The Case for the Amero: Optimum Currency Areas

[Previous] [Contents] [Next]

During the Great Depression of the 1930s, countries used currency devaluation to increase their exports and reduce imports in order to lower unemployment rates. These beggar-thy-neighbour policies were self-defeating since the gains of one country accrued at the expense of others while at the same time they disrupted trade and the flow of capital and caused protectionism. As a result, exchange-rate devaluations increased the depth and length of the Depression.

To avoid the problems of the Great Depression after the second World War, an international agreement was signed at Bretton Woods, New Hampshire, to create the parity exchange-rate system, under which individual countries committed themselves to an exchange rate fixed at a specified par rate with deviations permitted within a narrow band. Only so-called fundamental disequilibrium was considered a just cause for countries to change their exchange rates. The International Monetary Fund nominally was responsible for operating this system.

In practice, the US dollar played a key role. Central banks could convert dollar holdings into gold at $35 per ounce and the dollar was, therefore, the de facto international standard of value and reserve currency held by individual countries. Liquidity provided by the International Monetary Fund to individual countries represented only a small proportion of total official reserve assets. These reserves were used to buy and sell a country's domestic currency if excess supply or demand threatened to move the parity exchange rate in the open market.

For a number of reasons, the parity exchange-rate system began to run into problems during the 1960s. The world supply of gold was inadequate at the fixed rate and general inflation. The Vietnam War caused the United States to run large payments deficits and the adequacy of US gold reserves became questionable. Loss of confidence in the system caused some central banks to exchange their dollar holdings for gold, further aggravating the crisis. At the same time, Keynesian economic theory was in its heyday. It suggested that countries could lower unemployment permanently by expansionary monetary and fiscal policies at the expense of only relatively small and constant inflation. The fixed exchange-rate system was seen as the main obstacle to the free use of such Keynesian policies.

During this period, academics and politicians also gave much attention to Milton Friedman's ideas about the merit of freely floating exchange rates.2 These ideas were used by Keynesians as one important justification for the abandonment of the parity exchange-rate system during the 1970s. The new system of floating exchange rates permitted countries to increase their money supplies, which in turn caused the great inflation of the 1970s and increased rather than decreased unemployment. It is ironic that these developments following the adoption of floating exchange rates gave birth to Friedman's "monetarist" criticism of Keynesian economics and caused some of its central policy implications to become discredited.

What domain for flexible exchange rates?

While Friedman's recommendations for freely floating exchange rates were discussed widely, Robert Mundell (1961) published a seminal article in which he introduced the world to the concept of "optimum currency areas." He criticized Friedman's recommendation for freely floating rates by asking the following question. If flexible exchange rates are such a good system, why is their introduction limited to existing nation states? Why do not regions within countries adopt them?

Mundell's answer, which readily becomes obvious once the issue is raised, is that a common currency for trading areas brings its population important economic benefits in terms of micro-economic efficiency. If every small region of Canada had its own currency and central bank, the value of the money issued by each would be very unstable and unpredictable. Exchange rates would fluctuate frequently and widely. There would be large costs for currency trading and for measures to deal with exchange rate uncertainty. As a result, industry and commerce would suffer and economic well-being would be lowered.

The issue facing a country that contemplates joining a monetary union therefore involves the following trade-off. On the one hand, there are the benefits in terms of greater economic efficiency at the micro-economic level and, on the other, there are costs in terms of less economic stability and wider fluctuations in output and unemployment on the other.3 The following three sections consider these benefits and costs in some detail, focusing on conditions in Canada though the analysis is equally relevant for Mexico. The special conditions of the large American economy are considered later.

History of Canada's international monetary arrangements

Before turning to the gains and losses from monetary union, it is useful to review the history of Canada's international monetary arrangements. The following summary was presented by Senator Michael Kirby at the opening of the March 25, 1999 hearings of Senate Committee on Banking, Trade and Commerce in Ottawa:

Canada has had a variety of currency arrangements through its history. The dollar was first adopted as the monetary unit of the Province of Canada in 1858 and then in 1870 for the entire Dominion. The Canadian dollar, which was backed by the gold reserves of the government, was pegged in 1858 at par with the US dollar and at $4.87 to the British pound. With the exception of a short-term drop in the US dollar during the American Civil War, this relationship continued until 1914.

With the onset of World War I, Canada abandoned the fixed relationship with the US dollar until 1926, when the Canadian dollar was pegged at 82 cents (US). The fixed relationship was abandoned again in 1931 and the dollar was allowed to float until the beginning of World War II when it was pegged at 91 cents (US).

Canada had trouble holding on to a pegged exchange rate in the postwar era. It dropped out from 1950 to 1962 and again in 1970, even though the commitment to peg the currency was mandated by international treaty. In early 1970s, the international community abandoned its official support for fixed exchange rates, leaving the choice of a regime up to the individual country.

Since regaining its floating status in mid-1970, the Canadian dollar, measured directly against the US dollar has experienced two types of instability: broad swings in its trend exchange rate--appreciating from 1987 through late 1991 and subsequently declining--and significant short-term fluctuations around the trend rate. (Kirby 1999)

This history suggests that a number of times during the last century Canadians have had discussions resembling those taking place in 1999. In each of these discussions, the benefits and costs, the efficiency gains and loss in sovereignty were discussed using the language and economic tools of the day.4 The conceptual and theoretical arguments made in these debates are likely to have been the same every time. What changed from one to the other was the result of an interplay between recent economic developments and political and economic ideology. The same factor permeates all of the following analysis and public discussion considered in the section, The Politics of Monetary Union, below (p. 35).

[Previous] [Contents] [Next]

info@fraserinstitute.ca You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.

If you know someone who would be interested in this web page, please enter their email address below, and we will forward this URL to them: Email Address:

Last Modified: Sunday, September 26, 1999.