from Follow the Money

Too many currencies? Or too many dollar pegs?

January 22, 2006

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Emerging Markets

The world has too many currencies.   The dollar is too good a currency not to be shared.    The US has a clear comparative advantage in central banking.   National pride - and a desire to maintain "monetary sovereignty" -- should not stand in the way of outsourcing monetary policy to Ben Bernanke.

So says Benn Steil of the Council of Foreign Relations in a Financial Times oped (free link) and in a new book with Bob Litan.

Most macroeconomic problems in emerging economies - according to Benn -
could be solved if countries just abandoned their local currencies and either adopted the dollar or another sound currency.  Benn has no problems with the euro - just with various pesos, liras, dinars, reals and rupees. Maybe RMB too.

For Benn, Ecuador is the model.   It dollarized back in 1999 (after a huge devaluation).   And it grew faster than anyone else in Latin America in 2004.  Benn attributes Ecuador's star performance to dollarization.   Dollarization is a surefire way to generate counter cyclical capital flows and lower interest rates. 

It is a fair to say I have a somewhat different opinion.  On Ecuador.  And on dollarization. 

I suspect Ecuador's strong 2004 performance had more to do with the price of oil than its use of the dollar.   And Ecuador certainly has not enjoyed low interest rates after dollarizing - Ecuador's (dollar) debt trades at a wider spread than the dollar debt of just about any other emerging market.   Market chatter suggests Iraq's new dollar bonds - when they are issued - will trade at a lower spread that Ecuador's dollar bonds. Hardly a vote of confidence in Ecuador.

Dollarization certainly doesn't end the risk of default on dollar-denominated debt.  Ecuador's dollar bonds carry a juicy coupon, unlike Iraq's bonds.  That's part of the problem in a sense: it isn't clear that Ecuador would pay that coupon if oil ever should fall back to $40, let alone $30.   

Dollarization doesn't actually eliminate currency risk either. A country that unilaterally dollarizes could unilaterally dedollarize.

Dedollarization is harder than dropping a peg, but it is not entirely theoretical either.  Argentina came close to depesifying (if such a word exists) back in 2001, as Argentina's provincial governments started issuing their own currencies when peso revenues fell short of peso spending. 

Benn thinks emerging economies that export oil should dollarize; I don't think they should even peg to the dollar (see this Economist article as well).   Differences over international economic policy don't get sharper than that.

There are circumstances when the monetary policy that is right for an oil importer like the US will be wrong for oil exporters.    The dollar could well depreciate to help keep the US trade and current account deficits from widening further, and countries with massive oil-induced current account surpluses hardly need weaker currencies. 

More generally, a flexible currency can help oil states manage oil price volatility.

A concrete example:  Saudi Arabia had a difficult 98 and 99.  Oil tanked against the dollar.  That was a drag.   And that drag was compounded by the fact that Saudi Arabia pegged to the dollar.  At the time, the dollar was soaring.    Saudi Arabia was hardly alone.  Ecuador and Russia faced a similar set of problems back in 1998, but with less oil and smaller cushions. Both pegged to the dollar.  Both ended up devaluing their currencies.  Both ended up in default.

A repeat of 1998 is not the only possible scenario.  Right now, the opposite seems more likely. Oil could soar even as the dollar tanks.  My point is that oil exporters probably don't want the same monetary policy as the United States - or Europe for that matter - as the United States. I suspect that Ecuador is more likely to dedollarize than the rest of Latin America is to dollarize.  Benn's cri du coeur hardly seems likely to sway a Latin America that has grown disenchanted with Washington -- and perhaps parts of the Washington consensus.

Or to convince Nestor Kirchner to give up the peso.   I suspect  Benn - like Kurt Schuler --  thinks Argentina should have dollarized back in 2001.  I don't.

A few months ago, Econ Journal Watch published a Schuler broadside that accused a host of international economists of malpractice.  One of his accusations: too many economists argued that dollarization in Argentina was technically impossible back in the fall of 2001.

I plead not guilty to that charge.  I have no doubt dollarization was technically possible Argentina had enough dollars (including dollars borrowed from the IMF) to replace all pesos in circulation.  I just think dollarization would have been a bad idea.

Following an exchange at Macroblog, Econ Journal Watch graciously invited David Altig and me to respond to Schuler's various charges - and gave Kurt Schuler a chance to reply.   Among other things, my paper fleshes out why I think Argentina's dollar peg - its pseudo-currency board - was wrong for Argentina back in the 1990s.  And why I don't think dollarization late in 2001 would have averted Argentina's default, allowed Argentina to avoid a bank holiday or eliminated the need for a painful real depreciation.   Dollarization just would have assured that the depreciation came about through falling prices, not a fall in the currency.  And rather than having frozen peso deposits, Argentines would have had frozen dollar deposits.  Argentina had enough dollars to back all the pesos in circulation - but no where near enough to pay its debts, or allow all Argentines with short-term dollar and peso deposits to take their money out of the banks!

Full disclosure. I know Benn from my time as an International Affairs Fellow at the Council in 2003.  We have a long-standing agreement to disagree on dollarization.

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