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Dollarization Explained View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics FEDERALRESERVE Dollarization Explained BY STEPHEN SLIVINSKI In some developing o understand the power of government’s reserve of dollars from currency to decide the fate of falling lower due to increased demand countries, monetary Tnations — developing nations, by citizens for the sounder currency. in particular — Manuel Hinds, But it also scares international stability might best the former finance minister of El investors afraid of another devaluation Salvador, says it helps to know the and suddenly the country faces higher be achieved by fable of Dema Gogo. interest rates in international capital Gogo is the president of a fictional, markets. officially adopting poor developing nation. Shortly after The vicious spiral continues. More he assumes office, he has a conversa- political pressure from labor unions a stable foreign tion with the devil, who passes along spurs the president to order the print- an idea he got from a recently ing of more gogos to pay wages. Then currency. deceased macroeconomist: Create his advisors tell him that he has lost your own currency, make it the legal all credibility with foreign creditors tender, and force citizens to relinquish and many voters. Soon, the president their dollars in exchange for the new finds himself running from an angry currency. This appeals to Gogo since it mob of citizens and during the pursuit would allow the government to create falls off a cliff to his death. as much money as it wants and still This fable provides insight to the receive interest from placing the very real havoc created by political newly acquired dollars in a control over monetary policy in the U.S. savings account. It’s developing world, particularly in Latin called seigniorage, America. As a response to those eco- says the devil. A per- nomically dangerous impulses, some fect solution, it economists have suggested that a way seems, for a new for these economies to break out of ruler who wants to the trap is to hitch their currency to finance all the pub- the U.S. dollar — an action known as lic works projects he “dollarization.” Yet there are a variety was sure would of ways of achieving this, and the secure his continued distinctions between them could incumbency. He even have important consequences for gives the currency the economic growth. name “gogo.” But as is always the The How and Why case with Faustian of Dollarization bargains, there are The term “dollarization” describes a unexpected consequences. shift away from a country’s domestic Argentina instituted a “currency Oversupply of the currency creates currencies toward a foreign currency board” system in 1991, but inflation. That’s a nice thing for — typically the U.S. dollar, but not never adopted a policy of full exporters who can sell to overseas always — as a store of value, unit of dollarization. Argentine pesos consumers in exchange for more-valu- account, and medium of exchange. like those pictured are still able dollars but bad for laborers who Official dollarization occurs when a in circulation today. have begun to protest the increased country explicitly makes a foreign cur- prices of imports. rency the preferred legal tender. So the devil suggests devaluing the There are a few countries that have currency by raising the official taken this direct route. The two exchange rate of the dollar from one biggest economies in this category are to two gogos. That protects the El Salvador and Ecuador. The former 2 Region Focus • Fall 2008 has been dollarized since 2001, Dollarization also reverses the the latter since 2000. Panama The main benefit of official isolation that results from having dollarized in 1904. There are four an unstable currency: The newly other smaller countries that have dollarization would come dollarized economy will soon find fully dollarized: the Marshall itself more integrated with inter- Islands, Micronesia, Palau, and the from the monetary stability national capital markets. And the British Virgin Islands. Puerto ability of businesses to make long- Rico, the Northern Mariana that follows from the divorce term plans becomes more viable Islands, American Samoa, Guam, with the stability of the newfound and the U.S. Virgin Islands are dol- of politics and currency. larized, too, as a result of being There are trade benefits, too, U.S. territories. monetary policy. which are especially important to But the shift toward a foreign developing countries for which currency can occur in countries in exports compose a large share of which it is not considered legal tender. In fact, this form of the economy. Dollarization reduces the transaction cost of “unofficial” dollarization in which citizens prefer other cur- exchanging one currency for another. This may not seem like rencies in domestic transactions or as a means to safeguard a big problem, but it certainly can have real effects. Take the value of their bank savings is more common than the trade between Canada and the United States, for instance. official form. Various studies have concluded that Canadian provinces While data on the scope of unofficial dollarization world- tend to trade more with each other than with states in the wide are hard to come by, the most recent figures from United States to which they are closer geographically. Even economist Edgar Feige of the University of Wisconsin- with lower trade barriers between the two countries since Madison are illustrative. The countries with the highest NAFTA, it appears that the transaction cost of trading out degree of unofficial dollarization — the amount of foreign currencies has been a contributor to lower trade volume currency in circulation in each country as fraction of the than one would otherwise expect. effective money supply — were Bolivia, Nicaragua, Uruguay, But there is another side of this coin, so to speak. From Croatia, and Russia (see table on page 4). the perspective of policymakers, there are indeed downsides The holders of foreign currency in these economies are to getting rid of the government’s control over monetary investing in a hedge against the (often very high) inflation of policy. It eliminates the ability of a central bank to serve as a their domestic currency. So the main benefit of official dol- lender of last resort and pursue other actions that can pro- larization — especially when coupled with an elimination of vide stability to the macroeconomy in the face of aggregate the central bank functions of the government — would supply or demand shocks. The government would also lose come from the monetary stability that follows from the the revenue generated by seigniorage. divorce of politics and monetary policy. The transaction Others have argued that the incentives of the anchor costs from shifting to such an arrangement could also be low country could be altered by widespread dollarization of in the countries listed here since so many citizens already use developing economies. Because the anchor country presum- the sounder currency. ably already has a central bank with the ability to adjust to There are other ways of dollarizing an economy. Instead economic shocks, the policymakers there might have to con- of eliminating the central bank function, a government can sider how their actions will affect the smaller countries that replace it with a “currency board.” This board would be rely on their monetary stability This won’t be a problem if responsible only for maintaining a specific exchange rate the anchor country is likely to experience the same sorts of between the domestic currency and the foreign currency of simultaneous shocks as the dollarized country. But if the dol- choice. Another solution would be to keep the country’s larized countries are subject to idiosyncratic shocks that are central bank in its old form and task it with the exchange foreign to the anchor country, there may be international rate stability role. These forms of “soft” dollarization, how- pressure on the latter to take a policy stance that benefits ever, could tempt policymakers to use the monetary tools the former. that are still available to them and weaken the currency Dollarization could also deal a blow to “national pride” in again. (As we’ll see later, that’s the problem that afflicted a country that adopts it. Few politicians are likely to want to Argentina.) admit that their country’s currency is troubled. Indeed, such The textbook version of any of these forms of dollariza- a concern among policymakers in the developing world is tion would lead to a more hospitable environment for often pointed to by economists like Nobel laureate Robert economic growth. In a predollarized scenario, the risk Mundell as a reason for why more countries don’t dollarize. premiums — and, therefore, interest rates — charged by Perhaps most fundamentally, dollarization will achieve its overseas lenders would be high. In a dollarized scenario, desired goal only if the anchor country pursues wise mone- lower real interest rates for those borrowing from interna- tary policies that result in price stability. For instance, that tional capital markets follow when the risk premiums fall. has generally been the case in the United States for more Fall 2008 • Region Focus 3 than two decades, but there have also Unofficial Dollarization grated with international financial mar- been missteps along the way, such as in Index: Reported Ratios of kets, particularly after banking laws were the 1970s, when inflation reached double Dollar Holdings in Foreign liberalized in 1970. digits. Under such circumstances, it’s Economies (2003-2004) Juan Luis Moreno-Villalaz explained it unclear that dollarization is preferable to this way in a 1999 article, authored when maintaining an independent currency Country he was an advisor to the Ministry of and central bank.
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