FINA Committee Meeting

STANDING COMMITTEE ON FINANCE

COMITÉ PERMANENT DES FINANCES

EVIDENCE

[Recorded by Electronic Apparatus]

Tuesday, May 16, 2000

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[English]

The Chair (Mr. Maurizio Bevilacqua (Vaughan—King—Aurora, Lib.)): I'd like to call the meeting to order and welcome everyone here this afternoon.

As everyone knows, the finance committee is having a series of round tables on a number of issues during the months of May and June. Today we're doing a round table on monetary policy and currency regime.

We'd like to welcome Professor Christopher Ragan from McGill University; Professor Herbert Grubel, a former colleague, from Simon Fraser University; Mr. Andrew Jackson, research associate with the Canadian Centre for Policy Alternatives; and Professor Pierre Siklos, from Wilfrid Laurier University.

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As you probably know, you have five to ten minutes to make your introductory remarks, and that will give us a chance to engage in a lengthy question-and-answer session.

We'll begin with Professor Ragan.

Mr. Christopher Ragan (Individual Presentation): Thank you. Copies of my speaking notes have been circulated, and I'll do my best to stay close to them.

Thank you very much for the invitation to appear before you today.

Currency arrangements in Canada are important issues that seem to crop up every once in a while, and it's certainly important that they be debated properly.

I'd like to use my five or ten minutes to explain my view of why I think it's a slightly deceptive debate. There's an impression in the popular press—or at least the popular press that I read—that it's more or less a one-sided debate, that there are obvious benefits of fixing the exchange rate or having a common currency, but not such obvious benefits of having a flexible exchange rate. I'd like to try to explain why I think that is deceptive.

The short and sweet statement here is that I think the benefits of a fixed exchange rate or a common currency are pretty easy to understand. I think the benefits of a flexible exchange rate are just as real, but a little bit more difficult, at least for non-economists, to understand.

It's generally easy for an individual consumer or an individual firm to understand the benefits of either a fixed exchange rate or adopting a common currency—in Canada's case, typically the U.S. dollar. The big benefit is that you avoid the uncertainty that goes along with flexible and often volatile exchange rates. Less uncertainty and more predictability in the exchange rate is generally thought to lead to more trade and more investment, and with more trade and investment go more gains from trade.

An additional benefit—and this is the difference between a fixed exchange rate and having a common currency—if you go so far as to have a common currency, you benefit from avoiding all of the currency conversion costs required with international trade, either in goods, services, or assets.

Now, I don't want to suggest for a minute that those benefits are small. I think all of those benefits are real. But they are at best only half the picture. I think the other half is the half that's more difficult to understand. I think it's a much more subtle set of arguments, and that's what I'd like to try to explain.

The benefits of having a separate currency with a flexible exchange rate are reflected really in the macroeconomic adjustment of the economy in response to shocks from outside the economy. These benefits are especially important in small, open economies like Canada that rely to a large extent on trade and, as in Canada's case, rely to a large extent on commodity-based trade.

To understand the role of flexible exchange rates in the process of macroeconomic adjustment, I'd ask you to consider the Asian crisis that began in 1997. Think about how Canada responded to what an economist would call a shock to Canada, and think about how Canada would have adjusted to that set of events had we had a fixed exchange rate instead of the flexible exchange rate that we had.

As the Asian economies went into recession—and parenthetically, I'd say those recessions, the Asian crisis, were in some part caused by their attempts to maintain fixed exchange rates. Their demand for commodities and raw materials fell dramatically. The Asian economies are and were large users of raw materials, so when their economies went into recession, their reduction in demand for raw materials led to a large reduction in the world demand for raw materials. As Canada is a major exporter of raw materials, it's not surprising that there was then a reduction in demand for Canadian goods, and with it, a reduction in demand for the Canadian currency.

Now, the result of that was that the Canadian dollar depreciated 10% to 12% between the fall of 1997 and the spring of 1998. Another result, of course, was that the resource sector in Canada, in particular in British Columbia, was hit fairly hard, both in terms of employment and in terms of income.

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Just this morning I was surfing through Industry Canada's website, which is a fabulous website for looking at industry details. If you were to just look through the resource sector—I picked a number of industries within the forestry sector—it's amazing how many of them experienced significant reductions in employment and, more to the point, income from 1996 through 1997 and 1998.

Now, what happened in the face of such a shock from Asia? Well, as the Canadian dollar depreciated, other export sectors in Canada—and I'm thinking in particular now of central Canada, but not necessarily just central Canada—were stimulated, because the reduction in the external value of the Canadian dollar meant that Canadian manufactured and semi-manufactured goods were now more attractive to foreign buyers. The result was that an increase in economic activity in manufactured and semi-manufactured sectors offset to some extent the reduction in economic activity in Canada's resource sectors. That's what actually did happen.

Now, what would have happened had Canada had a fixed exchange rate? The Asian crisis still would have happened whether Canada had had a fixed exchange rate or a flexible exchange rate. That event was completely independent of Canada's exchange rate regime. There still would have been a reduction in Asia's demand for raw materials and commodities, and there would still have been a reduction in the demand for Canadian pulp and paper, softwood lumber, newsprint, iron ore, and all sorts of other Canadian-produced raw materials.

So the reduction in B.C.'s resource sector still would have taken place, but had we been operating on a fixed exchange rate, by definition there would not have been a depreciation of the Canadian dollar. That 10% to 12% depreciation that did in fact occur would not have occurred, because the Bank of Canada, by offering a fixed exchange rate, would have intervened to prevent that depreciation.

Well, without that depreciation, there would have been no offsetting expansion in the manufactured and semi-manufactured sectors in Canada. The result would have been that economic growth in Canada would have been slower than it in fact was if the Canadian dollar had not been allowed to depreciate.

That whole set of arguments I've just given you is the logic behind the claim, which I'm sure you have heard in this committee, that flexible exchange rates act as a shock absorber for economic activity in the face of economic shocks from the rest of the world.

This is a fairly subtle argument that is not appreciated by the typical individual consumer or the typical individual firm for the simple reason that individual consumers and firms don't spend a lot of time thinking about macroeconomic adjustment. They may think about what affects the prices of the goods they buy, what affects their decisions for investment and for international contracts, but they don't spend a lot of time thinking about macroeconomic adjustment. That's usually stuff that is reserved for economists and policy-makers. But it is a very important benefit, and I would argue that it is the important benefit of flexible exchange rates.

I'd like to make one final point. Many people seem to believe that by fixing an exchange rate we can avoid uncertainty and volatility in the economy. I'd like to suggest that the argument I've just made shows that's false. What is true is that by fixing the exchange rate, you can avoid the uncertainty and volatility in the exchange rate, by definition. But what you end up doing is shifting the uncertainty and the volatility onto other parts of the economy, in particular, output and employment.

So fixed exchange rates really redistribute the effects of a given amount of volatility in the economy. They don't eliminate volatility; they just change where that volatility shows up. I think most economists would agree that it would be better to have a volatile exchange rate than to have volatile output and employment.

In summary, I'd like you to keep in mind the reasons many people think there are obvious benefits to fixing Canada's exchange rate. The benefits—reductions in exchange rate volatility—are easy to understand. They're fairly obvious. But the costs of fixing an exchange rate or having a common currency are that you end up having greater output volatility and greater employment volatility in response to those outside shocks that will continue to happen.

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Those benefits are much less obvious. As I say in my notes, it's challenging enough to explain this point carefully and accurately to a classroom full of students who have been attentive for the past several weeks, so perhaps it is silly of me to try to do it here in just five minutes. But I hope there's some benefit to what I have just said.

At the end of my speaking notes you'll see five other points you may want to consider, and I'm sure they will come up in the discussion that follows.

Thank you.

The Chair: Thank you very much, Professor Ragan.

We'll now hear from Professor Herbert Grubel. Welcome.

Mr. Herbert Grubel (Individual Presentation): Thank you, Maurizio. It's very nice to be back here on the other side of the table.

I have handed for distribution to the members a publication that was issued by the Fraser Institute, The Case for the Amero, and it contains a much more detailed analysis of what I'm going to present now. It was just translated into Spanish, and it will probably soon be available in Brazilian and Portuguese.

The committee's interest in alternative monetary regimes is very timely. Monetary union in Europe is an overall success. There have been no tensions among members, and other countries are clamouring to join. Important for my analysis today, some national policies affecting economic performance and labour markets have been altered in response to the discipline imposed by the currency arrangements.

Dollarization is imminent in Argentina and Ecuador. Several Central American countries are debating it. I just attended a conference in Brazil where there was much interest in the creation of a common currency for MERCOSUR. Some Balkan countries and East Timor officially use the Deutschmark in place of their national currency.

There are very good reasons for the global interest in new monetary arrangements. I see this interest as a further step in the process of replacing Keynesian economics with classical policy prescriptions. Deficit spending and inflation are out. They did not deliver what was promised. Flexible exchange rates are next to go, because they too bring inferior economic outcomes.

I would like to address the issue that Christopher just raised. The defenders of flexible exchange rates for Canada rest their case on the proposition that these flexible rates are needed to deal with economic shocks. I ask these people the following question, which Mundell asked of them in Brazil last week. Every region of Canada faces its own isolated economic shocks. Should they all have a separate currency and a flexible exchange rate? Adjustment to the downsizing of the federal government during the last decade would certainly have been helped if there had been an Ottawa dollar and a dollar depreciation. So why not separate dollars for Ottawa, Halifax, and Prince George?

There are many who love the benefits conveyed by low and falling exchange rates. The workers and firms in Canada's natural resource industries love them because they help in dealing with the effects of lower world prices for natural resources. Employers of export-oriented firms love the higher profits brought by a low dollar. Workers love the wage increases they can demand as a result of the high profits. Politicians love to be known as the purveyors of such benefits, in the hope that they lead to appropriate rewards from the beneficiaries at the next election.

But, ladies and gentlemen, these benefits come at a cost, a cost that is downplayed by the advocates of flexible exchange rates. The higher wages in export industries, such as the producers of cars, are not matched by genuine increases in productivity. The lower exchange rates analogously allow wages and costs in the commodity-producing industry to be higher than they would have been with fixed rates. So when world commodity prices recover and the exchange rate is under upward pressure, the prices and high costs of producing cars and natural resources prevent the full recovery of the exchange rate, even if commodity prices return to their old level. Monetary policy has no choice but to accommodate these higher prices and wages.

This process of higher wages and prices caused by the depreciation of the exchange rate just described explains why the Canadian dollar has fallen by about a third over the last three decades. Unless we abandon flexible exchange rates, the next generation in Canada will have a 40-cent dollar and then a 20-cent dollar, and I don't know where it will end.

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The declining dollar has impoverished Canadians who travel abroad or buy foreign products. More fundamentally, it has reduced the pace at which our economy has adjusted to new industrial opportunities and adopted new technologies. In the car industry, labour cost is relatively low for a period, and the substitution of capital for labour is reduced. Firms in the natural resource industries fail to downsize, and labour is kept from moving into other industries.

Consider as an alternative what happened in California in the early 1990s, when the end of the Cold War devastated its defence industry, an effect at least as dramatic as is the decline in the world prices of commodities in Canada. The industry and its workers in California were not protected by a falling exchange rate, and they had to face reality promptly. So they made themselves available for retraining and work in new industries, which promptly came to California to take advantage of the superb infrastructure and well-educated workers. Unemployment dropped quickly, and California today is one of the most prosperous regions of the world.

I think the infrastructure and quality of the labour forces of British Columbia and the Atlantic provinces are as good as those of California, but labour, industry, and the entire economic system in the Canadian regions did not have the same incentives to adjust as did those in California. A flexible exchange rate has created these conditions in Canada. A fixed rate will cause Canadian conditions to become more like those in California.

Up to this point I have used interchangeably the concept of monetary union and fixed exchange rates. It's now time to say a few words about alternative arrangements for creating the conditions for greater market discipline and for more restraints on politicians and bureaucrats to curry favour with groups of electors.

Fixed exchange rates with a national currency and central bank are the least desirable approach. Even if monetary policy is constrained by the goal to maintain price stability and labour and capital markets are flexible, political disturbances and honest fiscal and monetary policy mistakes can lead to massive speculation and a breakdown of the system. The recent crisis in Southeast Asia is an example of what can happen.

A currency board, which is designed to create a direct link between the domestic money supply and foreign exchange balances, can still come under speculative attack because politicians and bureaucrats retain some discretionary power. The currency boards of Hong Kong and Argentina fiddled with the automaticity of their currency board system in the wake of the recent deep Asian crisis and the devaluation of the Brazilian real.

Dollarization eliminates discretion associated with currency boards, but it brings its own problems. Argentina is more likely to need low interest rates just when the U.S. interest rate needs raising. This is not as big an issue for Canada, but dollarization eliminates the profits of the Bank of Canada, about $2 billion annually, and prevents direct Canadian input into the determination of interest rates on the dollar. The circulation of U.S. dollar notes in Canada will give fits to nationalists.

Monetary union removes all discretion from politicians and bureaucrats in setting national exchange and interest rates. It allows the retention of seigniorage profits from the printing of money. Having Canadian symbols on one side of the notes and coins will please nationalists. Canadian members of the governing board of the North American central bank will permit official input into monetary policy formation.

In my analysis to this point I have dealt with the most often heard criticism of monetary union, namely, that it causes Canada to lose the flexibility needed to deal with unstable and declining commodity prices and other national economic shocks. I have argued that the exchange rate flexibility brings its own costs, which are hidden but probably larger than the benefits.

Monetary union is desirable on these grounds alone, but there are other good consequences. Monetary policy can and will be more stable. It is true that Canada has had an excellent monetary policy in the last ten years or so, but just like it makes no sense to argue that one does not need an umbrella because it's not raining just now, it is desirable to have permanent protection from national monetary policy adventures in the future. I would sleep better knowing that if the NDP ever formed the government it could return to inflation by directing the Bank of Canada to do so, but would have to renege on the international agreement for a North American central bank.

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Monetary union will also lead to lower interest rates and lower costs of foreign trade. The elimination of the exchange risk on Canadian securities will shrink substantially the historic 1.14 gap in Canada-U.S. interest rates. Lower interest rates in turn reduce the debt service costs of governments—about $6 billion for the feds alone. Private investment by industry will be increased and bring higher labour productivity and incomes. Lower mortgage and consumer borrowing rates will allow Canadians more money to spend on other things. The lower costs of currency exchange and hedging will bring similar benefits through increased trade and capital flows.

There are three major obstacles to monetary union. First, there is opposition from politicians and bureaucrats who would lose an important instrument with which to solicit votes from interest groups. A political party that sees merit in taking away this source of power from the political system could change this equation.

Second, there are the ardent nationalists, most of whom are social democrats with strong convictions that big government is needed to create a better society. This opposition is in the minority in Canada, though it is hard to tell since it has many allies in the media. It can be defeated, much like it has been in the fight over NAFTA, price stability, and balanced budgets.

The third problem is how to get the Americans to agree to a monetary union. The problem is that they do not have any obvious self-interest in giving up the prestige of the almighty dollar.

If I may just ad lib here for a second, Bob Mundell, who recently won the Nobel Prize, asked me to come to these international conferences so I could make the point I have just made about the merits, both political and economic, of fixed exchange rates. But he does not support my plan because he believes the Americans have too much to lose to give up the U.S. dollar. So we are in a little bit of a conflict here.

However, Americans do have some less obvious self-interest. They benefit from having stable and prosperous neighbours, especially to the south, where just a drop in the present interest rate of 30% to 6% would stimulate economic development and stem the unwanted tide of illegal immigrants. America joined the NAFTA, UN, IMF, World Trade Organization, and World Bank over the opposition of many nationalists because they promised greater world stability and prosperity. A monetary union, in a sense, is a logical extension of NAFTA and will enhance the benefits it has brought already.

Another reason is that the hegemony of the dollar is threatened by the Euro, especially if it's strengthened by the joining of a number of other countries like Hungary, Poland, the Czech Republic, and similar central European countries.

Finally, it's important to note that Americans will always have the majority on the policy-making board of the proposed monetary central bank. Canada and Mexico will have votes and will be able to call attention to their concerns, but they will not prevent the continuation of the historic policies that brought the dollar its world dominance.

Canada and Mexico, at this point, need to work out internally the arguments for and against the monetary union. The elected politicians in this room are in the best position to initiate such discussions, and can make the issue part of an upcoming election campaign in Canada.

My personal experience in discussing the issue with many people has convinced me it has a good chance of public support, especially when the dollar either appreciates or falls substantially. Once we have a national decision on this issue, we can approach the Americans. The only certain thing about their response is that we will never get one unless we ask for it at the official level.

Thank you for your attention. I hope you have lots of good questions.

The Chair: Thank you, Professor Grubel.

We'll now hear from Andrew Jackson from the Canadian Centre for Policy Alternatives. Welcome, Andrew.

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Mr. Andrew Jackson (Research Associate, Canadian Centre for Policy Alternatives): Hi. Thanks.

I find the debate about the currency arrangements—the fixed versus floating exchange rates for Canada—kind of interesting because I don't think the participants fall into the normal camps here. It's not a left-right issue in any sense. I think many social democrats in Europe favour fixed exchange rates. I note here in Canada that John Crow is one of the most fervent advocates for continuing the floating rates. It's very mixed in terms of where people come from.

In honesty, it's also a debate that is as much political as economic. You'll find economic arguments on both sides. Looking at EMU in Europe as an example, it's very important to bear in mind that the decision to embrace a common currency was very much part and parcel of a very conscious decision to work toward much closer political union, and should be seen in that context.

While I'm a big defender of a floating exchange rate, and we'll sort of concentrate on that, I think it's appropriate to note that there are some arguments for a fixed exchange rate in a common economic area, such as North America has become. It's interesting to just pose the question that if we were to proceed in favour of a North American monetary union, as Mr. Grubel and others advocate, what sort of conditions would have to be in place to make that possible?

First of all, one would have to start from the premise that monetary policy within that shared monetary union would be jointly determined, rather than simply set by one country. The United States has made it absolutely clear that they're not interested in running the U.S. dollar in cooperation with anybody.

I'll just read from something. I have some questions and answers notes from Senator Connie Mack's website called “A Guide to the International Monetary Stability Act”. It's actually a document of the Joint Economic Committee at the U.S. Senate. It says:

Wouldn't dollarization eliminate the ability of countries to run an independent monetary policy?

Yes. Countries that dollarize would adopt U.S. monetary policy as their own.

Wouldn't officially dollarized countries put pressure on the Federal Reserve to conduct monetary policy in their interests regardless of the U.S. economic situation?

According to Chairman Alan Greenspan, the Federal Reserve is already under foreign pressure, but this pressure does not lead the Federal Reserve to do things that benefit foreign countries to the detriment of the United States. Greenspan testified that official dollarization would not make the Federal Reserve more readily take such actions.

I think the U.S. to this point, including the treasury secretary, has been absolutely clear that the option of a joint currency is not on the table. It's also really important to bear in mind two aspects of Europe that don't apply in North America.

While it's far from being terribly well developed, informally in Europe workers do have the right to move from one country to another. There is mobility of labour within the European Union, which means if a particular shock hits one part of Europe, part of the adjustment mechanism that's in place under the common exchange rate is that workers could move from declining sectors to expanding sectors elsewhere within the monetary policy area. I don't know where Professor Grubel stands on this, but I think the idea of a free flow of labour between Canada and the United States within North America is not on the table.

Finally—again, it's not well developed in Europe, but it is certainly there in embryonic form, and many people are saying this aspect should be emphasized—in Europe, if there is a shock to one part of the European Community under the fixed exchange rate, there is some potential for fiscal measures to offset it. So in principle, funds could be allocated from the European Community to hard-hit regions to help them adjust to that shock.

I would suggest that perhaps in an ideal world there's a case to be made for NAMU, but in the real world of North America, I just don't think it's on the table. That then means the question is put rather differently. The question is really, do we want to adopt a fixed exchange rate as Canadian monetary policy?

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The starting point for approaching that is to make the observation that in a world of free capital movements between countries, countries have the choice of whether they're going to fix the exchange rate or have the ability to run their own interest rate policy. So long as you have capital mobility, if you're committing to fix the exchange rate, you're essentially committing yourself to set interest rates in order to defend that exchange rate.

Compared to the currency option, the option of moving interest rates to the level necessary to defend the floating exchange rate is the best option.

I won't repeat Chris's arguments, which I agree with entirely. The structures of the Canadian and U.S. economies are very different because of our great commodity dependency and the role of the floating exchange rate as a shock absorber. He's entirely correct. Just in recent experience, that shock would have been much more severe in Canada under a fixed rate.

Two points about the recent experience in response to the Asian crisis are worth underlining. A very large majority of Canadians seem to think their standard of living took a big hit because of the depreciation of the exchange rate—that somehow we're poorer as a country because of the fall in the dollar. That's actually not true at all, in the sense that inflation did not pick up in Canada as the dollar depreciated, contrary to what Mr. Grubel argued. We had that depreciation of the dollar without our inflation rate rising. That means the purchasing power of Canadians in Canada with Canadian dollars was essentially unchanged throughout that period. It's true of course that if you went outside the country it cost more, but the added cost of inputs didn't drive up the cost of living here in Canada.

It's also true that it wasn't a costless adjustment, in the sense that we then had to export more goods and services from Canada in order to import the same quantity of goods and services. But so long as our economy was not operating at full capacity, so long as we had, as we had at that point, still quite high unemployment, the depreciation of the exchange rate was a much better option.

I just want to address the question of whether, with a floating exchange rate, the dollar depreciation has had any connection with the slow Canadian productivity growth. The argument has been put that this has bred laziness on the part of Canadian producers.

It's really important to underline that there are different ways of achieving productivity growth. Just to give you an analogy, if the two worst scorers on a hockey team disappear, then the average goes up. It's the same with a country. If you go through a period of having an overvalued exchange rate and your least efficient plants and operations close down as a result, you get an upward impact on productivity just as a result of averaging across a higher base. I would argue that in fact is what happened in Canada in the 1989 to 1992 period. We had a temporary little bounce of productivity because of a range of plant closures, but it wasn't lasting.

Thinking back on that period, its real importance was that we went into the free trade agreement and NAFTA when Canadian companies had an extremely damaged bottom line and were very low in terms of profitability as a result of that overvalued exchange rate. It really wasn't until later on in the 1990s that we began to get the same investments from Canadian corporations as U.S. companies were getting earlier on in the period.

So I would argue, contrary to Mr. Grubel, it's true that with the depreciation in the exchange rate, for example, the auto industry now has been enjoying very, very high profits. The question is, what have they been doing with those profits? What have other businesses being doing with their buoyant profits in recent years? It appears on the face of it they haven't just been paying them out in massive dividends to shareholders. We've had an extremely high rate of capital reinvestment in Canada in the latter part of the 1990s. And as you'll see from the latest monetary policy report from the Bank of Canada, the argument is we're going to see significant productivity impacts coming from that very high level of capital investment over these past few years, really from 1996 on.

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So I would argue, in terms of productivity growth, our recent experience really shows we're getting much more payoff in terms of our long-term productivity growth than we would have done under the option of having a fixed exchange rate. Under a fixed exchange rate, we might have seen a lot of the more inefficient operations closed down and a temporary bounce in productivity, but not the long-term investments we really need.

I'll just leave it there for now.

The Chair: Thank you very much, Mr. Jackson.

We'll now hear from Pierre Siklos, professor.

Welcome.

Mr. Pierre Siklos (Individual Presentation): Thanks very much for having me. Please forgive the handwritten notes, but the final arrangements for me to come were made yesterday.

Aspects of the three themes this committee is looking at are related to each other, so I'll ad lib a bit, but I'll focus on the third theme, which is of most interest. I can also save everyone a little bit of time, since some of the arguments I agree with have already been made, so I'll try to focus on a few other issues and leave it at that.

As Chris and Andrew have mentioned, Canada maintains a floating exchange rate because by and large it's served the country pretty well. I liken it to a form of insurance against these adverse shocks that Chris and Andrew have talked about, which hit all economies, but the Canadian economy in particular as well, especially in the last few years.

Moreover, our economy is sufficiently different from the U.S. in structure to argue for the continued reliance on floating exchange rates. Clearly these conditions might change in the future, but at present I see little reason to change the current exchange rate regime.

One of the reasons for interest in common currencies and the adoption of the U.S. dollar has been the introduction of the Euro. But there is too little appreciation for the political motives that really created this single European currency. After all, European politicians ideally wanted to create a United States of Europe, and when that failed or wasn't acceptable or palatable to the public, they tried the second-best solution, which is a common currency. I doubt very much that the creators or those who wrote the Maastricht Treaty had optimum currency criteria in mind when they wrote the treaty. It's purely a political document.

Moreover, even if we did either adopt the U.S. dollar or create a new currency, as Professor Grubel suggests, it wouldn't prevent the depreciation of this new currency against other currencies, including the Euro. We know that since the Euro's creation, it's depreciated considerably. What would we do then? Would we simply decide to exit? Well, once you decide to adopt the U.S. dollar or create a common currency, you can't just leave. You're stuck with it for a while. So you don't necessarily solve all the problems by creating a new currency.

An argument sometimes made for changing the currency regime, especially nowadays, is that financial markets are highly integrated, and since they're so highly integrated, why not just adopt the U.S. dollar, since that's the country we're most tied to? First of all, it should be pointed out that capital market integration is not a new phenomenon. It has come and gone. There was a high degree of capital market integration at the beginning of the century and then less so, so it's not terribly new.

Certainly a flexible exchange rate allows Canada to adopt a monetary policy that if necessary can be substantially different from the U.S.'s. Currently both U.S. and Canadian monetary policies are dedicated to low and stable inflation, and together with an appropriate fiscal policy, which is something that's often left out of these debates, both of which are highly desirable—that is, good monetary and fiscal policies—the question of the exchange rate seems to me less important. We shouldn't be too concerned about that. As long as we strive for good monetary policy and fiscal policy, I don't think the question of the adoption of the common currency is as important as some suggest.

As I indicated earlier, at some time in the distant future perhaps, conditions might be ripe for either a common currency or possibly adopting the U.S. dollar. If the structure of the two economies becomes sufficiently similar, then it should be considered.

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But finally and most importantly, at least from my perspective, there are a number of very critical issues that Professor Grubel touched upon that tend to be not so much swept under the carpet, but it's suggested that they are less important. If we are to adopt either a common currency or the U.S. dollar, what's the institutional arrangement going to be? Are we going to be part of the FOMC? Would Canada be a regional fed? Would Canada be broken up into several regional feds? Would inflation targeting be dropped as a monetary policy framework? All these questions are crucial and have to be dealt with.

To echo one of the comments that Andrew Jackson made, he quoted from Connie Mack, but more importantly, Larry Summers, Secretary of the U.S. Treasury, not too long ago basically said that as far as he is concerned, while he has no objections to countries adopting the U.S. dollar, you can forget about having a voice in U.S. monetary policy.

I'll just leave it a that.

The Chair: Thank you, Professor Siklos.

We'll start with Mr. Forseth.

Mr. Paul Forseth (New Westminster—Coquitlam—Burnaby, Canadian Alliance): Thank you very much.

Professor Grubel, you made rather a startling statement. On page 2, you said “Unless we abandon flexible exchange rates, the next generation in Canada will have a 40-cent dollar.” And you ad libbed even lower. If that's the scenario, that's a direct pay cut for every hourly worker. That's really a pay cut, especially for those who can least afford it.

Then, on the next page, you say:

But labor, industry and the entire economic system in the Canadian regions did not have the same incentives to adjust as did those in California. A flexible exchange rate has created these conditions in Canada. A fixed rate will cause Canadian conditions to become more like those in California.

So in some respects, you're building the argument against what I would characterize as the somewhat welfare-type programs of HRDC, commonly known as the Transitional Jobs Fund. It's like the question of who adjusts first.

The picture that comes to mind is the arcade game, where the child has the hammer, and the different heads keep popping up. They pound the one down, but as soon as they pound one down, another head comes up. So the game is that you hammer them as fast as you can, but you never know which one is going to come up. That's somewhat like the scenario you're describing.

So I'm giving you this general question: what is our future, then, if we keep going along the way we are?

We have argument on the table saying basically, on the policy option choices of which heads we're going to hammer down and what else pops up, probably we should continue to go the way we are. So perhaps you could provide the converse argument: What are we likely to see, and what are the economic costs? What would be the best option for the economic health of average Canadians? When I talk about the hourly worker, obviously when I see a drop in the dollar, it's an immediate direct pay cut to the hourly worker.

Can you outline a picture describing if we just keep going along the way we are, but then outline some of the options of what you're suggesting and what the economic picture would be?

Mr. Herbert Grubel: Paul, thank you very much. You have learned a lot of economics, because what you've described about things popping up, Milton Friedman used to describe as economic policy trying to squeeze a balloon. You just can't do it. It keeps popping up everywhere.

Mr. Paul Forseth: Yes.

Mr. Herbert Grubel: My answer is that what we ought to be doing is removing these pegs.

There was a period in the post-war years when Andrew Jackson and everyone here at this table would have said we couldn't possibly aim for price stability, because the Keynesian model has shown that inflation will bring down unemployment; we couldn't possibly have balanced budgets because we need deficits to stimulate the economy to make it go up.

Mr. Paul Forseth: To prime the pump.

Mr. Herbert Grubel: A remnant of this type of thinking is that in order to deal with disturbances, we have to leave the politicians all kinds of discretionary power, and I just don't believe it.

One of the pegs was monetary freedom, inflation, one of the pegs was fiscal imbalances, and one of the pegs is to play around with the exchange rate to get yourself re-elected, and so on.

I was at a conference in Germany. There was a man there, Nils Thiegesen, a professor at Copenhagen, who travelled with the Delors before he wrote his commission in favour the monetary union in Germany. He said that in each case the central bankers they talked to said, when in the past we used to be forced by the politicians to print money to bail them out of difficult policy decisions, difficulties they had got the country into, we knew that when we did their bidding it wasn't good for Italy, it wasn't good for England. They wanted to take the opportunity away from the politicians to tell the central banks what to do; they wanted to take away one of the pegs.

• 1615

That's the way I see it, from a public choice, a political theory point of view. We want to take away forever the opportunity for Paul Martin to call up the governor of the central bank and say, you do the following. I think it would be in the long-run interest that these pegs be removed.

Mr. Andrew Jackson: But it seems to me that's an argument going back to the gold standard.

Mr. Herbert Grubel: Indeed, and Mundell would do it, and Mundell is arguing it.

Mr. Andrew Jackson: But you're not giving up political control of monetary policy; you're just turning it over to the U.S. Federal Reserve, and that's it.

Mr. Herbert Grubel: Yes, but you have to read the longer piece. That central bank, which is now under the thumb of Congress and is obligated to pursue both monetary stability and full employment, the new central bank, like that in Europe, according to my plan, would be given a constitution that would absolve it from the requirement to pursue full employment. It would simply be charged with maintaining stable prices.

Mr. Paul Forseth: I've obviously asked the right question, because we're getting the kind of cross-debate that obviously is part of the planning in why we've invited you here today. So perhaps Mr. Ragan and Mr. Siklos could also chime in.

Mr. Christopher Ragan: Sure.

As Herb Grubel knows, the same man, Milton Friedman, who taught us many years ago in his famous presidential address that inflation does not in fact reduce unemployment—on which I think we all probably agree—also had one of his most famous papers, called The Case for Flexible Exchange Rates. I think Milton Friedman would make the distinction that Herb Grubel is now not making, which is the distinction between having flexible exchange rates in a world of credible monetary policy and simply having incredible monetary policy.

I think what Herb Grubel is really arguing for, and I would be the first to back him up, is.... Well, he would probably argue for more central bank independence than we have today. I can see the arguments for that. I could also see that in the past ten years we've probably had a pretty good monetary policy, and the current system of joint responsibility between the Bank of Canada and the Department of Finance is probably working fairly well. But that's quite a different issue from having a flexible exchange rate, as long as you have credible monetary policy.

Herb Grubel talked about a central bank or a government, under government pressure, playing around with the exchange rate. I would be the first to argue that we should not have a central bank that plays around with the exchange rate, whether to get the current government re-elected or to get the current opposition elected as the current government. But I don't think that's what has been going on.

The Bank of Canada has been working effectively to inflation targets for the past eight years, and I think Herb Grubel said earlier in his comments that monetary policy in Canada has been good. I don't think there has been any evidence that the Bank of Canada has been playing around with exchange rates. On the contrary, they have been allowing exchange rates to move. I'm not saying they have not been intervening at all, but they have been allowing exchange rates to be determined largely by market forces.

Mr. Paul Forseth: I see Mr. Siklos chomping at the bit there.

Mr. Pierre Siklos: I think Chris has anticipated some of my remarks. I'll just add two points.

First of all, I'm not sure if I understood Herb Grubel's comments about exchange rate manipulation. As far as I know, Canada's floating exchange rate has from time to time been subject to intervention by the Bank of Canada. But even the bank now has come to admit, and I think it has persuaded—and this is true in Europe as well—that exchange rate intervention simply doesn't work. So I don't see any evidence of outright manipulation by Paul Martin or anyone else.

• 1620

Moreover, I should add that as far as I know, in all countries the choice of exchange rate regimes rests with government. There are few countries where that's not the case, so I don't see how his proposals would change that.

The second comment has to do with his California example. Herb Grubel came to our university in January. He kindly accepted an invitation. We had a public forum with several distinguished economists, Herb among them. He used this California example, but one thing he always leaves out is that one thing California has that we wouldn't have in a common currency, whether it's the U.S. dollar or the “Amero”, as he likes to call it, is this labour mobility. What happened when the California economy tanked was that there was a huge net out-migration.

Mr. Herbert Grubel: That's not correct.

Mr. Pierre Siklos: Well, no, it is correct.

Mr. Herbert Grubel: It's factually incorrect.

Mr. Pierre Siklos: I disagree.

Mr. Herbert Grubel: The rate of inward migration slowed.

Mr. Pierre Siklos: But even if I accept your arguments, there is still labour mobility. If someone doesn't like to stay in California, they can go anywhere in the U.S. I doubt very much—and you know the free trade agreement as well as I do—that if we adopted the U.S. dollar or created this Amero we would tack on this extra condition saying, well, all right, if we don't like things, we can live anywhere in the U.S., with perfect mobility.

That's one of the crucial optimum currency criteria, actually.

Mr. Herbert Grubel: May I respond for a second?

The Chair: You sure can. I think it can be more than a second.

Mr. Herbert Grubel: I mean, I can be very brief, and obscure, or long.

If you sit back and look at California, you see an enormously expensive infrastructure. Whenever you go down there, you can't but be impressed with the road system and everything they have. It's a huge, huge area.

As industry declines, would it really be wise for society to have a system that says to workers, okay, leave behind your homes, your telephone connections, and your roads—the total infrastructure, everything—and come to Arizona and build a new one? I don't know why they would want to go there. What's happened in California is that industries, with much lower capital costs than in Canada, discovered there were these terrifically highly trained workers, this highly efficient infrastructure, and finally there was some labour available to expand! They went to California.

Look at what we're doing. We say, oh, poor Newfoundland, you can't possibly be forced to go into other industries. Here's money. Stay where you are, and as long as you're poor, just be sure to stay poor. We're going to give you the money to stay there.

It just makes no sense. They have had lots of immigration, and it didn't work. Immigration is not a necessary condition for adjustment.

The second point I would like to make is that I'd put a little bit of historical perspective on this debate with Milton Friedman. I was extremely privileged to have been an assistant professor at the University of Chicago at the time.

The 1930s were catastrophic in the western world. There were competitive devaluations, and everybody agreed that we should have a system that had fixed exchange rates. The same arguments I am making now were made indirectly at the time. Bretton Woods was supposed to have done that. It was a political compromise with the Americans.

But it turns out that in the 1960s, already strains developed in the operation of a fixed exchange rate based on a permanently fixed price of gold. I've written books on that subject.

At that point, Milton Friedman put out the article that was mentioned, a famous article, on the case for a flexible exchange rate. The world said, yes, that's right, we ought to go that way.

The politicians loved it because a flexible exchange rate meant that they would be finally freed from the constraints that the fixed exchange rate imposed on them. They could run deficits and they could run inflation to produce a booming economy the way Keynes had predicted they would.

Bob Mundell at that point wrote what was a very short article, called “The Optimum Currency Area Theory”, and he said.... And I myself have asked Milton Friedman how he would answer Mundell on the following point: If your argument, Friedman, for a flexible exchange rate is so great, why stop flexible exchange rates at the borders of currently existing countries? Wouldn't Newfoundland have been helped tremendously, accordingly to the arguments of my three colleagues, if we'd had a flexible exchange rate and a Newfoundland dollar? They would be booming.

Why stop in Newfoundland? Why not have a flexible exchange rate for Hull? Hull has some troubles. If they had a flexible exchange rate, it would be wonderful.

• 1625

Already McKinnon, with whom I was a colleague at Stanford, said that will work only if workers have money illusions. If they accept lower real wages, they are willing to shift into other industries only if they accept these wages because of inflation rather than doing it endogenously. What these systems are bringing isn't this.

We have had a flexible exchange rate. It has not helped with Canada's average unemployment rate. It has not done any of the kinds of things that people originally said it would, just like monetary and fiscal policy imbalances did not solve the problem. They are structural problems, and structural problems are solved by having institutions where the members affected are forced by the market to do what is right. That is the position I'm taking.

Mr. Christopher Ragan: I want to come back to something Herb Grubel said at the beginning of his presentation, when he mentioned Argentina, possibly Brazil. Again, there's a mixing up of issues, and it comes back to the comments of Friedman. If the only way a central bank can get credibility is by fixing its exchange rate or operating to a gold standard or adopting another currency, then there's probably a very good reason to do it.

I posed a question at the bottom of my comments: is there ever an argument for a fixed exchange rate? What I say is yes. If a central bank really has no credibility, then fixing an exchange rate, which is what Brazil did—well, it was a type of fixed exchange rate—or having a currency board, which is what Argentina did, or dollarization, which is what Panama did, are all very good ways for a central bank that has no credibility to gain credibility instantly.

I don't think that's the right question to ask in Canada in the year 2000. I think what you want to do is look around this country and ask whether we have a central bank that has credibility in terms of its inflation or anti-inflation stance. I think most people in this room would probably look around and say, gee, in the past eight or ten years the Bank of Canada, if anything, has too much credibility in its anti-inflation stance. We could have a debate about that, but most central banks in the world look at the Bank of Canada and see that they have established formal inflation control targets and they have adhered to them. Some people would argue that they have actually kept inflation too low, but everybody would agree that they have been very successful in keeping inflation low and relatively stable.

I don't think the issue about needing a fixed exchange rate or needing a gold standard or needing a common currency to give the Bank of Canada credibility is relevant. The Bank of Canada has established its credibility.

Perhaps there is something in the near future that is going to damage that credibility. I don't know what that's going to be. Maybe Paul Martin will call up the governor and say “You have to do this” or “Let me give you some pressure to do such and such.” I don't think that's going to happen and I don't really think anybody here thinks that's going to happen.

So I would make that point. I think the Bank of Canada doesn't need any more credibility. It is not tinkering with exchange rates. It is working to inflation control targets and it is doing so successfully.

I do want to address the second issue of why we, as Canadian provinces, don't have separate currencies or why Hull doesn't have a separate currency. This comes back to Mundell's theory of optimal currency areas, for which he won, quite appropriately, the Nobel Prize last year.

It is true that Canadian regions have different structures in their economies, and it is true that there would be some benefits of the nature that I talked about if Newfoundland had a separate currency from Saskatchewan. As long as the world price of cod moves in a very different way from the world price of wheat, there would be some benefits.

Mr. Lorne Nystrom (Regina—Qu'Appelle, NDP): Or potash.

Mr. Christopher Ragan: Or potash, okay, or natural gas and oil.

But that's only half of the optimal currency theory. The theory of the optimal currency area is about weighing off two forces. You have two regions and they trade with one another. Mundell's theory says that the more these two regions trade with one another, other things being equal, the more they should have a common currency, the more they benefit from that, for the obvious reason that there are costs associated with conversion of currencies and costs associated with the volatility of having flexible exchange rates. The other half of the story is that the more different shocks hit these regions, the more those regions would benefit from having separate currencies and flexible exchange rates. This is the shock absorber argument that I was giving before.

• 1630

If you wanted to look at the various regions of Canada and make the economic argument for a common currency, what you'd try to say is that there's a lot of trade between Canadian provinces, and the benefits of having that common currency outweigh the benefits of having a separate Newfoundland currency and Saskatchewan currency. The same argument would come to the issue of Canada and the United States. I stated in one of my points that Canada and the United States probably aren't an optimal currency area. It's also probably true that the United States isn't an optimal currency area, yet it is a common currency area. It's probably also the case that Canada is not an optimal currency area.

The relevant question is this: what's the best currency area of the choices on the table? The question in the Canada-U.S. case is whether Canada plus U.S. is a better currency area than Canada by itself, which is the status quo. I would argue that the structure of the Canadian economy is sufficiently different from the structure of the U.S. economy that tying us to the U.S. currency doesn't make sense, precisely because it eliminates the shock absorber effect of the Canadian dollar.

Mr. Herbert Grubel: I have a quick footnote. Mundell wrote that article and then for some time dropped out of academia. He never participated in the literature that Christopher has cited. He never wrote any articles on this.

In this volume, you can see references to three articles published in The Wall Street Journal by Bob Mundell in which he disavows and distances himself from all the arguments that Christopher makes. In his latest article in The Wall Street Journal, he says that he travels around the world and he has been outside of his home, sleeping in hotel beds, 70% of the time since he has won the Nobel Prize. He argues that in fact what we need to have is an organization, an agreement, among the Euro, the U.S. dollar, and the yen area to keep exchange rates fixed between them. That's Mundell's position.

He totally thinks that all these arguments I've made are one-sided. I never hear from any of the three of them what are the benefits of having a fixed exchange rate. We have tremendous microeconomic benefits, and they are totally neglected in this discussion.

Mr. Christopher Ragan: I began with those benefits.

Mr. Pierre Siklos: This idea of a common bloc is not news. We've been there, we've done that. They tried this in the 1980s. And the reason it fails is that there's always at some time a shock that forces one of the members of the bloc to drop out or to cheat on the existing arrangement. Unless you're going to have a single currency for the yen, the Euro area, and North America, you're always going to have this problem. The fact is that historically fixed exchange rate regimes of whatever type you can dream up have never survived and they usually have not survived for long.

Mr. Andrew Jackson: You can certainly make an argument for having much more fixed or stable parity between the dollar, the Euro, and the yen. I think there was a lot about the post-war arrangements that made a lot of sense in terms of having quite stable relationships between currencies.

Whether it's possible to do that in a world of massive capital flows between countries, I don't know, but I think it's incredibly problematic. If you got finance ministers together from those three and made some announcement about where they'd like exchange rates to end up, I don't know how you would make that possible without major controls on capital flows between countries, which I would be prepared to contemplate but I don't think you would.

There's another important question when you look at this at the global level. At what level would you want to relate the Euro, the U.S. dollar, and the yen? In Europe now, everybody is talking about the Euro being a great success. The reality is that in Europe they're in a deep funk, or a lot of people are, on how fast it's been sinking against the U.S. dollar. That's actually probably quite appropriate at this point in time, with Europe having much slower rates of growth. That currency depreciation is enabling them to grow faster. The U.S. growth will slow, which again is quite appropriate.

• 1635

Having the currencies floating against each other performs a really important equilibrating role in the global economy as a whole. It might be a second-best mechanism, and the first best might be fixed exchange rates, but I don't know how you get from here to there in a world of massive capital flows. I don't think it's even on the table.

The Chair: Thank you.

Professor Ragan, do you want to add something?

Mr. Christopher Ragan: Yes, I have a final quick point. I started off by talking about how this debate was deceptive in the sense that the benefits of fixed exchange rates were easy to understand and the benefits of flexible were not.

There's another interesting part to this debate, which is that it's not very empirical, as you may have noticed. There's theoretical storytelling happening here. Nobody's actually picking up statistics and saying the effect of this is the following. That's one of the problems with this debate. I believe the benefits of fixed exchange rates, in terms of greater exchange rate uncertainty, greater trade flows, and investment flows, are there. I have never seen a number that says this is how big they are.

I believe the costs of exchange rate fixity or the benefits of flexibility are in terms of the shock-absorbing effects I've talked about. I've never seen a study that says this is how big those effects are. One of the problems is that it is really difficult to get an empirical sense of this.

My final statement would be that even if it's the case that it's in Canada's interest not to have fixed exchange rates or common currency today, it doesn't mean it's necessarily going to be the case ten years from now. If Canada remains a commodity-based exporter, as it probably will—at least to the extent that it currently is—and if world prices of commodities become less volatile over time and Canada-U.S. trade rises over time, as it surely will, then it may well be the case that ten years from now what was not a good currency area of Canada and the United States becomes a good currency area of Canada and the United States.

This is one of those issues that's going to have to be revisited every five years.

The Chair: What's the likelihood of that happening?

Mr. Christopher Ragan: Positive.

The Chair: The changes—

Mr. Christopher Ragan: The volatility of commodity prices—

The Chair: The possibility of the North American economy becoming so integrated that in fact Canada's economy—

Mr. Christopher Ragan: It becomes beneficial—

The Chair: —becomes very similar to that of the United States.

Mr. Christopher Ragan: Well, I would say it's a pretty good likelihood. The question is, over what timeframe, and I don't know. Will there be an increase in trade flows between Canada and the United States? Absolutely. Will there be an increase in investment flows between Canada and the United States? Absolutely. That force on its own will work in that direction.

The Chair: Yes. It's a question of whether you want to anticipate the times or not.

Mr. Andrew Jackson: There's one point about Canada that often gets overlooked. One thing we all know is that trade has increased greatly as a share of GDP. The point I'm trying to make is that our commodity dependence has slackened remarkably little over time. If you take the resource sector and the goods and services that are purchases from the rest of the economy, they have remained really quite constant over the whole period of the last decade and more.

It's often lost sight of because higher value-added goods are making up a bigger share of our exports, which is true, but also our exports in total have been increasing. So if you work it back, in terms of the structure of the economy, it hasn't changed all that much. Now, maybe it should have—

Mr. Herbert Grubel: If we hadn't had the flexible exchange rate protecting those sectors, we would have had the labour, the resources, available to have high-tech industry.

Mr. Andrew Jackson: Well, I think it's true. If we had fixed the exchange rate ten years ago, we would probably have a smaller resource sector. We might also have a significantly smaller economy—

Mr. Herbert Grubel: No, we might have several Ottawa Valleys.

The Chair: Well, the idea would be to develop scenarios of what would happen, or at least try to make a prediction.

Monsieur Marceau, then we go to Mrs. Redman, Mr. Nystrom, and Mr. Szabo.

Mr. Lorne Nystrom: Paul wants to know if his ten minutes are up yet.

The Chair: Well, it supports his attendance as being good.

• 1640

[Translation]

Mr. Richard Marceau (Charlesbourg, BQ): I wish to thank the four of you for being here. It is a fascinating debate. First I will address an issue that you raised, Mr. Ragan, when you said it is difficult to have science without empirical evidence. In my mind this is one of the reasons why the debate is very political. It is not only an economic debate; it is also a political one.

It is as well one of the reasons why what is happening here today is very significant and very important. On May the 11th, in the Parliament of Canada, the Finance Committee of the House of Commons looked into the possibility of a monetary union between Canada and the United States. This is something. At the very heart of the decision-making power of Canada, one of the G-7 countries, we are talking about dropping the dollar to create another currency or take up that of a neighbouring State. This is something and I think that it deserves underlining.

Professor Grubel, there is a brief comment I saw in the paper you wrote and that I quite liked. You are mentioning at the very end three barriers to a monetary union. I would add another one that is also a bit political. It is the fact that the people in Canada who made a suggestion about a monetary union with the United States are Quebec sovereignists. It is unfortunate but this somehow contributed to the feeling that this suggestion from the sovereignists was bad in itself for the rest of Canada. It is an aspect that came into it as well as the fact that last January the Block included the idea of a North American monetary union in its program.

Professor Ragan, I have a question for you. Somewhere in your presentation, you say that the fact that the Canadian dollar was so low was good for the Canadian economy as it allowed for an increase in exports.

Don't you think that a Canadian dollar as low as the one we had and still have is a bit like a drug? In the short run, it is good for exports but in the medium and long run it is very bad because Canadian businesses rest on this competitive advantage, do not invest in research and development and do not try to increase their productivity. Therefore, the productivity gap between Canada and the United States that Canada is already suffering from keeps growing as Canadian firms tell themselves that the dollar is low, that they are protected and that they don't have to invest so much.

It might be an advantage in the short run but could it not be devastating in the medium or long run, the day when the Canadian dollar will regain its value that everybody is pegging around 75 cents to 80 cents US?

[English]

Mr. Christopher Ragan: I think it's a perfect question, and the distinction you make between the benefits of flexibility in the short run and the potential costs in the long run on productivity is a very important point, a very important possibility. This is an interesting possibility that I think has come up only recently in the debate.

Productivity is a puzzling thing for economists, and the relationship between exchange rates and productivity is a bit puzzling for economists. This is the way I would try to explain to myself or to my students the question you've just asked.

Economists I think for a long time have believed they understand more or less what causes changes in exchange rates, and productivity is one of those things. So an improvement in productivity that comes out of the blue would be expected to lead to an appreciation of the Canadian dollar. That's a causal relationship that economists are pretty comfortable with—from productivity to exchange rates.

• 1645

The opposite relationship is the one you're talking about—the relationship from the dollar, the exchange rate, to productivity. Productivity itself is something we, as economists, don't have a great handle on in terms of what drives it. We can come up with some pretty good stories, some nice theories and good graphs, but the causes of productivity change is one of the remaining puzzles in economics. It's not the only one, but it's one of the remaining puzzles in economics.

The idea is that a cheap dollar—this lazy dollar hypothesis, which is exactly what Herb Grubel has been saying—can lead to individual firms, individual entrepreneurs, getting fat and lazy behind a depreciated dollar and, as a result, not coming up with better productivity improvements. It can lead to their not innovating, not coming up with the dynamic behaviour we hope is in our economy. That is a distinct possibility.

The problem is comes back to my earlier point about empirical evidence. Other than anecdotal evidence—and you can get lots of anecdotal evidence for almost anything you want—we don't have a good handle on that empirically. I'm not saying it's not there. In fact I think the relationship from productivity to the dollar and from the dollar to productivity—what an economist would describe as a simultaneous system—is an area that is really worthy of further research. I think that relationship from the dollar to productivity will have to be studied fairly thoroughly before we can answer that question.

But is it a possibility? Absolutely.

[Translation]

Mr. Richard Marceau: We talked a lot about theories. There is a problem we are facing and that you did not say much about Mr. Jackson, Mr. Ragan and Mr. Siklos but that Mr. Grubel briefly touched upon. I will ask you to look into your crystal ball. Somebody was saying somewhere that economists were put on this planet to make astrologers look good. It might be true.

We know that Argentina is thinking about dollarization and that the two largest business organizations in Mexico are also talking about dollarization. Panama is already dollarized. Besides, there was a seminar on July 23 and 24, 1999 under the auspices of the Inter-American Development Bank in Panama about the possibility of dollarization for Central America.

What is going to happen if say five, six, eight or ten Latin American countries go for dollarization, several countries of the Free Trade Area of the Americas we are aiming for by 2004 opt for the American dollar, and Canada as well as other neighbouring micro-countries are not on the same train? Might Canada run the risk of missing the monetary union train even before thinking of buying its ticket?

[English]

Mr. Andrew Jackson: Others said this earlier, but I think there's agreement amongst most of us that the main attraction of dollarization in the cases of Argentina, Equador, and so on was basically that in the eyes of foreign investors, the capital markets, etc., there was a deep suspicion they wouldn't just print more money to get their way out of economic troubles, given the sort of history of very high rates of inflation. For Argentina you could pose the question, “Was the dollar really the right currency to adopt?” In fact, Argentina and most of South America had about as much trade with Europe as with the United States, so from that point of view it was debatable.

Argentina got really hammered when the Brazilians devalued, because there was a lot of trade between Argentina and Brazil, and Argentina really suffered as a result. They went through a period of very high interest rates as well. I think the evidence from Latin America so far is maybe there was a case for Argentina doing it, given their history of very high inflation, but even there it's far from clear whether it was the right move for them to make. The question is, maybe they were forced into it, but why should we be?

• 1650

In the case of South America and what's going on there, it's not really driven by trade integration with North America. I don't think that's been the argument. It has come to the fore because of the whole crisis caused by rapid movements of capital between countries and how you insulate yourself from that. In fact, as Herb said as well, one of the main lessons from the Asian crisis recently was the danger of having a fixed exchange rate. The Asian countries that were fixed against the dollar really got hammered. So it's not a matter of a train leaving a station; it's more a matter of countries casting around for some kind of anchor of stability.

[Translation]

Mr. Richard Marceau: But might there be a risk? Despite the supposedly very good work of the Bank of Canada in the last ten years there is still what I call a

[English]

a creeping dollarization

[Translation]

in Canada in the sense that more and more deposits, even in Canadian banks, are in US dollars. We are talking about a commodity-based economy, a natural resources economy. An increasing number of large firms operate in US dollars and market forces are such that there is a danger of a de facto dollarization of an important part of the Canadian market while us in Parliament and in the civil service are saying that it is not a debate we are interested in, that we have a good currency, that we are a G-7 country and so on.

You told us, Mr. Ragan, that we are moving toward an increasing Canada-United States integration. Mr. Chairman asked you if ultimately it was worth our while preceding or following the movement. This is the question that we must ask ourselves.

Should we not tell ourselves that it might be better to position ourselves as this might happen in the next 15, 20 or 25 years? If it is to happen anyway, let's try at least to control the way it will be done.

Mr. Pierre Siklos: I will try to answer in French. Let's get back to the Central American or South American countries. Losing their monetary sovereignty was less important for them than losing investments and the confidence of the world markets. We must ask ourselves if we want to lose our monetary sovereignty. That is the question.

Mr. Richard Marceau: Do we really have monetary sovereignty?

Mr. Pierre Siklos: I think so.

Mr. Richard Marceau: I don't have your background. I am not an economist. However this morning, when I got up, I heard everywhere that the Fed was going to raise its interest rates by 0.5% and that the Bank of Canada would do the same in the following hours.

I looked into what happened in the last 50 years and I realized that it was about the same thing: the Fed would do something and we would follow except maybe under John Crow. I am not sure that this is necessarily the policy that we are hoping for as it has led to a made-in-Canada recession in the end.

Mr. Pierre Siklos: First, we don't always follow. Second, we follow because fortunately the economic conditions are similar in the United States and Canada. Therefore it is normal that we should also be raising our interest rates. Like Mr. Ragan was saying, we still have monetary sovereignty as the response to the Asian crisis demonstrated I think.

The Chairman: Professor Grubel.

[English]

Mr. Herbert Grubel: I have just a couple of quick comments.

I talked to someone who was very interested in monetary union and dollarization in Central America. He said the stimulus for these investigations came from a very subtle realization. All of the Central American countries have had bad presidents in the last 30 years. They all ruined their economies, but there was one country where the president's ability to mess it up was strictly limited, and that was Panama. Panama didn't have a central bank those bad presidents could use to mess up the country.

• 1655

The second point I would make is that Argentina had political dynamics where some people in power were trained in American universities and understood the role of markets in the prosperity of a country. They made the institutional changes, the political changes. But the problem is that in such countries these things are not universally accepted. Some demagogue may come along—as he or she has done several times in Argentina—and wipe them all out.

So dollarization puts a capstone on those changes that have taken place and locks them into place. It isn't that they can't get rid of them at some point, but it makes it much more difficult.

I think in Canada we have moved in the same direction as Argentina. We were never quite as far down as that, but I would like to have a capstone—a locking in of the movements toward increased reliance on markets—and prevent the NDP, when they come in, from doing their wild things.

Mr. Andrew Jackson: But do we have democracy?

The Chair: But in all your examples you were talking about presidents, right? We have a prime minister. And we are Canadian.

Mr. Herbert Grubel: That's a very interesting question. What about democracy?

A voice: I'm worried, sir, and I am Canadian. Right?

Mr. Herbert Grubel: This is a very important point. Andrew asked, what about democracy? Why do we have the Charter of Rights and Freedoms? It's because we say politicians have to be constrained when it comes to certain types of legislation that amount to exploiting minorities and so on. We accept that. We now think all democracies need to be constrained by such charters or constitutions.

I believe these moves for balanced budgets, the requirement for stable prices, and the requirement for fixed exchange rates within the larger area are all part of our understanding that has come from the mess we were in during the post-war years, when we lived without these constraints.

The Chair: I'm surprised you agree with Pierre Trudeau. But anyway....

Ms. Redman.

Mrs. Karen Redman (Kitchener Centre, Lib.): Thank you, Mr. Chairperson.

This holds true of something I learned personally when we were looking at productivity, and that's if you take two economists you can get three opinions. It's been a lively and very interesting debate.

A voice: I've been insulted.

Mrs. Karen Redman: No, I think it shows minds that can embrace diverse thoughts at the same time.

Mr. Grubel, you talked about the creation of the European monetary union and described it as a success. At least that's my recollection. Granted there's been the creation of an institution, with the European Central Bank, and the Euro for currency, but how do we determine whether or not this has been a success? You can create the monetary system and the institutions, but how do we determine if they've achieved their objectives or not?

What aspects of the European economy are now performing better, in your estimation, because of the Euro?

Mr. Herbert Grubel: That is a very good question. It relates to all the questions that were raised by the gentleman from the Bloc.

We don't really have very good measurement on these issues. That's why there will be lively debate for a long time. But whether we have empirical information done to the last minute or not, we're making this decision all the time. Every day that we don't go to fixed exchange rates, we make the decision to keep flexible exchange rates. We don't have a cross-benefit analysis supporting that either.

I'm saying we have to look at history. Bob Mundell lectures that the bookend decades of the last century were the ones when the world prospered the most—from 1900 to 1910 and beyond, and from 1990 to 2000. They were periods when we had exchange rate stability. The question is, can we lock it in? Can we keep it that way?

Europe is doing very well. Euro-pessimists predicted that by now the whole system would have fallen apart. It hasn't. The external value of the Euro has gone down, but there have been no great consequences because most of their trade is with each other. So I think it is doing very well.

• 1700

Two weeks ago, The Economist had as its leader, the big front-page story and several inside, “Europe is Getting its Act Together”, because companies have to now deal through the entire region with one currency. They can no longer charge one price for orange juice on one side of the Dutch border and another price in Belgium for the same orange juice. For some reason, that persisted even though there was free trade, and it persisted because they had two currencies. They are now going to have the same currency. Otherwise, people just go across the border and buy somewhere else.

As a result of the pressure of this unification, the companies are beginning to consider Europe their entire marketing area, and the unions are beginning to realize that no exchange rate depreciation is going to help them if they lose competitiveness, because they have wages in excess of their productivity, as they have done for many years, which brought the lira to astronomic highs of six or seven digits.

Mrs. Karen Redman: Can I extrapolate from your answer, then, that wages have come down, or they've moderated, and those are the kinds of indicators we can look at within economies to say that the Euro is having a positive benefit?

Mr. Herbert Grubel: For example, the Government of Italy used to have to go and borrow, like the Government of Mexico, and pay 30% for their long-term borrowing. If you were a company in these countries like Mexico, you had to compete with the interest paid on the Mexican long-term securities. Do you know what's happened to the historically very high two-digit interest rates in Italy? They have come down to where they are in Germany. It's a tremendous benefit. The whole structure of interest rates, mortgages, consumer loans, everything has come come. Can you imagine what that would do to Mexico? When I gave a paper like this to a Mexican audience, they stood up and applauded me because of just the thought that they could have an institutional arrangement that would assure them that interest rates would be competitive with the United States rather than the 30%. They can't afford to buy a house or a car. It's just crazy. So these are huge benefits.

Three-quarters of one percent, it has been estimated, has been the cost of exchanging Deutschmarks for French francs, etc. Somebody once took 100 Deutschmarks and went around and bought and sold currencies in the individual countries of the European Community, and they ended up with 60¢. That's the cost of doing business. That's been eliminated, it's gone.

Mr. Christopher Ragan: By your analysis, the last two years of Canadian monetary sovereignty must be a fabulous success, because we had interest rates 200 basis points below U.S. rates. But that success has come to an end.

Mr. Herbert Grubel: I knew that would come.

Mr. Christopher Ragan: I didn't have to say it.

Mr. Herbert Grubel: For 30 years, if you take the real interest rate, which is the difference between the nominal interest rate and the inflation, you will have a one percentage point difference between Canada and the U.S. The nominal interest rate difference was 1.14 percentage points. I do not believe that one swallow a spring makes and that this current lower interest rate will persist into the future.

Mr. Andrew Jackson: I think the point does have to be made that short of a North American monetary union, which I think the three of us agree isn't on the table, and even you say isn't on the table yet—

Mr. Herbert Grubel: We're putting it on the table. That's why we're here.

Mr. Andrew Jackson: —in all likelihood, if we were to try to fix the exchange rate with the U.S. we would have to have higher interest rates. I've never heard you say at what level you want to fix it either. At what level are you going to fix it at?

Mr. Herbert Grubel: Andrew, it's perfectly rational for investors to say, I have money, I'm going to put it in the United States or in Canada; it doesn't matter where you are. I look back on the history of the Canadian dollar and I have seen a depreciation averaging 1% per year over the last 30 years. Therefore, if we have the flexible exchange rate, I'm going to insist on getting a one percentage point premium before I lend to the United States.

Mr. Andrew Jackson: No, but listen, you're running around writing editorials telling people that we can fix the dollar so the dollar won't go down and that way we're going to get lower interest rates than we've had.

Mr. Herbert Grubel: I don't believe in fixed exchange rates. I told you that the fixed exchange rates recommended by my colleague Rick Harris and Tom Courchesne is the worst of all possible worlds. I fully agree with you—

• 1705

Mr. Andrew Jackson: But then we're not having a policy discussion, we're having a seminar discussion, really.

Mr. Herbert Grubel: I don't follow this.

Mr. Pierre Siklos: Herb Grubel's argument is still based on the economics of the situation. He talks about the very good example of someone starting with 100 Deutschmarks, but of course that's true of the people at the retail level, tourists. It's not true of companies.

For companies, the introduction of the Euro meant absolutely nothing, because transactions were already done electronically for the most part; they were already fully hedged. So these benefits weren't as great as you suggest. Ultimately the adoption of the Euro, of EMU, was a political one. It was a political decision. They didn't have economic considerations in mind.

One other thing is that he mentions the golden years of the early part of the 20th century, but he forgets to mention that when countries didn't like the rules of the game during the gold standard we had a huge deflation—

A voice: And the Great Depression.

Mr. Pierre Siklos: —and the Great Depression thereafter. There are consequences to adopting these kinds of exchange rate regimes.

Mr. Christopher Ragan: I'd like to add a comment about Italy. In terms of Herb Grubel's mention of Italy—and I feel like I'm saying the same thing over and over again—Italy's a lot like Argentina in the sense that Italy didn't have a very credible monetary policy and they certainly didn't have a very credible fiscal policy. So when we see bond rates come down in Italy to German levels, and we see debt come down, or deficits come down, there's a lot there that is about establishing monetary credibility and about the Maastricht guidelines on debts and deficits. We could still believe that Canada has a debt problem, but I don't think anybody in this room thinks that Canada has a monetary policy credibility problem. That's really what he's talking about in terms of Italy, aside from the micro benefits, with which I agree.

The Chair: Mr. Nystrom, you have a question?

Mr. Lorne Nystrom: Do we have time?

The Chair: Yes. We're extending it to 5:15.

Mr. Lorne Nystrom: Mr. Grubel seemed to be worried about the socialist hordes knocking on the gates.

Mr. Herbert Grubel: I am.

Mr. Lorne Nystrom: I think that has happened all around Europe, with this great red socialist, Tony Blair, and all those other people. It seems to be the prevalent way in Europe.

Anyway, I want to ask you one general question. If we did have a common currency with the United States, how do you have any balance between the two countries? One country is big, one country is small. It's like Herb Grubel getting in the ring with Mike Tyson; there would be a certain winner likely, and it might not be Herb.

It's a little different in Europe, where you have countries of roughly equal size and power that will balance each other out. But how do you assure that there's going to be protection of our sovereignty and our interests? It's the mosquito on this huge person. I think that's really what worries a lot of Canadian people.

Maybe you can respond to that in general, the four of you.

Mr. Christopher Ragan: I think Herb's response to that would be—

Mr. Herbert Grubel: No, you're not going to give my answer.

Voices: Oh, oh!

Mr. Lorne Nystrom: On a point of order, Mr. Chairman, can Chris give Herb's answer and Herb give Chris's answer?

Mr. Christopher Ragan: I think one of the benefits that some in this room might argue for having the common currency is precisely that it gives up Canadian monetary sovereignty. Some people will view that as a cost because they think the Canadian monetary sovereignty has been a success. Those who think that for some reason it has been a failure would think that loss of sovereignty would be a benefit.

Mr. Herbert Grubel: All of these things are half-truths. As we heard this morning from the governor, how we're going to react all depends on what the Americans do. We're going to look at what's going on.

The Americans themselves, in the wake of the Asian crisis, lowered interest rates even though it was already a booming economy and they would not have done otherwise. They did it for the good of the rest of the world. So they are really also looking at the effect of what they are doing on the rest of the world.

In my model, I would suggest that if we had a systematic input with data the way the fed of Cleveland and the fed of St. Louis have in the decision-making process of the board of governors of the Federal Reserve System, we would be better off than simply indirect signals of what might be in the interest of the United States. They will always dominate, and they should, but if in fact our prairie provinces have a bad time, chances are the American prairie states also have a bad time. So we could have an alliance between the representatives on the board of governors, between our and their prairies, to make a more powerful representation to take that into account when they make interest rate policy.

• 1710

Mr. Pierre Siklos: You asked if science matters. It certainly does in the European case. In the years leading up to the EMU, there were substantial transfers to countries such as Spain and Portugal. These supposedly are ending or will end or have ended because of the stability pact.

The other problem or complaint is that the ECB's monetary policy is dictated largely by France and Germany. But at least the smaller countries such as Austria and the Netherlands have a voice in the ECB. There's no way we would have a voice in this common currency. I know in principle it's possible, but I don't see how the Americans would buy any influence from Canada or any other country.

Mr. Herbert Grubel: How do we know? Have we asked them?

Mr. Pierre Siklos: Yes. Lawrence Summers has said no, forget it.

Mr. Herbert Grubel: What was in it for the Americans to join the International Monetary Fund? What was in it for them to join the United Nations? They are, just like many of you legislators, concerned about doing the right thing for their people. American legislators are interested in doing the same thing, and if it can be shown to them that it is in the interest of Americans to have a more prosperous Mexico....

One of the biggest and most insoluble problems the Americans have is illegal immigration from Mexico. What can they do? Nothing. They can chase them back ten times or a hundred times, but they keep on coming back until they make it through once. The only solution to that problem as far as they're concerned is to have the push factor reduced by having a more prosperous Mexico. How can you have a prosperous Mexico with 30% interest rates? You have to fix the political system through the capstone powers of a monetary union in order to prevent the misadventures that have characterized them in the past.

Mr. Pierre Siklos: Sir, the IMF was not about giving up monetary sovereignty. It was quite the contrary. It was a device to increase American influence over the international financial system. They gained something. What would they gain from us?

Mr. Herbert Grubel: Well, what about the United Nations? Cynics say—

Mr. Andrew Jackson: They don't pay their dues.

Mr. Pierre Siklos: That's why they don't pay their dues, yes.

Mr. Herbert Grubel: I have some cynical colleagues who say, now that the Americans are losing influence in the United Nations, the IMF, the World Bank, and all these places, they're ready to throw it out. Well, if you want to be cynical....

I think governments, legislatures, and congresses are peopled by individuals who want to do the best for their countries. Sometimes institutions make it impossible for them to do so. Before free trade came in, there was nobody who could say “Elect me; I'm going to get you free trade.” All the special interest groups that would lose would have made sure that party was defeated. But when, in a moment of sanity, all the parties and all the members of Parliament realized, look, this competition among parties for the favour of industries that want to be protected is bad for our country and we need free trade, we got a rallying around this, more or less, I remember—

A voice: I don't remember that.

Voices: Oh, oh!

Mr. Herbert Grubel: —and we got ourselves free trade.

The Chair: You're a bit of a revisionist, but that's okay.

Voices: Oh, oh!

The Chair: Mr. Nystrom, I promised Mr. Epp a question, and I'd like to honour my word.

Mr. Lorne Nystrom: Okay.

The Chair: Thank you.

Go ahead.

Mr. Ken Epp (Elk Island, Canadian Alliance): Thank you.

I really wish I could have been here for the whole time, but my question is very succinct.

One of you said the Canadian auto manufacturers have really benefited from this floating value of the dollar. I want to have you explain to me why that is and whether or not my guess is correct, which is that it's because when we import high-quality Japanese vehicles, with the exchange rate, they become very expensive, and therefore Canadian manufacturers can push up their prices to just beneath what the Japanese equivalent is, so now they are charging an inflated price, and because of that devaluation of our dollar—

A voice: There's a tariff too.

Mr. Ken Epp: —we all pay an extra tax, so to speak, in order to give the automotive companies their big profit. Am I right? Am I wrong? What's your explanation?

• 1715

Mr. Andrew Jackson: I'd make a couple of points.

I would commend to people, if they're interested in chasing it down, a paper on the auto industry done by Jim Stanford from the CAW for the productivity conference of the Canadian Centre for the Study of Living Standards recently.

It's really instructive to go back to this lazy dollar hypothesis. If you believed in lazy manufacturers, you would believe that because of the low dollar, basically industries such as the auto industry, which have benefited greatly because.... Essentially the advantage to them is they're paying their workers in Canadian dollars and then selling 80% or 90% of what they produce into the U.S. for U.S. dollars. So when the dollar goes down, the cost of production to them essentially falls.

The argument is they're getting fantastic productivity gains in that industry now. Incredible investments have been going into Canada. So it's not really the case that the big three have just been sitting there collecting very high profits. It has in fact been plowed back, to the point where more than 25% of all big three vehicles are assembled in Ontario now.

On the pricing question, if I heard you correctly, I think you're incorrect. A comparable model of car sells for less in Canada than it does on the U.S. side of the border, so they're pricing to the Canadian market essentially.

Mr. Ken Epp: But it sells for more than it would.

Mr. Andrew Jackson: In fact Canadian consumers are getting a better deal.

Mr. Ken Epp: But don't you think it is selling for more than it would if we didn't have this artificial price increase?

Mr. Andrew Jackson: What artificial price increase?

Mr. Ken Epp: Well, when you bring a Japanese vehicle in, there's an exchange rate advantage, and it presses the price up.

A voice: There's a Japanese tariff too.

Mr. Andrew Jackson: Well, the fact of the matter is they haven't passed on the full price increase you would expect from the change in the currencies.

Mr. Herbert Grubel: I have a quick response to Ken.

I've written here that in fact when the profits were very high in the automobile industry, it so happened that the labour contract matured. It was at a time when we in Parliament hadn't had a pay increase for I don't know how many years. I haven't had a pay increase at the university for fifteen years. What happened to the contract? Labour unions suddenly were able to get themselves a 13% increase—3% per year over three years or whatever it was.

Mr. Andrew Jackson: That was well below the productivity increase, Herb.

Mr. Herbert Grubel: But the point is no other industry was able to do that, only the automobile workers. I just feel that is unjust, because if the exchange rate were to go back up again, I doubt the automobile industry would be as competitive by definition as it would have been if they had not paid out these increases in pay.

This lazy labour and management hypothesis comes from John McCallum, who comes here all the time. He found that in fact when you get these depreciations of currencies, you get this productivity effect.

The Chair: Thank you, Mr. Grubel.

Thank you, Mr. Epp.

We'll have a final very short comment from Mr. Ragan, and then we'll have to adjourn.

Mr. Christopher Ragan: In response to this question, I don't think it's helpful to think of firms as benefiting from a flexible exchange rate. The exchange rate is a price, and it's sometimes a volatile price. It's the price of foreign currency. The price sometimes goes up and the price sometimes goes down. If you are a buyer of foreign currency, as you would be if you were an importer, then you are made worse off when that price goes up. If you're selling foreign currency, as you would when you're exporting, you're made better off.

So it has been the case that the recent depreciation of the Canadian dollar has helped some exporters, but by exactly the same argument, the strong appreciation of the Canadian dollar in 1991, when Canada embarked on its recent disinflation, hurt a lot of exporters. I don't think that's actually inappropriate. That's the way monetary policy works and ought to have worked in 1991, and in 1997 that's the way flexible exchange rates ought to have worked in response to external shocks.

The Chair: Thank you very much, Professors Ragan, Grubel, Jackson, and Siklos. On behalf of the committee, I'd like to thank you very much.

We have a vote, but we also have another meeting to go to. Actually, don't move, because we have to do clause-by-clause.

• 1720

On behalf of the committee, I'd like to express to you our sincerest gratitude. It was a very interesting round table.

Witnesses: Thank you.

The Chair: We'll probably call you back for more.

The meeting is adjourned.