Policy Debate: Does dollarization benefit developing economies?

Some countries have recently considered making another country's currency their own: in particular, adopting the dollar. This is a highly consequential step for any country, one that has to be considered very carefully and, in our view, should not be done without consultation with United States authorities. On one hand, dollarization offers the attractive promise of enhancing stability. On the other hand, the country also must be prepared to accept the potentially significant consequences of doing without the capacity independently to adjust the exchange rate or the direction of domestic interest rates. The implications for the United States are also consequential. We do not have an a priori view as to our reaction to the concept of dollarization. We would also observe that there are a variety of possible ways for a country to dollarize. But it would not, in our judgment, be appropriate for United States authorities to extend the net of bank supervision, to provide access to the Federal Reserve discount window, or to adjust bank supervisory responsibilities or the procedures or orientation of U.S. monetary policy in light of another country's decision to dollarize its monetary system.
~Treasury Secretary Robert E. Rubin, April 21, 1999

Our position on dollarization should start from the core assertion: A stable monetary order is the appropriate corollary to a free trade agreement. Whether we are thinking in terms of our NAFTA partners or looking beyond to the Free Trade Area of the Americas (FTAA), one of our primary objectives should be to establish a monetary union or common currency that would provide a consistent unit of account across borders. When price signals are distorted through currency fluctuations, markets cannot function at optimal levels. Individuals who bring their goods and services to the international marketplace are unfairly punished and rightfully discouraged when currency movements turn legitimate profits into foreign exchange losses. If we believe in free trade and free markets, we must work toward a common currency with the same fervor we bring to the effort to reduce trade barriers and fight protectionism.
~Judy Shelton, April 22, 1999

Developing economies often experience high and unstable inflation rates when their governments increase the money supply to finance higher levels of government spending. High and unstable inflation rates result in a more unstable investment climate and a lower rate of economic growth. When people lose faith in the domestic currency, it is not uncommon for another currency to be used as a medium of exchange in the domestic economy. Because of its relative stability and use as an international reserve currency, the U.S. dollar frequently is used for this purpose. "Dollarization" is said to occur when the U.S. dollar replaces the domestic currency as the official medium of exchange.

Advocates of dollarization suggest that developing economies that replace their less stable domestic currency with the U.S. dollar experience a lower and more stable inflation rate. A lower and more stable inflation rate, in turn, is expected to lead to a higher level of investment and a faster rate of economic growth. This benefit is larger when the domestic monetary authorities have established a poor track record in maintaining a stable domestic money supply.

Opponents of dollarization note that the domestic monetary authorities have no control over the domestic money supply under this policy. The government of a dollarized economy will not be able to use discretionary monetary policy to deal with domestic macroeconomic problems. If the domestic economy experiences a business cycle that closely corresponds to the U.S. economy's business cycle, this may present less of a problem (since the U.S. Fed might engage in appropriate monetary policy responses). Even if the U.S. Fed can be trusted to engage in "appropriate" policy responses, many countries are still reluctant to cede their control over domestic macroeconomic policy to a foreign agency. Countries that replace their national currencies with the dollar will also lose "seignorage," the profit made by governments that issue token money (seignorage exists because the purchasing power of coin and paper money exceeds the cost of producing the money).

Many U.S. policymakers argue that dollarization is an indication of the relatively high rate of success that the Fed has experienced in maintaining a stable currency in recent years. There is some concern, though, that foreign governments will attempt to exert political pressure to encourage the Fed to pursue monetary policies that are not consistent with U.S. monetary policy objectives.

The introduction, and apparent success of the Euro in establishing a common currency throughout much of Europe has encouraged discussions involving the use of the dollar for a similar role in North and South America. Argentina had maintained a fixed exchange rate (and full convertibility) with the dollar for over a decade and had considered completely switching to the use of the dollar as a medium of exchange. An economic and political crisis in Argentina (resulting in five Presidents in a two-week period), however, resulted in the floating of the peso on February 11, 2002.

Advocates of dollarization have made some inroads in Mexico. Panama has used the U.S. dollar as its official currency since its creation as a nation. Ecuador adopted the dollar as its currency in 2000. El Salvador began a gradual transition to the dollar in 1994 when it pegged its currency to the dollar. In January 2001, it began to phase out its own currency. Despite U.S. trade restrictions, the informal economy in Cuba primarily relies on the U.S. dollar. The successful introduction of the Euro in much of Europe has resulted in some discussion of dollarization in Canada. During the next few years, the dollarization debate is likely to be a major policy issue in the U.S. and in countries experiencing currency instability.

• Federal Reserve Board of Governors
  http://www.federalreserve.gov/
  The Federal Reserve Board of Governors web site contains information on the conduct of U.S. monetary policy. As the debate over dollarization continues, this site is likely to contain speech transcripts and other information relevant to the debate.

• Bank for International Settlements, "Central Bank Websites"
  http://www.bis.org/cbanks.htm
  This web site contain links to the websites of virtually all central banks that maintain an internet presence. These web sites often contain information about the conduct of monetary policy in these countries.

• Free Trade Area of the Americas
  http://www.alca-ftaa.org
  This site is the home page of the Free Trade Area of the Americas, a proposed free trade area that would encompass most of the countries of North and South America. Information about the nature and status of this proposal is available at this site. It is likely that future discussions of a common currency for North and South America would take place within this organization.

• U.S. Foreign Trade Statistics
  http://www.census.gov/ftp/pub/foreign-trade/www/
  This Census Bureau web site contains recent and historical data on U.S. imports, exports, trade balances, and other relevant measures of trade. U.S. trade statistics with major trading partners are provided for broad product categories.

• CNN's Financial Network's Currencies web site
  http://cnnfn.com/markets/currencies/
  CNN's list of current exchange rates provides information on the exchange rate between the dollar and the currencies of our major trading partners.

• X-rates.com Currency Calculator
  http://www.x-rates.com/calculator.html
  X-rates.com Currency Calculator provides online conversion between monetary balances for over 40 other currencies. It also provides a graph of the last few month's exchange rate between any two of these currencies. This helps illustrate the degree of exchange rate stability among these currencies.

• Joint Economic Committee, "Basics of Dollarization"
  http://users.erols.com/kurrency/basicsup.htm
  This July 1999 report (revised January 2000) contains a very useful discussion of the practical issues associated with dollarization. It describes the history of dollarization, alternative methods of dollarization, and introduces arguments for and against this process.

• Alan M. Taylor, "Dollarization as a Technology Import"
  http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-16.html
  Alan M. Taylor discusses the issues surrounding dollarization in this May 19, 2000 San Francisco Federal Reserve Board Economic Letter. This article contains a very nice history of past monetary crises in Argentina and the movement towards dollarization. Taylor also provides an interesting discussion of the network externalities associated with the use of a particular currency.

• Mark Falcoff, "Dollarization for Argentina? For Latin America"
  http://www.aei.org/publications/pubID.10158,filter./pub_detail.asp
  In this April 1999 Latin American Outlook article, Mark Falcoff provides a solid discussion of the pros and cons associated with dollarization. He notes that the potential benefits include price stability, less exchange-rate risk, lower trading costs, lower interest rates, and higher rates of economic growth. The potential cost includes a loss of monetary policy autonomy.

• Andrew Berg and Eduardo Borensztein, "The Dollarization Debate"
  http://www.imf.org/external/pubs/ft/fandd/2000/03/berg.htm
  Andrew Berg and Eduardo Borensztein provide a useful discussion of the costs and benefits associated with dollarization in this March 2000 Finance and Development online article.

• Global Policy Forum, "Dollarization"
  http://www.globalpolicy.org/nations/sovereign/dollarindex.htm
  On this website, the Global Policy Forum provides links to a variety of online essays and news articles related to dollarization.

• Dallas Federal Reserve District Bank, "Dollarization: A Common Currency for the Americas?"
  http://http://www.dallasfed.org/news/latin/00dollarspeech.html
  This website contains links to the text of a variety of papers and speeches delivered during a March 6-7, 2000 conference organized by the Dallas Fed. These documents provide a nice overview of the major issues surrounding dollarization. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• Steve H. Hanke and Kurt Schuler, "A Dollarization Blueprint for Argentina"
  http://www.cato.org/pubs/fpbriefs/fpb52.pdf
  In this Cato Institute Foreign Policy Briefing, Steve H. Hanke and Kurt Schuler argue that Argentina would benefit from dollarization. They note that Argentina has increased currency stability in recent years by maintaining a fixed exchange rate with the dollar. Replacing the peso with the dollar would remove any remaining exchange-rate risk and would be expected to result in lower interest rates and a faster rate of economic growth. Hanke and Schuler suggest that the benefits from having a stable currency outweigh the costs of foregone seignorage and of giving up domestic control over monetary policy.

• C. Fred Bergsten, "Dollarization in Emerging-Market Economies and its Policy Implications for the United States"
  http://www.iie.com/publications/papers/bergsten0499.htm
  C. Fred Bergsten, in this April 22, 1999 testimony, examines the conditions under which dollarization is beneficial to an economy. He concludes that a dollarization policy is desirable only in countries that:
  • are relatively small and have a high volume of international trade (thereby being subject to relatively large exchange-rate shocks),
  • have experienced recent hyperinflation or a history of hyperinflation, or
  • countries that have a high volume of trade with the U.S.

• Francois R. Velde and Marcelo Veracierto, "Dollarization in Argentina"
  http://www.chicagofed.org/publications/fedletter/1999/cfljune99.pdf
  In this June 1999 Chicago Fed Letter, Francois R. Velde and Marcelo Veracierto examine the costs and benefits of dollarization in Argentina. They argue that dollarization will be more successful if it is done in collaboration with the U.S. rather than unilaterally. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• Paul Krugman, "Monomoney Mania"
  http://www.pkarchive.org/trade/mono.html
  In this April 15, 1999 Slate article, Paul Krugman argues that the use of fewer currencies is not necessarily desirable. He notes that different countries may be at different stages of their business cycles. When one economy is growing faster than another, wages and prices in the faster growing economy will rise relative to those in the slower growing economy. Under a system of flexible exchange rates, an adjustment in the exchange rate will accommodate this adjustment without requiring either inflation or deflation in either country. If both countries shared a common currency, however, such an adjustment would require changes in the levels of wages and prices in one or both countries. Krugman argues that it is simpler to allow the exchange rate to shift in such a situation than to require the adjustment of thousands of wages and prices.

• Paul Krugman, "Argentina's Money Monomania"
  http://www.pkarchive.org/crises/MoneyMonomania.html
  In this online followup to the article listed above, Paul Krugman argues that Argentina should devalue its currency. He suggests that the cost of maintaining a fixed exchange rate with the dollar is doing more harm than good for Argentina's economy.

• Paul Krugman, "Don't Laugh at Me, Argentina"
  http://slate.msn.com/?id=32173
  Paul Krugman discusses the cost of dollarization in Argentina in this July 7, 1999 article in Slate. He notes that Argentina was able to gain credibility by maintaining convertibility between dollars and pesos. The cost of this, though, is an inability to conduct desirable monetary policy changes.

• U.S. Treasury Secretary Robert E. Rubin, "Remarks on Reform of the International Financial Architecture"
  http://www.ustreas.gov/press/releases/rr3093.htm
  U.S. Treasury Secretary Robert E. Rubin provides warnings of the potential costs associated with dollarization in this April 21, 1999 speech. He notes that countries that engage in dollarization will lose control over their domestic monetary policy. Rubin also suggests that the Fed will not provide bank supervision or discount window services to countries that adopt this policy.

• Senate Banking Committee, "Citizen's Guide to Dollarization"
  http://banking.senate.gov/docs/reports/dollar.htm
  This Senate Banking Committee document weighs the pros and cons of dollarization. It is argued that dollarization can provide benefits for both the U.S. and any country that pursues this policy.

• Alberto Alesina, Robert J. Barro, and Silvana Tenreyro, "Optimal Currency Areas"
  http://post.economics.harvard.edu/faculty/barro/papers/OCApaper.pdf
  Alberto Alesina, Robert J. Barro, and Silvana Tenreyro investigate optimal currency areas in this June 2002 working paper. They examine the pros and cons of the adoption of a common currency (in the form of the dollar, the euro, or the yen). They suggest that increased economic integration will result in increased adoption of common currencies. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• National Post, "Dollarization? Not here"
  http://www.globalpolicy.org/nations/dollar/0517canada.htm
  This May 17, 2002 National Post article discusses the pros and cons of dollarization. It is observed that, while a growing share of Canadian savings are held in U.S. dollar-denominated assets, there is little evidence of a movement toward dollarization. It is argued that dollarization is not likely as long as the Bank of Canada maintains a low and stable inflation rate.

• Kurt Schuler, "A Contingency Plan for Dollarizing Hong Kong"
  http://www.hku.hk/hkcer/articles/v52/kurt.htm
  Kurt Schuler, in this online HKCER Letters article, argues that Hong Kong would benefit from dollarization. He notes that the Hong Kong dollar suffered several speculative attacks as a result of the Asian financial crisis. Schuler suggests that a full conversion to the U.S. dollar would improve credibility and reduce speculation.

• Kurt Schuler, "Currency Boards and Dollarization"
  http://www.dollarization.org/
  This website, provided by Kurt Schuler, contains annotated links to online resources dealing with dollarization and related topics. Among the resources provided at this site are several essays on dollarization provided by Kurt Schuler.

• Kurt Schuler, "Some Theory and History of Dollarization"
  http://www.cato.org/pubs/journal/cj25n1/cj25n1-13.pdf
  Kurt Schuler provides a history of and an evaluation of alternative methods of dollarization in this article appearing in the Winter 2005 issue of the Cato Journal. He argues that the evidence suggests that dollarization has been provided positive long-run benefits for countries that have pegged their currency to the dollar. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• Juan Luis Moreno-Villalaz, "Financial Integration and Dollarization: The Case of Panama"
  http://www.cato.org/pubs/journal/cj25n1/cj25n1-14.pdf
  Juan Luis Moreno-Villalaz examines the role of dollarization in Panama in this article appearing in the Winter 2005 issue of the Cato Journal. He argues that dollarization, combined with a variety of market-based institutions have resulted in positive outcomes in Panama. (The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.)

• Tsang Shu-ki, "A Critical Comment on Government-sponsored Dollarization as a Rescue"
  http://www.hkbu.edu.hk/~econ/web9812.html
  Tsang Shu-ki discusses some of the problems associated with dollarization in the Hong Kong economy. He argues that the choice of a particular fixed exchange rate is somewhat arbitrary and that economies should preserve the option of exiting from a fixed-exchange rate system if that is in the national interest. The cost of exit under dollarization, however, is substantially higher than under alternative fixed-exchange rate regimes.

• Lawrence H. Summers, Testimony before the Senate Banking, Housing and Urban Affairs Committee, April 22, 1999
  http://www.senate.gov/~banking/99_04hrg/042299/summers.htm
  Lawrence H. Summers, the Deputy Secretary of the U.S. Treasury, discusses the implications of dollarization in his testimony before the Senate Banking, Housing, and Urban Affairs Committee. He indicates that fixed exchange rate regimes (and dollarization) offers stability to importers and exporters, but requires that the country gives up control of its domestic money supply. Summers notes that Panama, a dollarized economy, is the only Latin American economy that has an active 30-year fixed rate mortgage market. This, he argues, is a result of the credibility provided by dollarization.
  Summers notes that the U.S. economy benefits from dollarization since these economies are providing the U.S. with an interest-free loan when they acquire dollars for their own monetary use. A second benefit to the U.S. occurs as a result of the increase in trade that would be expected to result from a larger currency area. An additional potential benefit from dollarization is additional economic and political stability in the region. Summers states that the U.S. Fed will not provide deposit insurance or bank supervision services to dollarized economies.

• Wayne Angell, Testimony before the Senate Banking, Housing and Urban Affairs Committee, April 22, 1999
  http://www.senate.gov/~banking/99_04hrg/042299/angell.htm
  Wayne Angell argues in support of dollarization in his testimony before the Senate Banking, Housing and Urban Affairs Committee. He argues that dollarization would enhance economic stability and economic growth in both Mexico and Argentina. Angell argues that the Fed should assist the central banks in these countries in establishing a more rigid system of bank regulation and supervision. He also suggests that dollarized economies be invited to join NAFTA.

• Judy Shelton, Testimony before the Senate Banking, Housing and Urban Affairs Committee, April 22, 1999
  http://www.senate.gov/~banking/99_04hrg/042299/shelton.htm
  Judy Shelton lends her support to the dollarization process in her testimony before the Senate Banking, Housing and Urban Affairs Committee. She notes that high interest rates in Mexico have discouraged investment and slowed economic growth. Dollarization would be expected to reverse this problem. Shelton notes that U.S. monetary policy is already taking global economic conditions into account and suggests that dollarization would not necessarily change the monetary policy pursued by the Fed.

• Robert J. Barro, "From Seattle to Santiago, Let the Dollar Reign"
  http://www.hooverdigest.org/993/barro2.html
  Robert Barro argues for dollarization in Argentina in this Hoover Digest reprint of a March 8, 1999 New York Times article. He suggests that the U.S. should actively support dollarization by compensating Argentina for the lost seignorage. Barro suggests that dollarization could help reform monetary institutions in countries that have experienced problems in maintaining currency stability.

• Guillermo A. Calvo, Testimony before the Senate Banking, Housing and Urban Affairs Committee, April 22, 1999
  http://www.senate.gov/~banking/99_04hrg/042299/calvo.htm
  In his testimony before the Senate Banking, Housing and Urban Affairs Committee, Guillermo A. Calvo argues that dollarization is especially valuable for emerging-market economies that possess large dollar-denominated debts. These countries are very likely to experience high rates of inflation and have a larger debt burden as a result of currency devaluation. He argues that financial market "contagion" will be less likely if such economies are dollarized, since dollarized economies are not subject to currency-devaluation risk.

• Guillermo A. Calvo, "On Dollarization"
  http://www.bsos.umd.edu/econ/ciecpn5.pdf
  In this April 20, 1999 paper, Guillermo A. Calvo examines the rationale for dollarization in an emerging market economy. He notes that in most emerging market economies, a large share of assets and liabilities are already denominated in foreign exchange. Calvo argues that Latin American economies are already substantially affected by monetary policy and economic conditions in the U.S. He suggests that some emerging market economies would benefit from dollarization since it provides for a more predictable and credible monetary policy. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)

• Catherine L. Mann, Testimony before the Senate Banking, Housing and Urban Affairs Committee, April 22, 1999
  http://www.senate.gov/~banking/99_04hrg/042299/mann.htm
  Catherine Mann describes the costs and benefits associated with dollarization during her testimony before the Senate Banking, Housing and Urban Affairs Committee. She notes that partial dollarization has occurred in a large share of countries experiencing economic difficulties. This has occurred as a result of private-sector initiatives rather than a policy-initiated process. Mann notes that dollarization will not correct structural problems in these economies, nor will it improve the quality of fiscal policy decisions. She argues that dollarization (or a fixed-exchange rate system) will not work well in the long run since it does not allow relative prices to differ across countries in response to different rates of productivity growth. Mann suggests that the most appropriate strategy is to correct the structural problems that these countries are experiencing.

• John Chown, "Currency Boards or Dollarization - Solutions or Traps?"
  http://www.ciaonet.org/pbei/riia/chj01.html
  In this August 7, 1999 Royal Institute of International Affairs Briefing Paper, John Chown examines alternative methods of providing a stable money supply in Russia. The options considered include dollarization and a currency board arrangement under which the U.S. dollar (or other stable currency) serves as a reserve asset and is freely convertible at a fixed rate. Chown notes that a practical difficulty with either a currency board or dollarization is the cost of acquiring foreign currency reserves. He notes the problems that Russia would face if there were external control of its monetary policy. Chown argues that either dollarization or a currency board system would make it more difficult for the U.S. to maintain control of its domestic money supply (since it becomes more difficult to monitor the domestic money supply when a larger share of the domestic currency circulates abroad. He suggests that the best strategy for Russia would be the use of a currency board that receives its credibility from a stable foreign currency while allowing the Russian government to receive seignorage.

• International Monetary Fund Economic Forum,
  http://www.imf.org/external/np/tr/1999/TR990624.HTM
  This is a transcript of an International Monetary Fund forum on dollarization in Latin America. Participants in this forum are: Guillermo Otiz (Governor of the Central Bank of Mexico), Miguel Kiguel (Chief of Argentina's Cabinet of Advisors and Undersecretary of Finance, Ministry of Economy, and Public Works and Services), Jeffrey Frankel (Brookings Institute and former member of the U.S. Council of Economic Advisers), and Eduardo Borensztein (Division Chief of the IMF Developing Studies Division). This forum provides a good discussion of the advantages and disadvantages of dollarization.

• Roberto Chang, "Dollarization: A Scorecard"
  http://www.frbatlanta.org/publica/eco-rev/rev_abs/00er/q3/chang.pdf
  Roberto Chang provides a discussion of the costs and benefits of dollarization in this 3rd quarter 2000 Federal Reserve Bank of Atlanta Economic Review article. He argues that the costs of dollarization are large, but the benefits are uncertain. (To view this document, the Adobe Acrobat viewer plugin is required. You may download this viewer by clicking here.)