Fiscal Dominance and Dollarization: Less Whiteboard and More Reality
Original post written with Emilio Ocampo.
We often hear arguments against dollarization, claiming that the Argentine political system can’t adhere to a budget constraint. Consequently, it’s argued that the core issue plaguing the Argentine economy, excessive public spending, would persist. Supposedly, political entities (both national and provincial) would circumvent the monetary constraints of dollarization by introducing quasi-currencies.
Under this interpretation, dollarization would merely “transfer” the fiscal issue, previously resolved through monetary issuance by the BCRA, to another government entity without truly resolving it. Given the scale of the fiscal imbalance, this proposed remedy (dollarization) is deemed worse than the ailment (deficit monetization under fiscal dominance).
Some who follow this line of reasoning suggest that central bank independence and a fiscal adjustment program represent the appropriate way forward. They assume that well-intentioned central bank policymakers can implement optimal intervention rules to mitigate external shocks. The contention is that the solution to monetary imbalances lies in changing the behavior of political actors rather than substituting the peso with the dollar – essentially, seeking a kind of financial nirvana.
From this line of argumentation, three propositions emerge:
Proposition 1: Dollarization would fail under fiscal dominance.
Proposition 2: The “right” anti-inflationary strategy entails central bank independence and fiscal adjustment.
Proposition 3: If the “right” strategy is implemented, the central bank can manage external shocks through optimal intervention rules.
Let’s examine these propositions’ theoretical and empirical validity and their logical coherence.
Defining "success" and "failure" accurately is crucial when analyzing dollarization as an alternative to other proposals. The failure of dollarization cannot simply be defined as the theoretical impossibility of achieving optimal management by an independent central bank. We must avoid falling into the Nirvana trap of seeking a perfect solution, a common pitfall in this debate. Successful dollarization is defined as eliminating inflation without compromising growth or employment, as demonstrated in Ecuador. In Argentina, it’s challenging to imagine that the cost of official dollarization, in terms of lost flexibility and seigniorage income, exceeds the decades-long cost imposed by discretionary economic policies.
Official dollarization represents a fundamental shift in the monetary regime, not merely a tighter fixed exchange rate regime. This distinction is not just a matter of semantics; Lucas’s critique is crucial. A regime change alters economic agents’ behavior (including politicians), meaning we can’t assume that the economic dynamics will mirror those of a fixed exchange rate regime. In other words, it changes the parameters of the model.
Proposition 2 lacks empirical support. In Argentina, fiscal adjustment is often halted due to its recessionary impact and political pressures. Exceptions occurred during the early years of Convertibility and in 2002. In the former case, price stability coincided with economic expansion. In the latter, it was governed by Peronism. Dollarization enhances the feasibility of conducting an expansionary fiscal adjustment and implementing the structural reforms essential for economic growth.
In Argentina, eliminating inflation is the only public policy consistently garnering majority support, irrespective of ideology, as demonstrated by the Austral Plan (albeit briefly) and Convertibility (over a decade). This underscores the danger in assuming that the political system will willingly pursue a fiscal adjustment that undermines its interests, absent external discipline.
If Proposition 1 holds true, Proposition 2 would necessarily be false (making Proposition 3 unattainable). If Argentine politicians' alleged fiscal incontinence could derail dollarization, central bank independence would be equally impossible. It's inconsistent to assume that (a) dollarization doesn’t address the fiscal imbalance significantly and (b) a weaker or easily reversible reform could. Furthermore, if we accept the argument that fiscal dominance is insurmountable, we must accept perpetually high inflation rates.
Proposition 3 veers into the realm of magical realism. In Argentina and many other countries, monetary (exchange) policy serves two often inconsistent purposes:
stabilization (interest rate or exchange rate)
revenue generation through money issuance.
Fiscal dominance means the first objective is always subordinated to the second, making stabilization policy destabilizing. Dollarization conclusively resolves this issue by establishing irreversible central bank independence.
Dollarization eliminates a highly distorting mechanism political authorities use to finance fiscal deficits: the inflationary tax. This fiscal financing method is volatile, non-legislated, regressive, and disrupts price signals, inefficiently allocating resources. This, in itself, provides a strong argument in favor of dollarization. Even if fiscal dominance persists, dollarization forces the government to openly address how it intends to finance fiscal deficits, incurring the associated political costs.
With dollarization, the government is left with only two financing mechanisms: taxes and debt, both requiring congressional approval. While taxes can be excessive and distorting, they are less harmful than the inflationary tax. Debt, unlike paper money, carries an interest rate reflecting default risk. This means that those who acquire it are compensated for bearing Argentine risk, which is not the case with forced tender paper money, imposing a concealed real-term confiscation, particularly on lower-income individuals.
True, dollarization sacrifices some flexibility in exchange for credibility. However, the question arises: how much is that flexibility truly worth? Economies like Ecuador, El Salvador, or Panama, which adopted the dollar, have been less affected, in real terms, by external shocks than unstable non-dollarized economies like Argentina. Dollarization eliminates the option of devaluation to cushion asymmetric shocks but allows for the use of tariff policy. The benefits of long-term monetary stability outweigh the drawbacks of relinquishing an inefficient monetary/exchange rate policy.
Finally, if under dollarization, the national or provincial government decides to issue a quasi-currency in dollars due to fiscal dominance, this would automatically reduce public spending. The nominal value of these securities would never match that of a dollar issued by the Federal Reserve (and officials cannot counterfeit dollars). Ecuador and El Salvador's experiences demonstrate the difficulty of introducing quasi-currencies under dollarization. Those affected by this reduction in public spending would include suppliers, retirees, and public employees, and whoever issues the quasi-currency would bear a considerable political cost.
In conclusion, those who dismiss dollarization due to fiscal dominance and propose alternatives dependent on convincing politicians to behave “well” rely more on theoretical ideals (voluntarism) than the practical realities of public choice. Without a disciplining factor altering incentives, politicians' behavior won't change, and fiscal dominance will persist.
The original Spanish post can be found here.
Next: Loss of Seigniorage is not a Good Reason to not Dollarize.