To Dollarize or Privatize Currency in Argentina

Wall Street Journal, August 17, 2001.>
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Argentina is in a bind. Unless it can escape its current recession, its finances will continue to erode, forcing the government into default. But high interest rates are hampering a recovery. The prime commercial lending rate is 25 percent for dollar loans and a wrenching 41 percent for peso loans.

The all‐​around scarcity of credit in Argentina, and the premium on peso interest rates in particular, reflect investors’ fear that Argentina will devalue the peso. Although Argentina has a currency‐​board system that links pesos to dollars at one to one, and has more dollar reserves than there are pesos in circulation, devaluation remains a serious threat. This is not because the Central Bank of Argentina might run out of dollar reserves, but because the government might be tempted to go beyond its recent efforts to subsidize struggling exporters with a preferential rate, and intentionally abandon its currency‐​board arrangement. Because government monetary authorities can’t be sued, they don’t suffer the sanctions that commercial banks face when they break their promises.

Official dollarization would do away with pesos entirely, substantially reducing Argentina’s bank‐​lending rates and credit shortage, and helping to resuscitate its economy. Of course Argentina’s government could still default on its dollar‐​denominated debts. But a fully dollarized financial system would untangle the government’s credibility from that of private borrowers, allowing private borrowers to benefit from their good credit. That is why the Panamanian government’s default during the Latin American debt crisis of the early 1980s did not drive commercial lending rates in Panama’s fully dollarized economy to painfully high levels.

But dollarization has drawbacks. It would deprive the Argentine economy of seigniorage — the profit central banks earn by using their own paper notes (which don’t pay interest and can be printed for a small fraction of their face value) to purchase interest‐​earning assets. Argentina’s government earns about $600 million a year from issuing peso‐​denominated paper notes. Dollarization would transfer that seigniorage to the Federal Reserve System. Although $600 million seems like peanuts compared to Argentina’s $265 billion economy, it’s still a high price to pay for an import — paper currency — that might be produced at home, and a price that opponents of dollarization emphasize. Also, the supply of paper dollars would respond only imperfectly to routine changes in demand, because extra currency has to come out of banks’ limited dollar reserves.

Could Argentina enjoy the benefits from dollarization without these costs? It could, by allowing Argentina’s privately owned banks to issue their own dollar‐​denominated paper notes. The banks would have to redeem their notes in Federal Reserve dollars on demand. That should suffice to make the notes just as secure as dollar‐​denominated deposits. And Argentina would not have to give up seigniorage to the Federal Reserve. Although the Central Bank of Argentina wouldn’t earn any seigniorage, interest earned on banknote‐​funded investments would stay in Argentina. It would be earned in the first place by Argentina’s commercial banks; but ultimately it would be passed along (thanks to competition) to their customers in the form of cheaper loans and better services. The banks might even offer to make interest payments to their note holders in the form of jackpots paid on notes bearing “lucky” serial numbers.

According to some estimates, the Argentine public already holds about $17 billion in Federal Reserve notes. That makes over $30 billion in total (peso and dollar) paper currency holdings. If Argentina’s major commercial banks could persuade the public to hold $30 billion of their own circulating notes instead of either domestic or foreign central bank notes, they could expand their loans and investments by almost the same amount (allowing for the need to hold dollar reserves). Lending rates might therefore fall by considerably more than the present “peso premium.”

Allowing banks to issue their own currency might seem far‐​fetched or at least novel, but it is neither. Many financial firms already issue paper travelers checks, which resemble currency although they cannot pass from hand to hand without having to be endorsed. In Scotland and Hong Kong commercial banks actually issue paper currency and have done so for a century or longer, maintaining unblemished records of honoring their promises. How many of the world’s central banks can make the same claim?

Before the 20th century, commercial banks issued their own notes in most countries. In many cases governments horned in on the private sector because they wanted the profits, not because the private sector was doing a bad job. Strong private‐​currency systems, like those of Canada and Scotland, suffered very few defaults that harmed note holders or depositors. Other systems were less reliable, not because their currencies were privately supplied, but because of misguided regulations. In the antebellum U.S., for instance, restrictions on branch banking kept banks under‐​diversified and under‐​capitalized, and caused notes issued in one part of the country to command less than their face value elsewhere. Yet even the records of weaker private‐​currency systems look good compared to most of the government currency monopolies that replaced them.

Many of Argentina’s commercial banks are strong, thanks to a policy of allowing free entry to global banking firms. But even some of Argentina’s otherwise strong banks are smarting from devaluation fears. Were there no peso for the Argentine government to devalue — that is, were the Central Bank of Argentina to redeem all outstanding peso notes using its dollar reserves — Argentina’s banks would be relieved of this remaining source of weakness. The strongest of them ought to be able to get their own notes into general circulation, just as they have been able to convince people to hold their dollar‐​denominated deposits. It is the Central Bank of Argentina that people distrust, not paper currency per se.

Should Argentina’s authorities doubt this, they could allow their central bank to issue its own dollar‐​denominated notes while depriving those notes of any legal‐​tender status, so that the public can’t be forced to accept them and banks cannot use them as reserves. The public could then decide for itself whether it trusts government‐​issued paper more than that of Citibank, Deutsche Bank, or HSBC.

George Selgin

George A. Selgin is a professor of economics at the University of Georgia’s Terry College of Business and an adjunct scholar at the Cato Institute.