The US Dollar: Official Currency of 7(?) Nations?

Great Debates
1

A number of South American countries (a web search indicates Ecuador, El Salvador, Guatemala, Panama and Argentina) have declared the US dollar to be their official currency. Additionally, East Timor(!) apparently had the dollar imposed on it by the UN at least temporarily to get it past its civil war.

On the GQ side of things, I am curious as to how such a changeover works. One article I saw discussed the central bank’s switch to dollar compatible accounting systems and trucking greenbacks across the country (apparently US coins are not usually used). Are the local currencies worthless after awhile (so that people must dig them out from under their mattresses), or can they be converted to dollars indefinitely? Do the countries coordinate with the Federal Reserve and ask for more bills to be printed and shipped down? Has Argentina really adopted the dollar as its official currency since it seems only to have “denominated” (tied?) its local currency in (to) dollars? Do countries that adopt the dollar still have an official interest rate for loans from the central bank through which the government can attempt to influence the economy?

On the GD side of things, adopting the dollar as the official currency is usually an attempt to stop hyper-inflation–it disciplines the local economy by preventing the local government from simply printing more paper when it needs funds. Therefore, it is often viewed as a good thing by the World Bank and lenders. Do we have any evidence to date that this works? Any benefits will need to exceed the loss to the country of its ability to control its economy by manipulating monetary supply.

Is adoption of the dollar “imperialistically” imposed on poor countries by mean US lenders and the World Bank? This is what many of the websites I looked at think.

Finally, what are the policy implications for the US from this trend? How can the US Federal Reserve make monetary policy when it must take into account the currency needs of 7(+/-) nations and their economies, not to mention all the other loose bills floating around the world?

2

No, Argentina has not officially adopted the dollar, and in fact has recently moved away a bit from the dollar, in two ways. First, they have adopted a law that, if and when the Euro reaches parity with the dollar, the Argentinian currency will be pegged to both, that is, if the Euro then dives again, the Argentinian currency will also drift down.

My initial answer is no, but I admit that this bit of economic policy is beyond me, so don’t rely on my answer.

Pegging the peso to the dollar certainly killed hyper-inflation in Argentina. No knowledge of other places.

IIRC, the adoption of the dollar by Ecuador was strongly opposed by many economists, who believed that the underlying problems with that country’s economy would make dollarization a disaster. So far it hasn’t been as destructive as feared.

Actually the Fed has made it very clear that it will not take into account the economic conditions of countries that dollarize when setting policy. The countries adopt the dollar fully forewarned. As for the currency issue, that isn’t really that big of a deal - currency accounts for a pretty small fraction of the money supply of U.S. dollars.

Sua

3

There was a thread on this topic some months ago.

4

Thanks for the link, sailor. I had searched both GQ and GD back 2 years but my terms must not have matched up exactly. There is some very interesting material there and in the links posted in the threads.

Thanks for the responses, Sua. Do you by any chance remember where you saw the Fed’s official statement that it would ignore dollarized countries when setting monetary policy? I searched for that too, but seem to have search engine failure today. Geesh, it would seem to me that political pressure to take dollarized economies into account in the face of a serious South American depression would be pretty powerful.

5

In this case I doubt it, because US sovereignty would be pretty clearly compromised. I think the argument that “they adopted our currency, if they don’t like it they can (re)introduce their own” would win.

But the general point is sound. My guess is that a severe downturn in one of the EU countries will be a major test of the Euro and of European integration more generally.

6

Basics of
Dollarization Staff Report by US Senate Joint Economic Committee
Dollarizing Indonesia
How Do You Replace the Sucre With the Dollar?"

7

There is on again/off again “talk” about Canada going to the US $. It never appears very serious as the most you hear about it is some economist on some radio talk show giving the pros/cons. Does anyone think there is a chance in hell that this will actually happen within our lifetimes?

8

I agree for the short term; in the long term, I can imagine a “slippery slope” situation: Latin America is in big trouble, US lenders and manufacturers with big sales there complain, the US is doing pretty well and maybe the Fed was thinking about easing a bit anyway, so they ease. This is a bit like what happened when the Fed lowered rates in response to LTCM’s hedge fund losses resulting from the devaluation of the ruble, a clear, IMHO, demonstration that the Fed does look at and respond to micro (as opposed to macro) problems of US entities caught up in foreign economic crises. If it happens once, it may happen twice and then become an expectation. BUT–of course the Fed already takes into account the fact that the US economy is heavily integrated with the rest of the world’s, and, as others have noted, the currency tie may really just be a drop in the bucket.

And thanks again for the links, sailor, some of which were the links in the earlier thread. There are plenty of economic papers and reports from the Federal Reserve Banks which mention dollarization, but I would still like to find the official Fed position.

9

Humble Servant - I’ve never read the Fed’s official statement or whathaveyou that they will not consider the monetary/economic needs of dollarized foreign countries in setting policy. My information comes from the Economist, which has noted this as official U.S. policy when discussing Ecuador’s dollarization, as well as talk a little over a year ago about Argentina possibly dropping its currency board and going to straight dollarization.

Well, Canada is certainly a different situation that Ecuador-type countries. On the Canadian side, they would have to analyze whether their economic cycle is close enough in sync with the U.S.'s to avoid nasty dislocations and whether the advantages in terms of trade, etc. outweigh the possible harm of lessening their control over monetary policy.
I say lessening, because it would make little sense for Canada to dollarize without an agreement by the U.S. for Canada to have representation in the Fed, etc. Canada is a fully mature economy, and they have no need or desire to lose control of monetary policy - hyperinflation is not a concern in the Canada, barring nearly unforseeable economic catastrophe.

In the main, my guess would be no, it won’t happen. I don’t think the U.S. would object to including Canadians in the Fed, but I think Canada, while by no means jingoistic, derives a lot of its national identity from the fact that it is not the U.S. Losing the Canadian dollar would not sit well.
A possible alternative (though well down the line, if ever), would be the development of a North American dollar (possibly including Mexico, depending on how that nation develops). Given the size of the U.S. economy relative to Canada, a North American dollar would essentially be the U.S. dollar, but it wouldn’t have the same symbolism for Canadians.

Sua

10

My strongly held opinion is that any and all currency schemes like dollarization or pegs are doomed to failure. The Asian crisis of a few years ago occurred almost exclusively in countries whose currencies were tied to the dollar. Indonesia was a prime example. Because they had their currency tied to the dollar, an outfit in Hong Kong, Jardine Fleming I think their name was, lent large sums of money to an Indonesian car company fronted by the son of the president over there. They did this in part because they figured there was no currency risk because of the dollar peg.
When the Indonesian currency had to be devalued relative to the dollar, the loan went up in smoke, and so did Jardine Fleming. This same scenario was played out all over Asia, among something like seven different countries that had tied their currencies to the dollar.
All it does is hide festering economic problems until they explode all at once.

11

Pantom: Yes, that is a risk of trusting a pegged currency. There is always the chance that the peg will be lifted and the currency allowed to devalue.

But that particular problem wouldn’t occur under dollarization, since the country couldn’t devalue the US dollar no matter how much it wanted to and no matter how much sense it might make for the currency to be devalued. Dollarized countries simply buy US currency like any other international institution and ship them to the country and the government starts using them to pay for things.

Many countries already really have two currencies, the national currency and the US dollar. You can pay for most things with both, although you’d have to pay your taxes and such in the official currency, and there might be some vendors who would refuse one or the other currency depending on preference.

I would imagine that countries considering dollarization already have a lot of dollars already in circulation and dollarization would simply regularize the existing practice.

12

pantom, ya got a problem. That isn’t what happened in the Asian crisis.

There are (with variations) three ways a government can deal with their currency. The first, being discussed in this thread, is either dollarization or a “hard peg”. Panama is an example of dollarization, and Argentina is an example of a hard peg. The difference between the two is that, in theory (though unlikely in fact), a country with a hard peg can reverse themselves and let their currency float. The pro is that you eliminate the risk of hyperinflation and you have monetary stability and lower interest rates. The con is that your economy is now tied with that of the U.S., even if the U.S. is moving in a different direction.

The second is the “floating” currency. This is the U.S. system - you currency is worth whatever the market thinks it is worth. The pro is that you now have control over monetary policy and interest rates. The con is that your currency can become too strong or too weak, with commensurate effects on your economy.

What Indonesia, Thailand, etc., tried was a middle ground - the “banded” currency. Your currency floats, but only within a certain percentage above or below the dollar (or yen, euro, or combinations thereof). If it goes above or (more often) below the band, the central bank of the country intervenes in the market, buying or selling their currency to keep it within the band. Experience has shown that this is an extremely bad idea.
What happened in Indonesia, etc., is that the currency started dropping, and the central bank intervened, spending its reserves of hard currency to buy up the rupiah and thus bolster its value. Unfortunately, hard currency reserves are finite - Indonesia’s central bank essentially ran out of their reserves, and the downward pressure continued. So the central bank stopped buying, the rupiah plummented, and Indonesia, rather than having one bad problem, had three - an extremely weak currency, no hard currency reserves, and scads of nearly worthless rupiah.

Not only developing countries have problems with banded currencies. The EU tried it in the early 90’s in the lead-up to the Euro. The ERM called for EU countries to keep their currencies within a band of value relative to the Deutsche Mark. England went through a spot of economic trouble, currency traders attacked the pound, and England had to withdraw.

Back to Asia - one of the few “countries” that survived the crises relatively well was Hong Kong, which has a hard peg.

Sua

13

Well, you’re right SuaSponte, but I still think pantom’s view has much to recommend it.

Your point that banded exchange rates are more vulnerable rests I guess on the informational content of the XR always being at the top or bottom of the band and pressure almost visibly building up. But fixed rates all have to be paid out official reserves and they are all vulnerable. I don’t believe China is big enough to withstand a sustained view by the capital markets that they are overvalued. I don’t think any country is. The capital markets are just too big these days.

The difference between Hong Kong, Taiwan and Singapore v the Asian Crisis countries is that the rapid growth (and commensurate capital inflows) was new in the second group (Sth Korea being a partial exception). The capital account surpluses were huge and risk perceptions were always likely to be volatile.

In the Sth American cases, it is worth noting that the crawling peg (or tablita) and Argentina’s fixed peg were not exchange rate policies as such, but were nominal anchor policies adopted as a substitute for central bank and fiscal competence. That Argentina has so far succeeded is testament to their government’s newfound credibility (in being able to say, “Yeah, unemployment’s going to shoot up to 30% next month, but we’re sticking to our guns” and be believed. If you can do that, I’d question whether it’s the XR doing the job.

I still think that the only way to have a fixed exchange rate in the long term is to fix it such that it can’t be unfixed: monetary union or currency abolition.

14

No doubt - no currency policy is going to work in the long run if the nation’s economic policies are screwed.

Re: the portion of your post I bolded - I don’t think this is correct. It is my understanding that nations with currency boards keep the exchange rate fixed with automatic increases in overnight interest rates to draw in more hard currency if there is an uptick in demand for exchange of the local currency for dollars. Official reserves aren’t touched.

Sua

15

Well, it’s true a hard peg is a much tougher nut to crack. However, the big problem here lies in this part of the problem (from Sua):

The con is that your economy is now tied with that of the U.S., even if the U.S. is moving in a different direction.

The above is a problem even within a single country. For instance, the U.S. is a big country, with lots of local economies tied to different markets.
Example: the “oil patch”, Texas, Louisiana, and Oklahoma, have economies that are intimately tied to the price of oil and natural gas. The market for these commodities is only fitfully tied to the prosperity of the country as a whole. While hardly a major problem for them, it’s still true that it would be better for these states if they could lower their interest rates to ameliorate the effects of low prices in these commodities when they occur and have a depressing effect on their local economies. Obviously, these states can’t run their own interest rate policies, so they’re left having to hope that the Fed happens to be lowering rates when the prices of their commodities is going down.
Take this to a not-so-developed economy, and what is a middling problem for these states turns into a major crisis for an independent country trying to make it on its own. Argentina just had to pay out very high interest rates to keep its peg going, even though the sputtering economy there would seem to call for lower interest rates. With an independent currency, Argentina would be able to lower rates domestically, which would have the simultaneous effect of lowering the value of their currency and promoting their exports. But with a peg to maintain, if the economy sputters, foreigners need to be reassured that there is no currency risk (a deeply artificial condition), hence the higher interest rates. A few times going to the well like this and you could be too deep in the hole to avoid a default, with all the problems that brings - including the sudden introduction of currency risk.

16

It seems to me that the hard peg, assuming that it’s pegged to a solid currency, is a lot like the gold standard, with the same benefits and dangers. Both a hard peg and the gold standard allow a country to put off ecomonic troubles, especially a trade deficit. But the problem is that when the system finally gives, it’s very catastrophic, as the US found in the late 20s and 30s when the gold standard fell apart. But it seems to me that there should be a way to avoid this by making sure that the problem never gets out of hand. Of course, solving a problem before it gets out of hand goes against human nature.

Another problem I see is that this can lead to the devaluation of the dollar. In the US, if a bank has money physically in their vaults, they can lend out a certain multiple of that money, and no more (by law). But in another country there may be no such limit, which would lead to inflation.

17

True, but same difference. In order to move interest rates the central bank has to sell bonds. They only have so many of those too. If the market thinks the XR is unsustainable then everyone expects bond prices to rise (and yields to fall). They will buy as many as the central bank has. It’s a different channel of the balance sheet, but it works pretty much the same.

18

Here’s something I’m having trouble visualizing: Let’s say I’m going to Ecuador on vacation. If Ecuador had a local currency, and its economy was weak relative to the US, I could anticipate getting a “bargain” vacation (by travelling to Ecuador I am abosorbing whatever transaction costs are involved in getting my US dollars to that country). Can I still anticipate that now that Ecuador is using the dollar, but its economy is still weak relative to the US? While there’s still the problem of distance (labor in Ecuador cannot be instantly transferred to the US in response to lower wages in Ecuador), shouldn’t most goods (at least those which move fairly efficiently in international markets) cost me the same in Ecuador as in the US? Can you help me think this through properly?

Do you mean that abandoning the gold standard caused the Great Depression?

This is not strictly accurate. US banks must comply with “risk-based capital ratios.” So long as they have qualifying types of capital (equity, in accounting terms, not currency in vaults) relative to their overal investments, they can invest in (make loans to) any business in any amount they want to.

19

You don’t seem to need much help on the bargains issue, Humble Servant. Your thinking is right – net of tariffs, transport and transactions costs, prices for a whole bunch of things should be the same. This (the law of one price) should also be true regardless of what currency is used, but exchange rates seem to have some funny things going on with them.

The goods for which prices differ significantly belong to the (internationally) non-traded sector. Services make up a fair proportion of this sector, so you’ll be able to get bargain haircuts. If a good is light, storable, widely traded across borders, is not subject to tariffs and has a low retail margin, its price will be the same as in the US.

20

Thanks, picmr, I think I get it now.:slight_smile: