UCEMA – The year 2020 marks the twentieth anniversary of dollarization in Ecuador. The year 2020 also marks 13 consecutive years of high inflation in Argentina. In the last 20 years, Ecuador and Argentina have followed different paths in matters of monetary policy and institutions. The results are, of course, different. While Ecuador managed to tame inflation, Argentina cannot find a way out of its high inflation.
The issue of dollarization in Argentina is recurrent, it never ends up disappearing. It could be argued that Argentina is an informally dollarized country. Weight is used for daily transactions and tax payments. But the dollar is used as a saving currency and unit of account in large transactions (for example, buying real estate). Since Perón nationalized the BCRA in 1946, the average annual inflation has been around 60%. Shouldn’t Argentina once and for all formalize its dollarization following in the footsteps of Ecuador?
The idea of dollarization is received with considerable rejection in Argentina. However, this rejection is based on speculative arguments rather than on the experience of dollarized countries. Surely there are lessons to be learned from the 20 years of experience in Ecuador. Below, I contrast four of the most common objections to dollarization with what we know has happened in Ecuador.
Abandon monetary policy
Perhaps the most common objection to dollarization is that the possibility of conducting domestic monetary policy is abandoned. However, it seems to me that this objection misses the point of dollarization. Just one of the ideas behind dollarization is to abandon a terrible domestic monetary policy, not an efficient domestic monetary policy.
The concern is that, without a central bank, the dollarized country would be exposed to external nominal shocks. For example, changes in interest rates by the Federal Reserve or sudden movements of capital. However, we must be careful not to fall into a Nirvana fallacy, where a real situation is compared to an ideal one. The alternative to dollarization is not a central bank capable of navigating internal monetary shocks; the alternative to dollarization is a central bank that is a source of recurring and serious internal shocks. The country in which dollarization is an issue is not a country with an efficient central bank, it is a country with an inefficient central bank. Dollarization in Argentina implies choosing between dollarizing and staying with the BCRA, it does not imply choosing between dollarizing and having the Swiss central bank. In other words, the relevant trade-off is between external shocks and internal shocks. It is not obvious, then, that dollarization is a bad idea when the ideal central bank is not on the menu.
Ecuador offers two lessons. The first is that closing the central bank does not imply giving up domestic monetary policy entirely. Following the Ecuadorian case, a tax can be levied on the financial sector specifically applied to an emergency fund that the government can use to offer liquidity if necessary. This emergency fund can be administered by an entity independent of the Treasury.
In 2008 there was a great monetary shock. According to the argument of the danger of abandoning domestic monetary policy, Ecuador should have suffered one of its biggest economic crises. Ecuador not only faced the 2008 crisis, that same year its sovereign debt also fell into default. However, the economic crisis of 2008 was much less in dollarized Ecuador than in Argentina with its own central bank.
Abandoning the lender of last resort
A second objection to dollarization is the loss of the central bank as a lender of last resort. This argument is based on the idea that the financial system is inherently unstable. The free banking literature casts serious doubts on the idea that banks are inherently unstable. A careful study of banking history shows that crises are due to inefficient regulations or fiscal imbalances, not fractional reserves per se. But, beyond the lessons of the free banking literature, the important thing is to see what happens to the role of lender of last resort in the event of a dollarization.
The first question is to define what should be the behavior of the lender of last resort. In short, we can think of two types of lenders of last resort. The first fulfills the classic role of the central bank, which consists of offering financial aid only to illiquid but solvent banks. This behavior is known as the Bagehot Rule. The second lender of last resort seeks to prevent any bank from failing, even insolvent ones, for fear of a domino effect (similar to the too-big-too-fail doctrine). Is this second lender to last resort the one that generates problem of moral hazard and costs to the taxpayer.
If you are looking for a lender of last resort following Bagehot’s Law, then you don’t need to have your own central bank. In addition to the presence of an emergency fund as mentioned above, there are other alternatives to a central bank a la Bagehot. What the financial sector needs is access to credit, not necessarily to an issuer. In other words, the financial sector has access to the entire international financial market to obtain loans. Of course, these loans are going to be given if the bank only has a temporary illiquidity problem, but not solvency. Learning again from the free banking literature, it could be argued that, in this case (agreement between private parties), there are stronger incentives to comply with Bagehot’s Law than when depending on a central bank.
This is the situation we see in both Ecuador and Panama. The financial sector must show solvency when requesting a loan. Banks can turn to their parent companies, who have an interest in helping their branches financially if it is really worth it. In fact, the soundness of the banking system in Ecuador has improved after dollarization. Finally, an anecdotal but representative data. While the Great Depression led to the failure of thousands of banks in the United States under the watch of the Federal Reserve, no bank in Canada failed without a central bank to protect the stability of the system. The absence of a central bank in Canada is not the only difference with the United States. Unlike this country, Canada did have a genuine free banking system.
Another concern is the loss of seigniorage, which is the monetary authority’s gains from the creation of money. The central bank receives income from investing its reserves, and pays operating costs and interest rate for the issuance of its liabilities. To the extent that the market demands the local currency, the central bank can issue pesos, buy dollars, and invest them in the international market. However, to the extent that the market does not demand the local currency, the central bank must pay high interest rates to keep the pesos in circulation by reducing seigniorage. In fact, the central bank may be running a deficit rather than a surplus.
The main problem with this objection is conceptual. Let us remember, once again, that dollarization is an issue in countries with serious monetary problems. Dollarization is an issue in countries like Argentina, where high inflation leads to no demand for (hoarding) pesos, not in orderly countries like Switzerland.
What a country that must dollarize loses is not seigniorage, it is the inflation tax. Issuing money to finance the Treasury is not seigniorage, it is an inflationary tax. There are two problems with this type of tax. The first is that it is highly inefficient and regressive. The second is that it is an unlawful tax and therefore possibly unconstitutional in a genuine republic.
Beyond the difference between seigniorage and inflationary tax, giving up the former does not seem to be a high cost in exchange for the much desired and necessary monetary stability.
Dollarization and economic reforms
Perhaps the most elaborate objection to dollarization is to recognize that it does not seek to solve all the country’s economic problems. Therefore, other reforms such as achieving fiscal balance are necessary. The problem? If fiscal balance is not achieved, dollarization is not possible or is not sustainable. But, when fiscal balance is achieved, dollarization is no longer necessary. Thus, dollarization is either inapplicable or unnecessary.
First of all, again we must avoid falling into a Nirvana fallacy. If the reforms to be carried out in a country where dollarization is debated are the ideal, then obviously there is no need to dollarize. If Argentina were to apply the reforms that would transform it into Switzerland, clearly dollarization would no longer be necessary. Because of the possible reforms they may not be ideal. Reforms that make dollarization possible, but may not go deep enough, may make dollarization no longer necessary. What we have is dollarization as a necessary but not sufficient reform to put the economy of a country on track.
This is the situation where, for example, we obtain fiscal equilibrium, but we want to prevent the Treasury from starting to monetize fiscal deficits again. Let us remember that with the 2001 crisis the Treasury began to have a surplus, however, it returned to a deficit financed with monetary issuance and confiscations as in the case of the AFJPs. Fiscal balance is not a substitute for institutional reforms that guarantee the independence of the central bank, the independence power of attorney, or the protection of private property. It is important to bear in mind that dollarization first fulfills an institutional role, and secondly a monetary policy role. This is another lesson that the Ecuadorian case teaches us.
First, the strength of the reform. Dollarization in Ecuador not only survived the crisis and the 2008 default, it also survived a decade of fiscal deficit and the populist government of Rafael Correa. It is no longer so clear that dollarization cannot survive without fiscal balance.
Second, the role of dollarization as protection against authoritarian advances by the state. Since the late 1990s and early 21st century, a series of populist governments have come to power in several Latin American countries. Chávez and Maduro in Venezuela, Rafael Correa in Ecuador, the Kirchners in Argentina, Evo Morales in Bolivia and Daniel Ortega in Nicaragua, to mention the outstanding cases. In all these cases, high economic costs are observed. The exception is Ecuador, the only dollarized country in the sample. This result suggests that the institutional argument, where dollarization is a brake on the advances of a populist state, has some grip. Dollarization does not only seek to eliminate inflation, it is mainly a way of importing institutions that the country cannot, or does not want, to generate.
The debate around dollarization in Argentina is recurrent. After 20 years of experience in Ecuador (and other countries), the discussion should be less speculative and more empirical. How do dollarized countries cope with the costs of dollarization? The case of Ecuador offers several answers. It also offers some questions. If Argentina had dollarized in 2001, would Kirchnerism have been capable of taking populism to the extremes that we saw? Wouldn’t Argentina have been more protected from the 2008 shock, as was the case in Ecuador? If Macri had initially dollarized, at the beginning of his government, would he have been able to carry out further economic reforms and win reelection in 2019?
Perhaps a less speculative debate on the costs of dollarization in Argentina and learning from real cases of dollarization is appropriate.