Alexander (2000) Monetary Union

North American Journal of
Economics and Finance 11 (2000) 205225
Monetary unionsa superior alternative to full

dollarization in the long run
Volbert Alexandera,1, George M. von Furstenbergb,*,2
a
Justus-Liebig-Universitat, Giessen, Germany
b
Fordham University, Graduate School of Business, Rm 624E, 113 W. 60th St.,
New York, NY 10023-7484, USA
Received 1 August 2000; received in revised form 1 September 2000; accepted 1 September 2000
Abstract
The paper extends the debate about the exchange rate system that is appropriate in view of the
pressures for currency consolidation in open international financial markets to the issue of full
dollarization versus (multilateral) monetary union. Unilateral dollarization may not be sustainable
politically in the long run because fully dollarized countries may not be willing to keep on paying a
seignorage tribute to the United States once they have built a record of internal stability. Even in the
short and medium term, fulfillment of the fiscal and regulatory adjustments and reforms required for
multilateral monetary union is preferable to embarking on unilateral dollarization without assurance
that needed reforms will be supported by the countrys main constituencies. 2000 Elsevier Science
Inc. All rights reserved.
JEL classification: F31; F33; F36
Keywords: Monetary union; Dollarization; Exchange rate regimes; European monetary union
An earlier version of this paper was presented at the Conference on The Global Economy: Challenges and
Opportunities for the 21st Century, Athens, Greece, August 2527, 2000.
* Corresponding author. Tel.: 1-212-636-7953; fax: 1-212-765-5573.
E-mail address: vonfurstenb@fordham.edu (G.M. von Furstenberg).
1
Volbert Alexander is Professor of Economics (Money, Credit and Banking) at the Justus-Liebig-Universitat
of Giessen (Germany).
2
George M. von Furstenberg is Robert Bendheim Professor in Economic and Financial Policy, Fordham
University (New York); and President, North American Economics and Finance Association.
1062-9408/00/$ see front matter 2000 Elsevier Science Inc. All rights reserved.
PII: S 1 0 6 2 - 9 4 0 8 ( 0 0 ) 0 0 0 3 8 - 3
206 Alexander, von Furstenberg / North American Journal of Economics and Finance 11 (2000) 205225
1. Introduction
Since the breakdown of the Bretton-Woods system, a global exchange rate system has not
been re-established. Countries, on their own or in small groups, have tried to find the
exchange rate regime that is best for them. According to the IMF classification scheme, in
September 1999, out of 185 listed economies, 51 are classified as floating independently, 45
as fixed (currency boards, monetary unions) and 89 as intermediate regimes. The latter group
consists of 30 single-currency pegs, 13 economies pegged to a composite, 5 crawling pegs,
7 horizontal bands, 7 crawling bands and 27 managed floats (see IFS, March 2000).
The prevailing exchange rate regimes have changed often within short periods of time.
Klein and Marion (1994) reported that the mean duration of pegs among countries in the
Western Hemisphere is only about 10 months. Regimes like currency bands and pegs broke
down because of currency crises precipitated by speculative international capital flows and
the, often elusive, factors that triggered them. Apparently we are far away from having
settled on an optimal exchange rate system.
Any discussion of the exchange rate regime that is appropriate for any country at its
particular stage of economic and financial development and integration with other countries
must be mindful of the following:
Y In a globalized world with massive international capital flows and reduced importance
of capital controls, the competition between currencies is intensified dramatically.
Small, weak currencies are subject to speculative attacks leading to substantial deval-
uations, withdrawal of international capital, banking crises and far-reaching negative
repercussions for the real economy. As a result, there is a strong tendency toward
regional currency consolidation (von Furstenberg, 2000, pp. 1, 3, 4).
Y During the last five decades, Latin American countries have not been able to establish
long-run stability. Even dramatic political and economic reforms, the adoption of
different exchange rate regimes, and massive support by international organizations
like the IMF were not able to reduce permanently public deficits financed mainly by
money creation. The result has been an increasing substitution of US dollars for the
weak home currencies, not only in external but in many internal transactions.
Y After the breakdown of socialist systems in 1989/1990, many countries in Eastern
Europe and Central Asia became independent and entered the international economic
community. New national currencies emerged and had to be linked to the dollar, the
DM and other currencies like the Russian ruble (Bofinger, 1999; Fidrmuc & Schardax,
1999; Ghosh, 1997; Nuti, 1996; Sachs, 1996).
Y One of the main lessons from the East Asian crisis of 1997 was that pegs against stable
currencies may not hold in countries with poorly supervised and underprovisioned
financial systems. Distrust in a countrys financial system can quickly provoke a flight
from its currency so that even hard pegs may turn out to be weak. This experience has
changed attitudes towards the attractiveness of so-called intermediate exchange rate
regimes (Dadush, Dasgupta & Uzan, 2000; Summers, 1999).
Alexander, von Furstenberg / North American Journal of Economics and Finance 11 (2000) 205225 207
Y In contrast to the 1970s, nearly all major countries reduced their inflation rates
significantly during the 1980s and 1990s. Responsible for this increased stability was
an intellectual change in the conduct and goals of monetary policy: central banks
concentrated their efforts on fighting inflation by limiting the growth rates of money
supply or by targeting low inflation rates directly (Bernanke & Mishkin, 1997; Estrella
& Mishkin, 1997; Svensson, 1999). This increased the international reputation of the
hard currencies and strengthened their functions as anchors of stability for many
countries with unstable monies.
Y The long process of political and economic integration in Europe reached a new
dimension in the 1990s, when EU-member states decided to abolish their national
monies, to introduce a new currency for Europe and to establish a European central
bank. This implied dramatic changes in the national currency regimes of EU-members
(Artis & Lee, 1997).
The new developments and conditions briefly described above have intensified the
worldwide discussion of optimal or adequate exchange rate regimes. There is a significant
difference between the Western Hemisphere and Europe in the main focus of this debate: in
the former the discussion is about the pros and cons of unilateral full dollarization, while
Europe is evolving a model of multilateral monetary union. Thus, in the Western Hemisphere
there is some support for the call to let the dollar reign from Alaska to Antarctica, meaning
the abolition of weak national currencies and the introduction of the US dollar as the sole
legal-tender money in all the countries of the region (Barro, 1999).
In Europe, by contrast, the debate is concentrated on issues concerning the introduction
and the optimal design of a monetary union, where all members replace their national
currency with a new, shared currency and elect to integrate their financial systems. Instead
of the Federal Reserve Board and Open-Market-Committee making monetary policy for the
entire hemisphere (excluding Canada) by focusing on what is good for the United States, the
European Central Bank is governed by a structure which involves participation of all member
states.
The purpose of this paper is first to compare the pros and cons of full dollarization (FD)
and monetary unions (MU). To understand the importance of the different arguments, key
empirical lessons from the past are reviewed. Second, the paper deals with a comparison of
the short- and long-run implications of full dollarization and monetary union. We try to show
that the FD solution is not stable in the long run and that the EU-regime is preferable in the
short and superior in the long run.
At the beginning of the integration process, the requirements are established which
countries must fulfill before they are accepted as members. This implies that the major
adjustments in economic systems must take place in advance of entry in order to allow
countries to qualify for MU membership. In the FD case, reforms in the economic system of
a dollarized country may be initiated during and after adoption of the dollar (see Ecuador).
While the first way stimulates a common effort in groups of countries to meet entrance
requirements by accepting thorough reforms, the latter tries to impose ongoing constraints on
economic agents that may not be accepted.
FD involves a high financial tribute to the United States in the form of forgone seignorage.
Table 1
Economic Performance of Advanced Countries in Long-Run Perspective
197382 198392 199398 20002
US inflation rate 9.03 3.81 2.53 3.20
CAB (bill. of $) 0.46 91.26 135.67 411.60
fiscal deficit1 2.39 4.69 2.40 0.90
unemployment rate 6.99 6.82 5.57 4.20
long term interest rate 9.36 9.10 6.28 6.60
Japan inflation rate 8.42 3.45 0.70 0.30

CAB (bill. of $) 3.27 64.24 108.95 135.00
fiscal deficit1 5.50 0.44 3.52 7.90
Germany inflation rate 4.97 2.32 2.18 1.40

CAB (bill. of $) 1.61 24.52 10.38 3.00
fiscal deficit1 1.81 1.82 2.77 1.20
France inflation rate 11.02 4.42 1.60 1.20

CAB (bill. of $) 1.24 0.84 21.05 34.00
fiscal deficit1 1.25 2.45 4.50 1.70
UK inflation rate 14.20 5.50 2.73 2.40

CAB (bill. of $) 1.58 13.66 2.43 2.20
fiscal deficit1 4.86 2.40 4.47 0.80
Source: OECD, Economic Outlook, IMF, International Financial Statistics, own computations
1
in % of GDP
2
estimated
While dollarized countries are initially compensated by greater economic stability, lower
interest rates and easier access to world capital markets, they will not be willing to pay that
tribute once they have maintained stability for a long period of time. In the long run, the
incentives will grow to step away from FD and to construct an MU together with other
dollarized economies.
The paper is organized as follows: Section 2 presents some lessons from the past that are
crucial for the current debate about dollarization or monetary union. Section 3 tries to draw
some implications from the current debate. The pros and cons of FD and MU are then
compared and analyzed in Section 4. The conclusions are presented in Section 5.
2. Lessons from the past
To understand the empirical underpinnings of the current debate about FD and MU, the
following statistical background may prove helpful. Table 1 provides long-run averages for
Fig. 1. Long Run Inflation in Major Latin American Countries.
key economic indicators. The tremendous success of stabilization policies in the major
economies during the last 20 years is readily apparent. Inflation was brought down to low
levels (less than 3%) from what were sometimes double-digit levels. Nominal interest rates
also declined, but with substantial lags, so that real rates actually rose during 198392. With
the exception of Japan, fiscal deficits today are very low, and there are now annual surpluses
in the United Kingdom and the United States.1
When we turn to the major Latin American countries, the picture looks quite different
(Fig. 1). While the hyperinflationary conditions of the 1970s and 1990s have been
controlled, inflation remains a serious problem in many countries of the Western
Hemisphere. In recent years, inflation rates have come down in Argentina, Brazil and
Table 2
Macroeconomic Performance among the First Eastern European Candidates for Membership in EMU
1993 1994 1995 1996 1997 1998
Hungary inflation rate (CPI) 22.50 18.80 28.20 23.60 18.30 14.30
GDP-growth (%) 0.60 2.90 1.50 1.30 4.60 5.10
budget deficit/GDP (%) 5.60 8.10 5.50 1.90 4.00 3.70
unemployment rate 14.00 12.00 11.70 11.40 11.00 9.60
Poland inflation rate (CPI) 35.30 32.20 27.70 19.90 14.90 11.80
GDP-growth (%) 3.80 5.20 7.00 6.00 6.80 4.80
Czech-Rep. inflation rate (CPI) 20.80 10.00 9.10 8.80 8.50 10.70
GDP-growth (%) 0.60 3.20 6.40 3.80 0.30 2.30
Slovenia inflation rate (CPI) 32.30 19.80 13.40 9.90 8.40 7.90
GDP-growth (%) 2.80 5.30 4.10 3.50 4.60 3.90
Estonia inflation rate (CPI) 89.80 47.70 28.80 23.10 10.60 8.20
GDP-growth (%) 8.50 2.00 4.30 3.90 0.00 4.00
Source: Austrian National Bank (1999).
Chile, with Argentina the most successful country in fighting inflation. High inflation
rates are often accompanied by huge fiscal deficits (in Mexico the annual deficit peaked
at 14.2% of GDP in 1987).
Overall, the stability gap between the United States and Europe, on the one hand, and
major Latin American countries, on the other, has not been eliminated during the last twenty
years. Dollars and DM have become more and more attractive as permanently stable
currencies to the rest of the world. Weak home currencies lost their already low reputations
and their usefulness as means of payment and stores of value. Dollars and DM, and to some
extent Yen circulate in many countries, crowding out the home currencies in spite of their
status as legal tender.
The countries in transition in Eastern Europe face different problems. For the first time
since World War II they opened their borders in 1989/1990 to participate in world com-
modity and capital markets. They had no experience, however, in important areas of policy,
including monetary and exchange rate policies. Table A1 (see appendix) suggests that the
exchange rate policies of those countries can best be described as determined by a trial-and-
error approach: regimes alternated between managed floats, fixed, adjustable and crawling
pegs, crawling bands and currency boards.2 Exchange rate bands were changed frequently,
monthly devaluation rates of crawling pegs were high, and the value of underlying currency
baskets saw large and frequent changes.
If we look at the overall performance of these attempts to establish viable exchange rate
regimes (see Table 2), it is obvious that all countries managed to reduce inflation, to recover
and to grow, and to limit the size of fiscal deficits. The performance of Estonia stands out.
There, inflation was brought down systematically from high levels, fiscal deficits never
exceeded 2% of GDP, and unemployment remained low. In contrast to all other countries,
Estonia established a constitutionally-based currency board using the DM early on and this
arrangement has remained unchanged, except for the fact that the Euro replaced the DM in
January 1999. This very strong form of stability commitment limited the growth of money
supply and the governments ability to finance deficits through money creation. It improved
the transparency and credibility of monetary policy with positive long-run effects on inflation
and budget deficits (Bank of Estonia, 1999; Pautola & Bache, 1998).
A final piece of evidence comes from Southern European countries qualifying for EMU
membership in 1999. Before the most recent decade, the economic performance in Italy,
Portugal and Spain had been erratic. During the period 1970 75, average annual inflation
was 10.6% in Italy, 12.1% in Spain and 15.4% in Portugal. Year-over-year inflation peaked
in Italy at 21.2% (1980), in Spain at 24.5% (1977) and in Portugal at 28.8% (1984). The
Maastricht Treaty of 1991 permanently changed the stability behavior of these countries (see
Fig. 2). Though unemployment rates went up, the countries persisted in their stabilization
efforts in order to join EMU. This is impressively demonstrated by inflation rates, budget
deficits and long-term interest rates in Italy, Spain and Portugal during the 1990s relative to
prior decades. It becomes obvious that an achievement of this magnitude can only be
explained by a fundamental change in the intellectual climate brought about by the monetary
union project.
3. Theoretical issues
A closer look at the theoretical debate about currency regimes reveals that the differences
between FD and MU are neglected in the US-based literature.3 The focus tends to be on FD
and currency- and country-risk premia, globalization and currency consolidation, the inferior
performance of intermediate currency regimes (corner-solution-hypothesis), new aspects
of optimal currency area (OCA) criteria and the stability properties of FDs (Eichengreen-
Krugman-hypothesis).
3.1. Full dollarization, currency- and country-risk premia
Interest rates in countries with weak currencies include two different kinds of risk
premia (Berg & Borenzstein, 2000, p. 10 13): a pure default term representing the
normal risk that a debtor will not be able to repay a loan, and a premium that covers a
default due to a currency crisis. The latter premium increases with the probability that
a currency crisis occurs and that in this situation the loan is not repaid. In particular,
countries with substantially overvalued currencies pegged to the dollar or euro are
confronted with high currency crisis premia and therefore high interest rates. FD reduces
this kind of risk premium to zero and leads to significantly lower interest rates, which
Fig. 2. Macroeconomic Performance in South European EMU Member-States.

help stimulate domestic investment. Domestic investors generally benefit from cheaper
access to international capital markets.
3.2. Globalization and currency consolidation
The central argument here is that in a globalized economy characterized by free movement
of international capital, small currencies do not provide the financial liquidity and network
advantages of currencies that are widely used in international finance. Small currencies may
be vulnerable to financial sector shocks and to speculative attacks. Their credibility is
difficult to establish. Even small liquidity preference shocks in the region can spread by
contagion to neighboring economies (Allen & Gale, 2000; Chang & Velasco, 1998).
Consequently, assets denominated in domestic currencies experience higher nominal and real
price volatility. International investors are faced with high risk when variances in nominal
and real interest rates are large. All this makes the major currencies more competitive and
encourages currency consolidation through elimination or absorption of minor and weaker
currencies.
Diversified portfolios benefit from low correlations among market movements in different
countries. The inclusion of, say, a small Mexican share into a world portfolio realizes these
benefits. Starting from such a portfolio, FD reduces the distinctiveness of the Mexican from
the US portion of the global portfolio: diversification gains fall because the Mexican
economy now moves less independently from the US economy and because the correlation
between returns in the two countries is increased. On the other hand, exchange rate effects
on Mexicos dollar-converted rates of return are eliminated, leading to a reduction of the risk
in the Mexican portfolio. If the second effect dominates the first, dollarization results in a
superior earnings-risk combination for the portfolio as a whole.4 As a result, dollarization
would have a positive effect on Mexican asset valuations. In general, if the total effect of
dollarization is value-creating, currency consolidation is rewarding and small, low-credibility
currencies will disappear in the long run.
3.3. The corner-solution hypothesis
During the last two decades, the growing importance of free international capital flows has
led to numerous currency crises.5 Whenever speculators expect a risk-adjusted net return
from buying or selling a currency, international capital flows emerge with the consequence
that the affected central banks have to defend their monies in order to maintain existing
commitments like pegs, bands and so forth and to retain their credibility. They can do so by
sales and purchases or by short-term interest-rate policies. Unless unsterilized intervention is
involved, direct transactions in the currency markets often are not helpful, because the
volume of speculative capital significantly exceeds most central banks foreign exchange
reserves. Interest rate defenses may only be maintained for a few days, because the rates
required to stem capital outflows are extremely high and disturb the liquidity positions of the
domestic banking system.
Even currency board systems with 100% or more foreign exchange reserves are not
speculation-proof. Speculators may fear that the central bank will not be willing to reduce
significantly a countrys monetary base, preferring instead to devalue in case of a sustained

speculative attack. Every unsuccessful leaning-against-the-wind policy only undermines the
credibility of central banks and creates incentives for further attacks.
There is growing support for the view that exchange rate regimes which are subject to
speculative attacks have limited usefulness (Eichengreen, 1994, 1998; Crockett, 1994;
Obstfeld & Rogoff, 1995; Summers, 1999). That leaves the corner solutions as specula-
tion-proof systems. They are (i) absolutely free floats and (ii) permanently fixed exchange
rates like FD and MU. All intermediate systems are subject to potential speculative attacks
and thus offer little long run viability (vanishing-intermediate-regime hypothesis).
Consequently the current theoretical discussion centers around the pros and cons of
absolutely fixed versus flexible exchange rate regimes as well as about the kinds of
arrangements that would best achieve absolutely fixed exchange rates within a region.
3.4. Optimal currency area- (OCA-)criteria and credibility issues
Globalization and highly mobile international capital have influenced the discussion of
optimal currency areas (OCA). According to the traditional analysis, economic characteris-
tics like openness, labor mobility (Mundell, 1961; Romer, 1993), synchronization of business
cycles, and compatibility of macroeconomic priorities (Alesina & Grilli, 1991) are relevant
OCA-criteria. In the more recent literature (Frankel, 1999; Larrain & Velasco, 1999;
Williamson, 1995), emphasis is placed on policy credibility. A strong case can be made for
a common currency in the form of FD or MU, when the countries involved can be
characterized by the following (Frankel, 1999, pp. 19 20): a strong need to import monetary
stability (due to a history of hyperinflation or an absence of credible public institutions), a
desire for further close integration with trading partners, evidence that foreign money is
already widely used, a healthy, well-regulated financial system, fiscal discipline, and a sound
legal system.
3.5. The Eichengreen-Krugman-hypothesis
The debate about the pros and cons of FD has raised questions about the implications of
a common currency or full dollarization after they have been implemented. After the
elimination of exchange rate uncertainty, the further integration of the partner countries
economies will be stimulated. One result could be rising cross-border correlation of eco-
nomic activities.
Krugman and Eichengreen (Eichengreen, 1992; Krugman, 1993; Bayoumi & Eichen-
green, 1994) suggest, however, that when countries become more and more integrated, they
tend to become more specialized in production. Greater specialization reduces the correlation
of business cycles, because different industries are subject to asymmetric shocks. Under FD
or MU, countries cannot adjust to asymmetric shocks by de- or revaluations. They have to
find other, perhaps more costly, ways of adjustment. According to this hypothesis, therefore,
FD or MU may be preferable initially, but could become suboptimal in the long run.6 The
empirical evidence, however, does not support this hypothesis, as specialization appears to
occur predominantly within the production chains of industries and not primarily at the
interindustry level (Frankel & Rose, 1998). Intraindustry component specialization tends to
increase, rather than reduce, the symmetry of shock exposure across countries.
4. Full dollarization, currency boards, and monetary unions
This section examines more closely the characteristics and effects of FD and MU. Along
the way, the currency board (CB) is discussed as an alternative.7 The focus is on the
seignorage problem, speculative international capital flows, the lender-of-last-resort prob-
lem, adjustment processes and short- versus long-run perspectives.
4.1. Basic characteristics
Under FD, a country, say Ecuador, abolishes its own money and introduces dollars as legal
tender. That means the central bank of Ecuador first borrows dollars if the available
international reserves are smaller than the circulating home currency. It then buys up all of
the home currency with dollars. Meanwhile, applicable laws, and perhaps even the consti-
tution are changed so as to make dollars legal tender. An agreement like that between
Panama and the United States is possible but not necessary for full dollarization. Obviously,
the central bank of a dollarized country has little freedom in the conduct of monetary policy.
There are no formal obstacles, but competitive restraints, to unilaterally imposing reserve
requirements on the banking system. Furthermore, any attempt at an active monetary policy
by a small country that has adopted the currency of a large country or group of countries will
have little effect on conditions throughout the area. Rather, the money supply to the small
country will be demand-determined to the extent that interest-equalization applies across
countries in the region on similar risks. Generalizations are hazardous, since there are no
agreed rules of dollarization comparable to the stylized rules of the classical gold standard,
and thus a number of variants are conceivable.8
In contrast to FD, an MU rests on a contractual agreement between two or more partners
to introduce a new currency. The monetary bases of all members become part of the new
currency. No member country has to buy the new currency with interest bearing assets.
Profits from the unions monetary operations are shared by all members according to
predefined ratios.
According to Berg & Borensztein (2000, p. 18), a currency board (CB) is essentially full
dollarization with an exit option. Its strict form, not encountered in practice, has been
described by the following basic characteristics (see Frankel, 1999, p. 18):9
Y an exchange rate that is fixed not just by policy but by law.
Y a reserve requirement stipulating that each dollars worth of domestic currency is
backed by a dollars worth of foreign reserves.
Y a self-correcting balance of payments mechanism in which a payments deficit auto-
matically contracts the money supply, resulting in a contraction of spending.
Backed by foreign exchange reserves, the central bank of a CB-country can issue its own
money as legal tender. When its own money has enough credibility and reputation in
international markets, the CB can be removed. The central bank then regains full indepen-
dence in the conduct of monetary policy.
4.2. The seignorage problem
One basic difference between FD and CB, on the one hand, and MU on the other resides
in the distribution of seignorage gains. The basis of an FD is a simple deal: a country imports
stability and pays a tribute in the form of forgone seignorage. The seignorage loss consists
of two components. First, the central bank has to purchase the stock of domestic currency
held by the public and banks. Second, it relinquishes future seignorage gains from the flow
of new currency.10
A CB generates similar, but not identical, effects. The difference is that the country
may invest the overwhelming part of its foreign reserves in short-term international
capital markets and thus receive interest earnings. The forgone seignorage is then far
lower and depends on the difference between money market rates and rates on other
forms of investment. In the MU, no seignorage problem arises for the member countries,
because each of the national currencies is replaced with the new one and the seignorage
is shared among the partners, although the distribution key can be a matter of some
contention.
It should be stressed here that an FD is only profitable for the dollarized country and
therefore sustainable in the long run as long as the benefits from imported stability exceed
the losses from forgone seignorage by a margin large enough to dominate the available
alternatives. When a superior alternative emerges that yields comparable stability benefits at
lower cost, the country will have an incentive to opt out of FD.
4.3. Speculative attacks and currency crises
No exchange rate system can completely eliminate all country-specific risks. In times of
political instability, deep depressions or wars, international investors charge high risk premia
or withdraw their capital, resulting in nominal interest rates far above the world level. Of the
three exchange rate systems in question, the CB is most vulnerable to speculative attacks:
even 100% or more backing in foreign exchange reserves cannot convince international
investors that the central bank will buy out the entire stock of domestic currency. For
example, if the monetary authorities attach more importance to restoring economic activity
than to loss of reputation, they will react to a speculative attack by giving up high-interest
defenses and permitting a depreciation or devaluation even if they have not run out of
reserves. Investors also may not be sure about the permanence of a currency board, because
it is far easier to abolish than an FD or MU regime. Countries subject to frequent political
changes will not convince international investors that a CB will last forever. In contrast, the
other systems are not subject to speculative attacks. A fully dollarized country faces the same
currency-crisis risk as the United States. In the EMU, a Euro-dominated investment in
Germany is subject to the same currency risk as in Italy, Spain or Portugal.11
4.4. The lender-of-last-resort-problems
The loss of its capability to function as a lender of last resort for the banking system
creates serious problems for a central bank in an FD- and also in a CB-system. For a fully
dollarized country, the Fed is a potential lender of last resort, especially in times of banking
crises, but the Fed has disavowed any intention to perform this function. Other lenders of last
resort to dollarized countries may include public and private international financial institu-
tions that have offered contingent credit lines, or existing swap networks, but their commit-
ment and ability to act as lenders of last resort is quite limited.
This situation has far-reaching consequences: international investors will watch liquidity
conditions in the dollarized country very carefully, because the probability of default in the
whole financial system stemming from even unimportant liquidity crises will increase
significantly.12 This lowers the credibility of domestic banks of the dollarized country in
international markets and restricts their operations. On the other hand, it creates opportunities
for US banks to increase their share of banking in the dollarized country, because they can
count on the Fed as lender of last resort and have access to low-cost funds in the federal funds
market.13
The difficulties described above raise questions about the Feds role in an FD-system.
Many observers assume that the Fed will not react to problems in the dollarized countries.
The very independence of the Fed to follow a US-oriented monetary policy without serious
pressure from dollarized countries is treated as a fundamental advantage of FD compared to
monetary union where the conduct of monetary policy is no longer the exclusive business of
the United States.
A closer look, however, raises doubts about this very simple proposition: consider the
situation where the dollar reigns from Alaska to Antarctica and we have a banking crisis in
Brazil or Argentina. Obviously, the Brazilian central bank will try to do anything in order to
limit the negative effects for the domestic economy. It will use every source to support the
banks with dollars. One possibility is to go to the IMF and obtain dollar loans by drawing
on one or more of the IMF facilities. Also, Europe, Japan and other countries may supply
Brazil with dollars.14 The Fed cannot stop such activities. US base money is transferred to
the IMF or other industrialized countries and from there to Brazil. Another problem for the
Fed is the reaction of US banks working in Brazil. They, too, will use their channels to bring
dollars to Brazil in order to avoid serious losses.15 It is certainly in the self-interest of the
United States to supply liquidity in the form of dollars in order to protect US exporters.
As a consequence, the Fed will not be able to prevent dollar transfers to Brazil or to avoid
political pressure from the US government, from the rest of the world and from Brazil and
other Latin American countries to provide relief.
A similar situation arises in the case of a CB, but here the Brazilian central bank is
more flexible: it is possible to inject base money for a very short period of time to
improve the liquidity situation in the banking system without having full backing
through international reserves. Though this may lead to a small decrease in the credi-
bility of the CB system, it may be preferable to a banking crisis. As soon as possible, the
full reserve backing can be reestablished.16 Obviously, the central bank in an MU has no
lender-of-last-resort problem. As the exclusive issuer of its own money, it can react to
a banking crisis or to a liquidity shortage in the way the Fed or any other independent
central bank reacts.
4.5. Adjustment processes
Full dollarization and monetary unions both require structural and policy adjustments. But
important questions arise with respect to the nature and timing of such adjustments. Should
adjustments occur before, during, or after introduction of the new exchange-rate regime?
According to Eichengreen (2000), FD requires reforms in the following areas. First, the
labor market must be made more flexible in order to accommodate asymmetric shocks.
Second, the fiscal position must be strengthened and the term structure of public debt
lengthened. Since domestic monetary authorities may no longer be able to absorb new issues
of short term public debt, the probability of a funding crisis increases. The soundness of the
banking sector has to be enhanced in view of the limited capacity of the countrys central
bank to provide lender-of-last-resort services. The economy must be restructured to ensure
that cyclical fluctuations coincide with those in the United States.
A look at this reform agenda makes clear that such reforms take time to be implemented.
Labor market reforms require changes in the bargaining procedure between trade unions and
firms, as well as substantial reforms in legislation. Meanwhile, FD has an immediate effect
on public finances via two channels. First, interest rates are brought down to dollar levels,
reducing debt servicing cost. Second, by eliminating the inflation tax and monetization of
government debt, it forces governments to consolidate their budgets. FD implies that the
government sector is confronted with a long-run, permanent and credible budget constraint
(see Tornell & Velasco, 1995, 1998).
Though MU pushes countries in similar directions, the timing is different: normally
countries must fulfill the stability criteria before entering. If we take the Maastricht Treaty
as an example, annual public deficits had to be lower than 3% of GDP. This requirement
created massive efforts in all member states to bring down fiscal deficits. The question is
whether these stability efforts will persist after entrance into an MU. In contrast to FD, there
is a higher probability for a bail-out by the European Central Bank if a country runs into a
public debt crisis.17
Strengthening the banking system is especially important under FD because of the limited
capacity of the central bank to act as a lender of last resort. Financial sector reforms must take
place before the introduction of the dollar. Their main objectives must be avoidance of
banking crises. It is not necessary to standardize the banking business with the United States,
though competitive pressures and take-overs may point in that direction to some extent.
Construction of efficient, independent banking supervision is essential, especially since
countries which are candidates for full dollarization do not typically have such systems in
place.
If the foregoing reforms are implemented, the convergence of business cycles becomes
more likely. FD eliminates asymmetric monetary disturbances by definition. Consolidating
fiscal policy implies reduction of asymmetric fiscal impulses; the shift to one currency
encourages greater trade and capital flows between the economies, leading to further
business-cycle conformity.18 But to the extent that structural characteristics of the economies
differ, external shocks will have asymmetric effects.
We conclude this section with the following observations. Some adjustments like the
strengthening of the banking sector, must take place before implementation, because other-
wise the default risk in the financial sector is too high. This is important for several reasons.
First, it turns out empirically that adjustment takes time. Second, adjustments before the start
of an FD or MU may be less costly, because the option to adjust exchange rates remains
open. After FD and MU, this adjustment window is absolutely closed. Third, if asymmetric
shocks burden economies with increasingly negative effects, they may stop the FD- or
MU-project.19
In contrast, efforts to escape after implementation of the regime could be connected with
high social costs, although movements between different types of monetary union and
dollarization may still be feasible and attractive.
An extreme case of an economy that entered a monetary union totally unprepared
economically and overburdened politically is German reunification. The Eastern part of
Germany has received more than $1.2 trillion in transfer payments, but still has an unem-
ployment rate of about 17% compared with 7.4% in Western Germany.
It is important therefore, to keep in mind the conditions which lead countries to consider
FD. If FD is introduced in a crisis situation, then the objective is to gain control over extreme
economic instability. Though the stability gains from an FD are very high, the adjustment
costs are also high and may push the country into recession with negative implications for
political stability. When an FD is undertaken in unhurried, noncrisis conditions, perhaps after
a measure of stability has been achieved by means of a currency board, the rationale is
different. A country may then see FD as protection against speculative attacks, contagion
effects, or any future tilt toward less stability-oriented policies. Other advantages of FD may
include easier access to capital markets in situations of temporary shocks and participation
in the benefits of deep financial integration at a world-class standard of monetary and
financial services.
4.6. Short- and long-run aspects

If we compare the relative advantages and disadvantages of FD and MU over time, it is
likely that in the long run full dollarization will be unstable because the cost of forgone
seignorage will increase relative to the benefits from imported stability. Seignorage cost
accrues as long as the dollar is used as legal tender. The benefits from imported stability,
however, decrease over time. Every year of stability, combined with an improved stability
culture, increases the countrys international reputation, and reduces the need to import
stability (von Furstenberg, 2000; von Furstenberg & Alexander, 1999).
This situation creates incentives to abandon the FD and to save the seignorage costs. One
possible solution is MU among the FD-countries. Introduction of a stable new currency with
an independent common central bank distributes seignorage gains among member countries.
If the United States prefers to preserve FD, then it must redistribute gains from seignorage
via noninterest bearing loans to its fully dollarized partners.20
5. Conclusions
Globalization and free international movement of capital, combined with speculative
attacks against low-credibility currencies, are the most important reasons for the contempo-
rary debate on optimal exchange rate regimes. Regional currency consolidation is becoming
more popular as an increasing number of countries in Latin America, East Asia, Eastern
Europe and Central Asia consider the introduction of stable foreign currencies as legal tender
or consider engaging in monetary unions.
Comparison of unilateral and multilateral monetary union underscores the long-term
instability of unilateral full dollarization. Once a fully dollarized country reaches lasting
internal stability, its willingness to pay a seignorage tribute to the United States weakens.
Multinational monetary union, perhaps on the basis of a new currency and without the United
States, among formerly dollarized, stable countries offers a possible way out, enabling
members to influence policy and share seignorage profits.
In the short run, an adjustment process leading to monetary union is preferable to
unilateral full dollarization, because acceptance of the project among major interest groups
is more likely than under full dollarization. When FD is the chosen regime, an introduction
of the dollar after a period of preparation (Argentinean case) is preferable to an Ecuadorian
approach in which adjustment takes place after implementation.
In reality, the two regimes of full dollarization and monetary union are subject to a variety
of possible variations. The United States can arrange to share seignorage profits with
dollarized countries. Bilateral agreements between the Fed and national central banks of
dollarized countries can provide lender-of-last-resort assistance during banking crises. The
Fed also can help dollarized countries progress toward monetary union with the United
States, which requires a great deal more than a common currency.
Notes
1. In contrast to the achievement of internal stability, the world economy did not reach
overall equilibrium. In particular, the high current account deficits of the United States
and the surpluses of Japan show the need for future adjustments.
2. For detailed information, see Austrian National Bank, Focus on Transition, various
issues.
3. In Frankel (1999, p. 3) nine different exchange rate regimes are distinguished. FD,
MU and a currency board (CB) appear in the same group with nearly identical
characteristics. Berg and Borensztein (2000, p. 4) discuss the differences between FD
and CB because they treat a CB as the nearest competitor of FD. Even in
Eichengreen (2000), the FD-perspective dominates. For a formal treatment of the
benefits of dollarization, see Mendoza (2000). For exceptions, see von Furstenberg &
Alexander (1999); von Furstenberg (2000). See also: Ortiz (1999); Sachs & Larrain
(1999); and Stein (1999).
4. von Furstenberg (2000) finds support for the consolidation argument for Mexico.
However, the elimination of its currency risk relative to the United States could be
accompanied by greater exposure to any remaining country-specific shocks if ex-
change rates with the United States otherwise would have adjusted appropriately
(Zhang & Johnson, 1998). Alexander & Anker (1997) consider other factors limiting
the convergence of interest rates when currency risk is eliminated.
5. The most important events were the breakdown of the EMS in 1992/93, resulting in
a widening of the bands from 2.25% to 15%, the Mexican peso crisis of 1994/95
and the South-East Asia crisis of 199798.
6. In the Krugman-Eichengreen case, the question arises whether FD- or MU-partners
should have the option to exit. This problem is discussed below.
7. It should be stressed here that the choice between FD and MU was never an issue in
Europe, because no European country was willing to adopt the DM and abolish its
own currency.
8. For instance, the basic discipline on the money supply process in a dollarized country
would be similar to that under the classical gold standard if the central bank were
prevented from acquiring dollar claims on its own government or on other domestic
issuers even after full dollarization. However, no such restrictions need apply.
9. There are CBs in Hongkong (1983), Argentina (1991), Estonia (1992), Lithuania
(1994), Bulgaria (1997) and Bosnia (1998) as well as some (Caribbean) island
countries. The partner currencies in Hongkong and Argentina are US dollars, the rest
use Euros.
10. Calculations for Argentina show that the stock cost amounts to nearly 15 bill. dollars.
Long run experiences of the yearly seignorage gains in countries with low inflation
rates suggest that the flow-effect is about 0.3% to 0.35% of GDP. For Argentina,
this implies an additional 1.0 bill. dollars per year approximately. Countries with
higher inflation rates realize far higher seignorage earnings. Today, other countries
using dollars give the United States a yearly seignorage of about 15 bill. dollars (see
Meyer, 1999 and von Furstenberg, 2000, p.24). Full dollarization of Latin America
alone would bring the United States another 10 to 15 billion per year.
11. Weak countries may be better off in MU than FD, because the probability of a bail-out
by the other members in order to defend the reputation of the common currency is
higher (Alexander & Anker, 1997).
12. Normally, a central bank as the issuer of its own money can provide the system with
base money in times of liquidity crises. This monetary base injection can be sterilized
later with no damage to long-run macroeconomic performance.
13. All other things equal, customers in the dollarized country will prefer to deal with US
banks because in times of liquidity problems the latter are supported by the Fed,
whereas the local banks must rely on the home central bank, which is not able to help
them with base money. It is likely that an FD will be followed by widespread
take-over of domestic banks by US banks.
14. This is very realistic because these countries will suffer from a Brazilian crisis and
possible contagion to other Latin American countries.
15. If the world-wide demand for US dollars increases and the Fed persists in restricting
money supply, interest rates will be pushed up in the US.
16. It is clear that all other possibilities of international support are the same as in the FD
case. The complication in a CB-system is that a banking crisis may trigger a

speculative attack against the home currency.
17. To avoid bail-outs, Germany, in particular, insisted on inclusion of regulations in the
Maastricht Treaty and in the Growth and Stability Pact designed to limit this danger
(see Eichengreen & von Hagen, 1996).
18. Empirical estimates concerning problems of cyclical conformity in Europe are pre-
sented in Rose (1999); Frankel & Rose (1996). See also ECB (1999).
19. In Europe, this happened via special referenda: Denmark voted twice for staying out
of EMU. The UK, Sweden and Norway did not join EMU after intensive political
discussions.
20. Sometimes it is argued that FD-countries could switch to other anchor currencies like
the Yen or the Euro with better conditions concerning seignorage. This would
establish competition among the central banks of hard currencies. We do not regard
this competition as easily forthcoming because the change of legal tender is accom-
panied by extremely high political and economic costs.
Acknowledgments
We are indebted to Martin Mandler for helpful comments and to Carsten Lang and Carsten
Leferink who helped with the layout.
Appendix 1. Exchange rate regimes in eastern Europe
*Sources: Austrian National Bank, Focus on Transition, various issues, Ghosh (1997); Nuti (1996), own computations.
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North American Journal of

Economics and Finance 11 (2000) 205225

Monetary unionsa superior alternative to full

JEL classification: F31; F33; F36

Japan inflation rate 8.42 3.45 0.70 0.30

Germany inflation rate 4.97 2.32 2.18 1.40

France inflation rate 11.02 4.42 1.60 1.20

UK inflation rate 14.20 5.50 2.73 2.40

2. Lessons from the past

Fig. 1. Long Run Inflation in Major Latin American Countries.

3.1. Full dollarization, currency- and country-risk premia

Fig. 2. Macroeconomic Performance in South European EMU Member-States.

3.2. Globalization and currency consolidation

3.3. The corner-solution hypothesis

significantly a countrys monetary base, preferring instead to devalue in case of a sustained

3.4. Optimal currency area- (OCA-)criteria and credibility issues

3.5. The Eichengreen-Krugman-hypothesis

4. Full dollarization, currency boards, and monetary unions

4.1. Basic characteristics

4.2. The seignorage problem

4.3. Speculative attacks and currency crises

4.4. The lender-of-last-resort-problems

4.5. Adjustment processes

4.6. Short- and long-run aspects

case. The complication in a CB-system is that a banking crisis may trigger a

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