In the late 1990s, as the Banco Central de Ecuador rapidly expanded the quantity of its currency the sucre, prices denominated in sucres soared into hyperinflation. Ecuadorians in response spontaneously adopted the US dollar as a far safer savings vehicle, a far less chaotic pricing unit, and a far more reliable medium of exchange. Demand to hold sucres all but disappeared. With the collapse of the sucre Ecuador’s government finally bowed to the market verdict and officially dollarized in January 2000. (I have previously written about these events here).
Dollarization has been a clear success. The Ecuadoran monetary and banking systems have been much more stable and trustworthy (real bank deposits have grown considerably) since dollarization, and the economy has enjoyed better growth despite being ruled by a political party that speaks and acts in anti-market tones. Because of its success, dollarization is enormously popular. Even President Rafael Correa, who has complained that dollarization is a “straitjacket” because it prevents expertly managed monetary policy (this is in fact its greatest virtue), promises not to undo dollarization.
This background is useful for considering a recent Wall Street Journal news analysis article entitled “Cheap Oil and Strong Dollar: Ecuador’s Twin Troubles” by Carolyn Cui and Manuela Badawy. As many other writers have done, Cui and Badawy suggest that dollarization is currently hurting Ecuador, that the country “has the misfortune to be an oil producer with a ‘dollarized’ economy that uses the U.S. currency as legal tender.” Compared to what are these misfortunes?, one wonders. Having oil resources is better than not having them (provided that the wealth is not entirely squandered in battles to control it). And being dollarized has clearly been better for Ecuador than the unanchored monetary policy that preceded it.
Cui and Badawy acknowledge that “dollarization helped officials rein in inflation in 2000.” But this is oddly put. Dollarization is not a policy that local experts can manipulate as a tool, so it is odd to say that it “helped officials” to reduce inflation. Dollarization itself has reined in inflation. Local officials merely got out of the way. Under dollarization, arbitrage in traded goods ties the dollar price level in Ecuador to the dollar price level in the United States, more or less tightly, just as it ties the California price level to the overall US price level. Inflation rates cannot widely diverge. No local management is needed.
Cui and Badawy immediately continue with the supposed downside: “Now, it [dollarization] is depriving them of the relief valve a depreciating local currency can provide at a time when the drop in oil prices is hurting its exports.” This is exactly the line taken by President Correa, who a year ago said that “Dollarization was a bad decision” and that “Right now, it is doing exactly the opposite of what it must do to address the scenario of falling oil prices.”
How might a depreciating currency provide a “relief valve” in a period of declining oil export revenues? Relief can’t come from changing the world prices of Ecuador’s other main exports. Just as oil is competitively and flexibly priced in dollars on world markets, so too are fresh flowers, fresh fruit, and seafood. Flowers grown in a weak-currency country do not have a selling-price advantage over flowers grown in a strong-currency country. The coherent argument for a “competitive depreciation” is rather that considered in dollar terms it cuts wages and other input payments that are priced in local currency. Such input price reductions, the argument goes, are appropriate given the reduced demand for labor and other inputs that follows from the drop in oil revenue (or similar negative productivity shock), and depreciation makes the reductions faster (in a world of “sticky” wages and prices) than can be achieved by waiting for unemployment to force reductions in nominal wages and other input prices. Non-oil export businesses can take advantage of higher profit margins to expand their output and sales.
For the sake of argument, let us suppose that a prompt reduction of wage rates in dollar terms by a certain percentage is indeed called for in this case, and that a timely and well-measured depreciation of the local currency could accomplish this. Is this a cost of dollarization? Yes. It is nonetheless a mistake to think that it follows that the country would be better off with a monetary regime in which the currency sometimes depreciates against the dollar. Depreciation is not a measure that can be considered in isolation. It is only possible under a different monetary regime. We need to compare total costs and benefits of alternative regimes. Or in statistical terms: a regime that commits some Type I errors may still be much better than a regime that commits massive costly Type II errors.
There are two alternative regimes to dollarization to consider: an adjustable peg against the dollar and freely floating exchange rates. The first problem with an adjustable peg is that no expert knows in real time exactly how much wages and other input prices should be cut in dollar terms, and therefore the central bank cannot know just how much to devalue the currency against the dollar. It can easily err in the direction of overdoing it. The second and larger problem is that a pegging regime is simply not viable in a world of free capital flows. When the market begins to suspect that a devaluation is coming, speculators attack the currency, draining dollar reserves from the central bank, and forcing a devaluation that is likely to be larger than what was theoretically desired.
A freely floating exchange rate regime avoids the problem of speculative attack. And the market rather than the local central bank adjusts the exchange rate. But floating has its own fundamental problem: it removes the constraint that dollarization provides against the chronic problem of excessive money creation by the central bank. The “fear of floating” historically exhibited by many Latin American countries is justified: floating makes the inflation rate and the exchange rate unpredictable, which damages local capital markets and the financing of productive investment. High devaluation risk means highly risky real returns on long-term claims denominated in the local currency (call it “pesos”). The market for long-term peso bonds and mortgages evaporates. Foreign investors with dollars are similarly discouraged from bringing them into the peso economy by devaluation risk. Economic growth suffers.
The relevant alternative to dollarization is thus not an imagined regime in which precisely calibrated depreciations of the local currency’s exchange rate are administered by experts just when needed to adjust wages, an improvement over dollarization at no cost. To give a central bank like Ecuador’s discretion in issuing its own currency is to discard the dollar anchor that currently holds the public’s inflation expectations in place and thereby stabilizes the system. There is no way for the central bank to make a credible pre-commitment to use depreciation only for warranted real wage corrections. The replacement of the dollar by a New Sucre that can be depreciated by the Banco Central would immediately be greeted by justified suspicion that, as with the old sucre, the New Sucre will be copiously issued and depreciated. Few would voluntarily switch from dollars to the New Sucre. Forced conversions of currency and deposit holdings would be necessary to get the new currency into circulation, hardly a sign that the new regime would improve consumer welfare. Inflation expectations would once again be unmoored, and indeed the public would justifiably fear a return to very high inflation. Speculative attacks would likely drive depreciation far beyond any extent desired by the experts. Exchange-rate chaos would return.
The lesson here is that Ecuador’s exchange rate against the dollar cannot be re-pegged while the benefits of dollarization are retained. Re-pegging implies a fundamental change in the monetary regime, which history and theory tell us would be a strong turn for the worse. The suggestion that dollarization is hurting Ecuador is based on a very myopic accounting of the costs and benefits.