Dollarization would not save Argentina

Financial crisis
Financial Economics

Except for short periods, Argentina has experienced 75 years of macroeconomic instability. To defeat inflation, it has tried every possible monetary and exchange rate policy. And yet, inflation is more than 50 percent. A recurrent debate is whether Argentina should dollarize to achieve price stability and lay the groundwork for economic growth. To make the case for dollarization, Ecuador is often cited as a model to emulate. But, what can Argentina learn from Ecuador after 20 years of dollarization? Here are five important lessons.

First, dollarization defeats inflation. Ecuador dollarized its economy in January of 2000 and price stability was achieved by 2004. From then on, inflation has been on average 3.1% per year, lower than the 28% average between 1970 and 1999, and similar to Chile’s (3.3%), Colombia’s (4.4%), and Peru’s (2.9%) in the same period.

A second lesson to be gleaned is that dollarization does not necessarily imply fiscal discipline, an important consideration for Argentina, where chronic inflation has been associated with persistent fiscal deficits. In Ecuador, nonfinancial public sector spending rose from around 26% of GDP in the second half of the 1990s to 43% by 2014. To finance this fiscal expansion, the government used the windfall gains stemming from high oil prices, received Chinese financing, and defaulted on private external debt. Furthermore, the central bank issued paper and transferred it to the government to pay its bills; this action was only possible because the 2008 Constitution eliminated the central bank independence enacted in 1998, which banned central bank financing of the government. As a result, Ecuador’s country risk has remained high and well above that of its neighbors (Figure 1). To restore fiscal soundness, Ecuador has restrained aggregate demand, leading per capita growth into negative territory during the past five years, a trend expected to continue for at least three more years according to IMF projections.

Therefore, dollarization does not automatically boost economic growth, a third lesson to be learned. Despite the favorable international environment that prevailed for most of the past 20 years—oil prices soared above historical levels, the dollar remained depreciated, international interest rates were low, and the country received abundant remittances from abroad like never before—, real GDP in Ecuador grew, on average, 3.3% between 2000 and 2019, less than the 4.7% recorded in the previous 30 years. Moreover, per capita income in 2019, measured in constant values, was lower than in 2012, and has lagged over the past 20 years with respect to its neighboring countries (Figure 2).

Moreover, dollarization makes the economy more vulnerable to shocks and prone to volatility, a fourth lesson that Argentina must ponder. Because there is no longer an exchange rate that works as a buffer, economic activity is fully hit by shocks. In countries that issue a currency, the exchange rate depreciates following a shock, inducing a change in relative prices that favors domestic production and exports. This vulnerability is exacerbated if the country is a commodity exporter. In Ecuador, an appreciation of the dollar occurs in tandem with a decrease in the price of oil (Figure 3). The economy, thus, experiences a double whammy: public finances suffer as a result of falling oil prices and exports are harmed due to the loss of competitiveness caused by the strengthening of the dollar. And because the depreciation of the dollar occurs simultaneously with a rise in the price of oil, booms are magnified and economic cycles amplified. During 2000–2019, the standard deviation of real GDP growth was 2.66 in Ecuador, higher than in Chile, Colombia, and Peru, where it was 2.1, 1.79, and 2.44, respectively.

A fifth lesson is that dollarized economies become less competitive, unless the labor market is flexible. In Ecuador, wages do not adjust downward and labor mobility is limited. Therefore, firms cannot adjust their production costs when needed. In countries that issue their own currency, the exchange rate does the trick: wages in dollars decline as a result of the depreciation that follows a negative shock—provided the central bank keeps inflation in check. Moreover, in Ecuador, populist policies increased real minimum wages more than 50 percent since 2007. Minimum wages in dollars went from being the lowest in 2000 to being the highest at the end of 2019 relative to its neighboring countries (Figure 4).

Twenty years of data from Ecuador suggest that dollarization is a quick fix but does not address the underlying problems that hold countries back. Maintaining sound economic policies and introducing growth-oriented structural reforms are equally important when a country is dollarized. Moreover, the rule of law and having solid political and economic institutions are crucial for boosting investment. Otherwise, countries become dysfunctional and generate economic imbalances that adjust either via inflation (when they issue their own currency) or via low economic growth and unemployment (if they are dollarized). The result inevitably is lack of economic and social progress, irrespective of which currency is used.

Share this