The Case for the Amero: Alternatives to the Amero

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It has been argued that most of the benefits of a North American Monetary Union just discussed can be achieved by other institutional arrangements at lower costs to national economic sovereignty. Three alternatives have been proposed:

1. fixed exchange rates;
2. the establishment of a currency board;
3. the use American dollar notes and coins, also known as "dollarization."

These financial arrangements have been analyzed intensively by economists and there is an historic record in the use of all three. (The institutional characteristics and the financial and economic costs and benefits of different currency arrangements are presented conveniently in the Appendix,)

Fixed exchange rates

Two prominent Canadian economists, Richard Harris of Simon Fraser University and Tom Courchene of Queen's University have advocated that the Canadian dollar be linked to the US dollar through a fixed exchange rate (see Harris 1998; Courchene 1999; Courchene and Harris 1999a, 1999b, 1999c). In their analysis, the authors present essentially the same arguments that I have made above about the economic costs of the existing flexible exchange rate system. The authors recommend the fixed exchange rate rather than a system of monetary union because they believe that there would be too much political opposition from Canadian nationalists and other interest groups to the amero. They are hopeful that this opposition will lose influence as the euro functions well and brings the benefits they, I, and other euro-optimists anticipate. They also believe that a successful operation of fixed exchange rates in Canada will pave the way for a monetary union. In my view, for a number of reasons a fixed exchange rate is not an adequate interim solution and most certainly not a solution for the longer run.

First, the government's commitment to fixed rates is too easily reversed as different parties form government or a new economic ideology takes hold. Only a binding international treaty will avoid this problem, bring lower interest rates, greater labour-market efficiency, better rates of adjustment to changing world prices, and the other benefits noted above.

Second, even if there were to be no political or ideological developments that result in exchange-rate changes, other developments are likely to force them. Thus, external shocks can cause the domestic economy to overheat or enter a recession. Exchange-rate changes are often the easiest way to deal with these problems. For example, Canada's fixed rate was abandoned during the early 1970s because international inflation and rapid increases in world commodity prices caused a disequilibrium in the balance of payments. To maintain the fixed rate would have required changes in domestic policies, changes that were considered unacceptable.

Another frequent cause of the abandonment of a fixed exchange rate is domestic mismanagement of the economy, which creates balance of payments problems and encourages speculative capital flows. Under these conditions, typical attempts by national central banks to fight such speculation only succeed in delaying the inevitable for relatively short periods. Higher interest rates and the sale of international reserves attack the symptoms of the crisis and fail to correct the fundamental problems. Assistance by the International Monetary Fund is usually too little, coming too late.

During the 1990s, Mexico, Brazil, Indonesia, Thailand, and Malaysia experienced economic mismanagement in the form of large government deficits, excessive investment in projects not tested for a market, unsound banking practices, inflation caused by monetary policy, or the exercise of union power. For these problems, the abandonment of fixed exchange rate was the only viable way out of the crises.35

Perhaps Canada can avoid shifts in ideology and the problems arising from mismanagement. However, economic history suggests that this is not likely. Periods of good economic policies inevitably have been followed by the repetition of old mistakes or by the invention of new. Fixed exchange rates will make the effects of these mistakes more serious.

Currency board

Under a currency board, a country's money supply is fully backed by US dollars and changes only in response to international payments imbalances. When the country has a surplus, the excess supply of dollars brings about an increase in the domestic money supply. The opposite occurs when the country has a deficit.

Changes in the domestic money supply encourage economic stability since, in the case of an international payments surplus, the increased money supply lowers the domestic interest rate, raises economic activity, and lowers capital inflows. These changes push the payments into balance. Deficits in international payments have an analogous, stabilizing effect. Most important, the country's central bank is no longer able to influence monetary, interest, and exchange-rate policies and, thereby, serve the whims of politicians. The exchange rate is permanently fixed.36

Currency boards have a long history. All past experiments had been abandoned until recently when Hong Kong, Argentina, and Estonia have adopted them. The boards in these countries have been very successful during normal periods. One of their main two short-comings tend to appear during periods of international and domestic instability. There have been reports that the Hong Kong board manipulated the link between payments imbalances and the domestic money supply during the great Asian currency crises and recession in 1997/1998. In Argentina, speculators with doubts about the permanence of the system in 1998 withdrew funds and forced large reductions in the domestic money supply on the country. In the end, however, the system was not changed and the crisis has ended. Capital markets still have some doubt about the permanence of the Argentinian system since they demand a slightly higher interest rate on government obligations denominated in pesos than on those denominated in dollars.

The second main short-coming of a currency board is that it results in the complete loss of national monetary sovereignty. The country's interest rate is completely and permanently linked to that prevailing in the United States. At the same time, Argentina, Hong Kong, and Estonia have no influence whatsoever on American monetary policy.

One important advantage of a currency board over monetary union is that it does not require international agreement. The countries presently using currency boards did not need the permission of the United States.

"Dollarization"

"Dollarization" is a new word coined a short time ago to describe two processes.37 First, there is "market dollarization," under which much domestic business is carried out in US dollars. Large segments of the Mexican economy are dollarized as prices, wages, and contracts are denominated in dollars. Dollar notes and coins circulate widely and financial intermediaries accept deposits and make loans in dollars. In Argentina, a similar process of informal private dollarization had been so wide-spread so that the adoption of a currency board meant very little change in financial practices.38

The second form of dollarization is official and exists at present only in Panama and Liberia. It has been the policy of the government of Panama that all bank-notes in use are US dollars. Only coins are produced in the country, carry national symbols, and are called Panamanian dollars. In 1999, negotiations are under way to replace the Argentinian currency board with official dollarization. Early in 1999, the Mexican bankers' association and other influential lobby groups have asked their government to consider formal dollarization.

During the 1980s, some economists persuaded an influential politician in Israel to suggest that the country also should abandon the shekel and replace it with US dollars. This did not appear to be a very radical suggestion since, during several periods of high and unstable domestic inflation, the US dollar had developed into a parallel currency in Israel. Retail prices were given in dollars, which changed rarely, and simultaneously in shekels, which were adjusted frequently. Banks accepted dollar deposits and made dollar loans. Nevertheless, the recommendation caused a political uproar and was soon withdrawn.

The benefits from dollarization are that the country using it never faces currency crises. It does not have a central bank that can manipulate the money supply and interest rates in response to demands from ideologists and politicians. In effect, dollarization causes a permanently fixed exchange rate. It therefore brings all of the benefits noted above. Like the currency-board system, dollarization does not require international agreements. There is nothing the United States could do if Canada replaced its own currency with US dollars.

The main disadvantages of dollarization are that the country using it gives up its seigniorage and influence on interest rates. As noted above, Canada's seigniorage in recent years has been about $2.5 billion annually, a tidy sum but only about 1.5 percent of federal tax revenue.

However, there now exist proposals for removing this disadvantage, which appears in two dimensions. The first arises when the dollarization begins and a country's own currency is replaced by dollars. A country like Canada has reserves of gold and dollars large enough to buy all the needed US notes. To help a somewhat less wealthy country like Argentina, Robert Barro (1999) has suggested that the American government provide the dollar notes needed in return for an equivalent supply of pesos as collateral.

The second problem arises from the continuing need for additional dollar notes as the economy grows. In a report to the United States Congress, the Joint Economic Committee analyzed the issue and recommended that the American government pay to a country like Argentina the share of the total American seigniorage that is attributable to the new dollar notes used in that country (Schuler 1999).

It is possible that the American government would enter into seigniorage sharing agreements with Canada under which it would accept Canadian dollars as collateral in return for the initial supply and pay seigniorage annually in accordance with Canada's additional holdings of US dollars.

Nationalists in Canada would almost certainly oppose very strongly the official dollarization of the domestic money supply on the grounds that the currency is a very important symbol of national sovereignty and identity. It is possible that nationalists would be able to mobilize enough political opposition to dollarization to kill the policy, though Argentinian nationalists appear to have failed in their efforts. The main reason for this result in Argentina may well be that the country is so dollarized privately that making the process official and complete is not a big step.

In sum, the alternative methods for creating the benefits of a monetary union have a number of defects and basically are inferior substitutes. If a Canadian consensus emerges that flexible exchange rates are to blame for many of the country's economic ills, monetary union is the preferred alternative institutional arrangement.

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