Gentlemen, it is a pleasure to be here with you today and I thank Chairman Mack and Chairman Enzi for inviting me to testify before this joint Subcommittee hearing.
The subject of dollarization is not a new one. Numerous countries at various times in history have opted to use another nation’s currency to replace their own national money or to circulate as a parallel form of legal tender. What makes this issue one of critical importance deserving the attention of the distinguished Senators gathered here is that the dollarization option is now being discussed at the highest levels of policy debate in such countries as Mexico and Canada---our two most important trade partners.
The United States is compelled to take a position. These countries are talking about switching to the U.S. dollar to effectively replace their own domestic money or grant their citizens a choice in currencies. It would mean, at least for the three signatory nations to the North American Free Trade Agreement---the United States, Canada and Mexico---establishment of a common currency to more fully achieve the economic benefits of free trade and open markets. No more surprise devaluations, no more "competitive depreciation" tactics to gain a price advantage in shared markets, no more protectionist responses to exchange rate-induced market distortions.
So we need to decide. Are we in favor of dollarization? Are we against dollarization? Or should we take a neutral position that conveys the message: Go ahead if you want, we can’t stop you anyway.
My own view is that what seems to be the neutral position has strongly negative implications for the United States with regard to global economic leadership. Moreover, I am concerned that a policy stance by U.S. officials which suggests ambivalence---or calculated indifference---could impose an opportunity cost of historic proportions.
A Unique Opportunity
Let me focus on Mexico since I have been involved with a graduate business school in Monterrey since 1995. The school is called DUXX; I serve on the faculty as professor of international finance. What I encounter at DUXX is a tremendous sense of hope on the part of these graduate students as they have come to believe in the dream of entrepreneurship. Most of them are in their late 20s or early 30s, and they generally have several years of work experience in banking or high-tech engineering industries. They don’t seem very different from the graduate business students I often met on the campus of Stanford University when I was a Senior Research Fellow at the Hoover Institution.
Like their counterparts, the students at DUXX are fascinated by the magical atmosphere of SiliconValley which holds out the promise of success for creative entrepreneurs willing to work hard to achieve their vision. The formula seems simple enough: You bring an innovative idea, a new computer application, some useful new consumer service or software product to the table---and you can reasonably expect to receive sufficient financial resources as investors seek to share in the returns from a productive new enterprise. New jobs are created in the process, and new wealth is generated. Society gains from the expanded array of products or services that becomes available as the result of financial capital flowing to a productive economic opportunity.
The formula clearly works as promised in Silicon Valley and other high-growth regions in the United States. Entrepreneurial motivation plus financial capital equals explosive gains in wealth and economic output.
Let me assure you, the business students in Monterrey are plenty motivated. They lack neither imagination nor the capacity for innovation. What they are missing is access to financial capital. The cost of capital in Mexico is outrageously expensive. The rate of interest charged on a business loan---if you can find a commercial bank willing to make such a loan---is 32 percent. Even the most brilliantly conceived business plan for a breakthrough computer application or vastly-improved product or service will be hard pressed to justify paying 32 percent to get the funds needed to make it happen.
Yet the young men and women in Monterrey continue to earnestly pursue their Masters’ degrees in business, which both inspires and saddens me. While their faith in entrepreneurial endeavor and efficient capital markets is endearing, it is probably unrealistic for these Mexican students to believe that the American dream can actually work for them and their families.
And that is tragic.
The reason the cost of capital is so high in Mexico is fairly simple: The national currency, the peso, has not performed as a reliable monetary unit of account or meaningful store of value. Mexican citizens have seen their purchasing power undermined by inflation at home and diminished abroad through devaluation---not just once, but multiple times in the decades since the end of the Bretton Woods system. Indeed, there is embedded in the national psyche an ominous expectation of monetary disaster every six years, coinciding with the national presidential election, triggered by the fiscal compromises that inevitably occur during the campaign period.
The Mexican government is not unique in succumbing to populist spending measures and expansionary monetary policies during the critical months when voters are assessing their own economic welfare under the administration. But Mexico has proved uniquely vulnerable to unanticipated political shocks---from the horrendous assassination of political reformer Luis Donaldo Colosio in March 1994 to the rebel uprisings staged by Subcommander Marcos in Chiapas---and thus has suffered inordinately from capital flight and money meltdown.
Even now, as Mexico enters the tumultuous campaign mode for the presidential election that will take place in July 2000, just a few months ahead of the U.S. presidential election, the underlying question is whether or not political stability can be maintained this time around. And with it---economic, financial and monetary stability.
Mexico’s interest in dollarization is no mere coincidence of timing; it reflects the unspoken concern among Mexico’s leading businessmen that they could witness yet another replay of the devastating syndrome of devaluation unleashed by presidential politics.
But there is something else as well, something new. Mexicans sense that this next election could mark the turning point toward genuine democracy. Voters may finally have a true choice among candidates, and hence, a unique opportunity to support policies that hold out the potential for improving their own prospects for economic success. While Mexican citizens are no less cynical than U.S. citizens when it comes to believing in government "solutions," things could be different this time. If dollarization becomes a key plank in a viable party platform dedicated to political stability and economic growth, Mexican voters will finally be in a position to demand the opportunity to turn their entrepreneurial dreams into reality.
The Politics of Money
Economists and political scientists are prone to debate whether history is driven by economics or politics. Given my background, it’s not surprising I would come down on the side of economics. I believe economic circumstances are a powerful catalyst for human behavior that can lead to the rise and fall of empires. My own work in analyzing the deteriorating monetary and financial situation facing the Soviet Union in the 1980s---which resulted in my book The Coming Soviet Crash---convinced me that careful observation of economic developments could yield vital clues about the future of a nation. In some ways, the process might be compared to the way an accountant seeks to spot negative trends that threaten the ability of a company to remain a going concern.
The analogy does not quite apply, of course, because a nation-state is a different form of organized human behavior than a corporation or business enterprise. Nevertheless, numbers and statistics do provide useful indicators---especially with regard to a nation’s budgetary health. When government spending levels appear unsustainable due to falling revenues, it is generally time to start looking for signs of unwarranted increases in the money supply, that is, inflation. Governments resort to printing money when they find it politically unpalatable to lower spending and politically fatal to raise taxes. No big surprise if we take as given the fact that the same governments authorized by citizens to manage the domestic budget also exercise sovereign authority over the money supply.
What is surprising, actually, is that citizens permit this obvious conflict of interest to go largely unchallenged. Whereas an outside auditor called in to review the financial records of a corporation would likely recommend cutting expenses to address significant revenue shortfalls, governments do not face the same bookkeeping constraints as private enterprise. Because governments control the supply of money issued by their nation, and hence its value, they have a relatively easy way out of such dilemmas. They can create additional units of money based on their need to finance expenditures---even if they reduce the value of the national currency in the process.
In the sense that citizens are shareholders of their country, their equity interest in the domestic economy is diluted by such actions. Yet there is little they can do to protest the expropriation of wealth or redistribution of resources engendered by inflation. When governments issue debt to pay for current consumption, they expand the monetary claims to the economy without increasing the productivity of the economy. Each unit of money is accordingly worth less. Prices for valuable goods and services therefore must be raised to provide the same level of compensation to the vendor that he was willing to accept before the arbitrary increase in the money supply.
Abuse of monetary authority by governments can make businessmen appear as opportunists or price-gougers, when in fact they are merely trying to stay even. John Maynard Keynes, in his Tract on Monetary Reform published in 1923, wrote with sympathy about the changed status of the businessman when he is transformed into a seeming "profiteer" through the inflationary policies of the government:
To the consumer the business man’s exceptional profits appear as the cause (instead of the consequence) of the hated rise of prices….The business man, the prop of society and the builder of the future, to whose activities and rewards there had been accorded, not long ago, an almost religious sanction, he of all men and classes most respectable, praiseworthy and necessary, with whom interference was not only disastrous but almost impious, was now to suffer sidelong glances, to feel himself suspected and attacked, the victim of unjust and injurious laws---to become, and know himself half-guilty, a profiteer….To convert the business man into the profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards….This, then, is the second disturbance to the existing economic order for which the depreciation of money is responsible. If the fall in the value of money discourages investment, it also discredits enterprise.1
Some might be surprised that Keynes felt such compassion for the businessman victimized by inflation. Despite his overzealousness to manage the money supply, Keynes deserves credit for the humane impulses behind his objective: price stability. He believed the consequences of inflation were so detrimental to the social fabric that government was obliged to maintain constancy in the value of money. And this could be accomplished, he believed, by monetary authorities exercising careful control of its supply over both the short run and long run. No one would be more disappointed with the overall performance of governments in managing money than Keynes.
The distressing reality is that when government has the capacity to inflate the money supply and defile the value of the currency used by its citizens, it exercises undue influence---not only over the returns to workers, savers and investors, but over the very perception of business activity and entrepreneurial endeavor. The successful businessman is made to feel like a greedy member of society, or perhaps the fortunate but altogether passive recipient of economic largesse, rather than an innovative risk-taker whose creative actions brought about greater wealth and higher economic returns for his fellow citizens.
So it is no wonder that entrepreneurs would seek a better solution to monetary management than the failed policies of their own government. The United States should feel highly complimented that citizens of other nations would look to the dollar to serve as their own monetary unit of account. They trust it. Tired of piling up the phony rewards from inflated domestic prices or the self-defeating gains from export sales achieved through competitive depreciation, they just want money that plays it straight. They are willing to go with the world’s best brand.
But if entrepreneurs see an opportunity, governments see a threat. The political response to dollarization is predictable: Defend the status quo and question the patriotism of those who would abandon the national currency in favor of a more reliable form of money. The populist argument in opposition to dollarization is as predictable as it is despicable, misleading people into thinking that switching to the dollar is an act of political submission rather than economic liberation.
Expect to see stepped-up propaganda efforts to suggest that those who favor dollarization---or even granting legal tender status for the dollar as a parallel currency---are somehow selling out their heritage as loyal Mexicans. Nothing could be further from the truth. Dollarization advocates want to establish the stable monetary foundation that will permit their fellow Mexicans to build a better economic future for their families. The virtues of working and saving, whether to build a business or pay for children’s education, are blessed. They should be honored by government fiscal responsibility, not mocked by monetary mismanagement.
Strong Alliances and Shared Values
If would be a mistake for the United States to be so cowed by the potential for diplomatic clashes that it avoids encouraging movements toward dollarization in Mexico and Canada. Indeed, given that some of the potential "concessions" put forward as possible avenues for monetary cooperation may not prove practicable, it becomes even more important to send a signal that underscores the positive implications of stable monetary relations among vital trade partners.
Our position on dollarization should start from the core assertion: A stable monetary order is the appropriate corollary to a free trade agreement. Whether we are thinking in terms of our NAFTA partners or looking beyond to the Free Trade Area of the Americas (FTAA), one of our primary objectives should be to establish a monetary union or common currency that would provide a consistent unit of account across borders. When price signals are distorted through currency fluctuations, markets cannot function at optimal levels. Individuals who bring their goods and services to the international marketplace are unfairly punished and rightfully discouraged when currency movements turn legitimate profits into foreign exchange losses. If we believe in free trade and free markets, we must work toward a common currency with the same fervor we bring to the effort to reduce trade barriers and fight protectionism.
But how do we send a message of encouragement that neither seeks to entice nations toward dollarization with superficial rewards nor obligates the United States to compromise its own perceived economic interests?
The three chief areas being discussed in conjunction with dollarization have gained legitimacy as topics of debate through sheer repetition, but that does not mean they are the relevant issues. Instead of focusing on peripheral questions that require calculations of seignorage payments to countries making the switch to dollars, or politically-loaded proposals involving access to the Federal Reserve as lender of last resort, we should be emphasizing more basic opportunities to build strong alliances based on shared values.
Free trade must continue to be a bedrock principle of U.S. global economic policy. A sound international monetary order and the free flow of capital should likewise head the list of U.S. economic priorities. Our objectives from free trade should always be framed in terms of the increased productivity and higher levels of aggregate wealth attained when the benefits of comparative advantage are fully realized. Tariffs are an obvious betrayal of free market principles. But the most insidious form of protectionism is the free-for-all approach to currency relations that defines the global monetary regime today.
When countries such as Argentina pave the way for dollarization in Latin America, they are setting a precedent for achieving a common currency to serve throughout the Americas. Should it be the dollar? On a de facto basis, it seems the obvious choice. Certainly, the United States has no obvious reason at this time to pursue merging the dollar with other national moneys into a unified currency for the sake of some larger economic and political objective---as was the case for Germany. At the same time, the issues raised by Argentina’s request for special monetary arrangements with the United States, as they contemplate proceeding from a currency board to full-scale dollarization, need to be examined with an eye toward the future. Argentina seems poised to set the precedent for dollarization among other nations; it thus becomes imperative that any accords with that nation be likewise appropriate for future applicants seeking to use the dollar as their own currency.
The seignorage payment option---compensating a nation for the loss of revenues inherent in no longer being able to issue its own interest-free credit notes, i.e., fiat money---initially seems a promising way to indicate the generally cooperative attitude of the United States toward dollarization. After all, if Argentina cashes out its portfolio of U.S. government securities, which currently backs every peso in circulation, it stands to lose an estimated $750 million in interest revenue. The United States gets to substitute its least-cost borrowing instrument, cash, for the more expensive Treasury securities. Why not make some arrangement with Argentina whereby the United States remits a specified portion of its lowered borrowing costs to acknowledge Argentina’s sacrifice and help mitigate its budgetary impact?
Unfortunately, what appears to be a relatively simple approach to making a goodwill gesture can actually become quite complex in financial terms. And even if Argentina can fairly easily make the transition from issuing pesos through its currency board to using dollars outright, other nations might not evolve toward dollarization along that same path. It would be difficult, for example, to attach a precise figure to the amount of seignorage that would be appropriate for Mexico. Cashing out of U.S. securities to supplement the monetary base for an economy in the process of dollarizing does not necessarily justify full seignorage compensation. Redeemed dollars could be introduced into the economy, only to be reinvested in U.S. Treasury obligations. If Mexico chooses to permit parallel circulation of dollars in tandem with its own pesos, it becomes particularly difficult to put a quantitative figure on the appropriate amount of seignorage due to the Mexican government. One could argue that much of Mexico is unofficially dollarized already. Should seignorage compensation be assessed retroactively?
Aside from the virgin example where a nation changes at a precise moment from issuing its own currency to adopting the dollar as its exclusive legal tender, a situation we are not apt to encounter, the seignorage option becomes obscured---especially if compensation is anticipated on a continuing basis, say, annually. It could turn into a tempting subsidy for the dollarizing nation and a source of resentment for the United States.
The second potential area of cooperation that has been put on the bargaining table is to grant dollarizing nations the right to access the Federal Reserve discount window. Effectively, they would be entitled to rely on the central bank of the United States to serve as lender of last resort in the event their own banking systems were experiencing acute liquidity shortages.
This, too, is an area unlikely to yield any positive outcomes for cooperative official arrangements. So long as the Federal Reserve exercises regulatory authority over U.S. banks only, it seems doubtful that nonmember banks from outside the United States would be granted the same privileges and protections. Indeed, the premium over the federal funds rate that commercial banks now pay to avoid the increased Fed scrutiny associated with borrowing through the discount facility makes it clear that submitting to regulatory oversight is the price for retaining emergency access to liquidity.
To the extent that U.S. taxpayers are the ultimate providers of lender-of-last-resort funds, it would seem inappropriate to enlarge this particular financial umbrella to cover the banking systems of foreign countries. Moreover, countries such as Mexico and Canada are hardly willing to subordinate their banking systems to the controlling authority of the Federal Reserve, nor would the United States wish to assume that regulatory responsibility.
Finally, there is the matter of whether the Federal Reserve might take into consideration the economic conditions of a dollar bloc nation when formulating monetary policy on behalf of the U.S. economy. Surprisingly, this option, which is the least specific, offers the most promising avenue for cooperation. Though the Fed would likely resist any explicit requirement to take account of other nations’ monetary, financial and economic circumstances in deciding whether to pursue higher or lower interest rates, clearly such circumstances already figure prominently in Fed deliberations.
The three interest rate cuts engineered since last fall were hardly justified in terms of needing to stimulate the U.S. economy. When the prospects for the global financial system were at their most dismal in mid-October, the Chairman of the Fed took the initiative to lower rates outside of the regularly scheduled Federal Open Market Committee meetings. The United States was experiencing impressive economic growth and tight labor markets, and while inflation was "quiescent" in terms of the prices of goods and services, the stunning increase in the value of equities on major exchanges suggested the strong possibility of a financial asset bubble. If the Federal Reserve were concerned only with the monetary policy appropriate for the domestic economy without consideration of outside factors, it would have been more inclined to temper such seemingly unsustainable performance with an interest rate hike. Yet the next two Fed moves were likewise aimed at lowering interest rates.
So the Federal Reserve is already reconciled to the fact that the U.S. economy is not insulated from conditions in other nations. Indeed, it has become increasingly clear that the continued prosperity of our domestic economy is dependent on global financial stability. Expanded free trade improves living standards for U.S. citizens as well as foreign consumers and suppliers, and the discipline introduced through open markets has had an extremely positive impact on our own competitive performance. To preserve these benefits---more critically, to enhance them---we need to act now to ensure against currency turmoil in the future.
As I suggested in my 1994 book Money Meltdown, the chaotic state of the international monetary system is anathema to America’s vision of an open global marketplace dedicated to free trade. As exchange rate gyrations send domestic economies reeling and foment accusations of dumping and unfair competition, governments are increasingly tempted to resort to protectionist measures that could rupture international trade and investment relations.
The mission of the Federal Reserve, as augmented by the Employment Act of 1946 and the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act) is to promote high employment and price stability. The first requirement seems redundant at best, given the second; it turns out that price stability leads to greater employment opportunities. The integrity of monetary policy is compromised, however, by the assumption inherent in the dual mission that the Fed should attempt to alter the economic behavior of individuals through money illusion.
Congress could address the need to clarify the proper mandate for the Federal Reserve while simultaneously sending an encouraging signal to nations contemplating the use of the dollar as their own medium of exchange, unit of account and store of value. The Federal Reserve should have its mission explicitly refined to the single purpose of achieving price stability. Price stability could be defined in terms of a dollar that is anchored through convertibility at a fixed price into a universal reserve asset. Gold has functioned as the reserve asset in past successful international monetary systems, but other options should also be explored. A bimetallic system, linked to gold and silver, could provide an intrinsic anchor for defining dollar stability while at the same time providing a historically valid and culturally familiar approach for Latin American countries. Milton Friedman notes in his 1992 book Money Mischief that "bimetallism has much to recommend it, on theoretical, practical, and historical grounds" and suggests that scholars should reexamine the price stability aspects of bimetallism.2.
What is most important is that the United States send a clear message regarding its own commitment to achieve even greater heights of monetary reliability and integrity. As we applaud the willingness of other governments to give up their addiction to discretionary monetary authority and its potential abuse, the United States should demonstrate that it likewise believes in the rule of law versus rule of men. By defining the objective of price stability as the sole aim of monetary policy and by laying out a concrete approach to achieving monetary soundness, we express our fundamental economic philosophy. We let prospective dollarizing nations know that our future actions will confirm the principles that have brought them to admire the dollar. We will put into practice our belief that sound money provides the basis for productive economic growth.
Poised for Greatness
Leadership is a word that is often invoked yet rarely practiced. Too often, it is defined in terms of narrow self-interest or even the "national interest" when what is needed is something more altruistic. Despite its negative connotation as a synonym for naivete, altruism can lead to political and economic policy initiatives that reflect a deeper understanding and more profound wisdom than the obvious, safer alternatives.
From the visionary faith of Jean Monnet to the dogged determination of Helmut Kohl, the drive to achieve a common currency in Europe has been the result of individuals willing to subordinate their intellectual credibility and political acceptability for the dream of a united Europe. Though Kohl was defeated in his final attempt to remain as chancellor of Germany, he never veered from his conviction that European monetary union was a necessary step toward the economic integration and political unification that would ultimately reduce the chances for war on that troubled continent.
Whether the transition to a common currency has come too late, or is not sufficiently inclusive, or whether monetary union provides any kind of bulwark against future aggression at all, remains to be seen. There are doubts, too, about the fate of the euro---whether it will turn out to be a respected, trustworthy currency or merely the doomed paper symbol of a failed experiment.
But the key insight relates more to demonstrating leadership at the crossroads rather than relying on play-it-safe policies. When a unique opportunity to leap toward an embrace of democratic capitalism across the Americas presents itself---a chance to depoliticize money, encourage fiscal discipline, reduce the cost of capital, validate free market principles and expand productive trade and investment---you don’t retreat behind institutional barriers and exalt the status quo. You do the right thing.
Imagine our chagrin if, having passed up the opportunity to forge monetary union with our closest neighbors and trade partners, the forces of global financial instability are once again unleashed. Think what the United States would face if Mexico were to undergo another devastating devaluation, or teeter into political instability, in the aftermath of an unforeseen event. Could the Administration once again tap the Exchange Stabilization Fund? Is Congress likely to approve yet another massive bailout program administered by the International Monetary Fund?
It is long past the time when we need to implement more fundamental solutions to the economic devastation wrought by dysfunctional currencies. Dollarization has arisen as a spontaneous movement within our hemisphere; this puts the ball in our court. If the United States neglects to play it, we lose the chance to win a decisive victory for free trade and free markets.
Just as the architects of Bretton Woods sought to give hope to people not only devastated by war, but who had also lost faith in economic redemption after the Great Depression, it is incumbent today to send a message to emerging-market and developing countries. Capitalism works. Entrepreneurial passion is the most potent input for economic production. The businessman is one of society’s most useful and worthy members. And beware of those who would restrict capital flows and inject government into private economic and financial transactions, all under the guise of putting a "human face" on the global economy. They not only distort free markets---they demean capitalism.
But the monetary foundation for erecting strong economies cannot rest on quicksand. We cannot preach entrepreneurialism without practicing sound money. The dollarization debate gives us the chance---indeed, imposes the leadership responsibility---to take action toward a new monetary order to serve the needs of a free-trade zone that could potentially extend from Alaska to Cape Horn. We need to convey our vision of increased prosperity and freedom. And invite our partners to help make it a reality for all of us.
1. John Maynard Keynes, A Tract on Monetary Reform, reprinted in 1932 (London: Macmillan and Co., Limited), pp. 24-26.
2. Milton Friedman, Money Mischief (New York: Harcourt Brace, 1992), p. 155.
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