Dollarization

Official dollarization refers to the practice by some countries of using the U.S. dollar as their official currency. In such a system, there is no central bank, no independent monetary policy, and no independent exchange rate. By adopting the U.S. dollar, a country enjoys price stability because the job of currency production is implicitly outsourced to the United States. Moreover, the practice makes it possible for international commerce and trade to be conducted with fewer currencies.

Unofficial dollarization involves the unofficial use of a foreign currency, usually the U.S. dollar, by the residents of a country while the domestic currency still circulates alongside the foreign currency. Unofficial dollarization includes cases where holding foreign assets is legal as well as illegal. The motivation for holding foreign assets by residents is to hedge against spiraling inflation.

Proponents of dollarization argue that there are too many currencies circulating in the world today and that this can become dangerous and inefficient. All of these currencies are backed by the confidence that investors have in them. When there is too much pressure on these currencies, the monetary authorities yield to devaluation. Devaluation brings hardship to the people as a result of attendant inflation. On the other hand, dollarization results in low inflation and relatively stable interest rates.

When the focus is on the individual as a decision maker, an economic choice becomes logical. Economists argue in favor of “consumers' sovereignty” rather than a national monetary sovereignty. The question then becomes: Who should possess the power to choose what currency to use? Proponents of dollarization argue that the choice should reside with individual consumers.

The recent financial crisis in several developing countries of the world (for example, the Asian financial crisis) is an indicator of the failure of monetary management in these countries. The failure of the Argentinean currency board system is a case in point. These crises can be avoided if dollarization is adopted because the national government is removed as an issuer of currency. In most countries of the world, the central banks have performed poorly in terms of promoting low inflation, foreign exchange management, and general monetary stability.

Dollarization is not a mechanism for replacing the monopoly of a domestic monetary institution with a monopoly of a foreign monetary authority. Some scholars argue that it is an evolutionary process for selecting an appropriate currency in terms of economic strength. It gives a country the opportunity to examine several currencies from which it could abandon an inferior one for a strong one.

Another legitimate argument in favor of dollarization is based on the concept of impossible trinity. This concept is the foundation of macroeconomics of open economy. It is premised on the idea that a country cannot achieve a fixed exchange rate, free movement of capital, and an independent monetary policy at the same time. At best, a country can achieve two. A country that pursues dollarization can overcome exchange rate volatility relative to the U.S. dollar and, consequently, can avoid future currency crisis. Moreover, such a country will benefit from an increased economic integration with the U.S. economy.

...