Global Policy Forum

The Case for Fewer but Stronger Currencies


By Daniel Gross

New York Times
February 19, 2006

Outsourcing isn't just a one-way street on which rich countries shift jobs overseas. In recent years, some developing countries have contracted out the work of setting monetary policy to the United States. Ecuador and El Salvador, in 2000 and 2001, respectively, abandoned their own currencies, adopted the dollar and placed their monetary policy in the capable hands of Alan Greenspan, then the chairman of the Federal Reserve.

When outsourcing involves manufacturing and software programming it is often endorsed by economists and condemned by populist political leaders. So, too, is the tactic of outsourcing of monetary policy -- known as dollarization, or euro-ization. After all, noted Robert E. Litan, senior fellow at the Brookings Institute, ''currencies are symbols of national sovereignty, and countries are reluctant to give them up.''

And yet nations can impose enormous costs on their citizens when they take extraordinary efforts to maintain independent currencies. ''Devaluations of currencies cost people their savings and bring on rapid inflation,'' said Benn Steil, a senior fellow at the Council on Foreign Relations and co-author with Mr. Litan of ''Financial Statecraft'' (Yale University Press, 2006). The two argue that the globe's melange of 200-plus currencies, backed only by the faith of investors, is inefficient and dangerous. Many emerging economies, they say, would be well advised to swap their currencies for strong, stable, widely used ones like the dollar or euro.

Steve H. Hanke, professor of applied economics at Johns Hopkins University, has examined economic development in 32 countries that adopted foreign currencies from 1950 and 1993. He found that they had faster rates of G.D.P. growth, lower inflation and greater fiscal discipline than their counterparts who hung onto their sovereign currencies. Professor Hanke has been an adviser to Ecuador, which in 2004 was among the best-performing economies in Latin America, growing at a 6.6 percent rate with inflation at 2.7 percent. ''Dollarization tends to deliver low inflation, and relatively low and stable interest rates,'' said Ricardo Hausman, a former chief economist of the Inter-American Development Bank who now teaches at the Kennedy School of Government at Harvard.

So what's not to like? ''It's not like dollarization is a magic drug,'' Mr. Steil said. It certainly doesn't end the risk that countries will default on dollar-denominated debt. Panama has been using the dollar since 1904 and has repeatedly run into difficulties. And El Salvador's economic performance hasn't outpaced those of its Central American neighbors.

Some Latin American countries, notably Mexico, have tamed inflation without abandoning their own currencies. ''If you have sound economic policies in a country, you don't need dollarization,'' said Nouriel Roubini, professor of economics at New York University's Stern School of Business. ''And if you follow poor policies, I don't think dollarization will solve your problems.''

But economists say that smaller countries can encourage investment by lashing their monetary fortunes to larger regional powers. In Latin America, companies that need to make long-term investments -- like utilities -- are forced to borrow in dollars while they operate in local currencies, leaving them exposed to currency risk. Now that El Salvador has adopted the dollar, companies there can borrow or engage in hedging transactions in dollars with relative ease. And when small monetary boats tie themselves together or link themselves to larger ones, it encourages stability. ''European financial markets were able to navigate problems of 9/11 and the Madrid and London bombings without too much instability, because they didn't have the extra layer of exchange-rate problems,'' said Barry Eichengreen, professor of economics and political science at the University of California, Berkeley.

But one economist's reassuring stability can be another's troubling rigidity. If the price of coffee plummets or the price for textiles falls because of competition from China, a Latin American country that has dollarized won't have the option of cutting interest rates to stimulate growth. ''Dollarization takes away the option of depreciation,'' Professor Hausman said.

Dollarization advocates say that this is all to the good. Mr. Steil notes that the Dominican Republic, where a currency crisis in 2004 wiped out the savings of a significant chunk of the population, conducts about 85 percent of its trade with the United States. ''Why on earth would they need their own currency?'' he asks. Large countries like the United States have to tread lightly in advocating that small countries give up their currencies. In 2000, Congress considered -- but did not pass -- the International Monetary Stability Act, which would have provided financial assistance to countries that adopted the dollar.

What's more, moving to unite monetary policies without integrating political and labor systems is problematic. The 12 member nations of the euro zone have solved the political problems created by common currencies by adopting a transnational institution--the European Central Bank -- and giving every country a seat at the table, Professor Eichengreen said. ''Where is Ecuador's seat on the Federal Reserve Board?'' he asked.

Advocates of dollarization recognize that the trend is also at odds with the prevailing political winds in the Western Hemisphere. ''There is a mini-anti-American revolt going on in Latin America as we speak,'' Mr. Litan said. ''Countries that would otherwise be interested, like Bolivia and Venezuela, have elected leftist governments'' that are ardently opposed to dollarization.

But Mr. Litan says he believes that time may be on the side of the dollar: ''History has marched toward the euro, and it is slowly marching toward the dollar.''

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