The idea of dollarization, using the U.S. dollar as legal tender in a foreign country, is becoming increasingly popular to many countries in Central and South America. Currently, very few officially use the dollar as their monetary unit, though many use it unofficially for savings and high-end purchases. Official dollarization would benefit the participating foreign countries by lowering inflation and interest rates, and the United States by increasing demand for American goods.

Official dollarization occurs when a foreign currency becomes the prevalent or exclusive legal tender. In recent years, many countries in Latin America have begun discussion of official dollarization with the U.S. dollar due to the failure of their own currency. Countries do not need the United State’s permission to dollarize, though it would make the conversion process easier. Money serves three functions in a society: as a unit of account, a store of value, and a means of exchange. High interest rates and runaway inflation have caused local currencies to fail to meet those functions, and the citizens have been forced to look toward another currency, the U.S. dollar. Unofficial dollarization, when people maintain much of their financial wealth in a foreign currency that is not legal tender, is already widespread in Latin America and throughout the world. The U.S. dollar circulates equally with the domestic currency in 7 countries, accounts for 30-50 percent in 12 others, and accounts for between 15-20 percent in many more. Twelve economies, listed in Table 1, are already officially dollarized, with Panama being the best known.

The purpose of this paper is to show that official dollarization with the U.S. dollar, particularly with countries in the Western Hemisphere, would bring benefits to both the United States and the adopting countries.

Table 1: Officially Dollarized (US$) Countries

Panama has been using the U.S. dollar as legal tender since 1904, shortly after becoming independent from Colombia. They still issue a domestic currency, the balboa that trades one to one with the dollar that circulates only as coins.² Inflation has averaged a low 3 percent over the last 30 years, and its interest rate has remained among the lowest in Latin America. Panama remains the only Latin American country where a 30-year fixed-rate mortgage in the domestic currency is available. As an officially dollarized country, Panama has no central bank to be used as a lender of last resort. For that purpose, the country has established lines of credit with foreign, mainly U.S., banks. Panama has still experienced shocks over the years due to riots, oil, and the U.S. invasion. The economy, however, adjusted even without Panama’s ability to control their money supply.

Not all countries are suited to convert to full, official dollarization. Even those with a large percentage of unofficial usage of U.S. dollars, like those in Eastern Europe, may be better off using a more regionally dominant currency.

The Theory of Optimum Currency Areas was introduced in 1961 by Robert Mundell, Professor of Economics at Columbia University and the 1999 winner of the Nobel Prize for Economics. The theory suggests that an economy is part of an optimum currency area when a high degree of trade integration makes a pegged exchange rate more advantageous than a floating exchange rate.³ Other criteria include: a large country with a dominant currency, high labor mobility, and a high correlation of economic cycles. While not all of these are currently met by some countries in the Western Hemisphere, dollarization would strengthen these optimum currency area conditions.

From 1976 to 1998, inflation in Mexico averaged 37 percent per year, with the price of the dollar in pesos increasing by 81,000 percent. Since the peso has not proven to be a reliable monetary unit, borrowing is very expensive. Small business loans are nearly 30 percent, hurting economic growth. With 85 percent of Mexican exports going to the U.S., both the Business Coordinating Council and the Mexican Bankers Association are seriously considering a monetary union with the U.S., though Mexico’s Finance Ministry is much more hesitant. They must take into account a 1998 telephone poll in which Mexican citizens voted 6 to 1 in favor of replacing the peso with the dollar.

Argentina suffered inflation of over 20,000 percent from 1990 to 1991. The Convertibility Law of 1991, introduced by then Finance Minister Domingo Cavallo, pegged the Argentinean peso to the dollar one to one and outlawed devaluation. Inflation rates soon fell, and by 1998 the inflation rate was less than 1 percent. However, interest rates are still high because there is always the fear that the government may change the law and devalue its currency to counteract Brazil’s devaluation of its currency, the real.

Ecuador has been going through terrible financial turmoil during the last few years. Eight banks closed in March, 1999, and soon after the government froze deposits in the entire banking system.³ In one year the Ecuadorian sucre depreciated from about 7,000 per U.S. dollar to 25,000 per dollar. The president of Ecuador, who proposed official dollarization, was forced out of office in January, 2000 due to political unrest. His successor has also shown support for dollarization.

El Salvador’s currency, the colón, was pegged to the U.S. dollar for fifty years until it was devalued during a civil war in the 1980s.² In 1992 it was again pegged to the dollar, and in 1995 the government intended to proceed with complete official dollarization. The government dropped the idea due to opposition claiming it would eliminate a symbol of national identity. They are, however, considering it again since other Latin American countries are showing serious interest in dollarization.

At first, Canada may not seem to be a country in need of the U.S. dollar. Its currency has remained relatively stable over its history, but a common currency would cure Canada’s recent currency deterioration to the dollar. Due to this situation, Canada has seen several NHL hockey teams depart for the United States, and 5 out of 6 more are in serious financial trouble. This is a serious matter for a country that lives and breathes hockey. Canada is now giving dollarization serious thought because it would be in their best interest to join in a monetary union if the rest of the Western Hemisphere were linked. They would prefer, however, to use a new common currency, not to just adopt the dollar, similar to what Europe has achieved with the euro.

1. Reduces Risk of Currency Devaluation

Official dollarization eliminates the government’s ability to devalue its currency as a means to reduce government debt or to gain a competitive advantage with exports. When the government has the power to devalue and has used it in the past, interest rates and inflation remain high. By converting to the U.S. dollar, inflation and interest rates would lower toward U.S. levels.

2. Improved Economic Growth

Lower inflation and interest rates reduce the cost of credit. This, in turn, promotes investments, both domestic and foreign, that would increase economic growth. More jobs would be created and overall welfare would be improved.

3. Improved Government Finances

Without the ability to print more money to pay for government programs, dollarization would force the governments to be more disciplined. Wasteful programs are more likely to be eliminated, and the loss of purchasing power due to taxes charged now but paid later would be reduced.

4. Lower Transaction Costs

1. Gain More in New Seigniorage

Seigniorage is the profit a country earns from issuing its currency. It is the difference between the cost of printing a currency and the products the currency can buy. For example, it costs the U.S. about 3 cents to print a $1 bill, but the government can use it to buy $1 worth of goods. The seigniorage would then be 97 cents. A $100 bill would therefore have a much higher seigniorage value. The United States currently earns about $25 billion per year this way. More dollars in circulation through dollarization would increase the seigniorage for the U.S.

2. Increase in Exports

As noted earlier, economic growth in the dollarized country would increase. This growth would create a boost in demand for American goods, thus also increasing growth in the Unite States.

3. Eliminates Currency Conversion Fees

Transaction costs associated with currency conversion would be eliminated. Tourists and businesses would both save money with these fees removed.

4. Reduce American Producer Complaints

American producers blame foreign countries for dumping goods in the U.S. Large currency devaluations make these goods cheaper than before. Dollarization would make this practice impossible from other dollarized countries.

5. Maintain Premier Currency Status

1. Loss of Seigniorage

By replacing their domestic currency with a foreign currency, the adopting country would be losing the seigniorage it was collecting. The loss for Argentina alone would be about $750 million per year. One proposed solution to this drawback is to have the U.S. share seigniorage with the country. The U.S. would still have a net gain in new seigniorage while sharing with the country.

2. No Lender of Last Resort

Officially dollarized countries no longer have a central bank to be used as a lender of last resort. Critics warn that without a central bank, domestic banks may run out of money during economic crisis. Some countries have proposed that the U.S. Federal Reserve act as their lender of last resort, but the U.S. is against this. U.S. Treasury Secretary Lawrence Summers stated that "it would not, in our judgement, be appropriate for the 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 deciding to adopt the dollar." There are other ways for banks to receive money in times of trouble. As mentioned earlier, Panama has arranged lines of credit with foreign banks for this purpose. Argentina, too, has similar arrangements with foreign banks.

 

3. Loss of Monetary Policy

The monetary policy of the United States becomes the policy for the country. This is a big concern because this takes away the country’s ability to try to adjust to economic shocks by devaluing their currency. They are worried that what is good for the U.S. is not always good for their country. It’s this ability, however, that causes the high rates that reduce economic growth. There may be times that U.S. policy changes may temporary hurt their economy, but the U.S. policies would be beneficial overall.

4. Loss of National Identity

The popular consensus in some countries such as Argentina and Ecuador is that it would be unpatriotic to use a currency that pictures the presidents of another country. Other countries like Mexico do not seem bothered by it. Each country must ask itself, which is more important? Monetary stability or their own independent currency portraying their own leaders. A solution to this problem, already implemented by Panama, is to have a country mint its own domestic coins that are exchangeable one to one with the dollar.

5. Miscellaneous Costs

1. Monetary Policy Interference

The biggest concern of monetary policymakers in the United States is that a dollarized foreign country may try to pressure the U.S. Federal Reserve into policies that favor their country. For example, the Fed may feel it is beneficial for the U.S. to raise interest rates, but a foreign country might complain that it would hurt their economy. The truth is that U.S. policies already affect many countries and the Fed already receives much criticism, so nothing would change. At a hearing before a Senate Banking subcommittee, Federal Reserve chairman Alan Greenspan testified that the Federal Reserve already receives much criticism, and that he doesn’t foresee any additional pressure to adjust the Fed’s monetary policy form dollarized countries.⁴

2. Possibility of Returning to Original Currency

Dollarization isn’t a cure that will magically heal all of a country’s economic problems, but it can help put the country in a position for economic growth with low inflation and interest rates. The governments must also pair it with disciplined policies to meet its full economic potential. The United States greatest benefit would be economic growth due to an increase in exports. Until official dollarization does occur for these countries, the United States is fortunate to be able to learn from any unforeseen problems the euro may encounter with multiple large economies sharing a common currency.