Euro versus dollarization in international economics

the Euro vs. Dollarization

Dollarization takes place when one country decides to use a foreign currency in parallel to, or instead, of the domestic currency. Dollarization can occur unofficially, without formal legal approval, or semiofficially, where foreign currency is legal tender, but plays a secondary role to domestic currency, or officially, when a country no longer issues a domestic currency and uses only foreign currency. Estimates of the extent to which notes of the U.S. dollar circulate outside their countries of origin give a rough idea of how widespread unofficial dollarization is. Researchers at the Federal Reserve System estimate that foreigners hold 55 to 70% of U.S. dollar notes, mainly as $100 bills.

The term dollarization can be applied in the broad sense to using any foreign currency, or specifically using the U.S. dollar as the national currency. Unofficial dollarization may take a number of forms, including holding (1) foreign currency bonds or other noncash assets; (2) foreign currency cash, whether possession is legal or illegal; (3) foreign currency deposits in domestic banks; and (4) foreign currency deposits in foreign banks.

Until 1999, official dollarization was rare because it was considered politically impossible, but since then it has gained prominence following its implementation as official policy, in the case of Ecuador in 2000, and El Salvador in 2001. Additionally the following countries or U.S. territories also use the dollar (year adopted in parenthesis): East Timor (2000), Guam (1898), Marshall Islands (1944), Micronesia (1944), N. Mariana Is. (1944), Palau (1944), Panama (1904), Pitcairn Island (1800s), Puerto Rico (1899), Samoa, American (1899), Turks and Caicos Islands (1973), Virgin Islands, U.K. (1973), Virgin Islands, U.S. (1934).

Paper money originated in two forms: drafts, that is receipts for value held on account, and "bills," which were issued with a promise to convert at a later date. The use of paper money as a circulating medium is a result of shortages of metal for coins. In the seventh century there were local issues of paper currency in China and by 960 the Song Dynasty, short of copper for striking coins, issued the first generally circulating notes. A note is a promise to redeem later for some other object of value, usually gold or silver. In Europe, the first banknotes were issued by Stockholms Banco, a predecessor of the Bank of Sweden, in 1660, although the bank ran out of coins to redeem its notes in 1664, and ceased operating. In 1694 the Bank of England issued the first permanently circulating banknotes, and the use of fixed denominations and printed banknotes came into use in the 18th century. By the beginning of the 20th century, most of the industrializing nations were on some form of gold standard, with paper notes and silver coins constituting the bulk of the circulating medium.

The loss of seigniorage from giving up a national currency is a political and economic obstacle to dollarization. In an effort to reduce this problem, Senator Connie Mack (R-Florida) and Representative Paul Ryan (R-Wisconsin) introduced the International Monetary Stability Act in November 1999, although the law was not adopted. Seigniorage, is the net revenue derived from the issuing of currency. It arises from the difference between the face value of a coin or bank note and the cost of producing and distributing it. Seigniorage is an important source of revenue for some national governments. In defense of this bill, Senator Mack wrote:

While dollarisation would make it possible for emerging market economies to enjoy the fruits of monetary stability and increased trade, it would also benefit the U.S. The U.S. would gain from an expansion in trade due to lower transaction costs and fewer disruptions of our markets as the result of exchange rate devaluations by trading partners. By encouraging, though not forcing, official dollarisation, the U.S. has an opportunity to lead the way to a more prosperous and better world.

The 20th century has been a time of increasing currency disjunction. At the beginning of the century there were far fewer independent countries than exist today, and the majority of their currencies were linked to silver or gold, in effect dividing the world into two large currency blocs. Currency crises occurred, but they were less frequent and severe than they later became. Since World War I, the number of currencies coupled with independent monetary policies has consistently risen, in conjunction with the number of independent countries. With the creation of the European Union (EU), the world now appears to have once again begun a period of currency consolidation that will divide it into two or three large currency blocs.

The replacement of national currencies with the euro in eleven Western European countries at the start of 1999 created the first true rival to the dollar in half a century, and created pressure in developing countries to try to put in place their own regional arrangements, or to join the dollar or euro blocs. President Vladimir Putin has speculated that Russia might switch its trade in oil from dollars to euros, a change that could have far-reaching effect on the global balance of power, potentially hurting the U.S. dollar and economy and providing a massive boost to the euro zone. "Putin's words come in the wake of a protracted drive by the EU to attract more countries' trade and currency reserves into euros, in a bid to chip away at U.S. hegemony over the global economy and money supply. A move by Russia, as the world's second largest oil exporter, to trade oil in euros, could provoke a chain reaction among other oil producers currently mulling a switch and would further boost the euro's gradually growing share of global currency reserves."

A number of factors have created renewed interest in official dollarization. In Europe, the advent of the euro and the interest of Eastern European countries in considering a monetary union with Western Europe, whether by joining the European Central Bank, by unilaterally dollarizing, or by establishing currency boards, have created a great deal of speculation. Ecuador's dollarization project, which began on January 9, 2000, intensified academic and policy debate and moved it closer toward practical policy issues that are created in the course of implementing official dollarization. Finally, the worldwide effects of the financial crises in Mexico and Argentina (1994 -- 95), East Asia (1997 -- 98), Russia (1998), and Brazil (1998 -- 99) have inspired an examination of the attributes of stable exchange rate regimes.

A major factor in official dollarization is a high degree of unofficial dollarization. Where this situation exists, the host country earns less from seigniorage than if the degree of unofficial dollarization is low. It simply has less to lose from moving to official dollarization. This situation is particularly prevalent in developing countries in South America, where the dollar has become the unofficial currency. In these countries, the costs, measured as flow cost from official dollarization regarding lost seigniorage would be small, unless monetary expansion and inflation are high. These conditions point to the U.S. dollar as the dominant currency in the Caribbean and Central America, and possibly throughout the Western Hemisphere.

Some of the factors that are contributory to official dollarization, or other forms of a common currency, are a high factor mobility, symmetric shocks, and a relatively high degree of trade integration.

Domestic factor mobility refers to how easy productive factors, like capital, land, natural resources, and labor, can be allocated across sectors within the domestic economy. Different degrees of mobility come about because there are different costs related to moving factors across industries. This theory is silent on specifics that would make its application clearer, such as how much factor mobility and trade integration is enough to make an optimum currency area. It implies, however, that an optimum currency area for official dollarization exists where there is a large country that has a dominant currency and where considerable trade and labor mobility exists between it and its smaller neighbors. Labor mobility has not changed and, in any case, it is not necessary for a smooth functioning of European Monetary Union (EMU). The really important issues are real wage flexibility and structural adjustment. While some progress has been made, there is more that is needed to be done. Because the euro is the dominant currency in Western Europe, it would indicate that it has a much greater chance of becoming the dominant currency in much of the rest of Europe, than does the dollar.

Some sources indicate that the existence of a common currency in itself bolsters the optimal currency area conditions by making the regions in a currency area more assimilated over time. This infers wider applicability of common currency areas than that inferred by the original theory. The successful migration of the eleven very different European economies towards a common currency also seems to confirm this concept, and may portend an era of more extensive monetary integrations around the dollar, euro, and yen as key currencies.

A country's decision to officially dollarize depends on a number of factors as well as a calculation of the costs and benefits of seigniorage. The factors include how far a country wishes to become integrated into a wider currency and trade area, and whether it seeks to impose monetary discipline by eliminating discretion over its own policy, as well as whether it is seeking to change from a history of high inflation. The degree to which it looks upon a domestic currency as an indispensable element of national sovereignty, and the government's awareness of domestic political constraints on making a foreign currency the only legal tender, will also contribute to this decision. The mix of factors will be different across different countries. For the most part, however, the tradeoff for smaller countries will be between the elimination of the currency risk, including any currency crises, and the financial and trade benefits of integration into a dominant currency area on the one side, and the economic and political costs of giving up a domestic currency on the other side.

Significantly, the decision whether to officially dollarize is both political and economic, and in most cases political considerations will be more important than economic ones. As globalization proceeds, the politics of monetary policy may change from an emphasis on national sovereignty to an emphasis on regional integration, as has already happened in Western Europe. Countries joining a currency union lose their ability to stabilize output through an independent monetary policy and give up nominal exchange rate flexibility. Traditional wisdom states that countries with close international trade and financial links are more likely to be members of an Optimum Currency Area (OCA) while countries with contorted business cycles are less likely.

In countries that have already given up independent monetary policy, referred to as currency board countries, taking the final step by completely dollarizing may involve no increased loss of monetary sovereignty, except for the symbolism regarding the national currency.

With a fixed exchange rate, the exchange rate is the top priority of monetary policy (in an orthodox currency board system, the only priority). With a pegged rate, other priorities, such as interest rates, have equal status with the exchange rate. That creates a conflict between priorities that frequently ends in a devaluation. Orthodox currency boards maintain fixed exchange rates and therefore do not need to devalue; central banks that claim to maintain fixed rates in reality maintain pegged rates, which is why they have devalued again and again.

Neither the fiscal transfer mechanisms that are already in place within the European Union nor those that are envisioned under the EMU, the "structural funds," are as extensive as those in the U.S. Or Canadian national fiscal system.

The EMU is characterized by one common currency and one monetary policy. Although the sovereignty of member countries is restricted by the law of the EU, they remain separate political entities pursuing independent policies. The issue then arises whether a monetary union can work without a political union. A political union does not seem to be required for the success of a monetary union, particularly if fundamental issues are resolved. It has been argued that nationalized or even regionalized fiscal policies should be fixed individually and complemented by an interregional fiscal transfer mechanism to cope with financial shocks within the monetary unit.