Reassessing the Case of Ecuador's Dollarization

ABSTRACT The purpose of this paper is to conduct a cost/benefit analysis of Ecuador's decision to dollarize its economy in 2000. The study begins with a review of the literature pertinent to dollarization. The following section discusses the factors that led Ecuador to dollarize its economy. The study next discusses the benefits of dollarization through comparisons of economic theory with empirical data and select competitiveness rankings for the period 1997-2002. The study further continues the assessment of dollarization by comparing the costs with the empirical data available for the same period. The final section summarizes the study. INTRODUCTION The currency of nations serves three necessary functions: as a unit of exchange, as a store of value, and as a unit of account. All three functions must coexist for the currency to fulfill its proper role in the national economy. However, in the course of macroeconomic shocks to a particular nation's economy, a currency may lose one of these indispensable properties and, therefore, cease to function efficiently. These macroeconomic shocks may be the resultant outcome of high interest rates or high inflation that undermines the public confidence in the value and/or exchangeability of money, which leads to a loss of domestic and international support in the ability of money to serve its properly intended purpose. This paper explores the tumultuous political-economic situation of Ecuador during the late 1990s and early 2000s. During this period, Ecuador experienced a near-total breakdown of its monetary system, through both exogenous and endogenous macroeconomic shocks, which ultimately led the country to abandon its national currency, the sucre, and adopt the U.S. dollar. This adoption process is referred to as dollarization. More generally, official dollarization occurs when one nation adopts and recognizes the currency of another nation as the legitimate tender for all transactions, domestic and foreign, while simultaneously abolishing its own national currency. The process of dollarizing a nation is perhaps the most drastic monetary action that a nation can undergo; a subsequent reversal is virtually impossible. For politicians and economic pundits alike, the idea of dollarizing a national economy has become in recent years the subject of wide and controversial debate, fraught with misconceptions and substantiated with vague empirical evidence. Current political-economic thought has reached no consensus as to the full extent of benefits and costs that can be attributed to the nation that pursues monetary dollarization, as each is quite extensive and extremely difficult to quantify. This general lack of qualified agreement has created a void in the understanding of the consequences associated with the decision to adopt a policy of dollarization. This void offers the distinctive opportunity for this paper to examine the economically accepted costs and benefits of dollarization and to measure each with the costs and benefits that have actually been observed to exist in the Ecuadorian economy since dollarization. Each theoretical cost and each theoretical benefit will be assessed using a scorecard of macroeconomic variables and competitiveness rankings to test whether or not the economy has achieved the anticipated benefits and costs in each area. For all elements of comparison, the data have been selected and compiled for the years 1997-2002 from the Global Competitiveness Report and the Latin-Focus group. LITERATURE REVIEW Much research has been conducted in the last few years on dollarization and its costs and benefits. LeBaron and McCulloch (2000) found dollarization a positive monetary arrangement for nations whose anti-inflationary policies lack the requisite credibility to be effective. They further argued that emerging economies that have pegs or currency boards are able to most effectively benefit from dollarization, especially if other variables, such as seigniorage-sharing agreements, are accounted for. …