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Dollarization versus Currency Competition
Among certain analysts and opposition circles, the notion of currency competition is floated as a preferable alternative to dollarizing the Argentine economy. In essence, advocates of currency competition call for placing the peso and the dollar (along with other currencies) on an equal footing to compete, allowing the market’s “invisible hand” to phase out the peso’s circulation. Currency competition is touted as superior to dollarization because it avoids the problem of the Central Bank of the Argentine Republic (BCRA) lacking sufficient reserves to dollarize at a reasonable rate.
However, there are several factors to consider when comparing currency competition against dollarization.
Framing the options as “dollarization versus currency competition” is misleading, as dollarization isn’t incompatible with a regime of currency competition. To set the debate as one or the other is a false dichotomy. At least the dollarization proposal by Emilio Ocampo and myself includes a currency competition framework that permits contracts and bank deposits using the chosen currency by the parties. Those who wish to enter agreements in euros, pounds sterling, or any other major currency are free to do so.
If the emphasis is on currency competition, it would be more accurate to discuss currency competition with or without the peso. It is not the presence of the peso what defines the presence or absence of currency competition.
Exchange Rate and Reserves
It’s not evident that currency competition would circumvent the lack of central bank reserves problem. What would happen to the exchange rate under this regime, without currency controls or restrictions? What is the equilibrium exchange rate in this scenario? Criticisms of dollarization should apply symmetrically. If dollarization is criticized due to the lack of central bank reserves, then currency competition should be upheld if applied under the same conditions.
It could be argued that currency competition, by legalizing the use of the dollar, would attract funds from Argentinians abroad or even new investments. This might be the case (also true in the case of dollarization). However, it’s important to recognize that we are dealing with a monetary regime that permits dollar use in the local market. Consequently, there is no longer a need to sell dollars in the foreign exchange market to use pesos domestically.
It’s unclear why currency competition wouldn’t face a problem of lack of reserves in the central bank. Furthermore, which scenario is more likely to see an inflow of US dollars? Under dollarization, where the peso disappears, or under currency competition, where the government can restrict dollar use at any time (as repeatedly happened in Argentina)? It’s noteworthy that Cambiemos, not the Kirchner administration, imposed the current capital controls.
In his proposal, Hayek speculates about a “perfect competition” of fiat currencies. However, Friedman (1984) and Fisher (1986) challenge Hayek, asserting that he overlooked the network effects of money, leading to skepticism about the emergence of a wide array of currencies. A network effect means that the utility of a good increases as more people use it. A classic example is the fax machine—its utility is zero if no one else has a fax, and it grows as more people adopt it. A contemporary example would be social media platforms. Being on Twitter alone is useless if nobody else uses the platform. Money is also subject to network effects, which are significant in the context of currency competition.
In the case of network goods, there’s no guarantee that the superior good will dominate the inferior one. A network good introduced to the market earlier or with better marketing than a higher-quality network good can still dominate the market despite being of lesser quality. Twitter and Facebook, for instance, being dominant players in their respective markets doesn’t imply they are the highest quality products.
What empirical evidence do we have of this problem? Luther and White (2016) study a case resembling a natural experiment to test Friedman and Fisher's objection. They analyze what happened to the Somali shilling’s usage after the government's collapse in January 1991. Between 1991 and 1997, the exchange rate between the Somali shilling (SOS) and the dollar (USD) fluctuated around 0.12 USD = 1,000 SOS. By 2002, the exchange rate had fallen to 0.04 USD = 1,000 SOS. The Somali shilling depreciated to the point of being worth no more than the paper and ink it was printed on (Luther and White 2016, p. 7). Despite the absence of a government or law preventing Somalis from adopting other currencies (such as those of neighboring countries or trading partners), the Somali shilling continued to circulate. The fact that the U.S. dollar is higher quality money than the peso is not enough to conclude the peso will disappear.
It's crucial not to underestimate how challenging it can be to break the network effect of a currency that, even if rapidly depreciating, remains the common medium of exchange in an economy with over forty million inhabitants. Currency competition might encourage dollar savings, but it might not be enough to eliminate the peso as a medium of exchange. This leaves the door open to potential state abuses when a new populist regime occurs in Argentina.
Another issue is that currency competition maintains a significant problem in the Argentine economy: currency mismatch. The Treasury (and parts of the private sector) earns income in pesos but has dollar-denominated debts. As a result, devaluations can lead to a contractionary effect on the economy.
Currency mismatch is one of the most serious issues in the Argentine economy. It’s also a topic that isn’t given due attention to the pros and cons of dollarization.
High Risk of Failure
Lastly, the choice between dollarization and currency competition must also consider the cost associated with a monetary reform failure down the road. Is Argentina capable of weathering another major crisis? If the cost of a new crisis is substantial, the expected value of failure can be high despite a low probability of occurrence. In other words, there's a lot at stake. The Value-at-Risk is just too high.
The kind of dollarization we propose minimizes the probability of failure. It’s more likely that any Argentine government would backtrack on currency competition than with a de jure dollarized economy. The convertibility of the 1990s was harder to reverse than currency competition, but it didn't prevent the massive devaluation, corralito (bank withdrawal restrictions), corralón (freezing of bank deposits), default, and asymmetric peso conversion. Dollarization provides an additional safeguard against the reforms accompanying the monetary regime change. Without dollarization, the risk of losing currency competition remains ever-present.
To contrast the merits of both monetary reforms, I suggest the following question: Which mistake would we prefer to make?
Dollarize without the need for extra safeguards?
Currency competition and finding us back at square one?
Perhaps, ex-post, dollarization might seem to involve an excess of safeguards. However, it might be a safeguard that ex-ante assures us against another crisis that the country can't endure.
The original Spanish post can be found here.
Next: Why Consider Dollarization for Argentina?
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