Dollarization of other countries

My wife and I were talking about Ecuador’s use of the dollar as their currency, and we couldn’t find anything wrong iwth it except for the fact that it’s the U.S. currency. No, y questions are simple:

  1. Why is it a bad thing for other countries to use the Dollar instead of their own currency?

  2. Does this change anything economic in the US?

  3. How does a country switch? I assume it’s not as easy as hitting the local ATM, but what if the country runs out of dollars?

Keep in mind that I see the benefit of a stable currency, as I was in South America for a while and saw my local currencies transform into expensive toilet paper after 6 months (that’s the truth, a dollar in Cruzados(BR) was worth 1/64 of a penny 8 months later). I also get the national pride aspect, but when your economy is facing triple/quadruple digit inflation, perhaps any help is a godsend.

The only way to stop this would to make it illegal to transport American Dollars out of the country. (The Demoratic Republic of Germany [DDR] had policies similar to this) I believe that it can affect the stability of our dollars, but with the Federal Reserve’s complicated system of available funds and interest rates, this can be easily conteracted.

Usually the country does not actually switch, they just back up their money with ours. (Kinda like the old gold standard [before the FED moved in], but instead of gold, you can exchange the currency for dollars) Nobody is actually expected to ask for US currency. The government just says by fiat that the value of thier money is 250 pesos to the dollar or some simular statement.

There’s nothing wrong with it at all. Other countries often use the dollar because it is a rock solid stable currency. Often, it can help stableize the local economy. A large percentage of US currency is used in other countries.

(1) Dollarization is not pegging to the Dollar (which is what likearock refers to, a currency peg.), rather adopting the Dollar as the currency of the land. No other currency is circulating as legal tender.

Other regimes are found in Argentina which uses a currency board to maintain a fixed relationship between their currency and the dollar, however the dollar is not formally speaking legal tender, although it is de facto used. Technically, however, official and on-the-books transactions are in the Argentinian currency.
(2) Problems:

For the US trivial ones already faced due to large dollar holdings outside the USA anyway. Our official policy is that we make no allowances for outside needs. Problem of counterfeiting is perhaps extended to small bills, and even coins per what appears to be developing in Ecuador.

For Dollarized country:

(a) You lose monetary policy, i.e. the ability to use the money supply to effect short term adjustments in the economy as well as to respond to liquidity problems. Essentially your money supply is at the whim of the Fed. Clearly this takes away an important tool in managing an economy. Of theoretical value for Ecuador now, but in the future… If their economy is not linked to the US --i.e. if they need more liquidity when we need less, they could face serious problems. Also, if their trading partners currencies are floating against the dollar, and the home economy trades significantly with them, there could be serious impacts on trade patterns. Given the dollar’s value, probably encouraging imports and discouraging exports.

(b) Practical Application. In countries with high illiteracy rates our currency, not terribly friendly to the illiterate given its all the same size and color, may present serious transaction costs. People literally not knowing how much bills are worth. This will decline, but nonetheless imposes an added burden on the populace which may not be strictly necessary.

© Externalizes policy, probably retarding the development of local political discipline and thus the development of healthy local public financial institutions/traditions.

In short, I think its rather a bad idea for the adopting country. Stunningly bad really. The same results can be achieved different ways, and with better (in theory) long term consequences.

But we will see, Ecuador and El Salvador will be out guinea pigs.

I would concur with Collounsbury’s outline.

Dollarization is a measure of last resort because it’s the total surrender of monetary control on your economy. (and once lost, it is very difficult to regain independence)

It doesn’t only apply to “emerging economies” either. Witness the complications in Europe with monetary union. At any one stage in Europe there will be some countries in/near recession and others in boom and yet a common currency dictates a one-size-fits-all settings.

Those countries whose economic cycle isn’t tuned to the dominant country (e.g. US or Germany) will find itself in a difficult situation. Monetary policy will be set to amplify rather than ameoliorate the economic fluctuations.

<< At any one stage in Europe there will be some countries in/near recession and others in boom and yet a common currency dictates a one-size-fits-all settings >>

Well, we’ve certainly had the situation that one state or region in the U.S. was having recession while others were in boom, and the single currency in the U.S. hasn’t undermined the society… yet.

Here’s a previous GQ thread on this topic, with some interesting replies. I know I’ve seen a link to a US Treasury Dept. whitepaper on the topic, including a history of the practice, pros and cons (for the US and the other country), etc., which was extremely informative, but I can’t seem to find it …


Here’s an interesting piece from Slate on the issue: How Do You Replace the Sucre With the Dollar?

As to how a country does the switch:

Let me add one more item foregone before adding a comment to CKDH.

The dollarizing country also forgoes …damn I am forgetting the term right at the moment… well sovereign profits a state obtains from its own currency. Someone kick me in the head and remind me of the term. A relatively trivial item for advanced economies, but for a poor countries with poor tax collection not something lightly foregone. Especially as the remaining profit now goes to the USA. (oops, I see now after typing this all out that the other thread mentions it, seigniorage)

(By the way, I think the mixing of unofficial dollarization of the economy, e.g. in Lebanon, and the official adoption of the dollar, or another currency for that matter in the discussion in the other thread is a bit inaccurate. These are two very different animals in terms of impact, IMHO.)

Well, of course we are one huge free trade zone with excellent capital and labor mobility. Theory tells us that will help the differences balence out. I think the concern is that Europe, despite the legal abolition of limits on mobility (at least within the Schengen-Euro zone), many barriers continue to exist to effective mobility. E.g. unlike NE laborers, Portuguese laborers may find it hard to relocate to another part of Europe in response to a regional downturn. Language and culture will remain much greater barriers.

Still, I think the gamble is worthwhile for Europe, at least within the old EC states whose internal structures have had some time to converge. Gains from increased efficiency I think will outweigh inconveniences.

But, I guess we’re all gonna see.

That would be seigniorage. (Not that I knew that off the top of my head or anything, you just got the question stuck in my brain.)

Also, here’s another very interesting white paper on dollarizing: Dollarizing Indonesia

The FED seems to affect the value of the dollar [or maybe just stock prices] by adjusting the interest rate. Are those countries matching/locking the FED interest rates?