Fed up with decades of sky-high inflation, Argentinians have just elected a controversial new president who promised to Dollarize the economy, which means abolishing the central bank and ending the Argentinian Peso.
But, is that a good idea?
Well actually, the plan is more thought out than you may think, as it was drafted by a well-known Argentinian economics professor and backed by several prominent U.S. based professors such as John Hopkin’s Steve Hanke, and Stanford’s John Cochrane. At the same time, most economists have argued for decades that Dollarization is a really bad idea, and most Argentinian economists appear to be against the plan.
So, who is right? What are the problems that Dollarization is supposed to fix? How will it fix them? And, why are so many economists against this plan?
Well, to find out, I’ve immersed myself in the main arguments of both camps as well as research about how Dollarization has affected other countries that have given up their own currency in the past. And, yeah, let’s just say that Dollarization in the past has almost always crushed inflation, while at same time creating a lot of different new problems.
But, before getting into the arguments in favor and against, we first need to get into
The problem with Argentina’s economy
First, let’s start with an optimistic message. I know Argentina’s economy has a really bad reputation. But, actually, if we compare it to other Latin American economies like Brazil, Chile, and El Salvador, its economic growth, in Dollar terms per person, has not been so bad. On the other hand, if we com pare it to European and Asian economies like Spain, Korea and China, we can see that economic growth has not been great eit her. What’s worse is that economic growth has been very volatile, meaning that Argentina had to deal with 2 massive recessions just in the last couple of decades.
That being said, I think that the real problem that has given Argentina’s economy such a bad name has been inflation. After all, as you can see here, the country was hit by hyperinflation in 1989 and 1990, and then again by sky-high inflation in 2002 and 2003, and has now just emerged from an entire decade of sky high inflation that has only gotten worse.
And, so against this backdrop, I think it makes total sense that Argentinian voters were just completely fed up with the economy and voted for a president with a radical proposal for
la eliminación del Banco Central la dolarización
and, in practice, mister Milei and his advisors have said that this means that the Peso will disappear, and so the central bank will no longer manage its own currency. Instead, like El Salvador, Ecuador, and Zimbabwe have done before it, Argentina will come to rely completely on the United States Dollar as its national currency.
But,
How will Dollarization fix Argentina’s economic problems
of mediocre growth, excessive volatility, and sky high inflation?
Well, according to it’s proponents, Dollarization will likely solve all of these problems once and for all by taking away the ability of the central bank to bail out the government by printing a lot of money, thereby increasing inflation and making the country less attractive for investors.
But, are these claims realistic? To find out, let’s have a look at what happened to other countries that Dollarized their economies.
First, let’s have a look at the cases of Italy, Sp ain and Greece. And, yeah, before you say anything, these countries did not adopt the U.S. Dollar. But, they did Dollarize their economy, because in economics, Dollarization just means abandoning your ow n currency for a currency issued by someone else. So, yeah, I understand this is confusing. But, by adopting the Euro, these countries Dollarized their economy.
And, as you can see here, much like Argentina, these South European countries famously had quite high inflation, compared to for example, Germany. But, when they started the Dollarization process in the 1990s, by preparing to adopt the Euro, their inflation rates indeed rapidly converged to the low levels of Germany.
Similarly, while Ecuador, and El Salvador, were initially known as high inflation countries, their inflation rates started closely following that of the United States, after they Dolla rized in 2000 and 2001 respectively.
Finally, if we have a look at the inflation rate of Argentina itself, we can see that after adopting a so-called currency board, in 1991, Argentina’s inflation rate quickly dropped to low levels, only to shoot up again after Argentina abandoned its currency board in 2002.
Now, at this point, you might be wondering, Joeri, what the heck is a currency board? Well, in short, I think you can look at it as a scale. On the one hand, some countries have their own currency of which the value is freely determined by people trading currencies in financial markets. On the hand of the scale, you have countries that have abandoned their currencies completely. In between though, some countries manage their own currencies only to a certain extend because they have promised to keep them roughly in line with another currency, such as the U.S. Dollar or Euro. This type of arrangement is called a currency peg. However, currency pegs are difficult to maintain. For example, if you want to peg your currency to the U.S. Dollar, and then you create a lot currency to stimulate your economy, you could potentially get a scenario where people figure out that you have issued more currency then there are Dollars, prompting them to call your bluff, and forcing you to abandon the peg. But, there is one other arrangement in which this is impossible, and that is the currency board, in which you commit to holding exactly 1 Dollar for each Dollar equivalent of your own currency that you issue. So, In essence it is almost the same as complete Dollarization, with the only difference being that if you run out of Dollars, you could still abandon the currency board.
On the other hand, because it is extremely difficult to de-dollarize an economy. So, Dollarizing is like a currency board. But, without a way back.
And this is exactly why these economists are now proposing that Argentina should Dollarize. They say that while the currency board worked really well, Argentina’s bad politicians just couldn’t stick with the program. And, by abandoning it, they caused inflation to come back again. So, in essence, they now propose Dollarization rather than to have another currency board to prevent the next government from allowing inflation to come back.
And, yeah, as the experience by Italy, Greece, El Salvador, and Ecuador has shown us, it will probably work to eliminate inflation. But, will it also help Argentina to grow it’s economy and to avoid all of these painful crises?
Well, according to these economists, Dollarization can drastically increase growth in two ways. First, it creates confidence that inflation is gone and that there will be no wild exchange rate swings anymore, meaning that both foreign and local investors will be much more eager to invest in Argentina again. Second, since the government now has a lot of policies in place to protect the value of the Peso, such as capital and money restrictions, these can be removed after Dollarizing, which will lead to more investment and trade.
However, here, if we look at what happened to other countries that Dollarized, the evidence is not so clear as it was with inflation. First of all, let’s have a look at the European countries that abandoned their own currency for the Euro in 2001. At first, the impact was indeed that way more investment was unlocked for these countries, which is reflected by the fact that their average interest rates converged on those of Germany.
Similarly, borrowing costs for El Salvador and Ecuador dropped massively after they Dollarized their economies. So, I think that this is some pretty compelling evidence that, as these economists claim, Dollarizing your economy makes it more attractive for investors. However, then the question becomes, will this increased investment lead to more economic growth, and to less extreme boom and bust cycles. And, there I think the evidence is not so clear.
For example, if look at the economic growth of Dollarized El Salvador and Ecuador, and compare it non-dollarized peer s in South America, we can see that well, growth was just very average. And, if we zoom in a bit more, they also don’t appear to be very stable. A lthough Ecuador’s economy has stagnated since 2014, which I guess you could call a form of stability…
Similarly, if we look at the previously high inflation economies in Southern Europe, did they grow much faster and avoid major crises thanks to Dollarization? Well for a while they did. But, they certainly didn’t avoid a major crisis. A crisis that hit them way harder than the low inflation economies of Northern Europe.
Now, of course, you could say, Joeri, this is not very scientific, this just you cherry picking examples. But, actually, when I had a look at a recent study that summarizes decades of economic studies on Dollarization, their conclusion was that
dollarized countries on average display slower and more volatile output growth, and a lower inflation rate tha n non-dollarized countries.
and
Fully dollarized countries on average exhibit slower growth than non-dollarized and partially dollarized economies.
although they did note that
estimates vary widely both within and across studies.
In other words, the evidence seems to suggest that Dollarization crushes inflation. But, that it is bad for growth and tends to make economic crises worse.
But, why would that be the case?
Well, that brings us to the
The case against Dollarization
because, while we have seen that, Milei’s plan to Dollarize Argentina’s economy is backed by some really serious economists, I think it is fair to say that, on average, economists are against Dollarization in general, and also against Dollarization in Argentina. And, those against it, have, in my opinion, made 4 main arguments.
First, in general, economists these days tend to recommend that a country should have its own currency and that the value of the currency should be determined by the market, which is basically the opposite of Dollarization. The main reason why they recommend this is that the exchange rate tends to act as a buffer against outside forces, giving a country more freedom to optimize its own economy rather than responding to outside events.
To see how that works let’s imagine that the United States raises interest rates to respond to high inflation at home. As a consequence, Dollars will now naturally start flowing towards the United States, where they can earn a higher interest rate. Currently, with a free-floating c urrency, this would cause the Peso’s value to drop, and potentially inflation to increase. But, it won’t hurt economic activity directly as Pesos keep circulating in Argentina. However, if Argentina were to completely Dollarize it’s economy, then money would just flow straight out of Argentina, unless it increased its own interest rates as well, which can have really bad side effects for Argentina’s local economy.
So, in this situation the exchange rate acts as a buffer against what is going on the United States. Indeed, this effect could explain why, on average, the economies of Dollarized countries are more volatile, since they can now no longer use the interest rate to stimulate or slow down their own economies appropriately. Instead, they just have to follow what the United States does.
A second disadvantage that economists often mention is that, by giving up your own currency, your central bank c an no longer effectively bail out either the government or the banking system. This means that if there is a crisis, the government will have no choice but to implement harsh austerity measures at the worst possible time. Indeed, this is exactly what happened to countries like Greece, Spain, and Italy at the height of the Euro crisis in 2011. And, while they eventually got bailed out, they still had to implement harsh austerity measures in the middle of a crisis, after which all of their economies stagnated.
Thirdly, proponents of having your own currency have said that by issuing its ow n paper money, a government gets some money for free since they don’t have to pay an interest rate on issuing paper money, whereas they do if they borrow in the bond markets. This type of re venue is officially known as seigniorage.
Finally, with regards to Argentina’s current Dollarization plan, many economists have made the case that to Dollarize, you need Dollars, and while lots of Dollars already circulate in Argentina, the central bank simply does not have enough Dollars to replace the current Pesos in circulation with Dollars.
So, is Dollarization just a pipe dream? Well, not so fast. Of course the proponents of Dollarization have countered each of these arguments.
Firstly, in general, economists have increasingly recognized that the buffer effect that exchange rates provide is far from perfect. Second, proponents like professor Cochrane have argued that eliminating bailouts is exactly the point of Dollarization, and that this can be a good thing because, politicians will realize that precisely because they cannot be bailed out by the central bank anymore, they will no longer borrow irresponsibly. Thirdly, in response to no longer having seigniorage, professor Cochrane said that, indeed handing over seigniorage revenue is in effect a nice present from Argentina to the U.S. government. But, he also suggested that the country could likely strike a deal with the U.S. later to see some of that mone y returned. Even better, professor Emilio Ocampo has said that, because Argentina’s economy is already Dollarized to a large extend, seigniorage revenue isn’t that big anyway. Finally, economist Steve Hanke has made the case that while the Argentinian central bank might not have enough Dollars today, knowing that inflation is over and capital restrictions lifted, lots of Dollars that are currently hidden under matrasses would likely soon appear, which is exactly what happened when Ecuador and other countries that mr. Hanke advised Dollarized.
So, who is right?
Will Dollarization Work for Argentina?
Well, after making the obligatory disclaimer that nothing in macroeconomics is certain, and that the proponents of Dollarization have all admitted that the policy is not a panacea, and that it will have to be combined with many other policies, I think that Dollarization will work in solving Argentina’s inflation problem, simply because almost every country that tried it got rid of sky high inflation. However, I think the evidence is pretty clear that Dollarizing your economy comes at the cost of lower economic growth, and more extreme economic crises.
And, while I was convinced by the arguments of the proponents that Dollarization can be done, even if it might take a few years to fully implement, I simply was not convinced that full-scale Dollarization was a good idea and would argue instead that adopting a currency peg or a currency board is simply much smarter. After all, as the Greek and Italian experiences have shown, removing the central bank does NOT mean politicians will spend wisely from here on out, and abandoning your currency could mean that you end up in a massive crisis and then cannot easily go back to having your own currency. In a more optimistic case, adopting a currency board or peg, will still massively reduce inflation, and attract investments that can then be used to finally build Argentina into a modern, stable, and prosperous economy, which can then once again have a stable free-floating currency.
I mean, as people like Peter Zeihan have noted, if we look at Argentina’s geography the re is just so much potential there, and so to me, Dollarizing the economy feels a bit like just giving up. That being said, given Argentina’s history, it makes total sense to me that people are getting desperate and want to try something completely different. So, in the end, I think being in favor or against Dollarization is really a matter of how much hope you think there still is for Argentina’s economy.
If you think there is no hope, Dollarization can make sense. But, if, like me, you try to remain somewhat optimistic, Dollarization the wrong move. And actually, given that professor Emilio Ocampo recently stopped working with Milei, there are now some signs that Milei might agree with me and and will try a softer approach.
But, yeah, that is my take. What do you think, should Argentina Dollarize, commit to a currency board, or do something else? Let me know in the comments and if you like this type of deep dive into current events, consider supporting my work by buying me a digital coffee, or by supporting the channel long term as a member or Patron.