Dollarization By ALBERTOALESINAAND ROBERTJ. BARRO* The numberof independentcountrieshas almost tripled since World War II: in 1946 there were 76 independentcountries;today there are 193. Until recently, most countries had their own currencies. Hence, the expansion of the numberof countriesled to a proliferationof the numberof currencies.More recently, however, the identification of currencies with countries has weakened, and the discussion has shifted towardone of desirableforms and sizes of currency unions. Roughly 60 small countries or territories have for some time been members of currency unions or have used a large country's money. Examples are the 15-memberAfrican Financial Community (CFA) franc zone in Africa, the seven-member Eastern Caribbean Currency Area, the use of the U.S. dollar by Panamaand several smallercountries,the use of the Belgian franc by Luxembourg, the use of the Swiss francby Liechtenstein,and the use of the Israeli shekel in the West Bank and Gaza. In the future, currency unions will surely be more prevalent among large countries, as is clear from the recently formed union of the 11 European countries that use the euro. Greece will join soon, and several other countries may sign on later, although Denmark has said no, and the debate in the United Kingdom is intense. Dollarization has been contemplated by several countries in Latin America, including Argentina, Peru, and much of Central America. Argentina went part of the way toward dollarization through its adoption of a currency board linked to the U.S. dollar in 1991. Currency boards that lock local currencies to the dollar or the euro also exist in Hong Kong, Estonia, Bulgaria, and Lithuania. In 2000, Ecuador adopted a full dollarization, and El Salvador announced its determination to follow the same course. * Departmentof Economics, HarvardUniversity, Cambridge, MA 02138. This research is supportedby the National Science Foundation. 381 We seek in our analysis to understandthe forces that favor and oppose currency unions; that is, we extend the classic analysis of optimum currency areas from Robert A. Mundell (1961). One consideration, not touched on in Mundell's economic analysis, is that individual currenciesare sometimes valued simply out of national pride. One would have expected these nationalistic concerns to be more intense for language than for money, yet most countries willingly use the language of anothercountry, typically the one of a former colonial ruler. Given this acceptanceof transplantedlanguage, it is surprisinghow often people reject currency unions (which sometimes involve the use of another country's currency) simply on the grounds that importantcountries are supposed to have their own money. From an economic standpoint,the strongest argumentthat Mundell identified for individual money is that it allowed a countryto pursue its own monetarypolicy. In theory, if the country operateswith a flexible exchange rate, the monetaryauthoritycan design a countercyclicalpolicy thatrespondsoptimallyto its own economic disturbances. In contrast, under a fixed exchange rate, monetarypolicy has to be subordinated to the maintenanceof the exchange rate. Fixed-rate regimes include a peg to another currency,which may or may not be permanent, and the more serious commitmentsrepresented by currencyboardsand dollarizations(by which we mean one country'suse of anothercountry's money, which may not be the U.S. dollar). In Mundell's framework,the main force that favors a common currency is the transactionscost benefit. The use of the same money facilitates trade in goods and services and also in financial exchanges. The expansion of world trade, or globalization, has made this consideration increasingly important. Globalization and two other factors seem to explain why the world has been moving away from the doctrine of one-country/one-currency and towardmulti-countrycurrencyunions. The first additional factor is the already noted 382 AEA PAPERSAND PROCEEDINGS dramaticincrease in the numberof independent countries. For the many small, independent countriesthathave been createdsince the end of World War II, the costs in terms of forgone trade of maintaining one's own currency are unacceptablyhigh. The second additional consideration is that the benefit that economists and central bankers attribute to independent monetary policy has diminishedas we all have learnedto value price stability over active macroeconomic stabilization. In the 1960's and 1970's, there was much greaterconfidencethat monetaryexpansion and inflation, either in general or in the form of well-tailoredcountercyclicalpolicy, would convey benefitsin termsof highereconomic growth and lower unemployment.Now there is widespread belief that monetary authorities should concentrate on providing a stable nominal framework and otherwise staying out of the way. I. The Pros and Cons of Dollarization In two recent papers (Alesina and Barro, 2000; Alesina et al., 2000a) we have examined theoretically and empirically the determinants of optimal currencyareas. In our formal model, we begin with the effect of currencyunification in reducing the transactioncosts of trade. Recent results by Andrew K. Rose (2000), who examines existing currencyunions, suggest that the benefits of dollarizationfor trade may be large. His findings indicate that the sharingof a common currency,holding constantan arrayof other variables, increases the volume of trade dramatically,by a factor of 2-3. Although this effect seems large, the magnitudeaccords with other empirical results -that have identified a stronghome bias in trade (see John McCallum, 1995; John F. Helliwell, 1998). In fact, borders and other elements identified in the tradegravity literatureseem to mattera lot for trade and financial integration. To the extent that crossing a borderimplies, among other things, changingcurrencies,a currencyunion may have significant effects by reducing this large home bias. The Rose programof empirical research on existing currency unions has sometimes been criticized for focusing on small and therefore nonrepresentativeeconomies. Of course, this MAY2001 focus is dictated by the available data. In the future,when the euro and othercurrencyunions involving large countrieshave been aroundfor a while, the data will be much better.However, even at present, one can regard the existing unions as providing very interesting experiments about the effects of alternativemonetary systems. Consider, as a contrast, the plight of researcherson school choice, who eagerly examine the data for a few thousandstudentswho are the subject of short-livedexperimentalprograms. In the case of the small currency-union economies, we are effectively receiving experimental data for hundredsof thousandsof people who have submitted themselves to an economic experimentaboutthe long-termeffect of alternativemonetarysystems. Our formal analysis also considers that dollarizationcommits clients to a stable monetary policy, assuming a judicious choice of the anchor currency,which might be the U.S. dollar. Specifically, if an inflation-prone country adopts the currency of a credible anchor, it eliminates the inflation-biasproblem of discretionary monetary policy that was emphasized by Barroand David B. Gordon(1983). This bias may stem from two sources: attemptsto overstimulate the economy on average and incentives to monetize budget deficits and debts. For many developing countries, dollarization provides a much bettercommitmentdevice than alternativeforms of fixed exchange rates. The adoption of another country's money (or the joining of a currencyunion with a new form of money) makes the costs of "turningback"very high. Hence, these regimes are much more credible than customary (typically ephemeral) promises to peg the exchange rate. Many countries also lack the internal discipline and institutions that can provide a firm domestic commitmentto a monetarypolicy that is dedicated to price stability. In the currentworld, with relatively low inflation, some may argue that the commitment problemhas alreadybeen solved and, therefore, is not a valid reason to adopt a currencyunion. However, this argumentis misleading for two reasons. First, in many cases, inflation came down thanks to some sort of nominal anchor mechanism, such as a temporarilypegged exchange rate, implementation of a currency board,or the constraintsfrom "convergencecri- VOL.91 NO. 2 CURRENCYUNIONS teria"that were requiredbefore a countrycould join the EuropeanMonetaryUnion. Second, no one can be sure that the inflationarydecades of the 1970's and 1980's are an isolated historical event, never to be repeated,especially in developing countries. Therefore, the commitment provided by dollarizationremains valuable. As already mentioned, one cost to a country from giving up its own currency is the elimination of an independent monetary policy that can be used to help stabilize the business cycle. Guillermo Calvo and Carmen Reinhart (2000), among others, have argued that this benefit is largely illusory. However, if we assume that the domestic monetary authority can commit to a useful countercyclical policy, then the loss of an independent policy will represent a true cost. The cost from losing an independentmonetary policy will be higher the less correlatedis the business cycle of the client countrywith that of the anchor. We show in our formal model that two types of co-movements matterfor this calculation.One involves movementsof output, and the other involves changes in relative prices. With respect to output, if the anchor engages in effective countercyclical monetary policy based on its own economic conditions, then this policy will be useful for clients only to the extent that the countries' outputscovary. To the extent that outputsmove independently,the anchor's actions will create unnecessary variability in the client's inflationrate. With respect to relative prices, the point is that price stability for the anchor translatesinto price stability for clients only to the extent that relative prices of the countriesdo not change. For example, if the Federal Reserve maintainsa zero inflation rate in the United States, then the inflation rate in Argentinawill not be zero, but will correspond to the changein relativeprices (or real exchange rates) between the two countries. Another considerationis that currencyunion may (but does not necessarily) increase the integrationof country members and thereby create more synchronized movements of output and smaller movements of relative prices. In this case, currency union will turn out to be more favorable than one would estimate based on the co-movementsthatarise in the context of independent monetary regimes. Rose and Charles Engel (2000) provide a little empirical 383 evidence to supportthe idea that currencyunion increases the relevant co-movements. Anothercost of dollarizationis the loss of seignoragefor the client country.However,this loss is not a social waste, but rathera redistribution between the countries.In principle,the anchor could returnthe seignorageto the client. In fact, the allocationof seignoragecan be partof compensationschemesbetweenanchorsand clients. To understand the role of compensation, it is easiest to begin with the benchmark case in which the anchor country returns all the seignorage revenue to the dollarizing country. In this case, the anchor has no incentive to tailor its monetary policy to the interests of its clients. However, by allowing payments from the clients to the anchor, mutually beneficial transactions may occur. That is, a client may compensate the anchor for modifications of the anchor's monetary policy that reflect the client's interests. The allocation of seignorage may be part of these compensation schemes, and such schemes would be predicted to arise in an environment of competing anchor currencies. That is, the dollar or the euro may offer more or less favorable deals to potential clients, such as Brazil or South Africa, that are otherwise close to the margin with respect to their preferences for the two currencies. Fromthe pointof view of the anchor,is dollarizationbeneficialor costly?In principle,it should not matter,since the anchoreitherdoes not change its policy, or it is compensatedfor doing so (in a competitiveway if the world featuresan arrayof similarlyattractivepotentialanchorcurrencies).In addition,the anchormay obtainthe benefitsof the reductionof tradecosts. From a political-economy perspective, if the anchorbecomes the providerof the money for a large regional union, then the leader country may be worriedaboutinternationalpressureson its monetary policy. These pressures may be particularly strong if the central bank of the anchor country also assumes the role of the lender of last resort for its clients, but this role need not be tied to the provision of monetary policy. II. What CurrencyAreas? Based upon our previous discussion, the countriesthat should be more likely to abandon 384 AEA PAPERSAND PROCEEDINGS their currencies are those that exhibit the following characteristics: (i) a history of high and variable inflation, which we take as an indicator of a lack of domestic commitmentability; (ii) a large actual or potential volume of international trade, particularlywith the anchor country; (iii) business cycles that covary substantially with a potential anchor; (iv) reasonably stable relative prices (gauged by real exchange rates) with respect to a potential anchor. In ongoing empirical work (see Alesina et al., 2000a), we consider the U.S. dollar, the euro, and the yen as three potentialanchors.Then we examine which other countrieswould profitthe most from the adoption of one of these currencies. We computedco-movementsof outputand prices between the three potential anchors and all the countriesin the world. We also examined bilateral trade patterns, and we looked at the histories of inflation. We found first that the yen does not look appealing as a potential anchor. We reach this conclusion partly because few potential clients exhibit a high degree of co-movement with Japan. Also, Japanis relatively closed compared with the United States and the euro area,and the imports of Japan are highly dispersed. Therefore, few potential clients have a high share of their exports to Japan. With the exception of Indonesia, even East Asian countries do not display a high degree of co-movement with Japan. Our second finding is that the history of inflation in Central and South America should make many of these countriesinterestedin dollarization. For Central America and Mexico, there is little doubt that the U.S. dollar is the best anchor currency. However, the pattern is less clear for South America. This region trades heavily with Europe, and in many cases the co-movements are as high with the euro-area countries as with the United States. For Argentina, for instance, it is not clear that the U.S. dollar dominates the euro as an anchor currency. However, for Ecuador and El Salvador, we do find thatthe U.S. dollaris the best choice. MAY2001 Our third conclusion is that Africa and Eastern Europe are potential clients of the euro. Co-movements of output and prices among these countries are high, and so are trade shares. In summary,we found that there seems to be a fairly clear dollar area involving Canada, Mexico, most of CentralAmerica, and parts of South America. The Philippines, Hong Kong, and Singapore also belong. The euro area includes all of Western Europe and most of Africa. There does not seem to be a yen area beyond Japan, except perhaps for Indonesia. There are also several countries that do not appear to need anchors. This group comprises countrieswith low inflationthat engage in little internationaltrade(and seem even potentiallyto have little tradingprospects with the three anchor countries). III. Conclusions The proliferation of many small countries, the increasing volume of world commerce in goods and services and in financial exchanges, and the renewed emphasis on price stability are formidableforces leading toward dollarization. Therefore, we anticipate that the next decades will involve a transition toward a world in which the number of currencies is much less than the numberof countries. Increasesin economic integrationand expansions of currencyunions also have implications for the benefits of political unions. If countries are linked more by tradeand common currency, then the benefits from having a larger political union (i.e., a larger-size country) diminish.' Thus, if a country joins a monetary union, it may become easier for one of its regions to secede. The reason is that the benefits from free trade and common currency are no longer linked to the political union. To some extent, Europeis alreadya case in point. Togetherwith the progress of economic integrationand monetary unification, regionalism and the demand for regional political autonomyhave shown renewed vigor. We submitthatthis coincidence of events is not a coincidence. 1 See Alesina et al. (2000b) on this point. VOL.91 NO. 2 CURRENCYUNIONS REFERENCES Alesina, Alberto and Barro, Robert J. "Currency Unions." National Bureau of Economic Research (Cambridge,MA) WorkingPaperNo. 7927, September2000. Alesina, Alberto; Barro, Robert J. and Tenreyro, Silvana. "Optimal Currency Areas: An Em- pirical Investigation." Unpublished manuscript, HarvardUniversity, December 2000a. Alesina, Alberto; Spolaore, Enrico and Wacziarg, Romain. "EconomicIntegrationand Political Disintegration."AmericanEconomicReview, December 2000b, 90(5), pp. 1276-96. Barro, Robert J. and Gordon, David B. "Rules, Discretion, and Reputation in a Model of MonetaryPolicy." Journal of MonetaryEconomics, July 1983, 12(1), pp. 101-21. Calvo, Guillermo and Reinhart, Carmen. "Fear of Floating." Unpublished manuscript,University of Maryland, 2000; presented at the 385 Hoover Institution Conference on Currency Unions, Stanford,CA, May 2000. Helliwell, John F. How much do national borders matter?Washington,DC: Brookings Institution Press, 1998. McCallum, John. "National Borders Matter: Canada-U.S. Regional Trade Patterns." American Economic Review, June 1995, 85(3), pp. 615-23. Mundell, Robert A. "A Theoryof OptimumCurrency Areas." American Economic Review, September 1961, 51(4), pp. 657-65. Rose, Andrew K. "One Money, One Market: Estimating the Effect of Common Currency on Trade." Economic Policy: A European Forum, April 2000, (30), pp. 7-33. Rose, Andrew K. and Engel, Charles. "Dollarization and Integration." Unpublishedmanuscript, Universityof California-Berkeley,2000; presentedat the HooverInstitutionConferenceon CurrencyUnions, Stanford,CA, May 2000.
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