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Defending dollarization in Ecuador

I visited Quito and Guayaquil in Ecuador last month to speak at conferences celebrating the fifteenth anniversary of official dollarization. The conference in Quito was sponsored by the Universidad de San Francisco de Quito, headed by Dr. Santiago Gangotena; in Guayaquil by the think tank IEEP which is headed by Dora de Ampuero. Although dollarization is popular and successful, the government appears to be working to undermine it. Here are some highlights from the remarks I prepared.

Dollarization and Free Choice in Currency

The dollarization of Ecuador was not chosen by policy-makers. It was chosen by the people. It grew from free choices people made between dollars and sucres. The people preferred a relatively sound money to a clearly unsound money. By their actions to dollarize themselves, they dislodged the rapidly depreciating sucre and spontaneously established a de facto US dollar standard. (Many commentators refer to this decentralized process of voluntary currency switching “unofficial dollarization.” I prefer to call it popular dollarization, or dolarización popular.) Finally, in January 2000, Ecuador’s government stopped fighting their choice. Until that point the state tried to use legal penalties or subsidies to slow currency switching. Today the state threatens an attempt to reverse the people’s choice through legal compulsion. Such policy actions violate the widely accepted principle that the individual is sovereign over his or her own household property.

Everyone knows that free and open competitive markets better serve consumers (and producers) than state-granted monopolies. For example, it is clearly better for consumers to have several mobile phone companies competing for their business than to be subject to monopoly pricing from a single state-licensed monopoly. To make economic policy with the individual’s welfare in mind requires policy-makers to respect the principle of individual sovereignty in markets.

Many economists have thought, however, that currency is an exception to the rule. They don’t understand how there can be a competitive choice among currencies. Theory tells them that “network effects” ensure that a single monetary standard (silver, gold, US dollar, sucre, Mexican peso, euro, et cetera) prevails in any economy. The usual policy conclusion from this line of argument is that, since the market will only have a single provider in any case, the state should run the monetary system in the public interest.

Such economists are only looking at the blackboard and not at what is happening outside the window. (Evidently they have never lived where multiple currencies have been widely used.) Transactional network effects do exist, not only at the national level but at the global level: other things equal, you prefer to use the money that more of your trading partners use. Ecuadorans chose the US dollar over (say) the Swiss franc precisely because of such network effects. But current network size is not the only characteristic that matters to consumers and businesspeople when choosing among currencies for use in transacting, saving, or posting prices. The costs of holding and using a currency also matter. When people are free to choose, they will abandon an established currency, no matter how locally dominant, that is being so rapidly issued that its purchasing power is rapidly disappearing. If the established monetary standard could never be dislodged by free choice, then Ecuador would still be using the sucre.

Economists or policymakers who argue against a country’s dollarization, even when its people clearly demonstrate a preference for the dollar, either fail to think about dollarization as a market phenomenon that grows from individual choices, or they don’t believe that individuals deserve respect. Instead they think about the monetary system only as a tool to be engineered and manipulated by expert policy analysts (presumably themselves). They conduct themselves not as citizen advocates, but as technical advisors to the state.


Ecuador’s success with dollarization

Although some local critics of dollarization in 1999 predicted that the transition from the sucre to the dollar would cause a deep recession with high unemployment, the opposite happened. Due to high inflation, the people had of course already dollarized themselves by the end of 1999. Making dollarization official in January 2000 helped to complete the transition from the disorder of a collapsing currency to the calm of a relatively stable currency. The economy did not fall further into recession but responded with growth. After a steep drop in real output in 1999 (-4.74%), output growth returned to the positive range in 2000 (1.09%), then resumed a healthy pace in 2001 and 2002 (4.02% and 4.10%). Growth under dollarization has continued to be much healthier than under the sucre regime. From 2000 to 2013, Ecuador’s real GDP grew 75% in total, a compound annual rate of 4.4%. During the previous 13 years, 1987 to 2000, total real growth was only 36%, an annual rate of only 2.4%.

Today, the Ecuadoran economy is doing quite well on several standard macroeconomic indicators. The American economist Steve Hanke provides one way to rank its performance in his article in the magazine Globe Asia in May 2014. There he defines and applies a “misery index” in which a country’s current misery index = inflation rate + lending interest rate + unemployment rate (all bad things), minus per capita GDP growth over the previous year (a good thing). Venezuela has the worst score, the #1 highest measured macroeconomic misery not only in South America, but in the world. Ecuador’s score is the best in South America. Is dollarization responsible? Yes. The only two countries with better scores in Latin America are El Salvador and Panama, the only other dollarized countries.

Dollarization has also brought improvement to Ecuador’s banking system, according to two analysts at the Federal Reserve Bank of Atlanta. Mynam Quispe-Agnoli and Elena Whisler, in a 2006 article, noted correctly that dollarization, by ruling out an official lender of last resort able to create dollar bank reserves with the push of a button, eliminates an important source of moral hazard. In this way dollarization has the potential to reduce risky bank behavior, and thus so “make banks runs less likely because consumers and businesses may have greater confidence in the domestic banking system.” Lacking the expectation that “the monetary authority would come to the rescue of troubled banks” whether solvent or insolvent, banks in a dollarized system “have to manage their own solvency and liquidity risks better, taking the respective precautionary measures.”

We have long seen this benefit realized in the stability of banks in offshore centers like the Cayman Islands, the Bahamas, Jersey and Guernsey, and Panama, which have no official lenders of last resort – and no crises. The Atlanta Fed analysts saw it being realized in Ecuador as well. Ecuadoran banks now hold higher reserves and a greater share of liquid assets overall, and hold safer asset portfolios than in the 1990s. Just as importantly, because it has eliminated large swings in the inflation rate and in the expected inflation rate, dollarization “fosters an environment beneficial to financial intermediation.” In particular, it encourages the public to hold greater bank deposits (the ratio of deposits to GDP in Ecuador, which was just below 20 percent in 2000, is today just above 30 percent) and thereby provides a greater volume of funds to investors. On the lending side, loan quality has improved because banks no longer face loan default risks due to exchange rate swings that render borrowing firms unable to repay. Meanwhile, as compared to a system with partial dollarization, banks themselves have become less prone to large devaluation losses, because dollarization eliminates the devaluation risk that used to arise from currency mismatches on bank balance sheets.

While 15 years is only a fraction of a century, it is not too much to hope that Ecuador’s banking system is following in the path of Panama’s. With more than a century of dollarization, Panama has the deepest financial markets and most efficient banks in Latin America.

To summarize, official dollarization in Ecuador has (1) lowered inflation, (2) fostered financial deepening and thereby real growth, and (3) lowered transaction costs for importing, exporting, and making remittances. What it has not done, of course, is to limit the growth of government spending while government revenue has grown, although it has eliminated the ability to cover deficits by printing money.


Ecuador’s prospects

While we celebrate Ecuador’s fifteen years of success with dollarization, and think about extending it, we must take note of two dark clouds on the horizon.

First, Ecuador still has a central bank. Although the BCE is presently precluded from issuing paper currency, it continues to be assigned by public law “the responsibility of implementing the monetary, credit, foreign exchange and financial policies formulated by the Executive.” Why? We should have no doubt that the Executive would dearly love to once again have a monetary policy to conduct. We should expect the BCE’s own funcionarios to seek to enlarge the scope of the bank’s discretionary powers, if only in the sincere hope that they could do more good. But we know that the direction of greater discretion in monetary policy leads back toward the conditions of 1999. With dollarization, a central bank is completely unnecessary.

Second, I have been learning with concern – as I am sure you have – about the plans of the national government of Ecuador to issue its own digital mobile-phone currency. The idea is for the Banco Central to issue dollar-denominated electronic credits that customers of the government-owned mobile phone network CNT can use to make payments by phone. As the Associated Press reported August 2014: “Such mobile payments schemes are already popular in African nations including Kenya and Tanzania, where they are privately run. The new currency was approved, and stateless crypto-currencies such as Bitcoin simultaneously banned, by Ecuador’s National Assembly last month. The official in charge of the new currency, Fausto Valencia, said the software is already used in Paraguay by cellphone companies.”

There is no reason to believe that a national government can run a mobile payment system more efficiently than private firms like Vodafone (which originated and runs the successful M-Pesa system in Kenya) and Tigo (which runs the Giros Tigo system in Paraguay). Why not let the private mobile phone companies also compete to provide mobile payments in Ecuador, issuing their own dollar-denominated account credits? Instead they are banned unless they use the government’s credits. Such a ban is costly to ordinary consumers. Evidence from around the world shows that payment by mobile account credits is the type of service that firms in a competitive market can produce, will produce when there is a normal rate of return to be earned, and produce at lower cost than state-owned enterprises.

The government insists that its new system will be “voluntary.” But when the state gives itself a monopoly on a service, blocking individuals from the voluntary choice to use another provider, the option to “take it or leave it” is not fully voluntary. If the government sincerely wishes to help the poor and unbanked, it should let private providers enter the competition, which will drive down the fees that the poor and unbanked will have to pay.

It is very curious that a law supposedly seeking to provide the poor with low-cost access to payment systems would ban Bitcoin. (The only other country in South America to ban Bitcoin appears to be Bolivia.) In countries that receive income from remittances, Bitcoin has the potential to noticeably increase national income by lowering the cost of remittance. What the family in the home country receives is much closer to the amount that the worker abroad has paid to send when the worker uses Bitcoin rather than Western Union or another old-fashioned high-priced system. Researchers at the Pew Center in the United States estimate that remittances account for about 3% of Ecuador’s GDP. In 2012 the average Ecuadoran working in the United States sent home $2607 dollars. So this is not a trivial matter. Bitcoin remittances could contribute many dollars to the pockets of Ecuador’s poor.

A report from the news service Payment Week says of the government’s mobile payment project: “The currency will serve as… a way for the country to regain some control over its economic system. The production of the new currency would completely depend upon demand.” But these two sentences can’t both be true. The new system can’t both allow the government to “regain some control” over the economy and also make the volume of credits “completely depend on demand,” which implies that the government is passive and exercises no control.

Given that is doesn’t make economic sense, why does the government want to issue mobile payment credits as a monopolist? It seems likely that the project is meant as a fiscal measure. One million dollars held by the public in the form of government-issued credits is a million-dollar interest-free loan from the public to the government. According to Payment Week, “The government has said it won’t use the [new] currency to fund public spending,” but this is hard to fathom. If the project makes a profit, where else would the profit go?

If the government can make a profit at mobile payments, even though they have no expertise or comparative advantage in the area, surely Movistar or Claro can operate more efficiently and make larger profits, even while charging lower fees. Why not let the private sector operate in this area? Why not let the public choose which firm has the most reliable and trustworthy service? If the government desires to subsidize the use of the service by the poor, it has the option of issuing them vouchers. It need not provide the service itself, and certainly not as a monopolist.

Personally, I would find dollar-denominated account credits that are claims on Movistar or Claro more credible than claims on the government of Ecuador. After all, unlike the government, neither company defaulted on its bonds in the past 12 years. Claims on private companies are legally enforceable. The company cannot suspend payment or devalue its IOUs without taken to court and forced to pay or dissolve. Competition for business compels payment firms them to worry about reputation, and so compels them to manage the business so that their readiness, ability and willingness to pay is not in doubt. A government agency, by contrast, cannot be sued for breach of contract, and has no concern about maintaining a good reputation when it has no competitors. If CNT or the BCE decides to devalue mobile credits against the US dollar, holders have no remedy in court. People who are thinking about holding the credits need to consider the default risk. The “backing” requirements in the law are completely toothless against a government that chooses to default.

In sum, there is no plausibly efficient or honorable reason for the Ecuadoran government to go into the business of providing an exclusive medium for mobile payments. Consequently it is hard to make any sense of the project other than as fiscal maneuver that paves the way toward official de-dollarization. I gather that President Correa does not like the way that dollarization limits his government’s power to manage the economy. He has compared the limitation to “boxing with one arm.” But as I have already emphasized, retiring the government from boxing against the economy by means of money-printing is precisely dollarization’s great virtue.