Transcription
Fed up with decades of sky-high inflation, Argentineans have just elected a controversial new president who promised to dollarize the economy. This means abolishing the central bank and ending the Argentinean peso. But is that a good idea?
Well, actually, the plan is more thought out than you might think. It was drafted by a well-known Argentinean economics professor and backed by several prominent US-based professors, such as John Hopkins’ Steve Hanke, and Stanford’s John Cochrane. At the same time, most economists have argued for decades that it is a really bad idea, and most Argentinian economists indeed 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 the 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, 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 compare it to European and Asian economies like Spain, Korea, and China, we can see that economic growth has not been great either. What’s worse is that economic growth has been very volatile, meaning that Argentina had to deal with two 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. It 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 Argentinean voters were just completely fed up with the economy and voted for a president with a radical proposal for “the elimination of the central bank, dollarization”.
And in practice, Mr. Miller and his advisers 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 its 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 and 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 previously. First, let’s have a look at the cases of Italy, Spain, and Greece. And yeah, before you say anything, these countries did not adopt the US dollar, but they did dollarize their economy because in economics we tend to say that dollarization just means abandoning your old currency for a currency issued by someone else. So yeah, I understand that this is confusing. But by adopting the Euro, these countries have 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 a euro, their inflation rate 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 dollarized 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 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 value is freely determined by people trading currencies in the financial markets. On the other end of the scale, you have countries that have abandoned their currencies completely, and in between, though some countries manage their own currencies only to a certain extent because they have promised to keep them roughly in line with another currency such as the US 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 US dollar, and then you create a lot of currency to stimulate the economy, you could potentially get a scenario where people figure out that you have issued more currency than there are dollars in your economy, 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 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, it is extremely difficult to dollarize an economy, so dollarization is pretty much 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 in the past, Argentina’s bad, 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 another currency board to prevent the next government or the government after that 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 its 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 now be removed after the dollarization, which will then lead to much 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 went down to roughly the level of German interest rates. 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 have claimed, dollarizing your economy makes it more attractive for investors.
However, then the question becomes, will this increase investment lead to more economic growth and to less extreme boom and bust cycles? And there I think the evidence is really not so clear. For example, if we look at the economic growth of dollarized El Salvador and Ecuador and compare it to non-dollarized peers in South America, we can see that world growth was just very meh, very average. And if we zoom in a bit more, they also don’t appear to be very stable. Now, although 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 the euro, 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. Perhaps you are just cherry-picking examples, but actually, I didn’t. 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 a slower and more volatile output growth and a lower inflation rate than 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 indeed crushes inflation, but that it is bad for economic growth and tends to make economic crises worse.
But why would that be the case? Well, that brings us to the case against dollarization, which we can talk about after discussing the case against letting your data fall into the hands of data brokers, which can be prevented by enlisting the help of today’s video sponsor Incogni.
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And with that data hiding out of the way, let’s dive into 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 four main arguments.
First, in general, economists these days tend to recommend that a country should have its own currency and that the value of that 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. Now, 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 now can, of course, earn a higher interest rate. Currently, with a free-floating currency, 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 its 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 in 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 whatever the United States does.
A second disadvantage that economists often mention is that by giving up your own currency, your central bank can 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. Thirdly, proponents of having your own currency have said that by issuing its own 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 revenue is officially known as seigniorage.
Finally, with regards to Argentina’s current dollarization plan, many economists have made the case that to dollarize, well, 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 the seigniorage, Professor Cochrane said that indeed handing over in your eyes revenue is, in effect, a nice little present from Argentina to the United States government. But he also suggested that the country could likely strike a deal with the US later to see some of that money returned. Even better, Professor Emilio Ocampo has said that because Argentina’s economy is already dollarized to a large extent, seigniorage revenue isn’t that big anyway for Argentina. Finally, economist Steve Hanke has made the case that while the Argentinean 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 mattresses everywhere in Argentina would likely soon appear. Which is exactly what happened with Ecuador and other countries that Mr. Hanke advised dollarized their economies.
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 good 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 that 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 is 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 would end up in a massive crisis and then cannot easily go back to having your own currency.
In a more optimistic scenario, adopting a currency board or peg will still massively reduce inflation and attract investments that can be used to finally build Argentina into a modern, stable, and prosperous economy, which can then, once again, have a stable, free-floating peso. I mean, as people like Peter Zeihan have noted, if we look at Argentina’s geography, there is just so much potential there. And so to me, dollarizing the economy feels a little bit like just giving up. That being said, given Argentina’s history, it makes total sense to me that people are getting really 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 that there is just no hope, dollarization can make sense. But if, like me, you try to remain at least somewhat optimistic, dollarization is the wrong move. And actually, given that Professor Emilio Ocampo recently stopped working with me, there are now some signs that Milei might start agreeing with me and will try a softer approach. But that is my take. What do you think? Should Argentina dollarize? Or commit to a currency board or do something else? Let me know in the comments below. 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 long term as a member or patron. And finally, as I always recommend, checking out multiple credible sources about a subject. Why not check out Patrick Boyle’s Argentina video over here? And if you’ve already seen it, consider checking out my old video about how exchange rates are determined over here.