Dollarization

Louis-Phillipe Rochon, Mario Seccareccia

• Publisher: Routledge
• Year: 2003
• ISBN:
  9781134426058
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The use of the US dollar for domestic monetary transactions outside the USA has gone on for many years now - Panama in 1904 being the earliest example. Since the advent of the Euro, the debate over the benefits of monetary integration has warmed up - particularly for NAFTA countries.This collection, with contributions from experts such as Philip Ar

1 Introduction: Louis-Philippe Rochon and Mario Seccareccia

Dollarization has emerged in the last few years as a serious policy issue. Two events contributed to its policy relevance. On the one hand, the string of financial crises in the late 1990s in Asia, Russia, and Brazil – and most recently in Argentina – has triggered a revision of the conventional wisdom about the ways emerging market economies deal with the increased worldwide capital mobility. The central issue is one of policy possibilities: faced with a financial crisis, what can a country do? Devaluation is a possibility, although flexible exchange rate solutions have come under increased scrutiny and criticism, especially when applied to emerging economies (Hausmann, 1999). Some sort of fixed exchange rate system becomes, once again, a policy option.

Second, the relative success of the euro (at the time of writing this, the euro has regained much of its decline against the US dollar) has led many to argue in favor of currency blocks. Moreover, Courchene and Harris (1999) have argued that the success of the euro may represent a threat to the hegemonic role of the US dollar as an international reserve currency that American citizens desire to hold. The US should therefore promote dollarization in order to maintain this role.

If dollarization is increasingly a policy issue, we must differentiate between full and partial dollarization. In the latter case, also known as de facto dollarization, local currencies exist and circulate alongside the US dollar. Partial dollarization is fairly widespread, as many countries today have a significant proportion of bank assets or liabilities in US dollars. The US dollar can be used as a means of payment (medium of exchange), in addition to the local currency, which is known as currency substitution (see Calvo, 1996, Chapter 8), or can be used as a store of wealth (asset substitution). Full dollarization, however, is a situation by which countries fully abandon the local currency. Only the US dollar would exist and all assets and liabilities would be denominated in US dollars. In this way, exchange rate risk is eliminated for good, although country risk may remain.

However, de facto or partial dollarization, if irreversible (see Dean, 2000), represents for some a potential problem. For Eichengreen and Hausmann (1999), for instance, the use of a local currency mixed with the inability of that country to issue debt in its own currency leads to a currency mismatch: what they call “original sin.” The solution, therefore, appears to be full dollarization.

Dollarization, in this sense, is a form of currency union; and while there are similarities between a dollarized regime and a monetary union such as the euro, there are striking and important differences as well. Perhaps the most important one is the fact that, in a monetary union, all countries abandon their own currency and institutions in order to create a new currency supported by new institutions. The euro and the European Central Bank are good examples. In this sense, these new institutions are created that cater to no one specific country, at least in principle. These new institutions typically are governed by a body consisting of representatives from all countries. Monetary and interest rate policies, in turn, are based on the prevailing economic condition in the union rather than in any particular member country and are imposed on all countries: European monetary policy is aimed at Europe.

In a dollarized regime, however, things could not be more strikingly different. First, there is no creation of a new currency. Rather, countries accept the existing US dollar. Second, member countries must accept the existing American institutions. In this sense, the Federal Reserve would remain unaffected. Member countries would not be represented on the powerful Federal Open-Market Committee, for instance, and therefore have no say in shaping monetary and interest rate policies. Of course, these institutions could always be amended to reflect the new monetary reality, but this would require the consent of the American government and central bank, which is, in our opinion, a virtual impossibility.

If dollarization appears to be a policy option for some countries, it remains a fact that it has primarily been championed by those countries with a history of economic and financial problems, although ironically some economists in Canada have also defended this possibility. Dollarization, thus, is seen as a solution of last resort, once all other solutions have been considered. This was the case in 1999–2000 in Ecuador, shortly after the inflation crisis led to the collapse of the sucre. The reasoning appears to be that, after all, nothing else can be worse, so why not? The adoption of the US dollar is thought to restore hope and confidence in the local economy. Yet, if dollarization is mainly being considered by crises-prone countries, where does that leave countries like Canada, for instance? Moreover, as McCallum (2000) has argued, using the European model as a guideline for dollarization in the Americas may be inappropriate given the vastly different economic and political traditions.

Two questions therefore need to be asked and answered. First, what are the costs and benefits of dollarization for the dollarized economy? Second, what are the implications for the US dollar and the US economy?

There appears to be a large consensus in the literature concerning the pros and cons of dollarization for the dollarized country. Among the advantages (see for instance Berg and Borensztein, 2000a), economists claim that dollarization leads to the elimination of exchange rate risk, lower inflation, lower interest rates (at quasi-US levels, except for country risk, which could also be correlated with exchange rate risk), the elimination of transaction costs, an increase in trade and thus a closer integration with the US and global economies. Local governments would benefit fiscally since they would now be able to sell bonds at lower interest rates (given a reduction in the interest rate spread relative to the US). Moreover, international investors would show increased levels of confidence and invest more in the local, dollarized economy. Hence the principal attraction of dollarization rests in the expectation that the elimination of exchange rate risk will lead to more stable international capital movement, trade and growth. Dollarization would therefore bring stability, both economic and political (see Grubel, 1999).

As for the disadvantages, the literature usually points to the loss of control over monetary and interest rate policies, the loss of seigniorage, and the loss of the central bank role of lender-of-last-resort.

The loss of seigniorage is considered by some as rather substantial (Chang, 2000). Countries that unilaterally dollarize lose seigniorage revenue although, from the US perspective, dollarization would lead to increased revenues, since dollarization would imply increased circulation of US dollars. This forms the basis for Senator Connie Mack’s plan, proposed in 1999 in the US Senate, to recommend sharing seigniorage revenues with dollarized countries as a way to entice countries to dollarize.

The loss of the central bank and its role as lender-of-last-resort is often cited in the literature as an obvious problem. Under dollarization, the local central bank ceases to exist and hence there is no mechanism by which it could intervene to prevent a collapse of the banking system during a financial crisis, for instance. This is a major difference between dollarization and a common currency regime where the lender-of-last-resort role of the newly created central bank would still remain in effect. However, although the loss of a lender of last resort is an important argument, some economists – see for instance Calvo (2000) – have shown that in emerging economies central banks’ function as lender-of-last-resort has actually worsened already fragile economies.

Finally, the ability to set monetary policy and interest rates is linked to national sovereignty. A country able to set policy is a country that is able to influence the future course of its economy. It is thus essential for national economic policy. Giving up monetary policy, within the context of dollarization, is essentially tying its hands to the whims of the Federal Reserve, which sets policy according to the US business cycle and inflationary expectations. Moreover, fiscal policy may itself be constrained by monetary conditions, thereby creating further obstacles for a dollarized economy to conduct independent macroeconomic policy.

Proponents of dollarization, however, do not necessarily see the loss of monetary sovereignty as a disadvantage. They argue that if business cycles in the US and dollarized economies are more or less synchronized, then abandoning monetary policy is really not an issue. They argue that with increased economic integration, business cycles are more likely to be synchronized. US interest rates would correspond, or should, to interest rates that would have been set in the dollarized country. Moreover, since dollarized countries are usually prone to currency and financial crises, the adoption of US monetary policy will simply impose on them policy discipline. Given their history of inflation, US monetary policy would restore a sense of stability. Dollarization leads to “better policies” (Powell, 2000).

However, the synchronicity of cycles is not really the issue. Even synchronized economies can benefit from national monetary and interest rate policies, since their economies can respond differently to a given external shock. In this sense, economists should consider the composition of output. Canada’s economy, for instance, is more resource-based than the United States’ economy. Moreover, it becomes problematic if countries differ on their respective economic goal. While the US may want to fight inflation, other countries may want to fight unemployment (see De Grauwe, 1997).

The above discussion focused mainly on the pros and cons of dollarization on dollarized economies. It rests, however, on a very specific assumption. It implicitly suggests that dollarization, on its own, will bring about these positive changes: that is, dollarization, through the graces of perfectly flexible markets, will bring about the positive gains. Not all economists agree, however. Eichengreen (2000), for instance, suggests that before a country chooses to dollarize, it must undertake a number of significant market-friendly reforms; otherwise dollarization may worsen the situation. Instead of asking whether a country should dollarize, Eichengreen asks when should a country dollarize. Hence, he writes:

Dollarization, to work smoothly and yield more benefits than costs, must wait on the completion of complementary reforms. The banking system must first be strengthened, so that the authorities’ more limited capacity to provide lender-of-last-resort services does not expose the country to financial instability. The fiscal position must first be strengthened and the term structure of the public debt lengthened so that the absence of a domestic monetary authority able to absorb new issues does not expose the government to a funding crisis. Provisions must first be made, through the negotiation of commercial or intergovernmental credit lines, for obtaining the liquidity needed to finance intervention if a crisis nonetheless occurs. The labor market must first be reformed, so that the absence of the exchange rate as an instrument of adjustment does not leave the country without a mechanism for accommodating asymmetric shocks. And the economy must first be restructured, perhaps through the negotiation of a free-trade agreement, to ensure that cyclical fluctuations and appropriate monetary conditions coincide with those in the United States.

This view is certainly consistent with Gruben, Wynne and Zarazaga (2002), who claim that dollarization ought to be an “integral process of institutional, political and economic reforms,” although the authors are silent on the specific sequence of the reforms.

However, the debate over whether or when to dollarize, or what Gruben, Wynne and Zarazaga (2002) call the division between the “just-do-it” and the “coronation” approaches to dollarization, rests largely on the same arguments: that is, it rests on the need for perfectly flexible markets to receive eventually the benefits from dollarizing. Fiscal, financial and political reforms, as well as labor market reforms are all tied to dollarization.

Further, the above discussion is largely focused on the pros and cons of dollarization for the dollarizing country. Indeed, there is virtually no debate on the pros and cons of dollarizing for the United States, perhaps reflecting the (official) ambivalence of Washington on the issue. Yet, this does not mean that there are no costs and benefits to the US. In fact, perhaps the most important argument that needs to be made is the direct benefit the US would gain from opening money and financial markets in dollarized countries, an argument made by Rochon and Vernengo (see this volume). It should therefore come as no surprise that the debate over dollarization is often tied to schemes of privatization and financial liberalization.

At the time of the Ottawa conference on dollarization, little evidence was available to support the argument – or rather the allegation – that dollarization would eventually lead to the increased presence of American banks and credit financing of American firms in dollarized countries. Since then, however, there seems to be some evidence to this effect. Of course, the World Bank (2002) position is that the presence of foreign banks will add to the stability of the financial markets in emerging economies, and Berg and Borensztein (2000b) have claimed that this would lead to fewer financial crises. However, there is increasing evidence, or at least strong theoretical arguments, that this may not be the case.

For instance, the presence of American banks in dollarized economies may lead to a greater number of residents moving their savings outside of the dollarized country to the US, hence hurting the local financial system (D’Arista, 2000). Moreover, if dollarization does lead to an increased presence of American banks in dollarized countries, then it is conceivable that they would prefer lending to American firms rather than local firms. How would American banks feel about lending to local firms, farmers and various local arms of the government? In other words, how would dollarization affect the overall supply of credit and the composition of that supply?

These are certainly interesting questions to pursue. If post-Keynesians link the creation of money and output to the supply of credit within the framework of endogenous money, how then will dollarization affect the growth of dollarized economies? How will dollarization and the penetration of foreign banks affect local economies? Will this prove destabilizing rather than stabilizing?

Already, the 1999 Economic Report of the President had indicated that dollarization would lead to an important increase in the number of American banks and financial institutions. Dollarization is thus an invitation for expanding American presence in emerging markets. What impact that would have on local economies is certainly a question that needs to be addressed carefully.

Although their paper is not directly on dollarization, Weller and Hersh (2002, p. 3) argue that many crisis-prone countries tend to have a greater number of foreign banks. The authors also present evidence showing that foreign banks’ “clients are usually MNCs [multinational corporations] or large domestic corporations engaged in international transactions,” usually export-oriented. They further argue that “it is quite clear that MNBs [multinational banks] do not serve the majority of low- and middle-income households or even small- and medium-sized enterprises and startups,” a point also made by D’Arista (2000).

Structure of the book

As the authors had made already these points forcefully at the conference held in Ottawa in October, 2000, many of the contributions in this book address these points, in a rather critical perspective. Most authors would be deemed heterodox, with the possible exception of one, James Dean, who nonetheless is critical of dollarization for a country like Canada, but certainly does not reject it for other countries, like Ecuador. Yet the overwhelming position on this point is against dollarization, and perhaps even against monetary unions.

Each author in this book has made an important contribution to the ongoing debate on dollarization and monetary unions. The overwhelming conclusion is that dollarization and monetary unions should not be pursued as a serious policy issue, as they impose too many constraints, as seen in the previous section.

The book is divided into two overall parts. The first part, containing six chapters, deals more specifically with the European experience, while the second part, containing the remaining four chapters, is more specific to the debate on dollarization.

In Chapter 2, Philip Arestis, Iris Biefang-Frisancho Mariscal, Andrew Brown, and Malcolm Sawyer examine the causes of the general decline in the value of the euro following its adoption. The various explanations offered in the literature are assessed. And although the authors’ critical assessment draws on a number of papers in the literature, they focus on their own research and published output. The authors carefully review the decline in the value of the euro and examine two obvious explanations. They conclude that neither “bad luck” nor fundamentals such as interest rate differentials or measures of long run equilibrium magnitudes explain the decline. They then proceed to construct a more satisfactory explanation. The argument, prevalent in the literature, that the decline in value of the euro is due to “US strength,” rather than to any inherent difficulties with its imposition, is thought to be rather undeveloped. They suggest that US strength is an important but partial factor in euro decline.

The following chapter, by Marcello de Cecco, also looks at the initial weakness of the euro. The author begins his analysis by identifying the conditions under which a currency becomes an international currency. The author looks at issues of trade and spot market transactions, and to other more complex financial arrangements, such as forward contracts used for arbitrage and hedging. The author then proceeds to explain why the mark and the yen never made the transition to international currencies, and carries his analysis to the newly created euro.

Chapter 4, by Alain Parguez, Mario Seccareccia, and Claude Gnos, takes a careful look at the European monetary union and draws specific lessons for the proposed North American union. They begin by outlining the neoclassical or Mengerian foundations of what they call “European economics”: that is, the basis of arguments for monetary union in Europe. They then look at three required policy rules for implementation: the role of the central bank, the need for restrictive fiscal policy and, finally, the need that employment and welfare programs no longer ought to constrain the economic policy behavior of the member states. Combined, these rules should ensure that narrow national interests do not dismantle the new supranational monetary order. From there, the authors look at the North American situation.

Chapter 5 also looks carefully at the European case. Stephanie Bell correctly asks whether member countries have forsaken their economic “steering wheel.” The chapter examines the prospects for macroeconomic policy under a currency union. Although the focus is on European monetary union, implications of such a currency union between Canada and the United States, for example, can also be drawn. The paper focuses on Abba Lerner’s theory of Functional Finance, which essentially describes the ultimate form of policy flexibility, and the extent to which his proposal is tenable under the institutional arrangements that now govern the eurozone.

Tom Palley’s argument, in Chapter 6, revolves around an examination of how monetary policy should be conducted in a non-optimal currency area. The author argues that optimal policy requires a slightly higher rate of equilibrium inflation to avoid higher unemployment. Formation of a non-optimal currency area shifts the Phillips curve right and worsens the inflation–unemployment tradeoff. This has important implications for the ECB, since it is widely agreed that the euro area is not an optimal currency area. By carrying over the old Bundesbank’s 2 percent inflation target, the ECB is setting policy as if the euro were an optimal currency area. The euro area therefore stands to have higher unemployment. Finally, the analysis in the paper has important implications for plans to enlarge the euro area. To the extent that enlargement worsens the non-optimality of the euro area, it furthe...

Table of contents

• Cover Page
• Routledge International Studies in Money and Banking
• Title Page
• Copyright Page
• Illustrations
• Contributors
• Acknowledgments
• 1 Introduction: Louis-Philippe Rochon and Mario Seccareccia
• Part I The European experience
• Part II Lessons for the Americas