In making the case for a Canada-US or perhaps a NAFTA currency union, I shall elaborate upon and hopefully substantiate the following propositions:

  • that our system of flexible exchange rates has not served Canada well;

  • that a fixed-exchange-rate system is preferable to our current floating rate system, given the degree of North American integration, the nature of this integration (north-south economic regions) and the shift away from a resource-based economy and society to a human-capital-based economy and society;

  • that North American Monetary Union (NAMU) along euro lines is the logical longer term goal toward which a fixed-exchange-rate regime should evolve; and

  • that the last time that Canada had a common currency with the US (the Pearson era) represented one of the most creative periods in terms of enacting policies that have made us socio-economically unique in the upper half of North America.

Appropriately, however, the analysis begins with refer- ence to one of the most significant events in the annals of monetary and economic history ”” the advent of the euro.

Whenever the subject of the euro arises, we are imme- diately informed by our policy officials that the political objectives that motivated monetary union in Europe do not have a parallel in North America. I agree with this. But now that the euro is alive and running it has major implications for currency arrangements in other trading blocs. Among other things, the euro signals:

  • the ”œdenationalization” of national monetary regimes;

  • the emergence of common currencies as supra-national public goods; and

  • a dramatic shift toward currency consolidation, with well over two-dozen countries already using or com- mitted to using the euro.

One does not have to believe that the future will involve only a handful of currencies in order to recognize the wisdom of investigating the options for the future of Canada’s exchange rate regime.

Admittedly, the Spring of 2003 would not appear to be the most pro- pitious time to levy a broadside against Canada’s flexible rate regime. After all, Canada has avoided the US recession, has the highest GDP growth of the G7 and is the only G7 country running a fiscal surplus. Moreover, the Canadian macro environment is, arguably for the first time ever, char- acterized by workable and transparent fiscal and monetary targets. While I am happy to assign excellent grades for implementation to our macro managers over this recent period, my quarrel lies with the longer-term appropriateness of the underlying framework itself. Why, in a progres- sively integrating North American economic space, and where Canada is more integrated trade-wise to the US than is any European country to its Euro partners, would we want to pur- sue a monetary policy independent of that of the US?

Among the concerns that have been raised about the falling and volatile Canadian dollar over the last decade are that it has

  • led to a quite dramatic fall in living standards for Canadians (relative to those of Americans);

  • led to fire-sale prices for those of our assets that generate a Canadian-dollar income stream;

  • led to cost and competitive uncer- tainty as a result of the inherent exchange rate volatility, which uncertainty becomes more prob- lematical as we shift to a knowledge- based economy and may be playing an important role in our falling share of inward North American foreign direct investment.

  • led to a serious currency ”œmis- alignment” for long periods of time, where substantial overvalua- tion leads to downsizing, off- shoring, and exit, while undervaluation provides incentives for migration of human capital and underinvestment in productivity- enhancing technology, the net result of which will be a more resource-based and less human- capital-intensive economy than would otherwise be the case.

At one level, there are some easy counters to these claims ”” the falling dollar provides an important stimulus to exports and, a related point, that having the dollar fall in line with falling resource prices (see the figure ”œCanadian Dollar and Real Commodity Prices”) provides a ”œbuffer” to price shocks to the commodity sectors. I agree with both of these ”œfacts.” However, this stimulus and/or buffer- ing is a very mixed blessing over the medium term. Specifically, commodi- ty-price buffering may well be one of the causes of our productivity shortfall vis-aÌ€-vis the Americans. The story would go as follows. Cushioning Canadian dollar commodity prices, that is to say, depreciating the Canadian dollar in line with the fall in relative commodity prices provides incentives for labour and capital to remain in the commodity sector rather than shift to the ”œnew economy.” Moreover, assuming that the capital equipment and technology that drives the new economy is priced in US dol- lars, a falling Canadian dollar means that the price of this equipment will have risen apace.

These incentives point in the direc- tion of a smaller new economy, and less technology investment in both the old and new economies. In turn, this implies lower productivity growth than would be the case if there were no buffering, namely lower productivity growth than if there were a fixed exchange rate. As an important corol- lary, this also suggests that Canada’s rel- ative productivity slowdown will gradually offset the impact of the depre- ciation, so that any export stimulus from a falling dollar may well be tem- porary, that is, eroded by lower produc- tivity growth. While this theoretical approach fits well into the managerial theories of the firm, and while there is plenty of anecdotal evidence suggesting that this actually may be the case in many sectors, flexible-rate advocates let alone our macro officials steadfastly maintain that there is no causation going from exchange rates to produc- tivity. In the interests of our collective economic futures, they had better be correct. I do not believe that they are.

Apart from the commodity-price buffering argument, much of the rest of the case for flexible rates rests on the related assumption that only float- ing exchange rates can accommodate asymmetric Canada-US shocks. This too, I believe to be incorrect, especial- ly once one recognizes that Canada’s trade has dramatically veered north- south by region (see Table 1 for Canada and the chart for Ontario’s interprovincial and US trade). In effect, these trends suggest that Canada is moving in the direction of becoming a series of north-south, cross-border economies. In this context, assume that both the Canadi an and American components of each of these cross-bor- der economies (e.g. Ontario and Michigan, B.C. and Washington) are in some sort of cost/competitive equilib- rium. Now assume that there is a com- modity price increase. Initially, this affects both sides of the cross-border regions similarly (Michigan and Ontario; B.C. and Washington; Alberta and the Texas Gulf; Prairies and Montana, Quebec and New York).

But if we attempt to buffer this price hike by appreciating the exchange rate, then all of the Canadian regions are offside vis-à-vis their US counterparts. Why would we do this? The key continental asymmetries are typically east-west, that is between B.C. and Ontario (Washington vs. Michigan), or Alberta vs. Ontario (Texas vs. Mid-West) and not between the two sides of the cross-bor- der regions. National flexible rates can- not address these internal east-west asymmetries. Much better to keep exchange rates fixed and to address east- west asymmetries via national redistrib- utive instruments such as taxation, equalization, employment insurance and, where appropriate, sub-national stabi- lization policies. Phrased differently, let Ontario and B.C. adjust in the same way that Michigan and Washington adjust with the caveat that Canada, unlike the US, has regionally redistributive instruments to provide a helping hend, as noted in the previous sentence.

Given, therefore, that it is clearly possible to mount a case for fixed exchange rates, what range of options is available?

Contrary to the majority view, fixed exchange rate regimes are sustain- able a) when countries are highly inte- grated and b) where policy is geared to making the fixed exchange rate the key- stone of national economic policy. The best examples are the very successful Austrian and Dutch fixes to the DM, which even held through the union of East and West Germany. And since Canada is more highly integrated, trade-wise, with the US than are Austria/Holland with Germany, this should be eminently feasible were we to clearly commit ourselves to a fixed rate.

If, nonetheless, even greater certain- ty is desired, one can go the currency- board route. Currency boards are arrangements where circulating local currencies are fully backed by the anchor currency, usually the US dollar, e.g. Argentina and Hong Kong. Argentina’s unhappy experience with a currency board is usually raised in this context. However, in terms of the issue at hand, namely the sustainability of the curren- cy board’s parity value, Argentina’s prob- lem, among others, was that the currency board held too well. Hence, Argentina had no way to respond to Brazil’s 40 percent devaluation against the peso, short of abandoning the cur- rency board which it ultimately did. The real lesson here is along somewhat dif- ferent lines. Do not adopt a currency board that is anchored to the US dollar if the US is not your major trading partner. With 87 percent of our trade destined for US markets, this would not be our con- cern if we established a currency board relationship with the US dollar.

Over the longer term, however, the appropriate evolution would be toward a euro-type North American Monetary Union (NAMU).

When up and running, NAMU might be organized along the following lines. There would be a supra-national central bank ”” say the Reserve Bank of North America (RBNA). The Bank of Canada would be on the board of the RBNA, just as the Bank of France is on the board of the ECB (European Central Bank). The US would retain majority control of the RBNA ”” indeed, they would likely retain 12 seats, correspon- ding to their current Federal Reserve Districts, while probably granting Canada only one. The US dollar would continue to exist (why would anyone, least of all the Americans, want to replace the world’s most important cur- rency?) and would be the circulating currency in the USA. Canada would create a new currency that would exchange one- for-one with the US dollar. Suppose the ”œentry” exchange rate was 150 current Canadian cents for one US dollar. Then 100 new Canadian dollars would be equivalent to 150 current Canadian dol- lars ”” items that cost 150 old dollars would now cost 100 new dollars, and similarly for wages. Hence, we would maintain the existing relative price dif- ferences between Canada and the US. For example, if it now takes one day’s work to pay the weekly rent, this would also be the case under the new currency. This is exactly the currency-conversion process that every euro country has just come through. Note that our new currency could still have Canadian symbolism on one side, with one side adorned with a picture of the rockies and the other indi- cating that this new $5 bill, for example, is the liability of the RBNA and identical to and freely exchangeable for a US $5 bill. At the eleventh hour, the Europeans abandoned the notion of allowing one side of their new currency to vary across countries. But they have allowed this for the 1 and 2 euro coins. Seigniorage would stay with Canada, but the exchange rate would dis- appear.

As befits a unified monetary area, the RBNA would control the amount of currency out- standing at any given time, presumably in line with RBNA goals such as price stability, economic growth, etc. Canada’s share of this total currency would be ”œdemand determined” ”” for example, faster Canadian growth under NAMU would result in a larger Canadian share of the overall North American currency.

It took the Europeans more than a decade to converge to a series of ”œentry rates” for the various currencies. We would likely have to repeat this gradual entry process for NAMU as well, hopefully replete with some version of the Maastricht guidelines. One frequently expressed con- cern is that if we lock our- selves in at, say, 66 US cents for one Canadian dollar (or 150 Canadian cents for 1 US dollar) then we are underpricing our assets, vis-aÌ€-vis the Americans, for all time. This is not the case. Suppose we enter NAMU, or a fixed-exchange-rate regime, at 66 cents. If we perform better than the US, our wages and non-traded- goods prices will rise relative to those in the US. This is how we will close the cur- rent income gap with the Americans. And this is precisely what happened to the Irish ”” they entered the EMS/euro at an undervalued rate and have performed so well that they now have per capita incomes above the EU average.

Alternatively, we could simply adopt the US dollar as our currency. Many or most of the above benefits on the eco- nomic front would also apply to dollar- ization. However, there would be some significant policy and societal costs. We would lose seigniorage and lose currency symbolism. The clearings system would likely follow the north-south trading pat- terns and become north-south by region, (e.g., Toronto clearing with the US east- ern seaboard and Vancouver with San Francisco), thereby beginning a process of undermining our east-west comity. In contrast, under NAMU, clearings would occur nationally before we cleared inter- nationally, as is the case in Euroland. Under dollarization, our financial struc- ture and financial policy would likely fall under the US ambit and orbit. Not only would there be no rationale for main- taining the Bank of Canada, but with no fall-back institutions in place, this option would be difficult to reverse, at least over the short term. Indeed, one of the rea- sons why I got involved in this issue in the first place was to provide a range of currency options that would dominate and/or preclude dollarization.

Would the US ever agree to NAMU?

The almost unanimous answer from both sides of the border appears to be No. But many on both sides of the border would have also claimed that the US would never sign a free trade agree- ment with Canada, let alone with Mexico. At the very least this answer surely needs to be nuanced. First, the euro is making a big splash ”” one can foresee a day when close to 50 countries could be in the Euro zone, which will make the euro highly competitive with the dollar as a means of payment, as a unit of account, and as a store of value. At some point, the United States and the Fed will surely get concerned: Can one maintain and sustain economic hege- mony without also having the domi- nant currency? Second, while we fully recognize that Canada’s regions and the northern tier of Mexican states are pro- gressively integrating into North American economic space, it has gone largely unnoticed that 38 US states now have Canada as their largest (interna- tional) trading partner, and I would guess that many of the remaining states would have Mexico as their largest export market. While it is true for many of these states that exports to the rest of the US dominate exports to Canada, the fact remains that the US itself is becoming more fully integrated into North American eco- nomic space, and it is not difficult to foresee a day when Canada and Mexico will account for 50 percent of US exports. Beyond this, the spate of currency crises across Central and South America and their cost to the US in terms of loan guarantees, bailouts, lost markets and the like suggest that, at some point, US self-interest will force it to play a larger and more intervention- ist role in enhancing hemispheric cur- rency stability.

Yet none of this is intended to sug- gest that the US will, out of the blue as it were, offer to internationalize its central bank, even if it were to maintain the overwhelming decision-making authori-ty. Rather, if a move to a NAMU or a hemispheric monetary union emerges it will probably come about in a round- about way. For example, several key countries would dollarize, perhaps responding to US incentives so that they choose the dollar rather than the euro. After a while, these countries will quite naturally want some input into US mon- etary policy. Among other things, they will request periodic meetings with the US or the Federal Reserve System as to the likely evolution of US monetary pol- icy, during which meetings they will also state their own priorities. Gradually, these meetings will become more frequent and perhaps more formalized and, almost unwittingly, this process begins to move in the direction of a US-domi- nated RBNA and NAMU. Alternatively, as part of deepening NAFTA, Canada, Mexico and the US might acquire ”œobserver status” on the boards of some of each others’ institutions, including the central banks. Again, these informal linkages could then become more for- malized and eventually prepare the way for some version of a RBNA.

Our last experience with fixed rates was over the period 1962-70, when the Canadian dollar was set at 92.5 US cents. As already noted, this covered the Pearson years when we initiated, or finalized, our comprehensive range of social programs that distinguish us from the Americans. This provides tangible counter-evidence to the claim that we lose ”œsovereignty” over a wide range of policy areas if we tie our currency to the US dollar. Naturally, under fixed exchange rates, we do lose ”œmonetary sovereignty”: this is the very reason for fixing the exchange rate. But the NAMU variant of fixing would restore some say in overall monetary policy.

As an aside, when we finally float- ed the dollar in 1970, it appreciated from 92.5 cents to the 105 cent range in the mid-1970s. This is evidence that we were converging to the US (aÌ€ la Ireland in Euroland) under this 1962- 1970 ”œcommon currency.”

What might drive the system toward fixed rates and, perhaps, NAMU?

One factor will be the position that Britain takes on the euro. The British do not want political union with Europe, so that in this they are like Canada in the North American context. Their options are ”” keep the floating pound, fix the pound to the euro, allow euror- ization, or embrace the euro and the ECB. Note that they will have one vote out of thirteen now, and one vote out of25orsoinayearortwo.Myguessis that they will opt to join the euro, which should send a key message to Canada that currency integration is not inherently about sovereignty.

A move by Mexico to dollarize, which would give them monetary sta- bility at favourable wages, may trigger moves on our part to deepen NAFTA economically and, eventually, monetarily. In this context, it is important to recognize that any progress in the area of deepening NAFTA to incorporate framework policies relating to counter- vail, subsidy and anti-dumping will surely require that our exchange rates are fixed, or at least jointly managed. By way of illustration, it has not escaped the Americans that our exchange rate has depreciated significantly over the last dozen years. Phrased differently, the amount of the levy on softwood lumber is not unrelated to the amount of the depreciation.

There is a related storm cloud on the horizon. Over the 1990-2001 period, our real exchange rate depreciated from an index of 100 in 1990 to 70 in 2001. Over this same period our current account balance with the US went from a deficit of 1 percent of GDP in 1990 to a current account surplus of over 6 percent in 2001. If and when the Americans finally got around to focus on their trade deficit, we may well become the target for much of the adjustment in either or both of the exchange rate and the trade balance. I simply leave it to the reader to mull over the possible scenarios here, replete with how much sovereignty flex- ible rates will have provided us with.

On the purely domestic front, as was the case for the FTA, not much is likely to happen until business comes on side. Were the recent state- ment by Alcan favouring a North American currency to be endorsed by several other prominent companies, the game would be afoot. It is impor- tant to note, however, that much of the Canadian economy is already outside of the Canadian dollar area. The for- tunes of the largest Canadian compa- nies can rise and fall with hardly an impact on the Canadian dollar since most of the stock trading takes place in US dollars. Let me speculate that this is beginning to worry the Bank of Canada, in the following sense. In the current time frame, we are outperform- ing the Americans. If this is part of the long-awaited convergence (aÌ€ la Ireland), one would expect wages to rise and the prices of non-traded goods and services to be subject to upward pressure as well. If this is really conver- gence, then productivity will increase and this will not show up as inflation.

But measurement problems with respect to productivity are manifold, so that convergence may reveal itself in the data, initially at least, as inflation. And if this is so, it will be difficult for the Bank of Canada not to hike interest rates to choke off this inflation and, with it, choke off the convergence. One of the ways to interpret the Governor’s recent statement that he would hope that the exchange rate will increase (appreciate) as Canadian economic activity increases is that this would help stem the potential rise in meas- ured inflation and, therefore, facilitate convergence. This issue would not arise under a common currency, since there would be no assumption that Canada could affect NA inflation anymore than Ireland could affect EU inflation.

Those in favour of the flexible-rate status quo tend to take refuge in the following argument:

Fixed exchange rates are unsus- tainable and a common currency is unattainable. Therefore, the real choice is between flexible rates and dollarization.

Since dollarization is unacceptable, flexible rates shall rule!

Except for ”œdollarization is unacceptable,” this argument is, I respectful- ly submit, completely wrong. Given the pace of currency consolida- tion, it is unlikely that a floating or flexible exchange rate will even be in the longer-term choice set. Rather, the choice will likely be between North American monetary union (or some version of exchange-rate fixity) on the one hand, and dollarization on the other. Faced with this decision set, most Canadians would surely vote for NAMU! As a final comment, it is fair to say that it was because Canada had done its homework that we were able to say ”œyes” to the Canada-US Free Trade Agreement when the opportunity arose. The situation with respect to NAMU or a common currency is analogous. We need to assess the pros and cons of alter- native approaches to currency consoli- dation in North America, so that if and when a window of opportunity arises our homework/research will likewise be done. One cannot preclude that, as a result of this in-depth analysis, flexible rates will emerge as the ”œwinner,” so to speak. But let’s do the requisite analysis first, before pre-judging the results.


This article was based on joint research undertaken with Richard Harris.

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