Friday, January 18, 2008

Dropping Canada's floating exchange rate

Whether Canadians want to admit it or not, the floating exchange regime of the loonie is fracturing mechanism that exposes the tenuous geographical and economic links of the Dominion. Exchange rate uncertainty will pit one region against another. A strong loonie reflects the comparative advantage of one region (oil producers) versus another (non-oil producers). The policy strains caused by this imbalance are becoming increasingly evident both in monetary and fiscal arenas. Exchange rate uncertainty is extremely detrimental to commerce, and has a crippling effect on productivity. For that reason there should be an increasing debate about changing the current currency regime with an alternate vision that more aptly reflects our U.S. centric trading relationship. Currency Union and dollarization, although highly desirable options, are political swamps for those brave enough to espouse these objectives. Another alternative is set forth by Professor Herbert Grubel of Simon Frazer University, whose commentary below was found in today's National Post. Although currency controls are highly debated, the special circumstances of the Canadian economy vis a vis its U.S. partner - and the political intractability of the population on both sides of the border - makes Grubel's position worth entertaining.

Fix the loonie
Cure Canada’s Dutch disease by setting the dollar at par
David Laidler’s recent defence of Canada’s flexible exchange rate system misses completely the point made by Nobel Prize winning economist Robert Mundell in his famous article on optimum currency areas. Mundell’s article has been widely credited with providing the intellectual base for the European Monetary Union and merits attention.
Mundell’s point is simple and straightforward. If flexible exchange rates are best for Canada on the grounds presented by Laidler, why would flexible rates not be best also for Alberta, Ontario or New Brunswick? Like Canada, these jurisdictions encounter economic shocks the impact of which would be minimized by the exchange rate buffer.
Milton Friedman’s response to Mundell was that he would not advocate flexible rates for every possible region. He told me once that he did not think that Panama would benefit from flexible rates and that its hard currency fix, the use of U.S. dollars, served the country best.
Clearly, the standard FriedmanLaidler analysis misses essential ingredients needed to decide the case for Panama and, I would insist, Canada. The following analysis considers the costly burden suffered by Canadian manufacturing through the strong appreciation of the dollar during the recent boom in commodity exports, the short-comings of all suggested remedies, and the permanent cure to the problem by the adoption of a hard currency fix.
As Laidler notes, Canada has a bad case of the dreaded Dutch disease, which is named after the problems that developed in the 1960s when the Netherlands sold natural gas that had been discovered on its coast. The increases in Dutch exports of resources, like those of Canada in recent years, resulted in a strong appreciation of exchange rates, which was reinforced by interest rate policies of central banks and currency speculators.
The disease manifests itself through the loss of domestic manufacturers’ ability to compete abroad and with imports. In both countries many workers in these manufacturing firms lost their jobs. Some became unemployed but many undertook the desirable move into the booming export and steadily growing service sectors.
Less desirable was the move of some of the unemployed into public-sector employment, which was facilitated by fiscal surpluses due to the economic boom. During the year ending October 2007, Canadian public sector employment rose by 4.9% while private sector employment rose only .9%
This increase in public-sector employment reduces the growth in productivity because of the perverse incentives facing civil servants: punishment if innovations fail, no rewards if they succeed. Moreover, productivity growth in the private sector is slowed by the proclivity of civil servants to design and administer onerous private-sector regulations.
There are no simple remedies for Canada’s Dutch disease. Subsidies for manufacturers are complex to administer, inefficient and likely to become permanent.
The government can use fiscal surpluses to retire public debt, a large part of which is held by foreigners. While such foreign-debt retirement lowers the exchange rate and thus helps manufacturers, it comes at the expense of tax reductions.
The Bank of Canada can keep interest rates low to discourage capital inflows and thus exchange rate increases, but at the cost of fuelling inflationary pressures.
The most promising remedy for the Dutch disease is the increased importation of labour-saving capital by the private sector, taking advantage of the favourable exchange rate. The problem is that the resultant higher productivity and international competitiveness would grow only slowly.
While all of the opportunities for dealing with Canada’s Dutch disease have some merit as quasi palliatives, there is only one permanent cure: inoculation of the system by fixing the exchange rate at a level that allows manufacturers to be competitive, perhaps at the rate the Bank of Canada research identifies as the longrun equilibrium, around US90¢.
The Netherlands and Austria in the years before the introduction of the euro successfully operated such a system and enjoyed near perfectly stable exchange rates against the German currency. The essential ingredient in this success was the official commitment of the central banks of these two countries to maintain the same interest rate as that of the German central bank.
An analogous commitment by the Bank of Canada with respect to U.S. interest rates may not be credible, tested by speculators and therefore ultimately doomed to failure.
However, there is a solution to this lack of credibility. In Europe, it came through the creation of the euro and formal end of the ability of national central banks to set interest rates. The analogous creation of the amero is not possible without the unlikely co-operation of the United States.
This leaves the credibility issue to be solved by the unilateral adoption of a currency board, which would ensure that international payments imbalances automatically lead to changes in Canada’s money supply and interest rates until the imbalances are ended, all without any actions by the Bank of Canada or influence by politicians.
It would be desirable to create simultaneously the currency board and a New Canadian Dollar valued at par with the U.S. dollar. With longer-run competitiveness assured at US90¢ to the U.S. dollar, the creation of the new currency would reduce present incomes, prices, assets and liabilities from their current Canadian dollar value by the same 10%, leaving real incomes and wealth unchanged.
The public would readily use the new Canadian and the U.S. dollars interchangeably and enjoy savings in the conversion of one currency into the other. The present exchange risk premium on Canadian interest rates would be eliminated completely.
The creation of the New Canadian dollar and its credible fix against the U.S. dollar is not a panacea.
Fluctuations in global demand for natural resources will always result in competition for labour and capital among Canadian manufacturers and producers of resources. But, at least, the firms in these sectors would no longer have to concern themselves with exchange-rate fluctuations and policies of the Bank of Canada.
There will also always be changes in the U.S. (and Canadian) dollar exchange rate against the euro and other major currencies. But these changes would have minor effects on the Canadian economy because 80% of the country’s trade is with the United States.
Herbert Grubel is Professor of Economics Emeritus, Simon Fraser University.