Re: Dollarization

["Alan G. Isaac" <aisaac@xxxxxxxxxxxx>]

On Sun, 6 May 2001, Sebastian Dullien wrote:
> 1. That interbank interest rates in dollarized economies stay above those
> in the US is only the logical consequence of the absence of a
> lender-of-last-resort. Since without a lolr (even under very prudent
> supervision), the risk of bank runs and a resulting systemic crisis is far
> above that of the US, investors (or other banks lending in the interbank
> market) demand a risk premium. This risk premium could only be completely
> eliminated if the banks were holding 100-percent reserves, which of course
> would mean that they cease to work as banks.

An alternative is the establishment of an insurance pool
at the national level.

It is also worth pointing out that the presence of foreign
banks re-establishes a lender of last resort function.

> 2. This brings us to the second point: The spread between interbank rates
> and interest rates on commercial credits will always be higher in a
> dollarized economy than in the US. As there is no lolr, banks will have to
> hold more reserves in order to guarantee they can pay out funds the public
> demands. The cost for these reserves will have to be beared by debtors,
> thus increasing the interest rate and depressing the economy.

This of course depends entirely on what is counted as
reserves in the country in question.  US banks are forced
to hold non-interest bearing assets, which gives a cost
advantage to countries that allow interest bearing assets
to count against any required ``reserves''.  It is also the
case that not all countries require reserves (although capital
adequacy standards still play a role, of course).

> 3. Under dollarisation as well as under a currency board arrangement,
> monetary policy in effect gets strongly pro-cyclical. Let's assume constant
> interest rates in the anchor country. The interest rate now charged to the
> private sector consists of the anchor's country's interest rate, an
> additional marge for the banking sector (see 1. & 2.) and an additional
> risk premium for the business in question, depending on that business'
> outlook. If now there is a boom in the dollarised country, prices generally
> rise. At the same time, business outlook is bright. Thus the risk premium
> falls. Consequently, the real interest rate which firms have to pay falls
> in the boom, pouring oil into the fire.

This story has no dependency on dollarization.  See e.g. Minsky's
writings.  Furthermore it is pure speculation until bolstered by
empirical evidence.

> If we believe in any rationale for stabilisation policy, we should be very
> concerned about this development. It could well be a reason why - over a
> longer run - dollarised economies experience such weak growth rates as were
> reported for Panama.

Define weak, please.
Remember how Panama has been dollarized.
I have IFS data since 1950, showing
real GDP growth:        4.8%/yr
population growth:      2.6%/yr
real GDP p.c. growth:   2.2%/yr

Alan Isaac