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August 10, 2013
Canada, the United States, and the European Union:
Neglected Lessons in Building a Currency Zone out of Separate States
Christopher Kobrak
ESCP Europe
Rotman School of Management, University of Toronto
[email protected]
Joe Martin
Rotman School of Management, University of Toronto
Donald S. Brean
Rotman School of Management, University of Toronto
Abstract:
Recent tensions in the Eurozone have elicited relatively little public discussions of how large
federal systems grappled over time with forging a common financial and monetary system.
This paper draws on the disparate experiences of two North American countries from similar
traditions – Canada and the United States, with a view to putting that process in historical
context. Despite advantages which Europe does not enjoy, these countries’ efforts to build
their national banking systems and common currency as well as unify their national debt
followed a long and varied path. The paper argues that Europeans would profit from the
lesson that the process required many difficult political steps in order to build the necessary
consensus for these systems to function, with all their flaws, as a binding rather than divisive
force. We contend that those who supported and implemented the introduction of the Euro
ignored much of the institutional and organizational infrastructure required to successfully run
an “optimal currency area.”
1
European monetary unification is a process, not a grand achievement or a great blunder. That
process will end neither in Stage III begins on January 1, 1999, nor when the Euro replaces
national currencies in 2002. Rather, Europe’s monetary union will continue to develop.
(Eichengreen, 1997, p. 9)
Introduction
Since its conception just after World War II, the European project has had a paradoxical
relationship with history. Born in the minds of many Americans and Europeans first as an
antidote to long-standing national conflicts and later to American power and currency chaos,
at times the idea of a united Europe seemed to require a flight from experience into uncharted
territory. The vision of Europe seems to rest on a kind of historical need rather than historical
examples. Even the recent tensions in the Eurozone have elicited relatively little public
discussions of how large federal systems grappled over time with forging a common financial
and monetary system.
This paper draws on the disparate experiences of two North American countries from
similar traditions: Canada and the United States. Despite many advantages which Europe
does not enjoy, these countries’ efforts to build their national banking systems and common
currency as well as unify their national debt followed a long and varied path. The paper will
argue that Europeans would profit from the lesson that the process required many difficult
political steps in order to build the necessary consensus for these systems to function, with all
their flaws, as a binding rather than divisive force.
For over 200 years, financial and intellectual exchange between Europe and North
America has been extensive and fluctuating. Early United States attempts to stabilize its
finances profited from British ideas and money.
Alexander Hamilton, America’s first
Treasury Secretary, modeled the U.S. first central bank on the Bank of England, and his other
financial innovations on those in Britain and the Netherlands. (Sylla, 2007)
Many of
America’s first financial corporations, including the central bank, had sizeable European
investments. (Wilkins, 1992)
America’s trade during the first half of the 19th century and
industrialization after the Civil War could not have occurred without copious amounts of
foreign investment. When U.S. reformers finally accepted the need of a new central bank in
the 20th century, they sent representatives to Europe to gather information about European
banking. Several recent European immigrants not only participated in designing the U.S.’s
third central bank at the beginning of the 20th century, one also held a leadership position in
the new Federal Reserve. As financial flows reversed after World War I, so too did financial
advice.
Many Americans were reticent about foreign political and financial commitments,
2
but not about instructing Europeans about how to solve their financial problems. From
reparations to monetary and default policies during the interwar period, many American
financial and political leaders tried to shape European finance, often to the chagrin of many
European leaders.
But this level of perceived intrusion into Europe affairs paled in
comparison to that following World War II. As the only country whose finances were left
standing, the economic balance of power shifted to unprecedented level in America’s favor.
With much of Europe devastated and in the face of a renewed world communism threats, U.S.
public and private leaders were not bashful about using the Bretton Woods system and the
Marshall Plan to reshape European banking, push for a diminution of national economic
barriers, and stronger economic union.
Ironically, while American political pressure
contributed the first impetus for the first steps in creating the European Union, resentment of
American political power and economic carelessness provided the stimulus for the second,
tighter economic and political integration in the late 1960s and 1970s, especially the creation
of a common currency. With this history in mind, it is easy to understand why Europeans
have been slow to study America’s experience with federalism, but it does not explain why
they have ignored Canada.
This paper highlights several aspects of American and Canadian financial experience
that might be useful in dealing with the current European financial malaise.
Much of the
original intellectual impetus came from a Canadian, who spent most of his life in the United
States, the Nobel Laureate Robert Mundell. The paper will suggest that Mundell’s original
groundbreaking work (Mundell, 1961) on optimal currency areas and later explicit support for
a European currency (Mundell, 1973a, 1973b) neglected the importance of institutional and
organizational development, as already noted by some critics (North, 1990; Feldstein, 1997).
The paper will build on several papers discussing why Mundell’s seminal work may not apply
to Europe today, including comments by Mundell himself, and a recent paper dealing with
U.S. federalism and the European Union (Henning and Kessler, 2012). Like the Henning and
Kessler, this paper is a mixture of analysis and literature review. But unlike that excellent
piece, it will go beyond its emphasis on the “no bailout” aspect of the U.S. experience to
explore other elements of North American financial history. We will argue that operating a
common currency is just one aspect of an entire financial system, including banking, with
which it should live in harmony.
We will suggest some historical lessons, and unlike most discussion of the subject, we
will include Canada.
Though considerably smaller than either the U.S. or European
economies, Canada provides its own set of rather unique insights into creating a common
3
financial system. With greater linguistic divides and fewer constitutional provisions for
common financial and commercial integration, it parallels the European situation perhaps
even more than the United States. The crux of our argument is that in a Northian sense
(North, 1990), European leaders failed to build, indeed, to a large extent, underestimated the
importance of and obstacles to acquiring the institutional and organizational underpinnings
required for a common financial system, especially a common currency. North argued that it
is not just pure economic principles that explain economic success or failure, but also the
creation of the appropriate institutions (rules of the game) and organizations that formally or
informally enforce them. The existence and effectiveness of those institutions are a product
of historical processes, often of long duration, but always essential for resolving conflicts over
competing priorities.
The bulk of the paper is divided into three sections. The first section highlights some
of the intellectual and historical background of the Euro. The next two describe aspects of the
North American experience Europeans should integrate into their evaluation of efforts to
maintain the Eurozone.
While the authors certainly believe in the value of historical
comparison, many of the experiences described here serve as cautionary tales about the
dangers of drawing of history analogies, without sufficient attention to the context of events
or counter examples.
The Historical and Intellectual Issues
The idea of a common currency and financial system for Europe is not new. Although
dealing with the complexity and costs of many currencies was the rule rather than the
exception in European history, in the second half of the educated people could draw on many
examples of common currency system to assess its economic value.
From the Roman
Empire through the end of the Gold Standard, Europe enjoyed several periods were business
could be done through wide swath of the peninsula with one species. Even while the Bretton
Woods System continued to function as planned some advocates of a federal Europe dreamt
of a common currency, a dream that morphed for many into an economic necessity during the
1970s, as inflation and dollar value fluctuations increased uncertainty.
Not surprisingly, in this macro-economic environment the issues connected with
creating an optimal currency areas became of more theoretical and practical interest. Ignoring
some of his own caveats and contradicting many of his more theoretical views, the seminal
work of Robert Mundell in the 1960s and 1970s was interpreted by many as buttressing the
cause of those who pleaded for a European currency.
Canadian born but to a large extent
4
American bred, Mundell laid out several propositions that suggested that European monetary
union was not only possible but desirable (Mundel, 1961, Mundel, 1973a and b):
1) Currency devaluations among countries that should be in a single currency zone
are counterproductive;
2) Reduction in transaction costs would offset the costs of maintaining a common
currency;
3) Even in regions with segmented national labor markets and reactions to exogenous
shocks, a common currency may help mitigate economic shocks;
4) Flexible exchange rates among optimal different currency zones are an effective
way of overcoming the adverse effects of macro-economic shocks.
In the early 1970s, Mundell made his enthusiasm for a European currency explicit.
As the
commitment to pegging European currency to the dollar wound down, Mundell argued that
the only way to kill unsettling currency speculation and to achieve intra-European currency
stability, ostensibly necessary to establish a common market, was to create a common
currency. Europe needed less currency flexibility rather than more if it wanted to achieve its
commercial, financial, social, and political aims. By the time Bretton Woods came to an end
he wrote, “The exchange rate should be taken out of both national and international politics in
Europe.” (Mundell, 1973b, p. 147)
Even before the new currency circulated in Europe, many economists expressed their
reservations about its introduction. But rarely were the arguments historical or institutional.
Most argued, as did Mundell originally, that countries should have similar labor markets and
similar reactions to exogenous shocks. Creating the discipline of a common currency would
by necessity force very different economic regions to accept one monetary adapted the
weighted average of economic conditions in the whole region, which would exacerbate rather
than reduce the effects of economic cycles. National economies with high growth rates and
inflation would enjoy lower interest rates than would be advisable, and those with poorer
conditions too high. In general, many governments which once had to pay higher nominal
interest rates for debt would at least for a while enjoy the benefits of their neighbors fiscal
prudence and borrow more than they should. Conversely, in the face of economic downturns,
countries worst hit by shocks would have to live with tighter monetary conditions and higher
interest rates than they would if they controlled their own economic policy. (Feldstein, 1997)
Understandably, the early critics of the Euro are already sitting shiva. (Feldstein, 2012)
5
Obligations to State and Local Government
Henning and Kessler rightly stress one feature of the American experience: the early
decision of federal government not to intervene to save states from bankruptcy and the
ensuing movement to force balance budgeting on states. This feature of America’s history is
particularly important to those many Europeans concerned about the Greek and other past or
future bailouts. Although Alexander Hamilton’s reforms, which put the early federal finances
on a firm footing, contained extensive provisions for assuming state debt, this was not his
primary objective. Unlike Eurozone, the states of the United States began their lives in the
Union virtually debt free. Centralizing and thereby stabilizing American financing and taxing
in federal hands was designed to increase the new country’s ability to raise funds. Indeed, he
failed, however, to make the federal government the sole U.S. governmental borrower, and on
a few occasions, albeit after his death, the federal government took direct or indirect
responsibility for state or local debt payments. For over two hundred years, however, the
federal government played little or no role in bolstering the credit worthiness of state debt.
Within 60 years of Hamilton’s ill-fated attempt to put the U.S. solidify America’s fledgling
financial system, however, several U.S. states had run up large debt for public works and
defaulted. Even during the first half of the 19th century, when those defaults threatened the
federal government’s ability to borrow abroad and war with Great Britain, for many reasons a
bi-partisan rejection of assuming state debt prevailed.
This decision about state debt had three short- and long-term ramifications. First, the
debt was eventually repaid, before states could effectively use capital markets again. Despite
the no-bailout policy, states and local governments continued to be active borrowers on
domestic and foreign debt markets. For most of U.S. history, states were active players on
debt markets. As late as 2009, state and local borrowing accounted for over 20% of the Gross
Domestic Products of many U.S. states. Second, most states passed and took relatively
seriously balanced budget amendments to their constitutions, provisions which have been bent
over the years, but not fatally broken since. Lastly, through most of American history and
much of the time with a single currency, federal taxes and spending did not serve as a means
of making transfer payments among the states. Not until the 1930s, did the U.S. government
take responsibility for countercyclical macroeconomic policies, including large amounts of
automatic state transfer payments and subsidies for programs like Social Security, home
ownership, and later Medicare and Medicaid. Even with the government’s massive 2009
stimulus package, the vast majority of federal support to states since 2009 has come in the
6
form automatic payments mandated long before the financial crisis. (Henning and Kessler,
2012)
Although Henning and Kessler’s argument is well conceived and accurate as far as it
goes, the omission of several important contextual points reduces its value for policy matters.
First, through much of the period they described America was notorious in the civilized world
for its many financial crises, many brought on or exacerbated by state and local defaults.
While balanced budget provision of state constitutions helped control state commitments, they
did not eliminate actual or de facto defaults, even as late as the 21st century, such as that in
California This is hardly an experience European leaders want to replicate. Moreover,
safety-net transfer payments and fiscal policies lessoned the pressures on states to use
borrowing to fund their operations. More importantly, Henning and Kessler leave out that
during much of the period in which the “no bailout norm” developed, the United States had
neither an effective common currency nor a central bank that used “government” securities or
anything else to tweak money supply. The dollar was the nominal currency of the United
States and theoretically convertible into gold and silver. But regional banks could print their
own currency, with large differences from region to region in the value of the paper they
issued depending on the knowledge and reputation of the issuing bank and conditions in the
region. From 1864 on, only new nationally chartered banks could effectively issue currency,
backed up by gold, silver, and federal debt. But as the “no bailout norm” developed, no U.S.
private or central bank was confronted by the dilemma facing the European Central Bank,
namely relying on “national” (state) debt as means of augmenting the money supply. From
1837 to 1914, the United States did not even have a central bank. Not until 1935, did the
United States have a single paper dollar issued by the Federal Reserve. In part, what Henning
and Kessler ignore about the American experience with default is the other side of the coin, as
it were: the multifaceted benefits of having a large supply of federal debt as a benchmark and
monetary instrument, which took financial pressure off regional governments at the outset of
union, reduced the importance of state and local debt for public finance, and for the creation
of a unified financial system.
The Canadian experience also highlights some flaws in their analysis. Canada has had
an effective single currency longer than the United States, but without a central bank for much
of the period. What differentiated the Canadian experience from the American and European,
and contributed to the greater stability of Canadian banking, was federal assumption, from
day one, of responsibility for banking, as will be discussed in the next section.
7
The British North America Act, which created the Canadian Confederation in 1867,
was in many respects a response to economic and political developments “south of the
border.” It addressed fundamental issues about fiscal and borrowing responsibilities among
the four “provinces” that became Canada and the central government. Under the terms of Part
VI of the Act (Distribution of Powers, sections 91 and 92), the federal government was given
exclusive responsibility for defense, foreign affairs and all matters not specifically assigned to
the provinces (authors’ italics), the opposite of the U.S. division, which left to the states
anything not specifically delegated to the federal government. The provinces were given
responsibility for all local matters such as education.
To this day, there is no federal
department of education in Canada; not until 1919 did it have a department of health and
welfare. On the revenue side, the federal government was originally given unlimited taxing
powers (although it originally relied primarily on customs 1, plus inland revenue, postal and
public works duties), while the provinces were restricted to taxes levied directly, such as those
on property or income. Provinces relied on excise and sales taxes. In addition to public
borrowing and taxation (Public Credit, subsection 4), Parliament was given authority well
beyond that given to the federal government in the U.S. constitution. Its responsibility
included Currency and Coinage (subsection 14) and Banking, Incorporation of Banks, and the
Issue of Paper Money (sub-section 15). (Authors’ Italics)
Although the Canadian founding fathers did not establish a central bank, very much in
the spirit of America’s original financial legislation, the federal government assumed
provincial debt. 2 The largest amount was in direct debt which represented 76% of the gross
debt assumed by the Dominion but there was an additional 12% of capital liabilities,
principally for railways. In return the new Dominion received a variety of assets, the largest of
which were railways, canals and harbor improvements. 3
As in the United States, this policy (Part VIII of the Act) had two beneficial effects.
First, the provinces, like the states in the United States, started the Union with a clean slate.
Second, and perhaps more importantly, federal debt was firmly established as a benchmark
for all securities and a means of adjusting bank reserves and the money supply. As in the
United States, provinces were free to borrow for the public good, but under subsection 23 of
1
In the fiscal year ended in 1866 Nova Scotia received 75% of its combined [provincial and municipal] revenue
from Customs, New Brunswick 72 % and Canada 45%. Table 6, p. 44 Rowell Sirois Report
2
On June 30, 1867 Canada [Ontario and Quebec], New Brunswick and Nova Scotia had a net debt of $91.2
million. Most of this debt was Canada’s – over 80%. When British Columbia and Prince Edward Island joined
Confederation their debt was assumed as well. Manitoba did not have any debt to assume.
3
Table 5A _ Provincial Assets and Liabilities Assumed by the Dominion at Confederation, p. 42 Rowell Sirois
Report 1940.
8
Section 92 the provinces were also given authority over the borrowing of all public entities in
the provinces, (The borrowing of Money on the sole Credit of the Province), which included
“Municipal Institutions in the Province” (subsection 8).
The municipalities were in fact
“creatures of the province.” Indeed in Nova Scotia and New Brunswick local government was
not well developed beyond a few major centers.
Unlike the United States after the
Progressive movement, which witnessed a surge in local powers, there were no ‘home rule’
provisions in Canada. But like the American experience, then, direct provincial bailouts by
the central government seemed to be ruled out. Like Europe, but unlike the United States,
from the beginning, a series of transfer payments from the federal government to the poorer
provinces was envisioned.
As provinces entered the union, the amount of the transfer
payments was part of the agreements. “In the case of the Better Terms granted to Nova Scotia
in 1869, the financial terms surrounding the admission of Manitoba in 1870 4, British
Columbia, in 1871, Prince Edward Island in 1873 and Alberta and Saskatchewan in 1905, it is
very evident that the actual basis employed in fixing the amount of subsidies was fiscal
need.” 5 See above In short, the practice began, well ahead of the United States, of supplying
funds upfront to the provinces rather than bailing them out when they ran into fiscal problems.
But while both the Canadian and U.S. central governments do not take responsibility for state
or local borrowings, both Canadian state and provincial governments take charge of distressed
political entities in their jurisdiction.
As in most countries, Canadian government spending for social programs expanded
greatly after World War I.
In addition to new central government expenditures associated
with the wars and depressed economy, provinces increased their budgets. No industrialized
country was harder hit than Canada by the Great Depression, which put great financial
pressure on the provincial and local governments. The Depression “served to underline the
fundamental weaknesses of the Canadian fiscal system.” 6 During the 1930s, the province of
Alberta and Newfoundland, still a separate British territory, defaulted on their debt.
municipalities went bankrupt.
Many
As “creatures of the provinces” they were placed under
provincial Municipal Boards, which became ‘trustees in bankruptcy.’ Many municipalities
stayed under the Municipal Board for decades, because the municipal politicians could use the
Municipal boards as an excuse for not spending.
4
A shot gun marriage precipitated by the most controversial figure in Canadian history, Louis Riel, a Metis, who
was hung in 1885 for high treason.
5
Pp. 12-13 of the Submission By the Government of Saskatchewan to the Royal Commission on DominionProvincial Relations [Canada.1937]
6
Perry ‘A Fiscal History of Canada’, p. 369
9
The severity of the Depression led to the appointment of the Royal Commission on
Dominion Provincial Relations (the Rowell Sirois Commission), the most important of all the
Royal Commissions appointed since Confederation. Although most of the Commission’s
recommendations were not implemented, a key one was: the introduction of unconditional
grants from the federal government to the poorer provinces (which in 1957 became
equalization 7 grants) in place of per capita subsidies.
While provincial government
borrowing was still not guaranteed by the central government, these transfer payments from
the stronger to the economically weaker provinces, like those in the United States from
stronger states to weaker ones, acted as the kind of automatic transfer payments, the kind
European countries still have to negotiate, when they go beyond the original entry subsidies.
Until very recently, most ongoing transfer payments among member countries in Europe were
for agricultural subsidies and relatively small as a percent of European Gross Product. 8
As a result of the Depression, too, many charitable or municipal welfare activities
became provincial responsibilities.
Because the expenses became so high, many social
expenditures were transferred to the federal government, but administered by the provinces,
as in the United States.
In 1940, the provinces agreed to the introduction of federal
unemployment insurance and old age pensions plans. These trends continued after World
War II. After the war, federal officials decided to focus more on social services, even though
they were still the responsibility of the provinces, rather than economic infrastructure as was
more the case in the United States right after the war. 9.
This policy decision led to
significant federal provincial conflicts, especially between Quebec and Ontario and the
federal government. By the mid-1950s, the federal government dominated public spending
within the Canadian Confederation, accounting for over 60% of both revenue and expenditure
of all governmental entities in Canada. The provinces represented approximately 20%, and
the local governments around 14% of revenue and 16.5% of expenditures.
7
For years there were three ‘have provinces’ – Ontario, Alberta and British Columbia, with four really ‘have
not’ provinces – the Atlantic provinces, two near ‘have not’ provinces – Quebec and Manitoba and
Saskatchewan moving from have to have not depending on the commodity cycle. However in recent years
Ontario has become a ‘have not’ province while Newfoundland has become a ‘have’ province.
8
http://ec/europa.eu/budget/figures/2012/2012_en.cfm, updated January 19, 2012, May 21, 2012 search. Total
EU expenditures accounted for just over 1% of the Union’s Gross Product.
9
The Trans Canada Highway, for example, is a pale imitation Eisenhower’s Interstate Highway System.
Interprovincial trade barriers were not dealt with nor was a single Securities Regulator.
10
As in the United States, the shift in proportions of government spending in Canada
away from the federal toward provincial and local governments is part of a complex story that
makes clear demarcation among different levels of government responsibility difficult. In the
late 1950s, the national government introduced a shared cost hospitalization program. These
national initiatives were resisted in some provinces, most particularly by the Province of
Quebec. This was particularly true after the election of Jean Lesage in 1960 with a platform of
“maître chez nous.” 10
As costs at the provincial level continued to increase, agitation
increased to limit provincial exposure.
As a consequence, a Federal Provincial Continuing
Committee was created to examine the respective responsibilities and revenues of the two
levels of government. Just as the results of this report were distributed on a confidential basis
(showing significant future provincial deficits), the Federal government introduced a sharedcost Medicare program which would add greatly to Provincial deficits. This led to continuing
fighting (including the creation of a Tri Level Task Force on Public Finance), which resulted
in the introduction of
Established Program Financing [EPF] block funding for social
programs in the late 1970s. By 1980, the federal government and provincial governments
were spending almost identical amounts, although the federal government collected less than
it spent while the converse was true of the provinces. The growth in provincial spending, “Big
Spenders,” in the words of C. D. Howe Institute Senior Policy Analyst Beatrice Ip, was
largely due to increases in expenditures on health, education and welfare, which were still
provincial responsibilities. 11 Since 1980, there has continued to be lots of argument over
revenues and expenditures, but all levels of government have tended toward more balanced
budgets. In 2005, the federal government raised and spent 38% of the total pie, the provincial
governments 44%, and the local governments 18%. Most importantly for this discussion, on
the face of it, federal expenditures represent a shrinking rather than increasing portion of
Canadian government spending, without any threat to the Canadian dollar.
Federal Financial Regulation
Understandably recent discussions about the Euro’s weakness focus on sovereign debt.
In so far as national regulation of banks enters into analysis, they tend to examine the
problems caused by nationally regulated banking associated with the banks’ investment in
10
Lesage had a number of powerful Ministers and Deputy Minister who later became separatist Premiers.
Lesage went beyond Federal Provincial Conferences and introduced Inter Provincial Conferences, the better to
organize Provincial complaints
11
Although these were provincial responsibilities, the provinces were encouraged to spend in these areas by the
federal government, especially with their introduction of Medicare.
11
sovereign debt and the use of that sovereign debt as collateral for European Central Bank
(ECB) funding. The North American experience points to a more fundamental problem.
Many of the framers of the American Constitution were reluctant to give the new
federal government responsibility for banking and other financial regulation. The licensing
and regulating of bank and insurance firms grew quickly in the new nations, but was
decidedly then and still is to some extent a state responsibility. The only financial activity
delegated to the federal government explicitly by the constitution was the creation and
maintenance of the currency, which implied by the framers that the states should control the
organization of financial services. Hamilton understood that this division was untenable. In
a masterful stroke, he basically bribed the debtor states – and used other carrots with those
less indebted – to allow him to create a national bank and build a federal fiscal system, which
would allow for the payment of the new consolidated government debt.
The federal
assumption of state debt and the creation of a national bank achieved for a short time
Hamilton’s goals. U.S. debt and taxation was shifted to the federal government, whose credit
rating in the eyes of most of the world allowed it to raise funds on nascent international
capital markets. Defining dollars in terms of gold and silver bolstered faith in the new
government’s finances. Even though private banks issued their own paper currency, for a
short time the United States had an effective quasi-government organization (The First Bank
of the United States) in place to facilitate the “privately printed currencies could be accepted
as legal tender” by pressuring banks to keep sufficient species and government debt on hand
to insure convertibility.
It should be remembered that issuing bank notes played a very
different role in the banking systems of the 18th and 19th century, than it does today.
Moreover, once Hamilton became convinced that the new national banks should have
branches all over the country, the U.S. not only had an effective monitor of state chartered
banks, it also effectively had a national banking system.
From the last decade of the 18th to the first decade of the 21st, the American experience
has shown that financial stability and maintenance of a common currency required more
federal intervention in banking. Although the Constitution gave the federal government the
right to define a dollar, in practice the absence of federal powers to create money and
prevalence of fragmented banking law meant that the United States effectively had many
currencies issued by private banks. (Mihm, 2007)
The Civil War reforms of banking, the
National Banking Acts of 1863 and 1864, not only gave the Treasury the ability to issue
federal currency and created nationally chartered banks with the power to issue their own
paper money, but it also intentionally created obstacles to state-chartered banks continuing to
12
issue currency. Although nationally charted bank and government paper money co-existed
until the New Deal vested the power to issue paper money solely in the 20-year-old Federal
Reserve, the much changed but spiritual descendant of Hamilton’s original vision. From the
1860s through the 1930s, if not earlier, each successful step the United States took toward a
national currency was accompanied by greater national control of banking. By 1935, when
the U.S. counterpart of the ECB was issuing currency, it and other federal agencies had
extensive control of the whole U.S. financial system. By end of the New Deal, while states
still maintained some authority over banks, most bank regulation had been transferred to the
national government, a trend that would continue through the rest of the century and beyond.
In short, creating the regulatory conditions for a unified financial system and single currency
was a long, arduous process in the United States, even though political union proceeded
financial. (Rousseau, 2013)
The Canadian story is similar in that creating a national currency required more
unified control of banking, but with different starting points and progressed at a different
pace. Indeed, at critical junctions Canadians profited by learning from the mistakes of their
southern neighbor’s splintered banking system. (Smith, 2012) The initial impetus for banking
in Canada was replacing British Army Bills after the War of 1812. Banks were required to
satisfy the demand for a reliable paper currency to replace the bills and supplement species.
Before confederation, Canada had a number of colonial chartered, royal, private, and free
(banks without charters) banks, and bank failures. Actual government bills did not appear
until 1871, but several attempts had been made before. Canada’s first national banking act
(1871) and subsequent revisions addressed bank solvency and customer confidence,
especially in relation to private bank notes. Even before it had a central bank, Canada’s
banking system was cross-Provincial and regulated chiefly by the national government. As
discussed above, the British North America Act gave banking regulatory responsibility to
central government, at a time when the U.S. federal government took its first real steps to
remove some banking authority from the states.
Although private bank notes played a
reduced role in the Canadian economy in the second half of the 19th century and second half
of 20th, they began to be phased out in 1935, when Canada created its first central bank.
(Neufeld, 1972)
The introduction of a single, common currency came in increments and with
increasing central control over banking. As already mentioned, the British North America
Act gave the Federal government authority over both currency and banking. Currency and
banking regulation advanced in parallel. This provision was recommended at a meeting of
13
colonial leaders in Quebec City in October, 1864. Those colonial leaders were well aware of
the turmoil to the “south of the border” caused by American federalism’s failure to develop a
national banking system. In the year after Confederation, the Dominion Notes Act was
passed. It took over the existing Provincial Notes, which traded alongside those issued by the
chartered banks and redeemed them in Montreal, Toronto, Halifax and Saint John, the main
centers of the three colonies and territories which entered Confederation between 1870 and
1873. In 1871, the Uniform Currency Act came into effect, establishing the decimal currency
system uniformly across Canada at a rate of $4.8666 to the pound and $10.00 Canadian to the
American $10 Gold Eagle. While Dominion Notes were introduced in 1871, chartered banks
were allowed to issue $4.00 and larger notes, a minimum amount that was raided to $5.00 in
1880. Chartered banks continued to issue their own notes until the Bank of Canada, Canada’s
central bank began operations in 1935. From then on, the Bank of Canada issued paper
currency, replacing the old Dominion Notes and the chartered banks were required to phase
out their notes.
With the Gold Standard, issues of money supply were relatively straight forward.
Whatever monetary policy Canada had, and it was limited, was handled between the
Department of Finance and the Canadian Bankers’ Association. Before World War II, there
was no money market to speak of and Canada was on the gold standard with few interruptions
(1914 to 1926) until the Great Depression.
The severity of the Great Depression made banks
very cautious. The government offered little guidance and direction, and the agricultural
sector was particularly hard hit by credit restrictions. The political unrest led to the creation
of Canada’s first central bank. The Bank had from the outset a high degree of freedom from
government interference, a political policy that was reinforced that were enshrined in law in
the 1960s. Nevertheless, even before Canada had a central bank, it had established a national
system of banking and money supply.
Finance and Nation Building: The North American Experience
Money creation and its attending financial institutions have political as well as
economic implications. Hamilton and the Canadian founding fathers were well aware of this.
It can bring people together and separate them too. The Greeks remained separate city states
because they failed to create a unified currency zone; the Romans, in contrast, helped create
an Empire by establishing one currency, albeit with others traded. People identify with their
money and the institutions that support it, as did the English in the heyday of the pound and
the Germans with DM. For much of its history, Canada created serious penalties for Indian
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minorities for using and celebrating tribal forms of money. (Davis, 2002, p.12)
While
scholars stress the micro and macro-economic functions of money, such as unit of account,
measure, payment, and storage of value they tend to neglect the political. It is part of building
sovereignty, an evolutionary process requiring patience and flexibility. In what currency do
you measure your wealth, is not just a financial question. It is also a political one, answer to
which evolves over time.
This cursory review of American and Canadian financial history is not designed to
provide policy conclusions to the European debt crises and the integrity of the Euro.
Financial history cannot do this, no more than knowing one’s own personal history can
determine where one will or should eat dinner tonight.
But like that personal history,
knowing financial history frames some possibilities; it may even inflame the appetite or
discourage some courses of action.
Much of what is learned from history is that solutions from one period may not apply
in others, as their macroeconomic and political contexts change.
When the United States
and Canada created their common currency, national and local governments spent much less
than they do today, and international finance was smaller and less high-tech. Indeed, the
transaction costs of having multiple currencies were much higher than today, making the
comparative benefits of a common currency zone greater.
Given the economic effects of
multiple, independent currencies, in the mid-19th century, it should be no wonder then that
many western countries (regions) were fighting a two-front currency policy, establishing the
benefits of paper money and fixing the value of that money to one common currency, one
commonly accepted measure of value, gold. The North American achievement during the
second half of the 19th century unfolded against the background of an Atlantic community
single currency zone. Although not as stable and automatically self-correcting as many have
thought, the pre-World War I Gold Standard Era still is justifiably famous for its currency
convertibility and stability. In short, the North American experience in the 19th and 20th
centuries cannot be applied to Europe in the 21st mechanically. (Eichengreen, 1997)
European efforts to forge a common currency have been very important to Americans
and Canadians. Some of the most vocal opponents and advocates for the European common
currency have come from Americans or American organizations. Some North Americans like
to think that their distance from European political conflicts may give them special insights,
but their analyses of the importance of transfer payments, inflation rates, and the symmetry
(or lack thereof) of economic shocks rarely go beyond very recent data. The more interesting
questions involve the role of factor mobility and bailouts when the common currencies were
15
introduced and during their early development stages. (Eichengreen, 1997) Even if Europe
today is less set up for a single currency than the United States, the more relevant comparison
is between Europe today and the United States of the mid-19th century and how regional
differences in inflation and growth rates affected the single currency project. Even if we have
different sets of policy alternatives, how political actors dealt with the inevitable stress
brought on by economic downturns might offer some guidance.
This brings us to the chief insight provided by history. American efforts to establish a
common currency and financial system were among the most contentious in their history.
Although the Federalist Papers did not address the issue directly, they debated the basic
balance of powers for a new government that created the framework for financial decisions.
During the first sixty years with the Constitution, the very existence of America’s first two
central banks provided one of the most controversial issues in American politics, resulting
finally in the first two banks having only 20-year lives and a nearly 80 year hiatus until a
Federal Reserve had support.
To be sure, the North and South fought the Civil War over
other issues, but it is no accident that Republicans used their control of the federal
government to pass some national banking legislation. Well into the 19th century, support for
centralized financial control and the Gold Standard remained shaky.
Although William
Jennings Bryan lost the presidential election three times, the author of the famous “Cross of
Gold” speech received the nomination of the Democratic Party three times. The ability of the
federal government to raise more revenues through an income tax, which helped provide
funds that ended up as automatic distributions to less well-off states, required amending the
U.S. Constitution, an Amendment that is still referred to by some as the Karl Marx
Amendment to the Constitutions, nearly 100 years after its passage. Each of America’s
financial crises in the 20th century brought on very public debates about what kind of financial
system America should have. Some of these debates led to fundamental changes in that
system, sometimes over the objections of or bowing to sectional interests, but generally with
rather widespread public consciousness about the tradeoffs and why the changes were needed.
(Roe, 1994)
Here too Canada’s experience points in the same direct. Although Canada’s transition
to a unified financial system was less traumatic than America’s, only the cataclysmic
conditions of the Great Depression were sufficient to force the creation of a central bank, over
twenty years after America’s third. Moreover, Canadian financial regulators had the wisdom
to add a clause to its first financial act in the 19th century, requiring the government to review
policies every ten years, a requirement that has now become every five years. In short,
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forging a common financial system in Canada required Parliamentary debate about
fundamental principles and a flexible response to changing financial conditions.
From the very beginning of the European Union’s history to Valéry Giscard
d’Estang’s 500-page constitution through our current round of financial fixes, European
leaders have had a propensity to push greater union through a consensus of elites, well ahead
of a broader public consensus.
While this strategy has some merit, the lack of public
enthusiasm in the stronger and weaker economies for a tighter union should come as no
surprise.
Nonetheless, we should not despair: major economic policy transformations are
normally long-term processes. As the quote, which introduces this paper argues, history
counsels patience.
17
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