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November 04, 2004

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Challenging conventional wisdom

I want to share with you the story of how some of my research results challenged the conventional wisdom and gave rise to a nation-wide controversy and many personal attacks.


by Herbert Grubel
Knowledge in the natural and social sciences is very important in the determination of our living standards. For this reason it is important that we continue to add to this knowledge through the work done in academia.

I want to share with you the story of how some of my research results challenged the conventional wisdom and gave rise to a nation-wide controversy and many personal attacks. However, I will also relate to you the personal satisfaction I am able to derive to this day from knowing what impact the research has had on the present conventional wisdom and some government policies.

It is well known that as a result of the existence of public unemployment insurance workers no longer have to fear and suffer the consequences of unemployment.

The system is fair since it takes money from the fortunate employed, who can afford to give up some, to the truly needy who are unemployed. The system is self-financing and it is cheap to operate since there are no profits and wasted advertising. Honest, fair and hard working civil servants operate it.

In the middle 1970s any criticism of the existing employment insurance system was considered equivalent to an attack on a sacred cow. Nevertheless, Dennis Maki and I, in 1975, published in the Canadian Journal of Economics the first study in the world linking unemployment with unemployment insurance. We used official data and standard econometric technique to estimate that the increased generosity of the system caused Canada's unemployment rate at that time to be higher by about one to 1.5 points.

When I published a Financial Post article based on our findings, I found myself embroiled in a major controversy. No one in Canada gets away without a big fight challenging sacred cows. The media were after me for interviews. I received many letters condemning me personally. Newspapers happily published critical letters they had received. An SFU professor was quoted in a newspaper saying that he was ashamed to have me as a colleague.

In response dean of arts Robert Brown organized a seminar for me to face the academic community. When I arrived, I had to fight my way through the overflow crowd that sat in the aisles and stood in the back of the room.

Never before or since, not even during my years in Parliament, had I faced such a hostile crowd. There was an electric charge in the room that literally raised the hair on my arms and the back of my neck.

The controversy was hard on me, causing me anxieties, sleepless nights and worries about the correctness of our analysis. In retrospect it is clear to me that the controversy was less over facts, or the validity of economic analysis and econometric results.
In the early 1980s, Donald MacDonald headed the Commission of Inquiry into the Future of the Canadian Economy. I did not write a paper for this commission, but later MacDonald told me, “Your study hung like a shadow over the deliberations of the commission.” In 1986 the Forget Commission on the Future of the Canadian Unemployment Insurance System reported on the need for reforms, drawing heavily on the analysis and empirical results of our paper.

I take great satisfaction knowing that our work played an important role in preventing the adoption of inappropriate, inflationary economic policies.

Exchange rate
The conventional wisdom and the official government position presently are that Canada needs a flexible exchange rate to deal with external shocks that threaten the stability of employment and the economy. In a study published in 1999 I started a controversy that continues today and is likely to continue for some time to come.

Flexible exchange rates are indeed helpful in dealing with commodity price fluctuations. However, the dominant characteristic of the time series on commodity prices is their downward trend, which is driven by increasing global supplies of these commodities coming mostly from less developed countries that have rich resources, low costs of labor and low levels of effective regulation and environmental standards.

Canada should have been moving out of the production of commodities at a rate greater than it did.

The desirable reallocation of labor and capital in the economy was slowed because the downward drift in the exchange rate kept artificially high the returns in these industries in Canadian dollar terms. This process provided our commodity producers with the equivalent of tariff protection at the rate of about one per cent average a year, or 30 per cent over the last 25 years. Such subsidies never are good for an economy. The lack of labor and capital prevents the development of more profitable industries.

Tom Courchene of Queen's University and Rick Harris of SFU in 1999 jointly published a study that points to another unintended and damaging effect of the secular decline of the exchange rate.

According to their analysis, the low Canadian dollar caused capital goods, imported mostly from the U.S., to be more expensive relative to labour than they were in U.S.

As a result, during the 1990s especially, U.S. investment per worker has been greater than that in Canada. The important effect of this difference is that U.S. living standards rose more rapidly than those in Canada.

So what would the benefits of a Canada-U.S. monetary union be in terms to which the ordinary Canadian can relate? One study found, that in the long run, a monetary union between Canada and the U.S. would raise income per capita in Canada by about 30 per cent.

While I still think that a formal monetary union would be economically best, many discussions with economists and political pundits have persuaded me to recommend an alternative proposed by Courchene and Harris and by Robert Mundell, the father of the European Monetary Union. Under this scheme, Canada would replace our current currency with a new Canadian dollar designed to be worth one U.S. dollar.

Notes on one side would show the Queen and other national symbols. On the other side, they would display prominently the government's promise to exchange them for U.S. dollar notes of the same denomination.

All assets, including currency notes and all liabilities expressed in the present dollar would be converted into the new dollar at a rate that would preserve our competitiveness and would probably be close to the market exchange rate at the time. Canada gets all the profits from printing and minting the new dollar. The currency reform would not require any consent from the U.S. government.

There are also several economists who have analyzed the merit of monetary unions for a number of countries whose economies are close. Mundell promotes a grand scheme for the eventual creation of a world currency. The economic analysis contained in these studies suggests that the benefits from a union are likely to exceed any costs. Mainly, political problems and the self-interest of central bankers and politicians prevent the creation of the new institutions.

Herbert Grubel, emeritus professor of economics, received the 2004 Nora and Ted Sterling prize in support of controversy on Oct. 12. He holds the David Somerville chair in taxation and finance at the Fraser Institute. This is an excerpt from his Sterling lecture. The full text is available at www.sfu.ca/sterlingprize/














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