Home > The purpose of this paper is to point to three economic benefits that are neglected in the traditional analysis of the merit o
Small Country
Benefits from Monetary Union
by
Herbert Grubel
Professor of Economics (Emeritus), Simon Fraser University
Senior Fellow,
The Fraser Institute, Vancouver, Canada
Contribution to a special issue of the Journal of Policy Modeling, June 2005
THE DOLLAR, THE EURO, AND THE
INTERNATIONAL MONETARY SYSTEM, edited by Dominick Salvatore, Professor
of Economics, Fordham University
Abstract:
The paper reviews the technical methods available for the hard fixing of currencies and presents evidence from studies of the benefits and costs from monetary unions achieved through hard fixing.
The main costs are alleged to arise from the loss of national monetary sovereignty. In fact, these costs are much smaller than is argued traditionally since the exercise of this sovereignty has historically been responsible for many economic shocks. The costs are also shown to be lowered by efficient capital and labor markets that are endogenous to the adoption of hard currency fixes.
The paper focuses on the discussion of a neglected benefit of hard fixing, which is that small countries enjoy better monetary policy. The improved monetary policy arises because the large institutions to which they surrender their monetary sovereignty are more likely to be free from political influences and partly because they have more financial and human resources to design and execute the best monetary policy. Errors made by the large central banks have less impact on the member countries they serve because of the dominance of intra-union trade and capital flows.
The purpose of this paper is
to point to some economic benefits that are neglected in the traditional
analysis of the merit of small countries�� adoption of a hard currency
fix. The analysis is relevant to countries like Canada1,
which in recent decades has suffered from large fluctuations and a secular
decline in the value of its currency against the US dollar. It
is also relevant to countries like those of Southeast Asia that could
form a currency union in order to avoid a repetition of the costly financial
crisis of the 1990s and prevent the problems created by regional exchange
rate fluctuations and the declining value of the Chinese Yuen that is
fixed to the devaluing dollar.
It is not controversial to
assert all countries would benefit from the elimination of fluctuations
and secular changes in the external value of their currencies. In dispute
are the estimates of the costs relative to the benefits of such a policy.
The first part of my paper
discusses the nature of hard currency fixes, one version of which involves
a common currency of the type found in Europe. This analysis is
essential for the clear understanding of the benefits to be derived
from such fixes. Subsequent sections review the traditional costs
and benefits. The remaining part of the paper discusses benefits
for small countries that tend to be ignored in the traditional literature.
The Nature of Hard Currency
Fixes
The hard fixing of the exchange
rate under discussion here is fundamentally different from the traditional
system used to fix exchange rates.2 The latter was achieved by government
policies that required the central bank to intervene in foreign exchange
markets whenever the market rate deviated from a specified target, accumulating
or selling international reserve assets and drawing on borrowed funds
if necessary to influence the market exchange rate.
The key element of such traditionally
fixed exchange rate regimes is that the country��s national bank retains
its full power to make monetary policy and set interest rates, even
if the ability to exercise this power is constrained by the policy goal
of maintaining a fixed rate. In contrast, when a country
commits itself to a hard currency fix, it gives up national monetary
sovereignty explicitly and permanently. Its central bank no longer
makes monetary policy by determining the money supply and setting interest
rate.
A country can achieve at hard
currency fix using three different policies and institutional arrangements:
This is not the place to evaluate
fully the relative merit of these different approaches to hard currency
fixing. Suffice it here to note that the extent to which a country
can enjoy the benefits of a hard currency fix depends on the credibility
of government��s commitment to the institutional arrangement in the
future.
The Credibility of Hard Currency
Fixes
By the credibility standard,
formal union agreements like that in Europe ranks highest since it is
difficult to imagine economic and political scenarios that would cause
a member country to renounce the treaty and re-introduce its own currency.
Though, of course, given the nature of politics, the probability of
such an event never is zero.
The replacement of the domestic
currency with the dollar or euro is somewhat less credible since it
is the creature of purely domestic policies and therefore can be reversed
by the same means and without the difficult renunciation of any binding
international treaties. On the other hand, once an entire economy
and financial system has become accustomed to dealing in dollar or euros,
a regime switch would be accompanied by serious costs.
Panama is a country which has
used US dollars for nearly a century now and while there have been periodic
domestic movements in favor of abandoning it, the system has survived
and generally is seen to have benefited the people of Panama.
As one student of the issue put it to me, ��All Central American countries
have had Presidents that engaged in policies damaging to their economies,
including Panama. But because no President of Panama never could
use the central bank and monetary policy to serve his political aims,
conditions in Panama never were as bad as they were in the other countries
of Central America.��
The dollarization of Ecuador
is too short to assess its success and likely continuation with any
degree of certainty. However, its continuation after about four
years already is longer than had been expected by those who believe
that it would bring severe hardships for the country and therefore would
be abandoned quickly.
The third approach to a hard
fix, the commitment to a currency board, once was thought to be very
credible. However, the recent experience with the currency board
in Argentina showed that a government can readily break its commitments,
especially if it believes that it brings substantial political benefits
and few international costs.3
The experience with Argentina
also has revealed the need for carefully designed rules governing the
board��s accounting practices and the relationship between the government
and the currency board. The absence of legislation governing these
issues has been considered by some to be a major factor that contributed
to the demise of the board in Argentina.
For Canada, some economists
and I propose4 the creation of what might be called
a quasi currency board arrangement, which requires the revaluation of
the present exchange rate to make ��New Canadian dollar�� equal to
one US dollar. The exchange rate would be chosen to preserve the
country��s current competitiveness and reflect purchasing power.
The Bank of Canada would be required to keep the New Canadian dollar
at par with the US dollar in the market place.
The proposed legislation would
assure attainment of this goal by the specification of the mandated
outcome of market parity between the US and Canadian dollar. It
would avoid the rules-based approach that was used in Argentina and
which has the serious disadvantage that markets and politicians continuously
find loopholes in the rules to exploit to their advantage. Under
the outcomes-based legislation, the government is free to do whatever
is necessary to meet its objective. Moreover, external developments
and government policies that affect the parity can readily be identified
and dealt with.5
How credible hard currency
fixes are and how long they last is determined by the benefits and costs
that are associated with them. The following discusses the most
important costs and benefits.
Traditional Benefits
Hard currency fixing eliminates
the transactions costs incurred in foreign exchange markets when all
exports, imports, capital flows and travel between the affected countries
involve the exchange of one for another currency. In addition,
the fixing saves resources required to run institutions that evaluate
exchange rate risk and operate forward and futures markets to deal with
it.
It has been estimated that
in Europe the substantial shrinking of foreign exchange departments
of banks, firms and governments and the number of currency dealers made
possible by the introduction of the euro would lead to savings of between
.3 and .4 percent of national income of the average member country.6
Casual evidence suggests that
the introduction of the euro has indeed reduced the size of foreign
exchange transactions and the number of institutions and employees needed
to execute them, though there have been no publications estimating the
value of the actually realized savings. Travelers to and within
Europe have happily enjoyed benefits that are not easily measured involving
the absence of multiple currency exchanges and the difficult and costly
decisions they used to involve.
The Bank of Canada has made
very simple estimates of the savings in transactions costs from a formal
currency union with the United States and the use of a common currency.
The estimates are very close to those found for European countries.
No such estimates exist for the proposed arrangement under which the
New Canadian dollar would be used and the notes of the two countries
would trade side by side and exchanged at par. To the best of
my knowledge there are no corresponding estimates of transactions cost
savings for developing countries and others contemplating hard currency
fixes.
The best estimates of savings
in existence for Europe and Canada reveal them to be small in relation
to national income. However, they involve substantial absolute
sums. For example, the savings of .4 percent of Canada��s national
income estimated by the Bank of Canada of about is equal to C$4 billion
or a little less than half of the country��s annual spending on defense
in recent years. The economic impact of these savings goes beyond the
immediate savings of real resources since these savings are equivalent
to the reduction of tariffs on trade, capital flows and travel.
Tariff reductions, even small
ones, have been shown to have substantial effects on the levels of trade,
specialization and welfare in models involving intra-industry trade.
In such models specialization in the production of differentiated products
gives rise to decreasing costs and corresponding increases in productivity.
The savings also would further encourage financial arbitrage and the
integration of the two countries�� financial markets more generally.
Interest rates
Before the creation of the
euro, interest rates on bonds issued by central governments of European
countries in their own currencies often were much higher than those
issued by the government of Germany, which carried the lowest rate of
all countries in the union. The reason for this premium on interest
rates on the other countries was due to the financial markets�� assessment
of a country��s risk relative to that of Germany in three dimensions:
default, liquidity and exchange rate.
The importance of the exchange
risk has become clear in the five years or so leading up to the introduction
of the financial euro in 1999. The gaps between the yields on
the bonds issued by Germany and by the governments of Italy and Spain,
for example, often were over 5 percentage points through the middle
1990s. Thereafter these gaps narrowed rapidly and reached
near zero by 1999, where they have been since.
There remain small yield differences
on bonds issued by different countries in Europe, much as there are
such differences on bonds issued by different US states. These
differences reflect the risk of default and the relative lack of liquidity.
Over the last 40 years Canadian
interest rates of medium term bonds were about 1 percentage point higher
than those in the United States, in spite of the fact that the cumulative
rate of inflation in the two countries was virtually identical.
The higher yield on Canadian bonds just about compensated bondholders
for the secular decline of the Canada-US dollar exchange rate of one
percent per year, even if this decline was higher during some years
than at others and was reversed to some degree after 2002.
Bris et al. (2002) found that
the introduction of the euro also has lowered the cost of capital for
firms inside the union relative to that of firms outside it. This
fact reflects the inability of forward and future markets under flexible
rates to allow firms the full elimination of all exchange risk in their
markets for outputs, inputs and capital. Hard fixes eliminate
the need to deal with exchange risk on transactions with other firms
within the currency area.
The lower interest rates and
costs of capital experienced in countries that are members of the euro
zone will result in capital deepening and higher labor productivity.
A one point premium of the Canadian over the US long rate may not seem
like much in the absolute, but in fact it represents 20 percent under
the assumption that the cost of capital in the United States normally
is five percent.
Traditional Costs
The main argument against hard
currency fixes is that they completely deprive countries of their ability
to use monetary policy to deal with economic shocks that destabilize
the national economy. Here is an example of the sort used by opponents
to the creation of the euro to illustrate this cost.7
Consider that in Ireland the demand for Irish lace falls and unemployment
rises in the wake of downward pressures on prices and wages. At
the same time there is an increase in the demand for Greek wine and
the demand for labor in that industry leads to inflationary pressures.
In the absence of a hard currency
fix Ireland would lower its interest rate to stimulate aggregate demand
and provide alternative employment for workers released from the lace
industry. Greece would tighten monetary policy, decrease aggregate
demand and set free labor from other industries to move into the wine
industry.
Under a hard currency fix the
interest rates in Ireland and Greece cannot be changed. They both
face the same interest rate set by the European Central Bank, which
cannot change that rate to serve the needs of both countries.
As a result, Ireland suffers unemployment and Greece suffers inflation.
Many analysts concerned with
this problem predicted that it would overwhelm all arguments in favor
of a European common currency. They did so first at the planning
stage and then when it was to be implemented. After the adoption
of the euro and of the final symbolically important use of euro notes
and coins in all countries, these analysts predict that the problem
eventually will lead to serious economic crises and to the dissolution
of the common currency agreement.
The euro zone may well one
day succumb to conflicts over the appropriate interest rate, but the
experience of the first few years of experience give rise to optimism.
There have been no severe conflicts and the benefits from the use of
a common currency have become obvious.
This positive experience is
due to a number of factors. One of them is the realization that
in the past there have been relatively few asymmetric shocks.8
Most problems with economic instability, inflation, unemployment and
currency depreciation in the past were in fact due to faulty national
monetary policies, which could not occur under the new arrangement.
Of course, there were and there
always will be shocks that affect some countries in the union more than
others. But this has been happening in countries like the United
States ever since the union has been formed. It also has been
happening within Germany and France whenever one region boomed and another
was in a slump.
Eichengreen and Bayoumi (1993)
suggest that such shocks do not lead to problems within countries but
would in Europe. One reason is that labor mobility is much greater
between regions of the same country than they are between European countries.
A second reason is that central governments arrange for fiscal transfers
to help regions in distress while there is no such central government
in Europe.
On the other hand, there are
conditions within countries that facilitate adjustments between regions
and which will be brought into effect by a hard currency fix.
First, as Ingram (1973) pointed out highly mobile and low cost capital
readily flows to US regions suffering from a shock. Second, Kenen
(1969) notes that shocks randomly distributed over a given country tend
to offset each other and make for a more stable aggregate income and
employment. And third, it has been pointed out by Frankel and
Rose (1997), the hard fix forces special interest groups in the country
to become more disciplined. For example, excessive union wage
demands that used to lead to inflation and a depreciated exchange rate
under a hard fix only result in unemployment.
While the increased efficiency
of the capital market has been observed in the euro zone, labor markets
have been slow to adjust. However, politicians have begun to accept
the need for changes and we may expect that continued high unemployment
rates, slow economic growth and fiscal imbalances will eventually lead
to the public acceptance and eventual realization of these reforms.9
In sum, the traditional assessment
of the macro-economic costs of hard currency fixes is subject to major
qualifications suggesting that the costs are much lower than those flowing
from simple models that neglect capital market benefits, the geographic
spreading of risk and the pressures for labor market reforms.
The following analysis goes
further in the re-assessment of the alleged basic costs from the loss
of monetary sovereignty. It suggests ways in which the loss of
monetary sovereignty is accompanied by two different types of benefits:
First, the greater independence of monetary policy from political influence
and second, superior monetary policy due to the availability of better
data and better decision-making.
Neglected Benefits – Political
Independence of Central Bank
A hard currency fix prevents
national politicians from influencing monetary policy to serve the interest
of the government in power. In the past they have often done so
by forcing the central bank to buy government bonds to finance spending
deficits by the issuance of non-interest bearing money.
To the extent that such deficit
financing by the central bank was chronic, the country suffered through
secular inflation and currency depreciation, with significant negative
effects on efficiency and economic growth.
Some deficit spending financed
by the central bank was limited to periods leading up to elections.
It was designed to create temporary prosperity to raise the reelection
chances of governments. However, after the election the inflation
caused by the excess money creation eventually required policies of
tight money to restore price stability. The resultant ��political
business cycles�� imposed unnecessary costs on the economy.
Many countries have constitutional
provisions designed to assure their central banks�� independence from
political influences and they had fewer political business cycles than
those without them. However, even such countries suffered from
the influence of politicians since they always have provisions for regular
��consultations�� between bank officials and politicians to assure
��accountability�� of the civil servants and technocrats. On
the occasion of such consultations politicians were able to influence
monetary policy in more or less subtle ways.
The incidence of deficit-induced
inflation and political business cycles has decreased significantly
in all developed countries in recent decades, though it remains a serious
problem in many developing countries. In the industrial countries
politicians now understand that inflation often causes the electorate
to replace governments that cause them. Governments have also
learned that political business cycles cannot be managed precisely and
there are significant risks in their use to win elections.
Nevertheless, the potential
for political interference with monetary policy formation remains as
memories of bad past experiences fade and in the future unforeseen and
unforeseeable problems arise with unemployment, inflation and slow economic
growth. Hard currency fixes in a sense are like taking out insurance
against bad monetary policy made in response to pressures from national
politicians.
The European Central Bank is
largely free from political influences in the short run. Its independence
is assured constitutionally and even includes sovereignty in the selection
of operating and decision-making personnel. In the short run at
least, this arrangement assures that the citizens of countries of the
Euro zone will not be subjected to politically induced inflation and
business cycles.
However, as is the case with
all so-called ��politically independent institutions��, there are
provisions in the ECB constitution that are designed to keep it ��accountable��
to elected legislatures. For this purpose, the leadership of the
ECB is required to meet periodically with the European Council of Ministers.
Issing is a member of the Executive
Board of the ECB and Director of General Economics and Research.
In a paper published in 2004 and one in this volume he reports that
since its inception the ECB has been able to escape interference from
the Council of Ministers in its pursuit of price stability in the Euro
zone.
It is not clear what will happen
in the longer run. It is possible that eventually special interest
groups from individual countries unite and lobby the Council of Ministers,
which in turn will attempt to influence monetary policy to become more
inflationary. However, such efforts will be much more difficult
than they were within each country because there are so many more and
diverse interest groups in the large Euro zone than there were in individual
countries and the efforts of diverse groups tend to offset each other.
In addition, the use of monetary policy to increase reelection chances
is not possible since national elections in the countries of the euro
zone fall on widely different dates.
As noted above, hard currency
fixes can also be adopted through dollarization and the establishment
of true or quasi currency boards. Under these institutional arrangements,
the countries adopting the hard fix have no influence on the formation
of monetary policy. For example Ecuador, which adopted the US
dollar in all domestic financial uses will always have interest rates
equal to those set by the Federal Reserve Bank10.
The same would be true if Canada adopted the quasi currency board arrangement
suggested above.
There have been rumors that
if Canada were to adopt a hard fix to the US dollar, the Fed would be
willing to have Canadian officials participate in the deliberations
held before monetary policy is set. Such participation would be
limited to the presentation of information by Canadians, but only Americans
would be able to vote on specific policy proposals. In the longer
run, such an arrangement may lead to a vote for Canada and the possibility
of voting alliances with delegates from different US regions.
However, it is clear that even under such conditions, the influence
of Canada would be small, just like individual countries have limited
influence on the policies set by ECB and individual Federal Reserve
districts have on Fed policies.
Neglected Benefits – Better
Monetary Policy
The making of monetary policy
is a complicated process. Information on recent economic conditions
is collected, interpreted and projected into the future. The possible
development of economic shocks is given special attention. This
intelligence is used to study likely future inflation, unemployment,
the exchange rate and economic growth. The constitution of the
ECB requires it to use monetary policy only to assure stable price on
the grounds that monetary policy in the longer run cannot influence
the other indicators of economic performance. Changes in interest
rates and the quantity of money are the instruments used to assure stable
prices.
The making of monetary policy
just described requires the use of scarce and costly financial and human
capital resources. Smaller countries typically have less access
to these resources than do large countries or a collective central bank
like the ECB. By giving up their efforts to make monetary policy
these smaller countries enjoy better monetary policy.
The increased availability
of resources by the central banks of large countries or of a monetary
union increases the quality of monetary policy through a number of influences.
First, the data used to make projections is better and more current.
Issing (2004) reports the difficulties the ECB had during its early
years of operation because data from several countries in the monetary
union were not available at all or only with a considerable lag.
It is clear that if the statistical offices of countries could not supply
the ECB with the required data, they did not supply them to their central
banks when they still made their own policies. These deficiencies
have been remedied to a considerable degree with help of experts and
financing from the ECB working with national data collection agencies.
Second, highly trained economists
and statisticians working with a number of different models and using
high-powered computers and programs manipulate the historic data to
make forecasts. Small central banks tend to have fewer employees,
computers and models to do this work than do the larger central banks.
The stronger competition and greater variety of models available in
large central banks tend to produce more and better information.
Third, the most fundamental
factor determining the success of monetary policy is the process used
in sifting through the available statistical information to decide what
the best monetary policy is for the future.
This work is guided by theories
and empirical evidence backing them. But the making of monetary
policy never will be like the design of a bridge. It involves
many personal judgments and guesses. The history of the last 50
years shows that these judgments and guesses are necessary since prevailing
theories of macroeconomic relationships change often, making obsolete
what just short times before was considered to be conventional wisdom.
Most central banks in the developed
world presently have adopted inflation rates as the appropriate target
for their policies, with some considerable success. However, if
the past is any guide to the future, ��the end of history�� in the
proper design of monetary policy will never come.
In a recent book Snowdon and
Vane (2005) give an interesting taxonomy of theories that have dominated
macroeconomics and influenced monetary policy since the 1950s.
Most of these theories were
dominant for some time and their adoption was thought to end the search
for better models and monetary policy. They never did.
Issing (2004) asserts that
the ECB presently makes monetary policy by pragmatism that is free from
doctrinaire reliance on any theories. ����the systematic and
efficient use of all relevant information��requires the use of a comprehensive
set of information based on a diverse range of approaches and models
in order to obtain a comprehensive picture of the state of the economy
and the risks to price stability.�� (p.43)
One of the lasting and unresolved
debates in monetary theory and policy involves the use of the interest
rate and the quantity of money as instruments of monetary policy.
Orthodox monetarism noted that nominal interest rates can send false
signals about monetary conditions since they are influenced by unobservable
expectations about future inflation. The money supply numbers
are free from this problem but financial innovations and non-systematic
changes in public demand for money affect its velocity of circulation
and thus the usefulness of supply data for making monetary policy.
Issing reveals how the ECB
has handled this problem: ����the Governing Council decided against
monetary targeting in 1998 and also stuck to this decision in 2003.
The prominent role assigned to money in the ECB��s strategy is signaled
by the announcement of a reference value for monetary growth.
The reference value represents a public commitment to thoroughly analyzing
monetary developments and ensuring that information on monetary developments
is given appropriate weights in the decision-making process. It
specifies the growth rate of money regarded as consistent with price
stability over the medium term.�� (p.45).
This description of the methods
used to determine money supply growth and therefore interest rates in
the euro zone is likely to leave advocates of money supply targeting,
like Milton Friedman, dissatisfied. In my view the first and last
sentence of the preceding quote taken together reveal pragmatism and
the explicit use of intuition based on experience and wisdom that appear
to be essential in making successful monetary policy in our very complicated
and highly uncertain world.
It is alleged that US monetary
policy under Alan Greenspan��s leadership as the Chairman of the Federal
Reserve Board relies similarly on pragmatism and Greenspan��s injection
of his own highly personal interpretation of information into formal
models.
The likelihood that a central
bank ends up with influential personalities that have the required experience
and wisdom, such as Greenspan in the United States and Issing and others
in the ECB is greater in large than in small organizations. Therefore,
small countries that hand their monetary policy formation to such large
organizations on average can expect to enjoy better monetary policy
than they made before.
Canada as an Example
The preceding conclusions are
supported by my analysis of three recent monetary policy decisions by
the Bank of Canada, which may be summarized as follows. 12
The first episode occurred
in the late 1980s when both Canada and the United States experienced
renewed inflationary pressures at very similar rates. Under the
leadership of John Crow in Canada and Alan Greenspan in the United States
it was decided to use tough, restrictive policies to rid the economy
of all inflationary expectation and create public expectation in the
permanence of price stability. Resistance to pressures for easier
monetary policy in the light of serious economic distress was considered
to be essential to the working of the therapy. Both countries
followed this model.
Relevant to the present purposes
of analysis are the following facts: Canada��s Bank Rate reached
a maximum of 14 percent while the maximum Federal Funds Rate was only
10 percent. The Bank of Canada maintained its higher rates for
nearly a year longer than did the Federal Reserve.
The rates of inflation in both
countries were roughly the same before the monetary restraint and after
it. Yet, the cost of restraint were much higher in Canada than
in the United States in terms of unemployment, lost output, reductions
in tax revenues and increased deficits.
I am certain that John Crow
and his staff at the Bank of Canada acted in good faith and on the basis
of information and theories that they considered to be correct at the
time. This fact however does not invalidate the central point
of my analysis. If Canada��s monetary policy during this period
had been made in the United States, the costs would have been much smaller
and the benefits the same.
The second illustration of
the problems caused by Canada��s exercise on national monetary sovereignty
covers the period 1994 to 2002. During this period the Bank of
Canada pursued a much easier monetary policy than the United States.
The resultant capital outflow contributed substantially to the continuous
depreciation of the Canadian against the US dollar from about 76 cents
to a low of about 63 cents.
The Bank of Canada explained
that its low interest rate policy was needed to compensate for the reduction
in aggregate demand that accompanied the great success of Canadian governments
in the elimination of spending deficits.
This explanation may be valid,
but it will never be known how the Canadian economy would have performed
if the exchange rate had not been depressed by the capital outflows.
A good case can be made that the booming US economy would anyway have
provided sufficient incentives for increased exports to compensate for
the effects of tighter fiscal policy. It is also likely that the
elimination of the deficit would have revived consumer confidence and
spending and thus offset the fiscal drag. The depreciation of
the dollar had the opposite effect on consumer sentiments.
Whatever may be the truth in
these speculations, the fact is that the easy monetary policy was necessary
because of the error made during the preceding period of excessively
tight monetary policy, which had contributed much to the size of the
deficit through reduced tax revenues and higher debt service costs.
Therefore, if the first error in monetary policy had not been made,
the costs imposed on the economy by the subsequent low interest rate
policy would not have been necessary. Courchene and Harris (1999)
and Grubel (1999) argued that these costs were substantial, involving
lower productivity growth and slower changes in the mix of industries
in Canada. During the period of the sharply declining dollar,
Canada��s real per capita income fell behind that of the United States
by more than five percentage points from where it had been at the beginning
of the period.
The third episode of questionable
Bank of Canada policies occurred after 2002. At that time monetary
policy was tightened, Canadian interest rates rose while US interest
rates fell. The Canadian dollar, which already was going up because
of a boom in world commodities was pushed up even more by capital inflows
attracted by the high Canadian interest rates.
The Bank of Canada justified
its high interest rate policy on the grounds that inflation had become
a serious threat. Thus, early in 2003 for about 3 months consumer
prices rose at annual rates over 4 percent. Even the core rate,
which excludes volatile commodities like energy and fresh vegetables
and fruit, rose slightly above the upper limit of the Bank��s target
range of 3 percent.
The high inflation lasted only
about a quarter. In early 2004 the increases were much below the
lower target of 1 percent. This turnaround in inflation cannot
possibly be attributed to the tightening of the monetary policy.
Instead it was due to a slowdown in the rate of increase in energy prices
and the end of increases in automobile insurance costs that had been
responsible for the earlier, alarming price increases.
There are two main criticisms
of the increase in interest rates in 2003 initiated by the Bank of Canada.
First, increases in the cost energy and insurance should not be taken
as evidence of inflation that requires a tightening of monetary policy.
Price increases of this sort reflect changes in relative prices, they
tend to be limited and often are reversed once underlying special conditions
change.
Second, the increases in the
core inflation rate just discussed were caused in large part by a strong
increase in the cost of automobile insurance. The Bank of Canada��s
decision makers should have analyzed carefully the components of the
index responsible for the price increases. If they had, they would
have realized that these increases were due to cyclical factors affecting
the returns on insurers�� investment portfolios and therefore were
not cumulative and continuous. They did not require remedial tight
monetary policy.
In addition, the Bank did not
engage in due diligence in accepting uncritically the data on insurance
cost increases. It was left to Mullins (2003), an economist working
at the Fraser Institute on automobile insurance issues to discover that
Statistics Canada had made an error in recording the price increases.
The price increases had taken place over several preceding quarters,
but instead of reporting them as small increments when they occurred,
Statistics Canada included them all in the one critical quarter, which
prompted the Bank of Canada to raise interest rates.
I contend that such faulty
interpretation of basic trends and specific data developments would
have been much less likely to occur in the Federal Reserve and, almost
by definition, would have been avoided if there had been a monetary
union. Under these conditions, Canada could have avoided the unnecessary
costs of high interest rates, the more rapid and pronounced rise in
the exchange rate and the damage they have done to the Canadian economy.
According to a study by the Toronto Dominion Bank, the high dollar will
result in the loss of 50,000 jobs in 2005.13
Stephen Jarislowsky, one of
Canada��s richest men and head of a very successful money managing
organization, in an interview referring to the monetary policy episode
just discussed commented: ��Interest rates should not have been
raised faster than American ones.��14 He concluded with a remark supporting
my paper��s basic proposition: ��This country cannot live with a floating
currency. Europe can but even Japan has difficulty��.
The bigger they are, the harder
they fall
The preceding analysis and
conclusions are subject to the criticism that large central banks may
on average make better monetary policy than small central banks, but
when the former make mistakes, the costs are so much greater since they
affect large economies and populations. Under these conditions,
smaller countries with hard currency fixes suffer problems that would
have been avoided if they had pursued their own monetary policy and
avoided the big mistakes.
This may very well be the case
in principle, but in practice the situation is different. First,
the longer run correlation between interest rates reflecting the monetary
policy stance of Canada and the United States is .95. Most big
monetary policy errors made by the United States also were made by Canada.
Second, the prosperity of a
small country like Canada is highly dependent on its trade relations
and capital market integration with the United States, the country to
which it fixed its currency. Errors in US monetary policy under
these conditions will not affect the exchange rate and therefore leave
unchanged the vital trade and capital flows between the countries.
In Europe similarly, any errors made by the ECB may affect the euro
exchange rate values, but they will not reduce trade and capital flows
among the member countries of the union.
Summary and Conclusions
In this paper I have argued
that small countries that adopt hard currency fixes and surrender their
national monetary sovereignty to a large country or a common central
bank will enjoy lower costs of foreign exchange dealings and lower risk
premiums on interest rates. These benefits are allegedly gained
at the cost of losing the freedom to use monetary policy to deal with
external shocks.
The paper argues that the frequency
and size of losses are exaggerated since most shocks in the past were
caused by faulty national monetary policies. The cost estimates
also neglect the benefits of more efficient capital and labor markets
and the wider geographical dispersion of shocks that are the result
of hard currency fixes.
The main contribution of the
paper is to point to the fact that the large institutions that determine
monetary policy – the central banks of monetary unions or the central
bank of a large trading partner to which a country��s currency is fixed
– on average produce better policies than do the central banks of
smaller countries. This is so because these larger institutions
are more likely to be free from political influences and they have more
statistical, financial and human resources to design and execute the
best monetary policy. Errors made by the large central banks have
less impact on the member countries they serve because of the dominance
of intra-union trade and capital flows.
References:
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1 Some readers may not agree with the description of Canada as a small country. Nor are the countries of Southeast Asia small in terms of population and increasingly in the size of their national income. However, the comparison for my purposes of analysis is not with the truly small countries of West Africa or members of the former Soviet Union in Asia. The comparison is with large neighboring nation as Canada and Mexico with the United States, or individual countries with a collective of possible candidates for a monetary union as in Southeast Asia.
2 The analysis in the first part of this paper draws heavily on Grubel (2005a) forthcoming. That paper contains a number of graphs to back up some of the empirical relationships summarized here.
3 For an analysis of currency boards see Hanke (2002). Hanke (2003) provides an insider��s analysis of what went wrong with the currency board in Argentina.
4 Courchen and Harris (1999), Grubel (2005b) forthcoming. In previous publications I argued the case for a North American Monetary Union modeled after the European Monetary Union: Grubel (1999) (2000)
5 For a general analysis of the rules vs outcome approach to regulation see Grubel (2002).
6 For more detailed discussion of the estimates presented here and references to the original studies see Grubel (1999) (2005b) forthcoming.
7 For an analysis of these costs see Eichengreen (1992) and Bayoumi and Eichengreen (1993).
8 See Belke and Gros (1999)
9 It is an empirical question whether or not labor market institutions adapt to the hard currency fixes or whether the fixes will be reversed. There are signs that institutions will adapt not just in Germany but importantly in Ecuador, which a few years ago replaced its own currency with US dollars. The political uprisings and the reversal of the policy that many had predicted have not taken place and the people of Ecuador are adapting at a reasonable pace to the new financial and economic environment.
10 Except for premiums reflecting the country and other issuers�� default risk, which depends to a considerable degree on the political risk of exit from official dollarization.
11 This taxonomy draws heavily on Snowden and Vane (2005).
12 See Grubel (2005b) forthcoming.
13 See Beauchene (2005).
14 As quoted by Diane Francis (2005), page FP1 and FP5.
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