Dollarization: Unnecessary by its Necessary Conditions?
While advocates of dollarization in Argentina recognize that adopting the US dollar as the country’s legal tender currency is not sufficient to end a troubled economy, they see it as a necessary component of significant institutional reforms. There is a conceptual difference between a sufficient and necessary condition that friends and foes of dollarization should not overlook.
Granted that other reforms must complement dollarization because dollarization is not sufficient to fix an economy wholly, critics question why there would still be a need to dollarize. In short, critics of dollarization argue that dollarization is unnecessary because of its necessary conditions.
Questioning dollarization on these lines is not as easy as critics make it sound. Critics of dollarization must recognize that there are different levels of reforms. They should also distinguish between the technical quality and the credibility of a reform. For instance, a law that lays out a technically perfect independent central bank is worthless if said law is non-credible. Dollarization is a way to build credibility when this is not possible domestically. Argentine laws are non-credible because they are easily reverted (or worse, ignored), by politicians. Dollarization may be needed not because of its monetary policy characteristics, but because of its non-reversible institutional quality that limits the reversibility of the other reforms.
Looking closer at the critics’ argument reveals a hidden assumption. Let institutional quality range between 0 (worst institutions) and 100 (best institutions). Assume that Argentina can produce an institutional reform that increases its score to 90. Then dollarization would not be needed. This scenario depicts the situation where Argentina becomes Switzerland. However, this ideal institutional reform is unlikely to be feasible (because Argentina cannot create credibility). It is more reasonable to assume that Argentina can make some reforms that meet the minimum level required to dollarize the country, even if they are not good enough to make it unnecessary. It is an oversimplification of the problem to assume that the only reforms that can take place are the ideal ones. The figure below depicts this issue. The green area marks the scenario the critics rule out by construction.
Once again, Ecuador offers an example of this situation. Ecuador dollarized its economy with an institutional and economic situation far from ideal. Ecuador dollarized its economy at the brink of hyperinflation with weak political institutions (President’s Mahuad political capital was at very low levels). Yet, dollarization survived for twenty years. These two decades of dollarization include shocks such as:
President’s Mahuad removal through a coup days after announcing Ecuador’s dollarization
The Great Recession
The populist regime of Rafael Correa (strong enough to reform the constitution)
Two sovereign debt defaults (one taking place at the same time as the Great Recession)
Let’s use the Economic Freedom of the World Index (EFW) as a reference. If we ignore the monetary component of the index, Ecuador ranked 82 out of 127 countries in 2000 when it dollarized its economy. Ecuador’s percentile was 35% (meaning 65% of the countries had a higher EFW score).
The case of Ecuador shows two important points:
The minimum institutional quality needed to dollarize may be pretty low, meaning that the green area in the above figure may be quite large.
Dollarization can be a durable reform even with low-quality institutions. This robustness is one of the main benefits of dollarization for countries inclined to elect populist leaders.
Indeed, some reforms are crucial for successful dollarization. Zimbabwe is an interesting example because it shows how dollarization can be reverted when the banking sector is left unprotected from a predatory government.
If critics want to be more relevant and pay attention to what advocates of dollarization argue, they should be more careful about discarding dollarization just because other reforms should take place along with a change in the country’s monetary standard.
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Imagine what could have been of Ecuador if Correa had had access to his printing press. Imagine now how much more constrained the Kirchner would have been had Argentina dollarized in the late 1990s.