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Too many currencies? Or too many dollar pegs?

by Brad Setser
January 22, 2006

The world has too many currencies.   The dollar is too good a currency not to be shared.    The US has a clear comparative advantage in central banking.   National pride – and a desire to maintain "monetary sovereignty" — should not stand in the way of outsourcing monetary policy to Ben Bernanke.

So says Benn Steil of the Council of Foreign Relations in a Financial Times oped (free link) and in a new book with Bob Litan.

Most macroeconomic problems in emerging economies – according to Benn -
could be solved if countries just abandoned their local currencies and either adopted the dollar or another sound currency.  Benn has no problems with the euro – just with various pesos, liras, dinars, reals and rupees. Maybe RMB too.

For Benn, Ecuador is the model.   It dollarized back in 1999 (after a huge devaluation).   And it grew faster than anyone else in Latin America in 2004.  Benn attributes Ecuador's star performance to dollarization.   Dollarization is a surefire way to generate counter cyclical capital flows and lower interest rates. 

It is a fair to say I have a somewhat different opinion.  On Ecuador.  And on dollarization. 

I suspect Ecuador's strong 2004 performance had more to do with the price of oil than its use of the dollar.   And Ecuador certainly has not enjoyed low interest rates after dollarizing – Ecuador's (dollar) debt trades at a wider spread than the dollar debt of just about any other emerging market.   Market chatter suggests Iraq's new dollar bonds – when they are issued – will trade at a lower spread that Ecuador's dollar bonds. Hardly a vote of confidence in Ecuador.

Dollarization certainly doesn't end the risk of default on dollar-denominated debt.  Ecuador's dollar bonds carry a juicy coupon, unlike Iraq's bonds.  That's part of the problem in a sense: it isn't clear that Ecuador would pay that coupon if oil ever should fall back to $40, let alone $30.   

Dollarization doesn't actually eliminate currency risk either. A country that unilaterally dollarizes could unilaterally dedollarize.

Dedollarization is harder than dropping a peg, but it is not entirely theoretical either.  Argentina came close to depesifying (if such a word exists) back in 2001, as Argentina's provincial governments started issuing their own currencies when peso revenues fell short of peso spending. 

Benn thinks emerging economies that export oil should dollarize; I don't think they should even peg to the dollar (see this Economist article as well).   Differences over international economic policy don't get sharper than that.

There are circumstances when the monetary policy that is right for an oil importer like the US will be wrong for oil exporters.    The dollar could well depreciate to help keep the US trade and current account deficits from widening further, and countries with massive oil-induced current account surpluses hardly need weaker currencies. 

More generally, a flexible currency can help oil states manage oil price volatility.

A concrete example:  Saudi Arabia had a difficult 98 and 99.  Oil tanked against the dollar.  That was a drag.   And that drag was compounded by the fact that Saudi Arabia pegged to the dollar.  At the time, the dollar was soaring.    Saudi Arabia was hardly alone.  Ecuador and Russia faced a similar set of problems back in 1998, but with less oil and smaller cushions. Both pegged to the dollar.  Both ended up devaluing their currencies.  Both ended up in default.

A repeat of 1998 is not the only possible scenario.  Right now, the opposite seems more likely. Oil could soar even as the dollar tanks.  My point is that oil exporters probably don't want the same monetary policy as the United States – or Europe for that matter – as the United States. I suspect that Ecuador is more likely to dedollarize than the rest of Latin America is to dollarize.  Benn's cri du coeur hardly seems likely to sway a Latin America that has grown disenchanted with Washington — and perhaps parts of the Washington consensus.

Or to convince Nestor Kirchner to give up the peso.   I suspect  Benn – like Kurt Schuler —  thinks Argentina should have dollarized back in 2001.  I don't.

A few months ago, Econ Journal Watch published a Schuler broadside that accused a host of international economists of malpractice.  One of his accusations: too many economists argued that dollarization in Argentina was technically impossible back in the fall of 2001.

I plead not guilty to that charge.  I have no doubt dollarization was technically possible Argentina had enough dollars (including dollars borrowed from the IMF) to replace all pesos in circulation.  I just think dollarization would have been a bad idea.

Following an exchange at Macroblog, Econ Journal Watch graciously invited David Altig and me to respond to Schuler's various charges – and gave Kurt Schuler a chance to reply.   Among other things, my paper fleshes out why I think Argentina's dollar peg – its pseudo-currency board – was wrong for Argentina back in the 1990s.  And why I don't think dollarization late in 2001 would have averted Argentina's default, allowed Argentina to avoid a bank holiday or eliminated the need for a painful real depreciation.   Dollarization just would have assured that the depreciation came about through falling prices, not a fall in the currency.  And rather than having frozen peso deposits, Argentines would have had frozen dollar deposits.  Argentina had enough dollars to back all the pesos in circulation – but no where near enough to pay its debts, or allow all Argentines with short-term dollar and peso deposits to take their money out of the banks!

Full disclosure. I know Benn from my time as an International Affairs Fellow at the Council in 2003.  We have a long-standing agreement to disagree on dollarization.

25 Comments

  • Posted by Guest

    yes, but what about inflation-linked currencies or a commodity-reserve currency like “bancor” as keynes originally proposed (and graham envisioned)? (perhaps as a supplement to the IMF’s SDRs?)

  • Posted by Guest

    Yuan Jumps Against U.S. Currency

    The yuan Friday made its biggest daily gain against the dollar since being revalued and closed at its strongest level so far, signaling increased volatility in China’s foreign-exchange market.

    Rising short-term interest rates in China encouraged traders to sell dollars for yuan, and the central bank didn’t stand in the way of the fall, some traders said.

    Others said large daily moves will become more commonplace as banks trade the currency more actively and carry out more proprietary trading. Such volatility “should have happened earlier, but it’s just happening now,” said one trader.

    The dollar closed at 8.0601 yuan on the country’s automatic price-matching system, down from Thursday’s close of 8.0673 yuan. In the over-the-counter market, which closes two hours later, the dollar ended at 8.0643 yuan, down from 8.0665 yuan Thursday.

  • Posted by bsetser

    Interesting — The PBoC seems to be willing to tolerate a bit more flexibility/ volatility/ whatever you want to call. Is a real widening of the band next? Time will tell. Still not a market exchange rate tho …

    Guest 1. I am a bit more intrigued with the idea that commodity countries should peg to a basket that includes the price of their key commodity export. This is an idea that Jeff Frankel of Harvard hsa pushed. Saudi Arabia could still manipulate its currencies value by manipulating the price of oil — but if it pushed oil up, it would also end up pushing its currency up, keeping the riyal denomianted revenue stream from its oil a bit more stable (each barrel of oil = more dollars, but each dollar would buy fewer riyal …

  • Posted by HK

    Brad–I really don’t understand why anyone can argue for dollarization after the collapse of the Argentine currency board. The “two-corner solution” thesis should have been dead since then. The situation in Ecuador is exactly as you explained, and I predict its dollarization would collapse at some point (unless Ecuador should be included in the FRB system and some fiscal transfer mechanism with the US should be instituted).

    Of course, under increased regional economic integration, a regional common currency might be approriate, as shown by the introduction of the euro. So, by 2050, there may remain only 20-30 currencies in the world, rather than 140 or more currencies st present. But, this is completely different from unilateral dollarization by countries such as Ecuador.

  • Posted by DF

    Another pro domo talk.
    If you had up, dark matter, dollarisation, saving glut and no housing -asset bubble talk, all I can see coming from the USA is a wounded vampire seeking desperately new fresh blood, the US need foreign savings and export market for their debt based currency and their debts.

    So let them dollarize other countries. Quick.
    Let’s suck in new foreign savings.
    Let’s sell export dollars and debts.

    It makes an awful lot of pro domo talks, in english, self deserving myths …

    Oh and I forgot the mighty, “this time it’s different”, applies to another subject : the inverted yeld curve.

    So we have an inverted yeld curve, lack of household savings, huge twin deficits, an end coming to the dollar hegemony as a trade and reserve currency (see threats from china or Iran), growing needs of foreign savings and oil, rising debt/GDP growth, unprecedented housing bubble and reappearing stock market bubble, but hey, it does not matter, because “this time it’s different”.
    Other countries save too much, do not know how to invest, have poor currencies and read on my lips : there is no housing bubble (just some froth on local markets) …
    Gee

  • Posted by DF

    If you add up…
    sorry about the typo…

  • Posted by Elaine Supkis

    Don’t cry for me, Argentina!

    Heh. They dollarized and got pulverized so now they go to China for loans, not the IMF. The dollar is about to go buy-buy. You will see.

    The Chinese reached their happy goal of $1 TRILLION in reserves which they intend to use to buy up energy systems and fund policial moves that make America look bad (easy as pie these days).

  • Posted by DF

    The dollar will go buy-buy … That’s a funny one.
    That’s all it has done recently, bought lots of stuff…
    So if it goes buy-buy then it means it will be sold sold…

  • Posted by Dude

    The article by Mr. Steil seems to me much more an argument for a return to the international Gold standard than an endorsement of dollarization.

  • Posted by Guest

    10 Reasons Why the Income Tax System will Collapse in the Next 10 Years

    5.) Increasing number of alternative currencies are creating alternative forms of commerce, and un-taxable forms of income. Much of the motivation behind dealing in these currencies is to shield personal and business transactions from the prying eyes of government.

  • Posted by Gcst

    ” Dollarization just would have assured
    that the depreciation came about
    through falling prices,
    not a fall in the currency”

    look at
    how those two adjustment mechanisms
    differ
    how differently
    they distribute their pain

    and
    on that u can tell the moral of the tale

  • Posted by Gcs

    keynes’
    bancor
    was not backed by anything

    at least not
    in its first and most heroically far sight draft

    it was a a way
    to create a multilateral policy based
    global reserve currencyto deal
    with national ca imbalances

    that sublated the creditor bias
    built into all now existing
    systems

    well acutally
    uncle’s dollar
    has a unique role
    as one and only
    debtor king

    all else must obey their creditors
    or else

    bancor as freely “printable”
    could create as much additional liquidity
    as an expanding
    international trading and credit system needed
    very very
    unlike gold

    keynes:
    bancor was the heart of a payments system
    based squarely
    “on the banking principle
    as applied within a closed system”

  • Posted by bsetser

    I don’t think the world is ready for an international fiat currency … the euro is the closest thing we have, and it is the currency of a subset of a union of sorts (the EU). Bancor, SDR, you name it — the institutions that determine global monetary policy would need to be defined, and the distribution of monetary power matters.

    plus, why would the world want to give up currency flexibility between the big zones now? some currency adjustment seems to be a big part of any benign rebalancing scenario. one currency and one monetary policy = all adjustment comes through prices, so us prices need to fall/ chinese prices rise to equilibriate things. better for that to happen via changes in the price of two fiat currencies than via changes in lots of prices at the micro level.

    finally, what’s in it for the US. Big debtor. Borrows in its own currency. At low rates — shifting all the risk of a devaluation onto US creditors … What’s not to like? So long as the United States’ external debt is denominated in its own (Fiat) currency, the US has a few more options … no golden fetters here.

  • Posted by DOR

    As someone who suffered under six years of adjusting prices, rather than exchange rates, let me tell you it is a whole world of pain.

    Debt vs. equity equations go out the window. Net present value gets flipped on its head. People stop buying, because “it’ll be cheaper next month.”

    Hong Kong had the reverse in the early 1990s, of course, when prices shot up and living standards eroded. Pegs can be very useful, but they have a cost.
    .

  • Posted by DF

    If a huge chunk of your debt is in short term duration, and if creditors expect your currency to fall… What prevents them to ask for higher rates ?

    It is not sure that the foreigners bear all the risk of the fall of the US currency. They could well ask for a risk premium

  • Posted by DOR

    DF,
    Hong Kong’s short term debt is all trade related, and overnight rates shot up to high double digits during the Asian Financial Crisis, exactly the way the currency board was supposed to work.

  • Posted by Steven M

    Folks, I totally agree with you. It’s about time to get involved. Here are two groups I found. I am not actually part of these groups, but I just wanted to provide examples of groups which may or may not have something to add. If anyone has others, please feel free to mention them. Thanks.

    http://www.americaneconomicalert.org

    http://www.economyincrisis.org/

  • Posted by Joe Rotger

    Dollarization??

    You mean everybody in the world gives the US the right to print their money?

    and with those USDs they can buy anything?

    Listen, if you buy that, then I’ve got a nice little bridge called the Brooklyn bridge and I’m selling it…

    Or, why not take this here paper money I print in my garage in exchange for your stuff?

    Any country that dollarizes deserves to bear the consequences.

    On the other hand, a global currency controlled by a UN chartered bank or such… I don’t know, it’s somewhere in the future. Paretto and Nash say so.

    But, I don’t think the US and European community are going to give up so soon the power of being the defacto standards as currency goes…

    The Brits didn’t give away the £ so easily…

    I’m sure the PBoC will explain better than I how the USD benefits the US…

    It’s in the billions…

    Anyhow, great question, thanks Brad.

    I haven’t given up on someday finding a good answer for the exchange rates issue.

  • Posted by DOR

    Steven M,

    The websites you cite are anti-consumer groups that wants to raise taxes on poor families to pay for the unwillingness of Corporate America to invest enough to stay competitive.

    Sorry, I’m not interested in supporting whacko right wingnut protectionist flag wavers.
    .

  • Posted by Pedro Romero Aleman

    All of you have analyzing dollarization only from a macro perspective. Back in 1998-99 more than ever ecuadorians couldn’t make monetary calculations without devaluation risk like you do, then and now. Even small transactions implied make adjustments for Sucre devaluation. Businessmen and even lower-wage-earners changed their sucres to dollars as soon as they got new income. This behavior of economic agents, in the Ecuadorian case gave rise to the process of spontaneous dollarization of the economy that preceded formal dollarization adopted by Jamil Mahuad in January of 2000. The spontaneous process of dollarization was a sign of rejection by Ecuadorians to the monetary policy of BCE and the government.
    The BCE promoted this economic behavior of individuals by its detrimental role in the determination of the country’s monetary supply, due to the struggle among pressure groups.
    Even macroeconomically you forget to make an analysis about tradable and non-tradables prices, the situation pre-dollarization was that non-tradables prices were plummeting everyday and import goods were not affordable. Now the situation has reversed. And lower-wage-earners are not willing to give their dollars to the government (real state sector has been growing steadily last years). Now, for the firts time in more than 30 years, there is price stability and monetary credibility in Ecuador. All other remaining problems are fiscal and real in Ecuador, and the dollarization helped to call attention on them, there is no veil now only political stubbornness.
    high oil prices have helped to the ecuadorian government to postpone reforms, but most of ecuadorians do not get any dime from these fiscal revenue. in fact, they pay higher prices for oil derivatives for an oil-producer country due to the nationalization of its production.
    Interest rates are equal to US levels due to the lack of competition in the banking industry and barriers to entry, but the dollar has done possible for the few active bankers to earn profits.
    If you have questions about facts and public policy matters in Ecuador, I will be glad to help you as you wish.

  • Posted by Anonymous

    The effect of dollarization in El Salvador has been a dramatic reduction in interest rates, making the real estate market function much more effectively and making it easier to get capital to start a business.

    Dollarization has also allowed more effective remittances and trade from the U.S. to El Salvador.

    It has not been a miracle, but at least you can say that investments in El Salvador will not be at such a great risk of inflation as in many other Latin American countries that run their own currency.

    That is what dollarization is – a bet that the Fed will be better at fighting inflation than your democratic government. Taking the macroeconomic decisions out of the equation leaves the government with other things to concentrate on, like improving economic freedom and rule of law to grow the economy.

  • Posted by bsetser

    Mr. Aleman — I am not 100% up to date with all developments in Ecuador, but I am reasonably familiar with the country — i spent a lot of time thinking about it 98/99. I disagree somewhat with your analysis. No doubt there was a ton of monetary induced volatility in 98/99, impart because of the government’s response to problems in the banking sector. Printing sucres had rather predictable consequences. But it is possible for emerging economies to operate a monetary policy that is not based on running the printing presses.

    While the movements in the sucre during the crisis were no doubt excessive, i also believe that it was necessary for the relative prices of tradables and non-tradables to shift (and for imported tradables to become more expensive)? Why — because Ecuador got hit with a huge terms of trade shock when oil fell to $15 (particularly since I gather shrimp production was hit by el nino and banana prices were in the doldrums). A real adjustment was necessary.

    I consequently add another item to your list of macroeconomic problems — managing volatility in the dollar/ oil price, and terms of trade shocks. As i argued above, Ecuador’s real exchange rate will need to fall (as will imports) if oil prices fall, but without the exchange rate, the necessary adjustment will come through deflation. And high nominal dollar interest rates (as if the case in Ecuador now) and falling prices can generate very high real interest rates. See Argentina 2000-01.

    Anonymous — I recommend Ricardo Hausmann’s more critical assessment of the impact of dollarization on El Salvador’s economy. I am not opposed to dollarization in El Salvador’s case, given the remittance flow. But it probably does make adjusting to the China shock a bit harder. Hausmann argues real rates in El Salvador are low b/c demand for capital is low. And the Ecuador case proves that it takes more than just dollarization to lower real interest rates. Dollarization does not eliminate default risk. fortunately, that isn’t a major concern for el salvador, unlike ecuador.

  • Posted by Pedro Romero Aleman

    Brad; I think that we disagree more on the prognosis rather than on the diagnosis of the current situation in Ecuador. I would like to remind to all readers of this blog that the flip side of the rampant inflation (in sucres >100%) in Ecuador during 98/99 years was the deflation (in dollars 40%). What I want to highlight is that the continuous devaluatory policies of the government were confiscating time and again people’s income. Now, after dollarization, the government is unable to keep doing that, and only has taxes, debt, and I’d say royalties from owned-enterprises, as financial sources. These are more direct measures than inflationary policies.
    Before dollarization businessmen were used to profits of two till three digits percent, now they speak of one digit percent net profits, so they are more worried about reducing costs through productivity improvements. However, there are still important prices controlled by the governtment, eg gas, causing micro distortions that emerge as macro problems (what you mention about terms of trade).
    I ain’t saying that the BCE lacked qualified personell to do their job, but the real problem is they are immersed into a struggle for poitical power and vested interests that they contribute to keep alive. that’s one of my main reasons to distrust in domestic monetary policies in countries like Ecuador.

  • Posted by Puma

    Just dropping by to tell you I really agree with your view on Dollarization.
    As an Argentinian that saw the collapse of our economy thanks to twenty years of “free market” policies (starting with the 1976-83 dictatorship and another row with the 1989-2001 Menem and De La Rua governments), I really want other countries to LEARN FROM OUR EXAMPLE.
    Argentina followed every little policy recommendation from the US and the IMF, we pegged the peso to the dollar, lowered our tariffs, wide-opened our market to foreign imports, privatized every government enterprise on sight and the results were the obvious ones:
    *Lack of tariffs destroyed our national industry, that could not compete with the cheap multinational imports (Dutch butter was cheaper than the national brand!)
    *Economic deregulation, combined with the massive privatizations, ravaged the quality of life and allowed corporations to get away with all kinds of crap. Aerolineas Argentinas, after privatization, went from being one of the world’s best airlines and having more than 18 planes, to a bankrupt airline that only owned one plane and was leasing the rest of ‘em. Iberia, the spanish buyers, transfered all their companies’ debts to Aerolineas.
    Telecom and Telefonica, the two companies that took over our phone service, begun to charge people per-minute-spoken, rather than a fixed price as it’s done the rest of the world. Examples like these are tons.
    *The infamous currency peg only served to create a financial bubble that weakened our capacity to export products, and allowed argentines to travel abroad and act arrogantly while our economy was being destroyed. The day the bubble broke, all hell broke loose.
    *Privatized oil and energy companies refused to invest on new gas explorations, and there were little resources for the state to force them to do so. We are now in danger of an energy shortage, due to 10 years with no investment, and the new government was forced to create a new state oil company from scratch.
    *Privatized railroads closed “unprofitable” lines, creating ghost towns and destroying our internal market.

    The end result of all this was the ravagin of our economy and living standards (one rivalring those in europe), our country joining the list of the most socially unequal ones, weakened education and health systems, and the final blow in 2001 which caused massive riots that forced the crooked government out.

    The world should learn from our example! What Bush is doing in the US right now is exactly what Menem did over here: Massive market liberalization, cheap Chinese imports, a huge trade deficit, financial and housing bubbles, factories closing to move their production to the third world, increasing social inequality and deregulation.
    It can only end in a disaster.
    The problem is, being the US such an important part of the world economy, the effects of an US crash would be devastating, specially for the western world. I bet the Chinese are laughing all the way to the bank.

  • Posted by Puma

    Just dropping by to tell you I really agree with your view on Dollarization.
    As an Argentinian that saw the collapse of our economy thanks to twenty years of “free market” policies (starting with the 1976-83 dictatorship and another row with the 1989-2001 Menem and De La Rua governments), I really want other countries to LEARN FROM OUR EXAMPLE.
    Argentina followed every little policy recommendation from the US and the IMF, we pegged the peso to the dollar, lowered our tariffs, wide-opened our market to foreign imports, privatized every government enterprise on sight and the results were the obvious ones:
    *Lack of tariffs destroyed our national industry, that could not compete with the cheap multinational imports (Dutch butter was cheaper than the national brand!)
    *Economic deregulation, combined with the massive privatizations, ravaged the quality of life and allowed corporations to get away with all kinds of crap. Aerolineas Argentinas, after privatization, went from being one of the world’s best airlines and having more than 18 planes, to a bankrupt airline that only owned one plane and was leasing the rest of ‘em. Iberia, the spanish buyers, transfered all their companies’ debts to Aerolineas.
    Telecom and Telefonica, the two companies that took over our phone service, begun to charge people per-minute-spoken, rather than a fixed price as it’s done the rest of the world. Examples like these are tons.
    *The infamous currency peg only served to create a financial bubble that weakened our capacity to export products, and allowed argentines to travel abroad and act arrogantly while our economy was being destroyed. The day the bubble broke, all hell broke loose.
    *Privatized oil and energy companies refused to invest on new gas explorations, and there were little resources for the state to force them to do so. We are now in danger of an energy shortage, due to 10 years with no investment, and the new government was forced to create a new state oil company from scratch.
    *Privatized railroads closed “unprofitable” lines, creating ghost towns and destroying our internal market.

    The end result of all this was the ravagin of our economy and living standards (one rivalring those in europe), our country joining the list of the most socially unequal ones, weakened education and health systems, and the final blow in 2001 which caused massive riots that forced the crooked government out.

    The world should learn from our example! What Bush is doing in the US right now is exactly what Menem did over here: Massive market liberalization, cheap Chinese imports, a huge trade deficit, financial and housing bubbles, factories closing to move their production to the third world, increasing social inequality and deregulation.
    It can only end in a disaster.
    The problem is, being the US such an important part of the world economy, the effects of an US crash would be devastating, specially for the western world. I bet the Chinese are laughing all the way to the bank.

    PS: Posted again because my previous comment got somehow stickied with the one from the idiot that posted all those links.