The Euro vs. Dollarization: Currency Unions Compared

Introduction to Dollarization

Dollarization takes place when one country decides to use a foreign currency in parallel to, or instead of, its domestic currency. Dollarization can occur unofficially, without formal legal approval; semiofficially, where foreign currency is legal tender but plays a secondary role to the domestic currency; or officially, when a country no longer issues a domestic currency and uses only foreign currency. Estimates of the extent to which U.S. dollar notes circulate outside their country 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 in the form of $100 bills.

The term "dollarization" can be applied in the broad sense to using any foreign currency, or more specifically to using the U.S. dollar as a national currency. Unofficial dollarization may take a number of forms, including holding: (1) foreign currency bonds or other non-cash 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 Ecuador in 2000 and El Salvador in 2001. Additionally, the following countries or U.S. territories also use the dollar (year adopted in parentheses): East Timor (2000), Guam (1898), Marshall Islands (1944), Micronesia (1944), Northern Mariana Islands (1944), Palau (1944), Panama (1904), Pitcairn Island (1800s), Puerto Rico (1899), American Samoa (1899), Turks and Caicos Islands (1973), British Virgin Islands (1973), and U.S. Virgin Islands (1934).

Historical Origins of Paper Currency

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 arose from 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 became widespread in the 18th century. By the beginning of the 20th century, most industrializing nations were on some form of gold standard, with paper notes and silver coins constituting the bulk of the circulating medium.

Seigniorage and the Politics of Currency Adoption

The loss of seigniorage from giving up a national currency is a significant 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 banknote and the cost of producing and distributing it, and it is an important source of revenue for some national governments. In defense of the 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 was 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 alongside the number of independent countries. With the creation of the European Union (EU), the world appears to have once again begun a period of currency consolidation that may divide it into two or three large currency blocs.

The Euro and Global 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 generated pressure in developing countries to establish their own regional arrangements or to align with the dollar or euro blocs. President Vladimir Putin speculated that Russia might switch its trade in oil from dollars to euros, a change that could have far-reaching effects on the global balance of power, potentially weakening the U.S. dollar and economy while providing a significant boost to the euro zone. As one account noted: "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 considering 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 generated considerable speculation. Ecuador's dollarization project, which began on January 9, 2000, intensified academic and policy debate and moved it closer toward practical policy issues arising from the implementation of official dollarization. Finally, the worldwide effects of 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 existing unofficial dollarization. Where this situation exists, the host country earns less from seigniorage than it would if unofficial dollarization were 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 the 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.