dollarization, the functions of a central bank

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DOLLARIZATION, THE FUNCTIONS OF A CENTRAL BANK AND THE ECUADOREAN
ECONOMY
by
PAUL DAVIDSON
EDITOR, JOURNAL OF POST KEYNESIAN ECONOMICS
Author of FINANCIAL MARKETS, MONEY AND THE REAL WORLD
Paper presented at the 75th anniversary of the Central Bank of Ecuador,
Quito, Ecuador, August 2002
I was one of the speakers at the 50th anniversary of the Central Bank of Ecuador in 1977.
Now, twenty-five years later I am again privileged to be a speaker on the 75th anniversary of the
founding of the Central Bank of Ecuador.
Two years ago Ecuador abandoned the use of national money and instead adopted the
U.S. dollar as its official currency for settling domestic contractual transactions. Since it is
claimed that dollarization eliminates the use of monetary policy (and exchange rate policy) as
weapons to cure a nation’s macroeconomic problems, is there any need for a Central Bank of
Ecuador? More importantly has, or will, dollarization solve Ecuador’s macroeconomic problems
and be a useful aid in providing conditions that help foster substantial real economic growth for
its residents?
To intelligently respond to these queries we must discusses the following: (1) What are
the important functions (duties) of a Central Bank in any nation? (2) What are the claimed
advantages and disadvantages (i.e., potential benefits and costs) to “dollarizing” in general and
specifically for Ecuador, and (3) Is there an alternative to dollarization that would provide all the
same benefits (or more) with less costs? (4) What if anything should be done now?
One apparent cost of dollarization is the loss of seigniorage that the Central Bank earned
for the nation before dollarization. Others on this panel probably have a better estimate of the
actual cost of this loss, but I have seen suggestions that it might be as much as 0.2 per cent of
GDP per annum. If this is correct, this is a substantial cost to the nation that the benefits of
dollarization must offset.
THE IMPORTANT FUNCTIONS OF A CENTRAL BANK
According to the United States Federal Reserve System, the central bank has four major
responsibilities1:
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1. To conduct the nation’s monetary policy by influencing money and credit conditions.
2. To supervise and regulate Banking operations to assure the safety and soundness of the
nation’s banking and financial system and protect the credit rights of consumers.
3.To provide certain financial services to the government, to the public, to financial institutions.
4. To maintain the stability of the financial system and contain systemic risk that may arise in
financial markets.
A fifth, but somewhat less important, responsibility of the central bank that is not mentioned in
the U.S. Federal Reserve literature is:
5. To provide statistics on the operation of the financial system and to do statistical studies
regarding the financial and economic system.
The U.S. Federal Reserve notes that “most developed countries have a central bank
whose functions are broadly similar” to those listed above. What about the Central Bank of
Ecuador? Did it have these responsibilities before dollarization? Can it exercise such
responsibilities after dollarization?
I readily admit that my knowledge of the actual workings of the Ecuadorian economy and
its Central Bank is limited to the few things that I have read in the literature. As an outsider I can
not be acutely aware of how and why the severe financial difficulties of the 1990s led the people
of Ecuador and its government to believe there was no alternative except to abandon the sucre
and to dollarize. It may be that the Ecuadorean government found itself to be a fragile egg caught
between a rock and a hard place. Nevertheless, as I will try to explain, I believe that
dollarization after the adoption of the Washington Consensus reforms of financial markets and
the banking system may have resulted in the nation jumping from the frying pan into the fire.
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I did make some inquiries of those who invited me to participate in this meeting
regarding the Ecuadorean economy and its Central Bank. They inform me that prior to
dollarization the Central Bank of Ecuador did actively shoulder most of the aforementioned
responsibilities. Although under dollarization a central bank could regulate and supervise
banking operations, in Ecuador the supervisory authority is apparently given to the
Superintendence of Banks rather than the central bank. Moreover It seems obvious that
dollarization per se need not prevent a central bank from providing financial services to the
government (e.g., by acting as the depository of governmental funds) and to financial institutions
(e.g., a clearing house mechanism). The central bank also can collect statistical data and provide
analysis of the Ecuadorean financial and economic system. Finally it is still possible that the
Central Bank of Ecuador can influence money and credit conditions to some extend by altering
reserve requirements within restrictions set up in the law.
In my view the most important question is whether the Central Bank of Ecuador, under
dollarization, can maintain the stability of the financial system when a new exogenous shock hits
the country and whether it can promote conditions favorable for a high rate of real economic
growth.. If the dollarization law has made it impossible for the Central Bank to maintain the
stability of the banking and financial system, then the question becomes can the resulting market
forces guarantee stability in the face of inevitable exogenous future shocks to the economy?
In order for a central bank to maintain the stability of the financial system and contain
systemic risk it must have the power to be a lender of last resort during any serious financial
system crisis.
THE LENDER OF LAST RESORT CONCEPT
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Despite the continued use of the term “lender of last resort” , the concept is plagued with
numerous conceptual and practical difficulties. The classic definition of a lender of last resort
stems from Bagehot2 who argued that in a time of financial distress a lender of last resort should
lend freely, at a penalty rate, on what would be considered good collateral in normal times.
If one takes a strict interpretation of this definition, then the central bank, if it is to be a
lender of last resort, must be able to distinguish between financial institutions, intervening only
to stop unwarranted financial panics from disabling healthy financial institutions while leaving
unhealthy institutions to die. Elsewhere, I have suggested that in a heavily intertwined and
interrelated financial banking structure, limiting lender of last resort aid only to what would be ,
in normal times, healthy financial institutions can result in a systemic collapse of the system3.
Consequently I would advocate a less strict definition of the lender of last resort function that
would be willing to “bail-out” the creditors of almost all financial institutions when the system is
under stress. But my view on this is of secondary importance and the question I want to focus on
is the need for some form of a lender of last resort institution.
Modern orthodox economic theorists (as opposed to Keynes and the Post Keynesians)
have raised a substantial barrier to the question of the usefulness of having any fast-acting lender
of last resort institution willing to aid financial institutions before many parties are squeezed into
bankruptcy proceedings. This barrier goes under the technical name of the problem of moral
hazard. In other words, these modern savants suggest that if the financial institution managers
know that a lender of last resort institution will always actively intervene whenever a financial
institution is threatened by a potential systemic disaster, then these managers will have an
incentive to undertake the financing of unduly risky projects that promise extraordinary high
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returns. If the project is successful , then the profits for the institution (and the rewards for the
managers) will be fantastically great; and if the project should fail, the lender of last resort will
‘bail-out’ the institution and thereby leave the owners, depositors, and the managers of the
financial institution relatively “unpunished” for their bad decisions.
Nevertheless, some orthodox economists still advocate a lender of last resort despite the
moral hazard problem. They appear to assume that the central bank responsibility #2 supra —
the strict regulation and supervision function of the central bank -- will prevents banks from
financing reckless, ultra-risky investment projects. If regulation and supervision via auditing of
bank portfolios can keep banks from undertaking the financing of ultra-risky projects, then there
should not be moral hazard created by knowing that a lender of last resort is ready to “bail-out”
supervised, well regulated, but threatened financial institutions.
WHAT CAUSES SYSTEMIC FINANCIAL DISTRESS
Most experts agree that under dollarization, the central bank of the dollarized nation can not
function as a lender-of-last resort. Nevertheless, as we have already suggested, it is sometimes
argued that if the central bank of a dollarized nation still exercises normal supervisory and
regulatory powers, the likelihood of a domestic financial crisis is very small. Is that true for the
case of Ecuador?
Given the Ecuadorean experience of the 1990s it should be apparent that once a nation
permits off-shore branch banking, strict regulatory and supervisory controls face insurmountable
obstacles if bankers want to avoid these controls. The evidence is that before dollarization, while
the Central Bank may have attempted to exercise due diligence in its supervisory and regulatory
control of the banks, offshore branch banking and creative accounting compromised the balance
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sheets of Ecuadorean banks. Ultimately Ecuadorean banks -- including 4 of the top 5 -- had to be
liquidated during the 1999 Ecuadorean banking crisis.
Some may suggest that this was due to the laxity of Central Bank supervision and
regulation rather than the liberalization of the banking and financial system. In response I should
point out that even in the United States, which is usually the shining example of proper
supervision and regulation by the authorities, there has been direct and/ or indirect intervention
by the monetary authorities to contain the potential for financial systemic disaster in specific
situations that occurred in the 1980s and 1990s (e.g., the savings and loan banks collapse).
Supervision and regulation alone can not prevent the potential for bank and other financial
institution failures that, in a highly leveraged interdependent financial system, can result in a
systemic failure unless a lender of last resort is willing, and able, to operate swiftly when the
storm clouds gather.
Before dollarization, the Central Bank could always act as a lender of last resort by
issuing (creating) its own liabilities to banks and other financial institutions that were having
difficulties making sucre payments. After dollarization, the Central Bank of Ecuador can, at
best, act as a lender of next to last resort if either it has sufficient “dollar” resources available
from its own inventory of dollar reserves or can borrow additional dollars from external sources.
Consequently, the value of this next-to-last lending authority ultimately lies in its ability to
obtain external dollar loans from international investors, the IMF, or the U.S. Treasury. Since,
under dollarization all sucre denominated debt is effectively converted into the equivalent of
foreign currency denominated external debt, dollarization almost inevitable means that any
domestic financial crisis will almost inevitably spill over into an external crisis even if the
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problem did not originate as a part of an external financial crisis.
Accordingly the ability of any dollarized nation’s central bank “to maintain the stability
of the financial system and contain systemic risk that may arise in financial markets” is severely
constrained if not absolutely eliminated by dollarization. Consequently, a potential immense cost
for any nation in adopting dollarization is the absence of any true lender of last resort institution
whose primary responsibility is to maintain the stability of the nation’s financial system and
contain any systemic financial disasters that may arise due to exogenous shocks. And in a world
of uncertainty, such exogenous shocks to the nation’s economy can not be insured against. If the
real and financial sectors are interdependent, a financial crisis can have devastating effects on
whole industries as well as the entire domestic economy. Accordingly the potential for a
complete collapse of the real economy is Damocles4 sword hovering over any economy
adopting a “dollarization” solution to its macroeconomic problems.
Furthermore, the effect of the already outstanding pre-dollarization fiscal debt and its
associated debt servicing obligations can aggravate the situation. Before dollarization, the
government could always meet its domestic currency debt payments in sucres at a interest rate
cost that was set by the Central Bank. In essence, the Central Bank could finance any
government deficits (including debt service payments) and there was no possibility of default on
this internal debt. Dollarization converts all this sucre debt into the equivalent of foreign
currency denominated external debt. This means that the already outstanding government debt
(as well as any future increments) can only be serviced or redeemed if the private sector earned
sufficient foreign exchange, or the government sells off State-owned assets (the family jewels) in
exchange for dollars. [As we shall see when we look at the case of Argentina, this creates an
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almost assured failure of the financial system in the future.]
The statistics for Ecuador’s ability to service its external debt since dollarization is not
very encouraging. According to Central Bank statistics external debt service as a percentage of
exports has increased from 100.9 per cent in 2000 to 126.7 per cent in 2001. Thus the only
possibility available to Ecuador to finance servicing of its external debts in the foreseeable future
will involve (1) the selling of any remaining State-owned assets, or (2) to obtain substantial
additional loans from international agencies and private foreign lenders. Clearly, sooner or later
Ecuador will run out of family jewels to sell to external investors. (Can anyone picture the
Galapagos converted into one huge Disneyland South Amusement park?) Additional borrowing
to finance current debt servicing is a Ponzi-like scheme that merely exacerbates the problem for
the future.
WHAT CAUSES SYSTEMIC FINANCIAL PROBLEMS
There are many potential causes and systems of a systemic financial problem. In the simplest
case, even if most banks’ loan portfolios are still performing, it is possible that depositors fear
either that their local bank will become illiquid and not be able to honor checks drawn against its
deposit liabilities or the government will freeze deposits. In these cases, the initial bank run will
be by depositors seeking to convert their deposits into hand-held currency. A lender-of-last
resort Central Bank, as the issuer of domestic currency can readily protect the banking system
from collapse due to this demand for money as long as there is a domestic money in the system.
In a somewhat more serious case, a financial crisis can also occur if the domestic banks
system-wide have made (what appears to be from hindsight) too many nonperforming loans. Or,
in countries that permit “universal banking” as Ecuador has permitted recently, banks have made
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too many direct investments in equities or real estate whose market price bubble suddenly
collapses. If these real assets and/or nonperforming loans are marked to market, then the domestic
banking system can be said to be “unsound”. Unless the banking system can be shored up by a
lender of last resort either extending additional credits and/or buying up (at least temporarily)
these assets whose market price has dropped and remove them from bank portfolios in return for
deposits at the central bank, the resulting systemic financial collapse can result in cataclysmic
damage to the real economy.
In open economies, if domestic residents and business are free to convert their domestic
money into a foreign money, then when residents of the nation (and/or external investors) lose
confidence in the domestic banking system, then, even if the deposits are dollarized, it is in the
self-interest of depositors and investors to execute “fast exit strategy” to obtain foreign bank
deposits and assets denominated in one or more of what are perceived as strong (safe haven)
foreign currencies. Especially for most small, open economies, whether the nation dollarizes or
maintains its own domestic currency, any financial system problem tends to become an external
financial problem as long as a free market is permitted in foreign exchange.
In the open-global economic system where there are different national monies (even if all
nations do not issue their own different currency), if there is a single clearing accounting unit in
terms of a specific currency where almost all international clearings are transacted and in which
almost all foreign reserves are maintained, then the central bank of that nation has the power, if it
wishes to use it, of being the international lender of last resort for a financial crisis that occurs in
any other nation.
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WHY DOLLARIZE
When a nation experiences a long period of significantly high rates of inflation, residents lose
confidence in their nation’s domestic money as a good store of value to meet future liabilities for
the purchase of goods and services --even if their expected future liabilities will be legally
payable in terms of the domestic currency. Since the value of the use of any money to settle
contractual transactions so outweighs what Clower called the “double coincidence of wants”
necessary for the functioning of a barter economy, most nations will limp along with a domestic
currency even if that currency is being ravaged by inflation. Nevertheless, if residents can easily
gain access to foreign exchange, then these residents of the nation will look for another money
(or other liquid asset) that can be used as a preferred store of value in terms of meeting future
contractual commitments vis-a-vis the domestic money. Of course, the residents will change their
foreign money back into domestic currency only as quickly as payment of their domestic
liabilities in terms of the domestic currency are required
In other words, if there are “liberalized” markets for foreign exchange, and foreign
currencies are seen as being able to better maintain purchasing power than domestic money in
terms of buying goods and services domestically in the future, then liquid assets denominated in
foreign currencies will be preferable to hold as stores of value. This leads to capital flight of
residents’ savings accounts to foreign based banks. Often, in order to avoid this capital flight, a
small nation whose currency is being debased by inflation will permit and even encourage the
banks to keep deposits (and loans) denominated in terms of a foreign currency as well as the local
currency. Simultaneously, sellers will want to utilize another country’s currency as the
contractual measure of payment for large transactions that are not recurrent or routine, e.g., the
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purchase of a large durable or a loan that extends over a long period of time. At the same time,
daily purchases of smaller value items -- things like food -- are often still transacted in terms of
the domestic currency.
In nations that permit dollarized accounting -side-by-side with the domestic currency, we
can say that there is an unofficial dollarizing of the currency. A 1998 survey by the IMF indicated
that in seven countries, a foreign currency was 50% of the national money supply , in another
dozen nations “dollarization” accounted for 30-50 per cent of the nation’s money supply, and
commonly 20-50 percent of the residents’s deposits were in dollar accounts in those countries that
permitted residents to maintain such foreign currency accounts.
Official dollarization of an economy is when the government renounces the use of the
domestic currency as legal tender and indicates that a foreign currency will be the form of legal
tender acceptable for all payments public and private. Official dollarization is essentially similar
in its effects to what occurred when a nation entered as a member of the international gold
standard in the 19th century and became locked-in to a fixed exchange rate system. Thus the case
for dollarization in the 21st century is basically equivalent to the case put forth for adopting an
automatic international gold standard in the 19th century -- – only in the case of “dollarization” for
countries like Ecuador the only gold mines in the world are located within the borders of the
United States.
The major argument for dollarization is that this action publically announces to the world
that the nation has permanently eliminated the possibility of either a sudden, sharp devaluation or
even a continued, persistent decline in the exchange rate. By eliminating what is called “exchange
rate risk”, the dollarization announcement is expected to increase significantly the level of
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confidence among international lenders and investors, thereby lowering interest rate costs on the
nation’s international (and domestic) borrowing, encouraging more direct foreign investment
and loans, and thereby inducing greater economic growth while simultaneously reducing the rate
of inflation. Nevertheless, typically foreign lenders feel there is more risk in making a foreign
loan than one to a domestic borrower, so that there will still be a differential in the interest rate
charge by foreign lenders to their own domestic borrowers and those in dollarized nations.
Dollarization is supposed to be adopting a fixed exchange rate par excellence, If some of
the nation’s trading partners still have floating exchange rates (e.g., Brazil and Argentina), there
can still be both trading pattern problems and exchange rate problems for the dollarized nation.
Perhaps more importantly as long as there is a flexible exchange rate among the major nations of
the world, i.e., among the Yen, the Euro and the Dollar, there can still be the potential of an
exchange rate risk for international lenders and investors who keep their accounts in Yen or
Euros. To the extent that a nation’s external loans are denominated in terms of Euros or Yen, this
can make annual international debt servicing payments of the dollarized nation more difficult if
the dollar falls relative to these other hard currencies. Can anyone forget the sharp devaluation of
the dollar against the Yen in 1996-7 that caused the East Asian “tigers” who had fixed their
exchange rate to the dollar such painful financial and real trouble in servicing their large
interbank Yen denominated debts?.
With the dollar falling against the Euro and Yen in 2002, will that create a domestic and
external financial problem for dollarized Ecuador? If some of Ecuador’s external debt is
denominated in Euros (and/or Yen) will the higher real costs of servicing that debt prove to be too
greater a burden for Ecuadoreans? If the US dollar continues to decline against the Euro, for
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example, will Ecuadorians withdraw their dollar deposits to obtain Euro (and/or Yen) deposits
and assets overseas? If they do, what does this mean for the Ecuadorian real economy? Will
Ecuadoreans receive the price and financial system stability that dollarization proponents claim?
If dollarization is, as I have claimed, similar to the 19th century gold standard, then we
may learn a lesson if we look how the Latin American nations fared under the 19th century fixed
exchange rate gold standard system.
A LESSON FROM THE GOLD STANDARD ERA.
From 1880 to 1914, the gold standard provided the world with a fixed and credible exchange rate
system. During this period there were many banking crisis but “they rarely turned into currency
crises, except at the Latin American periphery ... despite the fact that international capital flows
became very large- as a percentage of world GDP, larger than today”5. Even though defaults
occurred, global investment continued as London, acting as the clearinghouse for international
trade, made “sterling the main vehicle currency in both international payments and investments. It
was the absence of alternative currencies to hold that reduced the speculative element in shortterm money flows”6.
In this gold standard period, recurrent Latin American currency crises were “partly due to
dependency on a narrow range of commodity exports whose price fluctuated violently. [Also]
Latin American governments ...frequently defaulted on foreign bond issues, following
revolutions, bouts of inflation, or a collapse of export prices. Then debt collectors moved in,
with rescheduling and fresh loans. Orthodox policies were reinstated and as soon as service on
the bonds was resumed, the investors came back apparently undiminished by their losses .... The
crucial point in all this was that the gold standard was stable at the centre, unstable at its Latin
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American periphery.... As a rule, currency crisis hit second class countries, not first class ones”7.
This stability at the center changed in the interwar period when international capital flows
crises struck the core countries as well as the periphery. In the 1920s even as the core countries
attempted to return to the gold standard, the resulting exchange rate peg was not credible.
Competition between financial centers in London, Paris, and New York made multilateral
clearing cumbersome and difficult, especially when there were persistent imbalances in
international payments. Only the continual recycling of the U.S. current account surplus by
American banks prevented the collapse of the world economy in the mid 1920s. Meanwhile the
United States adopted tariffs that made it very difficult for Europeans to run a balanced trade
position or to earn dollars to repay post war dollar loans.
In 1928 U.S. funds were diverted from international loans to Wall Street speculation.
Simultaneously the U.S. avoided any trade balance deficits via tariff policies. As a consequence
the international payments system started to crumble. Money began flowing from deficit to
surplus countries as reserves were liquidated to service debts to the United States. When the U.S.
stock market bubble burst and global commodity prices collapsed, the periphery defaulted on
these loans -- but this time “the contagion spread to Europe” as Germany tried to balance its
international payments by severely depressing its economy. As unemployment rose drastically, a
German default occurred in 1931. “A deflationary hurricane swept over the world, as investors
scrambled for liquidity”8.
Does this historical episode have any lessons for what has happened recently, first in
Ecuador and the global financial system? In 1999 Ecuador apparently underwent its worst
economic crisis in history as a combination of external shocks (drop in the commodity price of
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oil, the effects of “El Nino”, and the Asian and Brazilian financial crisis) as well as the slow pace
of reforms due to political deadlock. GDP plunged by 7.3 per cent, a banking meltdown resulted
with banks being closed, sixty percent of bank assets were then held by the State, a bank holiday,
the freezing of bank deposits, and the unwillingness of international financial institutions to act as
a lender of last resort, Ecuador defaulted on its external debt. The Ecuadorian banking crisis
turned into a currency crisis (similar to what Skidelsky described above). In 2000 the sucre was
abandoned, the US dollar replaced the national currency (as Ecuador adopted a dollar standard),
and reforms were approved by the Ecuadorean Congress in March 2000 that established the
“orthodox” policies of the Washington consensus. .
As a result, the IMF entered into a Stand-By (lender of last resort) agreement that
unlocked US$2 billion in loans over 3 years to Ecuador. In August 2000, Ecuador’s private
international creditors accepted the offer to exchange Brady and Euro bonds for new [Global]
bonds with a 40% discount from nominal value . Apparently as a result, the Ecuadorian economy
improved in 2001, inflation fell to around 30% and economic growth resumed. A major
contribution to this growth was the one-time investment of more than US$1 billion by
multinationals to build and operate a crude oil pipeline that is expected to be operational in 2004.
In terms used by Skidelsky discussing the recurring Latin American currency crises
when the world was on the gold standard rather than a dollar standard, the history of Ecuador
over the last two years is that debt collectors moved in, with rescheduling and fresh loans.
Orthodox policies were reinstated and as service on the external debt was resumed, it was the
hope that the foreign investors would come back with enthusiasm undiminished by the losses on
Brady and Euro bonds, while the world is still on a dollar standard.
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But what does Skidelsky’s history suggest occurred whenever a new external shock to a
Latin American country occurred during the gold standard period? The Latin American nation
was unable to service its outstanding debts and the crises-debt recycle situation began all over
again. The warning in all of this is , as one sage put it, “Those who do not study history are
bound to repeat its errors.”
I should point out that there is also a message for the global core nations in Skidelsky’s
history of the decline and fall of the gold standard. Between the World Wars, as three core
currencies vied for becoming the clearing center for international transactions, huge speculative
waves attacked the core currencies. Interbank credits could not stem these assaults. The result was
to end private foreign investment flows for decades. Can this happen again as the Euro and the
Yen compete with the US dollar as an international reserve currency especially if the United
States as the world’s largest debtor slips into a W shaped recession, the Wall Street bubble bursts,
and the world relies on liberalized financial markets to finance payments imbalances?
THE APPEAL TO MARKET DISCIPLINE TO CONSTRAIN GOVERNMENT
BUREAUCRATS
While browsing the Internet for information regarding Ecuador I came across a paper released by
the Foundation Francisco Marroquin. The Foundation claimed that a major purpose of the
dollarization plan adopted by the Ecuadorian congress in February 2002 was to “render Ecuador’s
central bank an unnecessary government appendage”. Instead “Ecuadorian politicians,
mercantilist businessmen, and bureaucrats will have to accept the market discipline imposed by
the US dollar.” If this statement of the reason why dollarization was adopted in Ecuador, it must
have been because the sponsors of dollarization desired to place the Damocles sword of “market
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discipline” over the head of all Ecuadoreans.
Of course, what the supporters of dollarization apparently did not realize is that despite the
rhetoric of the “Washington consensus”, whenever market discipline unleashes systemic risk to
the United States dollarized financial system, three weapons are rolled out to ameliorate the
otherwise disastrous effects of market discipline. These three last resort weapons are the Federal
Reserve acting as a lender of last resort, the federal government’s Comptroller of the Currency’s
“too big to fail” doctrine, and the Federal Deposit Insurance Corporation (and the earlier Federal
Savings and Loan Insurance Corporation) for those small enough to fail. The purpose of these
policy weapons is to stabilize the financial system and contain the systemic risk generated by free
market discipline.
Unfortunately, the United States is not going to use these weapons to perform a similar
function for the Ecuadorian dollarized financial system if “market discipline” threatens a
domestic financial crisis. On April 21, 1999 the United States Secretary of the Treasury, Robert
Rubin, warned that dollarization is “a highly consequential step that would limit the ability of a
nation to constrain a banking crisis”. Rubin stated ; “But it would not, in our judgment, be
appropriate for United States authorities to extend the net of bank supervision, to provide access
to the Federal Reserve discount window, or to adjust bank supervisory responsibilities or the
procedures or orientation of U.S. monetary policy in light of another country’s decision to
dollarize its monetary system”.
It should be noted that on the international financial level, most analysts expect the IMF to
play the lender of last resort role — but the difference is that unlike a central bank, the financial
resources of the IMF are much more limited and its loans always are tied with significant
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conditionality requirements. A proposal adopted by the IMF in 1999 set up a contingency credit
facility called the Contingency Credit Line (CCL) where countries that were considered in good
economic health can set up a precautionary credit line with the IMF to reduce the possibility of a
contagion leading to financial collapse. Unfortunately, many believe that if a nation applies for a
precautionary credit line, it will signal that “insider” policy makers know that a financial crisis is
brewing and that can, in itself, set off a period of capital flight that can overwhelm the credit line.
Moreover, financier George Soros has proposed the establishment of a new international
authority to insure international investors against debt default. This agency would be similar to
the FDIC in the US but with limits set on the amount a country can borrow9.
FINANCIAL DISTRESS, DOLLARIZATION AND SMALL OPEN ECONOMIES
Ecuador dollarized after experiencing both domestic and international financial crises
and a growing fiscal deficit. Apparently, Ecuadorian officials decided that the resulting
pessimistic expectations of both domestic residents, foreign investors and the IMF left them with
no alternative then to dollarize to provide a “credible” financial system.
Under dollarization, the health of the nation’s economy depends almost entirely on the
capacity of the nation to obtain additional foreign exchange. Can a dollarized Ecuador increase its
hard currency holdings? There are several possible sources for doing this (assuming that there is
no new systemic financial distress in the new dollarized economy). These sources are:
(1) Ecuador can export more than it imports in value terms by an amount that exceeds current
annual debt service costs on its external debt.
(2) If dollarization has restored foreign lenders and investors confidence, additional new loans
and foreign direct investment can be a source of increasing Ecuador’s foreign exchange. One
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example of this direct foreign investment is the recent one-time $1 billion dollar investment that
five multinational companies have contributed to build and operate a heavy crude oil pipeline in
Ecuador. Are there other big illiquid direct foreign investment projects to take up the slack when
this pipeline construction investment project ends in 2004? To the extent additional foreign
capital enters in terms of loans or liquid portfolio investments rather than illiquid direct foreign
investment, such increases in capital inflows are creating problems for larger debt service
outflows and possible capital flight in the near future.
(3) the possible repatriation of capital flight funds that went overseas after the Government began
unblocking demand and saving deposits in August 1999. What incentives does the private sector
have to bring large sums back when they are currently invested in safe haven assets such as U.S.
Treasuries or overseas Citibank deposits?
Will dollarization per se permit all three of these sources of foreign exchange to contribute
significantly to Ecuador’s economic growth in the near-term future?
I wish I could be optimistic and say certainly yes, but, in truth I do not know. Since
Ecuador’s external debt service payments in 2001 were 126.7% of the value of exports and rising
it is difficult to see much improvement in the nation’s health coming from this area. In 2001
Ecuador ran a $353 million adverse balance of trade in goods and services where exports equaled
$4,583 million while imports were $4,936 million. (Figures for the months January and February
show that the excess of imports over exports is widening.) . Accordingly it appears to me that
Ecuador’s economic growth will depend on continuous foreign loans and investments and the
return of the earlier capital flight funds. Since I suspect these will at best be short-term temporary
solutions, I believe that Ecuador will have to learn from Argentina’s experience in this area -- as I
19
will explain below.
Under these circumstances I can, at least, urge Ecuadoreans to be cautious about claims
that dollarization will solve the problems by increasing the global competitiveness of Ecuadorean
enterprise.
MARKET DISCIPLINE INCREASING COMPETITIVENESS.
One of the arguments often put forth – and apparently propounded by the Foundation Francisco
Marroquin for dollarization is that “market discipline” will make Ecuadorean export industries
“more competitive” on international markets in the short run and thereby gain a rising share of
anticipated growing foreign markets. The result would be export-led growth while domestic firms
would not lose market share to foreign competition despite the rapid reduction in trade barriers
[An alternative method of increasing competitiveness in small, non-dollarized open economies is
to devalue the exchange rate. Small economies can do this without fear of retaliation by their
larger trading partners. Unfortunately this alternative is not possible with dollarization.]
Typically, however, becoming “more competitive” means lowering unit labor costs –
which, in the short run, usually means using the threat of rising unemployment as a market tool to
force workers to lower, or at least limit, their wage and working condition demands. Ecuador’s
major export earners, however, are the oil industry (40% of the value of total exports) and other
primary products (47%) such as bananas, seafood, etc. It should be obvious that the cost of
extracting, transporting and exporting oil in Ecuador (even after the pipeline is completed and
operational) will never be more competitive in foreign markets than oil from the Middle East or
even Venezuela. Consequently the ability of Ecuadorian oil exports to increase foreign earnings
substantially will depend on its acquiring a bigger quota of the OPEC cartel’s production
20
limitations necessary to maintain a significant world market price of $25 per barrel. This will
depend primarily on rapid economic growth of the OECD nations rather than the improved
competitive oil position of Ecuador. And, in the worst possible scenario for Ecuador if a
significant recession occurs in the OECD nations in the last half of 2002 and 2003, both the price
of oil and OPEC’s total oil production quota might decline.
I suspect that in Ecuador’s agricultural sector keeping money wages in check depends on
a continuing supply of cheap adult and (especially in agriculture) child labor. An article on the
front page of the July 13, 2002 issue of The New York Times had the title “In Ecuador’s Banana
Fields, Child Labor Is Key To Profits”. This article reported that the International Labor
Organization estimates that 69,000 children ages 10 to 14, plus an additional 325,000 between the
ages of 14 to 19 were working in Ecuador in 1999. Of course with Ecuadorean labor laws tightly
restricting children under 14 from working, most of these children probably work on family
farms.
An abundant supply of child labor is usually an index of significant poverty among the
relevant rural population. If the nation can reduce poverty substantially, then parents are less
likely to send their children out to work even on family farms. But reduction of poverty means
more rapid economic growth –and so we have here a which comes first problem, the chicken or
the egg,
Finally, a cursory view of the major industries that are export earners for Ecuador suggests
to me that Ecuador has the wrong industrial mix to earn a growing source of foreign exchange
necessary for the health of the nation under dollarization. I reach this conclusion based on
Thirlwall’s law which indicates that for a country to grow faster than its major trading partners it
21
must have exports whose income elasticity of demand is greater than the nation’s income
elasticity of demand for imports. With the United States as Ecuador’s largest trading partner, and
Argentina the next largest, it would appear that Ecuador’s industrial mix tends to doom it to
growth at a rate slower than these major partners. With Argentina already collapsed and the
United States teetering on a W shaped recession— or at least a period of slow growth, the exportled growth policies implied in dollarization are unlikely to provide substantial increases in the
growth of Ecuador’s economy.
Finally, are there any lessons to be learned from the economic disaster in Argentina since,
after all, a currency board is a way of dollarizing a nation without officially abandoning the local
currency.
ARGENTINA
Argentina adopted a modified form of dollarization – the currency board– and that seemed to
bring the same benefits that dollarization is said to provide. The absence of exchange rate risk,
the reduction in domestic inflation, lower interest rates with more rapid economic growth and an
influx of foreign lenders and investors and a repatriation of capital flight funds that had flown
abroad during the 1980s implied a future of economic bliss for Argentina. So what happened?
On Christmas eve of 2001, Argentina announced the suspension on its debt service
commitments. It joined an ever expanding list of Asian and Latin American countries that had
once been applauded as examples of the benefits of sound economic policies implemented under
IMF structural adjustment programs — but whose success was rapidly reversed by a major
financial crisis.
During the last decade, Argentina has been under continuous IMF surveillance. During
22
this period, the share of debt to GDP and the size of the federal government’s fiscal deficits were
compatible with the convergence criteria set up by the European Union for participation in the
Euro payments system. As long as Argentina required residents to use pesos to pay taxes, the
Argentinian government could always meet its domestic fiscal payments. But once a currency
board “dollarization” system was established this effectively converted the entire domestic
government and private debt into the equivalent of a foreign currency denominated external debt.
This therefore required either a current account surplus or the government selling state assets to
foreigners, or by public or private sector increasing borrowings from abroad. In any dollarized
economy, the most appropriate measure of debt sustain ability is the ratio of debt service to
current account surplus!
Mexico, Brazil, and Argentina all followed IMF guidelines that required a currency peg if
not outright dollarization (which is a permanent currency peg), deregulating internal markets and
opening them to imports, liberalizing the financial sector and privatizing public assets to increase
the role of private decision making.
In the short run, these nations were successful in reducing inflation significantly, creating
expectations of profit opportunities in domestic markets and creating credibility that re-opened
the door to external capital markets. The result was that instead of paying down the large
overhang of debt by earning current account surpluses, it was the sale of public assets and the
refinancing of debt in international markets that seemed to solve the threat of default.
The persistence of large stocks of external debt put the economy at ransom to external
shocks. Domestic firms were unable to substantially increase their earnings as they competed in
foreign markets. Whatever growth occurred was not financed by increasing net exports but rather
23
by increases in external capital inflows. If growth occurred it was accompanied by a greater share
of imports (primarily consumption goods)— and the possibility of expanding external financing
crises.
Unlike Mexico and Brazil, however, Argentina passed a Central Bank law that required
the peso money supply to be fully backed by $US dollar reserves. Initially the fall in inflation
rates, brought improved real incomes especially to lower and middle income groups with high
marginal propensities to consume. This accelerated domestic aggregate demand growth especially
for imports just as tariff barriers were being removed. Within a few years ratio of imports to GDP
had almost doubled while the exports to GDP ratio had hardly increased. The result was a steady
deterioration in the current account balance. Capital inflows, rather than the Central Bank,
financed the mounting current account deficit.
The Central Bank could no longer finance a government deficit. Instead government
deficit spending was financed directly or indirectly by capital inflows some of these coming from
the sale of state owned properties. The result was that economic growth in Argentina was
accompanied by increased foreign borrowing and other capital inflows, while the resulting growth
of imports relative to exports (see Thirlwall’s Law) reduced the capability of the domestic
economy to earn net hard-currency reserves. When the Argentinian government ran out of family
jewels to sell the only method of financing growth was to increase foreign borrowing in what
Hyman Minsky would call a Ponzi financing scheme where each year more borrowing was
necessary merely to service the growing external debt. But as those of you who have contributed
to Pyramid letters and other Ponzi schemes know, you can expect to gain a significant return only
before the scheme runs out of additional “investors”. But as even Ponzi ultimately found out in
24
the 1920s, one finally runs out of “investors” who will continually pour more money into the
scheme.
The only thing left for Argentina was to either suspend convertibility or to default on the
debt service or both. Only if foreign investors expected the Argentinean trade surplus to turn
significantly positive in some reasonably near term future, or if official agencies such as the IMF
or the US Treasury bailed-out Argentina would private investors continue to finance the growing
Ponzi-like trade and debt service deficits.
It should be noted that after the Tequila crisis of 1994-5, Argentinian residents feared for
the safety of their bank deposits. The residents consequently removed approximately 40 per cent
of their deposits from Argentinean banks producing a sharp contraction in the money supply and
difficulties for the domestic banking system as 59 weak banks were closed or merged. But as soon
as the IMF supported Argentinian stabilization policies, including encouraging foreign ownership
of the majority of the banks and remunerating bank for their dollar reserves, Argentina seemed
able to continue to meet its debt service obligations. Foreign borrowing and direct foreign
investments increased and Argentina’s foreign reserve position continued to improve. Short-term
debt was substituted for long-term debt and more funds were borrowed from the IMF at the cost
of increased conditionalities which were designed to produce a government surplus of 2.75 per
cent of GDP through increased taxes and cuts in government spending.
When the Asian crisis and the Russian default followed in 1997 and 1998, external capital
markets closed to “emerging market” nations including Argentina. When Brazil defended the
Real plan, Argentinian exports declined as Brazilian growth fell. When Brazil devalued its
currency, it further pushed down Argentinian growth and export earnings even though imports
25
also slowed. To retain the confidence of external lenders the government built up reserves by
borrowing whenever possible and by increasingly calling on IMF resources. The IMF , in return,
required further cuts in government spending and the debt service burden became an even larger
portion of the GDP
The handwriting was on the wall and despite an increase in IMF stand-by credit in January
2001, as well as new World Bank and Inter Development Bank loan promises and a loan from
Spain, the end was in sight as the Argentine economy continued to deteriorate. Political unrest
produced a capital flight of over $5.5 billion in March 2001 and all debt rating agencies
downgraded outstanding Argentinian debts and placed them on a list for permanent exclusion
from capital markets.
In sum, dollarization via a currency board ultimately failed in Argentina and the resulting
economic collapse has been catastrophic— especially for those domestic residents who, perhaps
for reasons of patriotism or national pride, did not remove their deposits to foreign lands when
they could have.
Are there lessons in all this for Ecuador? I believe there are.
Lesson one is that the more open a nation is to exogenous shocks to its economy, the less able a
nation can survive with free movement of capital funds across its borders. All nations, big or
small, whether dollarized or not, should have legislation on its books to control the inflow and
outflow of capital.
Lesson two is that dollarization is not a panacea that will solve all the nation’s macro economic
problems. In the current international payments system, dollarization converts exchange rate risk
into other problems whose implications are more difficult to discern, especially if they give a
26
temporary short-term boost to the economy. The initial inflow of external capital following
dollarization may well create a delusional euphoria, similar to the creation of bubbles in
developed economies’ domestic financial markets, only to end up with a disastrous and usually
fatal disease that has been called Ponzi financing.
Lesson three is that the smaller, more open nations of this global economy ultimately suffer the
most from acquiescing to the conditions of the Washington Consensus. I would urge these nations
to band together and demand that the G-7 build a “new financial architecture” similar to the
clearing union proposed by Keynes at the Bretton Woods conference. I have adapted Keynes’s
plan to meet the conditions of the 21st century market oriented economy10. But that is the topic
for another talk.
ENDNOTES
1.Board of Governors, Federal Reserve System, The Federal Reserve System: Purposes and
Functions, 8th Edition, Washington D.C., 1994, p. 1.
2.W. Bagehot, Lombard Street: A Description of the Money Market. London, William Clowes
& Sons, 1873.
3. P, Davidson, Financial Markets, Money and The Real World, Cheltenham, Elgar Publishing,
2002.
4. Damocles was a flatterer who, having extolled the happiness of Dionysius, tyrant of Syracuse,
was seated at a banquet with a sword suspended over his head by a single hair to show him the
perilous nature of that happiness.
5. R. Skidelsky, “Historical Reflections on Capital Movements” in Capital Regulation: For And
Against, by R. Skidelsky, N. Lawson, J. Flemming, M. Desai, and P. Davidson, London< Social
Market Foundation, 1999, pp. 3-4.
27
6. Skidelsky, op. cit, pp. 5-6, emphasis added.
7. Skidelsky, op. cit., pp. 8-9. Does not this experience appear to have some similarities to events
of the last 25 years when the world was on a dollar standard?
8. Skidelsky, op. cit., p. 13.
9. G. Soros, The Crisis of Global Capitalism, Public Affairs Press, New York, 1998
10. P. Davidson, Financial Markets, Money and The Real World, Cheltenham, Elgar, 2000,
chapters 13-14.
28
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