The Case for the Amero: Some Other Important Issues

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Treaties and international agreements are relatively easy to discuss in general terms and with a focus on the large issues involved. However, once a consensus exists and it is decided to move ahead with the signing of such agreements, many smaller details have to be sorted out. While the devils in such details do not typically change the consensus about the overall merit, they need to be considered carefully. Rationally, they should be included in the analysis of the costs and benefits of the overall proposed agreement. The following sections discuss a number of such smaller issues.

How would the value of the amero determined?

There are several advantages to making the amero worth one US dollar. First, the cost of conversion would be minimized since, in the dominating, large American economy, all financial assets, liabilities, and other contracts remain unchanged. They do not have to be converted and accounting changes involve only the renaming of the currency. Second, US dollar notes and coins could continue to circulate after the introduction of the common currency. They could gradually be replaced by amero notes and coins as they wear out. Third, the opposition to the amero by Americans would be minimized as their financial transactions and accounting would be virtually unchanged.39

Basic economic principles suggest that with the amero worth one US dollar, the Canadian dollar cannot be equal to one amero also. I have encountered persons who argued that such a conversion rate of one for one in Canada would be just and that any other rate would be bad for Canada. This argument is false. If the two dollars were converted at par, it would be equivalent to roughly a doubling of the value of the Canadian against the US dollar. As a result, Canada's trade would be in very large deficit, there would be a recession, and the downward pressure on wages would be very strong. Canada would go through the same difficult process encountered by Germany, which, upon reunification with the formerly communist part of the country, decided that all wages and prices there would be converted at a rate of one East German for one West German deutschemark. The market exchange rate between the two currencies was about six East German deutschemark to one West German deutschemark. The official motivation behind this policy was that it would prevent massive migration to West Germany by workers attracted to higher wages there. In the adoption of the policy, an important role was undoubtedly also played by the pressure of unions and employers in West Germany, who had feared that low wages in East Germany would cause "unfair" competition and threaten living standards in West Germany.

It is ironic that the policy adopted reduced West Germany's living standards more significantly and for a longer period than would have occurred if wages and prices in the East Germany had initially been lower than those in the West Germany. Because of the policy adopted, it was necessary not only to invest large resources in upgrading the infrastructure in East Germany and in bailing out its unfunded pension system. But, as economists had predicted--this is most relevant to the current analysis--additional massive transfers were necessary to keep the economy of the former East Germany functioning at all and unemployment rates at a socially acceptable level. Five years after they began, the subsidies to labour and capital are continuing to flow because the wages paid still exceed the productivity of labour. Private capital still has few incentives to make unsubsidized investments in East Germany.

Most important, to finance these transfers, West Germany had to raise already high rates of taxation. As a result, the economic performance of all of Germany has been poor and there is no early prospect for improvement. There are important unresolved questions about the future. Will it ever be possible to stop the subsidies that have been built into the economic structure and are threatening to become considered a right? Canadians are familiar with the effects of continuous large transfers to the Atlantic provinces and the resultant dependency of the region on such support. Chances are that the same conditions will develop in much of the eastern part of Germany.

For economic reasons, the validity of which is evident from the German experience, the Canadian dollar will have to be valued at a rate that does not affect Canada's international competitiveness in the longer run. Such an efficient rate of exchange by definition would leave unchanged Canada's exports, imports, interest rates, capital inflows and outflows, production, employment, and unemployment.

Unfortunately, it is difficult to determine in practice what such an optimal rate of exchange would be. The market exchange rate is only an imperfect guide since it is distorted frequently by temporary, often speculative, short-term capital flows and random influences on trade in goods and services.

In Europe, conversion rates were established gradually during a period of ten years leading up to the official adoption of the euro on January 1, 1999. During this period, countries progressively co-ordinated their domestic monetary and fiscal policies. Increasingly stricter rules were applied to countries of the European Union aspiring to membership in the currency union with respect to acceptable inflation, deficits, and debts. This process resulted in growing exchange-rate stability and ultimately produced the rates for conversion into the euro.40 We might expect a similar, lengthy process, say, five to ten years, of co-ordination of monetary and fiscal policies to result in more stable exchange rates among the countries of North America, which would reflect national competitiveness as defined above, rates at which the final conversion would take place.

It should be noted, however, that it is not overly important that the exchange rate used for the initial conversion is precisely equal to the theoretical optimum. A deviation of perhaps two percent to three percent from that optimum would probably be eliminated quickly through normal increases in trade and productivity, without requiring changes to current rates of pay.

The external value of the amero against the euro, the Yen, and other currencies will be determined in the longer run by prices, income, and productivity in the amero region relative to those in the other zones. Chances are that the exchange rates with these large trading blocks will be close to those prevailing against the US dollar in the period preceding the union, simply because the trade and capital flows of the United States will be of overwhelming importance in the activities of the amero zone.

During the period before the union is created, speculators may distort the equilibrium dollar exchange rate. Cyclically low or high interest rates designed to minimize unemployment or inflationary pressures might result in capital flows and correspondingly distorted value of the dollar. We might see a repetition of the experience of the euro, which started life at 1.18 against the US dollar but, six months later, had fallen to near parity.

Nevertheless, just as no significant tensions and demands for change of that dollar-to-euro exchange rate have developed since its fall against the dollar, so we may expect that the amero's value will be relatively unimportant for the amero zone. The bulk of the trade of Canada, Mexico, and the United States will be with each other and will not be influenced by the external value of the amero. In 1999, fully 80 percent of Canada's trade was with the United States and monetary union would increase this figure even more.

The advantage of this relative independence of economic conditions in the amero zone from the value of the region's currency is, of course, one of the major benefits. It will allow the North American central bank to make monetary policy with price stability as its most important policy objective while the exchange rate is given even less consideration than it has been by the Federal Reserve since the 1970s.

Political accountability, independence, and escape clauses

In the description of the institutions of the proposed monetary union, I noted the requirement that the central bank will be independent from political influences and required to pursue only stable prices, not full employment. Such an institutional arrangement raises important questions about accountability. In democracies, all government institutions are subject to control and change by legislatures if conditions warrant. If the independence of such institutions is protected by constitutional clauses, changes are more difficult. But, in the case of true emergencies, as might be caused by natural disasters, war, or serious and prolonged economic dislocations, we may expect legislatures to assert their dominance.

The independence of other institutions like the World Trade Organization and the North American Free Trade Agreement is also less than complete. When the national interest is threatened enough, rules governing trade can be suspended by the invocation of "escape clauses" by any signatory nation. There are special provisions under which such threats to the national interest can be taken to agreed-upon tribunals and processes for adjudication.

The escape clauses and adjudication procedures under the World Trade Organization and the North American Free Trade Agreement have, in the view of many Canadians, been invoked too often and have damaged the credibility of these treaties. Much of this criticism is focused on the softwood lumber agreement between Canada and the United States and American quotas on Canadian steel exports. Other trade disputes periodically are discussed widely in the Canadian media, almost always with the suggestion that Canadian interests are battered by the United States government.

As it turns out, Canada has launched more complaints about unfair trade practices and injury to industry than has the United States. The rulings in the softwood lumber case and steel went against Canada but many went against the United States. It is just that the latter are never discussed in the Canadian media.

Most important about these rulings and the operation of the mechanism for resolving trade disputes are two facts. First, the amount of trade involved in these disputes is only a very small fraction of the total. Second, if there were no such mechanism the basic problems giving rise to them would still exist and lead to much more disruptive, often unilateral, actions by authorities wanting to protect their national interest. The resolution of these conflicts through a well-defined process based on the rule of law is much superior to the alternative.

It is almost certain that the proposed North American Monetary Union will contain provisions much like those contained in the free trade agreements. They will allow the reassertion of national sovereignty under exceptional circumstances. These will almost certainly include a procedure by which a country can leave the union, re-create a national central bank and re-assert its national monetary sovereignty. There will be rules and dispute settlement mechanisms to deal with complaints from members that the operation of the amero system has caused them harm. Such a settlement procedure might deal with the distribution of seigniorage from the issuance of currency, the costs and benefits of the North American Central Bank from its function as the lender of last resort, the effects of open-market operations in different debt obligations on the liquidity and interest rates in national capital markets and other rather technical matters.

However, the monetary union agreement will face a trade-off encountered in the design of all international, co-operative organizations. There has to be a delicate balance between, on the one hand, giving the central bank freedom from political influence and, on the other, making it ultimately accountable to politicians if conditions demand it. This delicate balance is not easy to achieve but experience with other international agreements has shown that it is possible to do so.

Deposit insurance and lender of last resort

One important function of governments throughout the world has been to prevent financial crises that in the past have often spilled over into the real economy, causing recessions and unemployment. Historically, such crises started when a bank was in financial trouble, which in turn induced a run on the bank by depositors who wanted to withdraw their money. As the bank in trouble attempted to convert its assets into cash and call in loans, the prices of securities crashed and borrowers were forced into bankruptcy. These events then affected overall economic conditions. Other banks faced cash withdrawals and the need to convert their assets into cash. The process involved an ever-larger number of financial institutions and firms in the economy. Unemployment and economic turmoil brought much hardship to the public.

After many years of experimentation governments have developed two lines of defence against such financial crises. First, the national central bank is charged with lending banks cash so that they can meet the demands of depositors. In practice, the central bank takes marketable securities and notes as collateral for such loans. As it has turned out, after the central bank's function as the lender of last resort had worked successfully during a number of crises, the public no longer made a run on banks. Since they now knowing that they can get their cash any time they want it, the public decided that it really did not want it.

A second line of defence against financial crises has been the creation of deposit insurance systems. In some countries, they are administered by separate government agencies, in others, they are handled by the central bank. In either case, banks pay to the deposit insurance authority small annual premiums on the deposits they hold. In return, this authority pays out to depositors their balances--normally up to a certain limit--even if their bank goes bankrupt. Such failing banks are then taken over by the insurance authority and its assets are liquidated slowly to prevent upsetting the market. The greater the recovered value on the failed bank's assets, the smaller is the authority's net cost of paying out the depositors. As in the case of the liquidity guarantee, the deposit insurance has helped greatly in the prevention of economy-wide financial crises.

However, the very existence of the deposit insurance has become a moral hazard that has induced banks to make riskier loans bringing higher returns. Depositors are attracted to the higher interest rates they can earn from such banks and they do not care about the riskiness of their investments. Whatever happens to such banks, they will receive back their deposits from the insurance authority. To limit moral hazard and its effect on the economy, governments have regulated banks and created powerful supervisory authorities. As a result, banks have to maintain certain ratios of equity to loans and must publish financial reports that provide information needed by the public to assess each bank's financial condition.

Importantly, there are also limits on the size of the deposits insured. Economists have long argued that in the United States and Canada these limits are too high and reduce incentives for the public to keep informed about the financial conditions of their banks. Economists' recommendations have been disregarded by politicians who insist that the high levels of insurance are needed to protect financially naive depositors. Financial institutions have supported politicians, no doubt because the insurance of large deposits was in their interest. Economists blame these conditions for a number of bank failures that have occurred with some frequency in Canada and the United States during the last 20 years. While these events did not result in wide-spread financial crises, they did put heavy burdens on the deposit insurers.

In some instances, like the bankruptcy of a large number of savings and loans associations in Texas during the 1980s, the value of loans on real estate assets held by banks fell so much that the American deposit insurance agency had to be given billions of dollars by the government to meet its obligations to depositors. Taxpayers in effect suffered as a result of inadequate deposit insurance provisions and bank supervision.

Presently, the United States, Canada, and Mexico have national systems of deposit insurance and bank regulation that differ substantially. The risk of failures and of having taxpayers burdened with deposit insurance payout differs among these countries. Is there a need to do something about this problem when a monetary union is formed?

In my view, there is no such need. Consider that there are two approaches to deposit insurance. One is to form one insurance agency for the entire region and pass uniform rules for bank regulation. Under this system, presumably, the premiums paid by the banks in each country are adequate to cover costs arising from bank failures in each on average and under normal patterns of failure. If large failures take place and insurance funds are inadequate, the costs to taxpayers can be prorated according to where the costs originated.

Such a centralized system for deposit insurance was rejected in Europe as too cumbersome and as infringing unnecessarily on the sovereignty of individual countries. Instead, it was agreed that each country would retain its own deposit insurance system and its taxpayers would be responsible for the cost of bailouts. However, under this system the question of foreign banks arises. Are French banks in Germany subject to French or German deposit insurance rules? The answer to this question was provided by the invocation of the principle of mutual recognition.

This principle had previously been adopted in connection with national regulations about product safety, health, occupational and other areas. After much effort, it had proven impossible to reach specific rules that were acceptable to all countries of the European Union. Mutual recognition of every country's set of rules was adopted as a compromise. As a result, a tractor built for example according to Dutch safety regulations could be sold in Spain even if Spanish safety rules were different. In return, tractors built under Spanish regulations could be sold in the Netherlands.41

The application of the principle of mutual recognition in the case of bank regulation means that each country retains its own rules and applies them to all banks chartered in its territory, in whatever member country of the union they operate. As a result, a Dutch bank operating in Spain pays deposit insurance to the Dutch authorities. If that bank fails, the Dutch insurance authorities and ultimately the Dutch taxpayer are responsible for making good on the bank's deposits. At the same time, the Dutch bank in Spain operates under Dutch regulations.

The system of mutual recognition is not perfect. The Dutch bank may be subject to such onerous regulations and high premiums that it cannot compete with its Spanish rivals. Such a problem is not likely to persist for long. To start, under these conditions the Dutch bank is highly unlikely to operate in Spain. On the other hand, the laxer Spanish rules will permit that country's banks to operate in the Netherlands. The competitive pressures from such different rules are certain to lead to an equalization of regulations. What governmental negotiations could not achieve, market competition will bring about.

Those in favour of a centralized solution to such problems tend to argue that the competitive process will result in a "race to the bottom." Countries will lower the cost of regulation and therefore bank safety in order to provide a competitive advantage for their country's banks. However, a country that goes too far in this direction will soon incur large bailout costs and therefore face pressures to tighten regulations. This process assures that national deposit insurance regimes not only converge but also become economically optimum.

There are no reasons why the system of mutual recognition cannot also be applied in North America. If it is, monetary union will not affect the safety of national financial markets and institutions. The government of every country will have to bear the cost of short-comings in their own national system. Insurance levels and regulatory environment will converge and become optimum.

But what about the North American Central Bank's function as the lender of last resort and provider of liquidity? For national central banks the operation of this function in the past has not been costly. One reason is that it has come into play only rarely. A second one is that loans of cash are backed by collateral so that even if a bank is unable to repay the loans, much of their value can be recovered.

If this history of national lenders of last resort is a guide, the North American Central Bank's pursuing this function for the entire amero-zone may be expected to involve very few costs. Nevertheless, it might be useful to design a system under which costs can be recovered from the treasuries of individual countries according to the location at which the costs are incurred. If the provision of liquidity to Canadian banks results in costs, the Canadian treasury will have to reimburse the North American Central Bank.

Transition costs and long-term benefits and costs

In the enthusiasm that often accompanies the creation of new institutions, it is easy to lose sight of the costs of moving from the old to the new system. Yet, these costs can be quite high and they should not be neglected when the long-term benefits and costs are considered.

In the case of the proposed monetary union, it will be costly to replace existing bank notes and coins with new ones, which will have to be designed and manufactured. In Europe, the design of euro notes involved a lengthy and complicated process to reach decisions on size, colour, and images. All of the symbols on the bills are abstract and carefully chosen to prevent the appearance of national icons. As it happened, one computer-created abstract design of a bridge was seen by some as a reproduction of a bridge in France. That design was promptly altered. It may appear a trivial issue to some but, while US bank notes are of equal size and colour in all denominations, many countries prefer to have different sizes and colours for each to assist the blind and people with other handicaps. It may be difficult to persuade Americans to give up their style of greenbacks using equally sized paper for all denominations. Similar resistance to change may be expected from Canada and Mexico.

In all countries, existing plants for the printing of bank notes and coins are designed to produce only the continuous additions to the outstanding stock of national money required as a result of economic growth and inflation. These plants, therefore, do not have the capacity to turn out in short order the much larger quantities of new euro notes and coins needed to replace the national ones. The capacity of the plants could have been increased for the task but it was decided instead that the production of the new money should be spread out over a number of years. As a consequence, there is a costly requirement to store and keep safe the growing stock of notes and coins.

Putting the new euro notes and coins into circulation after the official date of conversion and withdrawing the national currencies is also a lengthy and costly process. A public used to recognizing counterfeit national currency will have much greater difficulty distinguishing genuine new euro notes from fake ones. Many people will have difficulties adjusting to the new notes, coins, and prices for the things they buy.

In Europe, large numbers of automated machines are used to dispense merchandise, permit gambling, and allow the withdrawal of cash. These machines need to be replaced or adapted to accept and dispense the new notes and coins. There have to be new shapes to the receptacles and dispensers of notes. The electromagnetic sensors of coin receiving machinery have to be adjusted. The electronic brains of some machines have to be changed or replaced.

The accounting books, machines, and programs of private firms and governments in Europe have to be converted from national currencies to the euro. Provisions have to be made to deal with the large numbers of outstanding stocks and bonds denominated in domestic currencies. The price tickets on merchandise have to be changed to prices in euros. Such conversions to new prices often raise public concerns over gauging as there is a widespread perception that business is more likely to round fractional values up rather than down. This concern became a major issue in the 1970s, when Britain replaced the imperial with the metric system for fractional units of its currency.

The private costs of converting to the euro just listed will cost billions. The same level of costs will arise in the conversion of national currencies to the amero. However, in assessing the importance of these costs in the overall picture we need to remember that they arise only once. In contrast, the benefits of lower interest rates and greater efficiency discussed above accrue for the indefinite future. It is for this reason that the transition costs for the North American Monetary Union--as in other institutional changes--should be considered but are unlikely to upset the rational case for union.

Maintaining jurisdictional competition

A logical question arises if one concludes that on balance monetary union in North America is desirable. Why stop at that regional association, why not give the entire world one common currency? I have three answers to this question.

Let me approach my first answer in the context of the likely future development of the European Monetary Union. Assuming that it will be successful, it is likely that other countries will join it. As noted above, the original 11 countries will almost certainly be joined by Greece, Denmark, and Britain in the near future. There is a good chance that the Czech Republic, Hungary, Poland, and Estonia will not be far behind. Thereafter may well come requests for membership from Turkey, Russia, Rumania, Bulgaria, and other countries of Central Europe. Countries from Africa and the Middle East might want to join eventually. It is difficult to predict how such requests for membership will be handled but there are some obvious problems to be considered.

The cultural and political affinities between the present and potential members are much less than they were among the original group. There is no economic union among these potential members and the union may not be extended because of the very large differences in the levels of economic development and even economic systems. The vision of a politically integrated Europe resembling the United States in size and power stops at the continent's borders. In addition, the decision-making process in the European Central Bank will be very much more complicated by the cultural, economic, and linguistic differences. Economies of scale in administration may well disappear and become diseconomies if the union becomes too large and contains too many nations with different languages, different cultures, and different levels of industrialization.

My second answer to the question why it is not optimal to have only one world currency has been articulated effectively by European libertarians who are concerned with the growth and centralization of government. Their opposition to the European Monetary Agreement is based on the accompanying growth in laws and regulations that limit individual freedom and the reduction of competition among jurisdictions.

Roland Vaubel (1994) is a prominent European economist who developed the latter argument about reduced competition among jurisdictions fully, using the public-choice framework of analysis. In his view, Europe and possibly the world were saved from the mistakes of Keynesian economics, harmful inflation, and unemployment by such competition among jurisdictions. During the 1970s, economic policies inspired by Keynes were adopted by virtually all industrial countries, including the United States. The only hold-out was Germany's Bundesbank. It condemned government deficits and refused to adapt its monetary policy to accommodate them. As a result, Germany escaped the fallout from the Keynesian policies. It avoided the inflation, unemployment, slow growth, and wage and price controls besetting other countries.

Vaubel expresses the view that Germany's ability to be different was important in showing to the world the errors of Keynesian economics and, as a result, hastening the return to the more traditional policies of balanced budgets and stable prices.

I share Vaubel's basic view about the merit of competition, be it in markets or among jurisdictions, even if he may overestimate Germany's role in persuading the world to turn away from inflation and deficits. The analysis of competition among the national providers of deposit insurance presented above support this position. However, I disagree with his opposition to monetary unions in principle because a network of monetary unions in the world will preserve the valued jurisdictional competition, albeit in a setting resembling an oligopoly more than the economic model of perfect competition. However, the fact that there will be only few competing jurisdictions is not as important as one may think because, unlike economic competition, jurisdictional competition has no consumers to exploit. Moreover, as the modern theory of oligopoly notes, the market power of colluding firms is limited by the availability of substitutes and potential entrants. In the case of jurisdictional competition in monetary policy, the breaking-away of member countries serves the same functions as potential entrants into economic markets: the threat of the break-up of a union serves as an important constraint on the freedom of the central bank of any currency unions to impose self-serving and untested policies. For this reason, the optimum currency area is not the world.42

A third answer is implicit in the arguments in favour of the gold standard or a standard based on a basket of basic commodities. Professor Reuven Brenner (1999b), among others, is concerned about the political and bureaucratic manipulation of monetary policy. History since World War II is full of episodes where these forces made monetary policy serve their own rather than the public interest. Economists such as Brenner believe that the only solution to the problem is to make the value of money dependent upon gold or a basket of commodities, the supply of which is beyond the control of governments. If the world were to move to such a monetary standard, exchange rates among countries would automatically be fixed and the benefits noted above would accrue to all of them.

Implicit in the arguments in favour of a commodity-based standard of value is the fact that the larger the political constituency served by a central bank, the more likely it is to be subject to political manipulation by powerful or numerous groups that turn monetary policy into an instrument serving their interests at the expense of the rest of the world. Some of the United Nations agencies like UNESCO (dealing with education matters), the ILO (dealing with labour issues) and the WHO (responsible for health policies) have been accused of being dominated by left-wing bureaucrats and the large number of developing countries in the United Nations. They are seen to be operating inefficiently and making policies that are inconsistent with free markets and societies. They tend to apply policies determined centrally and not adapted to deal adequately with local conditions.

A growing chorus of criticism in this spirit has been levelled against the International Monetary Fund and the World Bank, some demanding their dissolution. It is possible that a world central bank would similarly become captured by interests making it too bureaucratic, subject to political influences, and remote from local issues. I share these concerns and therefore think that regional monetary unions are superior to one world bank and a common currency for the entire globe.

Of course, a monetary system based on a gold or commodity standard would achieve the objective of removing decisions about the supply of money nationally and globally from the influence of politicians. However, the history of gold standard has shown that it suffers from its own defects. There is the basic irrationality of people digging gold out of the ground at the expense of capital and labour, gold that is then reburied in the vaults of central banks. The supply of gold was subject to new discoveries and recovery methods, which at certain times led to inflationary increases in money supplies. For example, the development of the cyanide process for the recovery of gold from the South African fields in the 1890s dramatically increased the supply of gold and brought such disturbances. (For an analysis of the merit of the gold standard, see Grubel 1984, chapter 5.)

Money-supply systems based on gold and commodity backing have been proposed many times in this century but failed to attract sufficient interest from any government. The main reason for this lack of interest is the removal of the political influence that they require on interest rates and the money supply. While this feature makes the system so desirable for its advocates, it also makes it highly unlikely that politicians or the public will accept it. The best chance for returning to a gold or commodity standard will be a really major inflation and economic down-turn caused by politicized monetary policy. This is not likely to happen for some time or, at least, not while the economic and financial upheavals of the 1970s are alive. The fact that the world did not move to a gold or commodity standard after this experience does not bode well for its doing so in the near future.

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