Too many or too few currencies?
As the Greek crisis threatens to spread, and indecisiveness continues to engulf EU leadership, more economists are suggesting that the only viable solution is for Greece to withdraw from the Euro and reinstate its own currency. Is another small country with its own currency really what we need?
Many years ago, when the Canadian dollar was spiraling downward against the U.S. dollar, I argued in favor of dollarization – replacing our currency with the U.S dollar. This would have required shutting down the Bank of Canada and leaving our monetary policy in the hands of the U.S. Federal Reserve. I still favor dollarization even as the Canadian dollar has taken flight. But I seem to be in an increasingly smaller minority.
Economists tend to overstate the stability and predictability of currency markets, and the impacts of currency revaluations.
Let me start with the case of Canada. The two principal arguments supporting the Bank of Canada and the Canadian currency are the importance of conducting an independent monetary policy, and the role of our own currency and flexible exchange rates (a euphemism for letting speculators determine the values of exchange rates) in providing a tool for adjusting to external shocks.
In theory, these arguments sound impressive. In practice, they are flawed.
With the exception of 1989-90, the Bank of Canada has basically mimicked the monetary policy of the Federal Reserve. In 1989-90, the Bank precipitated the only made-in Canada recession. I seriously doubt that Bank has generated superior economic performance since its inception than would have been the case if we were part of the U.S. currency market without our own central bank.
During this past recession, the value of the Canadian dollar did not depreciate against the U.S. dollar as theory predicts, and thus lessen the negative spillover from the United States. In the early 1980s, the Canadian dollar did not appreciate to lessen the inflation spillover from the United States. The Canadian dollar has performed poorly in insulating Canada from external shocks.
Instead, the volatility of the currency markets has increased hedging costs for Canadian companies. The 30 year secular decline in the value of the Canadian dollar up to 2002 made manufacturing companies lazy. They relied on new rounds of depreciation to maintain their cost competitiveness rather on being innovative.
Unlike Canadians who cannot move freely to the U.S., Greeks do have the ability to migrate to other parts of the EU in search of jobs (I haven’t heard much from economists about this method of adjusting to the current crisis). This provides a safety valve of sorts.
Having their own currency and having it depreciate significantly in order to improve the competitiveness of the Greek economy would not necessarily work. Interest rates would be much higher. Further, speculators/traders who drive currency markets have a tendency to overshoot so-called equilibrium positions. Thus, Greek’s currency could depreciate dramatically more than desired, pushing up interest rates, inflation rates and bankruptcy rates. Finally, without a competitive manufacturing base to begin with, depreciation would do little to create one. Tourism would flourish, in the absence of strikes and civil disorder, and Greece would become the Mediterranean Disneyland, but without the fuzzy characters.
Currency markets have become much too volatile, and exchange rates are driven by capital flows, especially so-called “hot money”, not by trade flows. Thus, exchange rates are as likely to move in a direction to exacerbate the spillover effects of economic shocks, as they are to mitigate these effects. Small countries with their own currencies have little control over their exchange rates. As well, they are often tempted to issue debt in foreign currencies (the U.S. dollar, the Euro or the Yen) in order to reduce their borrowing costs. This requires that their currencies do not depreciate against the foreign currencies. This only exposes them to serious problems when hot money changes direction.
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.