Dollarization

Dollarization is the use of the US dollar (or another foreign currency) as a country’s official medium of exchange. Official dollarization means the central bank has abandoned its own currency entirely; unofficial dollarization (or currency substitution) occurs when residents use dollars alongside or instead of the domestic currency, often during crises. Ecuador and El Salvador are officially dollarized; Yugoslavia unofficially dollarized before its collapse.

Official dollarization

Official dollarization means a government legally adopts the US dollar as its sole currency and ceases to issue its own. Ecuador officially dollarized in 2000 after years of hyperinflation destroyed the currency (the sucre). El Salvador dollarized in 2001. Panama has used the US dollar officially for over a century.

Once official, there is no going back without a trauma equivalent to a regime change. The central bank issues no currency; the money supply is whatever dollars enter the country from trade, investment, or borrowing. Monetary policy is impossible — the country cannot print money to respond to crises.

In exchange, the country gains credibility. Inflation stops (it cannot exceed US inflation plus currency depreciation, which is zero). Capital flows in because investors trust a dollar-backed economy. Trade is simple — no currency exchange needed with the US.

Seigniorage loss

The US government profits from printing dollars — this profit is called seigniorage. When the US prints a $100 bill, the cost is a few cents. The US government gets $100 of value.

When a country officially dollarizes, it loses this profit. Ecuador no longer prints sucres and collects seigniorage. Instead, dollars flow into Ecuador from trade and the US Federal Reserve “prints” more dollars (via monetary expansion) and captures the seigniorage. Ecuador loses this revenue, which once funded government spending.

Most dollarized countries accept this loss as the price of credibility.

Unofficial dollarization

Unofficial dollarization occurs during crises when confidence in the domestic currency collapses. Residents stop using the domestic currency and switch to dollars (or euros, or gold, or anything of perceived stable value).

Zimbabwe suffered unofficial dollarization. After hyperinflation rendered the Zimbabwe dollar worthless, residents simply stopped using it and switched to US dollars, South African rands, and other currencies. The government eventually officially abandoned the Zimbabwe dollar in 2009 and adopted the US dollar (and other currencies).

Similar dynamics happened during the collapse of Yugoslavia in the 1990s: the Yugoslav dinar became worthless as war disrupted the economy, and residents switched to Deutsche marks and dollars.

Unofficial dollarization is a symptom of monetary collapse, not a policy choice.

The trade-off

Official dollarization offers stability and credibility but surrenders monetary policy. A dollarized country cannot:

• Print money to stimulate the economy during a recession.
• Use interest-rate policy independently (rates follow US rates through interest-rate parity).
• Conduct currency devaluation to adjust trade imbalances.
• Manage shocks that hit the country but not the US (a local financial crisis, a specific-industry shock).

For a small, open economy dependent on trade with the US, these losses might be worth the stability. For a larger, more diversified economy, the loss of autonomy is likely unacceptable.

Alternatives to dollarization

Instead of official dollarization, many countries use hard pegs or currency boards. These provide credibility (if believed) without formally surrendering the currency. But hard pegs can break; dollarization cannot (short of declaring a new currency, which is political and economic turmoil).

See also