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Chapman, Spira & Carson - Disscusion

Date: 4/24/99
Time: 11:47:27 AM
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FROM THE OFFICE OF PUBLIC AFFAIRS EMBARGOED UNTIL 10 A.M. EDT Text as Prepared for Delivery April 22, 1999 RR-3098


I am pleased to have this opportunity to reflect alongside Chairman Greenspan on the issues raised by recent discussions in a number of Latin American countries about the possible dollarization of their economies.

The recent traumatic events in emerging market economies have provoked a reassessment of the international financial system, here in the United States and across the international community. A great deal has been learned -- and a number of important reforms have been or are in the process of being put in place. But clearly, important and difficult questions remain.

As Secretary Rubin noted yesterday, one especially important issue arising out of these crises indeed, many crises in recent years is the difficulty of successfully maintaining fixed, or semi-fixed exchange rate regimes. Where these were present and proved impossible to defend in Thailand, Russia, Brazil and other countries, this has clearly created difficulties not merely for the countries concerned but for the international community as a whole.

These experiences, coupled with the advent of European economic and monetary union, have sparked renewed discussion of a possible reduction in the number of the world's currencies. In particular, in Latin America, the issue of dollarization has been raised in a number of countries.

To make another country's currency one's own is a momentous decision for any country and will need to be considered with a very careful eye to the potential costs and benefits. But before turning to these issues, we should remember that sound fundamentals are needed to underpin any credible choice. A sustainable fiscal position, well-functioning labor and capital markets, and an environment in which private property is respected and contracts are enforced with these things in place it is probably possible to make a success of a number of different exchange rate regimes. Where one or all of these things are lacking, it is probably impossible to make a success of any.

With this basic proviso in mind, let me now turn to some of most important considerations that would need to enter a country's decision to dollarize; and some of the considerations that might arise for the United States.

Considerations For Economies Considering Dollarization

Two sets of issues can usefully be distinguished in this area: first, the decision to maintain a fixed exchange rate system rather than a floating one; and second, the decision to create a stronger sense of irrevocability around that fixed rate system, as, for example, in the decision to dollarize.

Even economists who agree on most aspects of economic theory and practice will often be divided on the relative merits of fixed versus floating exchange rates. For some, such as Milton Friedman, exchange rates are a price: a price that should be flexible for the same reasons that others are. For others, it is a promise, one that should be firm and that should not be broken or devalued.

The right choice between these two options poses enormous questions and does not yield any simple answers.

On the one hand, a fixed nominal exchange rate provides stability to exporters and importers and can help to anchor domestic inflation expectations. These benefits will be especially attractive to countries with a record of financial instability and domestic monetary policy-making that has failed to keep inflation in check.

On the other hand, maintaining a permanently fixed exchange rate regime means accepting the loss of domestic monetary independence that goes with it. The domestic monetary authorities are ceding the capacity to use monetary or exchange rate policy to cushion the economy against external shocks. This, in turn could mean greater volatility in output and employment where domestic prices and wages cannot adjust rapidly in response to such shocks.

Where a country has already made a strong commitment to a permanently fixed exchange rate, it is clear that the trade-off is somewhat different. Notably: the traditional margins of adjustment working through the exchange rate or domestic monetary policy, theoretically, at least, are no longer available.

This has been said to make the case for dollarization, in such circumstances, somewhat stronger. But even here countries will need to consider the benefits against the potential costs:

On the one hand, the presumed irrevocability of dollarization holds the promise of lower interest rates, greater stability and possibly deeper financial markets, by adding to the credibility and discipline of its own policies and advancing its integration with the world economy. It is striking that dollarized Panama is the only country in Latin America with an active 30-year fixed rate mortgage market.

On the other hand, the country must also be prepared to embrace an equally irrevocable subordination of domestic monetary policy to that discipline. In addition, a dollarizing government will have to accept losing the seigniorage revenue that domestic currency creation produces. In this context, it is worth noting that President Menem of Argentina has discussed the possibility of fully dollarizing the Argentine economy, and Argentine financial officials have had informal discussions of issues relating to dollarization with Treasury and Federal Reserve officials. Those who favor this step in Argentina believe, among other things, that under their currency board system, they have already borne most of the costs of dollarization, but they are not yet enjoying dollarization's full benefits. For example, interest rates on Argentine peso-denominated deposits have been nearly 1 percentage points higher on average over past two years than on their dollar-denominated equivalents, and the spread has widened to more than 4 percentage points on occasion. In their view, dollarization, in addition to the other potential benefits, would result in substantially lower and less volatile interest rates.

Once again, for Argentina as for any other nation, the decision to adopt another country's currency is an enormously consequential one that would need to be considered in a careful and extended manner. Countries can obviously choose to adopt the dollar as legal tender without our assent. However, such a decision has some consequences for the United States, and we hope and expect that countries would consult with us in advance.

Let me turn now to the potential implications of broader dollarization for the United States, which I know to be of great interest to members of this Committee and others in Congress.

Possible Considerations for the United States

Speaking as an analyst, the question of the impact of dollarization by other economies on the United States economy raises a number of considerations.

If a country or countries decide to adopt the dollar, the United States can expect to benefit in a number of ways:

Most obvious, but perhaps least consequential over the long-term, by acquiring dollars for use in their domestic economies, dollarizing countries would be extending an interest- free loan to the United States. (Although the added revenues accruing as a result of any one country adopting the dollar would be extremely modest relative to the revenues earned globally already.)

Of potentially greater importance would be the increase in economic links that might be associated with the creation of a broader dollar area. The fact of sharing the same currency would reduce the cost of doing business with the dollarizing country and reduce uncertainty about future exchange rate changes. There might be greater capacity for capital and trade flows in both directions as a result. The desire to deepen economic integration was an important motivating factor behind the single currency project in Europe. The currently modest extent of trade between the United States and individual Latin American countries other than Mexico would limit the short-term implications for the United States unless dollarization were to become a regional trend. Excluding Mexico, Latin America accounts for 7 percent of United States trade more than any single country except Canada, Japan, and Mexico. But no single Latin American country accounts for more than 2 percent of the United States total.

That said, by and large these are economies whose tradable sectors with governments opening up after years of protection -- are growing much faster than the economy as a whole. United States exporters have also generally enjoyed a much higher share of Latin American markets that they have in those of most other emerging market economies. To the extent that dollarization helped to consolidate or expand our large role in Latin American markets, it might help to ensure that we continued to benefit disproportionately from their future growth.

As I noted earlier, experience with discretionary monetary policy in a number of countries in Latin America has been that its potential benefits have not been fully realized. If dollarization helped to achieve greater economic stability and growth in countries in our hemisphere which have suffered so much instability in the past, it would clearly be in the economic and broader national interest of the United States.

Looking beyond the immediate economic implications, analysts have raised a number of other potential implications of broader dollarization for the United States that would have to be very carefully considered in the event of any major country in the region choosing to adopt the dollar.

In this context, there has of course been concern that dollarization by an economy would give rise to pressure to use United States economic and regulatory policy tools to support that country's economic or financial stability. Our stake in the region's economic stability has meant that we have sometimes acted to support strong adjustments in policies in the wake of financial crises. Some argue that dollarized economies achieved greater stability, thereby limiting the chances of such involvement in the future. However, an opposing concern has also been raised, that dollarized economies, and their potential creditors, might believe they had a stronger claim on United States support.

Questions have likewise been raised about the possible impact of dollarization on the broader attitude of that country and its citizens toward the United States. To the extent that it furthered economic and other ties, this would clearly be a benefit to the United States and that country. But there would be the opposing risk that in difficult times, the loss of domestic monetary sovereignty would foster resentment and encourage policy makers to deflect blame for problems onto the United States.

As Secretary Rubin said yesterday, we do not have an a priori view as to our reaction to the concept of dollarization. There are a variety of means and modalities for achieving it and we would expect to discuss these with any government seriously considering taking such a momentous step. But there are certain limits on the steps that the United States would be prepared to take in the context of such a decision. Specifically, 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 deciding to adopt the dollar.

Concluding Remarks

All of these dimensions both for countries considering dollarization and for the United States - will no doubt play a role in future discussions of this issue going forward. As I have said, the choice of which currency regime best suits them is a choice for countries to make themselves and not one for the United States to prescribe. But if any country desires to consider adopting our currency, we would welcome discussions between our respective authorities on the various issues involved. Thank you. I would now welcome any questions that you might have.

Last changed: September 26, 1999