Mr Thiessen discusses the euro: its economic implications and its lessons for Canada  (Central Bank Articles and Speeches, 20 Jan 99)
Central bank: boc | Type: speech | Date: 1999-01-20

## Mr Thiessen discusses the euro: its economic implications and its lessons for CanadaRemarks by the Governor of the Bank of Canada, Mr Gordon Thiessen, to the Canadian Club Ottawa in Ottawa, Ontario on 20/1/99.We have just witnessed the dawn of a new era in Europe.

Beginning this month, 11 of member countries of the European Union have joined in a currency union.

And they are us euro as their common currency.

The currency union is yet another step on the road to economic, social, and political integration in Europe - a vision some 50 years in the mTo be sure, this is a remarkable achievement.

Especially when you think that not too many observers were still very sceptical that these countries would be prepared to giv national currencies.

Or, indeed, that they would be able to meet the requireme participation.The launching of the euro has naturally piqued public interest in Canada, leadin commentators to suggest that we should consider a similar type of monetary arrangemen follow-up to the North American Free Trade Agreement (NAFTA).Today, I would like to talk about some of the economic implications of the European c union.

I also intend to examine whether this common currency model has any relevanc North America.

Should Canada be thinking of a new monetary arrangement along similar lin

## A common currency for EuropeThe introduction of the euro no doubt qualifies as an economic event of historic propor some of the commitments required of the participating countries have, indeed, been mome This

month, 11 European countries permanently locked in their exchange rates, adop common currency, and effectively ceded the conduct of their national monetary polic supranational institution - the European Central Bank (ECB).

To some degree, the n central banks of the participating countries are now like the regional federal reserve United States.To understand how this major change in European monetary arrangements came to be, i important to keep in mind that profound political forces started the process and have the impetus for action through the years.

Indeed, one could argue that had this been economic initiative it might not have materialized.

The impetus essentially stemmed f belief that greater economic integration would foster permanent reconciliation, and t and stability, among European nations.

And with a shared currency, the economic inte would become much more difficult to reverse.The history leading up to the adoption of the euro is fascinating, with roots extending years immediately following World War II.

I will not go through the steps that le introduction of the euro.

Suffice it to say that the process has been a major administrative, and technical feat.Imagine the logistics of transposing monetary values from national currencies - German French francs, Italian lire, etc. - into euros during the first weekend of 1999.

And ap conversion was carried out without any major hitches.But the process of conversion is not yet complete.

New euro notes and coins are not circulating yet, and will not be until January 2002.

While financial market transactiocarried out in euros, for all other transactions the use of the euro is optional over years.

The euro can now be used for purchases by credit or debit card, cheque, or t cheque.

Companies may do their accounting and pay their workers' salaries in euros.

But whole, most Europeans are unlikely to notice much change right away in their daily liv than that prices in stores may be quoted in both euros and the old domestic currency.What is crucial, however, is that the conversion rates of the national currencies in t union are now irrevocably fixed against the euro and against each other.

In this national currencies now exist only as price measures and as temporary subdivisions of Just as the Canadian dollar is composed of 100 cents, you can think of the euro temporarily composed of 6.56 French francs or 1.96 German marks.What are the economic implications of the euro?What does it mean for these 11 countries to be sharing a common currency?First, you may have noticed that, as much as the launching of a common currency acros countries (collectively referred to as euroland) was a major event, it did not have initial financial or economic impact.

This is because of arrangements that have been i some time.

For example, all currencies in the system had been effectively pegged to the mark since May 1998; and some for much longer.

With pegged exchange rates, interest ra participating countries have tended to move together, in line with German interest r over the past year, short-term official interest rates in all 11 countries gradually co current single rate of 3%.

Moreover, with an effective common market already operat Europe, a common trade policy and more integrated internal markets have been in place f time.Just what does the arrival of the euro change, then?A shared currency undoubtedly brings a number of economic benefits to the euro-zone cou The main benefit comes from eliminating the costs of conversion from one currency to an the 11 member countries.

Thus, the flow of goods, services, and capital across national no longer complicated by the use of different currencies.

Comparisons of prices among s throughout the euro zone are easier to make, which should spur greater competiti efficiency.

And there is no need for hedging to protect buyers or sellers against currency movements.

On the whole, there is greater certainty about the future when th exchange rate fluctuations is eliminated among countries that have highly integrated investment.The migration to the euro has required a major investment in time, resources, and tech financial sector institutions to prepare for the conversion.

But over time, euroland is up with deeper and more liquid bond and stock markets.

And that has the potential to Europe's share of the global financial industry and the euro's attractiveness as international reserve currency.

Of course, this will not happen overnight.

It will takeAs for economic policy, the main change that comes with the euro is the shifting of res for monetary policy from national central banks to the European Central Bank.

Beginni month, a single monetary policy applies across all euroland countries - just as here in have the same monetary policy right across the country.

The responsibility for monetar decisions for the euro zone is now in the hands of the Governing Council of the ECcouncil consists of six members of an Executive Board plus the governors of the 11 central banks.

The ECB is an autonomous institution with a mandate to achieve price staUnder these new arrangements, member countries give up that part of their national sov which relates to monetary policy.

In effect, individual countries no longer have the pursue an independent national monetary policy.

What is the significance of this?Over the longer term, monetary policy has its effects only on the rate of inflation euroland countries were already aiming at price stability, the loss of sovereignty inv being able to choose a national inflation target may not seem all that important.

No there can be differences of opinion about the appropriate definition of price stabi quickly to return to the target inflation rate when unanticipated events cause a deviat target.More importantly, with a common currency, individual countries can no longer benefit having their national currency operate as a buffer in the event of an economic shock. case of a sharp rise in world energy prices.

In this instance, an energy-producing cou experience rising incomes, expansionary demand pressures, and perhaps increased c inflows.

Countries that are heavy users of energy would experience the opposite Exchange rate movements can help smooth the economic adjustment to such a shock, throu rise in the currency of the energy-producing country and a decline in the currency of t importing country.

Where exchange rate movements are not an option, as within the curre area, greater price and wage flexibility or greater worker and capital mobility betwe economies will be needed in response to the shock.

Otherwise, the adjustment will b painful and costly, involving greater fluctuations in national output and employment. still characterized by significant wage and price rigidities and by low worker mobil could make the adjustment to shocks more difficult.

Evidently, the hope is that parti the currency union will act as a catalyst for action to reduce or eliminate these rigidiThe economic case for a common currency in Europe rests mainly on a judgment that buff differential shocks in the partner countries will be a less important consideration tha from lower transactions costs and from the greater economic certainty because of currency risk.

This presumes that the economic structures of these countries are suffic that any shocks will be felt by all of them at roughly the same time and to a simila good number of the euro countries probably fall into this category.

Those that do not themselves having to adopt measures to increase price and wage flexibility, as well as worker and capital mobility, to take the place of adjustments in the exchange rate.What are the implications and relevance of the European currency model for Canada?Canada's trade links with Europe are relatively modest.

Only 4% of our exports go to countries and about 7% of our imports come from there.

So the direct economic effe Canada from any developments in Europe related to the move to a common currency are lik be rather limited, at least in the short run.

Of course, should the new monetary un changes in world trade and finance over time, Canada would feel an impact, like an country.

But it is difficult to assess the likelihood and extent of any such chan meantime, I hope that Canadian businesses trading with Europe have made the adjustment new currency and are seeking to benefit from the lower costs of operating in Europe tha it.One thing that the launching of the euro has done in Canada is to generate discussi notion that we should be thinking of a North American monetary union with the United (and perhaps Mexico).

The decline in the external value of the Canadian dollar over the has, no doubt, heightened interest in the issue.Before I get into the arguments, let me remind you that we are talking about a curren not just a fixed exchange rate.

Fixed rates that can be adjusted (that is, devalued or not eliminate exchange rate uncertainty.

Indeed, as we have seen recently in Asia, in 1994, and in Europe in 1992, when adjustments are resisted, fixed exchange rates can unsustainable.To obtain the economic benefits that I described earlier, a currency union, not ju exchange rate, is required.* But, as I have also noted, even with a currency union the benefits come at a price.

And that price is the loss of a degree of political an autonomy and flexibility.

Just how significant would that price be for Canada?It is important to remember that, in the case of euroland, the monetary union is a conscious choice that fits into the long-envisioned larger plan of greater economic, political integration.

But in North America, there are no parallels to these profou forces.

Nor does NAFTA entail the degree of economic integration involved in the Eur Union.Moreover, for Canada, any monetary union one might imagine with the United States would only result in a loss of autonomy over monetary policy but would work very differently European monetary union.

In Europe, there are three large partners of roughly compara and eight other medium- and smaller-size participants.

Any North American monet arrangement would most likely mean that Canada would have to adopt the US currency.For Canada, the other major problem with a single North American currency is that we wo giving up the buffer that a flexible exchange rate provides in dealing with shocks th differently from the United States.

An important contrast between Canada and the Unite is the distinctly different impact that fluctuations in the world prices of primary have on our two economies.

To a significant degree, Canada is still an important pro primary commodities.

And we are major net exporters of such commodities, while Americans are small net importers.

Thus, Canadian and US terms of trade (the ratio of import prices) move in opposite directions when there is a sharp movement in world com prices.

Take the past two years or so: with a decline of over 25% in such prices, ou trade deteriorated by about 6% while the US terms of trade improved by 5%.When the terms of trade turn against us, it means that, on average, we receive less prices for the goods we sell abroad compared with the prices we pay for the products we As a nation, we become less well off compared with our trading partners.

That is reali have to adjust to it, whether we are on a floating or a fixed exchange rate or even i union.

The value of the Canadian dollar reflected that reality by moving lower last helped to smooth the process of adjustment.

If the exchange rate is not allowed to move* Another arrangement that would involve greater commitment to exchange rate stability than just a fixed rate is a currency board.

With a currency board, there is a legislated commitment to convert local curre currency used as an anchor, say the US dollar, at a fixed exchange rate.

And enough reserves would be he dollars to cover all the local currency issued by the currency board country.

But, as the recent pres currency boards of Argentina and Hong Kong demonstrate, even then, exchange rate uncertainty is not comp eliminated, especially at times of major global nervousness and volatility.adjustment would have to take place primarily through declines in prices and wages movement of labour and capital.

And if those did not readily occur, the adjustment wo longer and cost more in terms of losses in output and employment.It is precisely for these reasons, and not by accident, that the Government of Canada better part of the past 50 years, operated a floating exchange rate.

## Concluding remarksThe introduction of the euro ushers in an exciting new era for the Europeans, and we s wish

them well.

But the euro is not a blueprint for a North American monetary unio political objectives that motivated monetary union in Europe do not have a parallel America.More importantly, Canada has a very useful economic safety valve in its floating excha Because movements in the Canadian dollar reflect external shocks as well as any do economic difficulties we may face, there is sometimes a tendency in Canada to blame movements as the cause of our problems.

In fact, these currency movements are a conseq not a cause.

Exchange rate flexibility has served us well over time.

Why would we want t up?