The Case for Fewer but Stronger Currencies

Economic View
The Case for Fewer but Stronger Currencies


By DANIEL GROSS
Published: February 19, 2006
OUTSOURCING isn't just a one-way street on which rich countries shift
jobs overseas. In recent years, some developing countries have
contracted out the work of setting monetary policy to the United
States. Ecuador and El Salvador, in 2000 and 2001, respectively,
abandoned their own currencies, adopted the dollar and placed their
monetary policy in the capable hands of Alan Greenspan, then the
chairman of the Federal Reserve.

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The Dollar Club When outsourcing involves manufacturing and software
programming it is often endorsed by economists and condemned by
populist political leaders. So, too, is the tactic of outsourcing of
monetary policy - known as dollarization, or euro-ization. After all,
noted Robert E. Litan, senior fellow at the Brookings Institute,
"currencies are symbols of national sovereignty, and countries are
reluctant to give them up."

And yet nations can impose enormous costs on their citizens when they
take extraordinary efforts to maintain independent currencies.
"Devaluations of currencies cost people their savings and bring on
rapid inflation," said Benn Steil, a senior fellow at the Council on
Foreign Relations and co-author with Mr. Litan of "Financial
Statecraft" (Yale University Press, 2006). The two argue that the
globe's mélange of 200-plus currencies, backed only by the faith of
investors, is inefficient and dangerous. Many emerging economies, they
say, would be well advised to swap their currencies for strong, stable,
widely used ones like the dollar or euro.

Steve H. Hanke, professor of applied economics at Johns Hopkins
University, has examined economic development in 32 countries that
adopted foreign currencies from 1950 and 1993. He found that they had
faster rates of G.D.P. growth, lower inflation and greater fiscal
discipline than their counterparts who hung onto their sovereign
currencies. Professor Hanke has been an adviser to Ecuador, which in
2004 was among the best-performing economies in Latin America, growing
at a 6.6 percent rate with inflation at 2.7 percent.

"Dollarization tends to deliver low inflation, and relatively low and
stable interest rates," said Ricardo Hausman, a former chief economist
of the Inter-American Development Bank who now teaches at the Kennedy
School of Government at Harvard.

So what's not to like? "It's not like dollarization is a magic drug,"
Mr. Steil said. It certainly doesn't end the risk that countries will
default on dollar-denominated debt. Panama has been using the dollar
since 1904 and has repeatedly run into difficulties. And El Salvador's
economic performance hasn't outpaced those of its Central American
neighbors.

Some Latin American countries, notably Mexico, have tamed inflation
without abandoning their own currencies. "If you have sound economic
policies in a country, you don't need dollarization," said Nouriel
Roubini, professor of economics at New York University's Stern School
of Business. "And if you follow poor policies, I don't think
dollarization will solve your problems."

But economists say that smaller countries can encourage investment by
lashing their monetary fortunes to larger regional powers. In Latin
America, companies that need to make long-term investments - like
utilities - are forced to borrow in dollars while they operate in
local currencies, leaving them exposed to currency risk. Now that El
Salvador has adopted the dollar, companies there can borrow or engage
in hedging transactions in dollars with relative ease.

And when small monetary boats tie themselves together or link
themselves to larger ones, it encourages stability. "European financial
markets were able to navigate problems of 9/11 and the Madrid and
London bombings without too much instability, because they didn't have
the extra layer of exchange-rate problems," said Barry Eichengreen,
professor of economics and political science at the University of
California, Berkeley.

But one economist's reassuring stability can be another's troubling
rigidity. If the price of coffee plummets or the price for textiles
falls because of competition from China, a Latin American country that
has dollarized won't have the option of cutting interest rates to
stimulate growth. "Dollarization takes away the option of
depreciation," Professor Hausman said.

Dollarization advocates say that this is all to the good. Mr. Steil
notes that the Dominican Republic, where a currency crisis in 2004
wiped out the savings of a significant chunk of the population,
conducts about 85 percent of its trade with the United States. "Why on
earth would they need their own currency?" he asks.

Large countries like the United States have to tread lightly in
advocating that small countries give up their currencies. In 2000,
Congress considered - but did not pass - the International Monetary
Stability Act, which would have provided financial assistance to
countries that adopted the dollar.

WHAT'S more, moving to unite monetary policies without integrating
political and labor systems is problematic. The 12 member nations of
the euro zone have solved the political problems created by common
currencies by adopting a transnational institution-the European
Central Bank - and giving every country a seat at the table,
Professor Eichengreen said. "Where is Ecuador's seat on the Federal
Reserve Board?" he asked.

Advocates of dollarization recognize that the trend is also at odds
with the prevailing political winds in the Western Hemisphere. "There
is a mini-anti-American revolt going on in Latin America as we speak,"
Mr. Litan said. "Countries that would otherwise be interested, like
Bolivia and Venezuela, have elected leftist governments" that are
ardently opposed to dollarization.

But Mr. Litan says he believes that time may be on the side of the
dollar: "History has marched toward the euro, and it is slowly marching
toward the dollar."


Daniel Gross writes the "Moneybox" column for


Slate.com.

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