David Dodge: Dollarization and North American integration
Remarks by Mr David Dodge, Governor of the Bank of Canada, to the Chambre du commerce du
Québec, Sherbrooke, Quebec, 5 October 2002.
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Good morning, ladies and gentlemen. Thank you for inviting me to this Congress, and for choosing to
spend part of your weekend listening to the discussion on this important topic.
The question before us sounds straightforward: "should Canada adopt the U.S. dollar?" But the issues
are complicated. I will not pretend that I can cover all the nuances of this topic in my allotted time. So I
am running the risk that I may oversimplify matters. I should also say that I want to stick to economic
facts and arguments. There is, of course, a big political dimension to the question, but I will leave that
to the politicians. I want to confine my arguments today to the field of economics.
Choosing an exchange rate regime
In the years following World War II, many countries operated under an exchange rate regime that one
might call "fixed until further notice." This system, known as the Bretton Woods system, saw most
countries peg the external value of their currencies to some other currency, most often the U.S. dollar.
But for a number of reasons, this system of "fixed until further notice" exchange rates proved unstable.
It has been abandoned by many countries in favour of one of two options - either a floating-rate
regime or the use of another currency. Most have chosen a floating-rate regime. A few countries have
decided to join some kind of monetary union or to use a foreign currency to replace their own.
Canada was one of the first countries to adopt a floating-rate regime. It did so at the beginning of the
1950s and, generally, this regime has served us well. But with increasing integration of the Canadian
and U.S. economies, the question now being asked is whether Canada might be better off giving up
the Canadian dollar, either through dollarization or by entering into a monetary union with the United
States.
What I want to do today is to discuss the benefits and costs of a floating exchange rate versus
dollarization at the present time, given the current degree of integration of the U.S. and Canadian
economies. Then I will talk briefly about the implications for our floating exchange rate should the two
economies become more integrated.
Let me just add here that Canada is not being inevitably drawn into adopting the U.S. dollar, or being
de facto dollarized, as some have claimed. Recent research conducted at the Bank of Canada shows
clearly that, if anything, Canada is now less dollarized than it was two decades ago. We are not drifting
towards dollarization. If we go down that road, it will be a deliberate choice.
When choosing an exchange rate regime, it is crucial to remember that monetary policy needs to have
a nominal anchor. In Canada, monetary policy is anchored by our use of an explicit inflation target. If a
country chooses not to float its currency, it essentially adopts the monetary policy of the country to
which it is tied. This may, or may not, provide an effective nominal anchor.
Let me briefly explain how the floating exchange rate fits into Canada's monetary framework. Our
monetary policy aims to keep inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. We
protect the domestic purchasing power of our currency by keeping inflation low, stable, and
predictable. By doing so, we support the conditions necessary for strong, sustainable economic
growth.
With a floating currency, our exchange rate acts as a mechanism that allows the Canadian economy
to adjust to important economic changes, or what economists call "shocks." These can include
movements in relative world prices, changes in capital flows, or divergent economic conditions across
countries.
Consider commodity prices, for example. As you know very well, Canada is an important producer of
commodities such as metals, paper, and chemicals. When the world prices of these goods rise, it
means that Canadian producers receive more income. This rise provides a boost to the Canadian
economy. When commodity prices fall, it means less income for Canadian producers. This has a
negative impact on the economy.
Changes in these sorts of relative prices are a signal to shift real resources out of some sectors and
into others. The Canadian economy needs to respond to such signals. Under a floating-rate regime,
movements in the currency help to smooth that process and attenuate the adjustments in output,
employment, wages, and prices.
Without a floating currency, the Canadian economy would still need to absorb the effect of changes in
relative prices. But the burden would fall initially on output and employment and, eventually, on all
wages and prices. This would be a far more difficult and costly process for many.
There will always be economic shocks that require adjustments. But because the structures of the
U.S. and Canadian economies are so different, the two economies often require very different
adjustments to shocks. Canada's floating exchange rate facilitates these adjustments by reducing the
amount of lost income and output during the adjustment process.
Weighing the costs and benefits
Our empirical analysis shows that these adjustment benefits are quite large during periods of
significant shocks. But there is no free lunch. There are costs involved in choosing a floating currency,
and these could be avoided under dollarization. These include the costs of currency transactions and
the need to mitigate currency risk - costs that can be considerable. At the present time, however, the
adjustment benefits clearly outweigh the costs. This is an empirical statement, not a philosophical one.
It is possible that, at some future time, the structures of our two economies could converge to the point
that the reverse would be true. But for now, and as far into the future as I can see, the floating
exchange rate is the best choice for Canada given the degree of integration of the Canadian and U.S.
markets for goods and services and labour.
The question can then be asked: "would further integration of Canadian and U.S. markets change this
assessment?" The fact that the structures of the Canadian and U.S. economies are so different argues
against using the same currency. But this could conceivably be overcome if there was much greater
integration of all markets between Canada and the United States. It is this integration that could help
us reduce the costs of adjusting to shocks that I described earlier.
Specifically, the markets for goods and services, and particularly for labour, would need to become
much more unified with those in the United States before it would make economic sense to adopt the
U.S. dollar. Right now, our capital markets are fairly well integrated. Our markets for goods and
services are supposed to be deeply integrated under NAFTA. But as any exporter will tell you, we are
not quite there. There is always the threat that the United States could take a countervailing or
antidumping action. In addition, NAFTA does not cover all goods and services.
Still, by far the largest problem is the labour market. Wages tend to be "sticky"; that is, adjusting wages
often takes time. So, under dollarization, the brunt of the economic adjustment to shocks would be
borne by the labour market. This would create a huge problem if workers were not free to move across
the border in both directions. At times it would create periods of much higher unemployment in
Canada than would otherwise be necessary, and at other times it would lead to periods of labour
shortages. One important feature of the U.S. labour market and, in my opinion, perhaps the most
important source of the U.S. economy's success, is that workers do, in fact, migrate easily - not just
from job to job, but also from place to place within the United States. We would need to share in that
flexibility.
But clearly, Canada and the United States are a long way from integrating their labour markets, and
further integration of markets for goods and services is proving difficult. If these markets - for labour,
capital, and goods and services - became much more highly integrated, then the benefits from having
a separate currency could decline enough to make considering the adoption of the U.S. dollar
worthwhile.
Here, the European experience is relevant for us. Some observers look at the successful launch of the
euro and suggest that this shows that Canada could easily adopt the U.S. dollar. But the euro marked
the end of a long process of political and economic integration, not the beginning. The countries in the
euro zone undertook a massive effort to integrate their markets for goods and services, capital, and
labour, and to harmonize their fiscal and regulatory policies. Only after all of this was in place did they
move to launch the common currency. It would not have made economic sense to go through the
process in reverse. It would not make sense in North America either. We would first need to more
closely integrate trade in goods and services, and, particularly, our markets for labour. Only then
would it make sense to deal with the currency issue.
Concluding comments
As I said at the beginning, this is an important topic for discussion and research. At the Bank of
Canada, we have been contributing to this debate for some time by laying out the economic facts and
by promoting the research needed to determine the facts and carry out our analysis. We will continue
to do this. But right now, our analysis tells us that Canada derives a significant benefit from having a
floating currency - a benefit that far outweighs the costs. This system helps the economy to adjust to
economic shocks, and allows us to have a monetary policy accountable to all Canadians. The floating
exchange rate system serves the interests of all Canadians very well.