Latin American countries are increasingly turning to the U.S. dollar to help them get control of inflation. While adopting a foreign currency is further than most countries are willing to go, some East European countries have pegged their currencies to currency boards as a way of enforcing fiscal discipline.
Prague, 20 January 2000 (RFE/RL) -- This month's announcement by inflation-plagued Ecuador that it plans to replace its national currency with the U.S. dollar has refocused attention on the so-called "dollarization" of Latin America.
Panama already uses the dollar as its official currency, and at different times over the past decade, Mexico, Brazil, and Argentina have all contemplated adopting the dollar as a way to pull their economies out of crisis. So far, the plans have not been realized. But all eyes are now on Ecuador, where the government says its intentions are serious.
With most of Western Europe on course to adopt the euro as a single currency, the question arises: Is the next step in economic globalization the emergence of a handful of two or three world currencies?
While few independent states have ever willingly given up their own currencies in favor of another country's legal tender, many countries have at one time or another experimented with what are called currency boards -- in essence, pegging their national currencies to a stronger currency.
Under a currency board, a country's monetary policy is, in effect, put on "autopilot." The government exchanges local currency for a designated "hard" currency at a permanently fixed exchange rate. This takes the power of printing money out of the hands of the central bank -- and, it is hoped, promotes low inflation and long-term macroeconomic stability.
Most of the transition economies of Central and Eastern Europe have faced periods of high inflation and currency devaluation in recent years. For some -- among them Bulgaria, Lithuania, and Estonia -- the answer has been to peg their currencies to the dollar or the German mark.
Philip Lane, an economist at Dublin's Trinity College, says the reasons the three countries adopted currency boards differ. But he says that the move has proved successful for all three countries, at least in the short term:
"The most interesting example is maybe Bulgaria, which has been one of the worst performers in terms of the transition to capitalism. And so you had very high inflation rates in Bulgaria and very slow economic progress. So in 1997, Bulgaria moved to a currency board regime where the currency was tied to the deutsche mark. And what we saw there has really been an example of success in the sense that inflation very quickly has come right down to European levels and the economy has seemed to recover. So one role for a currency board is, if you are in a crisis situation like Bulgaria, it's a very dramatic way to emphasize that you are changing your ways, that you are engaging in reform."
Estonia and Lithuania, immediately upon regaining independence, pegged their currencies to the German mark and the dollar in an effort to make their small economies stable and thus attractive to foreign investors. The strategy paid off, but Lane says that over the long term, the price may be slower growth.
"The other examples, of Lithuania and Estonia, are of countries which have had currency boards almost throughout the transition period. And in that situation, what you have is the question of whether a currency board is a good idea for a long period of time such as a decade or longer. Transition economies would tend to grow more quickly than Western economies because they are in the catch-up phase, and it's not clear whether these countries might now do better by moving from a currency board to a more flexible exchange rate policy."
Economists remain divided about the longer-term merits of currency boards. By giving up its ability to set interest rates, a country's central bank sacrifices important leverage. Even among countries now part of the euro zone, there is significant concern that the European Central Bank's binding decisions on interest rates will adversely affect some countries, to the benefit of others.
But, Lane notes, for small countries dependent on foreign trade for most of their revenue, a currency peg may still prove to be the most advantageous solution. Ireland, whose high-tech-driven economy has boomed over the past several years, offers an interesting test case.
From independence in 1922 until 1979, Ireland had a currency board fixed to the British pound. But from 1979 until 1998, the Irish currency was partially floated. The result convinced Ireland's politicians that it would be better to return to a peg, this time the euro.
"We [in Ireland] really paid for the 1979 to 1998 period with high interest rates, because of the risk associated with investing in a small country with an unestablished floating exchange rate. So the Irish experience has been that we don't regret giving up monetary independence -- that we're happy to leave monetary policy to the bureaucrats in Frankfurt."
By 2005, politicians in North and South America hope to expand regional alliances to establish a free trade area of the Americas. By then, the euro will have been in circulation in Western Europe for three years and Asia could see the emergence of a new trading zone. The incentives for other countries to tie themselves more closely to one of these blocs are bound to increase.
Mexico, Brazil, and Argentina -- all countries with strong national identities and historical traditions -- have been reluctant to adopt the dollar (although Argentina has pegged its currency to the U.S. currency) for fear of fanning latent anti-American sentiment. The advantage of the euro, says Lane, is that it has no home country and thus presents less of an affront to delicate nationalist feelings.