A system of income transfers from the winners to the losers in an economy also reduces the political costs of sustaining dollarization. If a decline in living standards produced by the unemployment and bankruptcies inherent to a sharp economic adjustment can be minimized by the presence of social safety nets, the willingness of society to accept the costs of adjustment will inevitably increase.
As a consequence, the capacity of government to sustain the economic policy that forced this adjustment on its constituents will also rise. Two additional important cushioning institutions are the rule of law, specifically an efficient, capable, and non-corrupt judiciary and bureaucracy to ensure the fair application of the law, and a well-functioning democracy. Although these institutions can do little to mitigate the economic impact of external shocks like sound financial systems and income transfers , they can reduce the incentive of lasers to agitate for changes in the economic order that has undermined their living conditions.
Where the judicial system and the bureaucracy are inept and corrupt or where the political order excludes popular participation, these political institutions can magnify this sense of unfairness. They can thereby reinforce rather than cushion the political effects of economic hard times, and undermine rather than reinforce the sustainability of dollarization.
By contrast, a just and efficient judiciary and bureaucracy encourages a sense of fairness in the minds of lasers. When citizens have the chance to rectify a perceived unfairness through a non-biased and effective judicial system or bureaucracy, they will be much less likely to demand changes in the economic policies which were the proximate cause of their suffering.
A well-functioning democracy offers lasers another institutionalized means to protect their interests - by voting out the politicians who caused their personal suffering. In either case, the rule of law and democracy can help to insulate a government from the political repercussions of recession.
The willingness of society to absorb the costs of adjustment relies on an environment that minimizes the divisions and competing interests within society. It depends on creating a national preference for dollarization strong enough to relegate other competing societal preferences to second tier status.
Instead, their policy preferences must be dominated by a single, overriding demand for sustaining a strict fixed exchange rate regime regardless of its short-term costs.
In societies split by a deep socio-economic opposition, sharp class divisions, or ethnic conflict, the emergence of a single national preference for any economic policy will be rare. In such societies, there is a deep-seeded sense that the competition among different societal groups is zero-sum.
Any gain for the other is seen to be an inevitable loss for me. In this setting, it is unlikely that any group will be willing to absorb the costs of adjustment even temporarily, considering this an unfair sacrifice they should not be required to make.
The consequence, as in Argentina and Chile during the s and in Ecuador during the s, is persistent fiscal deficits, macroeconomic instability, and devaluation. Yet even in societies without such deep-seeded conflict, the tendency to advance individual interests even when this undermines the collective interest is common place. How might this seemingly natural human tendency be overcome? A review of the experiences of countries that have adopted strict fixed exchange rate regimes in recent years points to the importance of a shared national trauma that a currency board, monetary union, or dollarization promises to help resolve.
Each trauma has a distinct origin, but they fall into three basic categories: a hyperinflationary trauma which brought the national economy to its knees Argentina and Bulgaria , national survival Panama , Estonia , Lithuania , or an outside threat to political and economic stability Hong Kong and the European Union.
Regardless of its precise origin, such a national trauma enables the adoption of a currency board, monetary union, or dollarization by building a national sentiment in favor of a strict fixed exchange rate regime as a key tool in the resolution of a shared, national crisis.
Equally important to the willingness of society to accept the costs of dollarization over time, however, is the duration of this national trauma.
Should the exchange rate regime eliminate the source of the trauma the end of hyperinflation in Argentina and Bulgaria, for example , time will often transform the trauma into a distant memory.
It also relies on the ability of the govern ment 3 3 This section intentionally refers to the capacity of the government and not the state. In the short-term, this government capacity can be enhanced by a strong executive and a cohesive governing coalition that dominates the political scene. Of even greater importance, however, is the long-term capacity of the government to fulfill this task, given the long-term nature of a policy of dollarization.
This depends largely on the presence of political institutions capable of extending the time horizons of politicians and their supporters, such as effective constitutions and strong political parties within the context of a well-functioning democracy. Executive strength governs the ability of the executive branch to dominate the other branches of government and to insulate itself from societal demands. Executive dominance over the legislature is clearly enhanced by presidential decree power and the authority to dissolve congress.
It also benefits from the existence of a welltrained and loyal bureaucracy capable of effectively designing and implementing economic policies. Where such a bureaucracy exists, particularly in the absence of similar expertise in the legislature or in society, the executive can often disarm it opposition by virtue of its economic expertise.
Finally, executive strength increases relative to the legislature when party practices and a legislative majority enable the executive to determine who the majority of legislators will be. In such a setting, legislators will hesitate to oppose the man to whom they owe their political future. Where the allies of the government are concentrated in sectors likely to suffer a significant proportion of the costs associated with the occasional automatic adjustments that affect a dollarized economy, sustaining dollarization will be difficult.
This implies that governments which rely on a coalition composed of large internationalized firms and professionals will be better able to sustain dollarization than governments whose allies include workers, non-competitive national firms, and small farmers.
The relative dominance of the government and its allies in national politics is the final factor determining the capacity of the government to force the lasers in society to absorb the costs of adopting dollarization. It is somewhat paradoxical, however, that while these authoritarian features of a government can enhance its capacity to implement dollarization, the ability of a government to ensure the compliance of lasers over time is promoted by a more democratic setting 4 4 A recent article by Joel Hellman argues that in the case of Eastern Europe, democracy actually deepens and improves the efficiency of a broad swath of economic reforms Hellman, The key factor is the presence of institutions which can extend the time horizons of politicians and their constituents and thereby increase the likelihood of cooperation and compromise.
Where constitutions clearly delineate a balanced separation of powers among the distinct branches of government, politicians know what powers are available to themselves and their adversaries. Time horizons thereby expand, the willingness of politicians to cooperate and compromise grows, and the capacity of the government to pursue a coherent policy in support of dollarization increases.
A well-functioning democracy can have a similar impact by creating the perception among opposition politicians that in time they will have the opportunity to govern.
In such a setting, the opposition has little interest in generating instability in either the polity or the economy. The essential institutions for fulfilling this task are well-disciplined political parties. By definition, such parties can exploit internal regulations, formal or informal, to convince or force their members to accept the short term costs associated with sustaining dollarization.
When government allies conclude that the costs of abandoning the ruling coalition are greater than the costs of tolerating a recession, the capacity of the government to sustain dollarization while surviving politically rises markedly. These costs can be mitigated by 1 a domestic economy whose structure approximates that of an optimal currency area with the United States, 2 the existence of institutions that either cushion the domestic economy from external shocks or insulate the political order from the costs of a recession in the domestic economy, 3 a society willing to absorb these costs, and 4 a government capable of imposing these costs on society.
But it unfortunately remains unclear precisely which of these factors constitute both necessary and sufficient conditions for the adoption and sustainability of dollarization. What policy recommendations can be derived from such nebulous theoretic conclusions? First, dollarization can be an effective route to stable economic growth for some Latin American countries, but it certainly is not the correct solution for every country in the region. On balance, dollarization seems to be reasonable policy option for El Salvador, but a very long shot in Ecuador, and not very feasible in Brazil.
Second, the worst option for Latin America is to look upon dollarization as a miracle cure for long-standing economic and political problems. Dollarization can do little to reduce foreign debt burdens, build effective state institutions, or reduce societal conflict, all essential sources of continuing economic difficulties in much of the region. Third, given the uncertainties associated with the effectiveness of dollarization as a means of creating stable growth in most of Latin America, the countries of the region would be well advised to redirect their policy attention toward the basics.
Latin America must strive to reduce its dependence on capital inflows by limiting fiscal and current account deficits and by encouraging the development of domestic financial markets capable of financing government deficits.
Finally, given the high costs associated with reversing a policy of dollarization once it has been implemented, countries need to think much more profoundly about the presence and effectiveness of the political and economic factors outlined in this essay that influence their long-term ability to sustain this dollarization.
Otherwise, Latin American governments may find themselves shackled to a policy that produces very high economic, social, and political costs whose long-term consequences are not pleasant to ponder. Abrir menu Brasil. Brazilian Journal of Political Economy. Abrir menu. E-mail: pkstarr dornsife. ABSTRACT The capacity of dollarization to generate stable growth in Latin America despite occasional instability in the international financial system has been the subject of significant economic analysis in recent years.
Cushioning Institutions The willingness and ability of society to absorb the costs of adjustment will inevitably increase as the actual costs they must bear decline. Societal Factors The willingness of society to absorb the costs of adjustment relies on an environment that minimizes the divisions and competing interests within society. International Studies Quarterly 38 June. International Organization Summer : International Organization 1 Winter : World Politics 48 January : Boulder, CO: Westview Press.
Cambridge, MA, August. International Organization 45 Autumn : Debt, Development and Democracy. International Organization, Autumn The Obsolescence of Capital Controls? World Politics 46 October : World Development, January : Washington, DC. Institute for International Economics. Small countries that engage in a relatively large volume of trade with and have strong economic ties to the U.
Zimbabwe ran a dollarization test to see if the adoption of foreign currency could stave off high inflation and stabilize its economy. Zimbabwe dollar inflation reached estimated annual rate of million percent in July Zimbabwe's currency had become so worthless that it was widely being used as insulation and stuffing in furniture, and many Zimbabweans had begun either to adopt foreign currencies for transacting business or resorting to simple barter.
The acting finance minister announced that the U. After the experiment, the finance minister announced that the country would adopt the U. Dollarization in Zimbabwe immediately worked to reduce inflation. This reduced the instability of the country's overall economy, allowing it to increase its citizens' buying power and realize increased economic growth.
Additionally, long-term economic planning became easier for the country, since the stable dollar attracted some foreign investment. However, dollarization wasn't an entirely smooth ride for the country, and there were drawbacks. All monetary policy would be created and implemented by the United States, some thousands of miles away from Zimbabwe.
Decisions made by the Federal Reserve do not take into account the best interests of Zimbabwe when creating and enacting policy, and the country had to hope that any decisions, such as open market operations, would be beneficial. Further, Zimbabwe became disadvantaged when trading with local partners, such as with Zambia or South Africa. Zimbabwe could not make its goods and services cheaper in the world market by devaluing its currency, which would attract more foreign investments from these countries.
In , Zimbabwe reversed course by reintroducing a new Zimbabwe dollar known as the Real Time Gross Settlement dollar in February and outlawing the use of the U.
Inflation in the new Zimbabwe dollars has been steep, and substantial use of the U. Monetary Policy. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Federal Reserve collects the seigniorage, and the local government and gross domestic product GDP as a whole thus suffer a loss of income.
In a fully dollarized economy, the central bank also loses its role as the lender of last resort for its banking system. While it may still be able to provide short-term emergency funds from held reserves to banks in distress, it would not necessarily be able to provide enough funds to cover the withdrawals in the case of a run on deposits. Another disadvantage for a country that opts for full dollarization is that its securities must be bought back in U.
If the country does not have a sufficient amount of reserves, it will either have to borrow the money by running a current account deficit or find a means to accumulate a current account surplus.
Finally, because a local currency is a symbol of a sovereign state, the use of foreign currency instead of the local one may damage a nation's sense of pride. Advantages of Dollarization Besides reducing risk and protecting against inflation and devaluation , there are some compelling reasons for a country to decide to give up so much control over its economy.
As we mentioned above, full dollarization creates positive investor sentiment, almost extinguishing speculative attacks on the local currency and the exchange rate. The result is a more stable capital market, the end of sudden capital outflows , and a balance of payments that is less prone to crises. Last but not least, full dollarization can improve the global economy by allowing for easier integration of economies into the world's market.
Conclusion Many emerging economies already use dollarization to some extent or another. However, many have shied away from it because economies that would consider full dollarization are those that are still developing. For many countries, having an autonomous economic policy and the sense of individual statehood that comes with it is too much to give up for full dollarization, an extreme option that is for the most part irreversible.
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