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Should Canada adopt the common currency?

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Comparing the consequences of both fixed and flexible exchange rate under a monetary regime. To say you have a monetary union, you have a monetary regime defined by the currency arrangement. Should Canada adopt the common currency? or not? which one is better?

Paper Body:

The recent world money crisis and the advent of the euro as the new common currency for 11 nations in Europe, make it necessary for the signatory nations of the North American Free Trade Agreement --that links Canada, the United States and Mexico into a tariff-free common market for goods and services-- to consider the plausibility of launching an initiative for a North American common currency that could provide the monetary stability necessary for the development of financial markets, economic recovery, and the fully realization of the economic returns from the tariff-free common market. Furthermore, it becomes necessary for them to look at the implications of a possible single currency that could serve the needs for the Americas in the future, as a Free Trade Agreement of the Americas --that would extend from Alaska to Cape Horn encompassing 34 countries-- is likely to come into effect by the year 2005.

In this essay I would explore the desirability --and potential benefits and costs-- of the adoption by Canada and Mexico, of a currency board system in contrast to dollarization (namely, the abandonment of domestic currency and the adoption of the U.S. dollar) as a necessary precondition towards a euro-like North American Common Currency.

I would argue that, for the time being, the currency board system is the preferred alternative, as it fosters Monetary as well as Fiscal Policy discipline --with its associated benefits in terms of price stability and higher economic growth-- at the time it definitely avoids the major problems that rise with dollarization, that is, the problem of giving up seigniorage to the United States, the problem of loss of sovereignty in the dollarizing country, and the problem implied for the United States (of) when acting as lender of last resort, and having to assume the responsibility of regulating and supervising the banking system of the dollarizing economy. I suggest that a common currency for North America --and eventually for all of the Americas in the future-- is a necessary development in the evolution of the global economy, and that the currency board constitutes the ideal previous condition to achieve that goal.

The implied common currency does not necessarily has to be an euro-like common currency; actually it could be the case that the U.S. dollar acting as a common currency, in the event that certain necessary conditions for an euro-like common currency could not be attained, and assuming that the participant countries --including the United States-- were willing to negotiate an agreement that might address the problems derived from dollarization.

The essay is organized as follows. The first three sections offer a description of each of the alternatives that Canada and Mexico would face if they were to formally link their currency to the U.S. currency --dollarization, currency board and (euro-like) common currency-- and present a general overview of its implications in terms of economic policy, as well as its advantages and disadvantages regarding growth, stability and other related issues. The last section (section IV) explores the desirability and readiness of these countries to opt for either one of the alternatives.

I. Dollarization

A. Overview on the recent discussion in dollarization

The financial crisis that struck Mexico in 1994-95, and the Asian currency crisis with its repercussions in Russia during 1998 and Brazil in 1999, coupled with the advent of European economic and monetary union (EMU), have sparked renewed discussion of a possible reduction in the number of the world's currencies.

On the one hand, the countries that have suffered most from the crises have been developing countries with central banks maintaining pegged exchange rates to the U.S. dollar. These countries are very interested in a policy that could offer them a way of achieving a truly fixed exchange rate that might contribute to prevent future currency crises as well as sustained economic stabilization, lower inflation, and greater long-term economic growth. Dollarization has emerged as an option, in particular in Latin America; the issue has been raised recently in a number countries within the hemisphere, causing significant debate.

The outgoing president of Argentina and the just-departed president of El Salvador, have called for official dollarization. Actually, Argentina's President Menem has already taken one step further proposing a dollarization plan that includes setting up an agreement with the United States . Advocates of dollarization are also making some inroads in Mexico. Mexico's business executives as well as a number of well-known economists speak for Mexico's emulation of Argentina's monetary reforms, suggesting that the country should abandon the peso and go on a dollar-based system. Mexican officials began exploring the idea of taking steps toward some sort of eventual monetary union with the United States.

The dollarization option has also been discussed in Canada, where the idea of the U.S. dollar as a common currency for the signatory nations to NAFTA is being seriously considered. Additionally, the influential Inter-American Development Bank has also triggered Latin American developing countries to dollarize, or even create a new regional dollar-linked currency.

On the other hand, the introduction and apparent success of the euro in establishing a common currency in Europe, has encouraged discussions involving the use of the dollar for a similar role in all of the Americas. The introduction of the euro had brought up questions regarding the role that the U.S. dollar will play in the international monetary and financial system when competing with the euro and the Japanese yen.

There is a fear that the U.S. dollar could lose its dominant role as trade vehicle currency after the European changeover, moving to a second position followed by the Japanese yen. It has been argued that due to network effects, the euro might gradually expand its share in global trade invoicing thereafter, primarily at the expense of the dollar in Central and Eastern Europe, the Mediterranean, and, perhaps, also in Asia .

B. Basics on dollarization: What dollarization is, How it works, and Where it exists.

Dollarization occurs when a country officially abandons its domestic currency and adopts the U.S. dollar, so that the latter serves the classical roles of money, that is, as means of exchange, as unit of account, and as store of value. This implies that in a dollarized economy saving holdings, goods pricing, and payments are all determined in U.S. dollars. This particular case is known as complete or full dollarization, to distinguish it from partial dollarization, in which case, the dollar circulates along with the domestic currency, and is used in any of the previously mentioned roles of money.

Typically, partial dollarization is unofficial and it happens as consumers and business in an economy choose to hold dollars as a store of value --keeping large bank deposits abroad or dollar notes as "mattress money"-- and/or to price products and write contracts on the basis of dollars, or to use them as means of exchange for transactions . This situation usually arises as a result of a lack of confidence of the economic agents, as they perceive that the domestic inflation rate will continue to rise followed by a subsequent depreciation of the domestic currency on international markets.

A recent IMF Occasional Paper dealing with dollarization (Baliño, Bennett and Borensztein 1999), indicates that partial dollarization is relatively widespread. The paper reports that in 7 countries, dollars circulate about equally with the national currency, account for about 30 to 50 percent in some 12 other countries, and account for about 50 to 20 percent of currency in many other countries. Examples are Bolivia, Peru, and Turkey. In Bolivia, for instance, although individuals are paid in bolivianos, they use them mostly for small transactions, numerous expensive goods are priced in and paid for in dollars. Bolivian people hold most of bank deposits in dollars (as much as 80 percent) and many bank loans are denominated in U.S. currency...