Price Stability through Dollarization

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Price Stability through Dollarization

• Marc A. Miles, Ph.D.
• San Jose, Costa Rica
• October 13, 2008

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Issue 1Why is Price Stability Important?
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Why Price Stability is Important

• Prices are the information system of the economy
• Price stability provides reliable information,
  eliminating uncertainty
• Everyone in the economy constantly makes
  decisions about how to use people and resources
  today and tomorrow
• Manufacturers Increase production today or wait
  to produce tomorrow?
• Consumers Buy a car, take a vacation now, or
  save and buy tomorrow?
• Exporters Base contracts on prices today or
  agree to prices on the delivery date?
• The more uncertainty, the harder it is to make a
  decision, the less efficiently resources are used

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Why Price Stability is Important

• Decisions are made based on expectations of
  whether prices will go up or down
• If prices are expected to rise, it distorts
  decisions
• Manufacturers may want to produce today (at
  lowers wages and material costs) and sell
  tomorrow (at higher prices) too many resources
  used today, not enough tomorrow
• Consumers will want to buy now before prices go
  up
• Exporters can take advantage of higher prices
  tomorrow, but worry whether the exchange rate
  declines

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Why Price Stability is Important

• Bottom Line
• The more dependable (stable) prices now and in
  the future
• The easier it is to make all these decisions
• The lower the costs of doing business
• The lower the costs of business, the more that
  occurs

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An Analogy

• Prices coordinate decisions in the economy the
  way a conductor coordinates the musicians in an
  orchestra

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An Analogy

• Provides information to each player about
  precisely where they are and what to expect in
  the upcoming measures
• Players do not have to guess which musical note
  comes next
• With a good conductor, an orchestra makes
  beautiful music

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An Analogy

• But with a bad conductor, who fails to provide
  dependable information about what note is next,
  the result is accidents and unbearable noise

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Issue 2How Stable are Prices in Costa
Rica?
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Inflation in Costa Rica Leveling Off Around
10?(1990 -2007)
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Inflation in Latin America and the
Caribbean2004-2007
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Issue 3Does Higher Inflation Stimulate
Economic Growth?
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Inflation Does Not Improve Economic Growth --
U.S. (1950-2007)
2.7
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Inflation Has Not Helped Economic Growth in Costa
Rica (1990-2007)
5.9
5.4
4.0
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Issue 4 Myths About Monetary Policy in a
Small Country
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Myth 1 The Costa Rican central bank can
independently manipulate or stabilize inflation

• Why not true
• The assumptions underlying this assertion (and
  indeed monetary theory itself) are
• The money supply in Costa Rica consists solely of
  colones
• The Central Bank can control the quantity of
  colones
• In other words
• People in Costa Rica hold only colones (not
  dollars, euros, etc.) in their pockets and bank
  accounts
• People outside Costa Rica do not hold any
  significant amount of colones ..people in the
  United States, Europe, or even Chile do not have
  colones in their wallets or bank accounts.

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Myth 2 Dollarization is an Extreme Idea

• Why Not True
• None other than Nobel Laureate Milton Friedman
  stated 35 years ago
• While the use of a unified currency is today
  out of fashion, it has many advantages for
  development, as its successful use in the past,
  and even at present, indicates. Indeed, I
  suspect that the great bulk, although not all, of
  the success stories of development have occurred
  with such a monetary policy, or rather an absence
  of monetary policy.
• Perhaps the greatest advantage of a unified
  currency is that it is the most effective way to
  maximize the freedom of individuals to engage in
  whatever transactions they wish.
• Italics added

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Myth 2 Dollarization is an Extreme Idea

• Over 45 years ago, Nobel Laureate Robert Mundell
  proposed optimum currency areas where small
  countries would peg their currencies to the main
  currency in their region, or even directly adopt
  common currencies, making transactions within the
  area much lower.
• The countries of Europe have adopted the
  dollarization concept in the form of the euro
  area
• Neighboring Panama has used the dollar as its
  currency for over 100 years

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Issue 5There Are Two Ways to Create a
Unified Currency

• A Currency Board
• Dollarization

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What is a Currency Board?

• First A country must maintain 100 reserves
  against the local money
• Example
• Suppose the central bank of Costa Rica set a rate
  of 1 dollar 1 colon
• For every colon issued, there must be one dollar
  of reserves to back it up
• When someone wants to convert colones to dollars
• For every colon presented for redemption, the
  central bank must give up a dollar of its
  reserves
• Because the exchange rate is fixed and reserves
  are 100, the colon becomes the same thing as a
  dollar -- Just has a different look and a
  different name

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What is a Currency Board?

• Second (Very Important) The government and
  central bank must behave consistently with the
  need to maintain sufficient reserves
• The government cannot run budget deficits and
  monetize them
• In other words, in Costa Rica the central bank
  cannot buy up government colon debt and issue
  more colones
• If a domestic budget deficit is monetized
• Colones increase, but not dollar reserves
• Colones would no longer be 100 backed by dollars
• There would no longer be a currency board
• Price stability would be destined to fail

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What About the Failure of Argentinas Currency
Board?
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What went wrong in Argentina?

• The Argentine government and central bank did not
  behave consistently with the rules of a currency
  board
• The Argentine government continued to run large
  annual budget deficits
• The Argentine central bank monetized this debt,
  creating pesos without corresponding dollar
  reserves
• Hence, the dollar reserves behind the peso fell
  further and further below 100

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• Source SHH, Cato Journal, Vol. 28, No. 2
  (Spring/Summer 2008), p. 279.

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Argentina Illustrates Why Dollarization is
Superior to a Currency Board

• Transparent
• Dollar reserves not required, cannot run out
• Eliminates the risk of a run on the currency
• As the economy grows, the sum of the trade and
  capital surpluses must be positive to have an
  inflow of needed extra dollars
• The country must have regulatory and tax
  environments that encourage these surpluses

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Argentina Illustrates Why Dollarization is
Superior to a Currency Board

• Running budgets deficits has no direct effect on
  the exchange rate or the rate of inflation
• No exchange rate the dollar is the currency
• The inflation rate is approximately the U.S.
  dollar rate of inflation
• Any government debt has to be issued in dollars
• Prolonged deficits affect the credit rating of
  the country, increasing the interest rate, and
  the future ability to pay back the debt