For release: Oct. 30, 2001
Contact: Charles B. Henderson, (314) 444-8311

ST. LOUIS -- Some countries that have adopted everything American from rock music to blue jeans may also be considering adopting the U.S. greenback as legal tender. Before that happens, however, policymakers in those countries, as well as in the United States, should consider the potential drawbacks as well as the benefits.

That's the view of economists Gaetano Antinolfi and Todd Keister. Their analysis of the growing literature on "dollarization" appears in November/December issue of Review, the bimonthly journal of business and economic issues published by the Federal Reserve Bank of St. Louis.

Ecuador and El Salvador have recently adopted the U.S. dollar as legal tender, replacing their own national currencies. At the same time, this move has received serious attention in policy debates in both Argentina and Mexico. "The current interest in official dollarization is largely a reaction to the recent string of currency crises," said Antinolfi and Keister.

The economists found that two of the primary benefits of dollarization are the elimination of exchange rate volatility and exchange rate crises, as well as a substantially lower inflation rate in most cases. They noted that one of the drawbacks, however, is the loss of monetary policy but even that may have a silver lining. "If it enhances the credibility of the adopting country's economic policy," they said, "dollarization could lower interest rates and substantially decrease the likelihood of future financial crises."

One cost of dollarization is the loss of revenue from seignorage the income that a nation derives from the ability to print money. Antinolfi and Keister said that for some countries, this is an important source of revenue. Even under a currency board, newly printed domestic money is used to buy interest-bearing foreign reserves and dollarization entails losing this interest. "In the case of a country such as Argentina, this has been shown to be about 0.2 percent of GDP, or $658 million a year," they said.

Losing seignorage revenue would require a government to decrease spending, increase taxes or increase borrowing. "To the extent that the loss of seignorage revenue is compensated by an increase in government borrowing, it may not be the case that a stable currency necessarily provides more macroeconomic stability," they said.

Antinolfi and Keister found that some studies suggest that dollarization may also undermine the incentives for fiscal responsibility in other ways as well. "If that is the case," they said, "should it be accompanied by legal restrictions on the government budget deficit, as was done with the European Monetary Union (EMU)? It's important to note that in the case of the EMU, the members relinquished control to a common central bank to conduct monetary policy. Legal restrictions on the budget of a government that adopted dollarization would constrain an already-shrunken set of policy alternatives, which could prove very costly in an economic downturn."

Another argument against dollarization is that it would severely limit the ability of a central bank to act as a lender of last resort when the banking sector is in distress. "When a domestic currency can be printed freely, the central bank can always meet a demand for liquidity by lending cash to the banking sector," they said. "In a dollarized economy, however, the central bank would not have unlimited resources to lend. As a result, there is a fear that giving up this ability to print currency will make these types of crises more frequent or more severe."

Although most of the arguments for or against dollarization have been stated from the perspectives of the adopting countries Antinolfi and Keister emphasized that the United States should have a keen interest in the issue as well. "When Ecuador and El Salvador adopted the dollar, the impact on the United States was minimal," they said. "It's doubtful that the same could be said of Argentina or, especially, Mexico, because of the larger size of their economies."

The financial integration with the United States that could follow dollarization is usually considered to be a major benefit, while at the same time giving U.S. monetary policy stronger effects abroad. "Suppose, for example, that a recession occurs in a dollarized Mexico, calling for a looser monetary policy, while events in the United States call for a tighter policy," they said. "U.S. policymakers could ignore events in Mexico, but doing so could cause an increased flow of illegal immigrants into this country."

Antinolfi and Keister concluded that although several countries are seriously considering adopting the dollar as their currency standard, the few small countries that have done so are not necessarily benchmarks for what may follow in larger countries. "The fact is, we just don't know how large the costs and benefits would be," they said. "But those potential benefits and costs need to be weighed well in advance of taking such an action."

Subscriptions to Review are available by calling (314) 444-8809. With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. In addition to serving as a bank for depository institutions and the U.S. government, each Reserve Bank monitors economic conditions in the District, participates in formulating monetary policy, and supervises state-chartered member banks and bank holding companies tofoster safety and soundness of the District's banking and financial institutions and to protect the credit rights of consumers.

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