https://www.cato.org/blog/dollarization-beyond-argentina

Daniel Raisbeck

An irony of the BRICS summit in South Africa last August, which included “de‐​dollarization” in the official agenda, was the touting of Argentina as one of the group’s new members. Argentina, of course, is on the brink of a presidential run‐​off in which the candidate who leads most polls, free‐​market economist Javier Milei, vows to shut down the central bank and officially dollarize the country.

Having lost over 95 percent of its value relative to the dollar since January 2019, Argentina’s national currency has been effectively destroyed. Even if Milei’s opponent, current Peronist finance minister Sergio Massa, wins the election on Sunday, he will have to face the fact that the country is already unofficially dollarized.

Indeed, Argentines have flocked to the dollar to protect their savings and gain monetary stability. For instance, 80 percent of used cars are now being sold through dollar transactions according to one report.

Nor is Argentina alone in terms of its de facto dollarization. In Venezuela, where socialists also destroyed the currency and unleashed hyperinflation, autocrat Nicolás Maduro relaxed a series of currency and price controls in 2019, thus granting people greater access to US dollars. Venezuelans embraced the opportunity without delay. By 2021, over half of all purchases of basic goods were being made in dollars. Maduro is now trying to curb the use of the dollar once again. Venezuelans, however, are fully aware that access to a sound currency is among the most basic of property rights.

Nearby, the citizens of Panama, Ecuador, and El Salvador, Latin America’s three officially dollarized countries, also know the advantages of a hard currency firsthand: low inflation, low interest rates, longer loan periods, and strong purchasing power. This is why large majorities in those nations have no desire to de‐​dollarize. Nor do they wish to grant legal tender to one of the BRICS currencies. The case for de‐​dollarization, it seems, has been overstated.

As economist Tyler Cowen writes, the US dollar is still used for the lion’s share of all global transactions, while American financial markets remain unparalleled in terms of their depth and liquidity. Fears of Chinese expansionism across the world have even strengthened the view of the dollar as a safe haven currency.

In Latin America, capital flight to the US financial system has long been the standard reaction to high taxes and fiscal profligacy, especially when governments add a penchant for monetizing the debt, devaluing local currencies and expropriating private property. Official dollarization, meanwhile, eliminates the option of devaluation, imposes a hard budget constraint on politicians, and introduces a strong rule‐​of‐​law element to the monetary sphere, as Professor Steve Hanke has argued.

Since Panama, Ecuador, and El Salvador are relatively small countries, dollarization’s success in Latin America has been mostly overlooked, regarded only as a regional anomaly. Argentina, on the other hand, is a large and influential country. If Milei wins, Argentina’s dollarization could be a regional watershed. If executed properly, other Latin American countries, not only those suffering under hyperinflation, might begin to consider the dollarization alternative.

In this sense, Brazilian President Lula Da Silva and his left‐​wing allies are correct in arguing that Latin America needs a common currency. Contrary to what they propose, however, the optimal currency for the region is that which ordinary Latin Americans use if given a choice: the US dollar.

Widespread dollarization would not only bring broad monetary stability to Latin America, an achievement in and of itself. Dollarization also can accelerate the next wave of regional integration through free trade, especially if the region’s democratic republics are granted access to USMCA, the free trade area formerly known as NAFTA (as a bipartisan group of members of Congress now propose).

In fact, as Shannon K. O’Neil notes, one of Latin America’s most underrated economic problems is its lack of intraregional trade, which accounted for a mere 15 percent of overall trade in 2018 compared to 55 percent for the European Union and 38 percent for North America.

Thus, a single free trade area encompassing most of the Americas is a brilliant prospect. Its achievement would create a trade bloc larger than that of the EU’s Single Market. And, as in the Eurozone, the widespread use of one, strong currency can boost the free flow of goods and services across national borders, especially for “later adopters.” In Latin America, this can be achieved without the serious drawbacks of an EU‐​like fiscal or political union.

If Milei wins the election on Sunday, Argentina’s dollarization can be a major step toward an enlarged, Latin American “dollar zone,” which can spur extraordinary opportunities for wealth creation across the region. But even if the Peronists hold on to power, the dollarization cat already might be out of the bag. Milei’s unexpected electoral success has made it evident that, in one of the region’s largest countries, “monetary sovereignty” has only amounted to sovereign monetary blundering.

https://www.cato.org/blog/economist-gets-it-wrong-dollarization-argentina

Daniel Raisbeck and Gabriela Calderon de Burgos

In a recent article, The Economist assures that inflation‐​ridden Argentina should not and cannot dollarize. The publication’s anti‐​dollarization stance is part of a broader warning against free market economist Javier Milei, who gained a surprise victory in last month’s primary elections and vows to dollarize the Argentine economy if he wins the presidency later this year.

The Economist misunderstands the most fundamental aspects of Milei’s plan to dollarize Argentina and shut down its central bank. This is, in fact, the best thought‐​out and most urgent part of his political platform. It affirms, for instance, that “Argentine banks and households would need a float of dollars to get up and running, which Mr. Milei has no way of providing.”

Dollarization and Available Dollars

As we explain in our recent policy brief, Argentina’s central bank might lack dollars, but Argentine citizens and companies do not. Private sector actors do try to shield themselves from the country’s frequent bank runs by holding dollars in other jurisdictions or under their mattresses. At the end of 2022, Argentines held over $246 billion in foreign bank accounts, safe deposit boxes, and mostly undeclared cash, according to Argentina’s National Institute of Statistics and Census. This amounts to over 50 percent of Argentina’s GDP in current dollars for 2021 ($487 billion). Hence, the dollar scarcity pertains only to the Argentine state.

To dollarize, Argentina needs to replace the peso‐​denominated monetary base with the equivalent in U.S. dollars at — or slightly above — the free market rate of exchange. Dollarizing at a rate far above that of the free market would be counterproductive because it would produce even higher inflation levels for a prolonged period. On the other hand, dollarizing at a rate below the free‐​market exchange rate would lead to a bank run because depositors would act to protect their savings from a forced devaluation.

In Argentina’s particular case, there is an official exchange rate—currently ARS $365—which most people cannot access. Hence, the black market exchange rate, known locally as the “blue dollar,” is the closest approximation to what a free‐​floating peso would be worth in dollar terms. At the moment, ARS $740 will buy you one blue dollar.

In Argentina’s case, economist Iván Carrino argued in May that, while the central bank’s liabilities amounted to ARS $18.8 trillion, dollarizing overnight at ARS $470, the blue dollar exchange rate at the time, would have required around USD $40 billion (the result of dividing the central bank’s liabilities by the exchange rate). The central bank’s total assets, meanwhile, were worth $34.5 billion. In theory, therefore, the government would have lacked around $5.5 billion—or around 1.1 percent of GDP— to dollarize at the market rate.

Nevertheless, the aforementioned imbalance is not as significant as it may seem at first. The last two dollarization processes in Latin American countries prove that “purchasing” the entire monetary base with U.S. dollars from one moment to the next is not only impractical, but it is also unnecessary.

The Mechanics of Dollarization

In both Ecuador and El Salvador, which dollarized in 2000 and 2001 respectively, dollarization involved parallel processes. In both countries, the most straightforward process was the dollarization of all existing deposits, which can be converted into dollars at the determined exchange rate instantly.

As Argentine economist Nicolás Cachanosky explains, when you dollarize deposits, the danger of a bank run is minimized insofar as dollarization takes place at the market rate and monetary transactions continue to take place within the banking system.

Crucially, in both Ecuador and El Salvador, dollarization not only did not lead to bank runs; it led to a rapid and sharp increase in deposits, even amid economic and political turmoil in Ecuador’s case. With the mere announcement of dollarization in January 2000, Ecuadorians began to deposit their dollars in banks even though the latter were so beleaguered they were paying negative interest rates.

The tendency held. Between January and December of 2000, Ecuador’s total deposits increased by $733 million, whereas the total amount of international reserves in December of 1999 stood at a mere $872 million. Also, whereas deposits accounted for just around 15 percent of GDP in 1999, they had increased to 19.1 percent of GDP at the end of 2000.

Deposits continued to increase over the following decades. At the end of 2022, Ecuador’s deposits amounted to 37.9 percent of GDP. By way of comparison, Argentina’s deposits reached a meager 22.5 percent of GDP at the end of last year.

Dollarizing the Circulating Currency

The other, parallel dollarization process involves turning the national currency in circulation into U.S. dollars. Critics who claim that Argentina cannot dollarize due to an insufficient amount of dollars assume that the government must count with the entire dollar amount necessary to buy all pesos in circulation on day one. Nevertheless, this was not the case in either Ecuador or El Salvador.

In Ecuador, the sucres in circulation were dollarized within a nine‐​month period mandated by the government, which had to rely on the Coca‐​Cola Company’s supply network to exchange dollars for sucres in remote rural areas.

According to Miguel Dávila, the president of Ecuador’s central bank when dollarization took place, the monetary authorities only had to back the central bank’s liabilities that needed to be liquid on day one of dollarization. These included all sucre coins and bills in circulation, banking reserves deposited at the central bank, and central bank deposits from state entities that were likely to require immediate withdrawals. The rest of the central bank’s liabilities were not available for withdrawal immediately. Rather, they were restructured.

This seemed like a risky bet. In December 1999, the central bank’s liabilities in dollars amounted to $1.25 billion, a figure that far surpassed the country’s international reserves. Experts thus claimed that dollarization was only viable at the extremely high exchange rate of 40,000 sucres. The market rate on the streets, meanwhile, was at or above 25,000 sucres. So who provided the dollars?

Ecuadorians did. Dollarization was announced on January 9, 2000, at a near‐​market rate of 25,000 sucres per dollar. By September of that year, 97 percent of all sucres in circulation—equivalent then to $577 million— had been exchanged for dollars. In other words, new dollar deposits had matched and even surpassed the dollar amount of the circulating national currency.

Emilio Ocampo, the Argentine economist whom Milei has put in charge of plans for Argentina’s dollarization should he win the presidency, summarizes Ecuador’s experience thus:

People exchanged their dollars through the banks and a large part of those dollars were deposited in the same banks. The central bank had virtually no need to disburse reserves. This was not by design but was a spontaneous result.

The Salvadoran Model

Dollar deposits also increased spontaneously in El Salvador, a country that dollarized in 2001. By the end of 2022, the country’s deposits amounted to 49.6 percent of GDP—in Panama, another dollarized peer, deposits stood at 117 percent of GDP.

El Salvador’s banking system was dollarized immediately, but the conversion of the circulating currency was voluntary, with citizens allowed to decide if and when to exchange their colones for dollars. Ocampo notes that, in both Ecuador and El Salvador, only 30 percent of the circulating currency had been exchanged for dollars four months after dollarization was announced so that both currencies circulated simultaneously. In the latter country, it took over two years for 90 percent of the monetary base to be dollar‐​based.

Cachanosky explains that, in an El Salvador‐​type, voluntary dollarization scenario, the circulating national currency can be dollarized as it is deposited or used to pay taxes, in which case the sums are converted to dollars once they enter a state‐​owned bank account. Hence, “there is no need for the central bank to buy the circulating currency” at a moment’s notice.

The corollary is that, although it is important for Argentina’s new government to announce dollarization as quickly as possible, the actual process of dollarizing the circulating currency can and should be drawn out. The region provides two relatively recent and successful examples of dollarization, one of which (Ecuador) was achieved fully in nine months, the other (El Salvador) in roughly 24.

The Remaining Stage of Dollarization in Argentina

The most difficult stage of dollarizing Argentina involves a particular feature of that country’s recent and tremendous inflationary build‐​up: namely, the $30 billion in LELIQ liquidity notes that, as we explain in our policy brief, are a fiscal time bomb:

The central bank issues LELIQs to mop up pesos from the market in an attempt to revive domestic demand for the local currency. Despite their constant escalation, nominal LELIQ interest rates—the current rate is 97 percent, versus 38 percent in early January 2022—have not kept up with what is now triple‐​digit inflation. The effective rate, on the other hand, stands at an astronomical 155 percent per annum.

The central bank has only been able to pay for such drastic interest rate hikes by expanding the monetary base aggressively, thus boosting inflation further. Since higher inflation leads to greater demand for hard currency, the use of LELIQs as a means to strengthen the peso has become counterproductive.

Ocampo and Cachanosky, who co‐​wrote a book titled Dollarization: A Solution for Argentina, propose to defuse the LELIQ bomb without defaulting or taking on further debt. The plan, which we summarize, involves swapping the central bank’s assets—namely, its loans to the Argentine treasury—for bonds in a foreign jurisdiction. As we summarize, the latter would then be deposited

In a new trust with the ability to issue asset‐​backed commercial paper with short‐​term maturities. The trust, which would be supported by an underwriting backstop facility … would swap LELIQs for dollar‐​denominated commercial paper, which would be paid off with proceeds from the trust’s assets until the entirety of LELIQ debt is liquidated.

Whether or not LELIQ debt is dollarized and restructured in this fashion, the issue at stake is not whether Argentina now has enough dollars to do so. The issue is that the central bank has no liquid assets with which to back this rapidly growing liability. With or without dollarization, the next government, which will take office in December, will have to deal with the LELIQ problem. After all, LELIQs are a fiscal liability of the Argentine state which will have to be restructured with or without dollarization and even without a central bank.

If done correctly, dollarization can provide a positive confidence shock that can help the new government steer Argentina away from the fiscal cliff. In fact, adopting a sound currency and reaching single‐​digit inflation levels as soon as possible are prerequisites for all the other supply‐​side reforms that Argentina needs. Dollarization is the surest and fastest way to achieve that. Furthermore, restructuring any fiscal obligation, including the LELIQs, becomes far easier with lower interest rates, another proven benefit of dollarization.

Is There a Realistic Alternative to Dollarization?

In fact, the burden of proof falls on dollarization’s critics, many of whom reveal a Panglossian belief in the sudden emergence of a responsible and independent central bank in Argentina, to show how they intend to stabilize the Argentine economy without granting legal tender to a hard currency. As Cato Senior Fellow Lawrence White explained with regard to Ecuador, “the relevant alternative to dollarization is thus not an imagined regime in which precisely calibrated depreciations of the local currency’s exchange rate are administered by experts to adjust wages.”

That is, the purported costs of losing the ability to depreciate the local currency with utter precision should be compared with the actual, massive costs of the central bank’s excessive money creation, spurred as it is by the fiscal profligacy of Argentina’s political class. It is true that ipso facto, dollarization will not turn Argentine politicians into fiscal conservatives. However, adopting the dollar will separate fiscal policy from monetary policy, which will no longer respond to local political pressure. Hence, dollarization in Argentina will significantly limit the scope of the damage that reckless fiscal policy can wreak. This brings us to another of The Economist’s mistaken assumptions

The Point of Dollarization

In its article on Milei, The Economist also argues that dollarization would make any future default “even more painful, since there would be no lender of last resort if Argentina’s central bank disappeared with the peso.” Argentina, however, already has no effective lender of last resort at the national level. Instead, its governments turn recurrently to the IMF (International Monetary Fund) as a de facto lender of last resort that provides them with—what else?—U.S. dollars.

The Economist adds that, even with dollarization, Argentine politicians “would still try to borrow too much, and there would be no central bank to inflate the debt away.” This fully misses the essential point behind the adoption of the dollar, which is to protect ordinary people’s purchasing power from the excesses of chronically profligate politicians and often subservient—or simply incompetent—central bankers. As we have mentioned, by depriving the local political class of all ability to manipulate the currency, dollarization separates fiscal policy from monetary policy.

This is why, as Manuel Hinds, a former finance minister in El Salvador, has explained, solvent Salvadorans in the private sector can borrow at rates of around 7 percent on their mortgages while international sovereign bond markets will only lend to the Salvadoran government at far higher rates. As Hinds writes, under dollarization, “the government cannot transfer its financial costs to the private sector by printing domestic money and devaluing it.”

This is yet another lesson of dollarization’s actual experience in Latin American countries. It is also a reason why the vast majority of the population in the dollarized nations has no desire for a return to a national currency. The monetary experiences of daily life have taught them that dollarization’s palpable benefits far outweigh its theoretical drawbacks.

https://www.cato.org/blog/dollarizations-critics-are-ignoring-evidence

Daniel Raisbeck and Gabriela Calderon de Burgos

After paying little attention to dollarization in Latin America for over two decades, the international press suddenly features regular commentary on the subject. This is a result of Argentina’s primary elections of August 13, when Javier Milei, a candidate whose flagship proposal is to dollarize the Argentine economy, delivered a surprise victory.

In our last blog post, we took on seven myths about dollarization in Latin America that are often put forth against the measure. Myth #3 refers to the theory that dollarization already failed in Argentina in the 1990s, when the government of former president Carlos Menem (1989–1999) implemented a convertibility system.

As we explain, the equivalence is false because the convertibility system amounted to an unorthodox currency board in which the central bank still carried out monetary policy, something that does not take place under an orthodox currency board. Under full dollarization, whereby the dollar is granted legal tender, the central bank either disappears or is rendered obsolete in terms of its ability to implement monetary policy.

In a recent article, Bloomberg’s Eduardo Porter relies on myth # 3, claiming that dollarization in Argentina is “a dangerous delusion” because “the proposition has essentially been tested already.”

Strangely enough, Porter recognizes that the convertibility system did not amount to dollarization. He writes that the set‐​up allowed “the government in Buenos Aires wiggle room,” which, though narrow, “could still be used destructively.”

He adds that economic agents “would operate under the assumption that laws could be changed and the plan could be undone,” so that “the promise was short of being rock solid.”

Nonetheless, Porter writes that the convertibility system was “the next best thing” after dollarization. It was not, because the next best thing would have been an orthodox currency board, which strictly limits a central bank’s scope to fixing the exchange rate to the dollar.

The claim that convertibility was not a “rock solid” promise, moreover, is a gross understatement; the convertibility system’s leeway to the monetary authorities caused its eventual failure. Thus, the convertibility system’s experience in no way proves that dollarization is not feasible in Argentina. If anything, convertibility’s failure shows that the country’s monetary authorities can do much damage with minimum leeway.

The main point of dollarization, meanwhile, is precisely to get rid of all leeway for the monetary authorities. Dollarization is a superior alternative because it requires no promise from a central bank to abide by a fixed exchange rate.

Porter, however, argues that anyone who points to the convertibility system’s fundamental design flaws “misunderstands the root cause of convertibility’s failure. It collapsed, in essence, because the Argentine economy — its households and businesses, governments and banks — could not generate enough dollars to cover the debts incurred to maintain consumption in the convertible era.”

While this might describe the consequences of the convertibility system’s failure, it is a bizarre argument against dollarization. In a fully dollarized country, there is no need to “generate dollars” in order to cover dollar debts incurred while using a local currency because there is no local currency.

In fact, a main advantage of dollarization is that, by granting the U.S. dollar legal tender, the entire economy operates in dollars, so that there can be no balance of payments crisis. Under dollarization, a debt crisis or a default will force the government to pay the price via higher interest rates in global sovereign bond markets, but this will not affect the money supply, the value of the currency, or even the interest rates for solvent private sector actors (see below).

It is only by creating a conflict between monetary policy and the exchange rate policy—that is, by keeping a national currency pegged to a foreign currency while allowing the central bank to dictate monetary policy— that a balance of payments crisis can arise. This is what took place in Argentina in 2002.

Porter further quotes a paper by economists Sebastian Galiani, Daniel Feynmann, and Mariano Tomasi, who argue that “the dollar value of incomes had to be sufficient to maintain spending and service debts, and for that to happen, a sufficient growth in the output of tradables had to materialize before the supply of credit dried up.” This was not the case in the wake of the Asian financial crisis of 1997, which, as Porter writes, “slashed capital flows and increased the costs of foreign borrowing.” Argentina’s exports suffered with the subsequent devaluation of the Brazilian real, and the convertibility system exploded thereafter.

But, again, the tension between rising debt and the dollar value of incomes and output earned in pesos was a feature of convertibility, not of a dollarized system. In their paper, in fact, Galiani et al. argue— in a footnote— that “the dollarization proposals would count as a particularly strong form of raising the bet, by exiting convertibility in the other direction.” But they go on to state that the proposal “did not find significant international support,” which is not surprising; as we have explained, no official institution in Washington supports dollarization.

They add that “in any case, (dollarization) could not restore export growth or solve the fiscal problems if the economy stagnated or went into a recession for more fundamental reasons.” This is true because dollarization is no guarantee of fiscal prudence or economic growth. However, dollarization does prevent the type of currency mismatch that blew up the convertibility system, which, at one point, established different exchange rates for imports and exports.

Porter doubles down on the “convertibility failed, hence dollarization is impossible” non sequitur when he writes: “It is a dubious proposition that ditching the peso altogether and adopting the dollar would have allowed Argentina to hold on. It rests on the fantasy that a dollarized Argentina would have kept attracting foreign money regardless of its economic realities.”

Although he does not state it explicitly, Porter seems to imply that dollarization would work in Argentina only if the country’s export growth outpaced or kept up with that of its imports. This focus on the balance of trade is wrong not only in terms of dollarization; it is a rehash of the fallacy that trade surpluses are desirable and even necessary for a nation to prosper, a theory refuted by Adam Smith in the 18th century as part of his demolition of mercantilist theory. (Porter displays mercantilist sympathies when he states that the government needs to run the economy).

Regarding trade, one of dollarization’s main advantages is that it provides an economy with a real exchange rate, through which trade and payments tend to balance each other. As such, dollarized economies operate in a way that is akin to the classical gold standard.

As David Hume, another eighteenth‐​century critic of mercantilism, wrote at a time when precious metals provided the means of exchange for international trade, the gold accumulated via exports that exceeded imports tended to raise a nation’s domestic prices. This made imports more attractive. Conversely, when imports began to exceed exports, gold flowed out and domestic prices would fall. The process would reverse once more as exports began to exceed imports.

Hence, under the classical gold standard, the balance of trade might never have been in a state of perfect equilibrium, but it did tend to balance automatically. Dollarization operates with the same type of automatic adjustment, with U.S. dollars, not gold, serving as the means of exchange. But politicians first have to allow dollarization to take place. To Argentina’s detriment, this did not take place in the 1990s.

The main problem with Porter’s argument is not even that he equates convertibility with dollarization, claiming that the latter would fail because the former failed. Much worse is that he assumes that convertibility is the only relevant comparison for Argentina today, but he fully omits the experience of all the Latin American countries that have dollarized successfully.

Panama had already used the dollar for nearly a century when the Asian crisis struck in the late 1990s and it suffered none of Argentina’s trauma: its last year of negative GDP growth before 2020 was 1988, the year before a U.S. invasion toppled General Noriega. In recent decades, dollarized Panama has posted some of Latin America’s highest growth rates in terms of per capita GDP, thus refuting the myth that dollarization prevents a country from achieving solid growth.

Nor did Argentina’s woes at the turn of the century prevent Ecuador and El Salvador from dollarizing in 2000 and 2001 respectively. Both countries have benefitted considerably from dollarization despite their lack of rapid growth.

El Salvador has proven that the private sector in a dollarized country still can access dollars at relatively low interest rates regardless of the government’s fiscal problems. Non‐​dollarized countries, on the other hand, must counter outflows in times of crisis with drastic interest rate hikes, thus undermining investing incentives across all sectors. As Manuel Hinds, a former finance minister in El Salvador, writes about his country’s recent experience:

In the last two years, there was a scare that the government would not repay a large instalment of its long‐​term debt, and the EMBI (the difference between the yield of the Salvadoran bonds and the American ones) went up to almost 30%… This indicates how the international secondary markets for sovereign debt consider the risks of lending to a government.

Yet, in El Salvador, both short‐​term and mortgage interest rates remained around 7%, highlighting how the international markets (into which El Salvador is directly inserted, without intermediation by the central bank) assigned a considerably higher risk to the government compared to the private sector.

It was dollarization, moreover, that reduced El Salvador’s interest rates and lengthened loan periods in the first place. As Hinds notes: “after dollarizing, the interest rate fell from 20% to 6% for mortgages, increasing their maturity from 5 to 25 years. Short‐​term loans also became cheaper. And this was not a fad.”

In Ecuador’s case, dollarization has succeeded in a classic “banana republic” — the country is the world’s largest exporter of bananas — that is also largely dependent on oil exports and remittances. Ecuador is thus uniquely subject to external shocks. Nonetheless, since it dollarized in 2000, the country has withstood major fluctuations in the price of crude oil, its main export, and sharp reductions in the flow of remittances.

Ecuadorians, in fact, lived through the Great Recession, the end of the country’s second oil bonanza, and the COVID-19 pandemic, all while maintaining a stable financial system and one of the lowest inflation rates in the region.

Yes, Ecuadorians could have enjoyed higher growth rates if other structural reforms had been implemented. In their absence, however, at least Ecuador did not experience the type of wipeout that was the norm between 1980 and 2000, when an external shock would be followed by an even stronger internal one.

Ecuador’s case also proves that a hard dollar regime, while no guarantee of fiscal prudence, still imposes significant budget constraints on profligate governments. Former president Rafael Correa, who governed from 2007 until 2017, was a poster boy for twenty‐​first‑century socialism and a declared enemy of dollarization. Nonetheless, Correa failed in his attempt to introduce a digital currency and was forced to reduce public spending — from 44% of GDP to 37% — between 2014 and 2017.

Being no free trader, Correa joined the European Union’s free trade agreement with Colombia and Peru in 2017 (after an accession process of several years). Mainly, this was because he found himself with no political support for further tax hikes, unable to monetize fiscal deficits, and with virtually no access to capital markets. Arguably, the EU trade deal was Ecuador’s most important trade liberalizing measure in the past quarter century.

The success of dollarization in Latin America has gone under the radar because the dollarized trio are relatively small countries, Ecuador being the largest with a population of 18 million. Were Argentina to dollarize, however, it hardly would be feasible to ignore or hide its benefits — monetary stability, low inflation, low interest rates, longer loan terms, built‐​in hard budget constraints — in one of the region’s largest and most influential countries.

If dollarization has been a regional anomaly hitherto, Argentina’s official adoption of the dollar could be a hemispheric watershed. Could this explain why the anti‐​dollarization camp has become so vocal of late?

https://www.cato.org/blog/seven-myths-about-dollarization-latin-america

Daniel Raisbeck and Gabriela Calderon de Burgos

When we published our Cato Institute Policy Brief (“Argentina Should Dollarize, Pronto,”) on July 27, few outside of Argentina were paying attention to the dollarization debate. This changed on August 13, when Javier Milei, the only pro‐​dollarization candidate taking part in the primary elections, won a surprise victory, thus unleashing a barrage of commentary about the supposed dangers of dollarizing the Argentine economy. Many commentators, however, appear to rely on theories that do not reflect the actual experience of dollarization in three Latin American countries: Panama, Ecuador, and El Salvador. In this post, we attempt to refute some of the most salient myths about dollarization in Latin America.

1. Dollarization leads to a loss of competitiveness and weak growth.

False: The main advantages of dollarization are a) it ends currency devaluation / depreciation b) it prevents the political class from monetizing the debt and causing high inflation à la Argentina.

Those advantages do not take away from a dollarized country’s ability to be economically competitive and maintain above‐​average growth. See the case of Panama, which dollarized in 1904. In recent decades, Panama’s economic growth has been among the highest in the region, and its current level of per capita GDP far exceeds those of non‐​dollarized peers such as Brazil and Colombia.

Source: World Bank

While some argue that Panama’s success is due to the Panama Canal, the proceeds from the Canal’s activity as a percentage of GDP has been less than what other countries in the region obtain by exporting a single commodity. Rather, Panama’s economic strength is based on its open, internationalized banking system, which allows the country to attract foreign capital and guarantees liquidity in the economy.

A country does not become competitive via currency devaluation or depreciation. Were that the case, Argentina today would be extremely competitive, but it is not. Conversely, if an economy became competitive by devaluing its currency in real terms, then Japan would have become significantly less competitive while its currency appreciated by 176 percent versus the U.S. dollar between 1960 and 2004. However, the Japanese economy enjoyed an export boom during said period. On the other hand, the Colombian peso depreciated by 48 percent between 1960 and 2004, yet its exports grew half as fast as those of Japan.

As Manuel Hinds, a former finance minister in El Salvador, explains, Japan succeeded not by devaluing its currency, but rather by “shifting from lower‐ to higher‐​value‐​added production when the currency appreciated in real terms. Germany did the same [in the post‐​war period]. That is true competitiveness.” Hinds adds that devaluation merely favors the profitability of current, lower‐​value‐​added production and deters a shift towards higher‐​value‐​added production.

2. Because growth has been slow in Ecuador and El Salvador, dollarization has not succeeded there.

False: Ecuador has not put in place the right supply‐​side policies to generate Panama‐​like economic growth, and El Salvador has backtracked in this respect since the 2000s. Dollarization is not a silver bullet. It needs to be accompanied by other pro‐​growth policies that have been absent in Ecuador and El Salvador, thus their mediocre growth since they dollarized in 2000 and 2001 respectively.

Nonetheless, dollarization has succeeded in both countries because their dollar regimes prevented fiscally profligate, hard left‐​wing governments from de‐​dollarizing, re‐​introducing weak currencies, and monetizing the debt (Rafael Correa in Ecuador and the FMLN in El Salvador).

As a result, both Ecuador and El Salvador have faced fiscal crises in the last few years. However, said problems have not affected the average citizen, who has maintained a sound currency and some of the lowest inflation levels in Latin America.

Also, as citizens of dollarized countries, Ecuadorians and Salvadoreans benefit from far lower interest rates and longer loan periods than under “monetary sovereignty” regimes. Plus, dollarization imposes an intrinsic hard budget constraint on both their governments and parliaments. Hence, those countries’ fiscal situation likely would have been much worse under a national currency.

3. Dollarization failed in Argentina in the 1990s.

False. In the 1990s Argentina had a currency board that exchanged dollars for pesos, a system and that is sometimes confused with dollarization. In fact, equating that exchange‐​rate system with dollarization is misleading. As Professor Steve Hanke explains, “There are three distinct types of exchange rate regimes: floating, fixed, and pegged—each with different characteristics and different results” (see the table below).

Source: Steve H. Hanke, “A Money Doctor’s Reflections on Currency Reforms and Hard Budget Constraints,” in Public Debt Sustainability: International Perspectives, eds. Barry W. Poulson, John Merrifield, and Steve H. Hanke (Lanham, MD: Lexington Books / Rowman & Littlefield, January 2022), pp. 139–69.

Given the differences between exchange rate regimes, it is incorrect to ascribe the main characteristics of dollarization to a currency peg, which can be changed or done away with. This is not the case with dollarization, whereby a country replaces its currency with the U.S. dollar at a given rate and grants the latter legal tender (de‐​dollarization is most feasible under a totalitarian regime such as Robert Mugabe’s in Zimbabwe). A peg also leaves a country with monetary policy faculties, a partly domestic source of the monetary base, and, hence, the possibility of a balance of payments crisis. None of these factors are present under dollarization.

An orthodox currency board provides an alternative version of a fixed exchange rate regime. Once in place, it sets the exchange rate but carries out no monetary policy, so that the foreign‐​based monetary base remains, as Hanke writes, “on autopilot.” Under a currency board—as with dollarization— the balance of payments determines the monetary base as it moves “in a one‐​to‐​one correspondence” with any changes in foreign reserves. This prevents monetary policy and exchange rate policy from colliding, thus precluding balance of payment crises (as is the case in floating rate systems).

Had Argentina implemented an orthodox currency board in the 1990s, it would have carried out a fixed exchange rate policy but no monetary policy (such a currency board acts as a straitjacket on the local monetary authorities). Under official dollarization, the dollar would have had legal tender, the peso would have ceased to circulate, and the central bank would have become obsolete in terms of monetary policy. Neither was the case.

As we explain in our policy brief, Argentina’s convertibility system of the 1990s, which fixed the peso to the U.S. dollar, had several characteristics that made it, in Professor Hanke’s terms, an “unorthodox currency board.” Namely, the central bank still controlled the impact of capital inflows and outflows on the money supply (through sterilization and neutralization), it carried out monetary policy, and it acted as a lender of last resort. The convertibility system even came under a dual currency regime, with different official exchange rates for imports and exports. Each of these features made the convertibility system incompatible with both an orthodox currency board system and official dollarization,

Despite its inherent defects, Argentina’s convertibility system did cause the inflation rate to drop from over 2,600 percent in 1989–1990 to less than 1 percent in 1998. Due to its design flaws, however, the Argentine peso began to lose parity with the dollar in 2001, when currency market speculators smelled blood. In January 2002, Argentina carried out a chaotic exit from its fixed exchange rate.

4. The loss of monetary sovereignty leaves a country at a disadvantage due to the inability to counter external shocks with monetary policy.

False. As Hinds writes, Panama, Ecuador, and El Salvador have all “calmly endured the 2008 and COVID-19 crises with much lower interest rates than in the rest of Latin America.”

Besides, dealing with a crisis by devaluing the local currency might bring the mirage of (very) short‐​term relief, but this is offset by the necessary consequences of devaluation: the loss of purchasing power, higher inflation and interest rates (than in a dollarized scenario), and the strong incentive to maintain low‐​value‐​added production.

In extreme circumstances, finance ministers of developing countries—both formally dollarized and non‐​dollarized— head to Washington looking for the same thing: a loan in U.S. dollars from the IMF, the repayment of which becomes more onerous with a weakening currency. As Hinds explains, the IMF’s power lies in its ability to allow developing countries to access dollars, particularly in times of crises and when the market shuts out funding for particular governments.

Consider, moreover, the effects of devaluation. As Andrei Levchenko and Javier Cravino found in the case of Mexico’s 1994 “Tequila crisis,” “the consumers in the bottom decile of Mexican income distribution experienced cost of living increases about 1.25 times larger than the consumers in the top income decile” during the two following years. Hence, the authors conclude that the distributional effects of large devaluations are “anti‐​poor”. In Professor Hanke’s words, “when the currency loses value, you import inflation.”

Maintaining a weak national currency might appeal to certain central bankers, who would remain employed and could still act as protagonists in times of crisis, when, according to theory, currency devaluation or depreciation is in the national interest. The very rich are largely unaffected, not least because a large portion of their assets tends to be held already in U.S. dollars or other hard currencies.

For the bulk of the population, however, maintaining purchasing power is of the utmost importance. In fact, as we have seen, a sharp loss in a currency’s value is most detrimental to the poorest segments of the population.

5. Dollarization can lead to very high unemployment levels because of external shocks, while flexible exchange rate regimes can withstand such shocks far better.

False: Panama and Ecuador have proved that dollarized countries in Latin America can maintain low unemployment levels compared to non‐​dollarized peers, even those with independent central banks such as Brazil and Colombia.

Source: World Bank

A depreciating currency hinders economic growth in the long term, all things being equal. While a weakening currency might reduce the price of labor, thereby stimulating growth and employment in the short term, it raises the cost of capital in the form of higher interest rates. This discourages investment, which is the source of job creation in the long run.

6. The Federal Reserve oversees all monetary policy for dollarized countries.

False. Although dollarization does take away a country’s ability to set its own interest rates and print its own national currency, while dollarized countries’ inflation rates tend to merge with those of the United States, liberalization of the banking system can grant an important degree of independence.

As economist Juan Luis Moreno‐​Villalaz argued in the Cato Journal in 1999, Panama’s banks, which have been integrated to the global financial system after a series of liberalization measures in the 1970s, allocate their resources inside or outside the country without major restrictions, adjusting their liquidity according to the local demand for credit or money. Hence, changes in the money supply—which arise from the interplay between local factors and the specific conditions of global credit markets—and not the Federal Reserve, determine Panama’s monetary policy. Fed policy affects Panama only to the same extent that it does the rest of the world.

7. Dollarization is a U.S. imperialist policy.

False. No official institution in Washington supports or promotes dollarization. The White House and the U.S. Congress are usually disinterested in the monetary policy of Latin American countries. On the other hand, the large multilateral organizations, namely the World Bank and especially the International Monetary Fund (IMF), tend to oppose dollarization initiatives. For instance, when former Ecuadorean president Jamil Mahuad dollarized in early 2000, he did so against the express wishes of the IMF and the World Bank. Unsurprisingly, current and former IMF economists now oppose Argentina’s potential dollarization.

In part, the IMF’s resistance to dollarization can be explained from a public choice perspective. As part of its mission, the IMF provides member countries with “capacity development, which is technical assistance and training of government officials” in different areas, including “monetary and exchange rate policies.” If a country dollarizes, it no longer carries out such policies. Nor does it employ central bank officials for the IMF to train in terms of monetary and exchange rate policies. This is problematic not only for the IMF. In Latin American countries, economists have strong incentives to work for the local central bank. As Professor Hanke argues, a stint at a Latin American central bank has become the equivalent of holding an advanced university degree. Moreover, central bank economists in Latin America often aspire to an eventual post at the IMF itself. In a dollarized country, no such career path exists for economists. In part, this also explains the opposition to dollarization that is often voiced by local macroeconomists.

Another frequent argument against dollarization is that it is economically harmful due to the loss of seigniorage, the price paid to a currency’s issuer. As we explain in our policy brief, however, the so‐​called loss involved is small and, ultimately, a minimum price to pay for an end to high inflation. Especially in countries with poor monetary policy, the cost of giving up seigniorage is the equivalent of an insurance premium paid for protection against the higher risks of maintaining a local currency.