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.