consider the following thought experiment.As a result of enhanced north-south integra-tion and the nonsynchronization of regional

shocks, Canada is appropriately viewed less asa single east-west economy and more as a se-ries of regional, crossborder economies. In thiscontext, suppose British Columbia were to alignits policies to become competitive in the USnorthwest and the Pacific rim. Likewise, sup-pose Alberta were to set its domestic cost andtax parameters so that they were on par withits competitors in the Gulf of Mexico, Ontarioand Quebec were to gear their economicpolicies to match those of the US Great Lakesstates, and so on, so that each province or re-gion aligns itself to be competitive with itscross-border counterpart.

Now, in the event of a commodity priceboom, BC lumber (for example) would be af-fected in the same way as northeast US lumber,Alberta oil would face the same price changeas oil from the Gulf of Mexico, auto manufac-turers in Oshawa and Windsor would remainin step with their counterparts in Detroit, andso on. But if Canada were to respond to thecommodity price shock by appreciating the


Table 1: Regional Economic Cycles inNorth America, 1966–86(correlation between eastern and westernCanada and other North American regionsin the timing of supply shocks)a

Eastern Canada Western Canada

Eastern Canada — 0.30

Western Canada 0.30 —United States

New England states 0.11 0.01

Mid-Atlantic states 0.15 – 0.26

Great Lakes states 0.06 – 0.07

Plains states 0.37 – 0.10

Southeastern states – 0.03 – 0.52

Southwestern states – 0.05 0.54

California 0.23 0.14

Northwestern states 0.05 0.52

Mexico 0.14 0.57

a The closer the number is to 1.00, the greater the similarity ofexperience in one region and another.

Source: Bayoumi and Eichengreen 1994, table 11.

exchange rate vis-à-vis the US dollar, then all ofCanada’s provincial/regional economies wouldbe offside with respect to their US counterparts.This is questionable policy, especially if the ex-change rate were to exhibit the volatility of thepast15orsoyears.Arguably,eachCanadiantrad-ing region would prefer to maintain exchangerate and transactions certainty with both east-west and north-south trading partners. The onlyway to do this would be to fix the Canadian dollarto the US dollar and to rely on other policies to ac-commodate the differing impacts of the terms oftrade shock on the two national economies. Bay-oumi and Eichengreen (1994) strongly suggestthat this is the way things worked in the past, par-ticularly for western Canada. They find less evi-dence of a link between eastern Canada andeastern US states, but their data are now quitedated.12

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, notnorth-south — one must still take account ofwhat we refer to as the “macro shock” of thelarger role that resources play in the Canadianeconomy. Thus, even if Canada’s regions wereaffected by external price shocks in ways simi-lar to their crossborder counterparts, therewould still be asymmetric macro implicationsfor the Canada and US economies.

Since this issue of adjusting to asymmetricmacro shocks plays a critical role in the argu-ments for a floating exchange rate, additionalperspective is warranted on the role of the ex-change rate as a shock absorber. Cross-countryevidence, in fact, challenges this role.

Cuddington and Liang (1998), in a cross-country study of commodity exporters and ex-change rate regimes, document an importantstylized fact regarding commodity prices us-ing alternative data sets covering the 1880–1996 period. They find that the volatility of realcommodity prices — defined as nominal com-modity prices deflated by the manufacturingunit value-added index — is systematically

higher under flexible exchange rate regimesthan under fixed exchange rate regimes. In theCanadian context, the real commodity price isthe price of commodities relative to the costs ofthe manufacturing sector. This, for all intentsand purposes, is also the price of exports in thewest relative to that in the east. Cuddingtonand Liang’s results imply, consistent with boththe Courchene and Mundell hypotheses, thatthe flexible exchange rate regime may actuallyhave destabilized the internal regional priceratio relative to what would have occurredwith fixed rates. There are a number of reasonsthis may occur, but one simple explanation isovershooting on part of the foreign exchangemarket in response to a commodity price shock.

But the task at hand is how to address themacro implications arising from a commodityprice shock.

Macroeconomic Adjustment

How do Canada’s regions, and the Canadianeconomy as a whole, adjust to macroeconomicshocks, as defined above? The current policyresponse is to use the floating exchange rate.But this is unlikely to buffer the shock, as theanalysis above suggests, whereas a fixed ex-change rate might reduce macro volatility.Suppose the Canadian/US dollar exchangerate were fixed, what adjustment mechanismswould be in place to accommodate potentiallyasymmetric shocks?

There would, in fact, be at least three suchmechanisms. The first operates through theinternal adjustment of prices. This is not, how-ever, as significant a challenge as one might atfirst imagine because terms-of-trade shocksaffect regional economies on both sides of theborder in a similar fashion — that is, it is the ex-change rate response, not the terms-of-tradechange, that triggers crossborder disequilibriumfor Canada’s regional economies. Phrased dif-ferently, Ontario and Michigan (and Alberta


and Texas, and so on) would be allowed toadapt in the same way.

The second mechanism is fiscal policy,which would have to come to the rescue in theevent of an external shock such as an oil pricehike. But this has always been an integral partof the philosophy underpinning fixed rates.Moreover, it is probably important that indi-vidual provinces or regions become involvedin the fiscal stabilization of the exchange rate.As Courchene (1990) argues, one would expectthat regions that experience a favorable terms-of-trade shock would use their fiscal levers totemper their booms. Had Canada been under afixed exchange rate system in the late 1980s,for example, the pressure on Ontario to tem-per, rather than fuel, its boom with fiscal policywould have been more explicit and intense,since everyone would have understood theimplications for the fixed exchange rate.

The third accommodating mechanism, andarguably the most important, is the set of auto-matic stabilizers — including the national taxand transfer system, employment insurance,the equalization program, and Canada’s highdegree of internal migration — already in placeto deal with region-specific shocks or Canada-wide terms-of-trade shocks, whether positiveor negative.

Thus, there are mechanisms for accommo-dating regional and macroeconomic shocks un-der fixed rates. At the very least, further re-search is warranted on the nature of theseshocks. It is also important, however, to recog-nize that the presumed buffering qualities offlexible rates are overestimated.

At an analytical level, it is instructive tonote that Mundell’s 1961 analysis of optimalcurrency areas was rooted firmly in the 1960s’Keynesian tradition, which treated nominalprice and wage adjustment as infeasible. In-deed, these short-term nominal inflexibilitiesconstituted the primary rationale for a flexibleexchange rate between two regions, as it al-lowed for relative price adjustments that, by

assumption, could not otherwise occur. Manyeconomists now regard this analytical frame-work as empirically indefensible, given thewell-documented studies of both price andwage adjustment mechanisms in modern in-dustrial economies.

From this perspective, one of the majorcriticisms of Mundell’s approach was that itignored the regime-specific dependence ofprice-setting institutions. Flexible and volatileexchange rates encourage price setters to delaychanging prices or renegotiating nominal con-tracts in the face of a real shock. In labor mar-kets, wage negotiations can be hampered bythe inability to make firm cost comparisons be-tween similar industries in different countries.The ability of small, highly open economiessuch as Ireland and Finland to operate success-fully under fixed rates suggests that, eventhough these countries faced differentialshocks relative to “core Europe” (the region towhich they are fixed), the mechanisms and in-stitutions that determine prices and wages inthe economy evolved toward greater flexibil-ity in response to the change in the exchangerate regime.

A second criticism of flexible exchange ratesas a buffer mechanism relates to a differenttype of exchange rate nonneutrality — one thatoperates through asset markets and that isstressed in modern accounts of the monetarytransmission mechanism: changes in nominalexchange rates affect the foreign currencyvalues of assets and liabilities. This means, forexample, that Canadian assets priced in Cana-dian dollars become cheaper as the Canadiandollar depreciates, which then has a series ofwealth effects on the economy:

• foreign firms are able to acquire Canadianfirms, whose assets are priced in Canadiandollars, at bargain prices (a kind of fire-saleforeign direct investment);

• Canadian firms seeking to enter the USmarket face higher acquisition costs;


• to the extent that Canadian and US equitymarkets are integrated, Canadian firms’balance sheets deteriorate in US dollars,limiting their ability to raise new capital inUS markets; and

• firms with US-dollar-denominated liabili-ties suffer from a deteriorating balancesheet when the exchange rate depreciates.

There are at least two implications of theseobservations for Canada-US exchange ratearrangements. First, one can expect that Cana-dian wage- and price-setting institutionswould also change if the exchange rate wereremoved as a nominal adjustment mechanismbetween the two economies. In particular,commodity risks would be more usefully di-versified through capital markets and otherrisk management tools, rather than accommo-dated through an aggregate adjustment in allrelative prices between the two economies,which an exchange rate change induces.

Second, one must recognize that an ex-change rate accommodation to an asymmetricshock, even if justified in the short run bynominal price rigidities, almost certainly car-ries with it other, less beneficial asset price ef-fects that can be detrimental both to longer-rungrowth and to the ability of individuals andfirms to make the necessary longer-run adjust-ments to the initial shock.

By way of summary, therefore, not only dofixed exchange rates possess important accom-modating mechanisms for external shocks, butthe supposed buffering qualities of flexiblerates are at the same time less effective andmore problematic than is typically assumed.

The Confidence Issue

One important, but inherently nonquantifiable,aspect of a internationally traded currency isthe confidence that individuals (meaningworkers, firms, and investors, both domesticand foreign) have in that currency. It is tradi-

tional to attribute confidence to countries thathave a low inflation rate and a stable fiscal po-sition. But confidence goes beyond that. As re-cent events have proven, currencies can declineprecipitously even if economic fundamentalsare sound on both the inflation and fiscal fronts.

Canada’s current exchange rate regime hasdelivered low inflation but, from time to time,bouts of appreciation and depreciation. A sus-tained and largely unanticipated currency de-preciation in a period of close to zero inflationis something that should be treated with greatconcern. The reason has to do with the centralissue of this Commentary. Arguably, interna-tional markets were abandoning Canadian-dollar-denominated assets and, therefore, theCanadian dollar. More important, Canadianmacro authorities’ initial indifference to thefall in the dollar may have prompted Canadi-ans to sell off assets denominated in Canadiandollars. Through this “market dollarization”process, the US dollar is embraced for a rangeof purposes, such as transactions and as a unitof account, and as a way to flee the uncertaintyand volatility of the Canadian dollar.

The fact is that, as a small country heavilyintegrated with the world’s largest economy,Canada does not have a lot of maneuveringroom on the currency issue. And it seems ap-parent, from a societal vantage point, that mar-ket dollarization, as the private sector seeksgreater protection from exchange rate move-ments, is an unfortunate outcome. Moreover,we suspect that further depreciation will giverise to both dollarization and demands byCanadians for currency integration with theUnited States. One way to restore confidencein the Canadian dollar would be for the cur-rency to enjoy a period of sustained exchangerate stability, and perhaps some appreciation,together with an official acknowledgment byOttawa that it is not indifferent to the value ofthe dollar.13

Ultimately, however, what is called for is a“hard” Canadian dollar. Practically speaking,


that means a currency that is stable against themajor international reserve currency, the USdollar. Fortunately, this is also the currencythat optimal currency theory dictates Canadafix against.14

Fixed Rates andTransaction Costs

We conclude the case for exchange rate fixityby focusing on transaction or efficiency gains.To be sure, the extent of such gains will dependon the nature of the exchange rate fix, withgreater gains arising in the context of a com-mon currency where, by definition, there is noexchange rate. While currency conversion costsare usually estimated to be small — a fewtenths of a percentage point of GDP — suchnarrow estimates do not include the broaderrange of transaction costs that now exist as aconsequence of the Canada-US border and theuse of two currencies that fluctuate in valueagainst each other. For example:

• Canadian firms operating in the NorthAmerican market could eliminate the ac-counting costs that arise from using twocurrencies.

• Companies that currently hedge exchangerate risk would no longer find it necessaryto do so, and most of the costs associatedwith providing exchange-rate-related de-rivatives would no longer be necessary.

• Menu costs associated with providingprice information and invoicing in twocurrencies would be eliminated, whichmight prove particularly important to thedevelopment of electronic commerce (e-commerce) in Canada.

• Capital markets would be deeper and in-terest rate spreads on government and cor-porate debt would be reduced, therebyimproving the efficiency of financial inter-mediation and reducing borrowing costsin Canada.

• Canadian issuers of new equity offeringswould find a larger market in the absenceof exchange rate risk.

• In product markets, price discriminationby national market would be less preva-lent, given better price comparison infor-mation on the part of consumers.

Alternative Approachesto Exchange Rate Fixity

Assuming our argument in favor of exchangerate fixity has merit, we now turn to thequestion of how a more formal link betweenthe Canadian and US dollars might be pur-sued. Table 2 presents a capsule summary re-lating to the various options.

We readily admit that there is considerableskepticism in academic and policy circlesabout the durability of fixed exchange rateregimes. The prevailing view, as reflected inCrow (1996) and elsewhere, is that a floatingexchange rate is viable for Canada and so arethe single-currency options (namely, dollari-zation and a NAMU), but nothing in between.From our perspective, however, this is highlyproblematical because the macro authoritiescould assert that dollarization is unacceptableand that a NAMU is unattainable, so that flexi-ble rates become, by default, the only optimalcurrency arrangement. But the entire analysisin the previous section was directed to theproposition that flexible rates are far from opti-mal. Our view is that such a position inappro-priately discards the analytical case for, andthe historical experience with, fixed exchangerates. Accordingly, in what follows we attemptto resurrect the case for intermediate optionsand, in particular, for fixed exchange rate re-gimes. Readers not inclined to be persuadedby this line of analysis may prefer to go directlyto the discussion of our preferred endpoint, asingle-currency option.


Exchange Rate Targets

The first, and least constraining, policy optionin the direction of exchange rate stability is theunilateral one of an exchange rate target. Thetarget can be informal or formal and can bestated as either a specific parity or a band. Onevariant would adjust the target for underlyingdifferences in inflation rates (crawling targets).The intermediate instruments of monetarycontrol are short-term interest rates, which areraised or lowered in light of exchange marketoutcomes. The central bank might intervene inthe foreign exchange markets, but only tomaintain an orderly market, much as the Bankof Canada does now. Exchange rate targetingcannot eliminate short-term volatility, but ithas been practiced with some success as ameans of reducing misalignment. Its majoradvantages are that it does not require themaintenance of large foreign exchange reservesand that it allows for temporary departuresfrom the targets in the event of unusual exter-nal circumstances.

As in the case of any exchange rate regimeshort of a currency union, the central bank’ssuccess hinges on its credibility and on thegovernment’s commitment to the exchangerate target. Specifically, the macro authoritiesmust occasionally be willing to impose higherinterest rates to defend the target, even if this isinconsistent with short-term inflation, growth,or employment goals. This task may be com-plicated by high levels of domestic or foreigndebt, but the recent experience of industrialcountries with strongly integrated and deepcapital markets suggests that it is manageable— indeed, it may be easier with fixed rates,since flexible rates can intensify capital flows,with each movement generating an expecta-tion of further movements in the same direc-tion, prompting more capital flows in search ofshort-term gains.15

Exchange Rate Pegs

In his analysis of alternative exchange rate ar-rangements for Canada, former Bank of Can-ada governor John Crow notes that the me-chanics of fixing the exchange rate are straight-forward: “[I]n Canada, all that is needed is agovernment declaration that its ExchangeFund Account will intervene in unlimitedamounts to defend a given exchange rate”(1996, 14). Typically, the exchange rate is al-lowed to fluctuate within a narrow band (plusor minus 1 percent or perhaps 2 percent) of thepar value. If this is all that is contemplated, wewould refer to this as a “pegged exchangerate.” We agree with Crow that a “pegged re-gime invites attack and is demonstrably brittleunder pressure” (ibid, 13). Indeed, the pres-sure could well come from within, since, underour definition of a pegged rate, there is no con-certed effort on the part of overall macro policyto defend the peg. While pegged exchangerates can prove valuable as temporary stop-gaps, this is not what we have in mind in termsof a fixed exchange rate.

Fixed Exchange Rates

Unlike a pegged rate, a full-blown fixed rateregime would perforce require as an integralcomponent the full coordination of fiscal pol-icy, both federal and provincial. As Courchene(1990) notes, what is involved here is a policyparadigm shift. Conducting overall macro pol-icy is quite different under a fixed rate systemthan under a floating rate system. Govern-ments with booming economies, for example,temper their booms via their fiscal stance, ifmaintaining the exchange rate fix requiredthem to do so.

It is, of course, still possible that fixed rateregimes can get caught in one-way bets on in-ternational capital markets. Indeed, Crow’searlier quote to the effect that a pegged ex-change rate would “invite attack” and is “de-


monstrably brittle” was actually in referenceto a fixed rate regime. Yet there are severalfixed exchange rate success stories — Austria/Germany and Netherlands/Germany, for ex-ample. However, Crow views these as specialcases:

The Netherlands guilder, which might seeman exception since it shadows the Germanmark within an explicit tight band, is to allpractical intents fixed, rather than adjust-able. This is because successive Dutchgovernments have made attachment to themark the keystone of national economicpolicy within the broader framework of

strong support for the political goal ofEuropean Union. Austria and Belgium areclose to being in the same camp as theNetherlands because of their overridingpolitical commitment to shadowing themark. (1996, 17, n12.)

Crow thus unveils the secret to a successfulfixed rate regime — namely, that Canada’s at-tachment to the US dollar would have to be akeystone of the country’s national economicpolicy within the broader North Americanframework. Indeed, a comprehensive policycommitment to shadow the US dollar, backedup by a full understanding of what this means


Table 2: Assessing Alternative Approachesto Exchange Rate Fixitya

OptionCanadian

Dollar Remains? Seigniorage?Bank of Canada

Remains?Exchange Rate

VariabilityPolicy

Flexibility

Fixed exchange rates Yes Yes Yes Fixed, within a narrowband

Partial, subject togearing policy tomaintaining thefixed rate

Currency board Yes Yes, but offset bycost of carryingforeign currency

Yes, but undercurrency boardrules

Fixed at one-to-oneb;no band

Less; Bank ofCanada is apassive actor;governmentdeficits can befinanced only byborrowing

Common Canada-UScurrency

Maybe; dependson arrangements

Yes Yes, but underthe euroarrangement

None (commoncurrency)

Depends onarrangements forCanadian inputinto US FederalReserve policy

Market dollarization Yes, but muchreduced scale ofuse

Yes, but much lessbecause of reducedscale of Canadiandollar use

Yes As great or greaterthan now, withreduced scale ofCanadian dollar use

Reducedrelevance of Bankof Canada policyfor Canadianhouseholds andbusinesses

Policy dollarization No No No None (no Canadiandollar)

Minimal, andCanada could bedrawn into USpolicy orbit

on the fiscal front and in the context of alreadyhigh and increasing north-south trade integra-tion could make a fixed Canada-US rate one ofthe most stable and viable such regimes any-where. This does not mean that it could not beunsettled by unforeseen events; what it shouldmean is that international capital marketswould come to view the Canadian dollar asfully integrated into the US dollar area and,therefore, a near-substitute for the US dollar.

While we regard a fixed rate regime as afeasible option for Canada, a number of transi-tion issues deserve mention. First, there is the

question of how one gets to a fixed rate. As theDutch experience indicates, a country cannotgo into a permanent fix without first demon-strating some commitment to more exchangerate stability. That is, the monetary authoritiesmust first demonstrate their willingness to usemonetary policy to deliver on exchange rategoals in the form of a target band for the ex-change rate, rather than simply intervene inthe foreign exchange rate market.

Once this credibility is established, foreignexchange speculation would become stabiliz-ing and interest rates between the two coun-


Table 2 - continued

ImplementationCosts

ImplementationTime Clearings Reversible?

Access to USCapital Markets

Maintain FinancialSector Policy?

Minimal; need to select“entry point”

One to threeyears; need toestablishcredibility

Status quo plussmaller transactionscosts for USclearings

Yes Enhanced access vis-à-vis flexible rate statusquo

Yes

Could require internalrevaluation of pricesand a new currencyb

Several years,presumablypreceded byfixed exchangeratesb

More integrationwith US clearingssystems

Yes, but,expectation mustbe that it will notbe reversed

Larger still Yes, but withmore US banksoperating inCanada

Internal revaluation ofprices and a newcurrency

Probably adecade, as in theeuro process

National clearingsand then fullintegration intoCanada-US clearings(presumably alongthe lines of the eurotarget scheme)

Yes, but onlyunderexceptionalcircumstancesand with largecosts

Full Yes, but may begreaterharmonizationover time withintegration ofclearing systems

Parallel currencies anda depreciatingCanadian dollar; largewealth transfers fromCanadian-dollar assetholders to Canadian-dollar liability holders

Variable,depends onprivate sectoragents

Progressivelyintegrated into USclearings systems

Unlikely, onceprivate sectoroperating on US-dollar basis

High for those usingthe US dollar

Will likely bedrawn more intoUS financialpolicies

Moderate to largedepending on currencyreplacement proced-ures and revaluation ofexisting Canadiandollar contractualarrangements

Variable,depends onprivate sectoragents

Progressivelyintegrated into USclearings systems

Not withoutmajor problems(no central bank,no separatecurrency)

Full Will likely bedrawn more intoUS financialpolicies

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 thanunder 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 theissuing of a new currency; the implementation time would also be much reduced.

tries should tend to converge. Over time, theexchange target band could be narrowed, andthe need for central bank intervention woulddiminish — this is the shadow policy to whichCrow refers. In short, credibility has to beearned and, therefore, it would be unwise tomove suddenly to a fixed exchange rate. Howlong would such a transition take? No one canknow for sure, but it took the Netherlandsabout three years from its initial shift to fixedrates before it achieved interest rate conver-gence with Germany.

The second issue relates to Quebec. If thereis one event that could undo an otherwise suc-cessful fix it would surely be the anticipationby markets of a Quebec separation: the mas-sive resulting uncertainty would very likelylead to an immediate loss of substantial for-eign exchange reserves under a fixed rate re-gime.16 Quebec independence would createenormous problems for any exchange rate re-gime and, indeed, would force a rethinking ofcurrency arrangements in the upper half ofNorth America. Thus, moving to a fixed ex-change rate regime in the context of substantialdomestic political uncertainty is probably anonstarter.

This caveat aside, we believe fixed ex-change rates are preferable to the flexible ratestatus quo. And, over the longer term, the es-tablishment of a NAMU, which may be themost attractive option of all, would requiresome interim variant of a fixed exchange rateregime.

Currency Boards

Currency boards, which back domestic cur-rency issue with identical values of foreigncurrency, provide institutional cement for afixed exchange rate regime. The conversionrate is fixed precisely and the currency boardstands ready to buy and sell at this dedicatedrate. In effect, there is no scope for domesticmonetary policy since there is no central bank

as such. In addition, under a currency boardregime, there is no lender of last resort — al-though, in Hong Kong, which has a currencyboard, the fact that reserves were well in excessof 100 percent did allow some flexibility; seeWilliamson 1997, 7–8).

Currency boards have attracted a lot of at-tention, especially in light of Hong Kong’s suc-cessful defense of its currency during the Asiacrisis and Argentina’s holding of its currencyvalue in the wake of both the Mexican pesocrisis and, more recently, the 40 percent de-valuation of Brazil’s currency. Currency boardshave also proven useful for emerging marketeconomies with fiscal credibility problems anda history of inflationary finance. Hanke andSchuler (1993, 20) canvass the pros and consof currency boards and conclude that “for theAmericas, the currency-board system offers ameans to establish sound money in a region”and facilitates “the region’s natural tendencyto evolve toward a common currency area.”

Whether or not a currency board is a rele-vant option for Canada, it serves as a usefulbenchmark. If Argentina, with its continuingfiscal problems, can hold its one-to-one peso/dollar exchange rate in the face of repeatedcrises involving other Latin American curren-cies in recent years, surely Canada’s macroauthorities could maintain international credi-bility under an exchange rate fix to the USdollar.

Dollarization

In line with our assumption that there will befurther currency integration in the Americas,in this section we focus briefly on the implica-tions of Canada’s formally adopting the USdollar as its currency. As a prelude, however,we address the likely implications of “marketdollarization” — namely, a scenario in whichprivate sector agents increasingly conducttheir affairs in US dollars.17 Such behaviorcould be triggered by a variety of causes; for


example, the US dollar could become the cur-rency of choice in e-commerce, or high-levelmanagement in Canadian corporations couldincreasingly insist on being remunerated ac-cording to US pay scales, or the rest of theAmericas could move toward dollarization,leaving Canada with little choice but to followsuit. The second-to-last row of Table 2 summa-rizes the implications of market dollarization.

While market dollarization would leaveintact the existing monetary institutionalframework, Canadian monetary policy influ-ence would be considerably diminished be-cause of the reduced range of Canadian dollaractivity. Generating a given monetary policyoutcome would then require larger changes ininterest rates and exchange rates. But thiswould be problematic because volatility in Ca-nadian public policy parameters would surelytrigger further market dollarization.

Thus, it seems likely that such a scenariowould lead to exchange rate fixity. Althoughthat situation ultimately might be unstable, thelonger-term equilibrium need not be “policydollarization” — it could also lead to fixed ex-change rates or a currency board arrangement.The general point is that market dollarizationwould tend to be self-reinforcing and to lead tounpredictable political dynamics, with the Ca-nadian monetray authorities placed in an in-creasingly defensive position.

Policy dollarization is, in a sense, the ulti-mate fix: Canada would simply abandon theCanadian dollar and adopt the US dollar as le-gal tender. This would generate the full rangeof transactions and efficiency gains alluded toearlier. It would also address the challengesarising from exchange rate variability sincethere would no longer be a Canada-US ex-change rate. Dollarization would certainlygrease the wheels of North American com-merce and integration.

But dollarization would do much morethan this. As the last row of Table 2 indicates,not only would the Bank of Canada become re-

dundant and disappear, but Canada’s finan-cial institutional and regulatory system wouldbe drawn inexorably under US influence anddesign. Indeed, it is likely that banking andfinance would become integrated north-southalong the lines of Canada’s crossborder re-gional economies. In turn, this would likely be-gin to impinge on Canadian policymakingacross a wide range of fronts extending wellbeyond the monetary and financial sector. So,although dollarization would solve theexchange rate problem, it would create a po-tentially more serious set of challenges, even-tually extending to sovereignty issues.

Policy dollarization is presumably a non-starter, except as a last resort. But, as noted ear-lier, market dollarization is already alive andwell and, arguably, on the increase. Indeed,market dollarization has “slippery slope”characteristics: the more extensive it becomes,the more volatile is the exchange rate and theless effective is Canadian monetary policy.

One could argue, of course, that a degree ofdollarization has long been characteristic ofthe Canadian economy and something thatCanada has been able to accommodate. Ac-cording to this view, further shifts toward dol-larization (for example, the use of US-dollar-denominated credit cards for e-commerce)presumably would represent changes only indegree, not in the substance of dollarization.We are not so sure that this is the case, how-ever, and it will be interesting to keep a closeeye on developments in Europe — particularlyin Switzerland, where market euroization istaking place even though that country (unlikeBritain) does not have the politically viable op-tion of joining the common currency area..

In any event, in terms of our analysis, twogeneral observations are warranted. First, itwould be a major mistake on the part of Cana-da’s monetary authorities to assign a zeroprobability to a dollarization scenario. Second,assuming that further currency integration inNorth America is likely, there is a much prefer-


able alternative to policy dollarization —namely, a NAMU, to which we now turn.

A Common Currency

The key distinguishing feature of a NAMU isthat, unlike the other options discussed so far,Canada cannot opt for it unilaterally — theUnited States obviously would have to partici-pate fully in any such arrangement. But does aNAMU hold any interest for Canada in thefirst place?

The easiest way to broach the notion of aNAMU is to view it as the North Americanequivalent of the European Monetary Union(EMU) and, by extension, the euro. This wouldmean a supranational central bank with aboard of directors drawn in part from the cen-tral banks of the participating nations.Whether Canada would be content to partici-pate on the basis of, say, a one-thirteenth role(its share in the combined Canadian-US GDP)on this board of directors is beyond our abilityto assess. If the mandate of this North Ameri-can central bank were framed largely in termsof pursuing price stability, the actual votingshare might matter less.

Since the US dollar is already the world’spremier reserve currency, there is no questionthat a NAMU currency would bear the samename; indeed, the United States would insistthat its dollar continue to exist. The euro’s ad-vent has shown, however, that the continuedexistence of the US dollar would not be incon-sistent with parallel and perfectly substitut-able national currencies — until the eleventhhour, the design of euro coins and paper was tohave been identical on one side in all EU coun-tries, but the other side could have been embla-zoned with country-specific symbolism (aswill still be the case for 1 and 2 euro coins).Hence, the Canadian component of the com-mon NAMU currency could embody nationalsymbolism.

The Bank of Canada would still have a roleto play in the larger NAMU institutional struc-ture, but it would be roughly similar to, say, theBank of France’s role within the new EuropeanCentral Banks structure. As Table 2 indicates,Canada would maintain its own financial in-stitution regulatory system, its own clearingsystem, and so on. The critical difference is thatthere would no longer be a Canada-US ex-change rate.

Should Canadians be in favor of a NAMU?Or, more properly, since further currency inte-gration in the NAFTA is likely, should Canadi-ans prefer a common North Americancurrency to dollarization? To us, the answer isclear, and positive.

Transition to a NAMU

Many difficult issues would have to be dealtwith in the transition to a NAMU. One of themost important would be the pace of the tran-sition. The European Monetary System (EMS),for example, operated from 1979 until last year.It was a complex and formal set of arrange-ments that, with one major exception, reducednominal exchange rate volatility among thecountries involved, and may have done thesame with respect to real exchange rates. Therelative success of the EMS certainly condi-tioned the ultimate decision to go ahead withthe EMU. It is an open question whether aNAMU could emerge without the experienceof something initially less than full monetaryunion, but involving cooperation between thecountries involved.

Another transition issue for Canada wouldbe the appropriate conversion rate. One could,of course, opt for the existing exchange rate ofabout 69 US cents for a Canadian dollar, whichwould set in motion a process of adjustmentthat would make 69 US cents an equilibriumrate. But what if this rate were inappropriatelylow? Within a currency union, the problem ofchoosing an appropriate entry parity becomes


a multilateral regional problem. Canada, andany other country that chose to enter theNAMU, would have to arrive at some jointlydetermined criteria by which entry points arechosen.

One approach, modeled in part on theEuropean convergence, would be for Canadato use the transition to a NAMU to gear downits debt-to-GDP ratio to that of the UnitedStates, so that there would be comparable fis-cal flexibility. From the perspective of a FEERapproach to exchange rate equilibrium, thisimplies that the equilibrium entry point wouldrise as Canada made progress on the debt-to-GDP-ratio front. In any event, European expe-rience suggests that, provided inflation is lowand the transition period has been sufficientlylengthy, the entry-point problem should beminimal.

Other transition issues would also have tobe addressed, although space does not permitus to do so here. They would, however, includethe types of cooperative arrangements thatwould be necessary as NAMU membersgroped toward the ultimate union, and the cri-teria, if any, that would be imposed on thosejoining with respect to macro indicators suchas inflation rates and debt levels.

What’s in a NAMUfor the United States?

It is frequently asserted that, since there is ap-parently nothing in a NAMU for the UnitedStates, the whole concept is a nonstarter. Butthe same might have been said about the possi-bility of Canada-US free trade. Fortunately,Canadian economists had done their home-work, and Canada was ready when the oppor-tunity presented itself. The same approach isnow called for on the currency-unificationfront.

In any case, it is not all that evident that theUnited States would oppose a NAMU initia-tive. The successful launch of the euro has cre-

ated challenges for the United States, whichsuddenly finds that it no longer has a monop-oly on the global reserve currency. The euro’seffective currency area has already spread be-yond the 11 participating EU members, andmany former communist countries of centraland eastern Europe are likely to link their cur-rencies to it. Moreover, euroization may wellspread in the private sector in Britain even ifthat country does not formally join the club.Thus, the euro, as it takes on an ever moreimportant role in international portfolios, willbecome a serious rival to the US dollar asthe global reserve currency. Henceforth, theUnited States will find it increasingly difficultto finance its balance of payments deficits. Inresponse, the Americans may well wish to ex-pand the reach of the dollar area.

Another reason for potential US interest ina NAMU is that the endless currency instabil-ity in the Americas, often involving US bail-outs, cannot be in its best economic interests.And the case for ensuring currency stability in,say, Mexico is not unlike the geopolitical real-ity that led to the United States’ supporting theNAFTA initiative.

Sovereignty and Symbolism

That a NAMU would mean the end of sover-eignty in Canadian monetary policy is clear.Most obviously, it would mean abandoning amade-in-Canada inflation rate for a US orNAMU inflation rate. But what are the impli-cations of exchange rate fixity on the broadereconomic or cultural sovereignty front? CanCanadians remain socio-economically distinctin the face of a common North American cur-rency? We do not claim to know the full an-swers to these critical questions. We can, how-ever, offer some observations drawn fromCanada’s social and economic history.

First, Canada embarked on the develop-ment of a much more generous interregionaland interpersonal transfer system or social


contract than that of the United States even asits trade became increasingly integrated intothe broader North American economy.

Second, in the post-FTA, post-NAFTA era,it is true that a further intensification of north-south integration has coincided with an un-winding of key aspects of Canada’s social en-velope. Our view, however, is that theproximate cause of this was not enhanced inte-gration, but measures introduced (largely inthe 1995 federal budget) to bring Canada’s fis-cal house under control. Now that Canadiangovernments are entering a period in whichsurpluses, rather than deficits, may becomethe norm, some of these social program cutsmay be restored. Indeed, with the recent socialunion framework agreement and the 1999 fed-eral budget, most of the earlier cuts to the Can-ada Health and Social Transfer have alreadybeen restored and the path cleared for futurefiscal expansion.

Third, it is nonetheless the case that theNAFTA, globalization, and the informationrevolution are having an impact on Canada’ssovereignty and policy maneuverability. Butthese challenges need not influence the goalsCanadians set for themselves. True, they willinfluence the choice of instruments Canadiansuse to achieve those goals, but this constrainton instrument choice applies to all nations. In-deed, our entire analysis is, in a sense, an exer-cise in instrument choice: a fixed exchange rateregime rate simply may now be a more appro-priate instrument than a flexible rate.

The fourth point relates more directly tothe exchange rate fixity issue. Many of the so-cial programs that Canadians hold near anddear are a product of the Pearson era of the1960s, a period in which Canada had a fixedexchange rate with the United States. Quite ob-viously, the Pearson government did not viewa fixed exchange rate as an impediment to as-serting Canada’s identity in terms of a compre-hensive social policy infrastructure. It maynow be time to make the opposite case: with

currency issues out of the way, as it were, thepolicy agenda would then be free to focus onthe issues that really matter in further fosteringa distinctly Canadian identity in the twenty-first century.

Fifth, although it is often claimed that po-litical unity is underpinning the euro, this hasyet to be proven. We do not believe for a mo-ment that the French view the birth of the euroas a threat to their national identity or sover-eignty. The reality is that currency arrange-ments are one of those policy areas that,following the dictates of subsidiarity, mightinvolve improved social welfare if passed up-ward to the supranational level. It will be in-teresting to watch developments in Britain,where prices are already being quoted in eurosas well as pounds; our guess is that British citi-zens and businesses alike will hold more andmore euro accounts in British banks. The fact isthat currency arrangements are increasinglybecoming a supranational public good. Thismeans that the overall costs of remaining out-side these supranational currency arrangementswill increasingly dominate the benefits ofmaintaining an independent currency regime.

This brings us to the sixth point, which re-lates Canadian sovereignty to the country’sbargaining position with respect to the UnitedStates. If either policy or market dollarizationproceed apace in the rest of the Americas with-out Canadian influence, Canada’s negotiatingstance will be permanently weakened. Thisbears on practical matters, such as the degreeof representation outside parties might hopeto achieve vis-à-vis the US Federal Reserve. If apan-American currency area were to developwithout Canada’s participation, the UnitedStates would derive fewer marginal benefitsfrom adding Canada to the arrangement andbe less inclined to trade influence (or seignior-age) in exchange for Canada’s later accession.This militates for speedy Canadian action inenunciating a coherent policy stance on multi-lateral currency arrangements.


Conclusion

Our aim in this paper was threefold: to arguethat Canada’s floating and volatile currency isnot serving the country’s economic interestswell; to make the case that a progressively inte-grated North America requires exchange ratefixity; and to propose that Canada pursuegreater fixity with a view to ultimately estab-lishing a North American currency union.

Even though the lead time for actually im-plementing a NAMU would likely be morethan a decade, the march of events elsewherein the Americas is such that a degree of ur-gency attaches to this issue. Argentina’s Presi-dent Carlos Menem recently proposed that hiscountry move from its currency board ar-rangement to full dollarization. More impor-tant, in January 1999, the head of the Mexicanbankers’ association called for the spread ofthe US dollar area to Mexico. And in March1999, Mexico’s most influential business lobbygroup called for full dollarization of the Mexi-can economy.

Intriguingly, US economist Robert Barro(1999) suggests that the United States could(and should) find creative ways to supportthese dollarization initiatives. Barro suggests,for example, that the US Federal Reserve givethe Argentine central bank a one-time allot-ment of $16 billion in newly issued US cur-rency, in exchange for $16 billion worth of non-interest-bearing pesos (the peso and the USdollar already exchange on a one-to-one basis)that the Fed would hold as collateral. Thiswould provide Argentina with the requiredamount of US currency to embark on full dol-larization, and the transfer would cost nothing(except paper and ink); over the longer term,the United States would garner the seignior-age arising from an expanding supply of USdollars in Argentina.

Barro further notes that, although dollari-zation would remove the lender-of-last-resortfacility of other countries’ central banks, the

United States could simply take over as lenderof last resort for its dollar-zone clients. Barroeven suggests that the United States take thelead in promoting this monetary integration.

To be sure, the US government does notnecessarily share Barro’s views. But discussionof dollarization is still at an early stage in theUnited States, and it is possible that growingawareness of its advantages for that countrywill persuade US officials to explore ways ofmaking some central banking services avail-able to countries adopting the US dollar.

Our concern with all of this is the emphasison dollarization, rather than on a NAMU. What


C.D. Howe Institute Commentary© is a periodicanalysis of, and commentary on, current publicpolicy issues.

Thomas J. Courchene is Jarislowsky-Deutsch Professor of Economic and FinancialPolicy, School of Policy Studies, and Director,John Deutsch Institute for the Study of Eco-nomic Policy, Queen’s University; he is alsoSenior Fellow of the C.D. Howe Institute.Richard G. Harris is BC Telephone Professorof Economics, Simon Fraser University, andFellow of the Canadian Institute of AdvancedResearch. The text was copy edited and pre-pared for publication by Barry A. Norris.

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are the prospects for a NAMU if Mexico, letalone the rest of central and South America,were fully dollarized? Would the United Statessimply take the view that Canada could followthe rest of the Americas and use the US dollar,with the Americans pocketing the resultingseigniorage? If Canada wants to keep theNAMU option alive, it must become a party tothese discussions and any resulting delibera-tions. Canada’s involvement should includenot just academics but, more important, keybusiness associations. It would be most unfor-tunate if, having finally realized the virtues ofa NAMU, Canadians were to discover that thisavenue was no longer open because dollariza-tion had already spread to the rest of theAmericas.

In summary, we have argued that exchangerate stability relative to the US dollar is impor-tant in sustaining and enhancing Canada’slong-term economic potential. The currentflexible exchange rate regime, while necessaryif Canada wants to pursue a different inflationrate than the United States, is increasingly atodds with both the economic stability and eco-

nomic integration that are vital to sustainingCanadians’ living standards in a competitiveglobal economy.

The cost of monetary independence is be-coming increasingly apparent as Canada shiftsinto human-capital-led growth and deepereconomic integration with the rest of NorthAmerica. The policy implications of this shiftare profound and in many ways parallel thesignal from the introduction of the euro. For-mal monetary integration in North America isan idea whose time may well be nigh; it isworth thinking seriously as to how it mightcome to fruition.

The transition to a single North Americancurrency will be slow in coming and will ap-propriately entail a great deal of research, de-bate, and negotiation. In the interim, however,we believe there is a more immediate need forexchange rate stability between the Canadianand US dollars, even if unilateral action werethe only course open. Arethinking of Canada’soptions on this account is long overdue.

Notes

We wish to acknowledge Ted Carmichael, John Crow,John Murray, Finn Poschmann, Bill Robson, and Dan-iel Schwanen for providing valuable comments on anearlier draft. Since not all of the above agree with thethrust of our analysis, it is more important than usualto attribute what follows solely to the authors.

1 In commenting on an earlier draft of this paper, TedCarmichael suggested that we distinguish between“market dollarization” and “policy dollarization.” Theformer, as described in the text, relates to the move byprivate sector agents to adopt the US dollar for a rangeof purposes, while the latter refers to an official deci-sion by the policy authorities to proclaim the dollar aslegal tender. The reference to “market euroization” isto be interpreted in this light.

2 See, however, Courchene (forthcoming), who extendsthe analysis to incorporate aspects of the Bank ofCanada’s conduct of monetary policy.

3 In fixed versus flexible regimes, there is a whole set ofissues having to do with small, inflation-prone coun-tries that attempt to achieve “credibility” on the infla-tion front by fixing their currency to that of a largecountry with a low inflation rate. This argument doesnot have much relevance in the Canadian-US case.

4 The real exchange rate is the nominal exchange ratecorrected for differences in the price levels of twoeconomies. From a macroeconomic perspective, thereal exchange rate is one of the two key relative pricesin the economy, the other being the real interest rate.Fortin (1996) and others argue that, for much of the


1990s, real interest rates have also been misaligned asa result of Canada’s attempt to run an inflation targetlower than that of the US Federal Reserve.

5 Economists have long used a balloon analogy in talk-ing about exchange rate volatility: if one removes thevolatility from the exchange rate, it just appears else-where in the economy. Flood and Rose (1998) presentevidence that this analogy is inappropriate.

6 From the point of view of a system change, one can ar-gue that abandonment of the Bretton Woods fixed ex-change rate system led to a loss of fiscal discipline (seeMcKinnon 1997). There is substantial evidence, how-ever, that some smaller countries on fixed rates — forexample, Belgium and the Netherlands — also had se-rious fiscal discipline problems in the 1980s.

7 Note that this 40 percent overshoot measures the ac-tual deterioration in unit labor costs (in a common cur-rency) over this period. Measured from a PPP bench-mark, the overshoot would be less since the exchangerate was, initially, below PPP.

8 Readers will note, as did a referee on a earlier draft,that we are trying to have it both ways as it were: over-valuation generates costs, but so does undervalua-tion. Are these costs reversible? Some probably are,but many are not. In short, volatility generates irre-versibilities! Firms that choose to exit in a period ofovervaluation and human capital that leaves in a peri-od of undervaluation are not likely to reverse their de-cisions quickly, if at all, as the exchange rate returns toequilibrium.

9 Grubel (forthcoming) comes at this comparative ad-vantage issue from a different angle. He notes that al-lowing the dollar to mirror commodity prices “has re-tarded the move of labor and capital out of commod-ity producing and into high-tech industries because itsignaled the wrong price trends to producers,” withthe result being a tilting of resource allocation in per-verse directions.

10 More recent data (Grady and Macmillan 1998) suggestthat, from 1989 to 1997, interprovincial exports slidfrom 22.7 percent to 19.7 percent of GDP. At the sametime, international exports grew from 26.1 percent to40.2 percent of GDP.

11 Mundell (1990) argues that east-west shocks domi-nate north-south shocks, which, among other issues,leads him to favor Canada-US exchange rate fixity.

12 Moreover, their “Canada East” region includes the At-lantic provinces, which tends to blur some of thenorth-south results.

13 Ironically, many of the Bank of Canada’s arguments infavor of the importance of low inflation were based onthe idea that maintaining confidence in the value ofmoney was an important policy objective. The Bankhad the objective right — it just got the instrumentwrong.

14 For a country with a wide portfolio of trade partners,such as New Zealand, the confidence argument couldjustify pegging against a basket of major currencies.

15 A useful example of a country that currently uses ex-change rate targeting is Norway, which officiallyadopted a policy of targeting the exchange rate be-tween the krone and the deutschmark (it now targetsthe euro). The country has had relative exchange ratestability since then, although discussions of externalversus domestic objectives continue. Norway is a con-structive example for Canada because, as a major oilexporter, it experiences shifts in oil prices that consti-tute a major asymmetric supply shock relative to theeuro zone (Nicolaisen and Quigstad 1998).

16 Readers wishing more detail on the potential financialand exchange rate implications of a political breakupcan consult Laidler and Robson (1998) or Courcheneand Laberge (forthcoming).

17 We are indebted to Bill Robson for his suggestion thatwe expand the discussion of dollarization to includemarket dollarization.

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