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The Case for the Amero: Efficiency Gains from Monetary Union

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Canada will gain from joining a monetary union with the United States through two different mechanisms. The first is static and rather simple: the reduced need to buy and sell foreign currencies and to deal with exchange-rate uncertainty. The second mechanism involves the dynamic development or modification of institutions that result in greater economic efficiency.

Static gains

Foreign exchange dealings

The creation of the amero will reduce the size and risk of foreign-exchange operations engaged in by banks, firms, and travellers as a routine part of their economic activities. For example, Canadian producers of exports paid in US dollars or Mexican pesos have to exchange these receipts into Canadian dollars to pay their workers, suppliers, taxes, and stockholders. If foreign buyers pay these producers in Canadian dollars, these foreigners have to buy Canadian dollars with their own currencies. Similarly, import businesses and travellers among the countries have to buy or sell the currency of the other country.

There is also a large international trade in capital-market instruments like bonds, short-term bills and common shares of corporations. As in the case of trade in goods and services, trade in financial instruments involves the currency market. For example, Canadian pension funds purchase and hold bonds and shares denominated in US dollars for investment purposes but pay out annuities to their customers in Canadian dollars. As another example, consider the provincial governments that finance a deficit by selling bonds denominated in US dollars. To service and repay this debt they must convert their Canadian dollar tax revenue into US dollars.

Finally, there is a large volume of trade in currency futures, forward contracts, and other financial derivatives. This business stems from the desire of exporters and importers of goods, services, and financial instruments to eliminate the risk of fluctuating exchange rates. For example, Canadian exporters of lumber to the United States usually sign a contract that pays a certain number of US dollars 90 days later. For financial planning, these exporters need to know whether in 90 days these US dollars will be exchanged for 1.5, 1.6 or 1.3 Canadian dollars. Forward exchange markets permit them to do so. Similarly, borrowers of US funds in Canada can lock in the Canadian dollar value of future payments of interest and principal. Other so-called derivatives are used to eliminate or reduce exchange risk associated with trade in assets in more roundabout ways, often involving a number of transactions.

All of this currency business uses up labour and capital in Canada, Mexico, and the United States. The research needed to forecast exchange risk and the determination of optimum strategies to deal with it requires much highly skilled labour. Foreign exchange trading divisions of commercial banks employ large numbers of traders, economists, and support staff and also use much capital, most of which is in modern communications facilities. Private firms use manpower and capital to operate their own foreign exchange departments. International travellers use up time and energy in currency dealings. The elimination of the need for foreign exchange transactions for trade among the members of the amero zone would free this labour and capital for the production of other goods and services. Living standards would increase correspondingly.

How big would be the savings in resources from the reduced need for currency transactions if Canada joined a North American Monetary Union? Unfortunately, it is not easy to make an empirical estimate of the savings. We know that in 1998 Canada's trade in goods and services with the United States and Mexico (exports plus imports) was valued at CDN$315 billion.5 If foreign exchange costs represent one percent of that value, the savings would be about $3 billion. The currency transactions undertaken in the context of international lending and dealing with exchange risk are known to be some multiples of net capital flows since there is much "churning," as agents buy and sell the same currencies many times during the day in order to take advantage of small differences in exchange and interest rates.

The most reliable estimate of the savings from reduced currency exchange dealings can be made by a study of the foreign exchange activities of banks, private firms, and travellers. In interpreting these data and estimating the savings from monetary union, it is important to remember that the need to deal in currencies of the rest of the world would remain. In other words, the exchange departments of banks and firms would not be eliminated, they would only shrink in size.

While such studies of the possible savings from currency union have not been made for any of the North American countries, we can gain some insight into them by considering a study of European conditions. In 1990, the "Delors Commission" (Commission of the European Communities 1990) analyzed the potential gains from currency unification in Europe and in the process sponsored special surveys of banks and firms. These surveys resulted in the conclusion that the introduction of the euro will shrink the size of the foreign exchange departments of banks and firms by about 85 percent. The resultant savings will represent between .3 and .4 percent of national income of the region, with some marked differences in the savings of individual member countries, depending on the size of their foreign sectors.6

The adoption of the amero would result in analogous savings. We may speculate that for Canada, with a foreign sector as large as that of most European countries, the savings will resemble those estimated for Europe. For the United States, which has a much smaller foreign sector relative to national income, the percentage savings would be much smaller. Mexico's savings may be expected to lie between those of Canada and the United States. My own, rather casual, estimates put the savings for the entire region at about .1 percent on national income, or about CDN$800 million.

Lower interest rates and less exchange risk

Interest rates on long-term bonds issued by the governments of Canada and the United States historically have differed because of the risk of depreciation of the Canadian against the US dollar, the fluctuations in the exchange rate around a trend (called the exchange risk), a difference between the two countries in the risk of default on their debts (called the sovereign risk), and the lower liquidity of Canadian government bonds because fewer are outstanding and traded daily.

Figure 1 shows the historic development of the spread between the nominal interest rates on long-term securities of Canadian and American governments: the excess of the Canadian rate has averaged about one percentage point over the entire period (1.17 percent between 1950 and 1997). However, there were some periods during the 1970s and early 1980s when the turbulence of international exchange and capital markets created a spread much larger than one point. 1983 saw the record spread of 3.5 points. Since 1998, the Canadian rates have been lower than the American rates.

Kevin Clinton (1998) attributes most of the interest-rate gap to the risk of currency depreciation. He estimated the other causes of the difference to be relatively minor, though the threat of Quebec's separating has undoubtedly increased the sovereign risk component of the spread during the 1990s. The developments since 1998, which have seen the Canadian rates lower than the American rates are not covered in Clinton's paper but they are likely to be the outcome of an inflation rate in Canada lower than that in the United States, which implies a credible and very likely future appreciation of the Canadian dollar.

These recent developments in the spread suggest that nominal interest rates are not the appropriate basis for measurement of gains from monetary union. One should study instead nominal interest rates adjusted for inflationary expectations in each country. Unfortunately, such expectations cannot be measured directly and the use of actual inflation rates is an imperfect substitute for expectations. Nevertheless, Clinton estimated real interest-rate differentials on the basis of differences in consumer-price inflation. He found that between 1961 and 1998 the spread in real yields was .97 points as compared with the spread in nominal rates of 1.17 points. So, even after adjustment for inflationary expectations, investors appear to demand a premium of about one point over the American interest rates to place their funds into Canadian assets denominated in Canadian dollars.

In Europe, the obligations of the governments of Italy and Germany similarly showed differences in yields to compensate investors for the risk that the lira would continue its postwar history of depreciation against the mark. There are firm expectations that the interest rate differential between Italian and German government bonds will narrow dramatically after they have been denominated in euro. In fact, this narrowing had started in the months leading up to the conversion on January 1,1999.7

The introduction of a common currency in Canada and the United States will result in the same developments and ultimately the complete and permanent elimination of the exchange risk and differences in the inflation rates between the two countries. There may well remain a risk premium due to the public's perception that Canada, the smaller country with a higher ration of debt to income and burdened with a separatist movement, is more likely than the United States to default on her obligations. We can observe the equivalent spread in the interest yield of the federal and provincial governments within Canada. These spreads tend to be very small. However, it is difficult to predict how big the Canada/United States spread will be, especially since it will depend on the uncertain future fiscal responsibility of both countries and the risk of Quebec separation. However, if we assume for the sake of illustration that, of the historic spread of 1.17 percentage points, .17 points will remain and reflect the sovereign risk, then the drop in the differential will be 1 full point. The benefits of lower interest rates will be very large.

A drop of one percentage point in the cost of borrowing for the federal government alone would bring savings of $6 billion annually on its $600 billion debt though, because of the maturity structure of the debt, it will take some time to realize the full amount of these savings. This fact alone should make the federal government an enthusiastic supporter of monetary union. The fixed-interest obligations of other Canadian governments, agencies, private companies, and individuals, particularly those with mortgage obligations, will similarly be reduced by many billions of dollars. The prices of common shares will rise for a firm's given expected profits and therefore the cost of borrowing in equity markets will also fall.

The stimulus to consumer spending by such lower borrowing costs will in large part be offset by lower interest incomes of lenders. However, the lower interest rates will encourage higher investment by business, which will increase labour productivity and raise Canadian living standards. The cost of housing will fall and stimulate the expansion of the building industry and the producers of furnishings. Cumulatively and through time, the growth in productivity and housing investments may well be large. Governments will have smaller deficits or larger surpluses and will be able to lower taxes, which in turn will increase incentives to work and invest.

Greater price stability

Inflation is defined as the persistent upward trend of prices. Price instability means that prices fluctuate through time either around a trend or around zero inflation. It is possible for a country's central bank to be committed to, and succeed in the prevention of inflation. However, no central bank can prevent entirely fluctuations in the price level around a mean of zero because of random economic disturbances affecting its output and trade.

Economic theory and evidence suggest that price stability encourages economic growth and efficiency. Thus, Benjamin Klein (1977) found that in American history the greater the price stability, the higher the economic growth. He attributes this correlation to the increased usefulness of money when prices are stable. During periods of great volatility in prices, economic agents are forced to reduce the use of money in transactions and resort more to barter. Some of the efficiencies derived from a monetized economy are lost.

Price stability is an increasing function of the size of a currency area for the following reason. Consider that a bad harvest of grains in Canada causes higher prices for food using grains. If Canada has her own currency, these higher food prices would raise the overall price level. However, this inflationary effect is dampened if, at the same time, bumper crops in another region of Canada lower prices for fruits or vegetables. Generally, the probability is greater that an opposite price development keeps the price index unchanged, the larger the number of regions and the more diversified the mix of industries. For this reason a North American currency area will have more stable prices than Canada or the other member countries operating their own currencies, given the pattern of exogenous disturbances causing fluctuations in output and prices. No estimates of their magnitude are available, but these benefits are certain to exist.8

Dynamic gains

Expansion of trade

The new international trade theory developed during the last 25 years suggests that gains from the lowering of trade barriers are much larger than had been estimated earlier. The traditional theory had predicted that lower trade barriers would cause a country like Canada, for example, to expand the production and export of forestry products. At the same time, Canada's machinery industry would shrink and imports of machines would increase. The new theory suggests (and empirical evidence shows) that lower tariffs affect only a very little the size and net trade of such industries. Instead, there is a large expansion of trade in all forestry and machinery products between countries as firms increasingly specialize in the production and export of narrow product lines.

As a result of this type of specialization and "intra-industry" trade, industries reap economies of scale and large productivity gains that had not been considered in the traditional theory and that were not significant in the operation of the kinds of firms important in trade in most industrial products. An econometric study by Richard Harris and David Cox (1983) using the new trade theory suggests that the dynamic gains from the elimination of tariff barriers between Canada and the United States in the longer run will equal five to ten percent of national income.

Lower costs of transportation, communication, and currency dealings are analytically equivalent to the reduction of tariffs. They encourage international specialization and trade. Quantitatively, the effects of monetary union are much smaller than those of lower tariffs and transportation costs. Nevertheless, savings in the costs of foreign exchange will bring dynamic benefits much greater than suggested by the initial cost reductions alone.9

More Efficient Price Structure

Studies have shown that in Europe the prices of identical products on two sides of national borders often were quite different, even for major products like automobiles and in areas over which consumers can travel readily in their search for retail bargains. On the supply side, such price differences can be explained by the organization of markets, taxation, the level of unionization, and the efficiency in retailing and other levels of distribution.

Whatever the causes of these price differences might be, the interesting question for the present analysis is why consumers have permitted them to persist. Geographic distances are not great and language differences in these regions tend not to be a serious obstacle to consumer arbitrage. Free trade has existed in Europe for some time and consumers are able to bring goods across borders freely and without the payment of tariffs. The answer to the puzzle has been found to lie in the fact that prices in the two countries are in different currencies. As a result, consumers find price comparison cumbersome. The technical term used in this context is that prices are not "transparent." In addition, the currency conversion adds extra costs to cross-border shopping.

A common currency in Europe is expected to make prices transparent and eliminate the cost of currency conversion. As a result consumers are expected to equalize the prices of consumer goods. The economic implications of these developments are as follows. Most important, inefficient retailers will be forced to become more efficient or go out of business. In addition, there will be a growth in community-wide, large and efficient distribution firms characterized by brand names and uniform quality known in all countries. These firms will charge the same retail prices everywhere. Consumers will gain from the increased efficiencies and enjoy lower prices.

Under the proposed North American Monetary Union, we can expect analogous developments with increased efficiency required of firms in both Canada and the United States. Consumers will benefit correspondingly.

The prospect of these developments merits two comments. First, for prices to be arbitraged it is not necessary to have large shifts in consumer buying patterns. What counts are marginal changes in the level of sales brought about by relatively small numbers of buyers. As retailers note these changes in sales they will look for causes and respond by becoming more efficient.

Second, differences in taxation and government-set prices are likely to remain obstacles to perfect arbitrage. Increased cross-border shopping may well cause Canadian authorities to impose the goods and services tax and provincial retail taxes on goods purchased in the United States. Of particular importance will be the much higher Canadian excise (sin) taxes on liquor and tobacco products. Problems will also arise if Canadians begin to import large quantities of dairy and other products, the domestic prices of which are set by supply management boards.

It is impossible to predict how Canadian authorities will react to much higher levels of cross-border shopping. During the 1980s, when Canadians took advantage of a favourable exchange rate and did much shopping in the United States, they tended to collect duty on products carrying sin-taxes and subject to marketing board controls. Other products tended to escape GST and provincial tax levies. Attempts to broaden tax collection would have resulted in long delays at border crossings and provoked a citizens' revolt. No government would have wanted to face such a condition in an election.

Some observers will welcome the dilemma faced by the Canadian authorities when the monetary union results in greater consumer arbitrage. It will increase incentives to dismantle supply management practices more rapidly than is now planned under the threat of sanctions permitted by the rules of the World Trade Organization. It will also increase incentives to lower taxes, which is welcomed by many who hope that it will lead to a smaller government. Other observers, mainly from the left of the political spectrum, will oppose the monetary union in order to avoid this dilemma. They like the income redistribution implicit in supply management policies, the social engineering of sin taxes, and the large government fed by excise taxes.

Increased labour-market discipline

The Delors Commission notes that one of the expected benefits from the creation of the Euro area will be "increased labour market discipline" (Commission of the European Communities 1990: 47). I believe that the same benefits would accrue in Canada, where unionization is about 35 percent of the labour force, much higher than that in the United States.

It is well known that unions provide their members with higher wages, greater job-security, and other benefits, all of which have a monetary equivalent value. The crucial question is who pays for the benefits that unions negotiate for their workers. Because of competition in international capital markets, the benefits cannot come at the expense of profits. Instead they come at the expense of other workers, the general public, or both.

The first effect occurs when higher labour costs induce firms to substitute capital for labour. Fewer workers are required to produce the same output and their productivity is raised so that it matches their higher wages. The workers forced to leave the unionized industries are re-employed in the rest of the economy, where they depress wages. Studies have shown that as a result there is a gap of between 10 to 30 percent in the wages earned by unionized and non-unionized workers of the same age, gender, educational qualifications, and work experience. To a large extent, therefore, the gains of unionized workers occur at the expense of other workers.

Most relevant for the present purposes of analysis is the second effect of the higher wages provided by unions to their members. Firms that have some market power are able to pass on higher labour costs through higher prices for the goods and services they sell. The consuming public in Canada ends up paying for the higher wages through higher costs of living and therefore reduced living standards.

However, the general inflation created by this process results in demands for nominal wage increases across the board to compensate the public for the loss in purchasing power. In addition, the higher price levels result in reduced international competitiveness and currency depreciation. The higher prices of imported and exportable goods add to the general inflation and reduced living standards for all, including the unionized workers. In response, wage demands for unions increase again and the cycle of higher wages and prices and depreciation is repeated.

In Europe, where rates of unionization are higher and labour laws are more favourable to unions than in Canada, such cycles have been frequent and pronounced, especially in Italy, France, and Spain. As the Delors Commission notes, these cycles will be curtailed and possibly even eliminated by the adoption of the Euro. The central banks of such countries will no longer be able to depreciate their currencies to protect firms and workers whose price and wage increases have made them lose international competitiveness. As a result, unions must either refrain from demanding inflationary wage increases or face higher unemployment for their members. Either response is equivalent to the achievement of greater labour market discipline.10

In Canada, the power of the unions works mostly through a somewhat different process that is initiated by falling world prices of commodities and the consequent currency depreciation. Figure 2 shows that the world prices of natural resources have been on a consistent and pronounced downward trend.11 These external developments are a theoretically plausible explanation for the fall in the real exchange rate, which is also shown in Figure 2.12

The correlation coefficient (r-squared) between real natural resource prices and real exchange rates is .7 for the period from 1955 to 1998 and supports the theory. However, figure 2 shows some interesting and important periods when it is clear that the relationship broke down. Between 1955 and 1971, commodity prices fell nearly 30 percent while the exchange rate remained unchanged. Between 1972 and 1980, commodity prices remained unchanged and the real exchange rate dropped nearly 20 percent. Only since about 1978 and until 1998, did the exchange rate and commodity prices move together closely along a pronounced downward trend.

The relatively inconsistent pattern of changes in the exchange rates and commodity prices suggests that the depreciation has had other causes. One of them, operative mainly since the middle 1980s, has been pointed out by Michael Walker (1998). In an econometric study, he found that the exchange-rate depreciation was associated with the growing debt of Canadian governments. He explained this phenomenon by suggesting that the increasing debt required growing interest payments to foreigners. To make these payments Canadian governments increased the demand for US dollars, which caused the price of the Canadian dollar to fall.

The second reason involves a dynamic process much like that described above for Europe. A fall in the world prices of commodities results in a depreciation of the Canadian dollar, which produces the desirable result discussed above: employment and output shrink by less than they would have otherwise. However, the lower exchange rate also has the effect of raising profits in other Canadian industries that either export their output or face less competitive imports. The higher profits in these industries bring union demands for higher wages and management's willingness to grant them. These higher wages spread throughout the economy.

Now consider what happens when the slump in the world demand for natural resources ends and prices return to their pre-slump level. The demand for Canadian dollars rises as foreigners buy more Canadian commodities. As a result, the Canadian dollar is under upward pressure. But the appreciation is limited because the higher structure of labour costs in all Canadian industries created during the period of the slump makes Canadian industries less competitive. At every level of the increasing exchange rate, Canadian exports are smaller and imports are higher than they were before the cost increases. Balance of payments equilibrium is reached before the exchange rate returns to the previous level associated with the same world prices for commodities.

For this reason, every cycle of falling and rising world prices results in a downward ratcheting of the Canadian dollar exchange rates. As obvious in figure 2, lower world prices of commodities depreciate the currency but higher prices do not make it appreciate by the same percentage.

The villain in the piece is wage-rate increases that are not matched by compensating gains in productivity in export-oriented and import-competing industries. Under a fixed exchange-rate regime, reductions in the prices at which natural resources can be sold result in downward pressures on wages. But under the flexible exchange-rate system, these pressures are mitigated or even eliminated. In the manufacturing sector, the currency depreciation raises company profits and there is a tendency to believe that labour has become more productive and therefore deserves higher wages. But these productivity gains are illusionary and disappear as soon as the exchange rate appreciates again.13

The creation of the amero will prevent the unfortunate process just described. Declines in world prices of natural resources will no longer cause the exchange rate to depreciate. Profits in other industries will not be increased and unions will be unable to negotiate higher wages based on their employers' profits. In effect, labour market discipline will be increased. Canada will enjoy the same benefits that the Delors Commission predicted would accrue to countries in the European Monetary Union.

The process just described has been analyzed intensively in the context of another large body of economic literature, that which deals with the effect of "temporary tariff protection," This type of tariff protection has been found to lead to wage increases and higher production costs in the affected industries and, as in the case of the exchange-rate protection14 just described, cannot be reversed without serious damage to the protected industry. During the postwar years, especially in developing countries, such temporary tariff protection often became permanent. The parallel between temporary protection of industry by tariffs and exchange rates is obvious. Both types of protection tend to be irreversible.

Better structural adjustment

The preceding analysis considered fluctuations in the world prices of commodities. As figure 2 shows, these fluctuations occurred around a secular decline in these prices. This secular decline has induced labour and capital to move out of industries producing these goods in Canada and to move into industries where their productivity is higher. The flexible exchange rate system has made this process take place at a less than optimal pace for two reasons.

First, the depreciation of the exchange rate provides temporary protection to the industries through mechanisms described in the previous section. Firms and workers may well understand that the decrease in the world price is permanent but, because of the fall in the exchange rate, they do not have to act on it. They can and often do postpone the required downsizing and investments to raise productivity. In doing so they tend to be driven by the hope that the most recent downturn in prices is not permanent.15

Second, under a flexible exchange-rate system the current exchange rate is determined not just by world prices of exports and imports in relation to domestic costs of production. It is also influenced by short-term and long-term capital flows that may be caused by monetary policy or speculation in anticipation of economic or political events. These capital flows are often large and therefore cause wide swings in the exchange rate.

For example, in the early 1990s tight monetary policy in Canada was accompanied by very high domestic interest rates. Capital flowed into Canada in large quantities and raised the value of the Canadian dollar. The event is clearly evident in figure 2. In 1993/94 the Mexican currency crisis spread to Canada, in part because the government was plagued by a large and stubborn deficit. The actions of speculators caused the exchange rate to depreciate. This event is also reflected in figure 2. Courchene and Harris (1999a) suggest that the decline of the Canadian dollar in 1998/99 may have been caused to a considerable degree by a large flow of portfolio capital into American stock markets, which had enjoyed very great price increases not matched by Canadian stocks.

The role played by factors other than commodity prices in the determination of the exchange rate is best summarized by the fact that in the 1990s the terms of trade, that is, the average prices of all of Canada's exports, fell only three percent relative to the average of all of Canada's imports, and all of this while the prices of commodities fell by 30 percent.

Changes in exchange rates caused by speculative and normal capital flows send confusing signals to Canadian producers of commodities. These fluctuations in the exchange rates can aggravate or reduce the impact of changes in world commodity prices on producer's profitability. There are always questions about the duration of the capital flows and their influence on the exchange rate. It is therefore easy to see that the price signals for producers under the flexible exchange rate system are much more uncertain and can delay adjustment more than they will if a monetary union eliminates the Canadian dollar and exchange rate.16

In sum, the problems associated with the flexible exchange rate system have contributed to Canada's continued high and excessive reliance on the production of natural resources.17 A monetary union will assure that these resources will move into the more profitable high-tech and other profitable and expanding industries at a more optimal pace. Canadians' productivity and living standards will increase correspondingly.18

Other efficiency gains

No more monetary policy adventures

Since World War II, most countries of the world have experimented with the use of monetary policy to lower unemployment and raise economic growth. These experiments were based on Keynesian economic theory and the concept of the Phillips-curve trade-off between inflation and unemployment. They were made possible in part because the governors of national central banks had accepted these theories as valid and in part by pressures from governments, which wanted to increase their re-election chances when they fought a campaign during the expected economic prosperity.19

Much of the world inflation and currency instability of the postwar years can be explained by these experiments in macroeconomic policies. It is now well understood that unemployment rates and economic growth cannot be improved by inflation but tend to become worse. As a result, some central banks like the Bank of Canada have adopted policies to assure stable prices, in spite of strong political opposition from some politicians who continued to believe in the trade-off between inflation and unemployment and liked to be able to pressure the Bank into serving their political agenda.20

However, there is no guarantee that the Bank of Canada or other central banks will always remember the outcome of the inflationary policies of the 1970s. Many economists therefore believe that central banks should be made independent of political influences. More important, the central banks should be given constitutions requiring them to pursue only price stability, not full employment.

The German central bank during the postwar years was independent and had such a constitution. Its record was excellent. By contrast, the American central bank, the Federal Reserve, while nominally independent, was subjected to much political pressure to live up to its constitution and make policies to assure full employment. Its record was not as good as that of the Bundesbank. As one indication of the difference in the two countries' monetary policy, we may note that the value of a dollar fell from 4 Deutschemarks to about 1.5 Deutschemarks between the 1960s and 1990s. The Bank of Canada is nominally independent but like the Federal Reserve faced strong political pressures to allow inflation to develop and bring lower unemployment rates.

Drawing on the lessons of postwar monetary history, the European Central Bank was given a constitution that makes it politically independent and responsible only for the pursuit of price stability. Full employment is not a mandated task for monetary policy. In the introductory section of this study describing the characteristics of the North American Monetary Union and its institutions (page 5), I assumed that its constitution will be modeled after that of the Bundesbank and the new European Central Bank.21

Constitutions cannot guarantee that politicians and bureaucrats behave in the way the framers of the constitution intended. However, I believe that the greater the number of independent nation states have a stake in it and have collaborated on the writing and enforcement of its constitution, the more likely it is that an organization will adhere to its mandate and remain free from political influence.22 Therefore, Canada is more likely to be protected from the adverse consequence of future misadventures in monetary policy as a member of a North American Monetary Union than if it had its own central bank exposed to influences by ambitious politicians and public opinion.

Imposing fiscal responsibility

Membership in the Euro-system imposes on governments the requirement to keep government deficits to less than three percent of national income. This rule was created because large deficits by a member country or a number of countries can lead to foreign borrowing which puts upward pressures upon interest and exchange rates in the Euro-zone. The deficits of one group of countries, therefore, affect the well-being of other members of the union. In this sense, the deficits are the equivalent of a classical economic externality since they affect all countries in the union. The limits on deficits are a method for preventing the development of such externalities.

I believe that the concern of Europeans over the effects of national government deficits is exaggerated. In federal states like the United States and Canada, the ability of junior governments to borrow and impose externalities on others is limited because of private capital-market sanctions imposed on the transgressors. Higher debt-service costs and often just the down-grading of the risk of debt issued by the jurisdiction tend to prompt legislatures to mend their ways, even if they do so often at an undesirably slow rate.

Nevertheless, in the description of the North American Monetary Union at the beginning of this paper, I have assumed that it includes an agreement that limits the freedom of member countries to incur large and persistent budget deficits. I hope that this policy will be adopted in the light of the reasoning that led to its inclusion in the European Monetary Agreement and in the memory of the large deficits of the 1980s and 1990s and the economic problems they have caused for almost all industrial countries.

Having a voice in policy formulation

The European Monetary Union and the United States are two very large, self-sufficient, currency areas. Trade and capital flows with the rest of the world represent only a small fraction of their national incomes. These conditions mean that monetary, fiscal, and exchange-rate policies in these regions can and will be determined almost exclusively with the objective of stabilizing internal conditions and maximizing economic growth. The exchange rate is a policy instrument of relatively little importance and consequence for domestic prosperity.

During the 1970s, an important academic discussion took place about the merit of such self-centred American policies, which were expected to be adopted once the dollar-gold exchange standard and parity exchange rates were replaced by flexible exchange rates. Exchange rates were important for the small countries of the world and many of them insisted that the United States take into account the effect that her exchange rate policies had on them.23

The main conclusion of the debate was that the United States should continue with her policies, treating the exchange rate with benign neglect, rather than as an instrument for gaining an advantage for herself. Smaller countries would gain from such a American policy stance because the resultant prosperity of the largest industrialized country would bring increased demand for their exports and significant stimulus for their own economies. It was expected that this stimulus could be determined by each nation through its own exchange rate policy.

We may expect that the European Monetary Union and the United States in the future will practice benign neglect of their exchange and interest rates. Such a policy may increase their prosperity but there will also be an increasing risk that the exchange and interest rates in the United States and the European Monetary Union will clash with the interests of Canada, Mexico, and other small countries. The problem will be how the voices of small countries can be made to be heard and their interests be made to count in the determination of policies of the large currency blocks.

Some international forums exist at which small countries can remind the United States and Europe of their concerns. The best known of these forums are the regular summits of heads of government and meetings of ministers of finance of the group of seven industrialized countries (plus Russia), the regular Bank for International Settlement consultations and the work of the International Monetary Fund. But the influence of smaller countries like Canada and Mexico in these forums will be reduced because they will have lost the support of the smaller European countries, which have joined the European Monetary Union.

As a result of these developments it will be increasingly more important that Canada and Mexico have direct input into American policy formation. The proposed North American Monetary Union offers such an opportunity. Canada and Mexico will be represented on the board of the North American Central Bank, where they will argue their case and may even be able to influence policies through voting alliances with American representatives.

It is clear that the United States will have a majority of members on the board and that, in principle, they can always vote for policies that maximize American interests. However, in practice we may expect divisions among American board members since they represent different regions of the country with different industrial and agricultural interests. This fact will give rise to the opportunity of board members from Canada and Mexico to ally themselves with these regional interests. For example, American prairie states and Canadian prairie provinces have more economic interests in common than they have with other states and provinces in their own countries. There are similar affinities between American states and Canadian provinces in the northeastern and northwestern sea-boards.

Another threat to small countries will come from their exposure to the whims of currency speculators from around the world. These speculators will find it more difficult to bring about changes in monetary and exchange-rate policies in the very large and deep markets of the European Monetary Union and the United States than in the small markets of countries like Canada and Mexico. Only membership in a North American Monetary Union will permit these two relatively small countries to escape periodic, damaging attacks on their currencies by international speculators.

Retaining seigniorage

The printing of notes and the minting of coins gives rise to large profits for any government since the cost of printing and coining is much smaller than the value of the goods and services that can be obtained through the use of the notes and coins. In Canada these profits, known as seigniorage, recently have been about CDN$2 billion annually.24 In practice, the Bank of Canada uses newly issued currency to buy bonds issued by the Government of Canada; these bonds yield interest that is used to pay the cost of operating the Bank of Canada.25 The remaining revenue is paid to the Receiver General.

Under my proposed agreement for the creation of a North American Monetary Union, Canada will retain the current level of seigniorage. Canadian institutions will continue to produce the notes and coins and the Bank of Canada can continue to put them into circulation through the purchase of government bonds. The profits may even be larger if some of the traditional operations of the Bank of Canada are no longer needed and operating costs decline correspondingly.

The merit of the proposed monetary union in this respect will be discussed further in a section below where I analyze the merit of currency boards and the use of American dollars, both of which have been suggested as alternatives to monetary union.

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