Daniel Raisbeck and Gabriela Calderon de Burgos
After paying little attention to dollarization in Latin America for over two decades, the international press suddenly features regular commentary on the subject. This is a result of Argentina’s primary elections of August 13, when Javier Milei, a candidate whose flagship proposal is to dollarize the Argentine economy, delivered a surprise victory.
In our last blog post, we took on seven myths about dollarization in Latin America that are often put forth against the measure. Myth #3 refers to the theory that dollarization already failed in Argentina in the 1990s, when the government of former president Carlos Menem (1989–1999) implemented a convertibility system.
As we explain, the equivalence is false because the convertibility system amounted to an unorthodox currency board in which the central bank still carried out monetary policy, something that does not take place under an orthodox currency board. Under full dollarization, whereby the dollar is granted legal tender, the central bank either disappears or is rendered obsolete in terms of its ability to implement monetary policy.
In a recent article, Bloomberg’s Eduardo Porter relies on myth # 3, claiming that dollarization in Argentina is “a dangerous delusion” because “the proposition has essentially been tested already.”
Strangely enough, Porter recognizes that the convertibility system did not amount to dollarization. He writes that the set‐up allowed “the government in Buenos Aires wiggle room,” which, though narrow, “could still be used destructively.”
He adds that economic agents “would operate under the assumption that laws could be changed and the plan could be undone,” so that “the promise was short of being rock solid.”
Nonetheless, Porter writes that the convertibility system was “the next best thing” after dollarization. It was not, because the next best thing would have been an orthodox currency board, which strictly limits a central bank’s scope to fixing the exchange rate to the dollar.
The claim that convertibility was not a “rock solid” promise, moreover, is a gross understatement; the convertibility system’s leeway to the monetary authorities caused its eventual failure. Thus, the convertibility system’s experience in no way proves that dollarization is not feasible in Argentina. If anything, convertibility’s failure shows that the country’s monetary authorities can do much damage with minimum leeway.
The main point of dollarization, meanwhile, is precisely to get rid of all leeway for the monetary authorities. Dollarization is a superior alternative because it requires no promise from a central bank to abide by a fixed exchange rate.
Porter, however, argues that anyone who points to the convertibility system’s fundamental design flaws “misunderstands the root cause of convertibility’s failure. It collapsed, in essence, because the Argentine economy — its households and businesses, governments and banks — could not generate enough dollars to cover the debts incurred to maintain consumption in the convertible era.”
While this might describe the consequences of the convertibility system’s failure, it is a bizarre argument against dollarization. In a fully dollarized country, there is no need to “generate dollars” in order to cover dollar debts incurred while using a local currency because there is no local currency.
In fact, a main advantage of dollarization is that, by granting the U.S. dollar legal tender, the entire economy operates in dollars, so that there can be no balance of payments crisis. Under dollarization, a debt crisis or a default will force the government to pay the price via higher interest rates in global sovereign bond markets, but this will not affect the money supply, the value of the currency, or even the interest rates for solvent private sector actors (see below).
It is only by creating a conflict between monetary policy and the exchange rate policy—that is, by keeping a national currency pegged to a foreign currency while allowing the central bank to dictate monetary policy— that a balance of payments crisis can arise. This is what took place in Argentina in 2002.
Porter further quotes a paper by economists Sebastian Galiani, Daniel Feynmann, and Mariano Tomasi, who argue that “the dollar value of incomes had to be sufficient to maintain spending and service debts, and for that to happen, a sufficient growth in the output of tradables had to materialize before the supply of credit dried up.” This was not the case in the wake of the Asian financial crisis of 1997, which, as Porter writes, “slashed capital flows and increased the costs of foreign borrowing.” Argentina’s exports suffered with the subsequent devaluation of the Brazilian real, and the convertibility system exploded thereafter.
But, again, the tension between rising debt and the dollar value of incomes and output earned in pesos was a feature of convertibility, not of a dollarized system. In their paper, in fact, Galiani et al. argue— in a footnote— that “the dollarization proposals would count as a particularly strong form of raising the bet, by exiting convertibility in the other direction.” But they go on to state that the proposal “did not find significant international support,” which is not surprising; as we have explained, no official institution in Washington supports dollarization.
They add that “in any case, (dollarization) could not restore export growth or solve the fiscal problems if the economy stagnated or went into a recession for more fundamental reasons.” This is true because dollarization is no guarantee of fiscal prudence or economic growth. However, dollarization does prevent the type of currency mismatch that blew up the convertibility system, which, at one point, established different exchange rates for imports and exports.
Porter doubles down on the “convertibility failed, hence dollarization is impossible” non sequitur when he writes: “It is a dubious proposition that ditching the peso altogether and adopting the dollar would have allowed Argentina to hold on. It rests on the fantasy that a dollarized Argentina would have kept attracting foreign money regardless of its economic realities.”
Although he does not state it explicitly, Porter seems to imply that dollarization would work in Argentina only if the country’s export growth outpaced or kept up with that of its imports. This focus on the balance of trade is wrong not only in terms of dollarization; it is a rehash of the fallacy that trade surpluses are desirable and even necessary for a nation to prosper, a theory refuted by Adam Smith in the 18th century as part of his demolition of mercantilist theory. (Porter displays mercantilist sympathies when he states that the government needs to run the economy).
Regarding trade, one of dollarization’s main advantages is that it provides an economy with a real exchange rate, through which trade and payments tend to balance each other. As such, dollarized economies operate in a way that is akin to the classical gold standard.
As David Hume, another eighteenth‐century critic of mercantilism, wrote at a time when precious metals provided the means of exchange for international trade, the gold accumulated via exports that exceeded imports tended to raise a nation’s domestic prices. This made imports more attractive. Conversely, when imports began to exceed exports, gold flowed out and domestic prices would fall. The process would reverse once more as exports began to exceed imports.
Hence, under the classical gold standard, the balance of trade might never have been in a state of perfect equilibrium, but it did tend to balance automatically. Dollarization operates with the same type of automatic adjustment, with U.S. dollars, not gold, serving as the means of exchange. But politicians first have to allow dollarization to take place. To Argentina’s detriment, this did not take place in the 1990s.
The main problem with Porter’s argument is not even that he equates convertibility with dollarization, claiming that the latter would fail because the former failed. Much worse is that he assumes that convertibility is the only relevant comparison for Argentina today, but he fully omits the experience of all the Latin American countries that have dollarized successfully.
Panama had already used the dollar for nearly a century when the Asian crisis struck in the late 1990s and it suffered none of Argentina’s trauma: its last year of negative GDP growth before 2020 was 1988, the year before a U.S. invasion toppled General Noriega. In recent decades, dollarized Panama has posted some of Latin America’s highest growth rates in terms of per capita GDP, thus refuting the myth that dollarization prevents a country from achieving solid growth.
Nor did Argentina’s woes at the turn of the century prevent Ecuador and El Salvador from dollarizing in 2000 and 2001 respectively. Both countries have benefitted considerably from dollarization despite their lack of rapid growth.
El Salvador has proven that the private sector in a dollarized country still can access dollars at relatively low interest rates regardless of the government’s fiscal problems. Non‐dollarized countries, on the other hand, must counter outflows in times of crisis with drastic interest rate hikes, thus undermining investing incentives across all sectors. As Manuel Hinds, a former finance minister in El Salvador, writes about his country’s recent experience:
In the last two years, there was a scare that the government would not repay a large instalment of its long‐term debt, and the EMBI (the difference between the yield of the Salvadoran bonds and the American ones) went up to almost 30%… This indicates how the international secondary markets for sovereign debt consider the risks of lending to a government.
Yet, in El Salvador, both short‐term and mortgage interest rates remained around 7%, highlighting how the international markets (into which El Salvador is directly inserted, without intermediation by the central bank) assigned a considerably higher risk to the government compared to the private sector.
It was dollarization, moreover, that reduced El Salvador’s interest rates and lengthened loan periods in the first place. As Hinds notes: “after dollarizing, the interest rate fell from 20% to 6% for mortgages, increasing their maturity from 5 to 25 years. Short‐term loans also became cheaper. And this was not a fad.”
In Ecuador’s case, dollarization has succeeded in a classic “banana republic” — the country is the world’s largest exporter of bananas — that is also largely dependent on oil exports and remittances. Ecuador is thus uniquely subject to external shocks. Nonetheless, since it dollarized in 2000, the country has withstood major fluctuations in the price of crude oil, its main export, and sharp reductions in the flow of remittances.
Ecuadorians, in fact, lived through the Great Recession, the end of the country’s second oil bonanza, and the COVID-19 pandemic, all while maintaining a stable financial system and one of the lowest inflation rates in the region.
Yes, Ecuadorians could have enjoyed higher growth rates if other structural reforms had been implemented. In their absence, however, at least Ecuador did not experience the type of wipeout that was the norm between 1980 and 2000, when an external shock would be followed by an even stronger internal one.
Ecuador’s case also proves that a hard dollar regime, while no guarantee of fiscal prudence, still imposes significant budget constraints on profligate governments. Former president Rafael Correa, who governed from 2007 until 2017, was a poster boy for twenty‐first‑century socialism and a declared enemy of dollarization. Nonetheless, Correa failed in his attempt to introduce a digital currency and was forced to reduce public spending — from 44% of GDP to 37% — between 2014 and 2017.
Being no free trader, Correa joined the European Union’s free trade agreement with Colombia and Peru in 2017 (after an accession process of several years). Mainly, this was because he found himself with no political support for further tax hikes, unable to monetize fiscal deficits, and with virtually no access to capital markets. Arguably, the EU trade deal was Ecuador’s most important trade liberalizing measure in the past quarter century.
The success of dollarization in Latin America has gone under the radar because the dollarized trio are relatively small countries, Ecuador being the largest with a population of 18 million. Were Argentina to dollarize, however, it hardly would be feasible to ignore or hide its benefits — monetary stability, low inflation, low interest rates, longer loan terms, built‐in hard budget constraints — in one of the region’s largest and most influential countries.
If dollarization has been a regional anomaly hitherto, Argentina’s official adoption of the dollar could be a hemispheric watershed. Could this explain why the anti‐dollarization camp has become so vocal of late?