Download The purpose of this paper is to point to three economic benefits that

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.
Draft of March 2, 2005
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 Canada1,
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.
1
Some readers may not agree with the description of Canada as a small country. Nor are the countries of
Southeast Asia small in terms of population and increasingly in the size of their national income. However,
the comparison for my purposes of analysis is not with the truly small countries of West Africa or members
of the former Soviet Union in Asia. The comparison is with large neighboring nation as Canada and
Mexico with the United States, or individual countries with a collective of possible candidates for a
monetary union as in Southeast Asia.
2
The analysis in the first part of this paper draws heavily on Grubel (2005a) forthcoming. That paper
contains a number of graphs to back up some of the empirical relationships summarized here.
Draft of March 2, 2005
1
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:
o 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.
o 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.
o 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.
Draft of March 2, 2005
2
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
For an analysis of currency boards see Hanke (2002). Hanke (2003) provides an insider’s analysis of
what went wrong with the currency board in Argentina.
3
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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 propose4 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.
4
Courchen and Harris (1999), Grubel (2005b) forthcoming. In previous publications I argued the case for
a North American Monetary Union modeled after the European Monetary Union: Grubel (1999) (2000)
5
For a general analysis of the rules vs outcome approach to regulation see Grubel (2002).
Draft of March 2, 2005
4
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
6
For more detailed discussion of the estimates presented here and references to the original studies see
Grubel (1999) (2005b) forthcoming.
Draft of March 2, 2005
5
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
Draft of March 2, 2005
6
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
7
For an analysis of these costs see Eichengreen (1992) and Bayoumi and Eichengreen (1993).
Draft of March 2, 2005
7
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.
Eichengreen and Bayoumi (1993) suggest that such shocks do not lead to
problems within countries but would in Europe. One reason is that labor
mobility is much greater between regions of the same country than they are
between European countries. A second reason is that central governments
arrange for fiscal transfers to help regions in distress while there is no such
central government in Europe.
On the other hand, there are conditions within countries that facilitate
adjustments between regions and which will be brought into effect by a hard
currency fix. First, as Ingram (1973) pointed out highly mobile and low cost
capital readily flows to US regions suffering from a shock. Second, Kenen
(1969) notes that shocks randomly distributed over a given country tend to
offset each other and make for a more stable aggregate income and
employment. And third, it has been pointed out by Frankel and Rose (1997),
the hard fix forces special interest groups in the country to become more
disciplined. For example, excessive union wage demands that used to lead
to inflation and a depreciated exchange rate under a hard fix only result in
unemployment.
8
See Belke and Gros (1999)
Draft of March 2, 2005
8
While the increased efficiency of the capital market has been observed in the
euro zone, labor markets have been slow to adjust. However, politicians
have begun to accept the need for changes and we may expect that continued
high unemployment rates, slow economic growth and fiscal imbalances will
eventually lead to the public acceptance and eventual realization of these
reforms.9
In sum, the traditional assessment of the macro-economic costs of hard
currency fixes is subject to major qualifications suggesting that the costs are
much lower than those flowing from simple models that neglect capital
market benefits, the geographic spreading of risk and the pressures for labor
market reforms.
The following analysis goes further in the re-assessment of the alleged basic
costs from the loss of monetary sovereignty. It suggests ways in which the
loss of monetary sovereignty is accompanied by two different types of
benefits: First, the greater independence of monetary policy from political
influence and second, superior monetary policy due to the availability of
better data and better decision-making.
Neglected Benefits – Political Independence of Central Bank
A hard currency fix prevents national politicians from influencing monetary
policy to serve the interest of the government in power. In the past they
have often done so by forcing the central bank to buy government bonds to
finance spending deficits by the issuance of non-interest bearing money.
To the extent that such deficit financing by the central bank was chronic, the
country suffered through secular inflation and currency depreciation, with
significant negative effects on efficiency and economic growth.
Some deficit spending financed by the central bank was limited to periods
leading up to elections. It was designed to create temporary prosperity to
raise the reelection chances of governments. However, after the election the
9
It is an empirical question whether or not labor market institutions adapt to the hard currency fixes or
whether the fixes will be reversed. There are signs that institutions will adapt not just in Germany but
importantly in Ecuador, which a few years ago replaced its own currency with US dollars. The political
uprisings and the reversal of the policy that many had predicted have not taken place and the people of
Ecuador are adapting at a reasonable pace to the new financial and economic environment.
Draft of March 2, 2005
9
inflation caused by the excess money creation eventually required policies of
tight money to restore price stability. The resultant “political business
cycles” imposed unnecessary costs on the economy.
Many countries have constitutional provisions designed to assure their
central banks’ independence from political influences and they had fewer
political business cycles than those without them. However, even such
countries suffered from the influence of politicians since they always have
provisions for regular “consultations” between bank officials and politicians
to assure “accountability” of the civil servants and technocrats. On the
occasion of such consultations politicians were able to influence monetary
policy in more or less subtle ways.
The incidence of deficit-induced inflation and political business cycles has
decreased significantly in all developed countries in recent decades, though
it remains a serious problem in many developing countries. In the industrial
countries politicians now understand that inflation often causes the electorate
to replace governments that cause them. Governments have also learned
that political business cycles cannot be managed precisely and there are
significant risks in their use to win elections.
Nevertheless, the potential for political interference with monetary policy
formation remains as memories of bad past experiences fade and in the
future unforeseen and unforeseeable problems arise with unemployment,
inflation and slow economic growth. Hard currency fixes in a sense are like
taking out insurance against bad monetary policy made in response to
pressures from national politicians.
The European Central Bank is largely free from political influences in the
short run. Its independence is assured constitutionally and even includes
sovereignty in the selection of operating and decision-making personnel. In
the short run at least, this arrangement assures that the citizens of countries
of the Euro zone will not be subjected to politically induced inflation and
business cycles.
However, as is the case with all so-called “politically independent
institutions”, there are provisions in the ECB constitution that are designed
to keep it “accountable” to elected legislatures. For this purpose, the
leadership of the ECB is required to meet periodically with the European
Council of Ministers.
Draft of March 2, 2005
10
Issing is a member of the Executive Board of the ECB and Director of
General Economics and Research. In a paper published in 2004 and one in
this volume he reports that since its inception the ECB has been able to
escape interference from the Council of Ministers in its pursuit of price
stability in the Euro zone.
It is not clear what will happen in the longer run. It is possible that
eventually special interest groups from individual countries unite and lobby
the Council of Ministers, which in turn will attempt to influence monetary
policy to become more inflationary. However, such efforts will be much
more difficult than they were within each country because there are so many
more and diverse interest groups in the large Euro zone than there were in
individual countries and the efforts of diverse groups tend to offset each
other. In addition, the use of monetary policy to increase reelection chances
is not possible since national elections in the countries of the euro zone fall
on widely different dates.
As noted above, hard currency fixes can also be adopted through
dollarization and the establishment of true or quasi currency boards. Under
these institutional arrangements, the countries adopting the hard fix have no
influence on the formation of monetary policy. For example Ecuador, which
adopted the US dollar in all domestic financial uses will always have interest
rates equal to those set by the Federal Reserve Bank10. The same would be
true if Canada adopted the quasi currency board arrangement suggested
above.
There have been rumors that if Canada were to adopt a hard fix to the US
dollar, the Fed would be willing to have Canadian officials participate in the
deliberations held before monetary policy is set. Such participation would
be limited to the presentation of information by Canadians, but only
Americans would be able to vote on specific policy proposals. In the longer
run, such an arrangement may lead to a vote for Canada and the possibility
of voting alliances with delegates from different US regions. However, it is
clear that even under such conditions, the influence of Canada would be
small, just like individual countries have limited influence on the policies set
by ECB and individual Federal Reserve districts have on Fed policies.
Except for premiums reflecting the country and other issuers’ default risk, which depends to a
considerable degree on the political risk of exit from official dollarization.
10
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11
Neglected Benefits – Better Monetary Policy
The making of monetary policy is a complicated process. Information on
recent economic conditions is collected, interpreted and projected into the
future. The possible development of economic shocks is given special
attention. This intelligence is used to study likely future inflation,
unemployment, the exchange rate and economic growth. The constitution of
the ECB requires it to use monetary policy only to assure stable price on the
grounds that monetary policy in the longer run cannot influence the other
indicators of economic performance. Changes in interest rates and the
quantity of money are the instruments used to assure stable prices.
The making of monetary policy just described requires the use of scarce and
costly financial and human capital resources. Smaller countries typically
have less access to these resources than do large countries or a collective
central bank like the ECB. By giving up their efforts to make monetary
policy these smaller countries enjoy better monetary policy.
The increased availability of resources by the central banks of large
countries or of a monetary union increases the quality of monetary policy
through a number of influences. First, the data used to make projections is
better and more current. Issing (2004) reports the difficulties the ECB had
during its early years of operation because data from several countries in the
monetary union were not available at all or only with a considerable lag. It
is clear that if the statistical offices of countries could not supply the ECB
with the required data, they did not supply them to their central banks when
they still made their own policies. These deficiencies have been remedied to
a considerable degree with help of experts and financing from the ECB
working with national data collection agencies.
Second, highly trained economists and statisticians working with a number
of different models and using high-powered computers and programs
manipulate the historic data to make forecasts. Small central banks tend to
have fewer employees, computers and models to do this work than do the
larger central banks. The stronger competition and greater variety of models
available in large central banks tend to produce more and better information.
Draft of March 2, 2005
12
Third, the most fundamental factor determining the success of monetary
policy is the process used in sifting through the available statistical
information to decide what the best monetary policy is for the future.
This work is guided by theories and empirical evidence backing them. But
the making of monetary policy never will be like the design of a bridge. It
involves many personal judgments and guesses. The history of the last 50
years shows that these judgments and guesses are necessary since prevailing
theories of macroeconomic relationships change often, making obsolete
what just short times before was considered to be conventional wisdom.
Most central banks in the developed world presently have adopted inflation
rates as the appropriate target for their policies, with some considerable
success. However, if the past is any guide to the future, “the end of history”
in the proper design of monetary policy will never come.
In a recent book Snowdon and Vane (2005) give an interesting taxonomy of
theories that have dominated macroeconomics and influenced monetary
policy since the 1950s.
o There was vulgar Keynesianism with its disdain for the role
interest rates and the supremacy of fiscal policy for stabilization
policies, all designed to fit a large, mostly closed economy model.
The Phillips-curve trade-off between inflation and unemployment
evolved straight out of Keynesianism as it struggled to meet the
growing demand for an operational definition of the theoretical
concept of full employment.
o Orthodox Monetarism with its total pre-occupation with the supply
of money came to prominence as a result of Milton Friedman’s
work and in response to problems encountered in the
implementation of Keynesian polices.
o The New Classical School led by Robert Lucas emphasized the
role of expectations in wage negotiations and the labor market,
buttressing the orthodox monetarist models and putting the final
nail into the coffin of Keynesian models.
o The Real Business Cycle School led by Edward Prescott focused
on developments in technology, real demand and supply and
consistency in economic policies, but in the end leading to a very
nihilistic view on the ability of government policies to influence
real economic variables.
Draft of March 2, 2005
13
o The New Keynesian School associated with the textbook by Rudi
Dornbusch and Franklin Fischer synthesized all that was good in
the doctrines developed in the wake of the demise of pure
Keynesianism and presented pragmatic policy options to deal with
the problems faced by national governments.
o The Post Keynesian School led by Paul Davidson and much alive
at Cambridge, England, argues that the money supply is
endogenous, union wage demands determine inflation and that full
employment can be maintained only through wage and price
controls.11
Most of these theories were dominant for some time and their adoption was
thought to end the search for better models and monetary policy. They
never did.
Issing (2004) asserts that the ECB presently makes monetary policy by
pragmatism that is free from doctrinaire reliance on any theories. “…the
systematic and efficient use of all relevant information…requires the use of
a comprehensive set of information based on a diverse range of approaches
and models in order to obtain a comprehensive picture of the state of the
economy and the risks to price stability.” (p.43)
One of the lasting and unresolved debates in monetary theory and policy
involves the use of the interest rate and the quantity of money as instruments
of monetary policy. Orthodox monetarism noted that nominal interest rates
can send false signals about monetary conditions since they are influenced
by unobservable expectations about future inflation. The money supply
numbers are free from this problem but financial innovations and nonsystematic changes in public demand for money affect its velocity of
circulation and thus the usefulness of supply data for making monetary
policy.
Issing reveals how the ECB has handled this problem: “…the Governing
Council decided against monetary targeting in 1998 and also stuck to this
decision in 2003. The prominent role assigned to money in the ECB’s
strategy is signaled by the announcement of a reference value for monetary
growth. The reference value represents a public commitment to thoroughly
analyzing monetary developments and ensuring that information on
11
This taxonomy draws heavily on Snowden and Vane (2005).
Draft of March 2, 2005
14
monetary developments is given appropriate weights in the decision-making
process. It specifies the growth rate of money regarded as consistent with
price stability over the medium term.” (p.45).
This description of the methods used to determine money supply growth and
therefore interest rates in the euro zone is likely to leave advocates of money
supply targeting, like Milton Friedman, dissatisfied. In my view the first and
last sentence of the preceding quote taken together reveal pragmatism and
the explicit use of intuition based on experience and wisdom that appear to
be essential in making successful monetary policy in our very complicated
and highly uncertain world.
It is alleged that US monetary policy under Alan Greenspan’s leadership as
the Chairman of the Federal Reserve Board relies similarly on pragmatism
and Greenspan’s injection of his own highly personal interpretation of
information into formal models.
The likelihood that a central bank ends up with influential personalities that
have the required experience and wisdom, such as Greenspan in the United
States and Issing and others in the ECB is greater in large than in small
organizations. Therefore, small countries that hand their monetary policy
formation to such large organizations on average can expect to enjoy better
monetary policy than they made before.
Canada as an Example
The preceding conclusions are supported by my analysis of three recent
monetary policy decisions by the Bank of Canada, which may be
summarized as follows. 12
The first episode occurred in the late 1980s when both Canada and the
United States experienced renewed inflationary pressures at very similar
rates. Under the leadership of John Crow in Canada and Alan Greenspan in
the United States it was decided to use tough, restrictive policies to rid the
economy of all inflationary expectation and create public expectation in the
permanence of price stability. Resistance to pressures for easier monetary
policy in the light of serious economic distress was considered to be
essential to the working of the therapy. Both countries followed this model.
12
See Grubel (2005b) forthcoming.
Draft of March 2, 2005
15
Relevant to the present purposes of analysis are the following facts:
Canada’s Bank Rate reached a maximum of 14 percent while the maximum
Federal Funds Rate was only 10 percent. The Bank of Canada maintained
its higher rates for nearly a year longer than did the Federal Reserve.
The rates of inflation in both countries were roughly the same before the
monetary restraint and after it. Yet, the cost of restraint were much higher in
Canada than in the United States in terms of unemployment, lost output,
reductions in tax revenues and increased deficits.
I am certain that John Crow and his staff at the Bank of Canada acted in
good faith and on the basis of information and theories that they considered
to be correct at the time. This fact however does not invalidate the central
point of my analysis. If Canada’s monetary policy during this period had
been made in the United States, the costs would have been much smaller and
the benefits the same.
The second illustration of the problems caused by Canada’s exercise on
national monetary sovereignty covers the period 1994 to 2002. During this
period the Bank of Canada pursued a much easier monetary policy than the
United States. The resultant capital outflow contributed substantially to the
continuous depreciation of the Canadian against the US dollar from about 76
cents to a low of about 63 cents.
The Bank of Canada explained that its low interest rate policy was needed to
compensate for the reduction in aggregate demand that accompanied the
great success of Canadian governments in the elimination of spending
deficits.
This explanation may be valid, but it will never be known how the Canadian
economy would have performed if the exchange rate had not been depressed
by the capital outflows. A good case can be made that the booming US
economy would anyway have provided sufficient incentives for increased
exports to compensate for the effects of tighter fiscal policy. It is also likely
that the elimination of the deficit would have revived consumer confidence
and spending and thus offset the fiscal drag. The depreciation of the dollar
had the opposite effect on consumer sentiments.
Draft of March 2, 2005
16
Whatever may be the truth in these speculations, the fact is that the easy
monetary policy was necessary because of the error made during the
preceding period of excessively tight monetary policy, which had
contributed much to the size of the deficit through reduced tax revenues and
higher debt service costs. Therefore, if the first error in monetary policy had
not been made, the costs imposed on the economy by the subsequent low
interest rate policy would not have been necessary. Courchene and Harris
(1999) and Grubel (1999) argued that these costs were substantial, involving
lower productivity growth and slower changes in the mix of industries in
Canada. During the period of the sharply declining dollar, Canada’s real per
capita income fell behind that of the United States by more than five
percentage points from where it had been at the beginning of the period.
The third episode of questionable Bank of Canada policies occurred after
2002. At that time monetary policy was tightened, Canadian interest rates
rose while US interest rates fell. The Canadian dollar, which already was
going up because of a boom in world commodities was pushed up even more
by capital inflows attracted by the high Canadian interest rates.
The Bank of Canada justified its high interest rate policy on the grounds that
inflation had become a serious threat. Thus, early in 2003 for about 3
months consumer prices rose at annual rates over 4 percent. Even the core
rate, which excludes volatile commodities like energy and fresh vegetables
and fruit, rose slightly above the upper limit of the Bank’s target range of 3
percent.
The high inflation lasted only about a quarter. In early 2004 the increases
were much below the lower target of 1 percent. This turnaround in inflation
cannot possibly be attributed to the tightening of the monetary policy.
Instead it was due to a slowdown in the rate of increase in energy prices and
the end of increases in automobile insurance costs that had been responsible
for the earlier, alarming price increases.
There are two main criticisms of the increase in interest rates in 2003
initiated by the Bank of Canada. First, increases in the cost energy and
insurance should not be taken as evidence of inflation that requires a
tightening of monetary policy. Price increases of this sort reflect changes in
relative prices, they tend to be limited and often are reversed once
underlying special conditions change.
Draft of March 2, 2005
17
Second, the increases in the core inflation rate just discussed were caused in
large part by a strong increase in the cost of automobile insurance. The
Bank of Canada’s decision makers should have analyzed carefully the
components of the index responsible for the price increases. If they had,
they would have realized that these increases were due to cyclical factors
affecting the returns on insurers’ investment portfolios and therefore were
not cumulative and continuous. They did not require remedial tight
monetary policy.
In addition, the Bank did not engage in due diligence in accepting
uncritically the data on insurance cost increases. It was left to Mullins
(2003), an economist working at the Fraser Institute on automobile insurance
issues to discover that Statistics Canada had made an error in recording the
price increases. The price increases had taken place over several preceding
quarters, but instead of reporting them as small increments when they
occurred, Statistics Canada included them all in the one critical quarter,
which prompted the Bank of Canada to raise interest rates.
I contend that such faulty interpretation of basic trends and specific data
developments would have been much less likely to occur in the Federal
Reserve and, almost by definition, would have been avoided if there had
been a monetary union. Under these conditions, Canada could have avoided
the unnecessary costs of high interest rates, the more rapid and pronounced
rise in the exchange rate and the damage they have done to the Canadian
economy. According to a study by the Toronto Dominion Bank, the high
dollar will result in the loss of 50,000 jobs in 2005.13
Stephen Jarislowsky, one of Canada’s richest men and head of a very
successful money managing organization, in an interview referring to the
monetary policy episode just discussed commented: “Interest rates should
not have been raised faster than American ones.”14 He concluded with a
remark supporting my paper’s basic proposition: “This country cannot live
with a floating currency. Europe can but even Japan has difficulty”.
The bigger they are, the harder they fall
13
14
See Beauchene (2005).
As quoted by Diane Francis (2005), page FP1 and FP5.
Draft of March 2, 2005
18
The preceding analysis and conclusions are subject to the criticism that large
central banks may on average make better monetary policy than small
central banks, but when the former make mistakes, the costs are so much
greater since they affect large economies and populations. Under these
conditions, smaller countries with hard currency fixes suffer problems that
would have been avoided if they had pursued their own monetary policy and
avoided the big mistakes.
This may very well be the case in principle, but in practice the situation is
different. First, the longer run correlation between interest rates reflecting
the monetary policy stance of Canada and the United States is .95. Most big
monetary policy errors made by the United States also were made by
Canada.
Second, the prosperity of a small country like Canada is highly dependent on
its trade relations and capital market integration with the United States, the
country to which it fixed its currency. Errors in US monetary policy under
these conditions will not affect the exchange rate and therefore leave
unchanged the vital trade and capital flows between the countries. In Europe
similarly, any errors made by the ECB may affect the euro exchange rate
values, but they will not reduce trade and capital flows among the member
countries of the union.
Summary and Conclusions
In this paper I have argued that small countries that adopt hard currency
fixes and surrender their national monetary sovereignty to a large country or
a common central bank will enjoy lower costs of foreign exchange dealings
and lower risk premiums on interest rates. These benefits are allegedly
gained at the cost of losing the freedom to use monetary policy to deal with
external shocks.
The paper argues that the frequency and size of losses are exaggerated since
most shocks in the past were caused by faulty national monetary policies.
The cost estimates also neglect the benefits of more efficient capital and
labor markets and the wider geographical dispersion of shocks that are the
result of hard currency fixes.
The main contribution of the paper is to point to the fact that the large
institutions that determine monetary policy – the central banks of monetary
Draft of March 2, 2005
19
unions or the central bank of a large trading partner to which a country’s
currency is fixed – on average produce better policies than do the central
banks of smaller countries. This is so because these larger institutions are
more likely to be free from political influences and they have more
statistical, 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.
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