No easy fix for loonie

A currency board with a fixed loonie would delegate Canada’s monetary policy to the U.S. Federal Reserve.Reuters File PhotoA currency board with a fixed loonie would delegate Canada’s monetary policy to the U.S. Federal Reserve.

In the wake of the loonie’s rise above parity against the U.S. dollar, there has been a revival of the debate around the idea of a common currency between Canada and the United States. In one corner stand people like David Laidler who argue that it is a bad idea ; the loonie should continue to float against the greenback. In the other corner, we have the likes of Herbert Grubel, Thomas Courchene and Pierre Fortin who clamour for some form of monetary integration between Canada and the United States.

Interestingly, this is the same debate with the same protagonists that took place a few years back when the loonie was at US65¢. For the no side (i.e. against monetary integration), the exchange rate must continue to fluctuate in order to deal with the Canadian economy’s dependence on commodities, which is not the case in the United States.

For the yes side, the Canadian dollar is either too low and it hurts productivity (since Canadian companies do not import more efficient machinery and equipment) or it is too high and it hurts firms’ international competitiveness. In any case, the loonie’s exchange rate with the greenback is volatile and this is bad for the economy.

The truth about this debate is that both sides make some valid economic arguments. This explains why the debate has not really progressed in the last 10 years. The real debate, however, should be about the shape that monetary integration with the United States should take. But even in this case, as we shall see, there is no real debate to be had because of the politics involved.

In his article in last Friday’s National Post, Herbert Grubel offered one yes-side solution to the loonie’s exchange rate volatility : a currency board and a new Canadian dollar. The currency board would fix the exchange rate between the loonie and the greenback, while the "new" Canadian dollar would be set at parity with the U.S. dollar (instead of a US90¢ fixed exchange rate).

In such a system, each new loonie issued by the Bank of Canada would require one U.S. dollar in its vaults. As a result, Grubel argues, the two dollars should be used interchangeably by the public (thereby making the greenback legal tender in Canada), potentially leading to the complete (U.S.) dollarization of the Canadian economy.

Such a monetary arrangement would no doubt be acceptable to our American neighbour, since there is no political and public support for the creation of a new North American currency (e.g., an amero) south of the border. In fact, it is probably the only monetary integration arrangement acceptable to the United States other than Canada adopting the greenback outright.

From a Canadian perspective, the proposed currency board would have the political advantage of keeping the loonie, which Canadians appreciate, especially when it is close to parity. The few opinion polls conducted on the issue between 1992 and 2002 show clearly that there is an inverse relationship between Canadians’ support for monetary union with the United States and the value of the Canadian dollar. According to the same polls, however, few Canadians are willing to abandon the loonie in favour of the greenback, at any level of the exchange rate.

A currency board with the loonie fixed to the greenback implies a delegation of Canada’s monetary policy to the U.S. Federal Reserve. The issue here is whether the Fed would do a better job than the Bank of Canada at running our monetary policy. One can doubt it by looking at the mess it created with, first, the IT bubble at the end of the 1990s and, now, the subprime mortgage crisis. In any case, U.S. monetary policy has and will always be geared towards U.S. political and economic realities, not Canadian ones.

Another aspect not discussed by the yes side is the rate at which the loonie would be fixed to the greenback. Grubel talks about fixing the exchange rate at US90¢, which he says is the current equilibrium rate as calculated by the Bank of Canada. The problem here is that back in 2001-02, the equilibrium rate was around US75¢ and this was the rate at which it was argued the exchange rate with the U.S. dollar should be fixed.

Had Canada opted for monetary integration back then, as Grubel and co. argued for, we would currently have an undervalued currency. Obviously, this would fuel inflation in Canada. Unfortunately, there is nothing that we could do, since monetary policy would be run by the Fed, which would now be reducing interest rates to deal with the subprime mess, rather than increasing them as Canada’s overheating economy would require. For sure, the current minority Conservative government would look to abandon the currency board in order to stay in power, assuming that Canadians are not very fond of inflation.

Grubel mentions that a currency board would be as credible as European monetary union. He forgets to mention, however, that Argentina had such a currency board in the 1990s. And it did not prevent the country from experiencing one of its worst financial crises ever between 1999 and 2002. Eventually, political pressures forced the Argentine government to abandon the currency board and let the peso float against the U.S. dollar.

Only complete monetary union can nowadays achieve a sufficient level of credibility with financial markets. The problem is that only the dollarization of the Canadian economy is acceptable to Americans, whereas only the creation of a new common North American currency (a la euro) with a supranational central bank with powers shared equally between Canada and the United States (a la European Central Bank) would be acceptable to Canadians.

In sum, the status quo is the only politically acceptable solution for Canada, even if it may not be the best economic solution (in fact, it is second best). Until this reality changes, the debate concerning the loonie and monetary integration with the United States will continue to be sterile. Let’s rather focus our energies on finding ways to make trade easier within Canada, as well as with the United States.