"The Lights Go Out in Lebanon as Financial Collapse Accelerates," declared a recent headline in The Washington Post. The headline refers specifically to worsening power outages but more generally to Lebanon's ongoing "economic implosion." This breakdown is due in large part to chaos in Lebanon's monetary and banking systems. Since October 2019 the Lebanese pound (also called the lira) has lost more than 80 percent of its value on the black market, with USD1 most recently trading around LBP8100. There is a black market because, although the Banque du Liban (the Lebanese central bank) continues to declare an official exchange rate of LBP1507.5 per USD, that rate is now available only to importers of a few favored goods.[1]
The peg became unsustainable, as pegged exchange rates invariably do, when the central bank created more money than was consistent with preserving parity between the purchasing power of its currency and that of the US dollar at the pegged rate. Instead of tightening when necessary to stop an outflow of dollar reserves, the Banque du Liban after 2016 began desperately to borrow from Lebanon's commercial banks (at high interest rates) the dollars it needed to maintain the semblance of a peg. The commercial banks attracted dollars by passing those high rates on to depositors who presumably hoped to cash out before a devaluation came. The scheme, called "financial engineering" by Riad Salameh, long-time head of the Banque du Liban, devolved into Ponzi finance, racking up an estimated $40 billion in losses.
There are legal exchange houses in Beirut at which the dollar could recently be purchased for LBP3850, but residents may buy only small amounts there, creating a dollar shortage at that rate. Around 75 percent of bank deposits are in US dollars, but commercial banks since October have refused to redeem their dollar deposits in dollars (with remarkable legal impunity), allowing only conversion to LBP at the 3850 rate.
In June, Lebanon's annualized inflation rate topped 50%. Imported goods' prices have risen at a much faster rate with the depreciation of the pound.
The monetary chaos is not unrelated to Lebanon's sovereign debt fiasco. Its ratio of sovereign debt to GDP is the world's third highest (after Japan and Greece), above 150 percent and climbing with the annual budget deficit running 11.4 percent of GDP in 2019. In March 2020, the government defaulted on its external dollar debt. Behind this fiscal crisis is the tangled history of a state built on clientelism (legislative seats are apportioned among the major religious communities) and fueled by widespread corruption.
Is there a way back to a sane monetary system? Full dollarization offers a reform that has proven practical and effective in Ecuador and elsewhere.
Types of Dollarization
"Dollarization" means the transition from using a domestic fiat currency to using an external currency, typically the US dollar, as the monetary standard. Lebanon has long had extensive popular or unofficial dollarization, as seen in the popularity of dollar deposits. Popular dollarization spreads as the inflation rate in local currency rises. But an end to the current chaos in Lebanon requires full or official dollarization: a discrete event in which the national government adopts the external currency and shuts down the local currency.
Official dollarization usually follows unofficial dollarization. In Ecuador, for example, as the inflation rate in sucres rose ever higher in 1998-99, Ecuadoran households and firms one by one put themselves on a US dollar standard. They shifted savings into dollars. They posted prices in dollars, even when accepting payment in local currency, so that they didn't have to reprice every day. Everyone followed the exchange rate daily. Sellers of high-ticket items wanted to be paid in dollars. Eventually every grocery shop wanted to be paid in dollars. Private sector wages began being paid in dollars. The driving force of this process is simple: people prefer to be paid in, and to hold, a money of relatively stable purchasing power to a rapidly depreciating money.
Lebanon is in the midst of the same process. Sellers of high-ticket and imported items want to be paid in dollars, which means that key transactions are blocked by the shortage of legal dollars created by the exchange-rate controls and freezing of dollar deposits.
By unofficially dollarizing their saving and spending and accounting, people dislodge their deteriorating official currency and spontaneously establish a de facto US dollar standard. A national government that relies on money-printing for revenue typically responds as the Lebanese government has, erecting an array of legal barriers to slow spontaneous dollarization. These legal restrictions put the government at odds with the citizens it is supposed to serve. Beirut's popular street protests—leaving the central bank building adorned with graffiti—are testimony to the conflict. ("Protesters on the streets, who once revered Salameh's ability to steer the financial system through bouts of unrest, now daub graffiti on the walls of the central bank," reported Reuters in November.)
In January 2000, Ecuador's government stopped fighting the people's choice and officially switched to the dollar. One motivation was that nominal tax revenues in its own currency were not keeping up with inflation, reducing the government's revenue in real terms. The government of Lebanon may yet respond to the same motivation. Official dollarization is the next step for Lebanon if it wants a better and less chaotic currency.
Official dollarization has a successful track record where it has been tried: Panama has held to its dollarized economy since 1904; the Turks and Caicos Islands since 1969; Ecuador since 2000; and El Salvador since 2001. Dollarization is so popular in Ecuador that even the left-wing government of Rafael Correa (2007-17), who complained that it was a "straitjacket," dared not end it.
Benefits of official dollarization
Why does official dollarization succeed? Most simply, with prices in dollars and no local currency in circulation, the national government can no longer print money to pay its bills. The prices of traded goods, and of goods and services generally, are constrained by prices in the US and other dollar-using countries. Dollars will flow out if local prices exceed prices elsewhere. The local inflation rate is thus constrained by the US inflation rate. Before official dollarization, Ecuador in 1970-99 suffered a 28% average annual inflation rate. The rate rose into hyperinflation (> 50% per month) toward the end of 1999. Ecuador officially dollarized its economy in January of 2000. Since 2004, Ecuador's inflation rate has averaged 3.1% per year.
Official dollarization benefits the public because it means that holding money is no longer taxed heavily. People no longer need to spend time and resources delaying payouts, speeding up collections, and keeping depreciating local currency balances low by making frequent trips to the currency exchange market. Prices of goods and services become less noisy, more informative, and more reliable, which enables longer-term household and business planning.
By reducing risk surrounding the future purchasing power of money, official dollarization makes interest rates lower and less noisy, both in nominal and in real terms. The reduced long-term risk opens a market for long-term loans. In Latin America most home mortgages in local pesos run only 5 years and then need to be rolled over at current rates. In the dollarized economy of Panama, however, 30-year fixed-rate mortgages are available. Although dollar loans are already available in Lebanon, it is risky to lend dollars to a borrower whose income is in Lebanese pounds, because devaluation makes the borrower unable to repay. With official dollarization, devaluation risk disappears for importers and exporters, which is very important for a small, trade-reliant nation like Lebanon.
Official dollarization also shields the currency, and therefore the private economy to a great extent, from government fiscal chaos. Even if the government defaults, as Ecuador did in 2008, and as Lebanon did in March, companies can still go about their business. A government teetering on the brink of insolvency can no longer resort to rapid money printing, with its results of high inflation and devaluation, to tax its citizens. It no longer has reason to impose financial and trade restrictions. When it has its own currency to print, by contrast, as economist John Cochrane put it, "the government's problems infect the rest of the economy."
Finally, official dollarization reduces instability in commercial banking. As the example of Panama shows, the Lebanese banks can call upon the Federal Reserve Bank of New York for supplies of fresh Federal Reserve Notes, and upon major New York commercial banks for standby lines of credit. With official dollarization the Banque du Liban would no longer conduct monetary policy. It could no longer drain banks of their dollar liquidity via "financial engineering," turning the financial system into a Ponzi scheme. In Ecuador, the hyperinflation of the local currency caused a banking crisis, but within a few years following dollarization the commercial banks became stable and prudently run, and have remained so.
Of course, official dollarization is not enough to cure all economic problems. It does not guarantee that the government will keep tax rates moderate, balance the budget, stop doling out favors to clients, root out corruption, obey the rule of law, allow free trade, or welcome foreign investment.
It may be a blow to nationalist pride to give up a national currency that once was internationally respected. But living in the past is an expensive indulgence. Lebanese citizens should consider the words of an Argentine advocate for dollarization—and former head of the Argentine central bank—Pedro Pou: "We do not suggest that each country should produce every possible good. We are happy with the idea that we should import automobiles or TV sets from the more efficient producers; why should we not apply the same logic to money?"[2]
We can expect opposition to official dollarization in Lebanon from central bankers and their advisers, who sincerely think that they can do a better job of expertly steering the economy—despite all evidence to the contrary. We can expect it from politicians who think that the Banque du Liban's power to print money can still benefit them personally. Never mind the Lebanese people clearly voting with their wallets and pocketbooks in favor of the dollar. Such policymakers either fail to think about dollarization as the market verdict resulting from choices of individual families and firms, or they simply don't believe that those choices deserve respect. They think about the monetary system only as a tool to be engineered and manipulated by expert policymakers and analysts (presumably themselves).
How might Lebanon implement official dollarization?
The first step for Lebanon is to eliminate its dollar shortage by eliminating exchange-rate fixing and dollar rationing. The government need only dismantle legal barriers to buying and selling dollars at a market-determined price, to importing and exporting dollars in unrestricted quantities, and the dollar shortage will end. It should also let contracts that call for payment in dollars be specifically enforced in dollars, i.e. not allow debtors or renters to swindle creditors or landlords by forcing acceptance of payment in lira at the obsolete official rate. Let the public freely express its preferences regarding currencies.
The second step is to pass legislation to officially dollarize, converting taxation and government expenditure to the dollar and setting a path for the retirement of the lira. The examples of Ecuador and El Salvador can be studied with advantage. They recommend declaring a one-time conversion at the freed market rate (which will presumably be below the current black-market rate), and having the Banque of Lebanon redeem its lira liabilities with dollars at that rate.
There is a complication: It isn't clear that the Banque du Liban has sufficient assets to retire its pound liabilities. It may be insolvent when its assets, especially sovereign bonds, are valued at market prices. The Lebanese government says that the central bank has lost about $50 billion. For his part, Mr. Salameh disputes that figure and claims that the bank has a positive net worth, but the Banque du Liban hasn't produced a credible balance sheet to show its solvency. In any case, the bank is owned by the government. Accordingly, the Association of Banks in Lebanon in May called on the government to sell off enough state assets to repay the Banque du Liban's borrowings from the commercial banks, in order to enable the banks to make depositors whole. The same proposal can be extended if necessary to redeem the Banque du Liban's lira banknote liabilities with dollars.
Once the lira is retired, the Banque du Liban will be removed from monetary policy decision-making. If it continues to exist, its role can be refocused to that of supervising and auditing the commercial banks.
Would a currency board make more sense?
A currency board works in jurisdictions where the authorities can be trusted to play strictly by the rules. It has worked just fine in Hong Kong, where so far China has kept its hands off the Hong Kong Monetary Authority. It has the advantage, where it works, of yielding a bit of income to the government from the interest earned on the USD Treasury Bills held as reserve assets. Of course, that interest is next to zero today and probably will be for years to come. So the choice between dollarization and a currency board comes down to whether the Lebanese people trust their government to play strictly by the rules and resist the temptation to grab the pot of money sitting at the currency board.
Argentina's example warns us of the dangers of a government cheating on an unorthodox currency board. In 1991 the Argentine central bank created a new peso, fixed to the US dollar at 1:1, and was supposed to keep at least 100% backing in USD assets. But the government compelled it to buy the dollar-denominated debt of the Argentine government, which traded below par value due to the risk of default. Thus the central bank began lending to the government and became under-reserved on a mark-to-market basis. There was a run against the peso for dollars, and the system broke its promise to buy back all the pesos at 1:1. (Worse still, the Argentine government took control of all dollar deposits in commercial banks and repaid them 1:1 in pesos simultaneous with devaluation, so it repaid only about 30 cents on the dollar.)
Outright dollarization, by contrast, eliminates the lira and with it any threat of devaluation and forced conversion of onshore dollar deposits into lira. It is not impossible to undo official dollarization, but it is impossible to undo it so suddenly, and much harder to undo even gradually.
What about a Bitcoin standard?
Some Lebanese already hold Bitcoin, and they should enjoy complete freedom to do so. Others save by accumulating gold. But few will find Bitcoin or gold currently suitable as an everyday medium of exchange. In contrast to dollars, hardly any sellers of goods and services inside the country accept payment in BTC or gold. (A 2019 Coindesk article on "How Lebanon's Economic Crisis Highlights Bitcoin's Limitations" mentions only a single retailer, a car dealer in Beirut, offering to accept Bitcoin.) The purchasing power of Bitcoin remains much too volatile for an everyday medium of exchange. It is imprudent to hold in Bitcoin the part of your monthly paycheck with which you plan to pay your rent, given the risk of Bitcoin's value falling 10% or more before the rent is due.
A small country on a Bitcoin or gold standard would have dramatically volatile exchange rates against the rest of the world. A dollar standard, by contrast, eliminates exchange rate volatility against the world's dominant medium of international trade.
Conclusion
The US dollar is not a perfect currency. But it needn't be perfect to provide a vast improvement over Lebanon's chaotic status quo. Annual inflation of 2 percent is far better than 50 percent. A free currency market is far better than one with price controls and discriminatory rationing. Full dollarization offers the best hope for turning the lights back on in Lebanon.
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[1] This essay contains the gist of my remarks made via Zoom to an audience in Lebanon on Saturday, 18 June 2020. My thanks to Forrest Partovi and Jalal Hasbini respectively for arranging the event and for leading the discussion.
[2]Pedro Pou, "Is Globalization Really to Blame?" In J. S. Little and G. P. Olivei (eds.) Rethinking the International Monetary System (Boston: Federal Reserve Bank of Boston, 2000).