Perspectives on a potential North American monetary union

Economic Review - Federal Reserve Bank of Atlanta, Fourth Quarter 2000 by Chriszt, Michael

IN AUGUST 2000, PRESIDENT-ELECT VINCENTE FOX OF MEXICO VISITED THE UNITED STATES AND CANADA. HE FORWARDED SEVERAL IDEAS REGARDING THE FURTHER INTEGRATION OF THE THREE ECONOMIES THAT CONSTITUTE THE NORTH AMERICAN FREE TRADE AGREEMENT, OR NAFTA. AMONG HIS PROPOSALS WAS AN EVENTUAL SINGLE CURRENCY FOR NAFTA MEMBERS.

The idea of a single currency for the United States, Canada, and Mexico is not new and has usually referred to one of two approaches. The first, and most discussed, is the unilateral adoption of the U.S. dollar by Canada and Mexico, otherwise known as dollarization. Dollarization has been advocated for not only Canada and Mexico but also many other countries in the Western Hemisphere (Hausmann 1999; Schuler 1999). Some Latin American countries are already dollarized: Ecuador unilaterally dollarized its economy in September 2000, and Panama has employed the U.S. dollar as its currency since 1904. Monetary union is the other interpretation of the single-currency idea; that is, rather than unilateral adoption of the U.S. dollar, a joint currency could be developed and managed by a number of countries.

This article examines the idea of monetary union in North America. Specific criteria for a single currency for North America are discussed, as are the pros and cons of a monetary union and dollarization in the North American context. On the basis of optimal currency area (OCA) criteria, the article concludes that available evidence suggests that a single currency for NAFTA countries is possible. Canada appears much more suited for joining the United States in a single-- currency arrangement than does Mexico. Mexico appears to be moving closer to fulfilling OCA criteria, however. The article also concludes that monetary union appears to hold several advantages over dollarization from the perspective of both the United States and its NAFTA partners. Although monetary union in North America is not likely to be a near-term development, it is an important idea that merits further study and consideration.

The Single-Currency Debate

The idea of a single currency-be it via dollarization or monetary union-gained support following the Mexican crisis in 1995 and more recently the 1998 Asian crisis and its spillover to other emerging markets. However, many analysts noted that recent international financial crises were caused or exacerbated at least in part by the prevailing fixed or semifixed exchange rate regimes among the affected countries and therefore forwarded the idea that flexible exchange rates were perhaps a better option (Espinosa and Russell 1996; Roubini, Corsetti, and Pesenti 1998; Sachs and Larrain 1999; Chang and Velasco 1998). Indeed, at a more fundamental level, Friedman (1988) found that a system of flexible exchange rates is a fundamental prerequisite for economic integration.

Nevertheless, flexible exchange rate regimes have come under increased criticism, especially as applied to emerging economies. Emerging markets that apply flexible exchange rate regimes are prone to instability and wide fluctuations in exchange rate values that inhibit long-term planning necessary for successful economic development (Hausmann 1999). Recognizing, however, that fixed or semi-fixed regimes are susceptible to the kind of breakdown witnessed in Asia, more formal links with the world's main currencies-the U.S. dollar, euro, or yen-- are often considered more preferable than a flexible exchange rate arrangement.

In the case of the Western Hemisphere, linking to the dollar via dollarization or monetary union has recently gained more attention and, in one instance, has become a reality. In Ecuador, a financial crisis led to the collapse of the Ecuadorian sucre, and the U.S. dollar is now the official currency. Ecuadorian officials concluded that the best way to restore confidence in the economy was to introduce the dollar as the official currency.1

The recent crises in emerging markets are not the only reason dollarization or monetary union has gained attention. The advent of the European Monetary Union and the euro, the single currency for eleven of the fifteen European Union members, has also focused attention on the possibility of such an arrangement for other economically integrating countries, namely, NAFTA countries.

Simply taking the European Monetary Union model and applying it directly to NAFTA countries is not appropriate, however, because of the dissimilar economic and political histories involved and because the current level of economic and political integration is much deeper in Europe than in North America (McCallum 2000). Nonetheless, important lessons can be gleaned from the European experience.

The European Monetary Union is an effort to create greater economic efficiencies among integrated economies. Creating economic efficiency among NAFTA countries is also an appropriate goal. The use of a single currency eliminates some transaction costs, increases economic and financial efficiency, and leads to increased trade and investment within the single-currency area. The close economic links among the NAFTA countries can be seen in the growing trade relationships among the United States, Canada, and Mexico (Chart 1) and have helped give rise to the debate over a single currency for the NAFTA countries. In addition, recent studies show that the potential gains from trade among countries that choose to participate in a monetary union can be significant (Frankel and Rose 2000).