The Purpose of This Paper Is to Point to Three Economic Benefits That Are Neglected In

Small Country Benefits from Monetary Union

by

Herbert Grubel

Professor of Economics (Emeritus), Simon Fraser University

Senior Fellow, The Fraser Institute, Vancouver, Canada

Contribution to a special issue of the Journal of Policy Modeling, June 2005

THE DOLLAR, THE EURO, AND THE INTERNATIONAL MONETARY SYSTEM, edited by Dominick Salvatore, Professor of Economics, Fordham University

Abstract:

The paper reviews the technical methods available for the hard fixing of currencies and presents evidence from studies of the benefits and costs from monetary unions achieved through hard fixing.

The main costs are alleged to arise from the loss of national monetary sovereignty. In fact, these costs are much smaller than is argued traditionally since the exercise of this sovereignty has historically been responsible for many economic shocks. The costs are also shown to be lowered by efficient capital and labor markets that are endogenous to the adoption of hard currency fixes.

The paper focuses on the discussion of a neglected benefit of hard fixing, which is that small countries enjoy better monetary policy. The improved monetary policy arises because the large institutions to which they surrender their monetary sovereignty are more likely to be free from political influences and partly because they have more financial and human resources to design and execute the best monetary policy. Errors made by the large central banks have less impact on the member countries they serve because of the dominance of intra-union trade and capital flows.

The purpose of this paper is to point to some economic benefits that are neglected in the traditional analysis of the merit of small countries’ adoption of a hard currency fix. The analysis is relevant to countries like Canada[1], which in recent decades has suffered from large fluctuations and a secular decline in the value of its currency against the US dollar. It is also relevant to countries like those of Southeast Asia that could form a currency union in order to avoid a repetition of the costly financial crisis of the 1990s and prevent the problems created by regional exchange rate fluctuations and the declining value of the Chinese Yuen that is fixed to the devaluing dollar.

It is not controversial to assert all countries would benefit from the elimination of fluctuations and secular changes in the external value of their currencies. In dispute are the estimates of the costs relative to the benefits of such a policy.

The first part of my paper discusses the nature of hard currency fixes, one version of which involves a common currency of the type found in Europe. This analysis is essential for the clear understanding of the benefits to be derived from such fixes. Subsequent sections review the traditional costs and benefits. The remaining part of the paper discusses benefits for small countries that tend to be ignored in the traditional literature.

The Nature of Hard Currency Fixes

The hard fixing of the exchange rate under discussion here is fundamentally different from the traditional system used to fix exchange rates.[2] The latter was achieved by government policies that required the central bank to intervene in foreign exchange markets whenever the market rate deviated from a specified target, accumulating or selling international reserve assets and drawing on borrowed funds if necessary to influence the market exchange rate.

The key element of such traditionally fixed exchange rate regimes is that the country’s national bank retains its full power to make monetary policy and set interest rates, even if the ability to exercise this power is constrained by the policy goal of maintaining a fixed rate. In contrast, when a country commits itself to a hard currency fix, it gives up national monetary sovereignty explicitly and permanently. Its central bank no longer makes monetary policy by determining the money supply and setting interest rate.

A country can achieve at hard currency fix using three different policies and institutional arrangements:

• It replaces its own currency with the US dollar, euro, yen or other major currency for use in domestic transactions and contracts. Obviously, there is no more national exchange rate that fluctuates against the currency chosen for the fix, most usually that of the country with which it has the largest bilateral trade and capital flows.

• It joins other countries in a formal monetary union, as has been done in Europe. The central bank of the union issues a currency that circulates in all countries of the union. It sets monetary policy and interest rates under rules set out in its constitution.

• It retains its own currency and commits itself to a currency board arrangement under which the exchange rate is fixed against a major currency like the dollar and the domestic money supply is linked systematically to the balance of payments, increasing the money supply when the payments are in surplus and decreasing when they are in deficit. Obviously, the country’s central bank under this arrangement is no longer involved in making monetary policy. The country accepts the monetary conditions made in the country against which the domestic currency is fixed.

This is not the place to evaluate fully the relative merit of these different approaches to hard currency fixing. Suffice it here to note that the extent to which a country can enjoy the benefits of a hard currency fix depends on the credibility of government’s commitment to the institutional arrangement in the future.

The Credibility of Hard Currency Fixes

By the credibility standard, formal union agreements like that in Europe ranks highest since it is difficult to imagine economic and political scenarios that would cause a member country to renounce the treaty and re-introduce its own currency. Though, of course, given the nature of politics, the probability of such an event never is zero.

The replacement of the domestic currency with the dollar or euro is somewhat less credible since it is the creature of purely domestic policies and therefore can be reversed by the same means and without the difficult renunciation of any binding international treaties. On the other hand, once an entire economy and financial system has become accustomed to dealing in dollar or euros, a regime switch would be accompanied by serious costs.

Panama is a country which has used US dollars for nearly a century now and while there have been periodic domestic movements in favor of abandoning it, the system has survived and generally is seen to have benefited the people of Panama. As one student of the issue put it to me, “All Central American countries have had Presidents that engaged in policies damaging to their economies, including Panama. But because no President of Panama never could use the central bank and monetary policy to serve his political aims, conditions in Panama never were as bad as they were in the other countries of Central America.”

The dollarization of Ecuador is too short to assess its success and likely continuation with any degree of certainty. However, its continuation after about four years already is longer than had been expected by those who believe that it would bring severe hardships for the country and therefore would be abandoned quickly.

The third approach to a hard fix, the commitment to a currency board, once was thought to be very credible. However, the recent experience with the currency board in Argentina showed that a government can readily break its commitments, especially if it believes that it brings substantial political benefits and few international costs.[3]

The experience with Argentina also has revealed the need for carefully designed rules governing the board’s accounting practices and the relationship between the government and the currency board. The absence of legislation governing these issues has been considered by some to be a major factor that contributed to the demise of the board in Argentina.

For Canada, some economists and I propose[4] the creation of what might be called a quasi currency board arrangement, which requires the revaluation of the present exchange rate to make “New Canadian dollar” equal to one US dollar. The exchange rate would be chosen to preserve the country’s current competitiveness and reflect purchasing power. The Bank of Canada would be required to keep the New Canadian dollar at par with the US dollar in the market place.

The proposed legislation would assure attainment of this goal by the specification of the mandated outcome of market parity between the US and Canadian dollar. It would avoid the rules-based approach that was used in Argentina and which has the serious disadvantage that markets and politicians continuously find loopholes in the rules to exploit to their advantage. Under the outcomes-based legislation, the government is free to do whatever is necessary to meet its objective. Moreover, external developments and government policies that affect the parity can readily be identified and dealt with.[5]

How credible hard currency fixes are and how long they last is determined by the benefits and costs that are associated with them. The following discusses the most important costs and benefits.

Traditional Benefits

Hard currency fixing eliminates the transactions costs incurred in foreign exchange markets when all exports, imports, capital flows and travel between the affected countries involve the exchange of one for another currency. In addition, the fixing saves resources required to run institutions that evaluate exchange rate risk and operate forward and futures markets to deal with it.

It has been estimated that in Europe the substantial shrinking of foreign exchange departments of banks, firms and governments and the number of currency dealers made possible by the introduction of the euro would lead to savings of between .3 and .4 percent of national income of the average member country.[6]

Casual evidence suggests that the introduction of the euro has indeed reduced the size of foreign exchange transactions and the number of institutions and employees needed to execute them, though there have been no publications estimating the value of the actually realized savings. Travelers to and within Europe have happily enjoyed benefits that are not easily measured involving the absence of multiple currency exchanges and the difficult and costly decisions they used to involve.

The Bank of Canada has made very simple estimates of the savings in transactions costs from a formal currency union with the United States and the use of a common currency. The estimates are very close to those found for European countries. No such estimates exist for the proposed arrangement under which the New Canadian dollar would be used and the notes of the two countries would trade side by side and exchanged at par. To the best of my knowledge there are no corresponding estimates of transactions cost savings for developing countries and others contemplating hard currency fixes.

The best estimates of savings in existence for Europe and Canada reveal them to be small in relation to national income. However, they involve substantial absolute sums. For example, the savings of .4 percent of Canada’s national income estimated by the Bank of Canada of about is equal to C$4 billion or a little less than half of the country’s annual spending on defense in recent years. The economic impact of these savings goes beyond the immediate savings of real resources since these savings are equivalent to the reduction of tariffs on trade, capital flows and travel.

Tariff reductions, even small ones, have been shown to have substantial effects on the levels of trade, specialization and welfare in models involving intra-industry trade. In such models specialization in the production of differentiated products gives rise to decreasing costs and corresponding increases in productivity. The savings also would further encourage financial arbitrage and the integration of the two countries’ financial markets more generally.

Interest rates

Before the creation of the euro, interest rates on bonds issued by central governments of European countries in their own currencies often were much higher than those issued by the government of Germany, which carried the lowest rate of all countries in the union. The reason for this premium on interest rates on the other countries was due to the financial markets’ assessment of a country’s risk relative to that of Germany in three dimensions: default, liquidity and exchange rate.

The importance of the exchange risk has become clear in the five years or so leading up to the introduction of the financial euro in 1999. The gaps between the yields on the bonds issued by Germany and by the governments of Italy and Spain, for example, often were over 5 percentage points through the middle 1990s. Thereafter these gaps narrowed rapidly and reached near zero by 1999, where they have been since.

There remain small yield differences on bonds issued by different countries in Europe, much as there are such differences on bonds issued by different US states. These differences reflect the risk of default and the relative lack of liquidity.

Over the last 40 years Canadian interest rates of medium term bonds were about 1 percentage point higher than those in the United States, in spite of the fact that the cumulative rate of inflation in the two countries was virtually identical. The higher yield on Canadian bonds just about compensated bondholders for the secular decline of the Canada-US dollar exchange rate of one percent per year, even if this decline was higher during some years than at others and was reversed to some degree after 2002.

Bris et al. (2002) found that the introduction of the euro also has lowered the cost of capital for firms inside the union relative to that of firms outside it. This fact reflects the inability of forward and future markets under flexible rates to allow firms the full elimination of all exchange risk in their markets for outputs, inputs and capital. Hard fixes eliminate the need to deal with exchange risk on transactions with other firms within the currency area.

The lower interest rates and costs of capital experienced in countries that are members of the euro zone will result in capital deepening and higher labor productivity. A one point premium of the Canadian over the US long rate may not seem like much in the absolute, but in fact it represents 20 percent under the assumption that the cost of capital in the United States normally is five percent.

Traditional Costs

The main argument against hard currency fixes is that they completely deprive countries of their ability to use monetary policy to deal with economic shocks that destabilize the national economy. Here is an example of the sort used by opponents to the creation of the euro to illustrate this cost.[7] Consider that in Ireland the demand for Irish lace falls and unemployment rises in the wake of downward pressures on prices and wages. At the same time there is an increase in the demand for Greek wine and the demand for labor in that industry leads to inflationary pressures.

In the absence of a hard currency fix Ireland would lower its interest rate to stimulate aggregate demand and provide alternative employment for workers released from the lace industry. Greece would tighten monetary policy, decrease aggregate demand and set free labor from other industries to move into the wine industry.

Under a hard currency fix the interest rates in Ireland and Greece cannot be changed. They both face the same interest rate set by the European Central Bank, which cannot change that rate to serve the needs of both countries. As a result, Ireland suffers unemployment and Greece suffers inflation.

Many analysts concerned with this problem predicted that it would overwhelm all arguments in favor of a European common currency. They did so first at the planning stage and then when it was to be implemented. After the adoption of the euro and of the final symbolically important use of euro notes and coins in all countries, these analysts predict that the problem eventually will lead to serious economic crises and to the dissolution of the common currency agreement.

The euro zone may well one day succumb to conflicts over the appropriate interest rate, but the experience of the first few years of experience give rise to optimism. There have been no severe conflicts and the benefits from the use of a common currency have become obvious.

This positive experience is due to a number of factors. One of them is the realization that in the past there have been relatively few asymmetric shocks.[8] Most problems with economic instability, inflation, unemployment and currency depreciation in the past were in fact due to faulty national monetary policies, which could not occur under the new arrangement.

Of course, there were and there always will be shocks that affect some countries in the union more than others. But this has been happening in countries like the United States ever since the union has been formed. It also has been happening within Germany and France whenever one region boomed and another was in a slump.