eli5: What is the reasoning for Argentina dollarizing their economy?


I keep seeing news stories on Argentina dollarizing their economy. Has it worked for other economies? How?

In: 28

“Dollarization” is one way for smaller countries to stop a hyperinflation spiral.

Due to economic collapse or poor financial governance (or usually, both) their own currency has been incinerated, losing most of its value and any faith it may have had. People’s savings are gone and international business won’t deal with you in your own currency anymore, rendering it useless.

Rebuilding faith in your domestic currency will take a long time – why trust a government that ruined a currency once to not do it again?

So to quickly get the gears turning again the country can simply scrap their currency and accept a more stable foreign currency for their government and international dealings.

This avoids the mistrust issue because Argentina cannot impact US inflation or interest rates in any meaningful way.

But it also presents a problem – Argentina cannot impact US inflation or interest rates in any meaningful way. Your currency is now beyond your control, and you’re stuck with whatever the current fiscal policy the US wants as your fiscal policy too.

Dollarized economies can’t fuck up their currency anymore, but they can’t manipulate it to encourage growth or deal with downturns either.

Dollarization means that your economy going to crap because the government can’t manage the currency is now something from the past.

Lower inflation, lower risk, and in theory, more foreign investment and growth (because people trust the dollar more than the Argentinian peso and because now direct investment has lower financial cost)

I’m usually against dollarization because it also has its cons: The country losses their power to control monetary policies, and in case of a Crisis like Covid getting dollars won’t be easy, so if you are not swimming in reserves, you probably are gonna get screwed (just ask Ecuador about that). Another con is that without a central bank a country has no effective way of dealing with a financial crisis that affects the banks of the country (no lender of last resort), and as we learnt in 2008, banks going bankrupt is bad for everyone

However Argentina has shown so many times they are so shit are managing their economy and currency, that for them I think dollarization would be a good idea.

In summary, if your economy is somewhat stable and your central bank competent, personally, I go against dollarization. This is not the case of Argentina, so that’s why so many people want to go for it.

Dollarization is a form of currency substitution, which means that the country is going to accept a foreign currency as an alternative currency or even as a replacement for their own domestic currency. This is usually done by a country that has royally fucked up their own local currency so consumers and businesses no longer want to use it. Dollarization is when the foreign currency to be used is the US dollar, though there are cases of euro-ization in which the euro was used instead.

In the case of Argentina, successive governments have completed destroyed any faith in the Argentine peso. Right now the Argentine central bank has set their interest rate at 133% to try and bring their inflation under control. For context, the Federal Reserve rate right now is 5.5% and the European Central Bank rate is 4%. If people have no faith in your national currency, the economy grinds to a halt. Dollarizing the economy will give the Argentine economy a stable currency to use for transactions.

When a country gets in certain kinds of economic trouble, it can print money. The idea is, instead of having a fraction of society feel very bad pain (some people lose their jobs, some companies fail, government cuts programs it can’t afford), you spread the burden out (everybody who uses money has their money be worth a little less).

This can avoid a domino effect that leads to something like the Great Depression: Shaky businesses collapse, people are out of work, they don’t buy anything so previously healthy businesses start to collapse, leading more people to be out of work, until your whole economy is totally wrecked.

But you have to print money sparingly, if you print too much money then people will stop trusting your money to be worth anything. Prices go higher and higher, because there’s more money chasing fewer goods. Foreign investors see this, and stop making loans that are paid back in your currency. This means you have to print even more money for your government to pay its bills. Money printing can quickly spiral out of control.

Most governments say “We pinky promise not to print too much money” but what to do when people stop believing that pinky promise? One answer is to switch to using another country’s money, that has a strong economy and hasn’t recently broken a “pinky promise” badly enough to seriously wreck their currency. (Usually, countries in this situation switch to the US dollar.)

Switching to dollars stabilizes the currency, but can lead to another kind of trap. If people take out too many loans and owe more money than they can repay, printing money can help; it spreads the losses from those bad loans across everybody who uses money, instead of having a bunch of lenders fail and causing a banking crisis. But if you use somebody else’s currency, you’re not in charge of printing it, so you end up suffering the crisis, perhaps unnecessarily.