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5: Exchange Rate Systems
Part 5: Dollarization, Currency Boards, and Single Currency
Areas
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
Since
the end of the modified Bretton Woods gold standard in the
’70s, the volatility of exchange rates and financial
markets has increased markedly. In a way, that is to be
expected: both the volume of trade and the size of foreign
exchange markets have also increased rapidly, and the oversight
of the postwar Bretton Woods system is gone. The increasing
volatility has especially been a problem for late-industrializing
economies—such as those in South East Asia—and
developing economies all over the world. Without stable
currencies and capital markets, industrialization, especially
on the IMF’s terms (i.e. export-oriented growth),
can be difficult, if not impossible.
Dollarization. One solution to currency
instability has been “dollarization.” When a
country dollarizes, they accept the US dollar (or some other
nation’s currency) as their own currency; by doing
so, they usually hope to contain inflation, which not only
hampers consumer confidence, but also drives away foreign
investors. Theoretically, the process of dollarization is
quite simple. Suppose, for example, that Mexico dollarized.
How would the process work? Well, if the current exchange
rate is 10 pesos per dollar and there are 10 billion pesos
in circulation, then Mexico could “destroy”
their currency and ask the US Treasury to print them a billion
US dollars. As a result, goods that used to cost 10 pesos
in Mexico would now cost a dollar.
But how would adding a billion dollars into circulation
affect US prices? It wouldn’t. Why? Because the billion
newly circulating dollars are covering a billion dollars
worth of Mexico’s output, which is now priced in dollars.
In other words, the overall ratio of the US money supply
to output covered by dollars remains the same, implying
prices in the US will be unaffected. Does Mexico’s
dollarization cost anything for the US? Other than the cost
of the paper, ink and labor required to make the dollars
for Mexico, not really.
What about the cost for Mexico? By using dollars, Mexico
is effectively handing over control of their money supply—and
their monetary policy—to the US Federal Reserve. Why
would Mexico do this? If Mexico had a history of exchange
rate volatility and mismanagement, it would be hard for
them to attract foreign investment, so dollarizing eliminates
this risk. In reality, of course, Mexico is not dollarized,
although it hasn’t gone without consideration; but
Panama and El Salvador are, and Argentina, Peru, and Uruguay
each have more dollars than their own currencies on deposit
in their financial systems—allowing them to successfully
defend the value of their currencies against the dollar.
Currency board. Argentina’s efforts
at dollarization suggest another related mechanism for curbing
financial volatility: a currency board. A currency board
oversees the domestic money supply and ensures financial
stability by making sure that domestic currency is backed
by another. In Argentina’s case, the supply of Argentine
pesos had to be matched one-for-one with dollars on reserve.
So, even though the Argentine peso was still the currency
in circulation, it had dollarized by assuring investors
and consumers that domestic money supply would not stray
from the supply of reserve dollars on hand.
A currency board, then, is more of an official exchange
window for a nation than a central bank—its sole purpose
is to ensure that any domestic currency introduced is fully
covered in reserves by the currency it is backed against.
As such, any nation wishing to successfully guarantee and
defend its currency in this way must also be willing to
relinquish sovereignty and forgo debt-financed monetary
expansion. Although Argentina was able to temporarily cure
its hyperinflation problem this way, the need of the government
to run deficits when the economy slowed pushed the peso
off the dollar standard and led to Argentina’s sovereign
debt default—and a severe political crisis—in
2002.
Single currency. Finally, we might consider
a single currency area, such as the European Union, as a
response to increasing financial volatility. This area is
defined by separate national governments and economic institutions,
but a monetary policy guided by a supra-national policy-making
central bank. There are basically four reasons why countries
would enter into a currency area agreement:
VIDEO: The Theory
of Dollarization and Currency Boards
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First, and most obviously, a single currency area eliminates
the transactions costs of changing one currency into another:
in doing so, it simplifies accounting and allows consumers
to compare cross-national prices more easily.
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Second, a currency area eliminates price volatility that
is a function of exchange rates alone: this will generally
ease business transactions and obviate the need for many
kinds of speculative hedging.
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Third, such an exchange area can cement trust among nations.
At the very least, trade disputes that might come about
because of fluctuations in the exchange rate will be eliminated.
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Finally, for developing countries, a common shared currency
can give them credibility in financial markets, which
could lead to lower interest rates, easier credit, and
greater opportunities for economic development.
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