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Dollarization means adopting the US dollar as the currency of choice in a foreign country.  Many countries today are already dollarized unofficially.  Where the purchasing power of the local currency has been volatile, as in Latin America and in the former Soviet Union, people often hold dollars as a store of value.  In those cases the domestic currency is commonly used in small transactions, but the dollar is preferred in large transactions and in savings. 

Official Dollarization

In some countries, using the dollar in transactions is perfectly legal, in others it is not.  In a very few, the US dollar is the official currency, mostly in small or developing countries.  Panama has been officially dollarized since 1904.  Other countries have on occasion considered moving to an official dollarized system. 

Under official dollarization the local currency is completely replaced by the dollar, with the possible exception of coinage.  That means domestic banks only accept dollar checking accounts and issue dollar loans.  Federal Reserve notes are legal tender and the only form of paper money recognized by the government. 

Before its latest political and economic crisis, Argentina operated under a currency board system that maintained an exchange rate of 1:1 between the dollar and the peso.  That required holding sufficient dollar reserves to fully back the pesos in circulation.  The dollar was recognized as legal tender along with the peso.  Argentina has since abandoned the peg to the dollar and gone to a floating exchange rate for the peso.

In the wake of the Asian and Brazilian economic crisis, Ecuador was unable to avoid a deep recession and banking crisis.  In March 1999 the government froze deposits in the entire banking system as the value of the sucre dropped.  A year later, after much political turmoil, and with the help of the IMF in structuring its financial system, Ecuador adopted the US dollar as its official currency.  This will be an important test of dollarization under very difficult conditions. 

The US Position

There is nothing to prevent a country from unilaterally moving to an official dollarized currency, although the Fed has recommended that it be consulted in advance.  At the very least, the Fed would need advance notification of the extra notes that it would have to make available. 

The Fed has stated that under no conditions would it act as a lender of last resort to foreign banks, nor would its monetary policy be contrary to the best interests of the US.  So far, US officials have taken a neutral position, neither encouraging nor discouraging dollarization.  However there are many issues, pro and con, for the US and a dollarizing country that deserve careful consideration.  Here are a few: 

A Stabilizing Factor

A country with its own currency, typically issued by a central bank, can exercise its own monetary policy.  In theory this enables it to manage its money supply, interest rates, and to some extent the exchange rates solely in its own self-interest.  In practice however many developing countries have experienced serious problems in their monetary affairs, lacking the institutions and experience needed.  It is likely that official dollarization would significantly improve price stability in those countries with a history of monetary problems. 

Loss of Independent Monetary Policy

On the other hand dollarization means that the country can no longer tailor its monetary policy to suit its own needs.  Unless its economy closely tracks the US economy, that can be a serious limitation at times.  Nevertheless the discipline required might be worth the loss of flexibility.  The added stability should offer a better environment for planning business expansion and new enterprise.  Under dollarization the central bank would no longer be able to create money, but it would still retain the important task of administering banking system regulations and ensuring sound banking practices. 

Seigniorage Effects

The US gains added seigniorage benefits as countries increase the use of dollar currency.  The annual cost to the US of creating and servicing its currency is now less than 0.1% of the face value of currency outstanding.  The notes however are sold at face value.  Thus notes that are purchased for use overseas are the equivalent of nearly cost-free imports of goods and services to the US. 

If the US wished to encourage certain countries to officially dollarize their economies, it could easily afford to share some of the seigniorage benefits.  That seems a reasonable tradeoff, since dollarization would enhance trade with those countries, to the advantage of both. 

Political Considerations

An important political issue is the effect on national pride.  Most people see their currency as a symbol of national sovereignty.  Losing their own currency could be difficult for many to accept.  It could foster the 'imperialist Yankee' reaction, particularly when some incident strains relations.  Also their politicians could find it convenient to lay the blame for their own mismanagement and poor economic conditions on US monetary policy.  These, rather than purely monetary issues, appear to be of primary concern to the US.  .

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