Dollarization and the Lender of Last Resort
Javier Milei, the surprising frontrunner in Argentina’s presidential primaries, has a bold plan for reducing inflation: getting rid of the peso altogether. His proposal, which involves adopting the US dollar as the official currency of Argentina, is gaining traction.
The allure of Milei’s dollarization proposal rests on its simplicity: Since Argentina struggles to produce monetary stability, it should just import its monetary policy. Earlier dollarization efforts in Ecuador and Zimbabwe show how fast adopting the dollar can make high inflation rates converge to US levels.
Some are concerned that dollarization would leave Argentina without a lender of last resort and, in doing so, remove any hope of achieving financial stability. The classic lender of last resort doctrine maintains that a central bank can promote financial stability by lending freely to solvent but illiquid financial institutions on good collateral at a penalty rate of interest. By injecting liquidity when needed, a central bank can prevent solvent financial institutions from failing when they shouldn’t.
Since dollarization relinquishes the ability to print money, it eliminates the traditional tool for combating bank runs.
How might a dollarized Argentina deal with financial instability? Surveying the experience of existing dollarized countries, like Ecuador, El Salvador, and Panama, reveals viable alternatives to the conventional central bank lender of last resort policy.
In Ecuador and El Salvador, banks contribute to an emergency fund managed by regulatory bodies. The access to funds is divided into tranches, with easier access to the earlier portion of funds and stricter conditions for later tranches. In later tranches, a bank may be required to present and have approval from the authorities for a restructuring plan before funds are disbursed (in much the same way as a central bank may require the failing bank to ask for an emergency loan). Despite adopting the US dollar as their legal tender currency, both Ecuador and El Salvador kept their central banks. These entities provide short-term liquidity through open market operations and manage the emergency liquidity fund.
Unlike Ecuador and El Salvador, Panama has never had a central bank. Its financial institutions are well-connected to international financial markets, and rely on those markets when additional liquidity is required. International banks with operations in Panama rely on their headquarters. Domestic banks secure credit lines from foreign banks.
There is a critical difference between the incentives key decisions makers face under traditional central banks and the alternative arrangements described above. In Ecuador and El Salvador, banks must provide meaningful oversight to ensure emergency funds are allocated properly, lest the fund become insolvent. In Panama, international banks have a strong incentive to ensure their domestic branches are run prudently; and, since foreign banks will only lend if they expect to be repaid, there is little risk that insolvent banks will be bailed out. Traditional central banks, in contrast, need not worry about insolvency, as they can always print more money. Consequently, they will be more inclined to extend credit to insolvent banks, which should be left to fail.
Concerns about losing the lender of last resort as a result of dollarization are probably overstated. A country with rampant inflation, like Argentina, typically finds that its central bank is unable to function as a lender of last resort, since the demand for liquidity is not a demand for local currency, like the peso, but instead a demand for foreign currency, like the US dollar. In these cases, the International Monetary Fund (IMF) might fill the lender of last resort role, but there is little the domestic central bank can do. If such a country were to replace its local currency with the dollar, the IMF would still be able to function as a lender of last resort. It would make no sense to attribute such a country’s loss of a domestic central bank as lender of last resort to the dollarization policy: you cannot lose what you do not have in the first place.
It is easy to understand why economists in rich countries might worry about the loss of a central bank as lender of last resort. They have access to a lender of last resort and are less familiar with alternative institutions that might serve a similar role. Typically, there is little risk of losing a lender of last resort in countries with troubled currencies that are considering dollarization because such countries don’t have a lender of last resort to lose. And real-world cases of dollarization show how the lender of last resort role can be reallocated to the market with more effective incentives for all parties involved.