October 15, 2002
Federal Reserve Bank of Cleveland
Dollarization: What’s in It for US? by David E. Altig
n January of this year, the Argentine the issuing country: Is dollarization in I Should the United States care if currency board, which had tied the interest of the United States? It is Argentina’s peso to the U.S. dollar since with this question that this Economic other countries abandon their own April 1991, was dismantled, ending one Commentary is concerned. currencies and adopt the dollar? of the best-known and important recent Dollarization imparts benefits to the examples of a nation foregoing indepen- ■ What’s a Country to Do? United States as well as costs, and dent monetary policy as a strategy for For purposes of general discussion, we these ought to be weighed as we promoting economic welfare. A year can think of three potential responses a decide what to do about the growing before the currency board’s demise, country might take when others attempt number of countries turning to dol- to adopt its currency. (Although I will public discussion of Argentina’s mone- larization or considering it. tary arrangements had focused on specifically refer to “euroization” in a moving in just the opposite direction: few paragraphs, throughout most of this Eliminating peso monetary liabilities article I will generically refer to the altogether, and fully dollarizing the adoption of another country’s currency Active resistance would, of course, be Argentine monetary system. as dollarization. It will be clear, however, the antithesis of active encouragement, that most of the issues I raise are not spe- but explicit examples of what this might That the discussion even took place in cific to the dollar and the United States.) mean are harder to develop. Both active the face of severe (and thus far, unre- encouragement and passive acceptance solved) strains on the Argentine econ- The three responses are passive accep- are strategies that can be unilaterally pur- omy is testament to the powerful allure tance, active encouragement, and active sued by issuing nations (by granting of dollarization. In fact, despite resistance. The attitudes represented by access to domestic institutions or by Argentina’s withdrawal from the group, each of these responses are just as the choosing benign neglect). However, there are currently 17 countries that labels imply. Passive acceptance neither without resorting to strict capital controls have effectively adopted another’s encourages nor discourages currency that effectively shut down international currency for their own, and another adoption. While a country following currency circulation, an issuing country 17 with currency board or dual mone- such a policy would do nothing to make has limited power to impose its will on tary arrangements. (For a list of these dollarization more difficult, it also would another sovereign nation. Nonetheless, countries, see Cohen 2001 in the recom- do nothing to subsidize or otherwise modern economies operate under the mended reading.) make dollarization more attractive to the umbrella of a broad set of cooperative adopting economies. Currently, passive arrangements, and this interconnected- That Argentina has, thus far, chosen to acceptance would be the best description ness can provide substantial leverage for reverse course and abandon its currency of U.S. policy toward dollarization. a country that is truly intent on inhibiting board arrangement bears witness to the the adoption of its currency elsewhere. unsettled questions that surround dollar- Specific concessions to dollarizing ization. In fact, a definitive assessment of countries, on the other hand, would be The European Central Bank (ECB) is a the costs and benefits of dollarization has the central characteristic of active case in point. As ECB President Wim proven elusive, and consequently, the encouragement. The most straightfor- Duisenberg indicated in November debate over its pros and cons continues. ward example might be an explicit 2001, the ECB has decided it would arrangement to share seigniorage rather not see “euroization” at this time, Most of this debate centers on the ques- revenues—the implicit tax associated at least among those countries that might tion of whether dollarization is desirable with creating money—with the adopting one day join the monetary union: for the adopting country: Should country. In principle, however, conces- Argentina (or Ecuador, El Salvador, sions that could make dollarization more “[Unilateral] adoption of the euro out- Mexico, or wherever) forego the creation attractive run the gamut of central bank side the [Maastricht] Treaty process and circulation of its own independent services, from providing settlement would not be welcome as it would run currency and make the dollar the nation’s accounts and lender-of-last-resort facili- counter to the important process of con- legal tender? Much less attention, ties to foreign-based depository institu- vergence prior to the adoption of the however, has been paid to the question tions, to allowing foreign representatives euro outlined in the Treaty.” of dollarization from the perspective of to participate directly in policy decisions.
ISSN 0428-1276 In this case, countries’ desire to join the America as the adopting countries. dollars into yen. This circumstance monetary union gives the ECB consid- Based on the average annual value of would cause no great practical diffi- erable influence on decisions regarding changes in the monetary base in these culty: The debit or credit card machine adoption of the euro. countries between 1990 and 20001— at the counter could make all the neces- which would determine the value of sary adjustments for you. In fact, if It should be clear that countries have a seigniorage if newly created dollars the exchange rate between the yen and choice to make when others find their were to replace the growth in domestic the dollar were always the same, the currencies worth adopting. As the currencies—the revenue gain to the dual-currency system would pose very differing attitudes in the United States United States would be somewhere in little problem at all. and the euro monetary union illustrate, the range of 0.2 percent to 0.8 percent of conclusions regarding the best choice gross domestic product (GDP) per year. But what if the dollar–yen exchange rate are not uniform or obvious. For that fluctuated over time? Even if the yen reason, considering dollarization’s pros This number is not small relative to the prices of your grocery items were con- and cons from the vantage of the issuing typical estimates of seigniorage revenues stant, the uncertain value of the dollar country is a useful exercise. in the United States, which generally would turn your shopping trip into a fall in the lower end of this range. financial adventure. On top of every- ■ Seigniorage: The Usual Furthermore, this calculation represents thing else you have to worry about, Suspect an annual flow of revenues. At the time exchange risk has now been added to The direct benefit of dollarization to the a country initially converts to another’s the equation. issuing economy is pretty straightfor- currency, there is, in addition, a one-time ward. When another country replaces its windfall to the issuing country as the The elimination of exchange rate risk is currency with dollars (or assets denomi- adopting country replaces its existing a likely explanation for evidence—see nated in dollars), it ultimately can obtain money supply with dollars (or euros, the recommended reading—that a those dollar assets only by “buying” or whatever). shared currency enhances the flow of them with its own exports of goods and goods and services across borders. To services. Because it costs the U.S. On the other hand, partial and (in the be sure, this doesn’t mean that moving government essentially nothing to create case of Ecuador) complete dollarization to a common money will guarantee dollars, this is a pure gain to the U.S. is already a fact in many of these trade expansion, and it may well be economy. In effect, the U.S. government countries, implying that the marginal that expanded trade leads to currency levies a tax—called “seigniorage”— gains in seigniorage are lower than the union, and not vice versa (as argued, for that other countries pay for the privilege numbers above suggest. The gain is instance, in the recommended article by of using the dollar as their own cur- reduced yet further if broader adoption Alberto Trejos). But for our purposes, rency. As such, dollarizing (or expand- of the dollar requires revenue-sharing it’s not clear that this distinction is really ing the quantity of dollars in an already arrangements. All of this suggests the important. What is important is the dollarized economy) is a direct cost to total benefits in seigniorage revenues following: If a country dollarizes to the dollarizing country. would be quite small relative to the facilitate trade by reducing exchange 18 to 20 percent of GDP collected in rate risk, the benefits of reduced risk Alleviating these costs presents an obvi- explicit tax revenues by the federal and expanded trade accrue to the U.S. ous avenue by which a country might government each year. economy as well. encourage broader adoption of its cur- rency. Because the seigniorage revenues The fact that seigniorage revenues are Some may argue, however, that the most collected by the issuing country are a small does not, of course, close the issue. important benefits of dollarization are tax on the adopting country, we don’t Even minimal gains in revenues can be not about trade as much as they are have to go much beyond basic princi- justified if the costs are correspondingly about financial stability. In this view of ples of economics to argue that reducing small. In addition, there are certainly things, the real benefit of dollarization— the tax rate would make it more attrac- other, less direct, benefits and costs to con- especially to smaller developing tive to dollarize. If, for whatever reason, sider. To these possibilities, we turn next. economies with mixed policy records— the ability to recover some amount of is credibility in the commitment to low ■ lost seigniorage is the difference Win–Win: Exchange Rate and relatively stable rates of inflation between a country adopting another’s Risk, Trade, and Credibility (credibility that follows because the currency or not, then the issuing country After seigniorage, the next obvious place dollarizing country no longer maintains gains revenue for any rebate that is less to look for potential benefits of dollariza- the capacity to create too much money). than 100 percent. If revenue gains are tion is suggested by the theory of optimal For countries that lack a record of the primary benefit of dollarization from currency areas (an idea for which econo- monetary stability, buying this type the issuing country’s point of view, then mist Robert Mundell won the 2000 Nobel of credibility can reduce the cost of some is better than none, and everyone Prize for Economic Science). Countries borrowing, reduce nominal exchange can seemingly win from a seigniorage- that qualify as optimal currency areas are rate volatility (which may, of course, sharing agreement. those for whom the benefits of using a stimulate trade), and reduce the likeli- single currency equal or exceed the costs. hood of speculative attack. How big might these benefits be? To get some sense of the answer to this ques- A little introspection should make the If these arguments are correct, dollariz- tion, let’s consider the case of the potential benefits clear. Suppose your ing countries would not be the only ben- United States as the issuing country and favorite grocery store accepted only eficiaries. As the events in Southeast Mexico and the countries of South Japanese yen. Every trip to the grocery Asia in 1997 and Russia and Brazil in store would require converting your 1998 amply demonstrated, a country does not have to be large or be a major Most economic arguments lead us to the adoptees. At that point, all of the ques- trading partner for instability to affect conclusion that the interests of the tions invoked by an active encourage- global financial markets, and hence adopter and the adoptee are aligned. ment policy bubble to the surface. U.S. policy. If dollarization mitigates the probability of such instability, dol- ■ Not All Politics Are Local Perhaps these possibilities are enough to larization is a benefit to the United There is one set of issues, however, that push some from advocating passive States as well. would appear to be of practical impor- acceptance toward favoring active resis- tance to the issuing country alone. A tance, particularly in the form adopted ■ Lose–Lose: Destabilizing surge of final settlement in dollars, for by the ECB. The current leadership of Dollarization? example, may complicate money- the ECB clearly prefers that before The benefits just described, of course, supply management for the Federal countries adopt the euro, they conform depend critically on dollarization having Reserve. Or it is conceivable that the to the full set of standards outlined in a stabilizing influence on the adopting network of relationships between the Maastrict Treaty, which brought the country. One downside for a country foreign financial institutions and U.S. European Monetary Union into being. that adopts another’s currency—the cost banks would dramatically expand, The Maastricht provisions are intended side of currency unification—is the loss increasing the exposure of the U.S. to bring the legal, regulatory, and of an independent monetary policy. If a banking system to international devel- macroeconomic policy institutions of country foregoes issuing its own money, opments and bringing new and poten- monetary union members into confor- then it essentially inherits the monetary tially complicated issues for U.S. regu- mity with standards (such as low policy of the currency union or issuing lators. But these sorts of problems are deficits) that maximize the probability country’s central bank. At any given not unique to questions of dollarization. that the union will be stable, credible, time, that policy may not be the one that They are not different from the issues and contribute to general economic would be chosen as optimal if the coun- that policymakers must, in any event, welfare. Unilateral “euroization” in this try were monetarily independent. grapple with in an increasingly com- view is unacceptably costly, to the plex, interdependent world. extent that it impedes such reforms. This may be a small price to pay if the Active resistance, then, becomes lever- loss of monetary independence yields The unique set of questions that dollar- age that promotes desirable long-run benefits in the form of lower inflation ization may raise is likely to comprise institutional reform among potential and more stable financial markets. But in those that are as much political as eco- adoptees. extreme cases, the lack of flexibility may nomic. One common concern is that result in economic stress that otherwise dollarization would heighten domestic ■ Good News and Bad News might be avoided with a more tailored policymakers’ sense of responsibility In a world of ever-increasing economic monetary response. Some believe that for the performance of dollarized integration (a wholly salutary develop- Argentina is a case in point. The argu- economies, creating a tension between ment), the issue of common currency ment goes like this: By rigidly tying the domestic interests and foreign interests. arrangements between sovereign peso to the dollar (and, in effect, dollariz- Clearly, a policy of active encourage- nations will arise with increasing fre- ing), the Argentine economy suffered ment raises issues of governance and quency. To date, most of the focus has greater exposure to adverse develop- participation in the policymaking been on the costs and benefits to dollar- ments in the Brazilian economy, a large process: Access to settlement accounts izing nations. However, if more and and important trading partner. at the issuing country’s central bank, more adopting countries find that the coverage under lender-of-last-resort benefits exceed the costs, interest in the I am not wholly convinced this arrangements, and even a direct role for costs and benefits to issuing countries argument paints the full picture of the adopting countries in the operation will inevitably expand. The good news Argentina’s woes, or that moving away and implementation of policy could be is that much of the thought and from dollarization was the best long- on the table. (In fact, some may argue research on the purely economic costs run response—see, for example, my that, because the adoption of a foreign and benefits to adopting countries Commentary on stable money refer- currency introduces taxation through appears to be readily transferable to the enced below. Nonetheless, there is a seigniorage, active encouragement of case of adoptee countries. The bad serious case to be made for the position dollarization would bring with it some news is that political judgments and that a lack of policy flexibility can responsibility to broaden the representa- institutions must inevitably come into exacerbate weaknesses that already tion of the adopting countries in the play. Economic reasoning is not mute exist in an economy. In the worst-case development and implementation on such topics, but it is surely a long scenarios, being tied to an inadequate phases of policy.) way from sufficient to the task. or perverse policy course has the poten- tial of turning a slowdown into a These issues are certain to arise with ■ Recommended Reading prolonged crisis. active encouragement, but it is conceiv- Altig, David E. 2002 (May 1). “Why Is able they could develop even with Stable Money Such a Big Deal?” But the bottom line of both the win–win passive acceptance of dollarization. Federal Reserve Bank of Cleveland, and lose–lose scenarios is as follows: If If increasing dollarization does in fact Economic Commentary. dollarization is beneficial to the adopt- change the exposure of the domestic ing country, it is hard to see how it can financial system qualitatively, there will Cohen, Benjamin J. 2001. “Monetary fail to benefit the issuing country. If be a strong argument in favor of bring- Governance in a World of Regional dollarization is destabilizing or harmful ing the regulatory and supervisory Currencies.” Unpublished manuscript, to the adopting country, it is hard to see apparatus of the issuing country to bear University of California at Santa how it can benefit the issuing country. on the financial institutions of the Barbara (June).
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