Sooner or later, Argentina should dollarise

On December 10, Javier Milei took office as president of Argentina. Milei ran on a platform that included drastic government spending cuts, elimination of the central bank and replacement of the peso with the dollar – that is, dollarisation. More recently, Milei has backed away from dollarisation in favour of more conventional stabilisation measures, but the question of whether or not Argentina should dollarise remains open. I believe that Argentina should dollarise – if not now, than soon.

Dollarisation is an extreme solution, but to an extreme problem. Argentine inflation is running at over 140%; Argentina defaulted against its private creditors in 2020 and will be hard put to repay its $44 billion debt to the International Monetary Fund (IMF); and the economy is set to enter a steep recession. More to the point, Argentina has been lurching in and out of recession, hyperinflation, financial crisis and default for the past four decades. There are many reasons for this, but they all boil down to persistent, large fiscal deficits financed by some combination of borrowing from foreigners and printing money. 

Dollarisation is extraordinarily effective at suppressing inflation. Only a small number of countries in the world have dollarised, but perhaps unsurprisingly, Latin America has three of them. Ecuador dollarised in 2000 following a decade of high inflation and rapid exchange-rate depreciation. Since then, its inflation rate has fallen to about 4%, on average, compared with 40% in the 1990s. In El Salvador, which dollarised in 2001 after having already reduced inflation through a pegged exchange rate, inflation has averaged below 3% compared with about 9% in the 1990s. Panama has used the dollar since its creation in 1904, and has generally had among the lowest inflation rates in the region.

My informal survey of the many writings triggered by Milei’s rise to power suggests that despite dollarisation’s successful record of squashing inflation, most economists do not like it. They argue that by fixing the exchange rate in perpetuity, dollarisation would deprive Argentina of the ability to adjust relative prices in response to shocks, and it would force Argentina to import the monetary policy of the Federal Reserve, regardless of whether or not that policy was appropriate for Argentina. 

I believe both of these costs would be decidedly second-order compared with the benefits of substantially reducing the level and volatility of inflation. In the absence of dollarisation, Argentina would likely continue to meddle in foreign exchange markets to try to restrain inflation, and there is nothing to suggest that its independent monetary policy would be an improvement over what the Fed would offer. Moreover, US monetary policies tend to spill over to foreign economies, whether or not they have their own currency; having one’s own (floating) currency may buy the central bank some independence to manage the short-term interest rate, but broader financial conditions will still be importantly influenced by US rates.

Economists also argue that dollarisation will not necessarily eliminate the root cause of high inflation, which is large and persistent fiscal deficits. That is certainly true, but a couple of important caveats are in order. First, in a dollarised economy, printing money to finance fiscal deficits is (nearly) impossible, so these deficits must be financed by borrowing. This borrowing may lead to higher debt and possible default, as has occurred in Ecuador, but it does not trigger the high inflation and the resultant drag on saving, productivity and growth that are caused by money-financed deficits. And once the default has occurred and the country is cut off from borrowing, as is largely the case in Argentina at present, the pressure to cut the budget becomes even stronger.

Second, while I agree it would be better for Argentina to reform its policies and close its budget gaps on the basis of widespread political support rather than the straitjacket of dollarisation, I am sceptical that is ever going to happen. This scepticism is the result of my own personal journey through Argentina’s economic history. As a young economist in the international finance division of the Federal Reserve at the beginning of the 1990s, tasked with monitoring Argentina’s economy, I watched with amazement and dismay as inflation climbed to quadruple digits and the economy collapsed. When the hyperinflation finally exhausted itself and the need for fiscal and structural reforms took centre stage in the country’s political discussion, I became convinced that Argentina’s political class had finally come to grips with its problems.

I strongly doubt that the country will curb its penchant for deficits unless it is forced to do so by the elimination of all possible funding sources

I was wrong, of course, as I discovered when fiscal stresses re-emerged by the end of the 1990s, the Convertibility Plan collapsed and financial crisis gave way to more than a decade of resurgent anti-liberal policies under the Peronists. But then Mauricio Macri was elected in 2015, pledging to carry out the market-friendly reforms needed to jumpstart the economy. And once more I became convinced, along with the many investors who purchased Argentina’s 100-year bonds, that this time was different and the country had finally “gotten religion”. Four years later, when Argentines despaired of the promise of neoliberalism and returned Peronism to the Casa Rosada, I realised I had been fooled again. 

I have no illusions that the third time will be the charm for Argentina. Milei’s election reflected anti-incumbency despair more than a concerted choice by voters to embrace fiscal austerity and structural reform. And with limited support in Congress, Milei will be hard put to implement difficult adjustment policies, even if he is able to focus his chaotic energies on so doing. Therefore, as I noted above, I strongly doubt that the country will curb its penchant for deficits unless it is forced to do so by the elimination of all possible funding sources. 

Of course, dollarising would hardly address Argentina’s other myriad challenges, including dismantling growth-strangling regulations and shifting a large share of the workforce from the public to the private sector. Moreover, cutting off the government’s access to the printing press and forcing drastic cuts to public spending would be extremely disruptive and contractionary in the short term. But at least one critical objective, quelling high inflation, would be crossed off the to-do list, laying the foundation for future recovery and growth. And the alternative to dollarisation is hardly stability; Argentina is looking at a steep recession and continued financial and economic turmoil in any event.

As I noted at the beginning of this article, Milei appears to have backed off from dollarisation for now, and he appears set to initiate a more orthodox programme of budget-cutting. This is probably a pragmatic approach since, on top of everything else, the government cannot afford to dollarise. Given that the central bank now holds net negative foreign exchange reserves, the dollars needed to buy out the existing stock of pesos – estimated at anywhere from $6 billion to $40 billion – just aren’t there. 

But if Milei’s fiscal programme is successful, dollarisation will become more feasible. A reduced dependence on printing money to finance government spending would make the straitjacket of dollarisation less disruptive, and better economic and fiscal performance would allow the central bank to replenish its stock of dollars. At that point, there would be many who would argue that dollarisation was no longer needed. But that would be exactly the right time to lock in the gains from stabilisation before the next cycle of rising spending, deficits, and inflation sets in.