A proposal to dollarize Argentina’s economy reached its Congress in March. As this route occasionally appears as a proposal in Argentina, we summarize here the potential consequences of such a move.
First, we point out broadly the implications of dollarizing an economy. Then, we check relevant Latin American experiences with dollarization. Finally, we address the case of Argentina.
Argentina’s fiscal imbalances will not be eliminated by dollarization. Even though dollarization would prevent the printing of money, it imposes no constraints on government spending and borrowing. The only result is that monetary policy ceases to be available as an option, leaving almost no response capacity in case of external shocks. Moreover, dollarization creates the possibility of being exposed to pro-cyclical monetary policies unrelated to domestic necessities. It also eliminates seigniorage benefits.
Latin American experiences of dollarization have been followed by attempts by Ecuador and El Salvador to find a way out of it. However, once dollarization is implemented, it is extremely hard to backtrack. So far, there is not a single relevant case anywhere of successful de-dollarization.
Argentina’s central bank has insufficient dollar reserves to match the monetary base. The monetary base (or M0) is the total amount of a currency either in general circulation in the hands of the public, or in the form of commercial bank deposits held in the central bank’s reserves. The creation of money (dollar deposits) by domestic banks needs M0 to be dollar denominated.
Proposing dollarization under current conditions would require a selective default of domestic currency liabilities, a brutal devaluation, and/or unilateral conversion of public deposits. None of these are emphasized by those who have made dollarization proposals.
Based on the general implications, the Latin American experiences, and the implementation difficulties, we discuss how these ideas are unfeasible in Argentina now.
Why Discuss Dollarization of Argentina Today?
In 2001, Kenneth P. Jameson published an article titled ‘Dollarization in Latin America: Wave of the Future or Flight to the Past?’ He argued that the region was moving towards dollarization and that changing the legal currency to the U.S. dollar represented the “last gambit” for Argentina’s president at that time, Fernando De la Rua. Kurt Schuler and Steve H. Hanke (2001) published an article titled: “How to dollarize in Argentina now”, in which they proposed four steps towards dollarization in order to “help Argentina return to an economic growth path”.
Even though these proposals never materialized, they were kept on the shelves, waiting for the right moment to reemerge. In March 2022, an Argentine lawmaker—Alejandro Cacace—proposed a bill to dollarize the Argentine economy. One of the candidates for the next presidential election in 2023, Javier Milei, announced he intended to call a referendum to achieve this goal (Burns, 2022). Moreover, local and foreign economists, including Nicolas Cachanosky (American Institute for Economic Research) and Steve Hanke (Cato Institute), have argued that dollarization for Argentina is “the only way out to avoid hyperinflation”.
What is Dollarization?
In general terms, ‘dollarization’ is often used to refer to residents holding a significant share of their assets in foreign currency. In Latin America and the Caribbean, the U.S. dollar is the main currency gravity center.
It is vital to illustrate the difference between de-jure and de-facto dollarization. The first refers to the case in which foreign currency is given legal tender status, which implies that the foreign currency is used legally for the three functions of money (store of value, unit of account, and medium of exchange). On the other hand, de-facto dollarization represents the situation in which the foreign currency is being used alongside the domestic currency, but not with an equivalent legal status. The most common case in Latin American countries is saving in hard currency. De-facto dollarization may take place to different degrees. Countries transitioning towards de-facto dollarization are called ‘bi-monetary economies’[1].
Another distinction is between domestic dollarization, when financial contracts between domestic residents are made in foreign currency, and external dollarization, which covers financial contracts between residents and non-residents.
What Are the Implications of Fully Dollarizing an Economy?
Dollarization is a step beyond choosing between fixed versus floating exchange rate regimes and full convertibility between domestic and foreign currencies.
A first consequence is the loss of seigniorage (the difference between the cost of production of money and its face value)[2], or its corollary: financing other nations’ seigniorage. There are two components to the seigniorage loss implied by dollarization: 1) An immediate ‘stock’ cost. To withdraw domestic currency from circulation, the monetary authority would have to purchase the M0 stock of domestic currency in exchange for U.S. dollars, returning the accumulated seigniorage earnings accumulated over time. 2) The monetary authority gives up future seigniorage earnings from the flow of new printing to satisfy money demand.
A second consequence is that proactive monetary policy ceases to be available, and the dollarized economy becomes tied to another country's monetary policy decisions.
Difficulties in implementing pro-active monetary policies are already present with fixed exchange rates under conditions of free capital mobility, as stipulated by the trilemma of international finance, also known as the ‘impossible trinity’ or the Mundell-Fleming trilemma (Figure 1). There is always a potential conflict between the exchange-rate fixed commitment and sovereign monetary policy when capital flows freely to a country.
Dollarization is a radical move away from any fixed exchange rate regime. Furthermore, as M0 moves beyond the control of domestic monetary authorities, the latter are no longer capable of implementing proactive monetary policies.
This is particularly problematic when the domestic economy is not deeply correlated with the economy of the country of the adopted currency. This is the “optimum currency area” argument also developed by Robert Mundell (1961). In other words, the dollarizing country not only loses the possibility of applying counter-cyclical monetary policies, but also might be exposed to inappropriate monetary policies from another nation. However, as stated by Mundell, abdicating from one’s own counter-cyclical policies would not be a major problem if shocks affecting the area as a whole are similar—a condition favorable to monetary integration. Free mobility of labor in the monetarily unified area also facilitates the absorption of shocks.
That is why monetary unification of areas—such as when the euro area was created—comes accompanied by several other reforms. Besides labor and capital mobility, a common fiscal framework needs to be implemented, as along with harmonization of financial regulation. To a great extent, the euro-area crisis after the global financial crisis exposed the incompleteness of the complementary reforms (Canuto, 2021).
A third consequence of dollarization is the restricted scope for lender-of-last-resort operations. Generally, central banks function as the ultimate guarantor of the financial system's stability in case of a bank run. In the case of a fully dollarized economy, the central bank loses the ability to print money, meaning that in a scenario of a generalized loss of confidence in banks, the central bank would be unable to guarantee the whole payment system or to back bank deposits fully.
Cachanosky (2022) dismissed this as a weak factor against dollarization in Argentina. He remarked that bank runs in the country cannot be countered with domestic-currency money, as dollar exit predominates and running agents will not take local-currency bonds. He also referred to the possibility of self-administered pools of bank deposits complying with that function without the need for a public pool of reserves. He pointed out the operation of emergency liquidity funds in Ecuador, El Salvador, and Panama.
In any case, proactive monetary policies are given up. Not by chance, Cachanosky praises dollarization for exactly doing this. It would be a sort of acknowledgment by the country that it should not have discretionary decision power over monetary subjects.
What would be the advantages of dollarization? It would in principle solve almost instantaneously the domestic inflation[3] problem. This does not mean that there will be no inflation, but—given the absence of exchange rate fluctuations, and assuming economic integration— the gravity center would be U.S. inflation, which is usually lower than inflation in Latin American economies[4].
A second positive element of dollarization would be the reduction of the risk premium associated with exchange-rate fluctuations. Therefore, following the interest parity condition, the domestic interest rate would diminish, supposedly increasing investment and potential GDP levels.
A third benefit, only observable in the long run, would be the elimination of currency crises and the macroeconomic instability that they bring.
There is also one relevant factor from the standpoint of long-term policy making: dollarization is nearly irreversible. Once you are in, it is extremely difficult to get out. As we will see in the next section, many people in Ecuador and El Salvador have been trying unsuccessfully to figure out how to leave dollarization for more than a decade.
It should be noted that the attribution of stability as a guaranteed outcome of abdicating the local currency and domestic monetary policymaking reflects a view that reduces all instability to the monetary sphere. Real-side shocks no longer have monetary policy as occasional shock absorbers. The larger a country, and the more dissociated from the mother-currency it is, the more unilateral foreign-currency adoption—not accompanied by euro area-like reforms—will leave the adopter subject to the risk of living with the local transmission of monetary policy options that are not appropriate for local circumstances. Getting rid of past monetary mismanagement does not mean automatically that appropriate monetary settings will replace it.