A Case Against U.S. Dollarization

Challenge, July, 2000 by George von Furstenberg

In our ongoing analysis of international financial architecture, the author argues that dollarization is at most a second-best answer to currency confusion.

FREE international movement of capital and free trade and e-trade in financial services have combined to make regional currency consolidation inevitable. Faced with this prospect, advocacy of rapid dollarization, in some cases of this entire hemisphere, has spread beyond the United States. Business and government groups in countries from Argentina to El Salvador and Mexico have openly expressed interest in formal dollarization. While complete dollarization may indeed be a useful step for the period immediately ahead, I will argue that it is distinctly second-best in the short run and unsustainable in the long run even in this hemisphere.

Specifically, uncooperative unilateral monetary unions, such as those brought about by formal dollarization, are inferior to the multilateral sharing model of monetary union pioneered in Europe.

Dollarization involves a very high financial tribute to the United States. Countries will be reluctant to continue paying billions of dollars' worth in forgone seignorage once they have become accustomed to monetary stability and internalized the virtues of low inflation. Rather than paying indefinitely for this lesson, they will reclaim co-ownership and co-management of their monetary asset in multilateral monetary union with like-minded countries.

The Business of External Dollarization

How did we get to the point of adoption of the U.S. dollar by other countries? As the paper dollar was coming into its own by being issued and accepted as a pure fiat money in its home market, it was also beginning to be accepted for transactions and store of value functions in foreign countries. Here is a brief look at history before evaluating the advanced stages of this development that could soon lead to formal dollarization--the unilateral adoption of the U.S. dollar as sole legal tender by other countries in the Western Hemisphere. In glancing back, I will ignore Panama's adoption of the U.S. dollar as, in effect, sole medium of payment in 1904 because it is doubtful that the new state had any choice in the matter.

For centuries countries obtained most of their money by mining or panning for it or importing the precious monetary specie in return for goods or by means of foreign loans at great expense. During the twentieth century, national monetary sovereignty became the norm as links to commodity standards were cut in crisis-driven spurts of reform and replaced by discretionary policy management of the growth of fiat money. In the United States, for instance, the demonetization of gold in 1973, in lifting the requirement that Federal Reserve notes be 40 percent backed by a fixed amount of artificially valued gold in the U.S. Treasury, completed the process of internal or national dollarization by cutting the last ceremonial links to an external or international standard. Henceforth the dollar was a pure fiat money whose "production" was entirely subject to national control arid to whatever internal disciplines by which U.S. policymakers cared to abide.

Informal external dollarization, with the U.S. dollar circulating side by side with the respective national currency abroad without benefit of legal tender rights, had become widespread in the aftermath of World War II, particularly in the occupied countries. It then receded as foreign monetary systems were rebuilt in Europe and Japan in the 1950s and the dollar proved weak against some of the other major currencies in the 1960s and 1970s. External dollarization started to advance again after the United States credibly rededicated itself to the virtues of hard money in the early 1980s. Also, postcommunist transition economies, as well as economies emerging from other disasters, particularly in Latin America, provided more liberal access to U.S. dollars in the 1990s. By the end of that decade, dollarization had become a hot issue from Mexico to Argentina, with informal, partial dollarization progressing. At the same time, formal or complete dollarization, under which the U.S. dollar would become sole legal te nder in the adopting country, is being debated ever more openly in business and government.

National currency, being subject to strictly enforced government "copyright," can be viewed as part of a country's marketable and exportable intellectual property. Foreign use indirectly involves the payment of "royalties" to the United States. Even though paper money costs the U.S. monetary authorities next to nothing to produce physically, foreigners have to pay full value in goods to acquire it or have to relinquish interest earnings or make interest payments as long as they hold it. (Of course, U.S. taxpayers do not get the greenbacks for nothing either, but whatever seignorage profits and interest savings they provide for their own government, they get back in lower taxes.) So while external dollarization is good business for the United States, the question is whether it is also the best the Americas can do by and for themselves in the long run.