Dollarization consists of a foreign economy completely adopting the US Dollar as their national currency. No other spot on earth has gotten into the habit of dollarization than South America, our Latin neighbors El Salvador and Ecuador have already adopted the US Dollar, to opposing effects to GDP growth rate. Some studies suggest that dollarization brought stability to their economy by taming the volatility of their inflation and interest rates, which has generally benefited Ecuador as it experienced an increase in their GDP growth rate post dollarization. However, El Salvador’s high public debt and inability to create jobs indicate that the “positive” impacts of dollarization were muted by fiscal policies not matching well with Fed’s monetary policies over the last 20 years. And now, just after a couple of months of announcing using the Chinese Yuan as their trading currency, the leading Argentinian presidential candidate is singing songs of dollarization. He argues that dollarization will bring about monetary stability that will help Argentina to fight hyperinflation once and for all. This isn’t Argentina’s first encounter with the prospect of dollarization, in fact it has flirted with this idea in the 1980s when they adopted the US dollar momentarily and during the 1990s after they pegged their currency to the US Dollar – and now, well maybe 3rd time’s a charm.
The impact of dollarization on a foreign economy has had mixed results and if Argentina’s government adopts the US Dollar, they would be the largest economy to date that would adopt the US Dollar (although most of Latin America is de facto dollarized) as their national currency. Which leads us to the question: how will it impact us?
The extensive use of the dollar in foreign countries brings substantial advantages to the United States, both economically and politically. While some downplay these benefits, the leadership position in currency affairs offers significant gains. There are four notable advantages worth mentioning.
Firstly, there is the potential for seigniorage. When a country’s currency circulates across borders, it creates an implicit transfer, akin to a subsidized or interest-free loan from abroad. This transfer represents a real-resource gain for the entire economy. Taking the example of Federal Reserve notes circulating abroad, updated estimates suggest that the current savings has increased since the pandemic putting US Gross Savings (to GDP) back to the all time high of 17.8% (last time US Gross Savings was this high was in 1965). Additionally, there are interest payment savings on US government securities, which are highly appealing to foreign holders due to their liquidity. This aspect, referred to as “often neglected source of seigniorage” and can provide a “liquidity discount” amounting to billions per year. Realizing these potential seigniorage income, it becomes evident that substantial economic gains are at stake.
Secondly, the increased flexibility of macroeconomic policy is a significant advantage resulting from the use of a country’s currency to finance foreign deficits. Similar to monetary unions, cross-border circulation reduces the real cost of adjusting to unexpected payment shocks. By internalizing these transactions through credit, the need to rely on scarce foreign exchange diminishes. As a consequence, concerns about the balance of payments when formulating domestic policy are alleviated. The ability to finance deficits using one’s own currency grants policymakers more freedom in making monetary and fiscal decisions without being overly concerned about current deficits or exchange rates.
The third advantage is more psychological in nature and revolves around the gain of status and prestige associated with market dominance. Money has historically played a symbolic role for governments, fostering a sense of national identity alongside flags, anthems, and postage stamps. However, when a local currency is displaced by a more popular foreign currency, especially one as widely used as the US dollar, it erodes this critical role. The global use of the dollar constantly reminds foreign populations of America’s elevated position in the international community. Robert Mundell aptly noted that “great powers have great currencies.” Therefore, the dollar has become a potent symbol of American primacy, exemplifying the concept of “soft power”, influencing beliefs and perceptions. While challenging to quantify, reputation plays a significant role in international affairs and should not be underestimated.
Lastly, the use of the dollar grants the United States political power derived from the monetary dependence of other countries. On one hand, the issuing country becomes better insulated from external influence in domestic affairs. On the other hand, it gains a favorable position to pursue foreign objectives without constraint and exert international influence. Monetary power has been said to serve as a potent instrument of economic coercion, providing command over real resources. Denying another country access to the means necessary for essential goods and services renders it vulnerable politically. There have been studies that list several ways in which currency dependence can be exploited, including enforcement, expulsion, extraction, and entrapment. The widespread use of the dollar places these possibilities within the reach of US policymakers.
While these benefits are significant, they have limitations that tend to be more pronounced in the early stages of cross-border currency use. As confidence in a currency wanes and external liabilities accumulate, gains may diminish, particularly if an attractive alternative emerges, like how the Chinese are propping up their Yuan. Foreign holders may become legitimately concerned about the risk of future depreciation or restrictions on the usability of their holdings. Consequently, the autonomy of the currency leader may be partially constrained by the need to discourage sudden or substantial conversions in the exchange market. Seigniorage income and macroeconomic flexibility can also be reduced if sustaining market share necessitates a sustained increase in interest rates. Likewise, overt exploitation of political power can be hindered if foreign actors can easily switch to another currency. However, despite these limitations, the overall advantages remain significant, as recognized by various sources.
On the negative side, there are economic risks associated with formal dollarization, particularly concerning the conduct of US monetary policy. Notably, if a large share of dollars enters circulation abroad through formal dollarization, it could impose constraints on Federal Reserve decision-making. Sudden or frequent shifts in money demand from dollarized countries could generate net flows that increase short-term volatility in US monetary aggregates, making it challenging for the Fed to maintain a consistent course of action, especially in today’s environment where the Fed is largely seen to be struggling to contain inflation.
However, it is important to note that a substantial number of US banknotes is already in circulation outside the United States, with little noticeable impact on policy. The Federal Reserve acknowledges informal dollarization and already considers overseas circulation in its daily open-market operations. Furthermore, the additional sums involved in formal dollarization, even if multiple countries were to adopt it, are unlikely to have a significant practical effect on the relatively closed US economy.
Another remote possibility is the sudden decision of one or more dollarized countries to reintroduce their own currencies, triggering a mass dumping of dollars in global exchange markets. This could lead to a significant depreciation of the dollar and increased inflationary pressures in the United States. However, the probability of major defections is low due to the high exit costs associated with such a move. Even in the event of defections, unless a large number of states were involved, the impact on US policy would be limited.
So there you have it, even with some uncertainty it’s hard to deny how Argentina dollarizing (during a time when dedollarization is trendy) will benefit the Fed’s balance sheet and the US currently rising “soft power”, the timing of Argentina’s currency regime change couldn’t come at a better time for US, should Argentina’s Javier Milei win in their upcoming elections and push through with his campaign promise.