A Case Against U.S. Dollarization

Challenge, July, 2000 by George von Furstenberg

Initial guidance comes from a "277-year-old" Scottish economist who wrote about the nature and causes of the wealth of nations. Adam Smith recognized that wealth arises from value-creating activities and not from government fiat or hoards of shiny things. So too with national money: It has value because a country produces goods and services that can be usefully transacted with it under noninflationary conditions. Let the price level explode or production implode, and the value of money is destroyed. But just because the value of a national monetary asset can be ruined by mismanagement or calamity does not mean that each nation should not aspire, and lay claim, to its monetary wealth potential either by itself or jointly with others.

Not just their fool's gold of national monetary-policy sovereignty but genuine national income is lost when financially small countries end up importing or renting the money they use. They then pay in goods and services exports and through interest payments on foreign loans for something they could have, by prudent policy and international cooperation, for free. A member of the Board of Governors of the Federal Reserve System recently rejoiced that "with about $300 billion of U.S. currency in the hands of foreigners, the United States earns roughly $15 billion per year in seignorage." [1] The last figure is twice the current U.S. budget for nonmilitary foreign aid and could soon be triple or quadruple. [2] Foreign aid, net, could be flowing the wrong way.

The Disappearing Small Brands of Money

In principle, every country, regardless of size, has a right to its own homemade monetary base by virtue of the national product of its citizens that gives transactions value to this base. Yet if the country is small and wide open to international financial flows, it may have great difficulty exercising that right for its national currency if it acts alone. That currency denomination simply is of little use and ultimately uncompetitive. It may still be needed to pay wages, taxes, and retailers, and local banks may have to keep it on their balance sheet if the government says so. Yet all the big financial transactions and contracts will eschew denomination in an internationally obscure and volatile denomination that has little liquidity or accounting use. Buffeted and made expensive by country and currency risks even when kept on a strict regimen of internationally prescribed best practices, the small currency loses out to a currency that is in wide international use.

No matter how small countries decide to roll with the punches of open capital markets with their own money and exchange rates, small really is not beautiful in matters of money. Inflation targeting for a small country with flexible exchange rates is a frustrating exercise with frequent misses: Mexico was down to 7 percent inflation before the crisis that started in December 1994 forced it to crash and float. Five years later, its inflation rate was only just edging back to single digits, having come down painfully and slowly from over 50 percent during 1995. Currency boards offer good shelter from inflation as long as the exchange parity with their dollar or deutsche mark/euro backing can be maintained. But long stretches of sunny weather tend to be punctuated by severe storms requiring costly, and politically risky, interest-rate defenses. When Argentina's sovereign debt rating was reduced by Moody's in early October 1999, the agency cited the country's fixed exchange rate with the dollar: The deterioration in Argentina's terms of trade--in particular with Brazil, which had given up on a less committed dollar peg in January 1999, and then also with Chile--was making the present downturn of its economy "particularly difficult." A peso interest-rate surcharge of 500 basis points or more over U.S. dollar claims issued by the same Argentine banks in 1999 showed that the market was far from convinced that the Argentine peso is as good as the U.S. dollar or that the program of "convertibility" at a 1:1 rate is here to stay.