Mr. Chairman, thank you for the opportunity to testify on the issue of dollarization and your proposed legislation that would establish a framework for potentially sharing seigniorage with countries that decide to dollarize. Given the interest in dollarization recently expressed in several Central and South American countries, your initiative is highly relevant. The issue of dollarization has many economic, financial, and political dimensions. In my testimony this morning, I focus primarily on the economic and financial aspects.
As the Administration has stated in prior testimony on the subject of dollarization, we do not have a view on whether dollarization is advisable in general. Each country, in principle, can dollarize unilaterally, and it must bear the responsibility to decide in light of its own economic and political circumstances if dollarization is the appropriate policy to pursue.
From the U.S. perspective, as Secretary Summers testified last April, it would not be appropriate for U.S. authorities to adjust the procedures or orientation of U.S. monetary policy in light of another country's adoption of the dollar; to extend banking supervision to that country's banks; or to provide access by those banks to the Federal Reserve's discount window. We have not changed our view. On the issue of sharing seigniorage, as we have said earlier, Congressional action would be required to permit the United States to pay seigniorage to a dollarizing country. Further, we believe strongly that, during the process of deciding whether to share seigniorage with any given country, there should be extensive consultation by the Administration with the Congress to limit the scope for subsequent problems. The technical issues associated with dollarization are many and complex, and we also would certainly want to draw upon the expertise of other agencies, including the Federal Reserve.
Considerations for dollarizing countries
A country's decision to end the legal tender status of its national currency and to bestow that status on the U.S. dollar is momentous regardless of the circumstances. The reasons a country may choose to dollarize can be varied, and the benefits are potentially significant. However, it is essential to remember that dollarization cannot substitute for sound macroeconomic policies, robust institutions, and flexible markets. The principal economic benefits of dollarization are the credibility and policy discipline derived from its implicit irrevocability. Its principal economic cost is the renunciation of national monetary autonomy.
The basic trade-off associated with dollarization is between the advantages and disadvantages of a regime with some degree of exchange rate and monetary policy flexibility and a regime with none. Exchange rate adjustment is a potential shock absorber and also allows greater scope for national monetary autonomy. However, that potential must be balanced against the added macroeconomic policy discipline and credibility associated with rejecting all scope for discretionary monetary policy and adopting the currency and monetary policy of another country with such credibility. As in all meaningful trade-offs, judgments about the appropriate balance can differ across countries and their circumstances. Moreover, sound fundamental policies and institutions are needed to underpin any credible currency regime. In particular, a dollarizing country, like all countries, should have a sustainable fiscal position, a healthy banking system, flexible and well-functioning labor markets, open capital markets, and an environment in which private property is respected and contracts are enforced.
In addition to assessing its economic fundamentals, a country considering dollarization must weigh carefully the potential benefits against the potential costs. On the one hand, the implicit irrevocability of dollarization holds the promise of lower interest rates, lower inflation rates, higher levels of economic activity, greater financial stability, and deeper financial markets. These benefits can be expected to be especially attractive to a country with a record of financial instability and high inflation, but financial and fiscal crises may still occur with dollarization.
On the other hand, the monetary authorities of a dollarizing country would be ceding the capacity to use monetary or exchange rate policy to cushion the economy against economic or financial disturbances. Moreover, there is no guarantee that the exchange rate used to convert a country's domestic currency into dollars, thereby fixing that exchange rate irrevocably, will be the right exchange rate for the near term. Setting that conversion rate either too high or too low could have adverse implications for the real economy's short-term performance. Over time, if domestic prices and wages cannot adjust rapidly in response to disturbances, dollarization could also mean greater volatility in output and employment. Dollarization should not greatly impede the ability of the authorities to provide very short-term liquidity to individual banking institutions, but the authorities would lose much of their scope to respond to a systemic threat to the banking system.
For a country that has already made a strong commitment to a permanently fixed exchange rate, the balance of considerations with respect to dollarization differs. The scope for adjustment working through the exchange rate or domestic monetary policy is, in principle at least, already limited. Therefore, the effective costs of dollarizing may be lower along with the effective benefits. However, even a fixed exchange rate regime has an exit option, which is presumed to be lost with dollarization. Nevertheless, it is worth noting that many observers, including Paul Volcker, have suggested that in the wake of continuing globalization, the years and decades ahead may see a dramatic decline in the number of independent currencies in the world.
Considerations for the United States
Obviously, countries can choose to adopt the dollar as legal tender without our assent. However, we hope and expect that countries would consult with us in advance because there are potential benefits as well as costs to the United States from the adoption of such a policy. The benefits include increased seigniorage; reduced transaction costs for U.S. resident importers, exporters, borrowers, and lenders; the possibility of increased business for U.S. banks and other financial institutions; and the "power and prestige" that might be associated with having a more international currency. Indirectly, the United States would benefit from increased economic activity or greater financial stability that would be expected in the countries that dollarize successfully.
However, dollarization also involves potential costs or burdens for the United States. U.S. economic and regulatory policy makers could come under pressure from the authorities of the dollarized country to help support their economy's economic and financial stability. Questions have likewise been raised about the possible impact on attitudes toward the United States in a dollarized country at times of financial stress. To the extent that dollarization furthered economic and other ties, this would normally be expected to be seen as a benefit to both the United States and the dollarized country. However, in difficult times, or when U.S. monetary policy is considered inappropriate or inconvenient for the dollarized country, there would be the risk that U.S. policies would foster resentment and encourage policy makers to deflect blame for their countries' problems onto the United States. Finally, if a substantial number of large countries should choose to dollarize, the monetary and exchange rate flexibility currently enjoyed by the United States itself would potentially be reduced.
A decision by another country to adopt the dollar as its currency would increase U.S. seigniorage revenues --in effect lowering the cost of financing U.S. government debt and improving the U.S. fiscal balance - because such an action would be expected to lead to increased holdings abroad of dollar currency. However, the size of this increase in the short run, let alone over time, remains an unanswered empirical question. The question of whether it would be appropriate to share those revenues or savings is an important public policy question.
As noted above, dollarization may bring potential benefits to the United States as well as the dollarizing country, but also potential costs.
Looking at seigniorage sharing narrowly, in principle, a decision by the United States to share the seigniorage revenues associated with the increased amount of dollars in circulation as a consequence of a country's decision to dollarize would not cost the U.S. taxpayer anything. However, if a country would have dollarized anyway, or has large amounts of dollars circulating already, then sharing seigniorage by the United States would imply foregoing additional seigniorage revenues. At the same time, if the benefits of dollarization to a country are significant, they should outweigh the lost seigniorage. In other words, the deciding factor for either country should not be whether seigniorage would be shared.
One added potential risk to the United States from the sharing of seigniorage is that it may imply a degree of U.S. endorsement or ownership of a country's decision to dollarize. Unless carefully designed and implemented, dollarization also could lead to unintended legal or financial complications and potential liabilities for the United States, particularly if a country seeks creative ways to meet its banking system's short-run liquidity needs - to provide lender-of-last-resort support for the domestic banking system - by securitizing potential seigniorage flows.
Sharing of dollar seigniorage raises complex questions. For example, where would we draw the line on the sharing of seigniorage? If the United States decided to share our increased seigniorage with one dollarizing country does that mean we would stand ready to share it with all countries that we view as meeting the economic criteria for dollarization and seigniorage sharing? How would we decide the right amount of seigniorage to share?
Senator Mack's proposed legislation suggests answers to some of these questions. He has contributed importantly to the intellectual debate on both dollarization and seigniorage sharing. The proposed legislation is one approach to arrangements for potential seigniorage sharing, that is, pass legislation to give the Treasury Secretary discretionary authority to rebate seigniorage to a specified degree to any country that makes such a request as long as it meets certain conditions. That approach has the advantage of providing a country that is considering dollarization with a framework within which to contemplate its decision and, in the process, may encourage responsible dollarization.
On the other hand, each country is likely to come to its decision to dollarize in the context of different economic, financial, and political circumstances, and U.S. attitudes toward that decision may differ depending on those circumstances. Another approach, therefore, would be to wait until a country makes a concrete request to share seigniorage and then consider specific legislation that would enable us to do so under the particular circumstances.
Let me mention some of the technical issues and complexities that would be involved in seigniorage sharing. The calculation of the appropriate amount of seigniorage to share is tricky. The Federal Reserve has only estimates of the total amount of dollars circulating outside the United States. We have no way of knowing the actual amount circulating abroad, and estimates of the amount used by the residents of any one country are even rougher. Thus, any formula for sharing seigniorage inherently would be only an approximation of the actual seigniorage "lost" by the dollarizing country or "gained" by the United States as a result of a country's decision to dollarize.
If it were decided to adopt seigniorage sharing as U.S. policy, important implementation challenges would arise in order to have reasonable confidence that the "right" amount is shared. U.S. taxpayers would want some assurance that they are not being exploited by seigniorage "rebates" to foreign countries in excess of additional seigniorage that is being "gained" by the United States. While the approach suggested in the proposed legislation is plausible, several considerations would arise about its actual implementation. These include:
§ Recognition that we would have no way of knowing the actual amount of U.S. currency in circulation in a given country at any point in time.
§ Second, it can not be fully guaranteed that a country would not receive more than its "fair share" of seigniorage revenues. For example, the formula in the Chairman's proposed legislation assumes implicitly that the dollarized economy has the same income elasticity of demand for currency as the United States and other countries in the world that use dollars. If the income elasticity of demand for currency was lower in the dollarizing economy, seigniorage sharing calculated by the formula would be too large. This would also be the case if the demand for cash in the dollarizing country were to fall as the demand for other monetary aggregates rose, for example, as a result of enhanced intermediation or the repatriation of flight capital.
§ Third, some might raise questions about the appropriate interest rate to use as a proxy for the opportunity cost of holding cash in dollars. This is also not a matter that can be settled on a factual basis. One could argue that the interest rate on U.S. government bonds would be appropriate because that rate most closely reflects the long-term liability nature of money. One could also argue that the 90-day Treasury bill rate as specified in the proposed legislation is more appropriate because it is a good proxy for the opportunity cost of holding reserves, as well as for the net return on the Federal Reserve's portfolio. Given the generally upward slope of the U.S. yield curve, the use of a short-term interest rate has the added benefit of being more conservative from a U.S. perspective than the use of a long-term rate. A third concept might be the rate that the dollarizing country would have earned on its dollar-denominated assets, which depends on the composition of its portfolio of such assets.
§ Fourth, any approach for sharing seigniorage with countries that have already officially dollarized inherently cannot be expected to reflect with complete accuracy a country's actual holding of dollars now or in the future.
§ Fifth, some might raise questions about whether there should be allowance for the ex-ante partial, but substantial, dollarization of countries, such as Argentina, that ultimately decide to fully and officially dollarize.
Nevertheless, these questions have reasonable answers as long as one is prepared in some instances to be satisfied with less than full precision.
I should also note that an approach to sharing seigniorage by means of paying interest on a consol issued by the United States would raise issues about the status of this security under the laws that govern the management of U.S. debt. Moreover, issues about the budgetary treatment and the full legislative implications of sharing seigniorage would have to be addressed.
Let me make one final comment on Chairman Mack's thoughtful legislation. The ten factors that the Treasury Secretary would be required to take into consideration in determining whether to certify that a country has officially dollarized, and is eligible for seigniorage sharing, are definitely relevant to any such determination. However, there may be other important factors to consider as well before we decide to share our increased seigniorage. For example, dollarization is more likely to succeed in a given country if, at the time of dollarization, a country's foreign reserves cover at least the local currency in circulation, and the commitment of the country's citizens to dollarization is high. Furthermore, the economic and financial context in which dollarization takes place can also play an important part in determining its success. Dollarization as a part of a coherent long-term economic strategy is likely to be a more successful than dollarization in response to a financial crisis. The latter is more likely to involve hasty decisions with unforeseen consequences.
In conclusion, again I want to commend you, Mr. Chairman, for your thoughtful proposal and many contributions to a complex and increasingly relevant policy discussion. We will want to continue an open dialogue with Congress and other interested parties as we proceed to analyze further the many facets of this subject.
Thank you, Mr. Chairman, and the other members of this subcommittee for your time. I will be happy to respond to any questions.
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