SHOULD NORTH AMERICA HAVE ONE CURRENCY? (Paper submitted for the Cambridge Mercantile Foreign Exchange Essay Prize)

Transcription

1 SHOULD NORTH AMERICA HAVE ONE CURRENCY? (Paper submitted for the Cambridge Mercantile Foreign Exchange Essay Prize) Nicholas Kim Joint MBA/LL.B. Candidate Schulich School of Business Osgoode Hall Law School 01 November, 2006

2 1. Introduction To answer the main question of whether North America 1 should have one currency, it is important to first recognize that there are two main regimes, or variations thereof, by which North America could have a single currency; namely, a unilateral monetary union and a multilateral monetary union. A unilateral monetary union is a regime whereby one country formally gives up its own currency and adopts as its sole legal tender a stable foreign currency, most commonly the U.S. dollar. 2 This is often described as dollarization, and an existing example of this regime is Ecuador s formal use of the U.S. dollar as its sole legal tender. 3 In contrast, a multilateral monetary union is a regime whereby multiple countries agree, among other things, to formally give up their own currencies and adopt a new legal tender for greater monetary integration. 4 The formation of a European monetary union ( EMU ) and the adoption of a new common currency, the Euro, among members of the European Union is a modern example of a multilateral monetary union. 5 With the successful launch of the Euro, there has been significant debate over a North American multilateral monetary union ( NAMU ) and the adoption of a new common currency, often hypothetically referred to as the Amero. 6 Given the two contrasting regimes by which North America could have one currency, this paper argues that neither one is currently a realistic alternative to the present system of flexible exchange rates. The current state of economic and political affairs in the North American region is arguably not only far from ready, but also uniquely different from other regions of the world where the two alternative regimes in question have been successfully implemented. So, to the main question of whether North America should have one currency, this paper answers: Not anytime soon. 1

3 2. Unilateral Monetary Union: Dollarization When contemplating how a unilateral monetary union may apply in a North American context, it is fair to say that it is more likely that Canada and/or Mexico would adopt U.S. s currency and not the other way around. The current economic reality is that the U.S. is far more credible, powerful and internationally significant than Canada or Mexico (or both combined) and, as such, the U.S. has no rational reason to adopt the Canadian dollar or the Mexican Peso. 7 With this hypothetical scenario in mind, it is argued here that dollarization may be currently beneficial to Mexico but not to Canada. Some of the potential benefits of dollarization are lower international borrowing costs and deeper integration into the world markets. 8 These benefits, however, are only really applicable to countries that have low-credibility currencies, no way of establishing financial respectability in the short run, great difficulty developing internal long-term markets in their domestic currency or engaging in significant amounts of borrowing in their own currency from their own financial systems. 9 Given these qualifications, one may make a case, albeit a weak one, that Mexico fits this profile and, thus, can benefit from lower international borrowing costs and deeper integration into world markets. On the other hand, however, it would be extremely difficult to argue that Canada currently fits this profile since Canada is one of the very few countries that possess, among other positive things, monetary discipline, stable government institutions, a credible commitment to the rule of law and open foreign investment policies. One major drawback of dollarization is the loss of seigniorage 10 revenue for the government of the dollarizing country. 11 If Mexico were to adopt the U.S. dollar as its sole legal tender, the Mexican government would lose about 4.7% of total government revenue, or roughly USD$3.8 billion per year. 12 Similarly, if Canada were to adopt the U.S. dollar as its sole legal tender, the Canadian government would lose about 1.5% of total government revenue, or roughly CAD$2.5 billion per year. 13 Given the material amounts at stake, neither Canada nor Mexico should be willing to give away their seigniorage revenue without compensation from the U.S., a proposition that is currently unacceptable for the U.S. 14 In theory, the U.S. could enter into a seigniorage-sharing arrangement with Canada and/or Mexico; 15 however, there is no strong incentive for the U.S. to enter such an arrangement since it has no particular interest in seeing Canada or Mexico dollarize in the first place. Some economists argue that there is a real threat to the U.S. dollar resulting from the greater use of the Euro in place of the [U.S.] dollar in the rest of the world. 16 However, this argument is still highly speculative since there is no compelling evidence supporting this to be the case. 17 All in all, given the economic and political realities of the North American region, it is argued here that dollarization may be currently beneficial to Mexico but not to Canada. 2

4 3. Multilateral Monetary Union: NAMU Proponents of a North American multilateral monetary union ( NAMU ) have cited many benefits that members of the European monetary union ( EMU ) have been able to realize such as the elimination of currency trading costs, expansion of trade, less exchange rate risk, greater price stability, increased labour-market discipline and so on. 18 When contemplating whether a multilateral monetary union is currently viable in North America, it is important to first recognize that there are key economic and political differences between the Eurozone 19 and North America, which may make a North American multilateral monetary union currently unrealistic. First of all, since World War II, Europeans have dreamt of a united Europe to prevent future European wars, and they see a [multilateral] monetary union as a logical step along this path to political integration. 20 It is highly doubtful that this sentiment of unity and political integration currently exists in North America. Secondly, the level of free labour mobility that has been present in the European Union is arguably far from reality in North America. This is evidenced by the U.S. government s recent plan to spend more than $2 billion on a U.S./Mexico border fence aimed to prevent illegal immigrants. 21 Similarly, the aftermath of 9/11 has seen greater restrictions on the movement of people across the U.S./Canada border. 22 These examples partly reflect North America s current attitude on border liberalization and labour mobility, two elements that many economists like Robert Mundell deem necessary for a successful multilateral monetary union. 23 Thirdly, members of EMU are relatively equal in size. A potential NAMU would consist of one large member (the U.S.) and two significantly smaller members (Canada and Mexico). This substantial difference in member sizes would likely mean that Canada and Mexico would need to incur substantial transition costs related to acquiring U.S. currency. 24 This transition cost was essentially negligible for members of EMU since they were similar in size and had previously developed similar policies prior to the launch of the Euro. 25 Fourthly, Canada s lukewarm support for the U.S. war in Iraq has arguably soured political relations between the two countries, or at least their governments. The U.S. government s disappointment with Canada was indirectly made known when President George W. Bush publicly declared Mexico America s best friend and closest partner, 26 a title long and undisputedly held by Canada prior to the war in Iraq. Finally, some observers argue that NAMU is a small and logical step from NAFTA. 27 The recent trade dispute between the Canadian softwood lumber sector and the U.S. government may suggest otherwise. A critical examination of how events unfolded throughout this dispute may lead one to believe that, even with NAFTA, Canada ultimately has little or no power when push comes to shove or when stakes are high. If this is in fact true, a North American multilateral monetary union may not be such a small and logical step from NAFTA, as some observers seem to suggest. All in all, given the economic and political differences between the Eurozone and North America, it is argued here that a multilateral monetary union may be currently unrealistic in North America. 3

5 4. Flexible Exchange Rates: The Status Quo When contemplating whether North America should adopt a new monetary regime, it is important to first understand the benefits of maintaining the status quo; presently, a system of flexible exchange rates. First of all, a free-floating exchange rate regime provides a country with flexibility to deal with economic shocks. 28 When commodity prices plunged during the Asian crisis, the Canadian dollar was able to absorb this economic shock by significantly depreciating. Meanwhile, however, the Canadian economy was able to successfully navigate through this turbulent period, with notable economic growths in 1998 and Looking back, the depreciation of the Canadian dollar proved to be a temporary buffer, as demonstrated by the steady climb of the Canadian currency following the Asian crisis. 30 Secondly, a flexible exchange rate regime enjoys the benefits of having a lender of last resort. 31 In a system of domestic banks with limited reserves, having a lender of last resort is crucial for reassuring depositors and creditors that their claims will be honoured on demand. If there is no lender of last resort, confidence crises and bank runs become more likely and more damaging if they occur. 32 Economists have shown that bank panics in the U.S became less frequent after the establishment of the Federal Reserve. 33 Thirdly, having different domestic currencies provide governments with seigniorage revenue. 34 As previously mentioned, the Mexican and Canadian governments receive, on average, USD$3.8 billion and CAD$2.5 billion per year, respectively. This number is significantly higher for the U.S. government (on average 0.4% of GDP per year), which can be attributed to the larger size of the U.S. economy, the wide-spread use of the U.S. dollar as the preferred currency in crossborder transactions, and the dollarization of various Latin American countries such as Ecuador and Panama. Last, but not least, a flexible exchange rate regime gives a country monetary sovereignty or control over its own monetary policy. 35 As the world s largest and most prosperous economy, the U.S. has no compelling reason to give foreigners a seat on the Federal Reserve, or a variation thereof, where monetary policy that affects its economy can be influenced. 36 Similarly, Canada has gone through considerable pain to establish monetary discipline under John Crow and turn its deficits into surpluses under Paul Martin and others. 37 To risk undoing this celebrated work seems doubtful and arguably imprudent. As far as Mexico is concerned, the Mexican government appears quite content with its monetary sovereignty, arguing that the free-floating exchange rate is one reason the country has been able to weather financial turbulence emanating from Asia, Russia, and Brazil. 38 All in all, given the current economic and political realities of the North American region, it is argued here that North America should maintain the status quo (i.e., the system of flexible exchange rates). 4

6 5. Conclusion As Milton Friedman once similarly put it, when political and economic boundaries do not match, this system of monetary unions is bound to be unstable. 39 Given the two contrasting regimes by which North America could have one currency, this paper argues that neither one is currently a realistic alternative to the present system of flexible exchange rates. The current state of economic and political affairs in the North American region is arguably not only far from ready, but also uniquely different from other regions of the world where the two alternative regimes in question have been successfully implemented. So, to the main question of whether North America should have one currency, perhaps North America should have a single currency one day. That day, however, may not be in the cards anytime soon as argued in this paper. As John McCallum once conceded: Suppose Bob Mundell is right, and suppose in the grand sweep of history the world evolved to only three currencies, two currencies, one currency. I will concede that if the world would otherwise have only three currencies, the Canadian dollar will not be the fourth. But I would also say that if you believe even half of what I have just said, then we should not do anything to accelerate this grand historical sweep. 40 5

7 1 For the purposes of this paper, North America refers to the three largest North American countries; namely, the United States of America, Canada, and Mexico. 2 Berg, Andrew, and Borensztein, Eduardo (2000). The Pros and Cons of Full Dollarization. IMF Working Paper. 3 Ecuador adopted the U.S. dollar as its sole legal tender in March of 2000 to address its on-going economic crisis. 4 Furstenberg, George von (2000). Does North America need an Amero? Policy Options, September Initially, only eleven of the fifteen members of the E.U. adopted the Euro. 6 Grubel, Herbert G. (1999). The Case for the Amero: The Economics and Politics of a North American Monetary 7 Robson, William B.P. and Laidler, David (2002). No Small Change: The Awkward Economics and Politics of North American Monetary Integration. C.D. Howe Institute. Commentary No July Berg, Andrew and Borensztein, Eduardo (2000). The Pros and Cons of Full Dollarization. IMF Working Paper. 9 Furstenberg, George von (2000). Does North America need an Amero? Policy Options, September Seigniorage are the profits accruing to the monetary authorities from its right to issue legal tender currency. 11 Arellano, Cristina and Heathcote, Jonathan (2005). Dollarization and Financial Integration. University of Minnesota. Working Paper. 12 Chang, Roberto (2000). Dollarization: A Scorecard. Federal Reserve Bank of Atlanta. Economic Review. 13 Grubel, Herbert G. (1999). The Case for the Amero: The Economics and Politics of a North American Monetary 14 Berg, Andrew and Borensztein, Eduardo (2000). The Pros and Cons of Full Dollarization. IMF Working Paper. 15 Humpage, Owen F. (2002). An Incentive-Compatible Suggestion for Seigniorage Sharing with Dollarizing Countries. Federal Reserve Bank of Cleveland. Policy Discussion Papers, Number 4. June Grubel, Herbert G. (1999). The Case for the Amero: The Economics and Politics of a North American Monetary 17 Chinn, Menzie and Frankel, Jeffrey (2005). Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency? John F. Kennedy School of Government, Harvard University. Faculty Research Working Papers Series. December Ho-Kim, Thu-Mai (1999). The Transition to Economic and Monetary Union: Conversion to the Euro. Minnesota Department of Trade and Economic Development: Issue Brief. 19 The Eurozone is the subset of European Union member states which have adopted the Euro. 20 McCallum, John (2000). Does North America need an Amero? Policy Options, September Pomfret, John (2006). Fence Meets Wall of Skepticism. Washington Post. October 10, Page A03 6

8 22 The Globe and Mail. After September 11. Border Series. Accessed online on 10/23/2006 at 23 Mundell, Robert A. (1961). A Theory of Optimum Currency Areas. The American Economic Review, Volume 51, No. 4. September, McCallum, John (2000). Engaging the Debate: Costs and Benefits of a North American Common Currency. Current Analysis, Royal Bank of Canada. April, Thiessen, Gordon (1999). The euro: its economic implications and its lessons for Canada. Remarks to the Canadian Club of Ottawa. Accessed online on 10/23/2006 at 26 Ramos, Jorge (2006). 700-Mile Mistake. Univision. Accessed online on 10/23/2006 at 27 Grubel, Herbert G. (1999). The Case for the Amero: The Economics and Politics of a North American Monetary 28 Edwards, Sebastian and Yeyati, Eduardo L. (2005). Flexible exchange rates as shock absorbers. European Economic Review McCallum, John (2000). Does North America need an Amero? Policy Options, September By May of 2006, the Canadian dollar had broken through the 90-cent U.S. level its highest rate since A lender of last resort is an institution that stands ready to provide credit to banks in the event that they experience a sudden demand for liquidity, as when bank runs occur. 32 Chang, Roberto (2000). Dollarization: A Scorecard. Federal Reserve Bank of Atlanta. Economic Review. 33 Miron, Jeffrey A. (1986). Financial Panics, The Seasonality of the Nominal Interest Rate, and the Founding of the Fed. American Economic Review 76. March, Berg, Andrew and Borensztein, Eduardo (2000). The Pros and Cons of Full Dollarization. IMF Working Paper. 35 Bank of Canada. Flexible Exchange Rate. Monetary Policy: The Framework. Accessed online on 10/23/2006 at 36 Grubel, Herbert G. (1999). The Case for the Amero: The Economics and Politics of a North American Monetary 37 McCallum, John (2000). Does North America need an Amero? Policy Options, September Katz, Ian (2000). Ecuador: Greenback Magic? Business Week. March 13, 2000 issue. 39 Friedman, Milton (2001). One World, One Money? Policy Options, May McCallum, John (2000). Does North America need an Amero? Policy Options, September