FINA Committee Meeting

STANDING COMMITTEE ON FINANCE

COMITÉ PERMANENT DES FINANCES

EVIDENCE

[Recorded by Electronic Apparatus]

Thursday, May 11, 2000

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[English]

The Chair (Mr. Maurizio Bevilacqua (Vaughan—King—Aurora, Lib.)): I'd like to call the meeting to order and welcome everyone here this afternoon.

As many of you may know, the finance committee is having a number of round tables on a variety of subject matter. Today we have the pleasure to have with us experts who will address the issues of monetary policy in our currency regime.

We have Pierre Fortin, professor in the Department of Economics, University of Quebec in Montreal. From the Royal Bank of Canada, we have Dr. John McCallum, senior vice-president and chief economist. We also have an individual from the University of Quebec in Montreal, Professor Bernard Élie, Department of Economics. Welcome.

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You've all appeared before this committee previously, so you know you have approximately the number of minutes you need to make your presentation—usually 5 to 10 minutes. Thereafter, we will engage in a question-and-answer session. Then we'll try to have a nice flow. We'll also get the individual witnesses to comment on each other's comments. That's also very helpful for members of the committee.

We'll begin with Professor Fortin. Welcome.

Mr. Pierre Fortin (Individual Presentation): Thank you very much.

First of all, I'm very thankful for this invitation. It was on very short notice, but of course it will give you an opportunity to realize how productive Canadian economists are.

The second point I want to make is that John, Bernard, and I are, or have been, professors of economics at the University of Quebec in Montreal, which is a sign that this university is much above average in terms of policy preoccupation. So I'm very glad to emphasize that.

The Chair: Do you want us to note that in the record?

Mr. Pierre Fortin: Yes, right. I think you should send notice of that remark to my rector.

Okay, let's begin. I distributed two papers at the beginning, but I won't go over them. I'll leave them for the committee to look at, and maybe we can discuss ideas in depth. But what I want to present is something that is focused on one single issue, which is setting the inflation target range for monetary policy after 2001. This is the question I have been asked to answer, so I guess for once I want to answer the question I've been asked, instead of going my own way.

The Chair: So you obviously don't plan to run for public office.

Mr. Pierre Fortin: Thank you.

First of all, I think setting an inflation target range is a reasonable way of conducting monetary policy in a country operating under a flexible exchange rate regime. It helps stabilize inflation expectations and gives a clear signal to public and private sector agents as to what monetary policy is up to and how it is going to react under various circumstances. In other words, this reduces uncertainty and is very good for the economy.

Second, the objective initially stated by the Bank of Canada in February 1991 was to achieve the goal of price stability. Since 1995, the inflation target range has been 1% to 3%, and the official target is the midpoint of this band, which is essentially 2%.

There's one general criterion for choosing an inflation target that the bank has stated officially. That criterion is that the target should be set at the level of inflation that allows the economy to post the best performance over time in terms of the level and rate of growth of national income and employment. The Bank of Canada believes this optimal state is achieved when the true inflation rate is zero—a situation it calls price stability. The bank's 1990 annual report contains essentially everything there is to learn from their views about this. I don't think they have changed their views concerning this.

Our imperfect methods, however, of measuring inflation imply that our measured inflation rate overstates the true inflation rate. In 1991, the bank stated, “The work done to date on an operational definition of price stability indicates a rate of increase in the CPI that is clearly below 2%.” Later, in 1998, two years ago, bank researcher Allan Crawford reported evidence that price stability meant a rate of increase in the CPI of probably about 0.5% per year, and no higher than 0.7% per year. In other words, there was an advance over what was said in 1991. They said price stability was an inflation rate of the CPI clearly below 2%. Then in 1998, they said they understood it was clearly below 1%. So this is... not necessarily the advance, because it may be wrong, we don't know, but there's a definite evolution in their views.

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If the bank still holds the view expressed by Crawford in 1998, it should logically ask for a further reduction in the official target below 2%. A 1% target is a possible request. I don't know if they're going to ask for this, either privately to the Minister of Finance or in public to you, but it's certainly a possible request. It would be a logical step, following what they said in 1998. That would bring the target range down from 1% to 3% to 0% to 2%.

However, some research done outside the Bank of Canada during the 1990s has questioned the view that price stability—that is, a true inflation rate of 0% or a measured CPI inflation rate of 0.5%—maximizes output and employment over time.

This kind of research has two strands. The first strand finds evidence that firms and workers strongly resist absolute wage cuts in the United States and Canada—a conjecture that was first made by the American Nobel laureate, James Tobin, in 1972.

The second more recent strand finds alternative evidence that information on inflation could be under-exploited by wage and price setters when the inflation rate is very low, which would allow permanent gains in terms of lower unemployment to be made by raising the inflation rate up to a point. That conjecture was made by the late Harvard economist, Otto Eckstein, also in 1972. That was a vintage year for people who believed you could trade off a little bit more unemployment against a little bit more inflation.

Both the Tobin and the Eckstein hypotheses—these are not twits; one was a Nobel laureate and the other was a famous Harvard professor—would imply that very low rates of inflation could be sustained only at the cost of permanently higher unemployment and lower output. For example, aiming for an inflation rate of 2% could entail a permanent unemployment rate one point higher than aiming for an inflation rate of 3% on this limited basis. That would not be extrapolated to higher and higher inflation rates, of course. On this basis, I and Akerlof, Dickens and Perry have advocated keeping inflation at the 2% to 4% target range.

So the committee is in fact facing two contradictory recommendations: to lower the inflation target range from the current 1% to 3% to 0% to 2%, following logically what the bank has said in recent years; or to raise it to 2% to 4%, depending on who is right—the Bank of Canada research department or Tobin, Eckstein, Akerlof and me.

I suggest that under the current uncertainty about who is right, the best decision is to raise the target range to 2% to 4%. The basis for this statement is that contemporary literature provides no evidence whatsoever that there is any significant output cost from shifting the average inflation rate anywhere between 0% and 4%, while according to the standard macroeconomic rule called Okun's Law, having a 1% lower unemployment rate on average would bring an annual income benefit of some $20 billion, which is 2% of GDP, to Canada. That might not sound like much by American standards, but we're Canadians and that is a lot of money.

Under these premises, raising the target range to 2% to 4% would bring only a net negligible cost, if Bank of Canada staff is right, and a substantial net gain if Tobin and company are right. The symmetrical argument is that lowering the target range to 0% to 2% would generate a negligible net gain, if Bank of Canada staff are right, and a substantial net loss if Tobin and company are right. I summarize this sort of payoff matrix of the game under uncertainty in the following table.

The optimal decision of this game is to raise the target range—against lowering it or leaving it unchanged—to the current 1% to 3% under all circumstances, except where the probability of Tobin and company being right is extremely small. The current state of knowledge does not allow anyone to be sure that the Bank of Canada staff is right, and Tobin and company wrong, that it would be optimal under uncertainty to lower the target range or to leave it unchanged.

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Of course, the pragmatic alternative would be to widen the existing range from 1% to 3% or 1% to 4% in order to allow for any these possibilities, and then leave progress of economic knowledge over the next decade to decide over the issue.

That is the main thing I wanted to say to the committee. I wanted to focus on the questions I was asked to answer—namely, how do we set the target, and what are my views in terms of setting the inflation target range in Canada for beyond 2001?

I wanted to make a very tight logical argument so that anyone who doesn't take the 2% to 4% target range would look stupid.

Voices: Oh, oh!

Mr. Pierre Fortin: I exaggerate, but it's more or less what I wanted to do. There are a couple of points that could be raised later, but I don't want to overutilize my time.

First of all, I think there's been a significant improvement in the strategy of monetary policy over the last three years. Some of this is clear from the content of the last two monetary policy reports. I think this is absolutely required reading for anyone who wants to understand the tremendous evolution and thinking that has been going on at the Bank of Canada compared with the first half of the 1990s.

There are two points the bank makes in those reports. The first is that it has stopped underestimating slack in the economy. It has changed its method of estimating how much slack remains in the economy. We can discuss this further. Let me give you a simple example.

In 1997, when the unemployment rate in Canada was a little bit over 9%, there was a sort of panic at the Bank of Canada that, gee, we're very close to full employment—that is, the unemployment rate below which inflation would start to go up again in an uncontrolled way. That bottom was 8.5% unemployment. Since then the unemployment rate in Canada has declined almost two points and there's no increase in core inflation in sight.

Of course, the bank has acknowledged this openly. I think it's absolutely great that there has been an evolution in their thinking in this respect.

The second point they are admitting is that the economy's response to changes in the real exchange rate may be long and uncertain. There are long and uncertain lags of the economy responding to changes in the real exchange rate. That makes it significantly difficult for the bank to manage the economy in the short run.

That of course is the basis for those who advocate either a fixed exchange rate of the Bretton Woods type—Tom Courchene in Kingston, for example—to the other extreme, to people who advocate going to the U.S. dollar for a fixed exchange rate regime. Even if we don't agree that a fixed exchange rate regime is what is needed in Canada, what should be clear is that the bank has an extremely difficult time managing the exchange rate within its monetary conditions index.

So that's where we are, and what we're here to discuss. Thank you very much.

The Chair: Thank you very much.

Mr. Pierre Fortin: How did I do in time?

The Chair: You were just perfect.

Mr. Pierre Fortin: You mean in content?

Voices: Oh, oh!

The Chair: No, no, we're talking about time.

Mr. McCallum.

Mr. John McCallum (Senior Vice-President and Chief Economist, Royal Bank of Canada): Thank you, Mr. Chair.

Well, I was going to focus mainly on your third question, about exchange rate regimes, partly because that's one of my favourite topics, and I couldn't come to your third meeting, where that is explicitly the topic. But it does come into the second one.

I'd also like to say a little bit about inflation targets. Pierre characterized the two extremes—the Bank of Canada 0% to 2%, himself 2% to 4%—but I'll be the voice of sweet reasonableness: how about 1% to 3%?

I do agree with Pierre that there's a need for more research to be done. My reading of it, although I admit I haven't looked at it very recently, is that the findings are not terribly robust. The Bank of Canada has its own evidence that it says shows Pierre is wrong. I think that needs to be revisited closer to the time of the decision, but my last reading of it is that it's not terribly robust.

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I think it's important for Canada not to be wildly out of line with our major trading partners. I think the markets would go berserk if the Bank of Canada all of sudden announced it was raising its inflation targets to 2% to 4%. I think having it the same would be okay, but Europe, I think, has a maximum as well. The Fed doesn't have official targets, but I don't think they'd ever accept 4%. The U.K. and Australia and other countries are not about to let inflation get up to 4%.

So I think we'd be out of step with our major trading partners if we were to move in that direction, and I think we could anticipate a very negative market reaction.

I think the whole world is going to much less tolerance of inflation, and I wouldn't want to go above the status quo, which is 1% to 3%, but neither am I convinced today that we necessarily have to go lower. I think 1% to 3% has served us quite well. I think we'd have to revisit the evidence closer to the time, look at what our trading partners are doing and so on.

As of now, then, with the information I have, I would say 1% to 3% is just fine.

Now let me come to currency regimes. I guess I'd make three or four points here.

First of all, in today's world I don't think there's a midway house.

Oh, thank you, Pierre. We may disagree on some things, but he gives me water.

I think many economists would agree that you have to be black or white in today's world of highly mobile capital. You can't be half pregnant, if you'll excuse the term. In other words, you either have to have what we have, which is flexible exchange rates with inflation targets, or go all the way to the other extreme and have dollarization, use the U.S. dollar or perhaps a currency union, as in Hong Kong or Argentina. But the one thing you can't have in today's world of hugely mobile capital is a simple pegged exchange rate, as we had in the 1960s.

I think the biggest evidence in favour of that point of view is that if you look at OECD countries today and ask how many of all those countries have a simple pegged exchange rate as defined by the IMF, the answer is “Not one.” Some have wider pegs, some have dirty floating; not one has a simple peg. Some countries, such as Greece, are on their way to the Euro; and other countries, such as Canada, Sweden, and the U.K.—well, the U.K. may be on their way to the Euro—have flexible exchange rates with inflation targets.

So when we have this debate in Canada, realistically I think we have to choose between what we have today and either using the U.S. dollar or having a currency board, as they do in Argentina or Hong Kong.

My second point is that I think this is almost entirely an academic debate that's not going to go anywhere in the real world. I say that especially with respect to English Canada. Quebec is a bit different.

Pierre and I were two participants in a debate with the Montreal Board of Trade a few weeks ago. I was on the side of the status quo—my partner was John Crow—and he was on the side of dollarization or currency board, along with Marcel Côté.

Mr. Pierre Fortin: Well, this is not...

Mr. John McCallum: Currency board, I thought. That's what I thought I heard.

The Chair: It's okay. We'll get the tape of the debate and we'll figure it out.

Keep going.

Mr. John McCallum: I bring up this topic because we had a big audience in Montreal. There was another big conference in Montreal with Bernard Landry and others participating.

My point is, it's no coincidence that these events took place in Montreal. The same people who organized our Montreal Board of Trade debate approached the Toronto Board of Trade for a similar debate, and they were told there was insufficient interest.

For various reasons, which Pierre could probably explain better than I could, there is some interest in this in the business community, in the academic community, and in the political community in Quebec, but I think only a handful of academics and a very small handful of business people in English Canada treat seriously at all this extreme idea of moving to dollarization or even to a currency board.

Since you raised the topic, however, I'll make three more points on it. As I mentioned, there are three reasons as to why I oppose this.

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The first is that Canada is not Argentina or Mexico or Brazil. We have achieved, at significant cost, both fiscal and monetary discipline. We achieved monetary discipline under John Crow when we got our inflation down to a very low number. We achieved fiscal discipline under Paul Martin and others when we converted deficits into surpluses.

As I think everyone would agree, we paid a price. It wasn't free. It was costly for Canada and Canadians to achieve these disciplines. But the point is that we did. The prize for that is that as of today our interest rates are slightly lower than those of the Americans, whereas all those other countries are way higher. So we are not in the same category.

My second point is that, having achieved the discipline, it is valuable to have flexibility, because the structure of Canada is very different from the structure of the U.S. and we are subject to different kinds of shocks. We have that flexible exchange rate that is something of a buffer to shield us from shocks, to improve our economic performance.

There's no better example of that than the Asia crisis, when commodity prices around the globe tumbled, when resource-based economies—and we are still to a significant degree resource-based, though less than before—like Canada, Chili, Australia, and New Zealand all took a substantial hit on their currency. Canada is more than halfway back to where we were before the crisis, so hopefully it's a temporary hit, but we took this hit, which helped the resource sectors to accommodate the shock, which helped the manufacturing sector to increase exports, and as a consequence our economy has performed very well through the Asia crisis and since.

The question I ask is, what is the alternative? We had to take that hit somehow. The alternative would have been to draw the line in the sand at some fixed exchange rate and allow, assuming we had a currency board, interest rates to go through the roof to whatever level would have been necessary to defend that currency. I submit we may well have had a downturn or a recession, and I would rather take that temporary hit on our dollar rather than take the hit in the form of skyhigh interest rates and an economic downturn. I think that's just one example—the most recent one, but a powerful example—as to the benefits of this exchange rate flexibility, given that one has acquired, at great cost, the discipline.

The final point I'd make—and I'm only one minute over—is that there are always costs and benefits to different things, and the one cost to the present system compared with the alternative of currency board or dollarization is that it is certainly true that exchange rate volatility, the fact that you don't know what the currency will be in the future, makes trade more difficult. It makes it harder for businesses to plan their trade or to make their location decisions when they don't know with certainty what the currency will be. If we just used the U.S. dollar, you'd obviously know the currency would be one U.S. dollar. So that is a point.

My argument there is that the burden of proof rests with those proposing major change. Over the course of the last decade, we had quite a lot of currency volatility, but we also had nothing less than an explosion of Canada-U.S. trade. So how can people say that this currency volatility is a huge barrier to trade, when we had fantastic growth in Canada-U.S. trade, more than a doubling? It was way more than anybody predicted before the free trade agreement was signed.

There is also international evidence. I'll quote American economists like Jeffrey Frankel, who finds, looking at a whole bunch of countries, that currency volatility doesn't appear to be a significant impediment to trade.

Given that we've achieved the fiscal and monetary discipline, given that flexibility is beneficial in an uncertain world when all sorts of shocks can hit us, given that our system has worked well over the last few years, I would be very much opposed to a radical shift to dollarization or currency board. However, it's an academic point, if you believe my first point, because I think this is just a flash in the pan, a fashionable idea in some academic circles, and it really isn't going to go much further than that.

Thank you very much.

The Chair: Thank you very much, Mr. McCallum.

We'll now hear from Bernard Élie. Welcome.

[Translation]

Mr. Bernard Élie (Individual Presentation): [Professor, Department of Economics, University of Quebec (Montreal)] Thank you for inviting me here.

I was notified only a few days ago, so I was not able to prepare a text. However, I will be quite clear and I will not speak too fast, for the sake of the interpreters.

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When I saw the issues that you wished to discuss, I told myself that you wanted to know whether Canada is capable of having an effective, independent monetary policy. The problem is that the economic situation or economic environment of the year 2000 has undergone huge changes in the past few years. This is certainly not the same situation that prevailed at the time of the Bretton Woods Agreements after the Second World War, when it was easy for governments to sign an agreement that provided for fixed exchange rates, since private capital markets were very small then, which is no longer the case now. It was therefore possible, in keeping with Bretton Woods, in the spirit of the times, to request or ensure freedom of payments, stability of payments and permanency by means of certain measures, including fixed exchange rates.

Of course, we no longer have this situation today. Just to give you an idea of the magnitude and volatility of private capital flows I will refer to the survey of currency markets conducted every three years by the Bank for International Settlements, with the help of the major central banks, including the Bank of Canada. The most recent survey was done in April 1998, and the first was conducted in April 1986.

In 1986, on the world's currency markets, for every day of April 1986, there was the equivalent of US$188 billion in transactions. Twelve years later, in 1998, there are more than 11 times this figure. In other words, on the currency markets in the month of April 1998, the equivalent of US$1,971 billion changes hands every day.

[English]

In American, it's $1 trillion.

[Translation]

These sums are absolutely enormous. To give you an idea of the value of transactions worth the equivalent of US$1,971 billion on currency markets in a single day in April 1998, I could tell you that it represents 80% of the world's entire official reserves. And that is for a single day of transactions.

On Canada's currency markets, in the month of April 1998, the equivalent of US$36 billion changes hands every day. Currently, it is estimated that this figure is approximately $43 billion per day.

These are gigantic amounts, which make it difficulty to manage a monetary policy, especially if the goal is to establish a fixed exchange rate. Currency fixity in such a context is relatively impossible.

Moreover, another important factor that has changed—in addition to this volatility and the volume of capital markets and currency markets in particular—is the role of the American dollar. In 1945, the American dollar was adopted as a reserve currency. In the last six or seven years, in addition to being a reserve currency, the American dollar has become a speculative safe haven currency, which in large part explains the high exchange rate that the American dollar enjoys in relation to the Euro and to the Canadian dollar.

This year, the Americans will have a trade deficit on the order of $350 billion, part of this with Canada. Normally, according to traditional economic theory, a trade deficit of this size should cause the American dollar to fall, which will not happen because this currency has become a safe haven currency.

In some quarters, there is surprise that the Euro is under- evaluated. According to some calculations, it is undervalued by 25% in relation to the American dollar. But the Euro is something of a special case. It is important to realize that the international transactions of the 11 members who make up the European Monetary Union—who will total 12 with Greece in a few months, and who will no doubt be joined by Great Britain in a year or a year and a half—are for the most part—80%—among themselves. Consequently, with the adoption of the Euro, 80% of the transactions of these European nations are done without currency risks, which is much more advantageous for the stability and permanency of commercial exchanges.

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It is obvious that, in North America, we have a long way to go before reaching the level of political and economic coherency that is found in Europe, and it is clearly very difficult to imagine, even in a 50-year time frame, that it would be possible, unless a real disaster befell us, to consider a situation similar to that of the Euro.

Consequently, at present, as far as the monetary policy of the Bank of Canada is concerned, given the volatility of the capital markets, maintaining a flexible or floating exchange rate is likely the solution with the least negative impact.

We must remember that, during the Canadian dollar exchange crisis in the summer of 1998, the fall of the Canadian dollar in the month of August and early September 1998, a drop of 7% in relation to the American dollar, nevertheless required that the equivalent of approximately US$15 billion be paid out of the Exchange Fund of Canada to support the Canadian dollar. This amount of $15 billion did not fall from the sky; the federal government had to borrow in order to provide this cash to the Exchange Fund.

That is a huge cost, but the model followed by Argentina or by the nations of South East Asia up to 1997 was no doubt even worse, considering how tough the financial markets can be, given their volume today, in the year 2000.

What must be grasped, in the current context, is that when we talk about the globalization of financial markets, what we are dealing with first and foremost are fluctuations in capital flows that are very great and in the same direction, which amplifies the risk of fluctuation in exchange rates and, hence, interest rates.

The problem we are facing is that, currently, it is very difficult for Canada to strive for an independent monetary policy. Furthermore, the very strict policy that the Bank of Canada applied in the 1990s under Mr. Crow no doubt contributed to the fact that our economic recovery was slower than in the United States.

In addition, the monetary policy followed by the Bank of Canada in recent years has always been similar to the US policy when the Canadian economy was going in the same direction as the American economy. And when the Canadian economy does not go in the same direction as the American economy, the Bank of Canada allows itself to adopt a more autonomous policy.

For the time being, I believe that when the US federal reserve announces an increase in interest rates on Monday, the Bank of Canada will have to do the same on Tuesday morning, on the morning of the 16th, given the current skittishness of the markets.

I will stop here and I will be pleased to answer your questions. Thank you.

The Chairman: Thank you, Mr. Élie.

[English]

We'll now hear from Mr. Krehm.

Mr. William Krehm (Individual Presdentation): [Chairman, Committee on Monetary and Economic Reform] Yes.

The Chair: You were not present when we were going through the format.

Mr. William Krehm: I'm sorry. I came by VIA; they were two hours late. I apologize.

The Chair: That's okay. You have five to ten minutes to make your presentation, and then we'll engage in a question-and-answer session.

Mr. William Krehm: Due to the worldwide gambles that deregulation has permitted them, our banks have already sustained substantial capital losses. Here are the stark figures taken from the Bank of Canada's statistics.

From a high of $1.46 trillion in assets in the second quarter of 1998, they had dropped by the third quarter of 1999 by $71 billion. That happens to be almost $10 billion more than the total capital of the chartered banks.

There's no difficulty in surmising what the origin of much of this loss was. The east Asian meltdown began in mid-1997 and ricocheted through much of the world. Besides, a loss of $71 billion was modest given the leverage. The combination of deregulation and globalization has encouraged our banks to take on risks incompatible with banking.

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In the third quarter of 1999, to which these figures pertain, the meltdown of Internet stocks had not even begun, and our banks in recent years have changed their food chain. They have turned their backs on retail banking to become stock market driven. They have taken over brokerages throughout much of the world. They are underwriting stock issues, expanding into merchant banking, trading in stocks and derivatives on their own account, and it would be a miracle if they have not sustained heavy losses in the current weekly sell-offs of the stock market. We'll know about that seven or eight months down the line.

Losses of such magnitude are particularly serious because bank credit makes up a substantial portion of our money supply, as do stock market winnings. The supreme test of what is money and what is not is this: will the government accept it in payment of its taxes? There has been no instance of the Department of National Revenue returning a payment made with the proceeds of a stock market killing, with the annotation, “Sorry, it stinks.”

That credit is increasingly unavailable to finance small businesses but serves the banks as a financial platform from which they can launch ever more daring casino games. The dogma of monetarism that took over the world's central banks in the early 1980s sees inflation as purely the result of excessive money supply. But since our banks have become stock market driven, the central banks of the world for a long time hesitated to raise interest rates.

High interest rates are deadly to stock markets and hence to our restructured banks. And from watchdogs over banks, the Fed and the BOC have become their servants. But since the sixties and seventies, all other proven methods of controlling inflation have been eliminated.

It used to be possible for the Bank of Canada to increase the reserve requirements to back their deposits and rely less on raising interest rates. But as early as 1967, a bill was slipped through Parliament requiring a special act of Parliament to alter the reserve requirement in Canada. The reserves that the banks had to hold with the Bank of Canada earned them no interest and were phased out altogether to help the banks out of their financial difficulties incurred in the 1970s.

That is how higher interest rates became the one blunt tool—its own expression—available to the central bank to fight inflation with. That explains why so little was done for so long to rein in the hyperinflation of the so-called new economy stocks. But old habits die hard. The central banks, both in the United States and in Canada, had been trained to respond only to even the slightest suspicion of tightness in the labour market.

In 1970, Prime Minister Trudeau was threatening that he would not buckle in the anti-inflation fight, even if the unemployment rate were driven up to 6%. Today, the allegedly tight labour market in Canada has an unemployment rate of 6.9%. Beauty, as ever, is in the beholder's eye.

Thus a few years ago, when the east Asian crisis was already casting its shadow, Governor Thiessen expressed a concern about deflation. Yet within eight days flat, he was back telling the Senate committee that he would regret for the rest of his life having uttered the word “deflation”. Why? And why did next to nobody ask why?

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Central banks today are like medical doctors specializing only in high blood pressure. They do not recognize low blood pressure, even to the point of death. Poor Mr. Thiessen and his vow were not a unique case.

Mr. Greenspan, icon though he has become, in 1996 referred to the irrational exuberance of the stock market in awarding capitalization greater than that of General Motors to an Internet stock that has yet to earn a bean. But the mighty Mr. Greenspan and his colleagues were told to leave stock market prices—I'm quoting from the Wall Street Journal of May 8—the f... alone and concentrate on commodity inflation.

Yet on May 4, Mr. Greenspan addressed a Chicago conference and remarked that the passage in November of landmark legislation removing depression era restrictions on banks getting involved in new areas such as security transactions, insurance, merchant banking, and buying stock in non-financial companies involved new risks for them.

But all this comes late in the day. Mr. Greenspan seems to be perfecting a new style of grave-side eulogy in which the wisdom of safe sex and a Spartan diet is commended to the deceased.

But from this farce, a blood-chilling detail emerges. Our government has no emergency plan to turn to when the stock markets of the world really sit down and the vast bubble of private credit creation collapses. That is why I will devote what time I have left outlining the lifeboats that are still on this unsinkable Titanic that our government will find useful in its coming moment of trial.

Let's begin. I will skip section 14, which establishes the power of the minister to say bye-bye to the governor if he doesn't recognize the government's course.

I will skip subsection 17(2), where it is established that Her Majesty is the sole shareholder of the Bank of Canada. You encounter people in the real world who will dispute that. Such is the scant light on monetary affairs in Canada. The significance of this is that when the Government of Canada borrows money from the Bank of Canada, substantially the interest paid on such debts reverts to the government in the form of dividends, resulting in a near interest-free loan.

Now I come to the important sections of the Bank of Canada Act, because they can acquire—they already have acquired—an extremely great importance.

Subsection 18(3) says there is no legal limit on how many securities issued or guaranteed by the Government of Canada or any province that the BOC may hold. Obviously the Bank of Canada cannot hold an infinite amount of government securities. The point to note is, are there unemployed resources in the country? If there are, then it can hold more.

Paragraph 18(j) empowers the Bank of Canada to make loans to the Government of Canada or the government of any province, but such loans outstanding shall not, in the case of the Government of Canada, exceed one-third of the budget during the fiscal year—one-third is quite a bit of money, as your committee will appreciate—or one-fourth of the current budget of any province, which is also a bit of money. This deals with unfunded debts and has a clear provision for the rollover of maturing loans. This article provides for the rollover.

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It is important to note that the lower levels of government are not shareholders of the Bank of Canada and therefore do not share automatically in the interest paid on their loans from the Bank of Canada, if such existed. But that provides Ottawa with a new dimension for reaching a consensus with the junior governments. In return for their observing national standards, part of the interest on their loans from the Bank of Canada that finds its way into the federal treasury could be refunded to the provinces or the municipalities.

You recognize, without detracting from the great merits of our finance minister, that much of the surplus was taken out of the hides of the municipalities, and they are in great agony. That would do more for national unity than a dozen constitutional conferences.

In the mid-seventies, the Bank of Canada held well over 20% of the outstanding federal debt. Today, it is down to around 5%. There is thus plenty of room for the Bank of Canada to finance essential infrastructural projects at all three levels of government and, by doing so—and this is the important point—replace the money supply that has been and is likely to continue disappearing as the stock market continues its stumble.

That's all I have to say.

The Chair: Thank you very much.

We're going to move to the question-and-answer session. Who's going to start?

[Translation]

Mr. Richard Marceau (Charlesbourg, BQ): I will begin by thanking the witnesses who were so kind as to travel here today. Mr. Krehm, this is the first time that I have had the opportunity to hear you speak and it has been a pleasure for me. I have heard the three witnesses who are with you at other times, and they always had interesting things to say.

Unfortunately, there is not much time available to us. At the start, Mr. Élie mentioned to me that the three points he wanted to discuss were normally the subject of two courses lasting 45 hours. It therefore pains me to have to decide the fate of the Canadian dollar in such a short period of time.

I would first like to ask a question of Mr. Fortin, whom I had the pleasure of hearing at the CORIM last year. Mr. Fortin, you say that the ideal economic solution—and I stress economic—would be to abolish the Canadian dollar and launch North America on a formal process to accede to a monetary union, which is really a fairly interesting proposal. You say that the problem is a political one, and that politicians as a whole, at least Canadian politicians, are not very interested in going down that road.

I was going to say that I remembered—which would have been stretching the truth a bit—but I think that in 1983—and you are more likely to remember this than me—Brian Mulroney, during the Conservative Party leadership race, said no to free trade. He said that there would never be free trade with the United States. It did not show up on the radar screens of Canadian politics. However, a minor development then took place: the MacDonald Commission report was released and changed everything.

What was politically impossible between 1980 and 1983, or even between 1911 and 1983, since Laurier had lost the election over reciprocity in 1911, has undergone a complete transformation. Now, we live in a world where, if you dare to take a position against free trade, at least for North America, you will be called a dinosaur, an endangered species.

• 1630

Do you think it possible, without history repeating itself, that such a thing could happen again, that is, what seems to be politically impossible but economically desirable might lead people to think that the management structure will be put in place afterwards and that, if it is economically the best option, we will end up adopting it?

Mr. Pierre Fortin: I really believe that situations may change. You could have alluded—if you were three years older like me, I am three years older than you—to the 1974 election campaign, when Mr. Trudeau made fun of Mr. Stanfield, saying that there would never be controls, that they made no sense.

However, people do change and do have reasonable opinions. Even Mr. McCallum, for example, might be prepared tomorrow morning to accept 2 to 4%, if he realized that the normal inflation rate in the United States was between 3 and 4%.

Mr. Richard Marceau: He might also become a sovereignist.

Mr. Pierre Fortin: No. That having been said, what I pointed out in the document on the monetary regime that I handed out, is that a currency must be governed not just by the economy, but also by political institutions. I also noted that, currently, Canada and the United States have no such institutions and have not even taken a step in this direction, as the European Union had done.

Secondly, it has absolutely no support from politicians, to whom you referred, and public opinion in Canada is opposed to it. Will Canadians change their mind in the near or more distant future? That is not impossible. Circumstances may lead them to do this.

For example, I personally do not agree with the analysis that was done, to the effect that the flexibility of the Canadian dollar allowed the Canadian economy to weather the Asian flu. I think that what we saw was a sudden drop in the value of the Canadian dollar, a considerable depreciation, followed, in August 1998, and therefore after a certain amount of time, by a sudden, one-point recovery in the interest rate in Canada, followed by progressively lower rates in keeping with American interest rates.

All of these signals are contradictory, in one sense or another, depending on the economic sector that is being examined, either the sector that is sensitive to exchange rates, or the sector that is sensitive to interest rates, and because of the very short term over which all of this took place.

We know, however, that it takes a great deal of time before the impact of interest rates and exchange rates is felt. My feeling is that the measures taken by the central bank, although done with the best of intentions, were not effective. The most important thing that Bernard Élie said, a few minutes ago, is that flexibility in the exchange rate, if it is to be acceptable, must allow monetary policy to be both independent and effective.

That is the subject of the current debate. Yes, we have monetary independence, but does it really help Canada have an economic performance that is better than it would have been under a fixed exchange rate system? I do not think so. I believe that, even if it were economically desirable to put in place a monetary union, public opinion is at this time not ready for it. I cannot speculate on the political factors that might cause this opinion to change in the future.

Mr. Richard Marceau: Your comments on that are somewhat similar to those of Mr. McCallum, to the effect that this is a primarily academic debate. I am not so sure.

Perhaps Mr. McCallum and perhaps you as well, Mr. Fortin, if we have time... Last year, this was not on the radar screen—obviously, polls are a snapshot of opinion at a particular time—but the Globe and Mail's latest opinion polls, from last summer, indicated that 77% of Canadians believed that in 20 years the Canadian dollar would no longer exist, and between 37 and 40% of Canadian were in favour of monetary union. In Quebec, over 50% of people held that opinion, for special reasons.

So monetary union, which was considered a non-issue a year ago, is supported by 40% of Canadians. I was really struck by that because I know the symbolic importance of the dollar.

• 1635

During a debate in the House of Commons—my colleagues may remember this—a Liberal colleague recalled that when he delivered newspapers as a boy, the first time he was paid was with a coin that had the word “Canada” written on it. He was proud because that, along with the flag and the national anthem, was a symbol of national identity.

My question to Mr. McCallum will be as follows: do you not think that this debate, which you feel is merely academic, is more than academic, especially considering that the American Congress, the Senate and the House of representatives, is considering the International Monetary Stability Act aimed at promoting the “dollarization” of countries that wanted it, by, among other things, sharing seigniorage?

Mr. John McCallum: I think that there are a couple of things to consider. Regarding the poll, I do not know exactly what the question was, but I would guess that the majority of Canadians who supported the idea of monetary union probably had the impression that one dollar American would equal one dollar Canadian, which would not be the case. But this is just speculation on my part.

You said that it was a political question. It is not just the Canadian political class, but also the American political class. There is no interest in a monetary union involving Mexico, Canada and the United States with one supernational currency. They are not at all interested in that. When the Florida Senator talks about “dollarization”, he is talking about other countries that would use the dollar, but would have no influence on the monetary policy of the United States, and no lender of last resort.

This Florida Senator is more in line with Helms-Burton or the Monroe doctrine than the European style.

Second, where the Canadian situation is concerned, I think that the majority of Canadians and business people would have no interest in attending a debate on this issue in Toronto. So I think that for most business people, it is an academic issue. I think that the fact that the euro was introduced just when the Canadian dollar fell to 63 cents created interest at that time, but the euro has not successfully held its value to this point, and the Canadian dollar is rising. So I feel that this interest will be temporary.

Mr. Richard Marceau: Would I surprise you, Mr. McCallum, if I told you that I had spoken personally to people working in Congress, while we were having a beer or a soft drink, and that some of them were saying that Canada's participation in the Federal Open Market Committee, in one form or another, would be taken into consideration? I am talking about people that cannot be considered in the same category as Senator Helms, but it surprised a little to hear that from them.

Mr. John McCallum: Is 1 seat out of 13 better than 0 out of 13?

Mr. Richard Marceau: Is 1 seat out of 13 better than...

Mr. John McCallum: Zero.

Mr. Richard Marceau: I think so, especially given...

Mr. John McCallum: One out of 13 is still a minority.

Mr. Richard Marceau: Perhaps, but there are two things to keep in mind. First of all, because of the rotation system, the FOMC never has 13 people at the same time; there are 5 out of 12 right now who are on the FOMC and there is a rotation, except for the chairman of the Federal Reserve Bank of New York, who is always there. So in this rotation system, Canada would be on at some point.

There is a second point, in my opinion, that is also important. I do not know if it was you or Professor Élie who said this. On Monday, when the American Federal Reserve Bank increases its rate, the Bank of Canada will do roughly the same thing a few hours later. When one realizes that there are 2 000 billion dollars' worth of transactions every day in the world, what kind of monetary sovereignty does Canada have? Does it have any? Is it possible to have monetary sovereignty? It seems to me the answer is no. So to have our say on North American monetary policy, even though the majority is American, it is better to play a small role than to read the newspapers to find out what Alan Greenspan is doing and see how the Bank of Canada is following suit the next morning.

• 1640

Mr. John McCallum: No country has total sovereignty. We live in a very indirect world. It is true that, most of the time, the Bank of Canada follows along.

Sometimes, there are important episodes, like the Asian crisis, where the Bank of Canada had a choice. The Bank of Canada decided to let the Canadian dollar fall to support the Canadian economy rather than increase interest rates to maintain the currency or exchange rate.

[English]

The proof of the pudding is in the eating.

[Translation]

The growth rate in 1998, the year of the Asian crisis, was very satisfactory, despite our situation and our resource-driven economy, and the following year was even stronger. So during this period, the Bank of Canada had a choice. The Bank of Canada acted and the economy grew very well.

Mr. Bernard Élie: The real problem is the monetary flow at the international level. If the monetary policy is not fully effective today, it is because of that problem.

There are two ways to resolve the problem; one way is through a single currency, which means that there is no exchange rate risk. In Canada, the standard of living in Newfoundland is lower than in Toronto. One dollar Canadian is worth one dollar Canadian in both places, but someone in Newfoundland cannot buy a house in the outskirts of Toronto. That is a single currency.

The other solution is to reintroduce rules into the national arena, to replace the old Bretton Woods Agreements with new agreements to regulate financial markets and prevent short-term capital from being so hugely speculative.

Politically, then, I do not believe that in the short term the Americans are prepared to make room for their Canadian neighbours, even though they love us, and I do not think that the Americans are prepared to lose the American dollar in favour of a currency that would not be identified with them, since they have an advantage under the current system. The entire world advances them credit.

Earlier on, I mentioned the $350 billion trade deficit for this year. For the Americans, that means that foreigners are lending them this money. The Americans are accumulating an ever- increasing foreign debt. The largest foreign debt in the world is that of the US, but that debt is in American dollars. So German insurance companies and Canadian banks and Japanese investment firms have no interest in seeing the American dollar fall, especially since the American dollar is used as a safe currency.

So the real problem at present, in my opinion, Mr. Marceau, is the need to establish new rules at the international level for the flow of capital. Perhaps Mr. Martin's committee, the Group of Twenty Committee, will come up with something, but for now, the problem remains.

[English]

Mr. William Krehm: I disagree that the matter of dollarizing our currency is purely academic. The blessed Thomas d'Aquino is not given to pure academic considerations. Do you notice how persistently his organization raises the matter of dollarizing, doing away with the currency? I should say that would put us in the sequence of what has become a sorry tradition.

You know, the United States of America didn't do away with its reserve requirements; it stands at 3%. Germany, the Bundesbank, didn't do away with the reserve currency; it stands at 2%. But Canada, which did not have the IMF at our door or in our door, did. Why? Canada and little New Zealand had some passing exchange difficulties because we had been treated as a colony, and we are being treated as a colony. It's not only that the dollar is a pretty thing—it is, and we all have our patriotic reaction—but in a squeeze, you have two alternatives. Keynes spelled this out. You can maintain your currency at a proud level, and then have to bash all classes on the head—cut down their standard of living—or adapt it.

• 1645

I agree with Mr. McCallum entirely. The Bank of Canada responded relatively well—I always must qualify my praise of the Bank of Canada—during the Asian crisis.

You know, those currencies, like the Argentinian, that in one way or another were dollarized are going through hell. There was a long article in the Wall Street Journal just a few days ago saying that Brazilian imports are flooding the Argentinian market. The Brazilians lowered their currency—they say clumsily—but Brazil is prospering. Argentina has a high rate of employment, and a trade war has sprung up between the two that is threatening MERCOSUR. Thus internationalization, globalization solves all problems.

It cannot be just an academic question, because it involves the distribution of hundreds of billions of dollars. I know there'll be many supporters in academe who honestly, sincerely, and interestingly support it, but it's more than that.

Mr. John McCallum: Just as a question of fact, neither Tom d'Aquino nor the BCNI supports it.

Mr. William Krehm: He's been advocating it succinctly.

Mr. John McCallum: He hasn't.

Mr. Pierre Fortin: Which one—the philosopher or the economist?

Mr. William Krehm: The philosopher is in heaven. About the ultimate destination of the earthly one, I do not know.

The Chair: Thanks for clarifying that point, because that's quite accurate, Mr. Krehm.

Mr. William Krehm: If he does not support it, then the Globe and Mail has been wrong.

Mr. John McCallum: No.

Mr. William Krehm: There was a trio. There was an American professor from some middle American state.

Mr. John McCallum: I've discussed it with him many times. He does not.

Mr. William Krehm: Well, he's changed.

The Chair: We all change.

Mr. William Krehm: You owe the Globe and Mail a letter to the editor.

The Chair: Mr. Fortin.

Mr. Pierre Fortin: I'm reluctant to follow those who argue that the Bank of Canada management of monetary conditions during the Asian crisis was effective in protecting Canada from the Asian flu. Certainly there was a lot of agitation in the exchange rate and in the interest rate in Canada, but I've yet to see any evidence that this agitation—the exchange rate going down and then up, and the interest rate going up and then down—had any effect on the course the Canadian economy would have followed otherwise. Of course, the exchange rate depreciation meant there was a big equalization payment from all Canadians to Canadian exporters—that's for sure—and perhaps to some regions, but in terms of the level of general economic activity, I don't see any evidence of that.

Second, concerning the opinion of business people on currency, I see a split right in the middle between those in the financial services industry who support exchange rate flexibility in general, and those in the real sectors in the economy, like the manufacturing sector, who are much more in favour of fixing the value of the Canadian dollar, a North American monetary union, and things like that. I think the business community is concerned about this issue, and their opinion is very different, depending on which industry they are.

The Chair: Are there any further comments?

Mr. John McCallum: Just to disagree with Pierre, I don't have scientific evidence on this, but I think the division within the business community is much more between Quebec and the rest of the country. In Quebec, I think there's fairly strong support—I don't know if it's as much as half, but it's a significant fraction—from the business community across sectors.

There are a lot of people I know in banking who are among the strongest supporters of dollarization, and there are a lot of people in the resource sector who are very much in favour of the flexible currency. You might not think it made any difference in the Asian crisis, but I can tell you that people in the oil sector, forestry sector, and mining sector sure thought it made a difference, and they don't want it fixed.

• 1650

Mr. Pierre Fortin: Sure, because it means a lot more money for them.

Mr. John McCallum: Yes, and it also means more jobs in their sectors. So it's partly a question of geography, but I think outside Quebec there's minimal support for this idea in the business community, in whatever sector.

The Chair: Thank you. Well, presumably you both deal with business people. Why is there this discrepancy? Mr. Fortin, are you speaking to basically business people in the province of Quebec versus nationally?

Mr. Pierre Fortin: I think this is a very touchy issue. It doesn't have to do with the PQ or whatever. It's quite obvious that the Quebec provincial government supports monetary union, dollarization, or whatever aspect of fixed exchange rate regime for Canada. But beyond that, I think currency is a basic symbolic instrument for a country. You recognize yourself in the currency. The example was given of the person who got his first salary and was proud to be a Canadian.

I think in Quebec people feel extremely secure in their identity as Canadians and Quebeckers—Quebeckers and Canadians. Quebec for me is part of Canada, therefore when they feel like Quebeckers, they feel Canadian. For example, the most important leisure activity is watching television. In Quebec, 95% of people watch Canadian television. In the rest of the country, the percentage is much lower.

In very many aspects, the penetration of American culture into Canada is more profound in English Canada, for obvious reasons, than in Quebec. You have to understand that the average Canadian outside of French Quebec suddenly becomes very concerned about this. When you say not only is everyone going to watch American television and have free trade, but we're going to flush our currency, they suddenly rise to the flag and say they don't want that. That's understandable.

Because people in Quebec have an additional shield of protection against American culture, they don't feel that urge to rise to the flag and defend the Canadian identity through the currency. That is my interpretation. You should recognize that in that interpretation I'm acting as an amateur psychologist. I'm not a true expert.

The Chair: We'll note that.

Mr. McCallum.

Mr. John McCallum: I agree with everything Pierre just said, even though I'm also an amateur sociologist. Mr. Krehm and I agreed a minute ago, so I'm not sure if that means I should revise my opinion, given your other... But I appreciate that.

I just want to say one thing. You talked about our evidence. My evidence is not from polls, but at least once a year I go to each province and give talks to large groups of business people. I try to give a brief talk and then say that in the question period we can talk about this or that or the other. I always talk about the common currency and what I think about it, which you've heard. But when I'm outside of Quebec, hardly anyone comes back on that issue. Nobody challenges my position. Nobody stands up and says they think we should do it, whereas in Quebec they do. So that's not terribly scientific, but it's something.

[Translation]

An Hon. member: Mr. Élie.

Mr. Bernard Élie: I would like to come back to Mr. McCallum's position. It is somewhat amusing to hear a representative of Canada's big banks say that the business sector does not agree with the idea of having a North American monetary union, since we know that approximately half of the transactions of the major Canadian banks are done in American dollars.

• 1655

Moreover, the major Canadian banks are expending their activities considerably in the United States, and Mr. Martin is expected to introduce a new bill to amend the Bank Act soon. Everyone is waiting for it impatiently. I do not know whether American capital will be able to take over control of our big Canadian banks or not, or whether the middle-sized banks will be dominated by American money.

So this is somewhat amusing. Mr. McCallum is against a common currency and in favour of flexibility, but the major Canadian banks do a lot of their business, as much as half of their business, in American dollars. It is a bit contradictory.

Mr. John McCallum: Yes, but I did my study as an economist. I said what I thought. It was not approved by the Board of Directors or the Chairman of the Royal Bank. I was not looking at what was good for the banks, but what I felt was good for the economy.

[English]

The Chair: Mr. Limoges.

Mr. Rick Limoges (Windsor—St. Clair, Lib.): Thank you, Mr. Chairman.

I assume that we can discuss other than just the exchange rate.

The Chair: Yes.

Mr. Rick Limoges: I'd like to get back to some statements started off by Monsieur Fortin with regard to his hypothesis—or the hypothesis of others as well—on the relationship between unemployment and inflation. You quoted Tobin and Eckstein and so on. In saying that we ought to be setting a higher target range, I'm wondering what your feelings or thoughts are with regard to the other ramifications of setting a higher target and the way that would be perceived around the world in particular?

Mr. Pierre Fortin: The 2% to 4% target range is exactly the one that the United States has observed over the last decade implicitly. At some point there was a decline in the consumer price index rate of increase in the United States below 2%, but that was in the midst of a very sharp appreciation of the U.S. dollar, accompanied by a significant drop in commodity prices. Of course, at that point those big shocks tend to lower inflation temporarily.

But if you look at normal times over the last 10 years, the CPI inflation rate in the United States has been between 2% and 4%. It's been sometimes between 3% and 4%, sometimes between 2% and 3%. I don't see that saying loudly to the world that we're going to do exactly the same thing as the Federal Reserve Board is doing, that we're going to send them, as John McCallum said, berserk.

Of course I agree that in the very short run saying it's not going to be 1% to 3%, but 2% to 4% or 1% to 4%, might raise some eyebrows here and there, but I think this is a public relations thing that can be managed and the bank is very clever at this sort of thing.

Mr. Rick Limoges: But I think we have to acknowledge the fragile nature of our very tiny economy beside the giant—

Mr. Pierre Fortin: Sure, but don't forget that there is a stake of at least $20 billion and one percentage point in the unemployment rate permanently involved in this. In other words, it may very well be both a humane and economic calculus that we would like to weather through such a temporary nervousness in Toronto or New York about this for a long term, permanent gain in terms of lower unemployment. I'm not saying it's going to be there, but the probability is sufficiently high that there be a gain that it would be worth going for it.

Mr. Rick Limoges: I live in Windsor, and one of the things that are noticed by most people, since we're so close to the border, is that frankly, even with the wide variance in our exchange rates over the last number of years, the fact that we've had lower inflation in Canada has borne itself out in the fact that it doesn't pay to go shopping in the U.S. Frankly, most goods and services are more affordable in Canada.

• 1700

Mr. Pierre Fortin: Absolutely.

Mr. Rick Limoges: That is something that people, when they comparison shop, find quite positive about our economic situation here in Canada.

Mr. Pierre Fortin: Absolutely. I agree with you.

Mr. Rick Limoges: Getting back to exchange rates, with globalization and the situation we have now with the need for capital, and all these start-ups and high-tech firms and so on, and also the fact that most corporations—very large, successful corporations—are multinationals and so on, can we think in the same terms when we're thinking about currency? Do we need a global-sized currency, or can we survive in the long term with a currency that is underpinned by an economy the size of Canada's in relation to the rest of the world?

Mr. Pierre Fortin: My perception is that we can survive. It's not the gulag. We can live with the Canadian dollar flexibility, and sometimes it can be helpful, I'm not denying that. But it may hurt, and it could hurt to the extent that the fraction of our economy that is tied to the international economy has been increasing over time, not only financially, which Bernard has emphasized, but also on the trade side, as John has emphasized. Our economy is more sensitive to exchange rate changes because it has a larger percentage connected with the international economy.

I think that with the much larger fraction of our economy connected to outside markets, Canadian firms will look more and more to take expansion outside of Canada too, which is on the one hand a normal thing. If you have a portfolio of plants, you should look at places all over the world. But what I wouldn't like is that the volatility of the Canadian dollar relative to the U.S. dollar be one of those arguments.

Mr. Rick Limoges: Yes, you have to take that out of the decision.

Mr. Pierre Fortin: Yes. I've been a director of a manufacturing company in Quebec that has made the decision to expand in the United States, and the exchange rate volatility situation was a major factor. This I don't like. Of course you can bring in all sorts of international macroeconomic evidence that so far exchange rate volatility doesn't seem to hurt trade expansion, but I've lived through this experience. I'm making exactly the same kind of argument we might have when we discuss the brain drain, for example. You don't see evidence that there is a brain drain and that it is significant, but I've seen three friends of my children move to the United States in the last two years. It seems to me that this may be anecdotal, but it's real.

Mr. Rick Limoges: But the companies in Canada, or companies nowadays, seem to be able to manage the exchange rate risk much better than they have in the past.

Mr. Pierre Fortin: Yes, absolutely.

Mr. Rick Limoges: The other thing I would like to throw out is that many companies—I'm very familiar with many companies that do—of course trade back and forth over the border and in fact may be buying some of their product and then finishing it and shipping it back. They're dealing with exchange rate variances, and sometimes the exchange rate in fact is their profit margin.

Mr. Pierre Fortin: Yes.

Mr. Rick Limoges: I'm just wondering how. Mr. McCallum, maybe you would have some comments on these issues as well.

Mr. John McCallum: Yes, as I was saying, I do think the onus of proof is on those who say it's such a terrible thing for trade. In the evidence I've seen both internationally and in our own experience in the last decade—as you from Windsor would have realized—there's been a huge increase in trade in the last ten years and people somehow managed that currency volatility. It hasn't stopped trade from exploding.

I think on the direct investment side, yes, it's a factor, and so some Canadian investment will go out partly for that reason. But we've also had huge inflows of foreign direct investment. What we've had over the last five or six years is huge flows both ways.

• 1705

Mr. Rick Limoges: Multinational corporations that have decided to build something in Canada, for example, because of the exchange rate differential, or it's cheaper labour—

Mr. John McCallum: Or because our costs are lower. When I said that—

Mr. Pierre Fortin: You're confusing mean and variance.

Mr. John McCallum: Now you're confusing me.

Mr. William Krehm: It's the state of the world.

Mr. John McCallum: I said that dollarization was an academic issue, but what I'm trying to say is that in terms of the location of business investment, whether it's Canadian or foreign, we want it to be north of the border as much as possible. I think the major element in this that we should attack, which is definitely not an academic issue, is any remaining border impediments.

If your company wants to invest to make a plant for the whole North American market, to the extent that there are border impediments you will put your plants where 90% of the market is. So I think that is where we should really be serious and forget about this pie-in-the-sky dollarization, which isn't going to happen anyway. So I think that's where we should put our efforts to try to locate investment here.

Finally, there are some economists—for instance, Bob Mundell, who just won a Nobel prize—who think the world is heading towards three or two or one major currencies.

Mr. William Krehm: As in the Euro.

Mr. John McCallum: Yes. I can't imagine the Chinese using the yen. But let's suppose he's right and you have the yen, the U.S. dollar, and the Euro. I'm not suggesting there should be a fourth one, the Canadian dollar. But neither am I saying we should rush this—

Mr. Rick Limoges: But I think you're saying it's academic mostly because it's a non-starter in the current climate—

Mr. John McCallum: Who knows what will happen in 30 years or 40 years? But I think in the foreseeable future it's a non-starter.

The Chair: We'll have to go to Mr. Szabo, Mr. Cullen, and Mr. Brison. We have 20 minutes, so keep your questions and answers short, please.

Mr. Paul Szabo (Mississauga South, Lib.): The issue of the independence of the Bank of Canada is really the fundamental question here. If we were to examine what steps and strategies the governor has directed the bank to since, say, 1996 relative to what the U.S. Federal Reserve Board did, would you see any patterns or co-relations that would either sustain or contradict the independence assertion of the Bank of Canada? Is there a leader and a follower despite the independence that we have?

Mr. John McCallum: I don't know what occurs in the weekly meetings between the minister and the governor, obviously. But by all appearances from the outside, it appears to be an independent policy, as promised. I think since that time, the world has moved towards greater independence. For instance, the European Central Bank on paper is one of the most independent central banks in the world.

One of the smartest things Tony Blair did immediately after his first election in the U.K. was to make the Bank of England independent, much more independent. That allayed any fears that Labour might mess up the economy. I think it helped a lot.

So we might have been ahead of some countries, certainly not the U.S., in terms of independence, but I think it was the right direction and still is.

[Translation]

Mr. Bernard Élie: The Bank of Canada is probably less independent than the Federal Reserve in the United States. Indeed, when Mr. Chrétien came into office, he showed Mr. Crow the door immediately.

In the case of a major disagreement between the Minister of Finance, Mr. Martin, and Mr. Thiessen or his successor, Mr. Martin would win, anyway. So the present federal government and the Minister of Finance are in agreement with the Bank of Canada's monetary policy.

Moreover, Mr. Chrétien and Mr. Thiessen signed a new commitment on the acceptable range of inflation and the continuation of the monetary policy that he criticized when he was in the opposition. The policy has remained the same. Therefore, I believe it would be unrealistic to think of the Bank of Canada being independent, since the federal government or the Finance Minister, which is the main and only shareholder, calls the shots. Mr. Martin plays less of a day-to-day role than he used to be able to, but overall, for the major policy direction, he has final say.

• 1710

[English]

Mr. John McCallum: I don't agree with that at all. On the fact of Mr. Crow not being reappointed, he had come to the end of his term.

The only way the Minister of Finance can get rid of the governor—and this is what came in after the Coyne affair—is that he has to write a public letter instructing the governor to do something, and then the governor would probably resign. But that has never happened—

Mr. Paul Szabo: No.

Mr. John McCallum: —and it probably never would, because assuming that the minister wants the government to be more lax than the government wants, what will that do to the markets if you write a public letter?

Mr. Paul Szabo: Sure.

Mr. John McCallum: So in practice, I think he's pretty independent.

Mr. Paul Szabo: Okay. I do have one other brief question.

The last time the governor was before the finance committee, I laid out for him some charts we had that showed that at the end of the decades of 1950, 1960, 1970, 1980, and 1990 Canada was in recession within a couple of months before or after the end of the decade. If you looked at the charts for interest rates and inflation, there was a clear pattern: rising inflation, rising interest rates. The symmetry was uncanny.

I asked him, “Are you prepared to sustain your estimates now that we're not going to be heading towards a recession at the end of this current decade, which we're now at, and in fact, past?” He said, “I see no evidence and hear no evidence that we're going to go into a recession.”

I wonder whether or not there are any signs that maybe because we hit the end of a millennium, there was this artificial suspension of the entire world to celebrate a millennium and to do a whole bunch of things that only happen once in a millennium, but now all of a sudden there are interest rate pressures, inflation is rising to the upper end of the accepted range, and employment is stagnant. We hit a first month where we didn't have any growth; we broke the 19-month cycle. All of a sudden, with some of these fundamental indicators and the dollar having remained relatively anemic all during this period, it doesn't paint a really good picture.

So how could even establishing a target or changing a target range on inflation really accomplish anything without an attendant change in some other elements of monetary policy?

The scenario seems to be evolving slowly and changing, and I just can't believe we're going to be in endless economic growth. There is going to be a downturn eventually, a correction. What signals are there that the Bank of Canada is at least preparing for that? When do we expect action in terms of either interest rates...

The Chair: Mr. McCallum.

Mr. John McCallum: I'll be very fast.

First, the business cycle isn't dead. We're going to have another recession sometime; we just don't know when.

Second, expansions don't die a natural death. Just because they've gone on seven years doesn't make it more likely that the eighth year will be bad.

Third, I think the situation today is about as healthy as it gets. We have low inflation; we have surpluses. Other than the last month or so, where we've had a little slowdown, I agree, if that continues, we might have more of a problem, but I think we have had very solid growth and a pretty sound economy. I think the U.S. is getting overheated. We're going to have a rate hike, half a point, hopefully not more than that. The stock market might correct, but we don't have a property boom, so it will be more like 1987.

Mr. Pierre Fortin: The fine-tuning is good.

Mr. John McCallum: So it looks pretty good to me.

The Chair: Thank you, Mr. Szabo.

I want to give Mr. Brison a chance to ask a question. He has to leave because he has private members' hour. So if Mr. Brison could ask his questions, we'll then go back to you, if you have any further questions, and to Mr. Cullen.

Mr. Scott Brison (Kings—Hants, PC): Thank you, Mr. Chairman. I have a couple of quick questions.

First, without a floating exchange rate mechanism, wouldn't the operative mechanism be unemployment rates? In the event of an Asian crisis or something like that, which would affect, for instance, commodity prices, that kind of hit, wouldn't that have reflected itself in Canada with higher unemployment rates, and wouldn't that have been more deleterious than what happened with our floating exchange rate mechanism?

Mr. Pierre Fortin: You're asking what my views are on that?

Mr. Scott Brison: That's right.

• 1715

Mr. Pierre Fortin: I think if we had had a fixed exchange rate situation, a credible one, which is a strong assumption to make because it would be difficult unless we had a monetary union, as John has emphasized, first of all, we wouldn't have had such an incredible difference in unemployment rates with the United States during the whole of the 1990s.

If you look at the excess unemployment rates, at the number of point years of unemployment rates in excess of the minimum sustainable non-inflationary, it's about 30 points during the 1990s in Canada and 10 points in the United States. Much of this came because we had much higher interest rates in Canada than in the United States. So Canada was in a situation where it was lowering interest rates in order to bring unemployment back to a reasonable situation. We wouldn't have had this situation if we had had a fixed exchange rate with the United States.

What happened during the Asian crisis was that essentially, if you look at the United States, they lowered their interest rate by three-quarters of a point and they weathered it. If we had been in the situation of a fixed exchange rate, that is exactly what would have happened in Canada. We would essentially have imported the reduction in interest rates, and our exchange rate wouldn't have gone down and then up again later.

So I don't see that the macroeconomic situation would have been very different from what we've had with the interest rate going up and then down, and the exchange rate going down and then up, except that there was much more volatility in the two under a fixed...

I'm sorry to have taken so much time, but that's it.

Mr. Scott Brison: Does anyone else want to comment quickly?

Mr. John McCallum: I agree with you, because you just said what I was saying.

It depends where you start. If Pierre goes back to his favourite point in history as to when the monetary union started, then you might have a different answer, but I'm just talking in the context of the Asian crisis.

Mr. Scott Brison: The other question is one of economic fundamentals. The Maastricht Treaty required at that time, I think, that the debt-to-GDP ratios of the countries had to be less than 60% and deficit-to-GDP ratios had to be less than 3%. Clearly the difference between Canada and the U.S. in terms of debt-to-GDP ratios is significant. Particularly, the U.S. has one plan that would see the debt eliminated within 13 years.

Is it possible to have a monetary union with that type of disparity? Wouldn't it be problematic if we were to enter now, arguably at a time of fiscal weakness or disadvantage relative to the U.S.? Wouldn't it be problematic to put ourselves into that situation at this point?

Mr. Pierre Fortin: I think there would have to be a transition period. But let me tell you that I don't believe that the statement that the Canadian debt situation is very different from that of the United States is a true statement. According to the Maastricht types of calculations, the U.S. has a 48% debt-to-GDP ratio, and we have, including all provincial and federal government debt, something like a 68% ratio. I agree with you that 68% is higher than 48%, and of course we would have to have a transition period, but we're not at 150% in Canada and 30% in the United States. That would be a much more problematic situation.

Mr. Scott Brison: I have one last very quick question, and I apologize for my haste.

The business-to-business e-commerce is targeted to be at $1.3 trillion or something like that within the next three years. The currency of choice for that, particularly business to business, will in all likelihood be the U.S. dollar. Most of that activity is, or is going to be, at least related to or based in the U.S. or by countries that want to access that huge market.

Isn't there a challenge to the Canadian currency, that we could see a Canadian dollar effectively hollowed out by this kind of transition, where people are looking for a currency of choice, and from a technological and globalization perspective this could have a negative impact?

The Chair: Mr. Krehm, do you want to answer?

• 1720

Mr. William Krehm: I just want to issue a caveat.

Picking up the blessed ratio of unemployment or the GDP going up is awfully misleading. Those statistics have more holes in them than Swiss cheese. Even the press—even the academic press—have recognized, for example, that externalities are not considered. You can have a growth in crime; you can have potholes, both in the streets of Toronto and other towns—we're the most prosperous, or used to be—and you can have ambulances running around with emergency patients, but no hospital to receive them. But the GDP goes up. If you looked after these basic things, even to the extent that they were looked after, then our rate of inflation as checked would be somewhat higher.

Look, while you go on looking after business—and after all, you are the Parliament of Canada, and the government, in theory anyway, listens to your committee—consider the fact that things are not fine and fundamentals are not sound, unless we are all blind and deaf.

You are in the midst of a monetary meltdown, not only the stock market. That stock market has produced more of our money, I believe, or as much as the banks... Besides, the banks are into the stock market. So with at least one lobe of our brains, we should continue examining these statistics that we take to be so holy, and ask, where are they leading us?

That's all I wanted to say.

Mr. Scott Brison: Mr. Krehm, I actually have to leave, but I am going to be calling my broker very quickly after this...

Mr. William Krehm: I think you can wait until tomorrow morning. You'll sleep better.

[Translation]

Mr. Bernard Élie: In answer to Mr. Brison's last comment, I can say that the development of e-commerce based on the American dollar will create a big problem for the Canadian dollar and other world currencies. The reason that the euro is valued 25% lower than the American dollar right now is because the American dollar is used as a standard in most international trade transactions, especially where commodities are concerned.

From that perspective, increase in electronic trade will no doubt also weaken the Canadian dollar in the future.

[English]

Mr. John McCallum: Don't take seriously for one moment the thing about the U.S. paying down its debt in 13 years to zero, because this is a civil servant estimate, before any political pressures to tax, cut taxes, or increase spending set in.

Mr. William Krehm: What would they use for money?

Mr. Scott Brison: Thank you very much.

The Chair: Mr. Cullen.

Mr. Roy Cullen (Etobicoke North, Lib.): Thank you, Mr. Chairman.

Thank you, gentlemen. I'm sorry I missed your presentation, so if I'm saying something I missed in your propositions, please excuse me.

Mr. Fortin, if I understand your proposition, it's a proposition that I had an interest in. When I was first elected, I floated the idea of trying to move the inflation band from 1% to 3%, to 2% to 4%. But looking at it now, if you look at the United States, we have contained inflation, low unemployment, and good economic growth, and if you look at Canada, we have good economic growth and relatively low unemployment. And the inflation range in both countries is within the range of 1% to 3%, so I'm surprised you're still advancing...

If your proposition is that we should move the inflation band from 1% to 3%, because in the trade-off between inflation and unemployment, if we trade off... When we go for low inflation, we trade off jobs. If you look at the performance of the U.S. economy, and the Canadian economy to perhaps a lesser extent, it seems to disprove that theory.

Mr. Pierre Fortin: No.

Mr. Roy Cullen: Why am I not surprised?

Mr. Pierre Fortin: Between reasonable people we can discuss this.

What could happen if we had too low a target range is that we would see inflation begin to increase beyond the 2% target, for example. If we maintain the 1% to 3% target range, it means the official target is 2%. In order to maintain 2%, it may be that the Canadian unemployment rate could fall down to, let's say, 6.5%. But if you allowed the inflation rate to be 3%—that is, the official target would be 3%—then it could be that the unemployment rate we could reach would be 5.5%. There's nothing yet that has disproved this.

• 1725

The second point is that in the United States, if you look at the numbers, their inflation rate is closer to 3%, and in recent quarters has sometimes exceeded 3%. In other words, they are using the margin between 2% and 4% fully in order to keep their flexibility. They don't get panicky before it reaches levels like 3.5%.

I agree this is a small percentage point, and I agree that it might look as if—given that we were at 11% to 12% unemployment and we're down now to 6.8% in Canada—we've not needed to have a 2% to 4% inflation target range. But the pressure of the too-low inflation target range will come when we try to lower unemployment from 6.5% to 5.5%. And if we cannot do this because the target range is too low, it will be an important income and employment loss for Canadians.

The Chair: Mr. McCallum.

Mr. John McCallum: I think if you look at inflation, excluding food and energy, the U.S. inflation rate is now about 2.5% over a year ago. So they haven't gone up over 3%, unless you think of the impact of energy. The Bank of Canada uses x food and energy.

But I do think, with all due respect to you, that Mr. Cullen makes a good point, a more general point. The U.S. and the world have changed a lot in the last two or three years, and economists have been consistently wrong. Economists used to say that with any unemployment below 6.5% you'd have rising inflation in the United States.

So I don't know how old those studies are, but I think if you're using them in a debate on what one should do in 2001, they should certainly be updated to take account of what has changed in the last few years. A lot has changed in terms of how we understand the economy.

Mr. Roy Cullen: At the time I investigated it, I talked to a number of economists who would agree at the outset that if you're setting monetary policy, you implicitly trade off employment with inflation—over what term, I don't know. But I could never get any economist to say the reverse is true, that by increasing inflation you're going to create jobs.

Maybe we could come back to that later.

I would like, if I may, Mr. Chairman, to move on to another topic, that of the Canada versus U.S. dollar. And by the way, my own personal view is that I don't support a common currency. Maybe it's emotional, or whatever. But if we come down to three currencies in the world, as you said, Mr. McCallum, I suppose it won't be the Canadian dollar. I just don't think Canadians would support it, and that's another reason I don't support it.

If we look at the Canada versus U.S. dollar, we hear the argument—we heard it this morning—that the market is the final determinant of the pricing. Frankly, I place a lot of importance on how the market is valuing the Canadian dollar, but by the same token, you see in the stock markets how the market can sometimes be irrational.

If you're coming back to the pricing of the Canadian dollar, if you look at the economic conditions in Canada, yes, the debt is too high. We've had good economic growth, low inflation, low unemployment, etc. So there doesn't seem to be that kind of rationale for it, in my mind anyway, with the fiscal situation in Canada.

I apologize if you've covered this in your presentations—I didn't hear it—but I wonder if any of you could give your rationale for the current state of the Canadian dollar vis-à-vis the U.S. dollar and other currencies. How would you explain it?

• 1730

Mr. John McCallum: Since no one else is talking, I will. I don't want to hog too much of the time.

We have done some work on this topic following work done by the Bank of Canada, where we try to explain the Canadian dollar as a function of four things: our inflation relative to the U.S.; our interest rates relative to the U.S.; world commodity prices; and our surpluses or deficits of government relative to the U.S. Over a long period of time, that thing performs well.

Now, it doesn't perform perfectly. It can't explain how we got as low as 63¢. Over the last 25 years, we've had higher inflation than the U.S. has had and we've had falling world commodity prices. We've got deeper into debt than has the U.S. That can explain why we went from parity to 70¢. But it can't explain... There are also bubbles in the market, and the 63¢, I think, was a bubble.

So I think the Canadian dollar is undervalued by perhaps 3¢ or 4¢. But I also think that if you look at the fundamentals, it should maybe be recovering.

The Chair: Mr. Fortin.

Mr. Pierre Fortin: I would agree with that. From a long-term perspective, I think the Canadian dollar is probably too low, because our inflation rate, as was mentioned, is lower than theirs. Commodity prices are bound to recover at some point and we'll go up again.

One point that may have been forgotten—to perhaps try to give you some value added and justify my presence here—is that people don't realize that when you straighten up public finances, as we did with the therapeutic budget of 1995 and later, this should lead to a depreciation of the exchange rate, not an appreciation of the exchange rate. This is essentially because you are shifting demand for goods and services from government to the private sector. That demand has to come partly from consumption but also from the external sector.

In order to generate that additional demand in the external sector, you have to have a lower currency. So contrary to what the financial types argue sometimes, if you rectify the course of your finances as a government, it leads to some depreciation of the currency. That has sometimes been forgotten in the debate in recent years.

The Chair: Mr. Krehm, did you want to add to this?

Mr. William Krehm: I'm sure nobody here has felt satisfied or undisturbed by the news coming out of Africa. That has a very close bearing on the United States raising interest rates, even if we do or do not go along with it.

This whole business of stabilizing an economy with the most destabilizing factor that could possibly be conceived, interest rates, is going to bring on international catastrophe. There have been revolutions in Africa. The last was South Africa, and it was peaceful. Zimbabwe was peaceful. But when a political revolution takes place, it has to be followed up with at least a moderate compromise solution of undoing the harm that was done at the time of colonization. Land has to be returned, but there is never anything in the local budgets... Allow for corruption. That has to be not only regretted but supervised in connection with international aid.

But here is the point. We are playing not with fire but with dynamite when we continue talking about whether we shall raise interest rates a sixth time for inflation, and we ignore the effect on the most vulnerable and most explosive part of the world, which is Africa. I'm sure you will know what I'm talking about.

Mr. Roy Cullen: Thank you.

Mr. Élie, I had a couple of other questions, but if you want to comment, go ahead.

[Translation]

Mr. Bernard Élie: Very quickly, like my colleagues, I acknowledge that the Canadian dollar is probably undervalued, given, among other things, our trade surplus with the United States. However, I explained earlier that the high level of the American dollar resulted from the fact that it serves not only as a reserve currency but also as a safe currency because of speculation around the world.

• 1735

That situation keeps the American dollar artificially high, even though the United States has a very large current account deficit with every other country.

[English]

Mr. Roy Cullen: I could ask a mischievous question—but I won't—in terms of the impact of the instability in Quebec, or the separatist policies of the government in Quebec and what kind of effect this has on the exchange rate. I don't want to turn this into a partisan event, but I think clearly it's a fundamental question that needs to be asked. If any of you want to volunteer a comment on that, I would appreciate it. But then let me throw in my final question, if I may.

Many Canadians are concerned that the Canada-U.S. dollar exchange rate is creating sort of bargain-basement prices, you know, in the acquisition of assets. Mr. McCallum, you rightly pointed out the information that I have as well, that over the last number of years there's been net foreign direct investment going both ways. In fact, until more recently there was more Canadian investment going into the United States than United States direct investment into Canada. But what part would the exchange rate play, in your opinion, on a company looking to expand or acquire assets in Canada, establish a business in Canada or acquire a business in Canada? How big a factor is the Canada-U.S. dollar exchange rate?

Mr. John McCallum: Since I'm an anglophone, I can answer your first question with some credibility when I say I don't see any evidence that the sovereignty issue has had any important detectable medium-term impact on the currency. Now, I can't prove that, but we have these equations that can explain it without invoking this. I think when you've had crises, whether it's a failure of Meech or whatever, you can have short-run impacts, but I haven't been able to detect—

Mr. Pierre Fortin: October 30, 1995.

Mr. John McCallum: Or whatever. You can name the events as well as I can, but I don't think they're discernible if you take a longer-term point of view.

As for your second question, until the latest year, when I think there was a big net inflow to Canada, I would describe it more as an internationalization, with larger flows going both ways, than particularly a Canadian takeover. But in the latest year, when the dollar was very weak, it was that. So I would prefer to see our dollar at 70¢ or 71¢ than where it is today, for a number of reasons, including what you just described as takeover, bargain-basement prices. But I wouldn't want to jack up the interest rates to get there, because I think that wouldn't be a good idea. But I think, for a variety of reasons, it's not healthy to have an undervalued currency. That's one of the reasons I'd rather see it at 70¢ than 67¢.

Mr. Roy Cullen: I'll give the others a chance in a moment. But just to embellish on that argument, if a company is looking at acquiring assets or expanding in Canada, the exchange rate... It's sort of like plant location or government subsidies; you have to make the decision based on the long-term business case. And the long-term business case might tell you that Canada-U.S. exchange rates could change; and if you build your decision, your business case, around locating in Canada or acquiring assets in Canada because of the current Canada-U.S. exchange rate, it might be folly.

Mr. Fortin or Mr. Élie or Mr. Krehm, maybe you could expand on that or pick up from Mr. McCallum.

Mr. William Krehm: It's actually strange. When the exchange rate is low it could attract capital. Of course there are other factors, stability and so forth. The European Union, as a matter of fact, seems to be picking up exports from some of the countries. Everything that was said about the stability... our good chap, Nobel Prize, couldn't have been more incorrect. It's a question of unifying currencies so that you don't have to pay exchange. Well, Europe, with Spain, for example, having close to 20% unemployment, is paying more than exchange on the currency.

• 1740

However, capital flows massively across frontiers. It not only gambles in individual stock, but every time it does so in a foreign currency, it gambles in currency. It's the combination of the two interacting, compounding, that determines it. So when a currency gets to be a little too high, with everybody rushing in, the point is reached where they start rushing out.

Some of us don't think there is a final solution by having a high stable currency or a high currency supported with high interest rates. Keep in mind that part of our low standard of living and our bargain basement is due to globalization, that we are competing with Mexico. We have said bye-bye to Canadian industries who have gone to Mexico and, in turn, have gone from there perhaps to Guatemala, etc.

[Translation]

Mr. Bernard Élie: I think we need to make a distinction between two types of foreign investment in Canada. First of all, there are the takeovers of existing firms by Americans. This is not investment in new plants or new firms; these are takeovers of companies that are strategically important and that appear to be attractively priced at some point. That is one type of investment.

The other type is the exporting by Canadians of capital to the United States to get higher returns than they would in Canada. This is a very important phenomenon; Canadians have become net exporters of capital over the past six or seven years.

These are probably the two most important reasons behind the Canadian dollar's weakness. In a world of mobile capital, the Canadian dollar is also caught up in this situation.

[English]

Mr. Pierre Fortin: There's been an effect on localization of firms, the exchange rate volatility, that I've seen myself. I've made the decision, with the rest of my board, that we are going to locate the next plant in the United States, because it was a major factor. This is anecdotal, although data is the plural of anecdote.

Mr. John McCallum: And it might not have been the right decision.

Mr. Pierre Fortin: Yes. Yes, we've made a lot of profits and no concern with the exchange rate since then.

The other point is that the kind of exchange rate volatility we're concerned about also is medium-range. In other words, what has happened to the Canadian dollar relative to the U.S. dollar is that we've lost 25% of value between the end of the 1970s until 1986. Then it went up 20% or 23% between 1986 and 1991, and then down again to 70¢, another 25%. So it's a five-year periodicity.

Mr. Limoges mentioned hedging. This is very difficult to do beyond one or two years. The people in business that I talk to are concerned about exchange rate volatility, not the very, very short run, but the long cycles I'm mentioning.

Mr. Roy Cullen: Thank you.

The Chair: When Americans buy Canadian firms, they always buy them in the expectation of profit and growth. When we say they're buying firms at bargain-basement prices... If you're in business, it doesn't matter whether you pay 50¢ or 60¢; if there is projected growth and profit you're going to buy that firm, unless you're going for strategic purchasing to remove that company from the market. That also happens.

Monsieur Élie.

• 1745

[Translation]

Mr. Bernard Élie: At present, a number of acquisitions by American firms are strategic takeovers of Canadian high-technology companies or Canadian resource companies. This is a mid-term perspective of five or six years. We are not talking about an entrepreneur that wants to ensure the long-term prosperity of his family. This flow of capital involves Americans acquiring important pieces in Canada as part of their strategy to develop their company at the world level. A number of Montreal electronics firms have come under American control as part of the development strategy of American companies.

So we are not talking about a long-term vision, but rather about the mid- or even short-term for this type of strategy. These are companies...

[English]

The Chair: What evidence is there of that? Have you charted some takeovers that illustrate that point?

[Translation]

Mr. Bernard Élie: To this point, I have not done any studies on that. It is something I am concerned about, but I have not yet done extensive research into it. However, I have looked at the Statistics Canada figures and those on the balance of payments, inflows of American capital and outflows of Canadian capital, which exceed the inflows.

So there is a transfer. It seems very clear that American capital is taking control of Canadian firms and that Canadians are putting securities in American portfolios to take advantage of higher returns.

That was the first thing I noticed when I looked at the figures.

[English]

Mr. John McCallum: As I said earlier, I think there's been roughly equal movements of foreign direct investment in both directions. So it's not just portfolio investments; it's Canadian companies making direct investments in the U.S. and vice versa.

In response to your comment, Mr. Chair... and also I'm not sure we fully answered Mr. Cullen's question. I think his question was what role the exchange rate plays in terms of decisions by foreigners to locate here. I think they'd be crazy if they located here, assuming the dollar would forever be at 67¢.

One of the things I've noticed is the KPMG study that looks at our costs relative to U.S. costs in a dozen industries in a dozen cities—so that's 12 times 12. In each city and each industry, there were lower costs at today's currency, and they calculate the currency that would break even in terms of costs on average. I think it's something like, if I remember correctly, 76¢ or 77¢.

I'm not sure what firms do, but I think they should be able to do half decently at, say, 73¢ or 74¢. I don't know exactly, but something like that. I don't think many would be foolish enough to base major decisions on the assumption that the currency would be forever where it is today.

Mr. Pierre Fortin: I would add that if we read OECD and Statistics Canada's evaluation of what the purchasing power parity exchange rate is between Canada and the United States, it's around 82¢ or 83¢ at this time. If you're sane in your mind and you see 68¢, you buy Canadian assets. Maybe it's not going to be tomorrow, because we know that convergence toward purchasing power parity is a very long-term phenomenon, but if you're in business and you have a plant and you're there for a long period of time, you can expect that over time this is an additional factor that will induce you to invest in Canada.

I think there could be a role, but it's good for Canada in a sense.

The Chair: And the point is that it comes down to the firm's expectations, the investor's expectation of future growth, basically.

Are there any further questions?

On behalf of the committee, I'd like to once again thank you. You're always around when we need you, and we gratefully appreciate that. Thank you.

The meeting is adjourned.