Dollarization and Lender of Last Resort
Javier Milei, a fresh face in Argentine politics, shook things up by taking the lead in the presidential primary elections (PASO). One of his crowd-pleasing moves is backing the idea of dollarizing Argentina. He publicly endorsed my work with Emilio Ocampo to lay out a solid plan for making dollarization work in Argentina.
Milei’s electoral success made waves worldwide, putting the concept of dollarization under the spotlight. People are genuinely intrigued, but beyond mere curiosity, there's also a lot of confusion and misinformation floating around. Emilio and I have focused our work on an Argentine audience, communicating in Spanish. Soon after our book hit the shelves, we started a blog to expand further and elucidate our proposal.
Following the timeline of my posts, below is the ant English translation of my first blog post on the subject. One of the earliest concerns thrown against dollarization in Argentina was the supposed lack of a "lender of last resort" in a dollarized economy. I intend to translate, in chronological order, my other posts. By following the chronological order of my interventions, you get a sense of how the debate evolved since it became public interest.
Dollarization and the Lender of Last Resort
Over the past few weeks, dollarization has once again become a hot topic on social media and in Argentine media circles. Various analysts have been battling it out with their pros and cons. Among all these considerations, some critics have been losing sleep over the thought of bidding farewell to the BCRA as the ultimate financial backstop.
In normal countries, the central bank's role is crucial. In times of liquidity crunch, it can inject funds into the financial market to prevent a bank stampede.
But applying this to Argentina is a whole different ballgame. Remember, during the Great Depression in the US, thousands of banks went belly up despite the presence of the Federal Reserve. Meanwhile, Canada stayed afloat without a central bank and a single bank failure. Still, despite these historical facts, the argument that a developing nation like Argentina can't afford to lose its "lender of last resort" doesn't hold water.
The first issue is that the argument that you cannot renounce to a central bank assumes that only a central bank can serve as an efficient lender of last resort. However, other dollarized countries have proven otherwise. Take countries like Ecuador, El Salvador, and Panama. How do they manage to access lender-of-last-resort services even when they're fully dollarized? They've got a couple of solutions, which can in principle, be combined to work together:
Domestic banks can tap into credit lines from international banks through deep financial connections. Meanwhile, international banks can fall back on their parent companies as their ultimate rescuers. In short, the small local financial market taps into the vast global financial arena.
Setting up an emergency liquidity fund. This fund could be overseen by a state entity or a group of private banks. Or, they can arrange credit access with banks or international organizations.
Banks can handle their own emergency reserves. These reserves can be stashed away as deposits in offshore banks, safely out of the reach of local regulators.
There’s always the IMF as a last resort.
Now, there are two major differences between these setups and a central bank as the lender of last resort. First off, the central bank can pour in unlimited liquidity. But this becomes relevant only when the limited funds aren’t enough. And that doesn’t seem to be the case in dollarized Latin American countries for which international markets are large enough.
In reality, none of these three countries have had to dip into their emergency liquidity funds, not even during the global financial chaos of 2008. The second difference is that a central bank is more likely to encourage moral hazard than the abovementioned methods. By curbing risky behavior, a lender of last resort that doesn’t fuel moral hazard also reduces the need for such a lender. It’s almost like a self-fulfilling prophecy. The overemphasis on the necessity of a central bank as a lender of last resort might stem from its tendency to promote moral hazard in the first place.
The second hiccup with this argument is that you can't lose something you never had. For a lender of last resort to function as such, it needs to issue the currency that the market wants. If the public wants pesos and fears a banking catastrophe, they’ll withdraw their money from banks and stash it away. That’s when the central bank can step in with liquidity - increase money supply as money demand increases, keeping nominal spending constant. But if the public wants dollars, as is often the case in Argentina, the central bank can’t strictly act as a lender of last resort. In this scenario, the public isn’t "running" against the banks; they're running against the pesos, whether they're in banks or not. These pesos are used to buy stuff (which spikes inflation) or get dollars (hello, currency crisis). In such a scenario, by injecting liquidity, the BCRA increases the risk of a currency crisis and, in extreme cases, hyperinflation.
Let's not forget that banking crises in Argentina, like the one in 2001, happened for two reasons: 1) growing exposure to a broke public sector and 2) a significant mismatch in exchange rates. In these circumstances, the BCRA can’t really play the role of lender of last resort. As Carlos Rodríguez and Aquiles Almansi warned back in 1989, the BCRA in Argentina is more of a debtor-of-first-resort than a lender-of-last-resort. And that’s the root of the issue.
The BCRA can’t effectively serve as a lender of last resort because the market demands dollars, not pesos. In practice, when it comes to Argentina, the International Monetary Fund is the real lender of last resort. Whenever a financial storm hits, Argentina looks to the IMF for help, not the BCRA. It's more crucial for financial stability to have access to the currency the market craves than to an issuer.
There are alternatives to a central bank serving as the lender of last resort. We just need to see how those economies that have embraced dollarization for years without experiencing bank panics tackle this challenge. In Argentina’s case, the argument that dollarization means giving up the central bank’s support isn’t a solid case against dollarization.
Next: Understanding the different positions in the dollarization debate