The Two Meanings of Dollarization (Excerpt)

Matias Vernengo

The expression of ‘dollarization’ has at least two different meanings. In the narrow sense, it refers to massive currency substitution, in which a country, most likely a developing one, supplements its domestic unit account of fiduciary reserve assets with a foreign currency, more often than not the United States dollar or, in some cases, the euro. Note that currency substitution could be complete and might even imply the elimination of a domestic token. Full dollarization in that sense has taken place in small countries, mostly in Latin America, the Caribbean and the Pacific which are heavily dependent on the United States. Dollarization, in this sense, is the exemplification of a country foregoing its national ‘monetary sovereignty’ (Mundell 1961, p. 661).

In the broader sense, dollarization refers to US hegemony in the world economy as a result of the US dollar being the numeraire currency in international markets. This christens the United States as the premier international monetary authority that regulates and dictates the flows of international financial commitments for global economic activity. Of particular importance in this context is the fact that the key international commodities, including oil, are priced in US dollars in international markets. The former conception of dollarization can be described as dollarization strictu sensu, while the latter as latu sensu dollarization, i.e. not the specific use of  the dollar by a country, but by the whole world economy—an international system in which the dollar is de facto a global fiat money.

Dollarization strictu sensu

In light of rapid increases in cross-border financial flows since the 1970’s, as a result of what has been referred to as “economic globalization”—international trade liberalization and financial liberalization accompanied by a significant increase in flows of goods and services, and an even larger increase in the gross flows of capital well above the needs to finance trade (Crotty 2009)—countries have suffered from repeated financial crises. Volatility of capital flows, which tend to be pro-cyclical, have implied that countries have access to significant amounts of hot flows during a boom, but are subjected to sudden stops and capital flight during crises. Accordingly, as a means of establishing a protective barrier in an international system of financial fragility and volatility, and ensure that economic development is not disrupted from its potential adverse effects, a solution suggested in certain circles was to adopt a fixed exchange rate mechanism by which the domestic currency of a country is rigidly pegged to a strong foreign reference currency, like the US dollar, or more drastically to adopt the dollar as the domestic currency.

The idea is to try to borrow confidence that the value of the domestic currency will not be disrupted, since it can be freely and readily convertible into this reference currency at any time at its fixed price. Argentina adopted a fixed peg in the 1990s, and Ecuador and El Salvador formally dollarized at the turn of the century. The perceivance is that financial crises are not necessarily the result of financial uncertainty per se, which stems from liberalized capital flows, but rather the inability to assure price stability or to allow sustained capital inflows for the long-term. In this view, which one may term neoliberal, since it suggests that liberalization would solve all the problems, this problem is due to excessive fiscal deficit spending that sets in motion a self-fulfilling prophecy of inflationary bias ). The suggestion is that discretionary fiscal policy expansion, followed by monetization of debt, leads to unrelenting depreciation of the domestic currency leading to a run on the currency. A banking and a balance of payments crisis or the so-called ‘Twin Crises’ occur as a result, which may be also accompanied by high inflation or hyperinflation and economic stagnation .

The solution to the problem is what Frenkel calls “credibility in a bottle”. In order to achieve the objective of maintaining an unchanging fixed peg to the foreign reference currency, adherence to budget surpluses through tax incentives and fiscal austerity is strictly adhered to.

The result is an inability to use monetary policy—central bank purchasing and selling of government bonds denominated in the domestic currency for purposes of controlling the money supply, and thus the cost of credit—and fiscal policy, via deficit spending, for domestic economic needs. Since implicit the assumption is that economic openness automatically translates into higher rates of growth, the expectation is that dollarization will build global financial market confidence and lead to the attraction of foreign capital along with anticipated lower interest rates on credit, because of a policy-mix that supposedly removes the likelihood of inflation and market externalities that arise from the conditions of foreign exchange risk.

The supposed benefits of dollarization, however, are from being a social fact. Since the central bank is forced to strictly maintain reserves of the foreign reference currency such that the price of the domestic currency in terms of the reference currency does not change, this produces a negative money-multiplier that cannot be mitigated by sterilized central bank interventions. This sets in motion an inherent deflationary bias, which, if not counteracted by capital inflows to spur aggregate demand, can lead to abrupt contraction of the monetary base, stinting any supposed progress towards economic sustainability.

Furthermore, under a dollarized economy, if any form of government spending is to be engaged, the country has to issue bonds that are not denominated in its own currency. This essentially amounts to the attraction of external commercial loans, with faith in the value of the domestic currency, as a result of dollarization, used as collateral. Even if foreign exchange risk is eliminated, which would only occur if the dollar is used as domestic currency, but not under a fixed peg, country risk is most likely going to exist leading to a spread over bonds like US treasury securities, if the foreign reference currency is the dollar, causing the exact of opposite of anticipated lower interest rates in the supply of credit. The higher interest rates make government spending very costly, creating a permanent contractionary fiscal stance, which essentially removes any form of a domestic capacity to spur public investment as an effective countercyclical policy in the face of economic downturns. This has been essentially the case of Argentina before the 2001-2 crisis, and of the European periphery since the intensification of the Greek crisis in 2011.

The country’s creditworthiness is essentially evaluated in terms of the degree to which the state takes steps toward lowering the social wage for the benefit of multinational corporations. This result is a balance of payments constraint that can be quite unsupportable, especially if international investors lose confidence and start shifting funds offshore, spawning self-fulfilling financial collapses. Any expectation that a balance of payment adjustment would immediately occur as an automatic stabilizer, as in David Hume’s price-flow-mechanism, supposedly reminiscent of the former Gold Standard international monetary system, is certainly misguided. On the surface, dollarization represents itself as an irresistible ‘juggernaut’. It, however, constitutes an ideological mask that normalizes the advance of global cosmopolitan money-capitalist power to dictate the terms of domestic democratic politics for the benefit of certain ‘vested interests’. It is important to note that while the main “losers” in the process of dollarization are the workers in developing countries, which are ultimately forced to live with lower levels of growth and higher unemployment, the process also has a disciplining effect on the workers of advanced economies.

This is part of an entry written for the Wiley-Blackwell Encyclopedia of Globalization.

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