Senate Banking, Housing and Urban Affairs Committee

Subcommittee on Economic Policy
Subcommittee on International Trade and Finance


Hearing on Official Dollarization in Emerging-Market Countries


Prepared Testimony of Dr. Wayne Angell
Chief Economist
Bear, Stearns & Co. Inc.


10:00 a.m., Thursday, April 22, 1999

I am delighted to have the opportunity to testify before the Joint Subcommittees on the subject of dollarization.

Never before have countries in the America's been free to choose one single policy step--dollarization--that would do so much to increase the well being of their people. The opportunity to use the dollar as a single currency would elevate consumers to become judges of the effectiveness of domestic producers. For the first time, domestic producers could earn the same dollars at home as they now seek in the export market.

If Mexico and Argentina were to adopt the dollar as their single currency, then the effect of a match-up of domestic savings and domestic capital spending would no longer initiate exchange rate and funding problems. High real interest rates on dollar obligations already attracts outside saving. Adding Mexican and Argentine savings and capital spending demand to the pot would hardly be noticed. But, most important, capital flow disruptions based on other non-dollar zone devaluations could no longer be a hindrance.

For Mexico, it is likely that dollarization would add as much as five, and perhaps up to ten, percentage points to the annual rate of economic growth over the next ten years. The most significant boon to Mexico would mean that all businesses would have greater access to capital at market determined dollar interest rates. The most serious restraint on economic growth is that all economic growth in Mexico is confined to the Maquiladora export sector. Over the last three years, growth of employment in Maquiladora industry has averaged 15.8 percent while total employment growth in the manufacturing, including Maquiladora, has averaged only 3.4 percent. Since devaluation in December 1994 the domestic sector growth rate has ranged from zero to a negative three percent.

Argentina has already enjoyed 80 percent of the growth enhancement potential from dollarization. In the 15 years before it instituted its currency board system in 1991, real GDP rose at a rate of less than 1 percent per year. Since 1991 growth has averaged more than 6 percent even counting the slowdown to average growth of about 4.7 percent from 1993 to 1998. Adding 2 percent to bring the annual growth rate to 7 percent would mean that Argentine real GDP could double versus growing by 60 percent each decade. If a dollarized Argentina were included in the North American free trade zone, then another 2 percent could be added on top of the gains from dollarization.

The most reliable incentive for economic growth is the realization of improved economic well-being by the people of a country. It is not export growth that drives an increase in economic activity as much as it is the realization of reliable spending capability by workers and managers that are most directly related to production for consumption.

Comparative advantage misunderstanding

Comparative advantage is generally mistakenly thought of as a process of selecting certain products that are more advantageously produced for export. Planning on goods to produce for export is not comparative advantage at all. Planning to select goods for export is a mercantilistic approach that never benefits a country and never enables businesses in a country to identify comparative advantage products.

Only, when a country opens its home market to imports will individual firms pass the comparative advantage test. Dollarization would make NAFTA member Mexico a home market replica of the process of discovering comparative advantage in the very large dollar market. For Argentina, dollarization would remove all doubt about the supremacy of Argentine consumers with their dollars.

Trade barriers on imports harms the people who are producers in the home market. Domestic producers are harmed in that they are cut off from the relative low cost of product innovation unique to a home market. A country that puts its consumers first likewise puts its producers first in graduating them to engaging in the process of designing desired high-quality low-cost products. Home producers should have an advantage of discovering what their consumers deem best.

The tragedy of currency devaluation uncertainty

Decades of currency devaluation increases the cost of capital. Even though the Argentine peso interest rate add-on has fallen to two percent, it still effectively gives more incentive to borrow in dollars for production for export. And even the cost of dollar credit faces a premium compared to the dollar being the sole currency.

In Mexico, the recurring periods of currency devaluation, has left producers for the domestic market with a 28-day Cetes rate of 20 percent. That is way too high to enable producers to give first priority of producing for the domestic market. As a result, Mexico has just recently gotten back to the dollar GDP level prior to devaluation in 1994.

Rather than growing to be 50 percent larger, they could surely double and possibly triple the real value of their output every decade.

Dollarization is such a valuable option that Argentina and Mexico should be encouraged to unilaterally dollarize. The Federal Reserve and the Treasury would do well by advising Congress as to the steps we can take that will encourage countries to dollarize.

But, dollarization would include more than the optional choice provided by the Argentine currency board arrangement that permits the dollar to circulate as a currency of choice along with the peso. Dollarization would mean that the government of Argentina would collect taxes and remit government spending vouchers in dollars.

Dollarization would cause fiscal discipline

Argentina has already moved away from a central bank lender of last resort option through its currency board arrangement. Without a lender of last resort that in emergencies creates, prints, money to avoid default on sovereign debt or government guarantee of private debt, the incentive for fiscal conservatism is built-in. Debt default is an important means for separating imprudent private managers from value contributing managers. That distinction is good.

Unfortunately, many policy makers and economist do not seem to understand that the possibility of default on sovereign debt can be just as effective in initiating market behavior in governmental units in a democracy as in disciplining private sector borrowing behavior. A common currency through dollarization would mean that sovereign governments and sub-country semi-sovereign states would be in the same arena as state and local governments in the United States. It seems self evident that state and local governments are accorded a credit rating differential in the common currency, that makes low priority borrowing imprudent. The cost is just too high. Fiscal imprudence in a democracy leads to the replacement of elected officials that do not get the message that the government can do more by doing less. A slower government spending growth rate stimulates faster economic growth and thereby faster growth of tax receipts.

Debt default versus monetary policy default

Many would argue that removing a lender of last resort that has an unlimited ability to monetize debt would be a problem. But, the most important monetary policy lesson of this decade is that sovereign debt default cannot inflict as much lasting harm as monetary policy default. If a central bank would resort to monetizing debt in order to be a lender of last resort then trust in that money is gone.

When monetary policy departs from price stability then monetary policy contributes to a problem causing monetary business cycle. During recessions, that kind of central bank provides sufficient liquidity to drive the economy to a monetary induced expansion. That "go" phase then is necessarily followed by a "stop" sign.

The lender of last resort function of seeking to avoid business failure, bank failure, and government failure by printing money is no loss.

Universally best monetary policy

Since the Federal Reserve is now only promising the one thing it can deliver, price level stability, then there is hardly any possibility that the Fed would need to do one thing for the economy of the United States and another thing for the economy of Mexico or Argentina. The monetary policy that the Federal Reserve delivers is a universally best monetary policy--price stability.

Thereby, there could not be an appropriate reason for the Federal Reserve to tune its monetary policy to the rate of growth or the rate of output in Argentina or in Mexico or in the United States. Consequently, there is no need for the direct inclusion of Mexico or Argentina in the determination of monetary policy. However, price stability needs to be codified as the sole priority of the Federal Reserve. That means amending or replacing the Humphrey-Hawkins Act.

The clear cut best choice for Argentina and Mexico is to dollarize.

Dollarization encouragement from the United States

Even though each country is free to unilaterally dollarize, officials of the United States would do well by engaging in a planning exercise as to how we can be of help. For we can do far more for the countries of the American hemispheres, and for ourselves, by assisting in dollarization than by direct aid or credit from the United States or from international monetary institution. Following are my suggestions:

Each country choosing dollarization would benefit by having its central bank paired with one of the district Federal Reserve banks so as to bring bank supervision to the level consistent with the what would be the private insurance risk of a deposit insurance system. Although dollarization would dramatically improve the performance of the banking sectors of the dollarized country, it would give rise to concerns that we are committed to a level playing field for all commercial banks in the dollar zone. Deposit insurance, paid for by the banks, along with our supervision and regulatory mantra enables commercial banks to operate with less capital than banks could get by with without the Federal Reserve, Treasury and FDIC supervision assurance.

If a central supervisory bank in Argentina or Mexico were paired with one of the Federal Reserve banks, then that Federal Reserve bank could be a conduit to the FOMC. Just as the FOMC monitors the state of the economy and the soundness of the banking system in each Federal Reserve district, so also, would it seem appropriate to Mexico or Argentina that their dollar economy and their banking system be monitored. Not that the FOMC should or would alter its proper restraint on money to achieve price stability but it would seem appropriate to be aware of banking conditions and economic growth in all formal dollar currency countries.

Consideration could be given to requiring the Board of Governors of the Federal Reserve system to calculate the windfall gains to Federal Reserve bank earnings due to the additional earnings stemming from issuance of additional non-interest bearing liabilities such as Federal Reserve notes. The Congress should ask whether the additional Federal Reserve earnings that would be paid to the United States Treasury could more appropriately be paid from the Federal Reserve banks into the central banks of Argentina and Mexico.

A central bank like supervisory bank in Argentina or Mexico would necessarily need a higher capital asset ratio than required of the Federal Reserve banks. Would it not be better for the United States to require an interest on seignorage payment to Argentina or Mexico which would enable their supervisory bank to have adequate capital to enable their banks be competitive with our banks? The larger the capital in the national bank of the country, the less likelihood of encountering a need to use the Exchange Stabilization Fund or Federal Reserve credit enhancements as we did in the case of Mexico and post fact by Brady bonds.

To encourage countries to dollarize we should adopt the principle that any country that converts to dollars as their single common currency will be extended an invitation to enter the North American Free Trade Association. Bringing Argentina into NAFTA likely would add another 2 percent to the Argentine growth rate.

I know of no other policy option with so much promise for the future of our neighbors and ourselves. Although unilateral dollarization by Argentina and Mexico is exactly the right initial step, a United States partnership with dollarized neighbor countries is too good an opportunity to be missed.

A partnership approach recognizes that we have something to gain. The United States economy will grow faster due to the reduction of exchange rate risk and due to the added efficiency perfection of the comparative advantage market test.

Payment of windfall seignorage gains would eliminate the possible perception in Mexico and Argentina that the United States wants them to pay "tribute" in the form of lost interest on seignorage. A partnership approach is likely to ameliorate any feelings of national humility associated with elimination of their national currency.

A partnership approach in improving bank supervision and depositor safety assurance would help to level the playing field of the cost of capital at banks in all dollar countries.

What a wonderful opportunity is before us in dollarization. I hope these ideas will continue to be paramount for this Committee and the Congress.


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