Published in Laissez-Faire City Times, July 30, 2001. A shorter, somewhat different, version was published in the Financial Post.
Hands Off the Currencies
A debate about dollarization has been raging in Canada over the last few months. (No, I won't make the easy joke that Canada is already dullarized enough!) "Dollarization" has become the standard term to describe the adoption of a foreign currency, whether it be the U.S. dollar (which is usually the case) or some other currency. In the Canadian context, dollarization means using the U.S. dollar instead of the Canadian dollar.
In a recent opinion poll among Canadian business executives and business owners, 45% answered Yes to the question, "Should Canada adopt the U.S. dollar?", while 42% said it was a bad idea. A majority of those who wanted to keep the loonie (Canadian dollar) cited "independence/sovereignty" and "national pride/emotional appeal." [1]
One wonders why "Canada should" adopt, or not adopt, this or that currency. Businessmen are free to put their money where their mouths are, and use the U.S. dollar if they like it -- or, for that matter, the Ethiopian birr. Perhaps those who trip on "national pride" (poor things!) should be let free to carry loonies. Why should one group impose its choice on other individuals? What is "Canada," by the way? Oh! You mean "the Canadian government"! Why do we need the government to decide which currency to use?
Two crucial issues are easily forgotten in the dollarization debate. First, it would be impossible to dollarize at a rate much different from the existing exchange rate, for the same reasons that a currency cannot be pegged at an unrealistic level. If the government of Canada mandated dollarization today, Canadians would earn on average 35% less than Americans, as the loonie is currently priced at 65 US cents on financial markets. Whatever businessmen or whoever think of the loonie's worth, there is no way around the market's evaluation of the relative credit worthiness of Canadian and American producers, which is what the exchange rate ultimately reflects.
The second issue is, indeed: Why we should need a Godly political decision to decide which currency to use? We should know better than the European Union's way of doing things, i.e., than replacing some currency by another mandatory one. Informal dollarization is the forgotten option.
In fact, Canada is already partly dollarized. Many Canadian multinational corporations use the U.S. dollar as a unit of account; a few, like Alcan, publish their financial statements denominated in that currency. The U.S. dollar is also used as a medium of exchange and store of value by many Canadians. Some 12% of outstanding commercial paper issued by Canadian corporations is in U.S. dollars. About 10% of outstanding deposits in, and business loans made by, Canadian chartered banks are denominated in foreign currencies (mainly the U.S. dollar). A standard measure of dollarization is the ratio of residents' foreign currency deposits to M3 (the largest definition of money supply, which includes all bank deposits). In April, Canadian residents' foreign currency deposits in Canadian banks were worth $66 billion (Canadian), while M3 stood at $687 billion, for a dollarization ratio of nearly 10%. The dollarization rate in Canada is lower than in many South or Central American countries because Canadians have less reasons to flee their domestic currencies.
Yet, as can be seen on our chart below, when Canadians' trust in their currency decline, they tend to dollarize their assets. The light curve plots the Canadian dollar in terms of US dollars, from May 1970 (one month before the loonie started floating and jumped from $US0.93 to $US0.96) until now (US$0.64 in April). The heavy curve traces the evolution of the dollarization ratio (foreign currency deposits in Canada over M3). In general, Canadians have decreased their foreign currency holdings when the loonie was on an upward trend, and (quite strikingly since 1983) increased them to hedge against a dropping Canadian dollar. Increased dollarization in the 1990s (from 3% back to 10%) is also related to the phenomenal increase in trade, but the dismal performance of the loonie has obviously been a factor.
This can happen because legal tender legislation in Canada (like in the United States) is quite liberal. Although banknotes issued by the Bank of Canada are legal tender (Currency Act, s. 8), nothing forbids contractual parties in Canada to agree on any other means of payment, including foreign currencies. The greenback could spontaneously become the major currency in Canada if only a majority of Canadians decided to conduct their transactions in that currency. There is a temptation to call on government to standardize -- in the fields of language, health care, money, financial markets, etc. The cost of standardization in terms of less choice and less innovation tends to be ignored. In currency matters, free choice prevents a government from debasing the currency through inflation and other bad economic policies. The argument for free choice in currency was forcefully made by Nobel Prize winner Friedrich Hayek in his 1976 Denationalisation of Money. Let currency issuers compete for consumer patronage!
Private issuers should be allowed to compete, too. As Hayek showed, good money would drive out bad money. "Gresham's law," i.e., bad money drives out good money, is only true when the state imposes a fixed rate of exchange that undervalues the good money. People will then get rid of the bad money, which will circulate, and hoard the good one, which will seemingly disappear. Even if we stay in today's statist world, it is better to have the choice between many bad government currencies than to be forced to choose one.
Free choice of currencies will restrict a public issuer's (i.e., a central bank's) monetary policy. Contrary to conventional wisdom, the loss of government control over monetary policy is not a cost, but a benefit. This applies as much to the U.S. Federal Reserve System as to the Bank of Canada. It is not obvious why Canadians should transfer control from Charybdis Dodge to Scylla Greenspan. Fortunately, there is the alternative of free choice, which could lead to unofficial dollarization or to a multimonetary system (like, for example, in Luxembourg before the Euro).
Suppose that Canadian governments continue to pursue policies that dampen economic growth relative to the U.S., keeping downward pressure on the loonie. More Canadians would open U.S.-dollar bank accounts. Entrepreneurial financial institutions would offer hedged packages whereby employers could pay salaries, or part of them, in U.S. dollars. Daily transactions could be painlessly made in loonies or greenbacks, and instantly converted if required, through credit cards, debit cards, and smart cards. It would help if banking regulations that complicate foreign exchange transactions were reviewed.
This raises a more general question: Why isn't there, in the world, more informal "dollarization," more multimonetary systems, or more use of basket currencies (like the DMT Rand [2]) if only as units of account? (Legal and regulatory obstacles to full-fledged private currencies exist everywhere, but this is another question.) In many countries, legal tender laws and accompanying regulations increase the cost of using foreign currencies (or, which amounts to the same, decrease their benefits). In countries like Canada or the U.S, another factor lies in the benefits of spontaneous standardization: people tend to use the same currency for the same convenience reasons that they speak the same language.
Another factor weights heavily: the very size of the state. For example, Canadian governments take in taxes, and re-spend, close to half of Canadians' incomes; they thus get to decide which currency is used in a large proportion of economic transactions. More choice in currencies would be another benefit of downsizing the state.
[1] "Drop loonie, 45% say in business poll", National Post, July 16, 2001.
[2] J. Orlin Grabbe, "The DMT Rand: A Currency for the Next Hundred Years", Laissez Faire City Times, January 10, 2000.