Committees (44th Parliament, 1st Session)

The Standing Senate Committee on Banking, Trade and Commerce has the honour to table its

TWENTY-NINTH REPORT

Tuesday September 14, 1999

Your Committee, which was authorized by the Senate on Wednesday, October 22, 1997, to examine and report upon the present state of the financial system in Canada, now tables an interim report entitled A Study of Common Currency: Canada and the United States – Views and Evidence Heard.

Respectfully submitted,

MICHAEL KIRBY
Chairman

A STUDY OF COMMON CURRENCY:
CANADA AND THE UNITED STATES VIEWS AND EVIDENCE HEARD

Report of the Standing Senate Committee on Banking, Trade and Commerce

Chair : The Honourable Michael Kirby

Deputy Chair : The Honourable David Tkachuk

September 1999

MEMBERSHIP

The Honourable Michael Kirby, Chair
The Honourable David Tkachuk, Deputy Chair

and

The Honourable Senators:

Angus, W. David	Kenny, Colin
Austin, Jack, P.C.	Kolber, E. Leo
Callbeck, Catherine S.	Kroft, Richard H.
*Graham, Alasdair B., P.C. (or Carstairs, Sharon)	*Lynch-Staunton, John (or Kinsella, N., acting)
Hervieux-Payette, Céline, P.C.	Meighen, Michael Arthur
Kelleher, James F., P.C.	Oliver, Donald H.

*Ex Officio Members

Note: The Honourable Senators Carney, P.C., Grafstein, Joyal, P.C., and Stewart were also present at this meeting.

Staff from the Parliamentary Research Branch, Library of Parliament:
Mr. Gerald Goldstein, Director, Economics Division and
Ms. Margaret Smith, Research Officer, Law and Government Division.

Staff from the Committees and Private Legislation Directorate:
Ms. Lise Bouchard, Administrative Assistant.

Gary Levy
Clerk of the Committee

ORDER OF REFERENCE

Extract from the Journals of the Senate, Wednesday, October 22, 1997:

The Honourable Senator Carstairs for the Honourable Senator Kirby moved, seconded by the Honourable Senator Callbeck:

THAT the Standing Senate Committee on Banking, Trade and Commerce be authorized to examine and report upon the present state of the financial system in Canada;

THAT the Committee have the power to permit coverage by electronic media of its public proceedings with the least possible disruption of its hearings; and

THAT the Committee submit its final report no later than December 10, 1998.

The question being put on the motion, it was adopted.

Paul Bélisle
Clerk of the Senate

By order of the Senate dated December 10, 1998, the date of tabling the final report was extended to February 28, 1999.

By order of the Senate dated February 16, 1999, the date of tabling the final report was extended to December 31, 1999.

TABLE OF CONTENTS

INTRODUCTION

History of Canadian Currency Arrangements
Glossary of Terms

VIEWS OF WITNESSES

A. THE CASE FOR A COMMON CURRENCY

1. Reducing the Uncertainties and Costs Associated with Exchange-Rate Volatility
2. Flexible Exchange Rates as a Constraint to Required Productivity and Policy Adjustments
3. A North American Currency Bloc as a Defensive Measure
4. Maintaining Fiscal Discipline

B. THE CASE FOR FLEXIBLE EXCHANGE RATES

1. Are Canada and the United States an Optimal Currency Area?
2. Absorbing Economic Shocks through a Flexible Exchange Rate System
3. The Size Differential between the Canadian and United States Economies
4. Loss of Sovereignty
5. Preservation of Seigniorage

C. CURRENCY ARRANGEMENT OPTIONS

APPENDIX 1 – WITNESSES

INTRODUCTION

Since the early 1970s, Canada's monetary system has been characterized by a flexible exchange rate. Recently, two developments in particular have rekindled interest in establishing a new currency arrangement for Canada: the introduction of a common currency in the form of the Euro and the weakness and increased volatility of the Canadian dollar. These developments have prompted a number of economists and members of the business community in Canada to begin discussing a move to some kind of fixed exchange rate system and to consider approaches such as an exchange rate pegged to the value of the U.S. dollar (fixed exchange rate); implementation of a currency board; adoption of the U.S. currency for use in Canada (dollarization); forming a currency union with the United States or perhaps a North American currency bloc that would encompass Canada, the U.S. and Mexico.

The Standing Senate Committee on Banking, Trade and Commerce views this issue as one of interest and importance to Canadians. The Committee hopes to contribute to the debate by exploring the advantages and disadvantages of a common currency arrangement with the United States. We do so on the understanding that informed public debate must precede any decision by government on a policy issue as significant as this.

On March 25, 1999 the Committee heard from a panel of experts who debated and discussed optimal currency arrangements for Canada. Members of the panel were Professor Jack Carr of the University of Toronto; Professor Thomas Courchene of Queen's University; Mr. John Crow, economic consultant and former Governor of the Bank of Canada; Professor Herbert Grubel of Simon Fraser University and Professor Bernard Wolf of York University.

This report outlines a number of the arguments made by the witnesses in respect of the potential merits and drawbacks of adopting a common currency between Canada and the United States.

History of Canadian Currency Arrangements

At the outset, it is worth noting that, over the years, Canada has had a variety of currency arrangements. The dollar was first adopted at the monetary union of the Province of Canada in 1858 and then by the entire dominion in 1870. The Canadian dollar, which was backed by the gold reserves of the government, was pegged in 1858 at par with the U.S. dollar and at $4.87 to one British pound. This fixed exchange rate continued almost without interruption until 1914. With the onset of World War I, Canada abandoned the fixed relationship with the U.S. dollar until 1926, when the Canadian dollar was again pegged, this time at 82 cents to the U.S. dollar. The fixed exchange rate was abandoned again in 1931, and the dollar was allowed to float until the beginning of World War II, when the Canadian dollar was once again pegged, this time at 91 cents to the U.S. dollar.

In the post-World War II era, and from 1950 to 1962 and again in 1970 Canada dropped out of the pegged exchange rate system even though the commitment to peg the currency was mandated by international treaty. Since the early 1970s Canada has had a floating (flexible) exchange rate.

Glossary of Terms

Before outlining the testimony and the arguments heard, it is useful to give a brief description of the various types of currency arrangements and the terms used by the witnesses.

Currency board: Under a currency board arrangement, expansion or contraction of a country's money would be undertaken in a strict relationship with changes in foreign exchange reserves. In the context of a Canada-U.S. currency relationship, a currency board would likely involve the transformation of the Bank of Canada into a currency board that would exchange its Canadian dollar liabilities for U.S. dollars at a fixed rate. As reserves, the currency board would hold high-quality interest-bearing securities denominated in the reserve currency (U.S. dollars).

Dollarization: Dollarization is the term used to describe the situation where one country uses another currency in place of its own. In the context of this summary, it refers to Canada using U.S. dollars and coins as the currency of everyday usage. Prices and wages, for example, in Canada would be set in U.S. dollars.

Fixed exchange rate: A fixed exchange rate involves the government pegging a price range at which the Bank of Canada will exchange Canadian currency for other currencies.

Flexible exchange rate: Under a flexible exchange rate system, the price of a currency floats freely in relation to other currencies.

Monetary Union: A monetary union involves two or more countries joining to create a joint currency that would be issued and administered by a common central bank. This is the model adopted in Europe with the creation of the Euro.

Optimal Currency Area: The economic literature on optimal currency reveals that regions or countries can be candidates for monetary integration if they have: labour and capital mobility, a high degree of trade integration, a common economic structure, and integration of fiscal systems so that revenues and spending can be shifted to deal with problems arising from discrepancies in the business cycle. (1)

Seigniorage: Traditionally, seigniorage is the net profit earned by the government that results from the difference between the face value of coinage and the actual value of the metal used to produce the coins that are put into circulation. Today, seigniorage consists of profits of the Bank of Canada and the Mint. The profits of the Bank of Canada arise from the deposits of commercial banks that are held by the Bank of Canada and invested in Canadian Treasury Bills. The difference between the interest paid on the deposits and that earned on the Bills provides income to the Bank which, after deducting operating costs, is similar to the historic definition of seigniorage.(2)

VIEWS OF WITNESSES

A. THE CASE FOR A COMMON CURRENCY

Professor Herbert Grubel asked the Committee to consider the case for a new North American currency that would cover Canada, the United States and Mexico. He cited ten economic advantages of adopting a common currency. These include:

reduced costs of foreign exchange dealings;
lower interest rates as the currency risk for investors is eliminated;
elimination of the exchange risk which is equivalent to lowering the cost of international trade and capital flow;
increased labour market discipline as union leaders and managers face the fact that currency devaluation can no longer be counted on to maintain the competitiveness of firms that have allowed real labour costs to increase;
a more appropriate pace for the necessary economic adjustment to the secular decline in world commodity prices as the depreciation of the exchange rate no longer protects domestic producers from falling world prices;
greater price stability around any existing inflationary trend;
the prevention of monetary policy initiatives driven by ideology or politicians;
the potential for greater Canadian influence on monetary policy of the currency union;
seigniorage from the issuance of currency will remain in Canada;
the likelihood that governments will be required to limit their deficits.(3)

Professor Thomas Courchene called for a fixed exchange rate between Canada and the United States as an interim step toward a North American currency union. He argued that:

price stability with freely floating exchange rates is a major policy error;
the resulting degree of exchange rate volatility is inconsistent with the geo-economics of NAFTA;
Canada is no longer a stand-alone optimal currency area -- the optimal currency for Canada now includes the United States;
a fixed exchange rate will restore fiscal discipline. (4)

A number of the arguments supporting a move from a flexible to a more fixed exchange rate or a common currency area are explored below under various headings.

1. Reducing the Uncertainties and Costs Associated with Exchange-Rate Volatility

Currently, over 80% of Canada’s exports are destined for U.S. markets. Exports to the U.S. have also become an increasingly important factor in Canadian GDP, in line with the shift from east-west to north-south trade. Between 1984 and 1996, for example, the ratio of exports to international destinations compared with those headed to provinces within Canada rose from 113% to 183%. Professor Thomas Courchene pointed out to the Committee that with the U.S. accounting for such a high share of Canada’s international exports, trade with the U.S. had clearly come to surpass interprovincial trade.

We have not yet in Canada realized just how dramatic our north-south integration is. In 1996, all but two of the provinces exported more to the rest of the world than they did to the rest of the country. Probably by now all of them do that. For each dollar exported in 1996, international exports were running at $1.83. More recent data put international exports twice as high as interprovincial exports. (5)

Proponents of a common currency maintain that as Canada and the United States move closer together in cross-border trade (and investment), the case for a common currency becomes increasingly more apparent. Indeed, they argue that the more integrated the two economies become, the more justification there is to eliminate exchange-rate uncertainty which, in turn, generates uncertainty regarding future costs and profits.

Flexible exchange rates can lead to large swings in the Canada-U.S. dollar exchange rate. The exchange rate for the Canadian dollar went from $1.04 in May 1974 to $0.71 in January 1986, back up to $0.89 in October 1991, then down to roughly $0.63 in August 1998. Flexible exchange rates can also produce short-term exchange rate volatility, which, as certain studies have pointed out, can adversely affect trade, investment and economic efficiency. Such volatility can pose problems for a country such as Canada, where 80% of exports are destined for U.S. markets.

The volatility of the Canadian dollar was particularly troublesome for Professor Courchene.

We have been focusing too much today on the fall of the dollar. Far more difficult is the inherent volatility in this dollar. The dollar has gone from 104 to 70 in 1986, then from 89 to the low 70s, then to 63 and back up to 66.

I do not think Canada can maintain its degree of exports with this volatility. As a foreigner contemplating locating a plant in Canada, you see that in the last decades, the exchange rate has fluctuated between 63 and 89. You will realize that you have to build in a huge margin of protection, because you could lose twelve-thirteenths of your market through the exchange rate. However, if you go to the U.S. and do something foolish, you only lose one-thirteenth. I think to maintain Canada's fair share of international investment under NAFTA, we have to minimize this exchange rate volatility. It is a problem both on the upside and the downside. On the upside of 86 to 89, during those years, firms exited because there was no productivity improvement over the short period of time they had.

Two things happen with a large depreciation. You do not want to invest in productivity particularly, as that costs you more now because you are buying U.S. equipment. Secondly, your labour is exiting to other markets because Canadian wages are falling relative to U.S. wages. If we add both those together, we end up with a comparative advantage that is focused toward resource-based and physical capital rather than human capital approaches. The result is a less-diversified and less human capital labour force than we would otherwise have.

This is the wrong policy when we know that knowledge is at the cutting-edge of competitiveness. We have to protect that human capital future in Canada, but we cannot do it under the degree of volatility that we have had in the exchange rate. (6)

Proponents of a new currency arrangement for Canada argue that it would be much easier for most Canadian firms doing business with foreigners to have a fixed exchange rate, regardless of how this would be achieved. Removing currency fluctuations through the implementation of a common currency would provide Canadian exporters, importers and investors with greater economic certainty on which to base their day-to-day decisions. In particular, moving to a system of fixed exchange rates could enhance the certainty of investments and, therefore, the economy’s growth and job creation prospects.

Moreover, greater exchange-rate certainty would reduce the cost of cross-border transactions because there would no longer be a need for currency conversion, hedging, or other such transactions. Lower foreign-exchange transactions costs would then naturally expand levels of external trade.

Proponents of a common currency argued that such an arrangement would yield economic gains through reductions in the size and risk of foreign exchange operations. Professor Grubel estimated that the reduced cost of foreign exchange dealings would result in North American regional savings of about .1% of national income.(7) He also suggested before the Committee that removing exchange risk would result in reduced interest rates for long-term government bonds, thereby reducing the costs of borrowing. (8)

Furthermore, a common currency, Professor Grubel argued, would bring about dynamic gains in output and therefore living standards. These gains, he maintained, would be due to the fact that the elimination of the costs of currency conversion and exchange risks would be equivalent to lowering tariffs and transportation costs. (9)

Professor Courchene argued that flexible exchange rates have had a negative impact on our standard of living in Canada.

All I am going to do right now is just focus on the first one of these four, falling living standards. In 1974 the Canadian dollar was worth 104 U.S. cents. Now it is worth roughly 66 cents. It was as low as 63.5 cents last summer. This represents an enormous fall in our living standards vis-à-vis the Americans. It not only puts Canadian prices at bargain basement levels ... but it provides an enormous incentive for young skilled Canadians to ply their trades south of the border, as they are doing in increasing numbers. (10)

John Crow, however, questioned whether the decline in our standard of living had much to do with our exchange rate. Professor Carr took a similar position, arguing that the decline could be attributed to the shocks that have hit the Canadian economy rather than a flexible exchange rate system.

The nominal exchange rate has moved because of the real exchange rate. Real forces have buffeted the Canadian economy. That is why I do not buy Professor Courchene's argument that the depreciation of the exchange rate has hurt our living standards. Of course it has hurt our living standards, but it has not been because the exchange rate is floated. It is because of these real shocks that have hit the Canadian economy. There is nothing we can do, no matter what exchange rate we are on. If the price of the things we sell goes down relative to the price of the things we buy -- if the prices of oil, gold and lumber fall -- then this will hurt Canadian living standards whether we use the U.S. dollar, have a floating exchange rate or a fixed exchange rate. That is why I think the reasons he gives for this change in living standards are incorrect. He would then argue that the floating exchange rate has helped the U.S. economy because their exchange rate has appreciated with respect to the Canadian dollar. Therefore, that same exchange rate regime must have given them a higher standard of living. (11)

2. Flexible Exchange Rates as a Constraint to Required Productivity and Policy Adjustments

A case for adopting a common currency can be made on the gounds that a common currency would help to stop the erosion of Canadian currency and productivity. The existing currency regime, it is argued, has brought about a cycle of currency devaluation and lower productivity.

Professor Grubel maintained that a common currency would produce labour market discipline. Perhaps, more importantly, he argued that a common currency would "force Canadian producers of natural resources to face the reality of falling world prices without the expectation of temporary relief through exchange rate protection."(12) Professor Grubel contended that the downward trend in the real world price of commodities should have resulted in a more rapid move of labour and capital out of Canadian industries producing these goods. The reallocation of labour and capital, he argued, has not taken place at a faster pace because of the protection implicit in a flexible exchange rate regime which makes it profitable for labour and capital to remain in these industries when they should have moved into other sectors. (13)

Some believe that the existence of a weak dollar helps keep exports competitive without the need for large increases in productivity. While a decline in the value of the national currency may provide Canada with a short-term competitive advantage, it is argued that such a decline serves as an impediment to the formulation of competitive-enhancing business strategies and government policies. Covering up low productivity with a cheaper currency actually perpetuates the low productivity by diminishing the need for industry to make the required structural changes, for example, by adopting new technologies. Moreover, as Professor Courchene told Committee members, if the technologies in question have to be imported, any sizeable depreciation of the dollar will cause their import cost to rise appreciably. The persistent depreciation of the value of the dollar, the argument goes, makes Canadian companies less interested than they otherwise would be in attempting to improve productivity growth, in making more sound investments, and in generally enhancing their competitiveness.

Proponents of moving away from a flexible exchange rate point out that adoption of a stronger currency would a competitive crutch and force Canadian firms to become more innovative. Greater innovation would, in turn, help to improve Canada’s relatively poor long-term productivity performance thereby leading to enhanced growth prospects and higher living standards.

Professor Courchene argued that exchange rate volatility of the degree recently experienced in Canada would overwhelm measures to improve productivity. In putting his case for exchange rate certainty, he pointed out that

... firms have a tendency to rev up production in times of exchange rate undervaluation and then to contemplate exit in times of severe overvaluation.... Exchange rate certainty provides a powerful incentive on the productivity front since firms will be able to reap the benefits of their productivity enhancing initiatives. ... And a low dollar will stimulate exports in the short term. However, if the medium and longer term implication is that our productivity lags vis-a-vis the Americans, then the undervalued dollar will become an equilibrium rate. And then what? Allow the dollar to fall further to stimulate exports again? This is a recipe for lowering our living standards as well as an open invitation for our educated young people to search for more attractive economic climes. (14)

The counter argument to the claim that flexible exchange rates harm productivity is that, as Mr. John Crow observed before the Committee, the causality could actually run in the opposite direction in that poor productivity causes a lower exchange rate. According to Mr. Crow, the allegation that exchange rate flexibility has damaged the economy by causing poor labour productivity in manufacturing cannot be taken too seriously. He cited three reasons for his view. First, the charge related to productivity in manufacturing only, rather than to productivity in the business sector as a whole where the performance has been less open to criticism. Second, the statistics cited cover only labour productivity, not total productivity which takes into account all inputs. Finally, he noted that correlation does not necessarily indicate causation; while one can find a statistical correspondence moving from exchange rate weakness to labour productivity, one can also, from an equally convincing statistical viewpoint, find a correlation in the opposite direction with the implied cause going from productivity weakness to declining exchange rates. (15)

In a working paper prepared for the Bank of Canada, David Laidler argues that macroeconomic empirical evidence suggests that there are many factors affecting productivity performance which are often industry or province specific. As a result, it is difficult to reconcile that evidence with the notion that the exchange rate has been a crucial factor in undermining productivity growth. Laidler notes that the exchange rate may have played a role in protecting some small import-competing manufacturers from foreign competition, but not enough to produce problems with the country's overall performance. (16)

The Governor of the Bank of Canada recently pointed out that not all the recent decline in global commodity prices has been offset by the depreciation of the Canadian currency. When the decrease in commodity prices from the early part of 1997 to the end of 1998 was approximately 20%, the exchange rate fell by only 8%. As a result, commodity producers were not totally shielded from the outside shock. Therefore, the existence of flexible exchange rates has not totally restrained the industrial adjustments that otherwise might have occurred.

3. A North American Currency Bloc as a Defensive Measure

Proponents of a common currency argue that adopting a new currency as part of a North American currency bloc could serve as a useful mechanism to offset the Euro. A separate Canadian currency is likely to become increasingly irrelevant as the Euro comes to equal the U.S. dollar in importance. Although this may take a considerable amount of time, one could envisage a world in which three currency zones begin to emerge: the Euro in Europe, the yen in Asia, and the dollar in the Western Hemisphere. In this new configuration, the Canadian dollar could become increasingly marginalized.

Professor Courchene has pointed out that the world appears to be unifying into various currency blocs, and that there is merit in joining a bloc with the United States. It is his view that while Europe is establishing larger currency regions, Canada should be striving for a reduction in exchange rate flexibility rather than for an increase.

Professor Grubel noted that a currency bloc consisting of Canada, the United States and Mexico would have a larger population and income than an eleven-member European monetary union. Such a bloc, he argued, would help protect the interests of smaller nations such as Canada and Mexico that might suffer from being caught in the middle of policies set by the European Central Bank and the U.S. Federal Reserve.

Investors’ flight to quality is another factor to consider. During the period of Asian economic and financial turmoil, short-term capital flowed in great quantities to U.S. dollar-denominated investments. On the other hand, foreign investors dumped the Canadian dollar because Canada’s economy was widely seen as being commodity-based and export-oriented at a time when commodity prices were depressed and export markets sluggish. Professor Grubel maintained that movement to a common currency could guard against speculative runs on a perceived weak currency such as the Canadian dollar. (17)

It has also been suggested that a North American currency bloc would be an important defensive move for the United States to preserve the dominance of its currency.

4. Maintaining Fiscal Discipline

Professors Grubel and Courchene respectively maintained that a common currency or a fixed exchange rate would have a positive impact on fiscal discipline. The former pointed out that member countries of the EMU are required to keep government deficits under 3% of national income. He suggested that a North American monetary union should also impose similar restraints on its members.

More pointedly, Professor Grubel felt that "a common currency would ... represent an institutional restraint on the ability of politicians to exploit the monetary and fiscal policy for their short-term gains and for the gain of their re-election at the expense of future generations in society as a whole." (18)

B. THE CASE FOR FLEXIBLE EXCHANGE RATES

Mr. John Crow, Professor Jack Carr and Professor Bernard Wolf argued that flexible exchange rates have served Canada well.

Mr. Crow was of the view that Canada's experience with flexible exchange rates has been positive. He rejected the notion that the exchange rate system has been a major factor contributing to the performance of the Canadian economy.

How has Canada done with flexible exchange rates? I would say we have done pretty well, pretty sensibly in general. It would have been, of course, inappropriate to push up interest rates to hold the dollar at 72 cents in 1998, for very good reasons given what happened to Canada's terms of trade, which deteriorated substantially in that year on the basis of declined commodity prices and in fact shaved about a half a per cent off our GDP in that period. It was a perfectly sensible response to the exchange rate to adjust and to shift resources within the Canadian economy....

I would say that the Canadian flexible exchange rate experience has essentially been positive. In this more recent period, we can go back over less positive experiences, perhaps, but in the recent period everything has worked out the way you would expect. The currency has depreciated; that is for sure. Interest rates have stayed down. There has been no inflationary effect particularly, and the Canadian economy has continued to perform pretty decently. There are other factors in how the Canadian economy performs besides this, but I do not think one can lay too much blame at the door of the exchange system. (19)

Among other things, Professor Wolf argued that it would be risky to eliminate the cushion that flexible exchange rates provide to absorb economic shocks.

Professor Carr argued that monetary unions represent a political as well as an economic statement. There would have to be good political as well as economic reasons for a union. He went on to note that the political and economic conditions for a North American monetary union were not correct at this time: outside Quebec, there did not appear to be sentiment in Canada for a closer political union in North America.(20)

1. Are Canada and the United States an Optimal Currency Area?

As noted earlier, research on optimal currency areas reveals that regions or countries can be candidates for a currency union if their economic structures are similar so that economic shocks are absorbed in the area relatively evenly, the factors of production (labour and capital) are relatively mobile between the countries, and there is a high level of trade integration.

Restricting exchange rate flexibility may not be useful when countries are affected differently (asymmetrically) by the same economic shocks. Some maintain that the Canadian and United States' economies are too different to consider a currency union. As the Asian economic and financial crisis demonstrated, Canada is much more vulnerable to outside shocks than the U.S. For example, the decline in commodity prices since mid-1997 led to a 6% reduction in Canada’s terms of trade (export prices relative to import prices), as contrasted with a 5% increase in the United States.

The principal structural difference between Canada and the United States continues to be Canada’s dependence on commodities. In volume terms, commodity-based exports account for 40% of total Canadian exports and commodity production comprises 15% of our GDP. Even though this share is now only one-half of the corresponding figure from twenty-five years ago, it is still much higher than that of other industrialized countries.

Professor Jack Carr maintained before the Committee that Canada and the United States are not an optimal currency area because there is a negative correlation in the way in which real shocks hit the two economies. (21)

It was also pointed out that unlike in the European community, there is relatively little labour mobility across borders in North America. Even with NAFTA, present immigration policies in Canada and the United States do not allow for a high degree of cross-border labour mobility.

In terms of Euro-land, one important question here is that what makes a common currency or a fixed exchange rate work is that there is mobility of factors across borders; people can move backwards and forwards in response to economic advantages. Europe does have mobility in principle. Whether people use it as much as they could or should is another question, but you can move anywhere in Europe in response to shifting economic circumstances.

However, labour flexibility, or labour factor flexibility, if you wish, is definitely not on the table in North America. In fact, with the North American Free Trade Agreement, moving from the bilateral to the trilateral now, in part from the U.S. point of view the incentive, as they saw it, was essentially to open up economic opportunities in Mexico in order to stop Mexican labour coming across the border. That is quite the reverse of what one would argue in the case of a common currency. (22)

Professor Courchene, on the other hand, contended that Canada is "no longer an optimal currency area in terms of maintaining a stand-alone, freely fluctuating currency."(23) He argued that the optimal currency area for Canada now included the United States. He took this position for reasons of "transactions certainty and accommodating economic shocks and ... pervasive forces triggering North American integration..." (24)

2. Absorbing Economic Shocks through a Flexible Exchange Rate System

Proponents of the status quo point out that a key advantage to the use of flexible exchange rates is their ability to absorb both foreign and domestic economic shocks. They stress that the existing floating exchange-rate system serves as an adjustment mechanism or safety valve. The existence of flexible rates permits smooth adjustment to external economic shocks, such as the large-scale declines in commodity prices resulting from the Asian financial and economic crisis. In the absence of such flexibility, external economic shocks may lead to greater volatility in domestic output, employment and prices.

Through exchange-rate flexibility, the Canadian dollar rises and falls to adjust to various economic conditions (e.g. inflationary periods, economic slowdowns) facing the country. The close relationship between the value of the Canadian dollar and global commodity prices has already been mentioned. When world commodity prices rise, the Canadian dollar is stronger; when they are low, our flexible exchange rate tends to act as a bit of a shock absorber, making Canadian exports more affordable in world markets and keeping the country out of recession. For these reasons, among others, John Crow, and Professors Carr and Wolf argued that Canada should retain its flexible exchange rate.

In his remarks to the Committee, Professor Wolf pointed out that recent commodity price declines had been well absorbed through the flexible exchange rate. If Canada did not have a flexible system, it would have had to accommodate the economic shocks from declining commodity prices through other means that would have had a greater negative impact on the economy.

Despite the strides taken in recent years, Canada's economy remains significantly more exposed to the resource sectors than does the U.S. economy, for 40 per cent of our exports are still resource oriented. The sharp decline in the Canadian dollar related to falling global commodity prices over the past 18 months is testimony to this kind of exposure, and it provides the obvious example of the benefit of flexible exchange rates. I do not decry the fact that the Canadian dollar has gone down; and I agree with my colleague Jack Carr that commodity prices have gone down, and one way or another that must be reflected, and it happens to have been reflected in a lower dollar. In the absence of such downward flexibility in wages and prices in our economy, we could not absorb the shock that way. The currency decline provided the necessary offset and support to the domestic economy, which allowed exports to be fostered, and it encouraged import-competing, production-stimulating investment. If we did not have the flexible exchange rate, we would have had been forced to adopt a very different monetary policy, and that monetary policy would have been extremely detrimental to this economy....

We should also take into account the history here. In the past, the effect has worked the other way, too. If we go back to the period from 1950 to 1970, at that time the generalized rise in commodity prices, which also led to a significant capital inflow into this country, put upward pressure on the currency. This made the maintenance of the existing fixed exchange rate and those at the fixed level impossible, or at least very difficult. Again, if we had not, we would have run into the opposite kind of problems. Commodity exposure is really the best example of the risk of asymmetric shock, a risk that obviously has been realized historically and is still with us. The currency cushion has no obvious substitute at the moment, and its elimination would be extremely risky. (25)

If the "shock absorber" provided by flexible rates were not available, adjustments would have to come through lower output, lower employment and lower wages.

Professor Courchene, on the other hand, took the position that exchange rates do not need to be flexible for a country to absorb economic shocks. Such shocks, he maintained, could be accommodated through internal price adjustments, fiscal policy, the national tax transfer system, employment insurance, equalization, internal migration and the operations of the banking system. (26)

3. The Size Differential between the Canadian and United States Economies

The argument here is that the U.S. would overwhelmingly dominate Canada if a common currency situation were to emerge in North America. Too much financial and political control would be handed over to the Americans. In contrast to the situation in North America, the major European countries such as Germany, France, Spain and Italy possess more highly similar economies and thus are better able to balance their respective interests to conduct a dialogue on policy interests. Enough of the Euro participants are of roughly equal size so as to create a balance of control.

However, the differences between several of the smaller Euro participants and dominant economies in the region such as Germany are proportionately larger. The desire to narrow the differences in employment, investment, and incomes encouraged smaller countries in Europe to join in the monetary union in the first place. The same motivation could also apply to Canada.

The point was made before the Committee that the establishment of the Euro was a rather unique development, in that it came at the end of a combined political and economic initiative aimed at integrating that continent. Professor Wolf suggested that the EMU was just as much a political initiative as an economic one.

The European monetary union did become a reality. The euro did come into existence. However, there are problems. I would suggest that if there had not been a political reason for the EMU, it would not have taken place. This was not an economic decision but a political decision. Just as Professor Carr indicated, there are people who went along with this, who saw that the economics of it was questionable, but who did it for political reasons. Clearly, we know that in Europe the paramount reason for a political point of view was the intertwining of the fates of the participants. Fostering cooperation, particularly between Germany and France in the pursuit of ensuring stability and peace, was seen as a worthwhile goal in spite of what I consider to be the net economic costs. (27)

He also noted that another benefit to the European currency union that would be largely missing from a Canada-United States union would be the reduction of the risk premium on medium and long-term interest rates. Finally, the Committee heard from Mr. Crow that there were almost no lessons from the Euro arrangement that would be applicable to North America.

4. Loss of Sovereignty

Countries joining currency unions lose a degree of economic and political independence by ceding monetary policy-making authority. Historically, many national governments have been reluctant to adopt another country’s currency since they have feared losing control over monetary policy, such as the ability to independently set interest rates or print money. Many economic nationalists and individual Canadians are also concerned that a currency union might ultimately lead to political union.

Under a monetary union, Canada would surrender substantial control over independent monetary policy to the U.S. Federal Reserve or a North American Central Bank, if such a new institution were created. It is unknown how much input Canada would have in the policies of the Federal Reserve or any new institution, given that the population of Canada is only roughly one-tenth that of the U.S. Some, therefore, argue that Canada would simply become the United States’ 13^th federal reserve district and U.S. monetary authorities would more than likely make their monetary policy decisions on the basis of domestic economic considerations.

Losing sovereignty over monetary policy is a concern to John Crow, Professor Carr and Professor Wolf, who argued that in recent years Canada has had a sensible monetary policy. Professor Wolf, for example, was of the view that loss of sovereignty was a more pressing issue for Canada than it was for the member countries of the EMU. He felt that the most significant cost of a monetary union would be the loss of an independent monetary policy. (28)

Professor Carr contended that Canada had nothing to gain from replacing the monetary policies of the Bank of Canada with those of the Federal Reserve.

The adoption of the U.S. dollar essentially means that we replace the monetary policies of the Bank of Canada by the monetary policies of the federal reserve system. Of late, the federal reserve has followed the sensible monetary policy, and the U.S. economy is one of the strongest economies going. That is why, I think, there is some attractiveness in saying, "Let us adopt a U.S. monetary policy." If you look at a broad picture of U.S. monetary policy, unlike Professor Grubel, they have had periods of time when, in the 1970s, things were fairly uncertain with U.S. federal reserve policy. They had high and volatile monetary growth rates, and we would have had those same ones. In fact, some of the data I handed out ... shows the price level in Canada from 1910 to the present. The price level in Canada and the United States ... behaved very similarly. We have had really a very similar monetary policy to the Americans. If we look at the 1970s and 1980s, we had a slightly higher inflation rate. We had 6.7 per cent average inflation; they had 5.8, which is well within the error of measurement in the Consumer Price Index. We have had a very similar monetary policy. I do not see us gaining. (29)

John Crow simply argued that it might be worth giving up authority over monetary policy in circumstances where a country's policy was bad but, where the policy was sensible, a country would not have a strong reason for ceding such authority to someone else. (30)

Professors Grubel and Courchene, on the other hand, questioned whether the loss of sovereignty would be that significant. Indeed, Professor Grubel welcomed the reduction of national economic sovereignty that a monetary union would bring. They also felt that there would not be a loss of political or cultural sovereignty. Professor Courchene noted that many of the institutions and social programs that Canadians hold dear and serve to distinguish us from the U.S. were not instituted during a period of flexible exchange rates, but rather during years of fixed exchange rates.

... that is really at the heart of what I am arguing for; namely, a strong preference for a North American monetary union over straightforward dollarization. The sovereignty-preserving aspects, including the symbolism associated with the currency itself, are able to be maintained. ... In arguing for fixed exchange rates, I looked back, and I said to myself, "What is it in our history that makes us not northern Americans, but Canadians?" Part of it, and only part of it, is our welfare system, our approach to health. Ask yourself, "When did this come about?" It came about largely during the Pearson years, along with equalization, Medicare, hospital insurance; the QPP and CPP and other pension plans and regional economic development. What was characteristic of the Pearson years? We were on a fixed exchange rate with the U.S. from 1962 to 1970. The notion that fixing exchange rates necessarily means that you throw your sovereignty away, I think, is wrong, in the sense that what we cherish most in terms of our social policies came during a fixed exchange rate period. We have to be wary, but I think that the sovereignty issue is not as straightforward as the average person might initially think. (31)

Others, however, are less sanguine about the potential impact of a monetary union on political integration. David Laidler was of the view that even if the creation of a currency union did not produce pressures to harmonize fiscal and social policies, such an arrangement would "require a good deal of de facto political integration between Canada and the United States as far as monetary policy and associated regulatory issues were concerned." (32)

5. Preservation of Seigniorage

Currently, the federal government collects, through the Bank of Canada, a total of $1.4 billion per year in domestic seigniorage (income accruing to the government from issuing currency interest free)(33). Any move to a straight adoption of the U.S. currency could jeopardize the receipt of seigniorage-related revenues. Under a North American monetary union, on the other hand, seigniorage could be preserved as the Royal Canadian Mint could continue to produce currency notes and coins (with a possible North American designation on one side and a Canadian one on the other).

C. CURRENCY ARRANGEMENT OPTIONS

Of the various currency arrangements discussed before the Committee, dollarization was the least favoured. As noted earlier, dollarization involves one country adopting another country's currency as its currency of day-to-day usage. Panama, for example, does not have a central bank that issues bank notes and coins but rather uses U.S. dollars and coins as its currency.

This option was not favoured for a number of reasons including: loss of control over or input into monetary policy, loss of sovereignty, loss of seigniorage to the government of Canada, and the removal of Canadian coins and bills from circulation.

Professor Courchene expressed concern about a gradual drift towards dollarization triggered by an unstable exchange rate as Canadians began to use U.S. dollars first as a unit of account and subsequently as a means of payment.(34)

A currency board was also not a popular option. Despite certain advantages of a currency board such as the ability to maintain seigniorage and issue currency with local symbols, under such an arrangement there would be no independent monetary policy. Witnesses also noted that a currency board's policies could be easily manipulated. Professor Courchene suggested that a currency board might forestall a move toward dollarization or serve as a step along the road to a common currency with the United States.(35) He took the position that a currency board would make sense only in the event that Canada could not adhere to a fixed-rate regime.(36)

Professor Courchene favoured a move from the present flexible exchange rate system to a fixed exchange rate regime. He argued that such a regime could serve as either a long-term policy for Canada or as an interim step toward a common North American currency (37). More particularly, a fixed-rate regime would reduce exchange rate volatility and provide fiscal discipline.

Professor Grubel, however, argued that a fixed exchange rate would not be an appropriate interim solution because of the loss of sovereignty associated with this approach and the ease with which the government could reverse its commitment to the regime. He called for the creation of a North American common currency modelled on the Euro.

Professors Carr and Wolf and Mr. John Crow were of the view that a flexible exchange rate system was appropriate. However, if some form of common currency were to be adopted, Professors Carr and Wolf felt that the only realistic option would be for Canada to adopt the U.S. dollar. They pointed out that the costs of implementing a monetary union were significant and there would be little sentiment in the U.S. in favour of giving up the U.S. dollar for a new currency.

There was some discussion before the Committee about the conditions that would have to exist before a common currency arrangement would be a viable option. Mr. John Crow felt that two conditions would be necessary -- inappropriate Canadian policies and the willingness of the U.S. to support such an arrangement (38). Professor Carr felt Canada should consider adopting a common currency with the U.S. when it could trust the policies of the U.S. federal reserve.(39) Professor Wolf took the position that a common currency might be possible if Canada and the United States had a similar economic profile, Canada reduced its dependence on resource industries, labour mobility between the two countries increased and the U.S. was receptive to such an arrangement. (40)

Professor Grubel felt that it was necessary to begin a public debate on the common currency question and to create a climate where a common currency would become a viable alternative to the present flexible exchange rate system.

Arguing that the conditions that would allow for a currency arrangement with the United States are now in place, Professor Courchene maintained that a process to achieve that end was lacking.

APPENDIX 1 – WITNESSES

ISSUE NO.

DATE

WITNESSES

March 25, 1999

From the Simon Fraser University:

Professor Herb Grubel, Department of Economics.

From the John Deutsh Institute for the Study of Economic Policy, Queen’s University:

Professor Thomas J. Courchene, Department of Economics.

From the University of Toronto:

Professor Jack Carr, Department of Economics.

From York University:

Professor Bernard Wolf, Department of Economics.

The Former Governor of the Bank of Canada:

Mr. John Crow.

NOTES

Morgan Guaranty Trust Company, Monetary Union in the Americas, Economic Research Note, 12 February 1999, p. 3.
Herbert G. Grubel, The Case for the Amero: The Merit of Creating a North American Monetary Union, Draft paper prepared for the Fraser Institute, March 1999, p. 36-37.
Senate of Canada, Proceedings of the Standing Senate Committee on Banking, Trade and Commerce, 25 March 1999, Issue 48:31-33. (hereafter referred to as "Evidence")
Thomas J. Courchene, Towards a North American Common Currency: An Optimal Currency Area Analysis, Paper prepared for the Sixth Bell Canada Papers Conference "Room to Manoeuvre? Globalization and Policy Convergence", November 5-6, 1998, p. 29.

Evidence, Issue 48:37.

Evidence, Issue 48:61-62.
Grubel (1999), p. 14.

Ibid., p. 17.

Ibid.

Evidence, Issue 48:36.

Evidence, Issue 48:46.
Grubel (1999), p. 29.

Ibid., p. 28.
Courchene (1998), p. 27.
John Crow, "A 'common currency' for Canada?", 24 March 1999, p. 2-3.
David Laidler, "The Exchange Rate Regime and Canada's Monetary Order", Bank of Canada, Working Paper 99-7, March 1999, p. 8.
Grubel (1999) p. 11.

Evidence, Issue 48:34.

Evidence, Issue 48:41-42.

Evidence, Issue 48:44.

Evidence, Issue 48:46.

Evidence, Issue 48:43.
Courchene (1998), p. 35.

Ibid.

Evidence, Issue 48:48.
Courchene (1998), p. 31.

Evidence, Issue 48:50.

Evidence, Issue 48:48.

Evidence, Issue 48:45.

Evidence, Issue 48:75.

Evidence, Issue 48:56.
Laidler (1999), p. 12.
Grubel (1999), p. 37.
Courchene (1998), p. 48.

Ibid., p. 44.

Ibid., p. 49.

Ibid., p. 50.

Evidence, Issue 48:86.

Evidence, Issue 48:87.

Ibid.