Published in Financial Post, July 17, 2001, p. C-15. A more elaborate article was published in the Laissez-Faire City Times.

 

Dollarization by Default

 

If 45% of Canadian executives and business owners want to use the U.S. dollar, as reported in yesterday's National Post, they are free to put their money where their mouths are. Contrary to popular belief, the choice of a currency isn't something that needs to be imposed by government.

Two crucial issues are easily forgotten in the emerging dollarization debate. First, it would be impossible to dollarize at a rate much different than the existing exchange rate, for the same reasons that we cannot peg the Canadian dollar at an unrealistic level. If the federal government mandated dollarization today, Canadians would earn on average 35% less than Americans. Some executives think the Canadian dollar is worth maybe 70 or 80 U.S. cents. But there is no way around the market's evaluation of the relative creditworthiness of Canadian and American producers.

The second issue is whether we need a political decision to decide which currency to use. The European Union's way of doing things was to replace a group of mandatory currencies with another, single, mandatory currency. We should know better than to consider aping Europe, because there is another, superior option: informal dollarization.

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 the 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 as a proportion of M3 (the largest definition of money supply, which includes all bank deposits). In April, residents' foreign currency deposits in Canadian banks were worth $66-billion, while M3 stood at $687-billion, for a dollarization ratio of nearly 10%. This is lower than in many Latin American countries, simply because South Americans have more reasons than us to flee their domestic currencies.

As can be seen on our chart, when Canadians' lose confidence in their national currency, they tend to dollarize their assets. The light curve plots the Canadian dollar in terms of U.S. dollars, from May 1970 (one month before the loonie started floating and jumped from US$0.93 to US$0.96) 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%) may be 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 (as in the United States) is quite liberal. Although bank-notes issued by the Bank of Canada are legal tender under section 8(1)(b) of the Currency Act, 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 is often 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 book Denationalisation of Money. Let currency issuers compete for consumer patronage!

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 we 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, Luxembourg before the Euro).

Suppose that Canadian governments continue to pursue policies that dampen economic growth relative the United States, 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.

The major obstacle to voluntary dollarization probably lies in the very size of the state. Since Canadian governments take close to half of Canadians' incomes in taxes, they get to decide which currency is used in a large proportion of economic transactions. Downsizing the state would have many advantages besides giving individuals more choice in currencies.

When one considers the alternative of free choice, the dollarization debate looks like another political tempest in a collectivist teapot. Nowhere is it written that we must have only one currency, and that currency must be the Canadian dollar. Ten years from now, under current policies, we may end up dollarized whether Ottawa and policymakers want it or not: dollarization by default.