An interesting debate has arisen in Ecuador during recent weeks over the following proposition advanced by authors at a Quito think tank: a dollarized country shouldn't reduce its tariffs when the dollar is overvalued relative to the currencies of its regional trading partners (according to purchasing-power-parity measures) because that would undermine its "competitiveness" in export market. As several commentators have noticed, this is reminiscent of the Mercantilist view that a country will lose too much of its gold if it does not discourage imports with tariffs or promote exports with subsidies, a view that David Hume and Adam Smith debunked long ago.
The debate began with the publication of an essay by José Hidalgo Pallares and Daniel Baquero for CORDES, a leading economic policy think tank in Quito. They proposed that it is not "convenient" to reduce the general level of tariffs at the moment, with a strong dollar already making imports cheaper and exports more expensive for Ecuador, and with the economy operating at below capacity. Their concerns were macroeconomic and balance-of-payments related: "In recent years, imports have also grown more than exports … [T]he trade balance, which is one of the main components of the current account, registered a deterioration: from a surplus of $227 million in the first quarter of 2018 to one of just $2 million in the same period of 2019." Reducing tariffs across the board, they argue, "would mainly favor consumer goods," whereas "to revive the Ecuadorian economy, it is more advisable to take measures that really allow some recovery of external competitiveness, in order to encourage exports. Here fits an efficient labor reform, the elimination of excessive paper work[,] and trade agreements" that give Ecuadoran products better access to foreign markets. (This and all other translations are mine, Google-aided.)
Critical response to the essay was swift. Gabriela Calderón tweeted incredulously that CORDES, for years a strong critic of the tariff surcharges imposed by then-President Rafael Correa supposedly to "safeguard" dollarization, was now adopting the Correa position: "Amazing! Spend 10 years complaining about Correa and then reproduce his erroneous arguments in favor of trade restriction."
I will argue that the CORDES proposition – namely that the advisability of a unilateral general tariff reduction depends on macroeconomic conditions – is mistaken. In a nutshell: The stock of money and the price level are self-regulating for a small country under dollarization. The size of Ecuador's economy (gross domestic product) is comparable to that of Mississippi. Both are dollarized. What is true for Mississippi, in regard to the balance of payments, is also true for Ecuador: When the local prices of traded goods are too high for equilibrium with neighboring countries, arbitrage will bring them down. The problem of overvaluation that reduces Ecuador's export competitiveness will resolve itself by a combination of (1) internal adjustments (input price reductions or productivity increases) that lower the cost-covering prices local producers need to charge when exporting goods, and (2) rising nominal prices in the trading partners (Colombia, Peru) whose currencies are presently relatively undervalued in exchange markets because inflation higher than Ecuador's is anticipated.
Lowering tariffs does not make money tighter or looser, or impede the adjustment process, in any appreciable way. Dollars will flow out of Ecuador (a "negative" balance of payments) if and only if the current stock of dollars exceeds the Ecuadoran demand to hold dollars given the current international purchasing power of the dollar. The dollar's international purchasing power is effectively parametric or given to Ecuador, not affected by its policies. The Ecuadoran demand to hold dollars is approximately unaffected by the level of its tariffs. If anything, lower tariffs will slightly raise the country's real income, which will increase real money demand and draw dollars in. In general, the balance of payments reflects a monetary self-correction process and flows will return to normal as the process runs its course.
(By the way, the Federal Reserve Chairman Jerome Powell has lately advanced a somewhat related and equally false proposition, that looser money can usefully offset the reduction in real income from higher tariffs.)
Many Ecuadoran critics of the CORDES proposition have stressed a different and equally valid, but microeconomic, point: Lower tariffs on imported goods are better for consumer welfare whether the exchange rate is floating against all currencies or is instead fixed to the US dollar. Having a strong currency does not overturn the desirability of lower tariffs.
Franklin López, however, has cogently emphasized that the proposition's fear of excessive money outflows violates the modern theoretical and empirical version of Hume's analysis, known as "the monetary approach to the balance of payments." And Gabriela Calderon has noted that the price-dollar-flow analog of the Humean price-specie-flow adjustment mechanism applies to Ecuador, whose citizens live "in the closest thing to the gold standard in the modern world," a system in which "[t]he money supply is on automatic pilot and … the supply of currency is determined by Ecuadorians."
In a reply to one critic of his essay, José Hidalgo Pallares makes it clear that, rather than recognizing the balance of payments as an endogenous variable for a dollarized economy and treating deficits or surpluses (inflows or outflows of dollars) as artifacts of a process that equilibrates money demand and supply, he persists in thinking of the trade balance as a causal or even exogenous factor: "For a dollarized country, the result of the balance of payments is very relevant since it determines whether the amount of "primary money" in the economy grows (when there is a surplus) or shrinks (when there is a deficit)." Rather than recognize that a balance of payments deficit (dollar inflow) persists only until the demand for dollars is satisfied, then stops, Hidalgo Pallares sees no equilibrating mechanism at work: "But in a context of loss of external competitiveness … unilaterally reducing tariffs … can cause recurrent deficits in the balance of payments. These, by reducing the amount of primary money could produce a credit crunch with negative effects on activity and employment, putting at risk the viability of dollarization even socially." [Emphases added.]
Fundamentally, the CORDES proposition errs by thinking that the Ecuadoran government needs to choose policies to manage the country's dollar inflows and outflows. As Hidalgo Pallares' reply puts it: "The desirable solution [to an outflow of dollars, seen as a problem rather than part of a corrective mechanism] is to encourage a permanent income of dollars, for example by creating an environment conducive to foreign investment or achieving better access conditions for Ecuadorian products in foreign markets, which would also generate positive effects on employment." Those are both laudable policy paths to enhance Ecuador's real income, but they are not at all needed to make sure that Ecuador retains enough dollars. The stock of dollars in Ecuador, as in Mississippi, will manage itself.