The downside of dollarization
William Watson
National Post
Before he cemented his reputation for having single-handedly saved Western civilization, Winston Churchill was probably best known for having single-handedly destroyed the British economy. In 1925, in a pamphlet called The Economic Consequences of Mr. Churchill, no less an eminence than John Maynard Keynes charged the then chancellor of the exchequer with a policy error that would usher in a long period of stagnation and unemployment. In the event, the late 1920s recession in British manufacturing did have the silver lining that it made the worldwide depression of the 1930s relatively painless: But that's very faint praise.
What was Churchill's policy blunder? Putting Britain back on the gold standard, and doing so at the pound's pre-war value, 77 shillings 10 1/2 pence per standard ounce, which had been set by Isaac Newton in 1717, and in dollar terms translated into US$4.86 to the pound. Canadians interested in fixing the value of the C$ or even of giving up the Canadian dollar altogether could learn from Churchill's experience.
Economists (naturally) dispute whether going back on to gold was the real source of Britain's economic slump in the late 1920s. Churchill himself said it was no more responsible than the Gulf Stream, a statement Keynes characterized as being "of the feather-brained order." But in the folklore of these things, Churchill's decision, apparently taken mainly for reasons of nostalgia, national pride and an understandable unwillingness to mess with Isaac Newton, stands as a warning of the dangers of fixing at the wrong exchange rate.
What was wrong with US$4.86 per pound? People who wanted to buy British goods had to buy pounds first. If the pounds were too expensive, the goods would be too expensive, which means the demand for them would dry up. According to Keynes' calculations, US$4.86 made the pound at least 10% too expensive. (Something like US$4.30 would have been better.) If British manufacturers wanted to keep selling as many goods abroad as they had been doing before 1925, they would have to cut their prices by 10%.
That meant British wages had to fall by 10%. But cutting people's wages is never easy. It leads to strikes, violence and unemployment. Strikes and violence because workers will resist the cuts, and unemployment because their resistance will be at least partly successful, which means wages don't come down by the full 10%, British exports therefore fall and workers lose their jobs. As it turned out, Britain had a general strike in 1926 and high unemployment through most of the next decade.
If we fixed our dollar at US65¢, most of our exporters would probably be OK. They've had a couple of years of selling at that price and have done quite well at it: Our trade surplus with the United States was $92-billion in 2000. But importers and even exporters who import machines and other equipment and who have been hoping for a higher dollar wouldn't be at all happy about making 65¢ permanent. Like the British manufacturers of the 1920s, many would have to get wage concessions from their workers or go out of business.
The only rate we could choose that wouldn't cause disruption would be whatever rate Canadians in general have been thinking the dollar would eventually return to, since that's the rate they've presumably built their long-term plans on. But of course there isn't any such rate. We all have a different idea of where the dollar's headed next, so picking any given rate means lots of people will have to throw away their plans.
The consequent "costs of adjustment," to use the euphemism, would only be transition costs, but the transition might take time. In the United Kingdom in the 1920s, it took at least five years. Eventually, however, the transition would be done. Some industries would have expanded and others would have contracted or even disappeared. In theory, you could calculate the overall damage done during the transition. It would differ according to which exchange rate was chosen -- and the exchange rate to choose would be whatever minimized the damage. But in practice no one has done such calculations for Canada, partly because they would be very hard to do. That's not very helpful to policymakers and others who say "What are the costs and benefits?" but that's the way it is.
Then there's the long run (over which, as Keynes famously wrote, we're all dead). Giving up the C$ would cost us what's usually referred to as a macroeconomic "shock absorber." I actually prefer Milton Friedman's concept of daylight saving. Here's how it goes:
The Canadian and U.S. economies are structurally different. Less different than they used to be, perhaps, but still different. To our never-ending embarrassment, we do more commodities and less high-tech manufacturing than the Americans. That means our economies are subject to different "shocks." A fall in commodity prices hits us more than it hits them. A high-tech implosion hurts them more than it hurts us.
Suppose that on average the demand for Canadian goods falls. We've got three choices: do nothing and watch unemployment rise; work wages and prices down until Canadian goods are competitive again; or let the exchange rate fall so that Canadian goods become competitive without any change in wages and prices.
How's that like daylight saving? As Friedman wrote in 1953: "Isn't it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously, it is much simpler to change the clock that guides all than to have each individual change his pattern of reaction to the clock, even though all want to do so. The situation is exactly the same in the exchange market. It is far simpler to allow one price to change, namely the price of foreign exchange, than to rely upon changes in the multitude of prices that together constitute the internal price structure."
(Friedman hasn't changed his mind since 1953. I lifted this quote from his debate last December with Robert Mundell in the Financial Post. You can read it at www.nationalpost.com.) From time to time, governments hire economists to reassess the costs and benefits of moving to daylight saving time. The results are often not very convincing: The whole society is affected in large and small ways, most of which are hard to put a value on.
The same is true for the society-wide changes dollarization would bring. The nature of the costs and benefits is clear: reduced flexibility in macroeconomic adjustment versus greater certainty in trade and commerce. But on the exact size of the costs and benefits economists aren't very helpful -- as Winston Churchill might have told you. In 1925 he conceded to the advisers who were telling him to go back on to gold that he had only a "limited comprehension of these extremely technical matters." By 1930 he may have thought that was true of them, too.
William Watson, editor of IRPP's Policy Options, teaches economics at McGill University.
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