Plenty. When a country abandons its currency, it surrenders a central symbol of national identity. It also loses one instrument to control its economy and throws itself at the mercy of policies determined elsewhere–in this case, in the United States. We are courting trouble if many countries dollarize. They would blame us for their problems; and they would try to influence U.S. policies, pushing for either lower or higher interest rates.
For the moment the dangers are hypothetical. Only one country, Argentina, has seriously suggested dollarization. But the hazard of this idea lies in its apparent harmlessness. If we accede to one country’s doing it, we could hardly object if more countries want to follow. Other Latin countries already seem interested. Over a period of years–perhaps a decade or 15 years–dollarization might spread. American foreign policy and economic policy would be fundamentally altered without our ever having fully considered the consequences.
At a recent congressional hearing, Federal Reserve chairman Alan Greenspan and Deputy Treasury Secretary Lawrence Summers were subtly encouraging. They didn’t fully endorse dollarization as an antidote to currency crises and economic instability. But they didn’t criticize dollarization either, and they insisted that it wouldn’t threaten independent U.S policies. This is implausible. The United States could not “be indifferent if the greater part of the world’s effective supply of dollars… were held outside the U.S.,” writes Samuel Brittan in the Financial Times. The Federal Reserve might set economic policy for much of the world.
The dollar, of course, already plays a pivotal role in the world economy. It is the main currency used to conduct foreign trade. Countries hold about 60 percent of their foreign-exchange reserves in dollars (these reserves consist of currencies useable to buy imports). And the dollar is used heavily in cross-border bank loans and bond issues. Indeed, the dollar’s global role helps explain why U.S. trade deficits have persisted since 1976.
People need dollars to trade and invest. This demand props up the dollar’s exchange rate. U.S. exports become more costly; imports to the United States become cheaper. We record a trade deficit. In reality the rest of the world is paying us, through an excess of imports, for the services the dollar provides. One service is as everyday cash in some countries. Dollar bills have traveled to countries like Peru, Russia and Turkey. These societies have informally dollarized. People distrust their own money, because inflation or political instability threatens its value.
We know this, says Edgar Feige, a retired economist from the University of Wisconsin, because otherwise there’s more cash than Americans need. There are now about $480 billion of bills (from $1s to $100s). That’s almost $1,800 for every adult and child in America. Do you hold that much cash? By Feige’s estimates, between 38 and 44 percent of U.S. currency exists abroad; government estimates range from 50 percent to two thirds.
Whatever the true number, it’s high. Argentina has, in this sense, already heavily dollarized. By 1995, perhaps half of its bank deposits were in dollars. Dollars are often used for large purchases: cars, homes, cattle. And the national currency, the peso, is tightly tied to the dollar through an arrangement known as a currency board. Argentina effectively issues new pesos only if they’re backed by dollars (the exchange rate is $1 = one peso). The present proposal would go the final step and eliminate the peso.
On paper, this is appealing. The mere possibility of devaluation–reducing the peso’s value in dollars–exposes Argentina to confidence crises. People might cash in pesos for dollars; interest rates stay higher to deter this. Switching to the dollar would seem to erase the threat. Interest rates would drop; economic growth would rise. The immediate gains seem huge.
But disadvantages lurk. Consider, for starters, how dollarization might work in practice. In Argentina, there are roughly 15 billion pesos in circulation. The country also has $25 billion of foreign-exchange reserves–most probably in U.S. Treasury securities. To replace pesos, Argentina could sell $15 billion of Treasury securities and buy $15 billion of U.S. currency. Dollars would be exchanged for pesos. Fine.
But there are also lots of bonds and bank deposits and loans in pesos. How would these to be converted? One answer: Argentina would simply declare them changed to dollars. Although U.S. officials profess to be unworried by this hocus-pocus, they should be. If many countries did it, they would create huge amounts of dollar financial instruments essentially out of thin air. No one knows the consequences of that.
Moreover, dollarization would not guarantee other countries strong economic growth or prevent financial crises. These depend mainly on their own policies. Interest rates might initially drop. But in the future, economic policies that suited the United States–say, high interest rates to control inflation–might not suit dollarized countries. And money transfers in and out of these countries would become simpler, because there would be no currency risk. Social or political unrest could easily prompt people to shift dollars abroad.
It is naive to think that, if other countries adopt our money, our economic and political relations will remain unaffected. Even now, we are not aloof from other countries’ problems and complaints. Witness our rescue of the ailing Mexican economy in 1995. We cannot stop informal dollarization. But we can resist formal conversions. Dollarization is a vast black hole, and rather than being nonchalant about exploring it, we should discourage other countries from dragging us over the edge.
