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C.D. Howe Institute

Institut C.D. Howe Communiqu

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

Canada shoul d pursueNort h Ameri can currency union,

economi st s sayCanadas floating exchange rate is not serving the countrys economic interests well, and thesolution could be to work toward establishing a North American currency union, say two ofCanadasmostdistinguishedeconomistsinastudyreleasedtodaybytheC.D.HoweInstitute.

The study, From Fixing to Monetary Union: Options for North American Currency Integration,was written by Thomas J. Courchene of Queens University and Richard G. Harris of SimonFraser University.

The authors argue that Canadas experience with a floating exchange rate for the dollarhasbeendisappointing.Floatingratesmakerealexchangeratesmorevolatile,donotappeartooffer 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 andvolatility maytend to discourageproductivityimprovements in Canadianfirmsthatexportorcompetewithimports;biasinvestmenttowardUSlocationsandthusawayfrom 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 and

other 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 policyauthoritiestoproclaimtheUSdollaraslegaltender)allthewaytoaformalNorthAmericanMonetary Union (NAMU). Courchene and Harris argue that, of the single-currency options, acurrency union would be far preferable to dollarization.


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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 the

Americas 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 Canadas 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: 71 Sparks Street, Ottawa, Ontario; 12 Adelaide Street West, Toronto, Ontario); or directly fromthe C.D.Howe Institute, 125Adelaide Street East, Toronto, Ontario M5C1L7. The full textof thispublicationwill also be available on the Internet.

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


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C.D. Howe Institute

Institut C.D. Howe CommuniquEmbargo : diffuser le mardi22 juin 1999 10 h

Le Canada devrai t rechercherune uni on montai re en Amrique du Nord,

aff i rment des conomi stes

Letauxdechange flottantduCanada naidepasles intrtsconomiquesdupayset lasolutionpourrait consister tablir une union montaire nord-amricaine. Cest du moins ce quaffir-ment deux des conomistes les plus minents au pays, dans le cadre dune tude publie au-jourdhui par lInstitut C.D. Howe.

Intitule From Fixing to Monetary Union: Options for North American Currency Integration(Du taux de change fixe lunion montaire : choix de lintgration montaire en Amrique du Nord),ltude est rdige par Thomas J. Courchene de lUniversit Queens et Richard G. Harris delUniversit Simon Fraser.

Les auteurs soutiennent que lexprience qua faite le Canada du taux de change flottantpour le dollar sest avre dcevante. Un taux flottant entrane une instabilit des taux dechange rels, ne semble pas offrir un tampon efficace contre les chocs externes et peut se solderpar un mauvais alignement prolong des devises, ainsi quen tmoigne la priode actuelle defaiblesse prononce de la devise canadienne par rapport au dollar amricain. Une faiblesse etune instabilit tellesauraient tendance dissuader lesentreprises canadiennes qui sont expor-tatrices ou qui font concurrence aux importations deffectuer des amliorations de la produc-tivit, elles pourraient encourager les investissements vers les emplacements amricains audtriment des emplacements canadiens et elles pourraient dcourager lessor des industriesaux besoins levs en capital humain au pays.

SelonMM.CourcheneetHarris,aufuretmesurequelconomiecanadiennesouvreda-vantageaucommerceetauxfluxdinvestissementetquecesfluxseconcentrentdavantagesur

les tats-Unis, le calcul cots-avantages crot en faveur dune fixit accrue du taux de changepar rapport au dollar amricain. De telles dispositions, ajoutent les auteurs, stimuleraient lasouplesse en matire de prix et de salaires au Canada, car les entreprises et les travailleurs se-raient plus conscients de leur position concurrentielle en Amrique du Nord; elles permet-traient galement une stabilisation des prix pour les biens financiers et immobiliers, et ellesrduiraient la conversion montaire et les autres frais de transaction du commerce et de lin-vestissement transfrontaliers.

MM. Courchene et Harris expliquent que les choix dune fixit accrue du taux de changesont vastes, quil sagisse dobjectifs de taux de change, dun systme de parit ajustable, dun


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taux de change fixe entirement soutenu par la banque centrale, et les politiques budgtairesdes gouvernements fdralet provinciaux, dun conseil de la devise, dune dollarisation consistant en une dollarisation du march (ladoption par les agents du secteur priv dudollar amricain dans divers secteurs) ou en une dollarisation politique (une dcision offi-cielle par les responsables politiques de proclamer le dollar amricain comme monnaie lgale)

ouencoreduneunionmontairenord-amricaineenbonneetdueforme.Lesauteurssouti-ennent que parmi les choix de monnaie unique, cest celui de lunion montaire qui serait deloin prfrable celui de la dollarisation.

Face aux craintes que ladoption dun rgime montaire taux de change fixe ou duneunion montaire nentrane une perte de souverainet pour le Canada, les auteurs affirmentquecette perte serait plus apparente querelle. Ils soulignent galement que cest au cours desannes 60, durant lesquelles le Canada avait adopt un taux de change fixe, que le pays a pulaborer son infrastructure dtaille de politiques sociales.

En conclusion, MM. Courchene et Harris font la remarque que de toute manire, les v-nements quise droulent ailleurs en Amrique imposent une dcision. Il se manifeste dj unetendanceladollarisationnonseulementdansunpaysmembredulibre-change,leMexique,

mais galement en Argentine, et cette situation pourrait restreindre les possibilits dune un-ion montairenord-amricaine. Selon lesauteurs, le Canada doit participer tout dbat publicsurlvolutiondesdispositionsmontairesenAmriqueduNordpourveillercequeloptiondune union montaire nord-amricaine demeure une possibilit.

* * * * *

LInstitut C.D. Howe est un organisme indpendant, non-partisan et but non lucratif, qui joue un rleprpondrant au Canada en matire de recherche sur la politique conomique. Ses membres, individuels etsocitaires, 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 mdias), Institut C.D. Howetlphone : 416 865-1904, tlcopieur : 416 865-1866;

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

From Fixing to Monetary Union: Options for North American Currency Integration, Commentaire no 127 delInstitut C.D. Howe, par Thomas J. Courchene et Richard G. Harris, Toronto, Institut C.D. Howe, juin 1999,28p.,9,00$(lescommandessontpayablesdavance,etdoiventcomprendrelesfraisdenvoi,ainsiquelaTPS prire de communiquer avec lInstitut cet effet). ISBN 0-88806-459-6.

On peut se procurer desexemplairesde cetouvrage auprsdes : ditions Renouf lte, 5369, cheminCanotek,Ottawa ON K1J 9J3 (librairies : 71, rue Sparks, Ottawa ON, et 12, rue Adelaide Ouest, Toronto ON) ouencoreen sadressant directement lInstitut C. D. Howe, 125, rueAdelaide Est,Toronto(Ontario) M5C1L7.

On peut galement consulter le texte intgral de cet ouvrage dans le site Web de lInstitut.

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


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Monetary Policy

FromFixingtoMonetaryUnion:Options for North American

Currency Integration

by

Thom as J. Courchene

and

Richard G. Harris

Canadas experience with a floating

exchange rate for itsdollar has been

disappointing. The floatingdollar has been

prone to major misalignments, asits current

weakness demonstrates, that put Canada at

a disadvantage in the North American

competition for physical and human capital

investment. As the Canadian economy

becomes more open to trade and

investment flows, and asthose flows

become more focused on the United States,

the benefitsof greater exchange rate fixity

with theUS dollar aregrowing.There are many options for greater

exchange rate fixity, running fromexchange

rate targets through a formal North

American Monetary Union (NAMU).

Particularly in comparison with growing

spontaneous use of theUS dollar by the

private sector in Canada, a NAMU would

offer important benefits for macroeconomic

stability and financial integration.

With interest in using theUS dollar

growingelsewhere in the Americas, delay

on Canadas part in embracing this option

could prove costly. US cooperation in

establishingthe new currency and in

providing central banking services to

Canadian financial institutions would be

valuable, but if other countries adopted the

US dollar without such concessions,Canadas chances of obtaining them would

diminish. For that reason, Canada should

make hastein investigatingthe possibility of

establishing a monetary union in

cooperation with the United States.


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Main Findings of the Commentary

Canadas 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-

mentsinCanadianfirmsthatexportorcompetewithimports.Moregenerally,avolatileex-changeratewilltendtobiasinvestmenttowardUSlocationsandthusawayfromCanadianones,andtodiscouragethedevelopmentofhuman-capital-intensiveindustriesinCanada.

Canada's growing openness to international trade and investment, and the concentrationof those trade andinvestment flows on theUnited States, aretipping thecost-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, through

adjustablepegs,afixedexchangeratefullybackedbyboththecentralbankandfederalandprovincial 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 ina fixed rateregime would be moreapparent thanreal. Itwas during the fixed rate period of the 1960s that Canada developed its comprehensive so-cial policy infrastructure.

Eventselsewhere in theAmericas areforcing the issue. Theapparent trend towarddollariza-tion in both Mexico and Argentina may serve to constrain the potential for a North Ameri-cancurrencyunion.CanadaneedstobepartofanypublicdebateontheevolutionofNorthAmerican currency arrangements to ensure that the NAMU option remains on the table.


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The introduction of the euro in January1999 represents a watershed in the an-nalsofeconomicandmonetaryhistory.Atonelevel,theadventoftheeurosig-

nals the denationalization of national mone-

tary regimes; at another, it signals that, in aprogressively integrated global economy, cur-rencyarrangements area supranational publicgood, one that is arguably consistent with atwenty-first-centuryvisionof whatconstitutesnational 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 monetary

union. The political objectives that motivatedmonetaryunioninEuropedonothaveaparal-lel in North America (1999, 123).

Granted, the North American Free TradeAgreement (NAFTA) is largely a trade andeconomicblueprint,whereasintegrationintheEuropean Union (EU) incorporates, in addi-tion, aspects of a confederal or federal over-arching structure. But to link the euro solely toEuropes 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 theoverarchingEuropean 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 embracingmarket 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 calleddollarization.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 Marylands, is surrounded byfoureuronationsGermany,France,Italyand Austria and conducts about 70 per-

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

For its part, Canadas exports are even moredependent on the US market (more than

80 percent of our exports go there) than Swit-zerlands are on the EU. This enhanced degreeof NorthAmerican integration featurespromi-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 Thiessens preference for main-tainingCanadasflexibleexchangerateregimeis 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 movementsare

a consequence, not a cause. Exchange rateflexibility hasserveduswell 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 American

currency. The purpose of this Commentary is toexamine these propositions and to look atsome of the alternative approaches along thecontinuumfromfloatingratestomonetaryun-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


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place the currency union issue on the publicpolicy agenda. Policy developments within theNAFTAand elsewhere in theAmericas appeartobemovingquicklyinthedirectionofdollari-zation. Since widespread dollarization could

preclude 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 dollarizationfromaCanadianperspective,Canadamustbe-come engaged on this issue with its NAFTAandhemisphericpartnersandsoonerratherthan later.

One final introductory note is in order.One of the by-products of Canadas pursuit ofmonetary independence is that the exchange

rate has been a market-determined variable,and in this sense there is a close link betweenmonetary policy andexchange rate policy. Thepurpose of this Commentary is to assess Cana-dasexchangerateoptions:itisnotintendedasa criticismof 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

TheEconomicsofExchangeRateFixity

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 howeconomies work under float-ing versus fixed regimes, we start with a lookat the implications of the exchange rate regime

for living standards, productivity, currencyconfidence,andanumberofsubsidiaryissues.

What Economists Know

about Exchange Rate Regimes

Since thedemise of theBretton 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-ganitsfloatingrateregimeaslongagoas1970,

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 hadimagined they would. In 1953,Milton Friedmans case for flexible exchangerates included the proposition that

instability of [flexible] exchange rates is asymptom of instability in the underlyingeconomic structure...a flexible exchangerate

need 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.)

Thishasturnedoutnottobethecase,however.Rather, the evidence points to three basicpropositions.3

First,overanyperiodoftimeshortenoughto be interesting, real exchange rates4 are sub-stantiallymorevolatileunderaflexibleratere-

gime than under a fixed one, and almost all ofthisvolatilityisduetomovementsinthenomi-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 isimportanttorecognizethatrealexchangerates

4 / C.D. Howe Institute Commentary


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moveallthetimeandthattheywilladjustevenif thenominalexchangerate iscompletely fixed,but at a much slower rate, in line with move-ments in the general level of prices. Eliminat-ing volatility in thenominal exchange rate will

eliminatemostof the short- and medium-termvolatility in the real exchange rate.5

Second,macroeconomicfundamentalscan-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:

Simplyput,toafirstapproximation,coun-tries with fixed exchange rates have less

volatile exchange rates than floating coun-tries,butmacro-economiesthat 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, 23.)

An important corollary of this observation(Bank of Canada Governor Thiessens viewsnotwithstanding) is that the benefits of either

fixedor flexible ratesasshockabsorbersshouldnotbeoverstated.Aseconomistsdiscoveredinthe 1970s, neither flexible nor fixed rates canprevent the rapid international transmissionof inflation nor, as economists learned in the1980s,cantheypreventalargenumberofcoun-tries (including Canada) from pursing unsus-tainable fiscal policies. Poor economic policies(whether micro- or macroeconomic) lead toundesirable economic consequences, whateverthe exchangerateregime. Theprocessbywhich

thepolicymistakeistransmittedcandiffer,butthe ultimate consequences are similar.Third, nominal exchange rates can wander

from important long-term-trend fundamentalsfor significant periods of time, often two yearsor longer. This is referred to as the misalign-mentproblem.Themostinfamousglobalmis-alignment was that of the soaring relative

valueoftheUSdollarintheearly1980s,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 the

past decade: the late 1980s, when the dollarreached 89 US cents, and the recent period, inwhich the dollar has approached 63 US cents.

Identifyingmisalignmentunderflexibleex-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,itdoesseemtohavelong-runpredictivepower.Long-term exchange rate trends are relatively

well 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 afundamentalequilibriumexchangerate(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.



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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 a

shock absorber. The evidence on mac-roeconomic volatility suggests, however,that this is not the case. Much of the impetusonthepartofsmallercountriesformovingtoa fixed rate relates to volatile exchange ratesand periods of severe misalignment and theconsequencesoftheseproblemsfortheecon-omy. The larger the portion of the economyexposed to international trade and invest-ment, the more serious these consequencesbecome. Amajor reason Canada should move

toward the fixed end of the spectrum of al-ternative currency arrangements is to avoidthese costs. We develop these arguments fur-ther below.

Livin g Stand ards

and Exchange Rates

Duringthe1960s,theCanadiandollarwastiedto the US dollar at a rate of 92 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 63 cents during the sum-mer 1998 currency crisis.

A substantial part of the Canadian dollarsdepreciationfrom1973tothemid-1980scanbeattributed 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-changeratedepreciation,whichsuggeststherehas been a significant fall in Canadians aver-agestandardoflivingrelativetothatofAmeri-

cans.Thistrendisreflectedinthemovementofyoung, well-educated people to the UnitedStates, increasingly attracted by employmentopportunities in that country especially onthebasisofafter-taxcomparisonsandinthe

growing 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, itmighthave 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 Recent

Decline 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)and

Orr (1999) have done. For example, Canadasproclivity 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



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tradesurplusinordertoequilibratetheoverallcurrent account balance and, therefore, a pro-gressively lower exchange rate.6

Yet many economists, particularly those intheneoclassical tradition, discount calculations

oftheequilibriumvalueofthedollarusingthecurrent 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 nationalinvestmentovernationalsavings.Infact,arealexchange rate adjustment is only one of manyinfluences on each item that make up theidentity. Moreover, there are good reasons on

fundamental 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 Canadas (and McCallums)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 197399 peri-od,therehasbeenacloserelationshipbetweenthe decline in commodity prices and the ex-change rate. And, over the past year, the Bankhas put a positive spin on the dollars fall,arguing that it is serving as a buffer to offsetfalling commodity prices and ensuring thatCanadas level of economic activity is likewisebuffered. But the buffering argument can ac-

countforonlyasmallpartoftheexchangeratemovements of the past decade or so.The run-up in the exchange rate from 1988

to 1991 to 89 US cents during Canadas acces-sion to the Canada-US Free Trade Agreement(FTA), forexample, was inducedby tightmone-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 Canadas terms of trade, which, using theBank of Canadas export and import price in-dexes, declined by 3 percent from the firstquarter of 1991 to the fourth quarter of 1998.Thus, Canadas 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-facturedexportsandbyreductionsinthepricesof imported consumer and capital goods.

Whether or not there is a correlation over a

longer time frame between commodity pricesand the value of the dollar, the buffer argu-ment adds little to an understanding of thedollars 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 dollars relative

decline 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 bubblewithvaluationsthatcannotbesustainedUSFederal Reserve chairman Alan Greenspan has



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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 shift

into 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 beso inpart. None, how-ever,contradictsthefactthattheCanadiandol-lar is currently far below any value justified by

fundamental benchmarks, and the downwardtrend has now been intact since 1992.

Depreciation and Productivity

Perhaps the most visible argument in mediadiscussion of thedollars relativedecline is thepossible relationship between the exchange rateandaslowerrateofproductivitygrowthinthemanufacturing 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 fallinthedollarmeansa10percentriseinthepriceof competing goods from abroad, as well as inthe price of US capital equipment (or equip-ment priced in US dollars) for productivityen-hancements. This issue is not new in theCanadian context the Canadian dollar was

low and productivity performance poor in the1980s. As Harris (1993, 36) notes,

[o]ne consequence of an undervalued ex-changerate is that it protects inefficientop-erations from otherwise appropriatemarket signals. In the Canadian case, therobust demand growth in the [mid-1980s]recoveryplusthelowexchangerateproba-

bly delayed appropriate productivity-improvinginvestmentsinourmanufactur-ingindustryuntilmuchlaterinthedecade.

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

Canadas 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.Theidea that a weak currencyinduces lazi-ness on the part of the manufacturingsec-tor is not one that appeals to this author,but it seems to be broadly consistent withthe data, [which] suggests a double dipin Canadas relative manufacturing pro-ductivity for the first half of the 1980s andthen in the period 199497. 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 a

weak currency has been a cause rather thana consequence of poor productivity growthin our manufacturing sector. (1998, 34;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. SinceCanadians future living

standards depend on productivity growth, thisfinding is ominous indeed. Given the federalgovernments 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-



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ued Canadian dollar, coupled with low infla-tion,leadstoaproductivityslowdownrelativeto the United States, which is forging ahead onthe strength of a boom in high-technologysectors.Thistendstoconverttheoriginallyun-

dervalued dollar to an equilibrium of sorts. Inturn, this puts pressure on the Canadianauthorities to accommodate a further drop inthe dollar to restore Canadas 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 Canadas recent experience, butit is muchmore in the nature of a hypothesis meriting

further 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 Canadiansliving standards ultimately depend on produc-tivity, this is an issue with which defenders ofCanadas 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 198692 overshoot,7 which,from trough to peak, increased Canadian unitlabor costs by nearly 40 percent (measured ina commoncurrency), generated a degree of over-valuation that swamped any productivity im-

provements. Moreover, the FTA presented Ca-nadian firms and subsidiaries with an optionotherthanlowering costsorshuttingdown: theycould move to a US location, and a number ofhighly publicized moves did occur. No doubt

some 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 Canadas shift away from a resource-basedeconomy toward one increasingly driven byhuman capital and technology what Harris(1993) has called a fundamental shift in theirwealth-generationprocesses.From1989,thefirst year of the FTA, until 1997, the export sec-tors that saw the greatest increases (as a per-centageofgrossdomesticproduct,GDP)were,in order, transport equipment (including autos),machineryandequipment,electricalandcom-munication products, lumber and wood, andchemical and chemical products, followed byseveral services categories. The export groups

that contracted the most (again, as a percent-age of GDP) were, in order, grains, utilities,metallicoresandconcentrates,nonmetallicmin-erals,andpetroleumandcoalproducts(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 lesseasily 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:



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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 the

larger 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 ofayearorso]andthelowerthedegreeofen-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 directinternationalinvestmentdecisionshavebeenexchange 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, 3940.)

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-tionistoshiftincomeinCanadafromwagestoprofits. 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 lowexchange 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-dencethisdoesoccurintraditionalsectors.For

firms whose business is based on skilled labor,the difficulty is that, during periods of ex-changerate undervaluation, skilled labor mar-kets become very tight. New entry, based on acostadvantageduetoanundervaluedexchangerateoronwages thatmight betemporarily 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 likelytoresultin the shift ofCanadiancom-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:

Thebenefits of exchangerate fixity increasewith the degree of international openness,especially when this openness incorporatessuch a high degree of export integrationwithacurrencyandeconomicsuperpower(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 toisolatefirmsfromexchangeratevolatility).



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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). Thetime hascomefor 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-southintegrationappearparticularlyrelevant:

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 Canadasinternational exports are destined for theUnitedStates, north-southtradeclearly 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 provinces interna-tional exports were roughly two and a halftimes its interprovincialexports and grow-

ing nearly a magnitude faster. More recentdata indicate that about 90 percent of On-tarios international exports are destinedfor the US market. Indeed, nearly 44 per-cent of Ontarios GDP is now exported tothe United States.

Compare these integration data with thosepertainingtothe15countriesoftheEU.Onav-erage, 62.9 percent these countries exports go

to 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 importantdif-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,theargumentforacommoncurrency

is at least as compelling from Canadas van-tagepointasthatfortheaverageEUmember.

A Regional Perspective

on Asymm etric Shocks

To this trend toward sharply increased north-south trade integration one should add thatCanadas 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 administrations 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



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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 fromotherregionsofthecontinent.Whenoneelimi-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).

Intandem,north-southintegrationandthe

nonsynchronization of east-west business cy-cles raise the central issue of whether or notCanada is an optimal currency area. To besure,thisisnotanovelissue,sinceitwasatthecore of Mundells influential 1961 essay on op-timal currency areas, which argued that NorthAmerica(oratleasttheUnitedStatesandCan-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.11This 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 evidenceinsupportofastand-alone

currency. 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.

Considerthefollowingthoughtexperiment.As a result of enhanced north-south integra-tion and the nonsynchronization of regional

shocks,Canadaisappropriatelyviewedlessasa single east-west economy and more as a se-ries of regional, crossborder economies. In thiscontext, suppose BritishColumbia were to alignits policies to become competitive in the US

northwest 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-fectedinthesamewayasnortheastUSlumber,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


Table1: Regional Economic Cycles in

N ort h A merica, 196686

(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.


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exchange rate vis--vis the US dollar, then all ofCanadas 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 the

past 15orsoyears.Arguably,eachCanadiantrad-ing region would prefer to maintain exchangerate and transactions certainty with both east-west and north-south trading partners. The onlywaytodothiswouldbetofixtheCanadiandollartotheUSdollarandtorelyonotherpoliciestoac-commodate the differing impacts of the terms oftrade shock on the two national economies. Bay-oumi and Eichengreen (1994) strongly suggestthatthisisthewaythingsworkedinthepast,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 Canadas 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-changerate as a shock absorber. Cross-countryevidence, in fact, challenges this role.

Cuddington and Liang (1998), in a cross-

countrystudyofcommodityexportersandex-change rate regimes, document an importantstylized fact regarding commodity prices us-ing alternative data sets covering the 18801996period.Theyfindthatthevolatilityofrealcommodity 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 ofcommodities relative tothe costs ofthe manufacturing sector. This, for all intents

and purposes, is also the price of exports in thewest relative to that in the east. Cuddingtonand Liangs 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 exchangemarketinresponsetoacommoditypriceshock.

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

Macroeconomic Adjustment

How do Canadas regions, and the Canadianeconomy as a whole, adjust to macroeconomicshocks, as defined above? The current policy

response 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 crossborderdisequilibriumfor Canadas regional economies. Phrased dif-ferently, Ontario and Michigan (and Alberta



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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 price

hike. 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.AsCourchene(1990)argues,onewouldexpectthat regions that experience a favorable terms-of-trade shock would use their fiscal levers totempertheirbooms.HadCanadabeenunderafixed exchange rate system in the late 1980s,for example, the pressure on Ontario to tem-

per,ratherthanfuel,itsboomwithfiscalpolicywould 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 Canadas highdegree of internalmigration already in placeto deal with region-specific shocks or Canada-wide terms-of-trade shocks, whether positiveor negative.

Thus, there are mechanisms for accommo-datingregional andmacroeconomicshocks 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 to

note that Mundells 1961 analysis of optimalcurrency areas was rooted firmly in the 1960sKeynesian 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 Mundells approach was that itignored the regime-specific dependence ofprice-setting institutions. Flexible and volatileexchangeratesencouragepricesetterstodelaychanging prices or renegotiating nominal con-tracts in the face of a real shock. In labor mar-kets, wage negotiations can be hampered bytheinabilitytomakefirmcostcomparisonsbe-tween similar industries in different countries.

The ability of small, highly open economiessuchasIrelandandFinlandtooperatesuccess-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.

Asecond criticismof flexible exchangeratesas a buffer mechanism relates to a differenttypeofexchangeratenonneutralityonethatoperates 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 of

wealth effects on the economy: foreign firms are able to acquire Canadian

firms, whose assets are priced in Canadiandollars,atbargainprices(akindoffire-saleforeign direct investment);

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



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to the extent that Canadian and US equitymarkets are integrated, Canadian firmsbalance 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 mechanism

between 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-fectsthatcanbedetrimentalbothtolonger-rungrowth and to the ability of individuals andfirms to make thenecessary longer-run adjust-ments to the initial shock.

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

The Confi dence Issue

Oneimportant,butinherentlynonquantifiable,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-centevents have proven, currencies candeclineprecipitously even if economic fundamentals

aresoundonboththeinflationandfiscalfronts.Canadascurrentexchangerateregimehas

delivered 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, the

Canadian 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 dollarizationprocess, the US dollar is embraced for a rangeof purposes, such as transactions and as a unitofaccount,andasawaytofleetheuncertaintyand volatility of the Canadian dollar.

The fact is that, as a small country heavilyintegrated with the worlds largest economy,Canada does not have a lot of maneuveringroom on the currency issue. And it seems ap-parent,fromasocietalvantagepoint,thatmar-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 confidence

in 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 ahard Canadian dollar. Practically speaking,



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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 and

Transactio n Costs

We conclude the case for exchange rate fixityby focusing on transaction or efficiency gains.Tobesure,theextentofsuchgainswilldependon the nature of the exchange rate fix, withgreater gains arising in the context of a com-mon currency where, by definition, there is noexchangerate. While currencyconversion 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 the

development of electronic commerce (e-commerce) in Canada. Capital markets would be deeper and in-

terest rate spreads on government andcor-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.

AlternativeApproachestoExchangeRateFixity

Assuming our argument in favor of exchangerate fixity has merit, we now turn to thequestion of how a more formal link between

the 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 thepropositionthatflexibleratesarefarfromopti-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.



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Exchan ge 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 underlyingdifferencesininflationrates(crawlingtargets).The intermediate instruments of monetarycontrol are short-term interest rates, which areraised or lowered in light of exchange marketoutcomes. Thecentral bank might intervene inthe foreign exchange markets, but only tomaintain an orderly market, much as the Bank

of 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 exchangereservesand that it allows for temporary departuresfrom the targets in the event of unusual exter-nal circumstances.

As in the case of any exchange rate regime

short of a currency union, the central bankssuccess hinges on its credibility and on thegovernments commitment to the exchangerate target. Specifically, the macro authoritiesmust occasionally be willing to impose higherinterestratestodefendthetarget,evenifthisisinconsistentwithshort-terminflation,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,promptingmorecapitalflowsinsearchofshort-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-

chanicsoffixingtheexchangeratearestraight-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-surecouldwellcomefromwithin,since,underour definition of a pegged rate, there is no con-certedeffortonthepartofoverallmacropolicyto defend the peg. While pegged exchangerates can prove valuable as temporary stop-gaps,thisisnotwhatwehaveinmindintermsof 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 policyparadigmshift.Conductingoverallmacropol-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, Crowsearlier quote to the effect that a pegged ex-change rate would invite attack and is de-



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

TheNetherlands guilder, whichmight 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 Canadas at-tachment to the US dollar would have to be akeystone of the countrys 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


Table2: Assessing Alternative Approaches

to Exchange Rate Fixitya

OptionCanadian

Dollar Remains? Seigniorage?Bank of Canada

Remains?Exchange Rate

VariabilityPolicy

Flexibility

Fixed exchange rates Yes Yes Yes Fixed, within a narrow

band

Partial, subject to

gearing 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 by

borrowing

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 and

businesses

Policy dollarization No No No None (no Canadiandollar)

Minimal, andCanada could bedrawn into USpolicy orbit


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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 be

unsettledbyunforeseenevents;whatitshouldmean 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 optionfor Canada, a numberof 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 authorities

must 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-


Table2- continued

ImplementationCosts

ImplementationTime Clearings Reversible?

Access to USCapital Markets

Maintain FinancialSector Policy?

Minimal; need to selectentry point

One to threeyears; need toestablishcredibility

Status quo plussmaller transactionscosts for USclearings

Yes Enhanced access vis--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 must

be 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

Forall options,the Canadianpricelevel wouldbe tied tothe USpricelevel, and Canadawould followthe USbusinesscyclemorethanunder the status quo.b This need notbe thecase.If a currency boardwere implemented at,say, 75US cents to theCanadian dollar, this would notrequire the

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


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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 be

earned 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-changerateregimeinthecontextofsubstantialdomestic 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; see

Williamson 1997, 78).Currency boards have attracted a lot of at-tention,especiallyinlightofHongKongssuc-cessful defense of its currency during the Asiacrisis and Argentinas holding of its currencyvalue in the wake of both the Mexican pesocrisis and, more recently, the 40 percent de-valuationof Brazils currency. Currency boardshave also proven useful for emerging marketeconomieswithfiscalcredibilityproblemsanda history of inflationary finance. Hanke and

Schuler (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 regionand facilitates the regions 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 repeated

crises involving other Latin American curren-cies in recent years, surely Canadas 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 Canadas 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



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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 the

Americas could move toward dollarization,leaving Canada with little choice but to followsuit. The second-to-last rowof 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 situationultimately might beunstable, thelonger-term equilibrium need not be policydollarization it could also lead to fixed ex-changerates or a currency board arrangement.The general point is that market dollarizationwould tend tobeself-reinforcing and tolead tounpredictable political dynamics, with theCa-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 challenges

arising 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,notonlywouldtheBankofCanadabecomere-

dundant and disappear, but Canadas finan-cial institutional and regulatory system wouldbe drawn inexorably under US influence anddesign. Indeed, it is likely that banking andfinance would become integrated north-south

along the lines of Canadas crossborder re-gionaleconomies.Inturn,thiswouldlikelybe-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,exceptasalastresort.But,asnotedear-

lier, market dollarization is already alive andwell and, arguably, on the increase. Indeed,market dollarization has slippery slopecharacteristics: the more extensive it becomes,the more volatile is the exchange rate and theless effective is Canadian monetary policy.

Onecouldargue,ofcourse,thatadegreeofdollarization 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 closeeyeondevelopmentsinEuropeparticularlyin Switzerland, where market euroization istaking place even though that country (unlikeBritain)doesnothavethepoliticallyviableop-

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-das 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-



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

A Comm on Currency

The key distinguishing feature of a NAMU isthat, unlike the other options discussed so far,Canada cannot opt for it unilaterally theUnitedStatesobviously 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,byextension,theeuro.Thiswouldmean 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 terms

of pursuing price stability, the actual votingshare might matter less.Since the US dollar is already the worlds

premier 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 euros 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 eleventh

hour,thedesignofeurocoinsandpaperwastohavebeenidenticalononesideinallEUcoun-tries,buttheothersidecouldhavebeenembla-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.

TheBankofCanadawouldstillhavearoleto play in the largerNAMU institutional struc-ture,butitwouldberoughlysimilarto,say,theBankofFrancesrolewithinthenewEuropeanCentral Banks structure. As Table 2 indicates,

Canada would maintain its own financial in-stitution regulatory system, its own clearingsystem,andsoon.Thecriticaldifferenceisthatthere would no longer be a Canada-US ex-change rate.

ShouldCanadiansbeinfavorofaNAMU?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),forexample,operatedfrom1979untillastyear.It was a complex and formal set of arrange-ments that, with one major exception, reduced

nominal 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.

AnothertransitionissueforCanadawould

be 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



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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, thisimpliesthattheequilibriumentrypointwouldrise as Canada made progress on the debt-to-GDP-ratio front. In any event, Eu

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