#54 What is dollarization?

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Your faithful writer,
Dr. Daniel Smith

Over the last year, you might have heard of Javier Milei.

Five months ago, he was elected President of Argentina — Latin America’s third-largest economy.

During his campaign, the self-described libertarian promised to slash government spending, close Argentina’s central bank, and replace the Argentine peso with the U.S. dollar as Argentina’s official currency.

The last proposal has garnered the most attention, with a move to the U.S. dollar being seen as a potential solution to the country’s runaway inflation.

Argentina has the world’s highest inflation rate, with prices rising by a mind-boggling 276.2% over the past year.

The Argentine peso has seen its value disappear in recent years. In 2018, a single U.S. dollar was worth 20 Argentine pesos. By late 2023, one dollar was worth 1,000 pesos on Argentina’s thriving black market for U.S. dollars. (The official exchange rate is 350 pesos-to-1 dollar.)

Let’s learn about dollarization, some of the problems facing Argentina’s economy, and what people on both side of the dollarization debate are saying about this controversial policy proposal.

What is Dollarization?

Economists at the Chicago Federal Reserve defined Dollarization as “the elimination of the Argentine currency, the peso, and its complete replacement with the U.S dollar.”

The term can also be used to refer to a partially dollarized dual-currency system, where the peso is pegged to the U.S. dollar, i.e. the value of the peso is based on the value of the dollar.

The idea of replacing a weak currency with the U.S. dollar isn’t new to Latin America.

Panama did it in 1904, the same year that construction on the Panama Canal began. Ecuador officially replaced its currency, the sucre, with U.S. dollars in 2000. El Salvador did the same thing in 2001.

Did it Work?

Ecuador and El Salvador haven’t exactly been economic powerhouses since they dollarized, but it appears that dollarization did stabilize inflation in both countries after it took place.

It’s not just inflation: Argentina, which was once the most prosperous country in Latin America, has dealt with growing poverty in recent years.

A recent study found that 57.4% of Argentina's population of 46 million is living in poverty, with 15% living in such destitution that they cannot afford food.

What should Argentina do?

Arguments for Dollarization: Milei and other proponents of dollarization claim that it’s the only way to save Argentina from the unholy trifecta of high inflation, growing poverty, and stagnant economic growth.

Dollarization would be especially valuable for dealing with high inflation, which has crippled the Argentine economy and made it difficult for many Argentines to plan for the future.

Essentially, it’s a radical solution to long-term problems inherent to Argentina’s economy that previous governments have failed to solve with all manner of reforms.

Former Federal Reserve economist Steve Kamin, who argued in favor of dollarization after Milei’s election, acknowledged that dollarization would be a difficult process:

Arguments against Dollarization: One of the main arguments against dollarization comes on the grounds that it would essentially limit the Argentine government’s ability to implement monetary policy.

This could weaken the competitiveness of Argentine businesses, hurting economic growth and preventing the sort of entrepreneurial activities that Milei and others want to see more of in Argentina.

In a pre-election survey from Reuters, a majority of Argentine business leaders said that they would prefer a dual-currency system over Milei’s dollarization proposal. Some pointed to the stagnant growth seen in other fully-dollarized economies as evidence against dollarization.

Some dollarization critics point out the fact that Argentina’s economy is unofficially dollarized in many ways. Much of Argentine debt is denominated in U.S. dollars, and there has been a robust black market for U.S. dollars in the country for decades.

Others argue that there simply won’t be enough dollars in Argentina to have a fully functioning economy without pesos.

This is an open question, as Argentina’s economy and population are both significantly larger than those of Ecuador and El Salvador when they dollarized.

Economist Steve Hanke, a former advisor to the Argentine government and long-time supporter of dollarization for Argentina, noted that Argentina has $265 billion in dollar bills saved or in circulation — more than any other country besides the U.S. itself.

ART OF THE DAY

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Yours,
Dan