GET READY FOR DEBATE ON DOLLARIZATION

Several hundred billion dollars in cold, hard, U.S. cash now act as everyday money in places as different as Buenos Aires and Moscow. This dollarization is largely an informal grass roots response by citizens who have seen their governments print money that rapidly becomes worthless. Argentina is now contemplating formal dollarization, and the idea could prove contagious across Latin America. This prospect has led to overblown claims of an end to financial crises or exaggerated fears of the Fed held hostage to new foreign responsibilities.

The truth does not always lie in between the extremes, but in this case it does. In Latin America, dollarization would modestly enhance price stability and economic growth without compromising the Fed’s ability to manage the American economy. The nations that would benefit most are smaller economies that trade a fair amount with the U.S., like Chile, and countries whose past policies have left a residue of citizen and investor distrust, like Argentina. Since the currency remains an important symbol of sovereignty, the likeliest barriers to dollarization are political, not economic.

Giving up the national currency seemingly eliminates two important policy instruments. No longer can a country use monetary policy to manipulate domestic interest rates or devaluation to pump up demand for domestic goods. Appearances can deceive. Countries that already peg their exchange rate to the dollar can’t have an activist U.S.-style monetary policy, and repeated devaluations were part of their past inflation problem.

Argentina cannot move its interest rates independently from those in New York or investors would move massively into the currency whose risk-adjusted rates were higher. This would, of course, demolish the existing fixed exchange rate. The government can regain monetary control only if imposes capital controls to regulate how many dollars its citizens are allowed to acquire. Thus a free and open capital market cannot coincide with fixed exchange rates and monetary independence. One has got to go, and Argentina chose to forego monetary independence some time ago.

Those who remember the inflationary years between the late 1960s and early 1980s may smile, but for many nations today, hitching their monetary policy to the whims of Alan Greenspan and the U.S. Fed is a welcome prospect. Many of our South American neighbors rode a more extreme inflation roller coaster in the 1970s and 1980s. In those days they opted for capital controls and used money creation to finance enormous and unsustainable budget deficits. They have battled back from hyperinflation and no growth using fixed exchange rates and a new openness to private capital flows.

The fixed exchange rate anchored the domestic prices of most goods to U.S. levels. It also provided extra anti-inflation discipline since budget deficits could not be monetized. Allowing full capital mobility encouraged an inflow of foreign investment in plant and equipment while ending the institutionalized corruption and inefficiency surrounding government rationing of scarce foreign exchange.

If fixed exchange rates and capital mobility are such a smashing success, why dollarize? There are two answers:

• First, fixed exchange rates are not carved in biblical stone. Since everyone knows they may be changed quite suddenly one day, there is an added risk to holding that currency. This risk means Argentina’s interest rates are somewhat higher than they need be, which reduces investment and the rate of growth. As Treasury Secretary Lawrence Summers recently noted, dollarized Panama is the only country in Latin America whose local interest rate on 30-year mortgages is in single digits.
• Second, a fixed exchange rate is a catastrophe waiting to happen, especially if capital is internationally mobile! All is well if people think the rate will stay fixed. Once a critical mass of investors believes the monetary authorities lack the will or the resources to exchange dollars for pesos on demand, the game is up.

The analogy with a bank run is quite close. As Argentina discovered in the wake of the Mexican currency crisis, and Brazil has recently experienced following East Asia’s collapse, herd behavior by skittish foreign investors trying desperately to reduce their exposure to currency risk can claim innocent bystanders far from the scene of the crime. Defending the exchange rate against the assault of frightened investors is a costly undertaking. In 1995 Argentina’s banking system required an 8 billion dollar rescue package. Brazil’s trauma is still unfolding.

By opting for dollarization, countries like Argentina would be choosing credibility over flexibility. Dollarization is the ultimate commitment to hard money and sound fiscal management. The traditional currency crisis based on fear of devaluation becomes a bad memory. This doesn’t mean immunity from all problems. Capital flight could still occur if bad policy threatened the banking system or the safety of foreign owned assets. Thus dollarization would work best for nations whose banking practices and financial oversight regulations are transparent and conform to accepted international norms.

For better or for worse, sharing a common currency may strengthen somewhat the trade and investment ties between the U.S. and Argentina. This could enhance the prospects for further coordination of hemispheric trade and investment policies. Should dollarization spread, the Free Trade Area of the Americas initiative may gain more life. Contrast this with the European experience in which currency unification has come at the very end of a long process of economic integration.

Finally, a dollarized Argentina is hostage to Fed policy, which may not always coincide with Argentina’s needs. This last point is an entree for domestic critics of dollarization. If several countries go down this path will the Fed start to behave as the hemisphere’s central banker instead of our own? Actually, the Fed already keeps one eye on the international consequences of its actions.

Any change in U.S. inflation rates or interest rates has a pronounced effect on the world’s economy, and especially on any nation whose currency is pegged to our own. Dollarization changes this equation very little. And no plans exist to offer seats on the Fed’s governing board to foreign finance ministers! The risk to us and to them is political. If and when things go sour again, the dollar becomes a visible symbol of foreign influence and control. The leadership in Argentina, or any other potential dollarizer, knows this in advance.

Dollarization is neither poison nor panacea. For small open economies in our hemisphere -- and some outside of it -- dollarization can be a useful tool to help them maintain stable prices and a healthy climate for investment by domestic and foreign investors alike. For the U.S. this is economic small potatoes, but the politics will be fun to watch.