Commentary Type

Dollarization as Diet

Catherine L. Mann (Monetary Policy Committee, Bank of England)

Statement before a joint hearing of the Subcommittee on Economic Policy and the Subcommittee on International Trade and Finance Committee on Banking, Housing, and Urban Affairs United States Senate Washington, DC


What is Dollarization?

There are three functions of money: means of exchange, unit of account, and store of value. Complete dollarization means that the dollar (and at this point in time, only the dollar is a candidate) serves all three purposes to the exclusion of a national currency: indeed, the national currency ceases to exist. Only Panama has this kind of complete dollarization.

Partial dollarization, where dollars circulate along with the national currency, is relatively widespread. A recent IMF Occasional Paper on the topic (no.171) reports that in 7 countries, dollars circulate about equally with the national currency, account for between 30-50 percent in some 12 other countries, and account for about 15-20 percent of currency in numerous other countries.

The point from these examples is that the dollarization we observe in all countries is a consequence of policy failure, not of policy initiative and this is a key distinction. Dollarization does not require a legislative act nor "permission" from the United States. In those countries were dollarization is prevalent, it is the result of market forces. But, even in countries with a history of policy failures, private market actors of consumers and business have not chosen to use only dollars. Would policy-initiated dollarization be viewed as a superior outcome for consumers and businesses by making it easier to obtain and use dollars, or would policy-initiated dollarization that excludes the use of national currency make some consumers and businesses worse off?

What Policy Failures have Contributed to De Facto Dollarization?

As a general observation, the decision by consumers and business in an economy to hold dollars instead of national currency as a store of value, to use dollars as a means of exchange for transactions, and to price products and write contracts on the basis of dollars is a consequence of high inflation rates of the national currency and subsequent depreciation of the national currency on international markets or, similarly, results from the expectation that these events will unfold. Examples of the former are Argentina and Russia, of the latter, the countries of Central and Eastern Europe during the initial period of their transition. Indeed, the degree of dollarization is a barometer of consumer and business attitudes towards policy.

To be sure, there are other issues as well, including those related to international trade transactions where holding a store of dollars ensures buying power in any country at any time in the international marketplace. And large dollar holdings in some countries, for example Poland, result from familial ties with the US.

Policy failure by what institutions in a country precipitates the choice by consumer and business to dollarize? Observers often lay the blame at the feet of the Central Bank, for pursuing unbridled money growth. From this belief, tying the hands of the monetary authority will keep money growth in check and stabilize and bring down inflation.

But the Central Bank does not act alone to create policy failures in a country: fiscal authorities play a very important role, usually by pursuing excessively expansionary and unpaid-for programs. Most Central Banks are not independent of the fiscal authorities and so become the "fall-guy" for fiscal mismanagement. This observation is important in that it points out limits to the gains that countries might obtain from pursuing policy-initiated dollarization.

What are supposed to be the benefits of policy-initiated dollarization?

Removing the threat of rapid inflation and of depreciation against the dollar should lead to lower interest rates by eliminating the inflation and exchange devaluation premia on a country's interest rates. Lower interest rates, as a general rule, benefit the growth process by reducing cost of credit and encouraging productive investments. In addition, price stability encourages growth by reducing volatility in domestic prices which reduces uncertainty in the economic environment. Finally, dollarization would reduce transactions costs in international trade and finance, particularly with trade with the US.

Why Might These Benefits be Smaller Than Expected?

Risk premia on interest rates will still exist depending on the performance of the fiscal authority, the quality of the financial system, and on the flexibility of labor and product markets. For example, interest rates differ on bonds issued by different US states and municipalities, even though all are issued in dollars. And, some states have defaulted on their obligations.

Dollarization, at least over the short and medium term, does not produce magic changes in fiscal performance, it just makes the price of policy mismanagement easier to spot in interest rates. Risk premia depend on structural characteristics of the financial system, since banks can still fail even if both assets and liabilities are denominated in dollars. Risk premia reflect structural characteristics of the economy; the more static are labor and product markets, the more difficult it is for resources to be reallocated according to the supply and demand forces generated by dollarization.

Proponents of policy-initiated dollarization must believe that the disciplines imposed by dollarization will force changes in industrial structure and banking systems, as well as improve the conduct of fiscal policy. While money is a powerful tool, this is a very tall order.

Moreover, transactions costs will still exist for international trade with non-dollar countries, e.g. Europe and Japan. Variation in the G-3 exchange rates have been quite large in recent years, and prospects for greater stability in the near term seems dim. Swings in relative price competitiveness to these three large marketplaces could tend to concentrate trade toward the US instead of enhancing stability through diversification of markets. Tying to the dollar and the US economy seems to make sense now, but would countries have thought so in the 1980s?

What are Costs of Dollarization?

One not-so-hidden-cost of dollarization is political. Not only does policy-initiated dollarization eliminate the national currency, but it puts the prospects for growth in the hands of another country's policymakers. And, in the near term, the country must pay the price of industrial restructuring as well as a change in direction for fiscal policy.

Second, a one-size-fits-both policy (for the US and for the dollarized country) might lead to a long-term allocation of resources that are inappropriate for the level of development of the dollarized country, even if the policy might work well initially to support growth and development. The US and most countries considering dollarization are at different stages of development. One reason why every fixed exchange-rate regime since (and including) the gold standard has ultimately broken down is because over time, differences in productivity growth rates between countries need to be reflected in changes in relative prices and allocation of resources between the traded and non-traded goods sectors. If a country is dollarized, the development process will be distorted from what it would be if the relative price in these sectors was allowed to evolve according to its own trajectory appropriate for that stage of development.

Third, loss of the monetary authority means that only one policy tool is available to deal with all the kinds of economic shocks that hit a country. Indeed, it may even be the objective of policy-dollarization to eliminate the independence of the fiscal authority, leaving no policy tools.

There is no denying that monetary policy has, perhaps more often that not, been detrimental to growth and development. But a good monetary authority has tremendous ability to assist a country's development prospects. Fiscal policy simply does not work well for some kinds of shocks. Moreover, putting even greater responsibility on fiscal authorities, who themselves have been more often than not part of the problem, seems mistaken.

Dollarization as Diet

Policy-initiated dollarization is like wiring your mouth shut to lose weight. It is effective in the short-run, but unless you undertake life-style changes (eating habits, exercise) you are not a healthier individual, just a thinner one. Moreover, once you have achieved your desired new weight, you'll want to take off the braces and eat something besides a liquid diet.

Un-wiring your mouth, de-dollarizing is very difficult since you can't be sure, absolutely sure, that you won't go back to the old habits. Similarly, once dollarized by policy, changing the regime to regain monetary autonomy simply may not be possible—in order to get the benefits, even if over-rated, you have to forswear ever changing.

The choice appears to be: Use the straightjacket of dollarization to force market and institutional change yet be exposed to greater volatility in output and non-dollar exchange rates (which is to keep your mouth wired forever). Or, end up on a lower long-term path of development on account of unbridled and poor behavior of fiscal and monetary authorities (which is to stay obese forever).

This is a poor choice and not one that is necessary—a better one is to work to improve the functioning of the authorities and their environment-in the diet analogy, to work harder at the "life-style" change. Harder work, but rewards well worth it.

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