ECONOMY OF MONETARY INTEGRATION:
LESSONS FROM EUROPE FOR CANADA -
A REPORT FROM A CONFERENCE
20 October 2000
TABLE OF CONTENTS
CASE FOR A NAMU
UNDERLYING THEORY: MUNDELLS OPTIMUM CURRENCY AREA
CASE AGAINST A NAMU
CLOSER LOOK AT THE EUROPEAN EXPERIENCE:
ANALYSIS FROM THE CONFERENCE
ECONOMY OF MONETARY INTEGRATION:
LESSONS FROM EUROPE FOR CANADA -
A REPORT FROM A CONFERENCE
If all goes as planned,
the French Franc, the German Mark and the Italian Lira (among others)
will virtually disappear from day-to-day use by the middle of 2002, closing
at least one chapter in the long history of European nationalism. At that
point, the Euro will become the medium of exchange for the 11 countries
that make up the Economic and Monetary Union (EMU).(1)
This means that the Euro will be used to pay salaries, fund social programs,
and buy goods and services throughout the Euro-11.(2)
The road to 2002 has not been easy. Since its inception in January 1999,
the Euro has fallen roughly 27% (see Figure 1) against the U.S. dollar,
defying the predictions of most economists and observers who thought the
strict conditions laid out in the Stability and Growth Pact, as well as
the more general edicts in the Maastricht Treaty, would ensure a strong
currency.(3) Indeed, most recent academic
research suggests the Euro is at least 15% cheaper than it should be.(4)
Despite the less-than-stellar
performance of the Euro so far, some prominent Canadian economists have
suggested that Canada, the United States and Mexico pursue a similar path.
Thomas Courchene of Queens University and Richard Harris of Simon
Fraser University (1999), for example, have argued in favour of a North
American Monetary Union (NAMU) and some prominent politicians have said
they would not dismiss the idea out of hand.
CASE FOR A NAMU
Before considering the various
arguments presented at the conference on the Political Economy of Monetary
Integration: Lessons from Europe for Canada, held in Ottawa in September
2000, it is worth briefly revisiting the key elements of the Thomas Courchene
and Richard Harris argument. It hinges on two key propositions.
a flexible exchange-rate regime has not served Canada well,
contrary to statements by Bank of Canada Governor Gordon Thiessen
and other prominent economists. In fact, they suggest that flexible
exchange-rate regimes are plagued by a tendency for currencies to
"overshoot" their long-run purchasing power parity rate
and to be consequently "misaligned" relative to the economic
and financial fundamentals.(5)
This imposes severe and distortionary costs.
Canada must seek a NAMU now or suffer the consequences of creeping
dollarization, a process they argue is already well underway and that
would not prove so advantageous to Canada.(6)
Courchene and Harris outline
three key benefits that might flow from a currency union similar to Europes.
currency union would eliminate some of the uncertainty inherent in
a flexible exchange-rate regime. Uncertainty is costly to firms because
it forces them to adopt complicated and sometimes risky hedging strategies.
They have to hire university graduates with doctorates in public finance
and mathematics to ensure that abrupt changes in currencies do not
cause losses on otherwise sound investments. Currently, firms wishing
to avoid these risks and costs would tend to favour investments in
the United States. Furthermore, Courchene and Harris suggest that
the misalignment of the Canadian dollar (because of the flexible exchange
rate) has distorted price signals and consequently sheltered many
Canadian exporting firms, which has also hurt Canadian productivity.
In other words, the flexible exchange rate has so distorted prices
that firms have made bad long-term investment decisions. Similarly,
Canadian firms would no longer have to worry about losing workers
to the United States because they cannot afford to pay U.S. dollar
moving away from a floating exchange rate towards a NAMU-type arrangement
would reduce transaction costs associated with converting one currency
into another. Similarly, a currency union would reduce the (menu)
costs associated with publishing financial results in two currency
fixed exchange rate or NAMU regime would encourage wage and price
flexibility much as is starting to happen in Europe. In other words,
demand and supply shocks would no longer be absorbed by the exchange
rate but by wages and prices "as firms and workers become more
conscious of their competitive positions in North America" (Courchene
and Harris, Introduction: "Main Findings," 1999).(7)
UNDERLYING THEORY: MUNDELLS OPTIMUM CURRENCY AREA
Most of the arguments in
favour of NAMU or, for that matter, any notion of a common currency, rest
on the work of Robert Mundell, who earned a Nobel prize in part for his
"optimal currency area" (OCA) theory. At its core, this theory
says that OCAs should have high labour and capital mobility, a high degree
of product market integration, and a synchronized business cycle both
in timing and amplitude. In other words, there should already be
strong economic linkages in the area under consideration. In his original
1961 paper, Mundell proposed a two-currency area for Canada and the U.S.:
one linking eastern Canada with the eastern U.S. and another linking western
Canada with the western United States. The Courchene and Harris argument
falls back on a similar observation, namely that Canadas economic
links are increasingly (much more so than in the 1960s) north-south rather
Alain Parguez, a conference
participant and professor at the University of Bourgogne in France, argued
that the OCA argument has even deeper theoretical roots. The 19th century
economist Karl Menger argued that the choice of the medium of exchange
occurred historically without any intervention by government. In straightforward
terms, everyone eventually realized it was in their own best interest
to adopt a common currency to minimize transaction costs. The existence
of many currencies, in other words, is costly. Economic efficiency demands
a single currency which a free market will provide. This is the historical
and, indeed, theoretical foundation for Mundells theory.
CASE AGAINST A NAMU
A number of prominent Canadian
economists including David Laidler (1999) and John McCallum (2000)
have come out against the NAMU proposal, arguing in essence that
the existing flexible exchange-rate system has served Canada well. They
have two arguments.
argument is that a floating exchange rate helps cushion the economy
from adverse economic shocks such as an increase in oil prices or
a financial crisis such as the Asian debacle in 1997-1998. Absent
this kind of currency system, a negative shock would quickly and painfully
translate into higher unemployment and reduced output, assuming some
sort of wage "stickiness." Wage rigidity theory says that
workers rarely accept cuts in their nominal wages although they may
allow inflation to erode the real value of their wages. They may,
in other words, suffer from some kind of monetary illusion where they
allow themselves to be fooled into thinking that their income has
not changed when in fact it has in real terms. Alternatively, they
may be more concerned with their relative place in society. In that
case, workers may be willing to accept a real-wage cut brought on
by a generalized price increase for a purely rational reason: Everyone
is affected in roughly the same way so that there is no relative loss
of social standing, especially in ones more immediate peer group.
A nominal wage cut, however, will generally worsen ones relative
position in a peer group.(9)
If wages are not sticky, than money wages and prices bear the
full brunt of the shock and this could have consequences for demand,
again implying slower output and higher unemployment.(10)
argument, complementary to this first one, says that the Canadian
economy is in fact quite different than that of the United States
because much of Canadas output comes from the commodity sector
and must be exported because of insufficient internal demand. The
U.S., on the other hand, suffers from a chronic excess of demand and
insufficient exports. This suggests, says Laidler (quoted by Spotton
Visano, p. 11) that "the real Canada-U.S. exchange rate, the
relative value of a representative Canadian-produced bundle of goods
and services in terms of its U.S. counterpart, must change, regardless
of the regime governing the behaviour of the nominal exchange rate."
In other words, given the different natures of the U.S. and Canadian
economies, a shared currency cannot be justified economically.
CLOSER LOOK AT THE EUROPEAN EXPERIENCE:
ANALYSIS FROM THE CONFERENCE
Interestingly, the EMU has
gone ahead despite a general consensus that the EMU-11 do not, in fact,
meet the OCA criteria.(11) U.S.
economist Thomas Palley, of the AFL-CIO (a large U.S. union), argued at
the conference that pursuing monetary union and especially the so-called
"Harmonized Index of Consumer Prices" (HICP) inflation target
of 2% given the lack of an OCA could therefore prove costly
especially to workers, who would bear the brunt of this policy in the
form of even higher unemployment. The thrust of his argument is that monetary
policy can have dramatically different effects across regions because
these regions are not well integrated.(12)
Later in his paper, Palley presented some new empirical tests for evaluating
whether a region really is an OCA. Much like Mundell and Courchene and
Harris, he found some evidence suggesting that Canada and the United States
are a good fit. Palley did not, however, conclude from this that currency
union is a good idea for Canada. His objection boils down to concerns
about the reduced scope for fiscal policy, a view echoed by many at the
Stephanie Bell, a professor
at the University of Missouri at Kansas City, was equally concerned about
the loss of fiscal manoeuvring room implicit in a currency union. She
suggested that adopting the EMU and, by implication, the NAMU
was tantamount to driving the economy without a steering wheel. The thrust
of her argument is that the EMU effectively robs nation-states of their
fiscal power with or without the limitations on deficit-financing or debt-to-equity
ratios imposed by agreements such as the Maastricht Treaty and the Growth
and Stability Pact. Her reasoning is straightforward: because national
central banks are no longer permitted to issue treasury bonds on behalf
of their governments and because the European Central Bank (ECB) is not
allowed to directly or indirectly monetize government debt, governments
that want to deficit spend have no choice but to float bonds on the capital
market, where they must compete with the financing needs of private borrowers.
"It may well be that financial markets if they can price risk
correctly will be able to impose discipline by constraining public
spending without the need for penalties for fiscal violations" (Bell,
p. 21). The corollary to this argument, of course, is that nation-state
debt (in the Euro-11) will no longer be considered default-risk-free,
as is currently the case for the United States, Canada and other major
countries who can, as a last resort, always repay their debt simply by
"printing money."(13) The
end result is that Euro-11 countries with high debt-to-equity ratios will
likely face higher interest rates when they borrow and, consequently,
have less scope for fiscal policy. The implications for Canada are clear:
any attempt to adopt a system similar in structure to the EMU will effectively
reduce the Canadian governments room to adopt independent and cost-effective
Marcello de Cecco, a professor
from the Università di Roma "La Sapienza," looked at the Euro
from an historical geo-political perspective, noting that Germany, France
and (Northern) Italy form the core of Europes industrial base and
are the driving force behind the Euro zone. This area whose economic
might rivals that of the United States and Japan has been largely
driven by an export-oriented economy much like Japan. To some extent,
this orientation was set in motion by the U.S., which guaranteed access
to its market (and hence aggregate demand) after World War II as part
of a broader attempt to stabilize the area (again, a similar policy was
pursued with Japan). Relying on this historically rooted analysis, de
Cecco accurately predicted at the outset that the Euro would lose value
against the U.S. dollar if only out of necessity: Euro-11 politicians
would make the appropriate noises pressured by their respective
manufacturing sectors to drop the Euros value because internal
demand simply couldnt keep up with output. At the same time, the
U.S. Federal Reserve has effectively assured a strong dollar by keeping
(relative) interest rates high. The implications of de Ceccos argument
for Canada are somewhat less clear, although Canada is highly reliant
on its exports to the U.S. market. Still, de Cecco, like Bell, was concerned
about the lack of fiscal control under a currency union and did not advocate
such a system for Canada.
Simon Fraser University
professor James Dean suggested that Canada is a poor candidate for dollarization
based on his analysis of the "de facto" dollarization
taking place in Latin America. He believes that Latin America should move
to dollarize "de jure" (i.e., legally) for four principle
reasons, none of which apply to Canada.
most Latin American countries have putatively flexible exchange rates,
real exchange rates almost never depreciate because exchange-rate
fluctuations quickly translate into higher domestic prices. This is
due, at least in part, to cost-of-living adjustments (COLAs
or wage indexation) built into the wage structure of many Latin American
countries. Exchange-rate policy is therefore impotent.
exchange-rate depreciation (one of the key advantages of a flexible
rate) have become too dangerous because of the large amounts of dollar-denominated
debts held by residents of those countries.
use of U.S. cash is so widespread that it may be virtually impossible
short of draconian government action to revert to a
national currency. This is at least in part the result of so-called
"network externalities," a term that captures the idea that
frequent and public use of the dollar by some people makes it more
generally accepted by others.
dollarization increases the currency risk premium on Latin American
interest rates, at least in part because so many debts are denominated
in U.S. dollars and the government has limited ability to pay these
According to Dean, Canada
faces none of these problems, at least to any serious degree. He explains
his position by offering four arguments.
of the U.S. dollar in day-to-day transactions is very low in Canada
compared with Latin American countries. Canada also does not have
the same degree of wage indexation as Latin America, and the Bank
of Canada has taken measures to keep inflation subdued.
although Latin American countries find it difficult if not impossible
to sell bonds denominated in their domestic currencies, the same is
not true in Canada.
Canadian banks are net debtors in U.S. dollars, Canadian firms and
banks generate significant U.S. revenues. Also, bank balance sheets
tend to be much better managed than those of their Latin American
counterparts. In other words, they have no difficulty meeting their
commitments and are relatively immune to dramatic changes in the currency.
and more importantly, although Latin American interest rates are generally
higher than in the U.S. because of a risk premium, Canadian interest
rates have been lower than in the U.S. for quite some time. In other
words, Canada still has room to conduct independent monetary and fiscal
Parguez, for his part, looked
at what a NAMU would mean in concrete terms. He asked, for example, how
would Canadian dollars and Mexican pesos be converted into U.S. dollars?
(Parguez argued that the U.S. is unlikely to abandon its currency, which
means that Canada and Mexico would have to dollarize). How would the new
central bank allocate the money supply between the three countries? What
are the institutional consequences of NAMU? Drawing on his knowledge of
Europes move to the EMU, Parguez argued that Canadian dollars and
Mexican pesos would probably be converted into U.S. dollars based on the
average (or long-run) exchange rate since the NAFTA established a de
facto economic union between the three nations. Canadians and Mexicans
would lose out on this conversion to the extent that their currencies
have been under-valued relative to that of the United States.(14)
Philip Arestis (South Bank
University, UK) evaluated competing theories behind the Euros dramatic
decline since its inception in 1999 (see Figure 1). Arestis and his co-authors
(see references section) dismissed arguments claiming the Euros
decline (15% away from its purchasing power parity, according to research
by Deutsche Bank Group) is due to short-term circumstances that amount
to little more than "bad luck." History, they argue, shows underlying
and identifiable causes for these deviations. Others have suggested that
interest-rate differentials explain the Euros fall. However, a closer
analysis of the data shows that the real-interest rate differential has
remained roughly constant since January 1999. They conclude that most
of the decline is probably due to long-term investment flows out of Europe
because of the better returns offered in the fast-growing U.S. economy.
These flows stem, at least in part, from a lack of confidence in the Euro
which is in turn rooted in weaker European fundamentals (higher unemployment,
larger debts, etc.). Unlike most commentators, however, Arestis does not
conclude from this that Europe must weaken its labour market institutions
and pursue more strict financial requirements (debt-to-GDP ratios, etc.).
Rather, Europe is lacking what the U.S. has in spades, namely aggregate
demand (albeit driven by record levels of consumer indebtedness). To achieve
this will require, he argues, coordinated fiscal and monetary policies
that are almost impossible to work out under the current system, with
its divorced political institutions (working at the national level) and
monetary institutions (working at the supra-national level).
John Smithin (York University)
and Markus Marterbauer (Austrian Institute of Economic Research)
developed a model for a small open economy in a monetary union which showed
that, given certain assumptions and the limitations imposed by the various
European treaties, the scope for independent fiscal policy is much reduced.
Under the Euro-11, "only differences in tax rates would allow for
differences in expenditures rates" (Smithin and Marterbauer, p. 22).
All other things being equal, their model shows that taxes can be higher
in country A than in country B given higher productivity, higher expected
prices and lower after-tax profit rates, nominal interest rates and after-tax
wages. Given that nominal interest rates are set supra-nationally, this
means that small open economies within a currency union can only increase
taxes (and hence expenditures) through higher productivity and expected
inflation or lower after-tax wages. Offsetting these possibilities, however,
will be competitive pressure towards harmonized tax rates. A textbook
analysis suggests that tax rates will fall for the most mobile factors
(capital, highly skilled labour) and rise for the least mobile (less-skilled
labour). The end result is, again, that labour bears the brunt of the
move towards currency union. Again, the Smithin and Marterbauer argument
hinges on the notion that the Euro-11 do not, in fact, meet the criteria
for an OCA. In other words, although labour may be perfectly mobile in
law, it is not in fact (due to language barriers, attachment to home,
imperfect information, etc.).
Finally, Brenda Spotton
Visano addressed the question of how technology might affect existing
and future currency unions. More explicitly, she wonders whether technology
has severed the (presumed) transmission mechanism from monetary policy
to the real economy. "Recent advances in capital market structures
and process suggest the potential of a real threat to central bank monopoly
over the clearing of final settlements balances a monopoly that
is critical to any known story of monetary authority influence."
In other words, rapid technological change which may permit a private
clearing system to operate without a central bank could render
the whole idea of a monetary union and, for that matter, central banks
other than the U.S. Federal Reserve, obsolete.
Virtually all of the authors
at the conference offered evidence and arguments suggesting monetary union
with the United States and Mexico may not be in the best interest of a
sovereign Canada, especially one intent on pursuing independent fiscal
and monetary policy. Although few disputed the presumed benefits of a
monetary union (reduced uncertainty and transaction costs), most downplayed
the size of these benefits, especially relative to the costs that might
follow from a loss of control over domestic economic policy. Indeed, some
commentators were not convinced that Europe or North America constitute
OCAs. Some even suggested that the U.S. cannot logically be considered
an OCA given the vast economic differences that exist between its western
(entertainment, high-technology, and aircraft manufacturing) and eastern
regions (industrial and financial centres), not to mention its northern
(large-scale wheat, canola and dairy agriculture, some industrial base)
and southern areas (agriculture, oil and gas). If anything, these differences
were even more pronounced when the U.S. dollar first came onto the scene.
The existence of a single currency in the United States and in most countries
speaks to the fact that geo-political and historical factors are and will
probably continue to be necessary conditions for a successful and strong
currency. Indeed, most authors stressed that the great failing of the
Euro has been the way it divorces the political from the economic. The
only workable Euro solution, it seems, might be one that takes the process
a step further by moving the political process and not just the
monetary and economic process to a supra-national level. The same
is true, they argue, for Canada.(15)
Philip, Iris Biefang-Frisancho Mariscal, Andrew Brown and Malcolm
Sawyer. "The Cause of Euro Instability." 2000.
"Common Currency Lessons from Europe: Have Member States Forsaken
their Economic Steering Wheels?" 2000.
"Why Ecuador is Ripe for Dollarization, but not Canada."
Marcello. "The Euro: A Preliminary Assessment." 2000.
Thomas I. "Monetary Policy in Imperfect Currency Unions: Lessons
for the European Central Bank." 2000.
Alain. "The Theory and Practice of European Monetary Integration:
Lessons for North America." 2000.
John and Markus Marterbauer. "Fiscal Policy for the Small Open
Economy under Currency Union." 2000.
Visano, Brenda. "Electronic Finance and Exchange Rate Regimes:
Industry Changes and the Question of a Single North American Currency."
Matias and Louis-Philippe Rochon. "Does NAFTA Need a Common Currency:
An American Perspective." 2000.
Eric. "Alliance Adds Single Currency to Debate." The Ottawa
Citizen. Wednesday, 18 October 2000.
Thomas J. and Richard G. Harris. "From Fixing to Monetary Union:
Options for North American Currency Integration." C.D. Howe Institute.
David. "The Exchange Rate Regime and Canadas Monetary Order."
Bank of Canada Working Paper 99-7. 1999.
D. and F. Poschmann. "Leaving Well Enough Alone: Canadas Monetary
Order in a Changing International Environment." C.D. Howe Institute.
John. "Engaging the Debate: Costs and Benefits of a North American
Common Currency." Current Analysis (Royal Bank of Canada).
The EMU acronym is frequently and mistakenly thought to mean European
Monetary Union. Note also that France, Germany and Italy have the biggest
economies of the Euro-11. Other countries involved in the currency union
include Austria (Schillings), Belgium (Franc), Finland (Markka), Ireland
(Punt), Luxembourg (Franc), Netherlands (Guilders), Portugal (Escudo),
and Spain (Pesetas). The European Union includes 15 countries. Four
have opted out of the Economic and Monetary Union. They are Sweden, Denmark,
Norway and the U.K.
Foreign-exchange and money-market transactions are already conducted in
These conditions include a provision forbidding deficits in excess of
3% of GDP and requiring a debt-to-GDP ratio of less than 60%.
See, for example, an investigation by Deutsches Bank Research (2000).
In other words, we are always in disequilibrium and so our relative prices
are more often than not, wrong.
Little evidence is offered to support this position. In fact, Laidler
and Poschmann (2000, p. 9, quoted by Spotton Visano, p. 10) argue that
the degree of dollarization today is roughly where it was in the 1970s.
What is known is that if the currency does not absorb the shock, the real
sector must. What we are not sure about is the extent to which the shock
will be absorbed by prices or by output.
These arguments ultimately rest on the standard, textbook analysis that
places primacy on moneys medium of exchange role and that posits,
consequently, the long-run neutrality of money.
This argument is obviously closely tied to notions of fairness and social
standing. George Akerlof and Janet Yellen explored this issue in a seminal
1990 article from the Quarterly Journal of Economics called
"The Fair Wage Effort Hypothesis and Unemployment."
This can be seen by remembering that debt is valued in nominal terms.
In other words, a $100 debt before the economic shock is still a $100
debt after the shock. If the shock is a deflationary one (like the Asian
financial crisis), then people will find it harder to pay off their debts
and consequently will have to devote a greater portion of their income
to debt repayment instead of consumption. The "real value" of
their debt, in other words, will have increased. This can be seen by remembering
that real debt is simply debt/price: a fall in prices increases this ratio;
the converse is true for an inflationary shock.
See Tamim Bayoumi and Barry Eichengreen, "Shocking Aspects of European
Monetary Unification," F. Giavazzi and F. Torres, eds., The Transition
to Economic and Monetary Union in Europe, New York: Cambridge University
To understand Palleys argument, it might be useful to use an analogy.
Consider a teacher facing a single classroom with many students, all of
different abilities. If the teacher teaches at too high a level, then
the weaker students suffer. Likewise, if the teacher makes the material
too easy, then the best students find themselves bored with too much time
on their hands. The first scenario is analogous to a high interest rate
environment that hurts the poor and increases unemployment. The second
is analogous to a low interest rate environment that is inflationary.
Of course, the different students and their abilities is analogous to
the very different nature of the Euro-11 economies and their relative
Of course, any country that resorted to this act ("printing money")
might lose credibility in the international financial community because
the "real" value of its repayments could be very small if the
repayment sparked inflation and caused the exchange rate to depreciate.
Recall that this is a key element in the Courchene and Harris argument.
Some commentators noted that this may account for the Bloc Québécois
support of NAMU proposals.