It’s a radical move, but it has been done before — and it could end the country’s inflationary woes.
It’s a radical move, but it has been done before — and it could end the country’s inflationary woes.
L ast week, Javier Milei, an unconventional politician and economist, shocked the world by coming in first place in Argentina’s presidential primary, with 30 percent of the vote. The general election, which will decide who becomes the next president, will take place in October.
Milei holds staunchly libertarian views. He supports privatizing state-owned enterprises and dramatically cutting taxes and government spending. Perhaps Milei’s most controversial economic proposal is to abandon the Argentine peso, close the central bank, and adopt the U.S. dollar as the country’s new currency. While “dollarization” would come with steep costs, Argentine policy-makers should seriously consider the idea.
Embracing another country’s currency (the dollar being the most common) is a radical move, but it has been done before. Panama has used the dollar since 1904. Ecuador and El Salvador dollarized in 2000 and 2001. These are examples of official dollarization, in which the government formally adopts the dollar. Many developing countries are partially or heavily unofficially dollarized, as people simply prefer to buy and sell in dollars. Typically, an economy dollarizes because high inflation has seriously weakened the local currency. For example, economists have estimated that roughly half of all transactions in inflation-ravaged Venezuela and Lebanon in the past two years have been conducted in dollars.
In the late 1990s, the Central Bank of Ecuador dramatically expanded the supply of the local currency, the sucre. Inflation soared, prompting Ecuadorians to start transacting and saving in the more stable dollar. Although the Ecuadorian government initially resisted official dollarization, it eventually gave in to stave off economic collapse. This transition was not painless as it reinforced the sucre’s depreciation, causing further harm to those still holding the local currency. However, the economy then rapidly stabilized as real growth rose and inflation fell. For Ecuador, dollarization has been like a strong medicine that temporarily caused some unpleasant side effects but ultimately made the patient healthier.
Like Ecuador in the 1990s, Argentina suffers from severe inflation. Since February, the year-over-year inflation rate has exceeded 100 percent. Also, like Ecuador before 2000, many Argentines already deal in dollars. For years, black markets have existed where people can get more pesos by selling their dollars than they would get at the official exchange rate. Anyone familiar with the economic history of Argentina, once one of the world’s wealthiest countries, will know that it has repeatedly experienced currency crises and defaulted on its international debt. Decades of statist policies, including excessive regulation and spending, have produced an anemic economy. Over the years, Argentine politicians’ profligate spending has caused the Central Bank of Argentina to monetize the country’s deficit, further exacerbating inflation.
With Argentina’s recurring problems in mind, it is easy to understand why many favor dollarization. Dollarization would mean that the government would no longer be able to turn to monetary policy, a tool Argentine governments have repeatedly misused, to fund imprudent fiscal policy. Jorge C. Ávila and Emilio Ocampo (economists at the University of CEMA in Buenos Aires), the Hoover Institution’s John Cochrane, and Johns Hopkins University’s Steve Hanke are among dollarization’s proponents. Of course, dollarization is a double-edged sword. It constrains the government’s ability to conduct fiscal policy and removes its ability to conduct monetary policy, for better or worse. If some negative shock such a banking crisis occurs, the dollar-adopting country would not be able to use monetary policy to mitigate that shock’s impact. Moreover, Argentina’s monetary system would be at the mercy of the Federal Reserve in Washington, D.C.
Some skeptics of dollarization have compared the proposal to a previous Argentine monetary experiment: the failed 1991–2002 Convertibility Plan, which aimed to maintain a fixed exchange rate between the peso and the dollar. The plan was initially successful as inflation fell dramatically. However, in the late 1990s, the U.S. dollar strengthened, causing the peso to also appreciate. This development, coupled with the devaluation of the real in Brazil, one of Argentina’s major trading partners, harmed Argentine exports. Economic stagnation along with an increasing debt burden denominated in dollars eroded investor confidence, leading to a massive recession, widespread unemployment, and political turmoil. Eventually, the government defaulted and abandoned the plan.
Critics correctly point out that, should the dollar appreciate, a dollarized Argentina could similarly experience a downturn. However, there are crucial differences between dollarization and the Convertibility Plan. To maintain a fixed exchange rate, a central bank trades the domestic currency with the anchor currency to ensure that the market rate does not deviate from the official rate. However, if speculators suspect that the domestic currency is overvalued because the central bank lacks adequate reserves to maintain the official rate, they will sell the domestic currency in large quantities. This “speculative attack” can rapidly deplete the central bank’s foreign-currency reserves and force the central bank to abandon the fixed exchange rate.
This is exactly what happened during the Convertibility Plan. Floundering competitiveness and growing deficits prompted speculators to suspect that the fixed exchange rate was not sustainable. To boot, unlike a currency board, the Central Bank of Argentina did not hold 100 percent dollar reserves against the pesos it issued to ensure conversion. Instead, the central bank held dollar-denominated Argentine-government bonds as part of its reserves. These bonds lost value in the late 1990s, adding to the central bank’s impossible challenge of maintaining the fixed exchange rate. The Convertibility Plan was a flawed scheme whose unraveling led to a full-blown currency crisis. This sort of chaos would not happen under dollarization because there would be no domestic currency at risk of being devalued.
Whether Argentina should dollarize is a complicated question. Should Argentina fail to follow through on other badly needed reforms to make its economy more competitive, a strong dollar could cause its economy to stagnate further. On the other hand, dollarization would bring an end to Argentina’s inflationary woes. Also, since monetizing deficits would no longer be an option, dollarization could also motivate policy-makers to pursue pro-market, pro-growth reforms. At minimum, dollarization is worthy of discussion.