Central banks issue currency and exercise widediscretion over the conduct of monetary policy.Although widespread today, central banks arerelatively new institutional arrangements. In1900, there were only 18 central banks in theworld. By 1940, forty countries had them, andtoday there are 164.
Before the rise in central banking (monetarynationalism) the world was dominatedby unified currency areas, or blocs, the largest of which was thesterling bloc. As early as 1937, the great Austrian economistFriedrich von Hayek warned that the central banking fad, if itcontinued, would lead to currency chaos and the spread of bankingcrises. His forebodings were justified. Currency and bankingcrises—while nowhere to be seen at present—have engulfed theinternational financial system with ever-increasing strength andfrequency. Indeed, for most emerging-market countries withcentral banks, relatively free capital mobility has produced hotmoney flows and repeated exchange-rate and domestic bankingcrises. What to do?
The obvious answer is for vulnerable emerging-market countriesto do away with their central banks and domestic currencies,replacing them with a sound foreign currency. Panama is a primeexample of the benefits from employing this type of monetarysystem. Since 1904, it has used the US dollar as its official currency.
Panama's dollarized economy is, therefore, officially part ofthe world's largest currency bloc. To integrate its banking systeminto the world's dollar-based financial markets, Panama changed itsbanking laws in 1970. As a result, international banks have beeneager to take part in the offshore financial revolution. The growth ofPanama's banking system attests to the fact that the 1970 bankingreforms allowed Panama to take advantage of the trends in globalizationand free flow of capital.Panama's dollarized monetary system eliminates its exchangerate risks and the possibility of a currency crisis vis-à-vis the USdollar. And the possibility of banking crises is largely mitigated becausePanama's banking system is integrated into the internationalfinancial system. The nature of Panamanian banks provides the keyto understanding how the system as a whole functions smoothly.When these banks' portfolios are in equilibrium, they are indifferentat the margin between deploying their liquidity (creating orwithdrawing credit) in the domestic or international markets. Asthe credit-creating potential in these banks changes, they evaluatethe risk-adjusted rates of return in the domestic and internationalmarkets and adjust their portfolios accordingly. Excess liquidityis deployed domestically if domestic risk-adjusted returns exceedthose in the international markets and internationally if the international risk-adjusted returns exceed those in the domestic market.This process is thrown into reverse when liquidity deficits arise.
The adjustment of banks' portfolios is the mechanism that allowsfor a smooth flow of liquidity and credit into and out of thebanking system and the economy. Excesses or deficits of liquidity inthe system are rapidly eliminated because banks are indifferent as towhether they will deploy liquidity in the domestic or internationalmarkets. Panama is just a small pond connected by its banking systemto a huge international ocean of liquidity. When risk-adjustedrates of return in Panama exceed those overseas, Panama draws fromthe international ocean of liquidity, and when the returns overseasexceed those in Panama, Panama adds liquidity (credit) to the oceanabroad. To continue the analogy, Panama's banking system acts likethe Panama Canal to keep the levels of two bodies of water in equilibrium.Not surprisingly with this high degree of financial integration,the levels of credit and deposits in Panama are uncorrelated.
The results of Panama's dollarized money system and internationallyintegrated banking system have been excellent whencompared to other emerging market countries (see accompanyingtable).
Panama's GDP growth rates have been relatively high andtheir volatility relatively low. This is rather remarkable whenyou consider that Panama is a classic dual economy. On theone hand, the services sector (banking) is export-oriented,capital intensive, highly productive, generates little employmentand is largely free of government interference. On theother hand, the agricultural and manufacturing sectors arestagnant, highly regulated and subsidized, inefficient, laborintensive and uncompetitive.
- Interest rates have mirrored world market rates, adjusted fortransaction costs and risk.
- Inflation rates have been somewhat lower than those in theUS.
- Panama's real exchange rate has been very stable and on aslightly depreciating trend vis-à-vis that of the US.
- Panama's banking system, which operates without a centralbank lender of last resort, has proven to be extremely resilient.Indeed, it weathered a major political crisis betweenPanama and the United States in 1988 and made a strongcomeback by early 2000.
To insure against currency and banking crises, emerging marketcountries should follow Panama's lead: forego monetarynationalism by dumping central banks and domestic currencies,and fully integrate their banking systems with internationalcapital markets.