Rebutting Raganomics

Today, I had the following commentary posted on The Globe and Mail’s Economy Lab:

The loonie is overvalued and the Bank of Canada has room to act

On Tuesday, Christopher Ragan characterized the notion of an overvalued Canadian dollar as a “seductive myth” that the Bank of Canada should not act to address. I have made the case that we should broaden our central bank’s mandate to include managing the exchange rate and welcome the opportunity to advance this important policy debate.

Significantly, Ragan agrees that currency “depreciation would spur Canadian exports and provide a much-needed stimulus to medium-term economic growth.” Yet there are three main points of disagreement: Whether the Bank of Canada could manage both inflation and the exchange rate, whether the loonie is overvalued, and whether the benefits of a higher exchange rate offset its costs.

Ragan writes, “Central banks have but one policy instrument – the setting of a short-run interest rate. And with only a single instrument, monetary policy needs to be directed at a single target [i.e. inflation]”.

Surely the global response to the financial crisis has demonstrated that central banks possess an array of policy instruments in addition to interest rates. Whether the Bank of Canada should deploy these instruments is debatable, but we should not deny their existence.

In particular, the Bank of Canada could sell (or credibly threaten to sell) Canadian dollars into foreign-exchange markets to moderate the exchange rate. Of course, this approach could boost inflation by expanding the global supply of Canadian dollars and/or by stoking inflationary expectations.

Some inflation helps the economy function smoothly. The Bank of Canada has concluded that 2 per cent is the optimal inflation rate. If inflation were already at that level, there would be a trade-off between keeping it on target and intervening to lower the exchange rate.

In reality, inflation has fallen below that target for 13 consecutive months and is now down to 0.7 per cent. If the Bank of Canada is serious about meeting its target, it should be trying to boost inflation.

In recent years, the Japanese and Swiss central banks successfully intervened to lower their national currencies, but no one would claim that they have allowed excessive inflation. Central bankers have proved capable of walking and chewing gum at the same time.

The Bank of Canada could manage both the inflation rate and the exchange rate. In certain circumstances, there would be trade-offs between the two. In current circumstances, efforts to lower the exchange rate would complement efforts to hit the inflation target.

Of course, we should endeavour to clip the loonie’s wings only if it is flying too high. The exchange rate set by financial markets is currently far above purchasing power parity (PPP), the actual buying power of a loonie in Canada versus that of a U.S. dollar in the United States.

Ragan objects to this comparison because “movements in the PPP exchange rate are a poor indication of movements in the actual exchange rate.” By this logic, our currency can never be overvalued (or undervalued). If the exchange rate equals purchasing power, then there is no case for overvaluation. If the exchange rate deviates from purchasing power, then Ragan deems purchasing power to be invalid as a guideline for the exchange rate.

Indeed, in a C. D. Howe Institute e-brief also released Tuesday, he explicitly argues that our currency can never be mispriced: “It is more sensible to view the forces of demand and supply in the foreign-exchange markets as determining the ‘right’ value of any freely floating currency. It makes little sense to think of such currencies as ever being ‘overvalued’ or ‘undervalued’.”

That view is based on a theoretical faith in the market rather than on an empirical analysis of fundamentals. Recent years clearly demonstrate that financial markets make mistakes. While policymakers can also make mistakes, there is a role for central banks in moderating financial-market activity, including exchange-rate speculation.

Finally, Ragan argues that a higher loonie provides benefits as well as costs. His e-brief specifies, “If rising global commodity prices drive up the Canadian dollar, the clear winners are those firms and workers involved in the production and export of commodities.”

Commodity producers clearly benefit from higher commodity prices. However, they do not benefit from the higher exchange rate associated with higher commodity prices. Like other exporters, commodity producers sell their output at prices denominated in U.S. dollars but buy many of their inputs using Canadian dollars. At any given level of commodity prices, a higher exchange rate shrinks U.S.-dollar revenues relative to Canadian-dollar costs.

In theory, Canadian consumers should be the beneficiaries of a higher loonie. But as Ragan himself points out, there has been little connection between the exchange rate and purchasing power in Canada. If the benefits of a stronger currency are not being passed through to Canadian consumers, then it is difficult to contend that they outweigh the very real costs of lost output and fewer jobs in export industries like manufacturing.

The Bank of Canada can and should act to moderate the exchange rate to a level consistent with purchasing power parity and conducive to exports, economic growth and employment.


  • David Macdonald

    Great post Erin! Too bad you couldn’t get it in the globe.

  • The Bank of Canada could indeed sell large quantities of Canadian dollars and amass US dollars to force our currency down to, say, 80 US cents, and no doubt this would increase our exports.

    The question is whether this really is the best course of action to be taken by a wing of our federal government. I would argue it is not.

    About half our exports are basic natural resources, some virtually unprocessed, others lightly processed. It is the increase in the price of some of these, oil in particular, that has been a major factor causing our currency to go up in value. Forcing the value of our currency down by central bank intervention will further increase the export of these natural resources, a poor outcome in my opinion since I would rather see us produce more high value-added goods and services. Furthermore as resource exports increase, the Bank of Canada would need to sell even more Canadian dollars to offset the currency effects of the currency-induced increase in exports, a never-ending tango.

    There is also the matter of who benefits and who loses. Clearly a lowered value of our dollar would benefit exporting companies with higher profits and those who work there through higher wages and more employment.

    The losers would be the rest of Canadians who would face higher prices for imported goods and services due to the substantial decrease in value of our currency. In addition importers and their workers would also experience lower profits and job losses.

    We should also ask if it is necessarily a good idea to expand exports in the first place. When we export, the output accrues to foreigners who buy our goods and services, not to Canadians. Wouldn’t it be preferable to produce things for ourselves – like more daycare, elder care, high speed trains, a better natural environment instead?

    Granted we more or less need to pay for the things we import but I disagree that developing an export- oriented economy is in itself a good thing, something that large-scale currency intervention implies.

    If we do want to develop industries in Canada then let’s just do it through selected industrial policies, rather than fiddle with the exchange rate. Let’s support industries directly rather than target all exporting industries indiscriminately. Surely better public transportation and high speed trains would be more worthy for support than continued over-development of the tar sands that currency intervention would promote.

    Finally, fixed currency regimes also encourage currency speculation. If in the future speculators come to believe the government will change its policy on currency intervention, currency speculation and accompanying massive profits will accrue to speculators, something I think we can do without.

    If we do not have enough jobs in our economy as is indeed currently the case, let us have the federal government finance enhanced public services of the sort I gave as examples above, both in social programs and public transportation.

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