The pitfalls of dollarisation

TK Arun

Senior Journalist

ARGENTINA is some 16,000 km away and normally does not impinge on the public discourse in India, except in relation to its star footballer Lionel Messi. But after the country recently elected maverick populist Javier Milei as President, his political and economic policies hold interest for democracies everywhere, particularly his promise to ‘blow up’ the country’s central bank and adopt the dollar as the domestic currency.

Dollar prices cannot vary across Argentina’s borders. When the price cannot change to determine who gets how much, you get rationing.

Milei is an economist by training, an anarchist by instinct and a recent entrant to politics, having served as a member of Argentina’s outgoing Congress for about a year. Argentina has been racked by economic mismanagement, inflation (143 per cent), a steep rise in unemployment and poverty, and a thriving black market for hard currency. The South American nation is an exporter of many commodities and the government had imposed multiple exchange rates for different purposes — beef exporters would get an exchange rate for converting their export proceeds into local Argentine pesos different from the one used to import farm machinery. At the end of 2022, Argentina had 15 exchange rates for various purposes, including one for travel to Qatar to watch their team play in the football World Cup.

Argentina owes the most to the International Monetary Fund (IMF) among all countries of the world — about $46 billion. Despite such generous accommodation of its requirements, the IMF failed to get Argentina to sort out its macroeconomic policy mess. This is thanks to Argentina’s politics, whose mainstream is free-spending populist, from which it would occasionally swing to fiscal conservatism that comes twinned with other kinds of conservatism, and occasionally to Leftist delusion, in which the government spends freely on the people, in addition to whatever it lavishes on its clients, without regard to fiscal capacity and macroeconomic consequences.

When a government spends more than it collects as taxes and non-tax receipts, it must borrow. Argentina boldly borrows from abroad to bridge its fiscal deficit, unlike India, which relies on domestic borrowings to meet the government’s funding gap. Argentina’s external debt is $276 billion, almost 45 per cent of its GDP. Yet, Argentina is no basket case. With a per capita income of $10,000 and a diversified economic base, including the world’s third largest reserves of lithium — a key metal in the emerging electric vehicle and battery ecosystem — it still attracts significant foreign investment.

As a solution to runaway inflation and multiple exchange rates, Milei has proposed dollarisation of the Argentine economy, meaning that the peso would be dispensed with and everyone would use the dollar for domestic transactions. This would immediately bring inflation down to the low single digit and do away with an exchange rate altogether for the dollar, not just multiple exchange rates. What could possibly be wrong with such a policy?

Loss of monetary sovereignty might offend nationalistic sentiments, but does it matter? It absolutely does. The ability to print money and set interest rates is not an abstract right such as to pursue happiness. When an economy grows, the money supplies grows, too, the proportion between GDP and money supply depending on many factors, including culture. That is for a normal economy, which can print its local currency. But in an economy in which the currency in use is a foreign one, whose supply is primarily determined by inflows either as export receipts, remittances or inward investment, and the policy rate of interest is set by a foreign monetary authority that calibrates policy to the requirements of its economy, things can go seriously awry.

Now, a big part of money supply is the credit created by banks. When the newspaper vendor collects his monthly payment, he has created credit and added to the money supply, but such credit creation is relatively small, and does not matter much. An Argentine bank can create credit and increase the money supply, even if the overall inflow of dollars has not changed. But suppose there is a crisis of confidence and the bank has to pull back loans to meet the demand to return deposits. This contingency constrains how much credit the bank can disburse in relation to the capital it maintains. The normal lender of the last resort, the central bank, lacks, in a dollarised economy, the capacity to offer such support on the scale of its choice because it cannot increase the supply of dollars.

So, the money supply, and the economic activity it supports, would be hemmed in by the availability of dollars. Dollar prices cannot vary across Argentina’s borders. When the price cannot change to determine who gets how much, you get rationing. When prices are inflexible, the real economy has to do the adaptation. Real wages get depressed, access to food and healthcare gets crimped. Enclaves catering to foreign demand would still receive dollar investment, even as domestic sectors are starved of capital. Lithium exports might boom, even as farms go untilled and food goes into short supply.

Zimbabwe tried dollarisation — partially in 2008 and completely in 2009 — as the solution to domestic economic mismanagement. Soon, the government had to supplement dollars with its own I-Owe-You (IOU) notes or quasi currency notes because the supply of dollars was too small to meet the requirement. IOUs multiplied without limit, leading to inflation of 2 million per cent. In 2019, Zimbabwe made it illegal to use the dollar for domestic transactions.

Politicians who spout facile solutions to economic problems that impose hardships on the people sometimes get elected to office. If they try to implement their solutions, we get disasters such as dollarisation or demonetisation.

The way to keep such populists out of office is not just to govern responsibly when in office but also to create and nourish a public discourse that engages with the real world and exposes tall promises. Magic realism is good in fiction, but terrible as attempted fact.

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