The adoption of the US dollar as Canadian currency: is it a practical vehicle for forming a monetary union?

• Jurisdiction: European Union
• Author: Angelidis, John
• Date: 22 December 2009

1. INTRODUCTION

   Mundell's idea of the Optimal Currency Area (OCA) was certainly invigorated as several countries in Europe adopted the Euro as their common currency. Once the Euro became a reality, some researchers raised the issue of whether a common currency would bring benefit to North America, or more specifically to the US and Canada. The US and Canada are at first glance likely candidates for a monetary union; the significant amount of trade between them continues to keep on integrating their economies and therefore, a common currency should bring substantial benefits.

   If Canada and the United States could establish a monetary union, what form should this union take? Recently, several countries accepted the US dollar as their currency and one wonders if Canada could do that as well.

   The objective of this paper is twofold:

1. To establish whether Canada and United States form an Optimal Currency Area.

2. If so, would dollarization be a vehicle for a successful monetary union?

   1.1 Method of Analysis, Contribution of this Paper, and the Papers' organization

   In order to form a monetary union between Canada and the US one has to first examine more formally whether the two countries from an optimal currency area (OCA). This methodology was originally designed by Mundell (1961); Tavlas (1993), Krugman-Obstfeld (1997), Cohen (1997), Williamson(2000) and others incorporated additions to Mundell's work. The methodology consists of examination of several criteria that need to exist before a monetary union could be established. These can be summarized into five groups:

   * Openness of the economy

   * Common policy preference

   * Similar industrial structure

   * Mobility of resources

   * Asymmetry of shocks

   If these criteria are met, we can conclude that a precondition for a successful monetary union does exist. If the criteria are not met, there is a probability that a monetary union would not bring a desired benefit.

   If Canada and the United States form an Optimal Currency Area, one way of establishing monetary integration between the two countries is dollarization. The reason for selecting dollarization as a potential monetary integration between the two countries is that some observers claimed that market forces are dollarizing Canada already (Dodge, 2002; Murray at al, 2003).

   To examine whether dollarization is a viable method of monetary integration several issues will be examined:

   * Evaluate the costs and benefits of dollarization. Specific issues examined here include transaction costs and other efficiencies, seigniorage, lender of last resort, etc.

   * Evaluate whether market forces are dollarizing Canada. As evidenced in the literature, this is measured by investigating what specific role the US dollar plays as the medium of exchange, unit of account, and a store of value.

   * What are the attitudes of those working in various markets? Do they favor a single currency, and would the US dollar satisfy this need?

   The contribution of this paper is that it does not use only the analysis adopted by Mundell (and others); although that type of analysis is sufficient to evaluate whether two countries would benefit from a common currency. It also examines whether market forces are also leading toward a single currency outcome, as well as it includes summaries of studies about attitudes toward a single currency between the two countries.

   This paper is organized as follows: First, the paper will examine weather the US and Canada form an OCA area; second, issues of costs and benefits of dollarization are explored in order to see how they may affect Canada; and third, an analysis of whether market forces are in the process of dollarizing Canada is also included.

2. DO THE US AND CANADA FORM AN OCA AREA

   The first step in evaluating the potential for two countries to form a monetary union is to establish whether Canada and the United States form an Optimal Currency Area (OCA). Below, various OCA requirements between Canada and the Unites States are examined.

   2.1 Openness of the Economy

   Openness refers to the degree of integration among countries and in the literature, the volume of trade measures it adequately. If the goods markets are well integrated then the benefits of a common currency are greater in terms of transaction costs saved, reduced exchange rate uncertainty, and price transparency.

   Canada and the US share a land border that extends over 5,500 miles (including 1,540 with Alaska), a border that is busy with high volumes of trade. In 2007, Canada's exports to the US were valued at US$ 341.9 billion, while imports from the US amounted to US$ 210.2 billion (The World Factbook, 2008). For the longest time Canada and the US have been each other largest trading partner; the NAFTA treaty further expanded this trade relationships.

   Trade between US and Canada is not only growing in size but also in the variety of products exchanged. Hillberry and McDaniel (2002) examining the decomposition of trade between the two countries between 1993 and 2001 have found that US exports to Canada on average have increased in variety by 3.4 %, and the imports from Canada have increased in variety by 4.4%. These numbers, when compared to trade flows internationally, represent a steady and continuous march toward more integration.

   The increase in trade between the US and Canada has led to significant increase in intrafirm trade that now accounts for about 50% of total bilateral trade. The best example of this is the car industry, where in 2006 US exported $49.1 billion in Motor vehicles and parts, while importing $107.6 billion from Canada. This large amount of intrafirm trade is additional evidence of economic integration. If the same firm produces, markets, and sells goods and services in both countries, this trade activity adds to the evidence that the two economies are increasingly more integrated.

   Since the 1970's, both countries have heavily and consistently invested in each other's industries another sign of integration as the broader issue of trade also encompasses the amount of foreign direct investment (FDI). Dobson (2002) reported that 60% of all FDI invested in Canada originates from the Unites States, and that the 50% of FDI invested in Canada is of US origin. . By 2006, US Bureau of Economic Analysis (BEA) reported that US received $159 billion from Canada as FDI, while Canada received $246 billion from the US.

   A joint program by the two countries was established to assure free and secure trade (FAST). By 2004 this program provided inspection lanes to goods carried by approved lower-risk shippers and by 2005, this program had 55,427 drivers enrolled in the program. This assured that at present time goods move quickly across boarders.

   From the above only one conclusion can be reached: Canada and the United States are major trading partners, with economies that are integrated and becoming more so. This fulfils the OCA criterion concerning the openness of the two economies; under such conditions, the high volume and ease of trade should bring large savings in transaction costs if a common currency is introduced.

   2.2 Common Policy Preferences

   Countries that enter a monetary union should have similar goals for their economic policy in order to share a uniform perception of future economic progress. Canada and the United States, as well as the G-10 countries, have exhibited the same policy preferences, and the literature in the area supports this. For example, over the past 50 years the year-by-year movements in the Canadian and US consumer price indexes (CPI's) have been similar. Overall, Canada's GDP growth and other indicators have shown similarity and stability (Murray, Powell, 2002). The policies of Canada's Central Bank have managed well the supply of money and thus inflation, while the banking system is sound and it contains an adequate loan loss reserve (Dean; 2001). In conclusion, the common policy preference OCA criterion is also fulfilled.

   2.3 Similar Industrial Structure

   If industrial structures are dissimilar between two (or more) nations, changes in demand in one country will influence demand in the other country leading to asymmetric shocks. An example of different structures could be that a one country is predominantly agricultural while the other is industrial. Another example is that one country is a manufacturing economy while another is mostly service economy.

   Table 1 shows the economies of Canada and the US divided into three major sectors and the volume of activity in each sector is shown as a percentage of GDP. The two economies are rather similar in structure, although not identical. Agriculture plays a small role for both economies; Canada is somewhat more industry intensive while the US shows a higher proportion of service.

   The similarity of Canada and the Unites States with respect to industrial structure seem very close when compared to members of the European Monetary Union. In fact, in Table 2, one observes that the disparities in economic structure among some of the European nations that adopted a common currency are greater that the differences found between Canada and the United States; as evidenced by less services and more agricultural products.

   Table 3 shows essential industries as a percent of GDP for Canada and the US in two different periods 1980 and 2007. Over time we ca see that while some sectors maintained the same proportion to the GDP, most declined for both countries. This closer look at economic segments provides a more micro picture captured in Table 2. Indeed, Canada...