The last time Policy Options hosted a discussion of whether Canada should return to the fixed exchange rate it had during the Second World War and then again from 1962 to 1970, following the ”œDiefenbuck” episode, was in the late 1990s, as the loonie sank toward 60 cents and, it seemed at the time, oblivion. Now, with our dollar having soared as high as US$1.10, an elevation that has induced altitude sickness in important parts of the econ- omy, the subject is back. It seems, not surprisingly, that the value of the dollar explains debate about the dollar.
Last time round, three distinguished former presidents of the Canadian Economics Association ”” Pierre Fortin, Tom Courchene and Rick Harris ”” all proposed that Canadians think hard about giving up a float and adopting some form or other of fixed exchange rate, with the options varying from a peg, in which we would target a given value of the loonie, through complete abandonment of a separate national cur- rency in favour of the US dollar. It is no disparagement of these three wise economists to say that their concerns gained traction in the national debate only when a number of busi- ness leaders, especially importers, also began to question where or even whether the loonie would hit bottom. At the time, serious people talked about the possibility Canadians would on their own bring about ”œdollarization” by replacing their loonie bank accounts with US dollar accounts and thus dump a currency that seemed headed for worthlessness.
With the loonie’s recovery in the early 2000s, however, the idea of Canadians giving up their currency went into qui- escence. Recent estimates from the World Bank suggest that in 2005 the loonie’s average value for the year coincided exactly with the bank’s estimate of the purchasing power parity value (C$1.20 per US dollar, at the time), something that in recent Canadian experience very rarely happens. (A stopped clock may be right twice a day but economists relying on PPP to pre- dict the loonie’s value are lucky to be right twice a decade.) With the loonie flying at least temporarily at heights that to many people made economic sense, there seemed little reason to reconsider the currency regime (even if stability, not level, is the real problem). Moreover, as the loonie recovered, people talked much less about the euro, which, now well established, was no longer headline news and therefore not so frequent a headline example for Canadians to consider following.
But the loonie’s recent apogee at US$1.10, higher than at any time since 1864 when the US was in the throes of Civil War-induced inflation, has people asking again, ”œCan’t we do something about the dollar?”
In some respects, where you stand on the dollar depends on where you sit, and it mirrors the zero-sum inter- views that are the typical beat reporter’s response to any sig- nificant move in the currency. If the dollar goes up, importers are happy, exporters are not. If the dollar goes down, the reverse is true When the loonie was at 62 cents, exporters were tickled ”” for what manufacturer wouldn’t want the option of being ”œlazy,” as the catego- rization went at the time? ”” but importers moaned. When the loonie hit $1.10, exporters suffered but Canadians deprived for years of access to US malls were delighted.
If the question of currencies really were zero-sum, so that whatever value the loonie assumed at any given time some Canadians gained what others lost, it would be a simple and banal question of politics. Which Canadians can impose their preferences on the political system and obtain the currency regime that suits them most? The appar- ent effectiveness of recent lobbying by central Canadian manufacturers must raise fears in the hinterland that, as usual, ”œvote-rich” Ontario will decide. (In a democracy, that’s not surprising!)
What makes the problem more interesting and more than just a political tug-of-war is the possibility that all Canadians suffer from the cur- rent system. Everyone has his or her own idea of the ideal value for the loonie, but we all suffer from our cur- rency’s variability and could all be bet- ter off if its path were levelled, possibly completely to horizontal.
Real roller-coasters create unpleasant sensations that are ultimately thrilling. But no one needs the very real pain that our currency’s rising and plunging has created, now here, now there, in our economy’s different sectors and regions. Even if we chose the ”œwrong” value for the loonie, this argument goes, other economic variables eventually would adjust to that value, while ending the volatility for good would eliminate an important element of uncertainty for investors. The greater investment that would result eventually would leave us with a larger capital stock, higher output per person and incomes closer to American levels. (However, a small point: eliminating exchange risk might actually cause some investors to take their assets elsewhere.
Some firms likely hedge exchange risk by investing on both sides of a border or indeed on many sides of many borders. Eliminating the exchange rate as a vari- able in decision-making would allow them to consolidate at least some of their investments and this will not always benefit Canadian subsidiaries.)
In response to the argument that (prices always wanting to move) having a fixed price for anything is irrational, there is the persuasive case that for the loonie to fly as close to the sun as it did last fall was not rational. Even Bank of Canada Governor David Dodge, ordi- narily a strong believer in the wisdom of markets, appeared to believe that in putting the currency up almost 10 cents in a month the markets had lost their grip on rationality, and he gave every evidence of abandoning the bank’s cus- tomarily laissez faire approach to the exchange rate to try to talk the curren- cy back down, as one would talk a potential suicide off a ledge. Whether it was his doing or not, after he spoke the currency did step back down.
No doubt, markets can be irra- tional. They certainly work in mysteri- ous ways, as anyone who has sought profit in them knows. What needs to be decided is whether they are like democracies: the worse systems imagi- nable except for all the rest.
There are two general objections to the idea that we would be better off with a fixed exchange rate: first, that it wouldn’t work and, second, that it wouldn’t be worth what we would have to give up.
On the first objection, that it wouldn’t work, the question is whether we would actually eliminate or merely displace variability in the economic system. The current concern in cen- tral Canada is that the high loonie is squeezing resources ”” people and investments ”” out of man- ufacturing. Many, of course, end up not in unemploy- ment but in Alberta, which is host to a number of industries that do seem able to compete, despite the dollar ”” though in fairness, we have not yet seen whether they can compete in the long run with the currency at such levels.
Another way to look at things, how- ever, is, not that Alberta’s indus- tries are competitive despite the high loonie, but that the loonie is where it is because Alberta (and Newfoundland and now Nova Scotia) have the indus- tries they do. With the rise in the world price of energy there is a surge ”” at least in money terms ”” in the demand for goods, energy mainly, but also a number of other commodities that Canada produces in abundance and whose price rapid worldwide economic growth has pumped up. Fixing the exchange rate would not alter that. Even if we did abandon the floating exchange rate, an increase in foreign demand for the output of our resource- rich provinces would still produce regionally skewed economic growth. Under such conditions, Alberta’s econo- my would still grow more rapidly than central Canada’s.
If the national economy were at full employment, as it now is, Alberta’s expansion would require slower growth in other provinces. One mech- anism that would help bring this about is inflation. Shortages in Alberta would give rise to wage and price increases that would spread through the economy as workers and capital were pulled in the direction of the strongest demands.
Central Canadian manufacturers might find that although the loonie was holding firm at whatever value had been chosen for it, rising wages and other costs were putting them out of business. In economists’ jargon, the ”œreal exchange rate” would rise even though the ”œnominal exchange rate” was fixed. We can fix the nominal exchange rate but unless we somehow also control inflation ”” and if we choose to fix the currency we can’t control inflation ”” we can’t fix the real exchange rate. As a result, fixing the nominal value of the currency would not end the inter-region- al differences in demand and supply pres- sures that are such a concern today.
Would it not at least mitigate the pressure? Maybe it would. It’s hard to imagine that under a fixed exchange rate regime prices in general would have risen by the roughly 65 percent by which the loonie rose between 2002 and 2007. It’s equally hard not to believe, as Governor Dodge suggested this fall, that some of the loonie’s remarkable buoyancy was the result of pure speculation. If we eliminated the possibility of speculat- ing by credibly pegging the loonie, we presumably could at least reduce the speculative effect and thus get off the roller-coaster we have been riding over the last few decades. And if, as some countries’ experience has suggested, durable pegs are difficult, we might at least limit speculative episodes to short bursts around what we’d hope would be relatively infrequent devaluations and revaluations.
Maybe so. But will speculators let us off so easily? Some people will bet on which route a raindrop takes slid- ing down a windowpane. Even if we do eliminate the exchange rate as an object of such betting, will that elimi- nate speculators’ desire to somehow bet on the Canadian economy? Will they not find other Canadian assets with which to satisfy their speculative desires? And will the increased fluctua- tion in these assets’ values not take us on different but at times equally unnerving roller-coaster rides?
At bottom, though, given the wild flight the loonie has been on, it seems reasonable to suppose that fixing the nominal exchange rate probably would reduce the overall volatility of the Canadian economy. On the other hand, there would be costs to fixing.
The most obvious but least impor- tant are the symbolic ones. The most effective way of fixing the loonie once and for all would be loonicide: abolish- ing it entirely and adopting the US dol- lar. When the loonie was at 62 cents and falling, many people probably regarded this as the merciful thing to do. With the loonie stronger than it has been in 150 years, most Canadians would think it passing strange ”” even if, strictly, the problem is not the loonie’s exact health at any time but its highly variable and unreliable health. Eliminating the loonie would eliminate any and all exchange risk essentially for good ”” even if there were still some small resid- ual risk that Canada would decide to go back to having its own national curren- cy and bring the loonie back from the dead. It would also, of course, eliminate a potent national symbol. But perhaps national currencies are not as essential to national identity as people think. Scotland does well in identity terms despite for the last 300 years having had various versions of a fixed exchange rate with the rest of the United Kingdom. France, Germany and Italy seem to be surviving despite having given up the franc, the mark and the lira. (How strange it still is for a person born in the mid-20th century to write such a sen- tence!) China has an equally strong national identity, despite having a cur- rency that until recently was formally fixed to the US dollar, and even after some unmooring in 2005 still does not float freely. Would the loss of the loonie or, less drastically, securing it to the US dollar deal a body blow to Canadians’ sense of themselves? Only if our identi- ty is less secure than these other coun- tries’. Unfortunately, there are many Canadians, though mostly in Toronto, who believe it is.
The real cost of un-floating the loonie would be the consequent obligation to run the economy, and therefore monetary policy, so as to keep the exchange rate at the chosen value, whatever it might be. When the loonie is rising, as it has been recently, that obligation will strike many people as no burden at all. For politicians and pop- ulists, keeping the loonie low couldn’t bemorefun.Thewayyoudoitisto bring down interest rates so Canada is a less attractive place to park money and pump up the economy so our imports rise and our trade surplus declines. Easy money and fast growth are traditional ingredients to electoral success. The obvious drawback is that they eventual- ly lead to inflation. But if you have pledged to run policy so as to keep the loonie at a target value, you can’t take time out for an attack on inflation. The higher interest rates such an attack would require would drive the loonie above its target value, which would vio- late the pledge that is your core eco- nomic policy. True, you could run a monetary policy that says we’ll target the exchange rate when it’s getting too high but we’ll target inflation when it seems to be getting out of hand, and we’ll also worry about unemployment when that’s a problem. But if your over riding goal is to reduce economic uncertainty ”” which is why you are fix- ing the exchange rate in the first place ”” then a monetary policy in which the Bank of Canada changes its target from year to year, quarter, to quarter or even week to week as political and economic pressures ebb and flow is unlikely to accomplish that goal. Maybe you can have economic certainty with policy ambiguity, but that’s a longer shot than betting on raindrops.
(Strictly speaking, you can have more than one policy target if you have more than one policy instru- ment. But monetary policy seems to be our only effective anti-inflation policy. Controls don’t work in the absence of cooperative monetary policy, while fis- cal policy is too lumbering to help in any but the longest and deepest of eco- nomic contractions. The last time it was tried in Canada was in the early 1980s, but the fiscal stimulus designed to help us out of the recession of 1981- 2 didn’t arrive until 1984, by which time it wasn’t needed.)
The logic therefore seems inescapable that when the market wants the loonie to fall below its target value you must raise interest rates and pull back on economic growth ”” and do so whatever economic conditions may be in different parts of the country. An Alberta boom may have to be hauled back even if New Brunswick is in reces- sion. There will be times, clearly, when running a fixed exchange rate isn’t at all fun. It is important that Canadians understand that before opting for it.
If the exchange rate is broke, how- ever, that doesn’t matter: we have to, well, fix it. If going to a fixed rate would have a big productivity payoff, maybe even close the (puzzling, post-FTA) pro- ductivity gap with the US, then we should do it. But we should do so only in the full realization that we would be breaking something else of substantial value: a monetary policy regime ”” infla- tion targeting ”” that took a hard half- decade to devise and that has served us well for 15 years now.
We didn’t always have a monetary policy that aimed for a 2 percent infla- tion rate and did so by targeting infla- tion forecasts two years out. In the 1970s and early 1980s monetary policy was mainly a mess. Monetarism, which was fine in theory, proved difficult to put into practice. The mess it created was followed by anti-inflation shock therapy in the early 1980s. The therapy took more quickly and thoroughly than almost anyone had expected, but it was another five years before rich countries began to formalize and insti- tutionalize the policy of constant vigi- lance that Paul Volcker had personified in the US. (In the end the US did not formalize it but gave policy over to another wizard, Alan Greenspan.)
In this country, John Crow’s Hanson Lecture, the ”œEdmonton Manifesto” he delivered 20 years ago this January, her- alded a new approach to inflation and in February, 1991, Governor Crow and Finance Minister Michael Wilson (now our man in Washington) agreed on for- mal inflation targets. Our inflation per- formance has since been very good, and there is some evidence that the resulting decline in uncertainty has improved real economic performance, as Bank of Canada theorists suggest it would. True, there are other reasons why this may have been a deflationary period (even if China’s effect on OECD economies is usually overstated). But the bank clearly has learned how to do inflation targeting, and the markets generally seem to have a good idea of what the bank is trying to do. It is a regime that is widely under- stood and in which policy therefore introduces few surprises into the invest- ment mix.
This is not to say that over time the Bank of Canada the markets could not learn the rules of a new game, namely exchange rate targeting. But the game would take time to learn and it would require giving up Canadian control over the Canadian inflation rate. By fix- ing to the US dollar, we would entrust ourselves to the US Federal Reserve Board and its conception of an appro- priate inflation rate. The US has not done spectacularly worse than we have on the inflation front in the last two decades, but it has done differently and not necessarily better. We would have to judge whether our losses on the insti- tutional and inflation fronts were worth the reduction in uncertainty on the loonie front.
Economics stresses that bygones should be bygones and sunk costs should be forgotten, but it’s not clear that a policy regime so long in the making that has been working tolera- bly well for a decade and a half should be scrapped.