Is Dollarization Unnecessary due to its Initial Conditions?
While proponents of dollarization in Argentina admit that making the U.S. dollar the official currency won't single-handedly resolve the nation’s economic woes, they consider it a vital element of a broader plan encompassing institutional and structural changes. In the discourse about the desirability of dollarization, it's important to recognize the conceptual distinction between a necessary and a sufficient condition.
Recognizing that dollarization alone won’t entirely remedy a nation’s structural issues and that supplementary reforms are essential leads detractors of dollarization to question why dollarization would even be necessary. Essentially, they argue that dollarization becomes redundant due to its own prerequisites.
However, this criticism presents several issues. Those critical of dollarization must acknowledge that reforms come in varying degrees and should differentiate between a reform's technical soundness and credibility. For instance, a technically impeccable law establishing an independent central bank becomes ineffective if the law lacks credibility—this is the case under institutional anomie, much like in Argentina. Dollarization serves as a means to regain credibility when conventional methods are out of reach. Dollarization might be essential not solely for its monetary policy attributes but because of its cost of reversion, which consequently bolsters the durability of other reforms.
Delving deeper into the critics’ argument against dollarization reveals a problematic implicit assumption. Suppose institutional quality is rated on a scale from 0 (poor institutions) to 100 (excellent institutions). Let’s say Argentina manages to put forward an institutional reform that elevates its rating to 90. This hypothetical scenario mirrors a Switzerland-quality situation. In this instance, dollarization would not be necessary. However, due to the configuration and incentives of the political system, such a comprehensive institutional reform isn’t feasible. It's more reasonable to assume that Argentina could enact certain reforms, meeting the bare minimum required to enable dollarization, even if these reforms don't quite make dollarization superfluous. Simplistically assuming that reforms are only of the ideal type is misleading. The graphic below illustrates this example. The green-shaded region is the territory critics overlook. Argentina is on the red mark. The realistic reform would fall somewhere in the green area. The ideal (but unrealistic) reform would locate Argentina to the right of the green area.
Ecuador's example again sheds light on this discussion. In January 2000, despite being far from an ideal institutional and economic setting, Ecuador dollarized its economy. The nation teetered on the brink of hyperinflation, and its political institutions were feeble (President Mahuad's political standing was at an all-time low). Nevertheless, dollarization endured for two decades, resiliently weathering a series of internal and external shocks, including:
The removal of President Mahuad via a coup d'état ten days after announcing dollarization
The 2008 Global Financial Crisis
The tenure of Rafael Correa's populist regime, which possessed the power to reform the constitution
A seismic earthquake
Two sovereign debt defaults (in 2008 and 2020)
For reference, let's consider the Index of Economic Freedom of the World (EFW). Excluding the monetary component of the index, Ecuador ranked 82nd out of 127 countries in 2000 when it adopted dollarization. Ecuador stood in the 35th percentile, meaning 65% of countries scored higher on the index. Ecuador dollarized far away from having ideal reforms.
Ecuador's case underscores two critical points:
The minimum institutional quality required for dollarization can be relatively low, implying the green-shaded area in the figure above is likely much broader.
Even with low-quality institutions, dollarization can endure as a robust reform. This resilience presents a key advantage of dollarization for countries ensnared in populist tendencies.1
Notably, specific reforms are pivotal for the success of dollarization. Zimbabwe’s case serves as an intriguing illustration of how dollarization can be reversed when the banking sector is left unprotected from a predatory government.
Critics of dollarization should refrain from brushing it aside by asserting that dollarization is unnecessary because other reforms must still take place.
The original Spanish version of this post can be found here.
Next: Dollarization and foreign shocks in Latin America.
Imagine what could have become of Ecuador if Correa had had access to his printing press. Imagine now how much more constrained Kirchnerism would have been if Argentina had dollarized in the late 1990s.