Javier Milei was recently elected president of Argentina on a platform that included dollarizing the economy (by making the U.S. dollar legal tender instead of the Argentine peso) and ending the country’s central bank, a policy which would face political resistance. In some respects, Zimbabwe’s recent post-hyperinflation reform efforts can serve as a guide, as dollarization can address Argentina’s inflation but not underlying fiscal problems.
Unofficial dollarization has been a reality in Argentina for decades. U.S. dollar and dollar-denominated assets have served as a store of value given the declining purchasing power of the peso. These situations arise in response to high domestic inflation. With high inflation, nominal prices generally change rapidly, such that they can interfere with people’s abilities to use prices to coordinate economic activity.
As a simple example, imagine living in Argentina and being given a choice between being paid in pesos and dollars. Argentina’s rate of annual inflation has of late exceeded 100 percent, while in the U.S., it’s now under 5 percent. Clearly, a salary in pesos would lose purchasing power much faster than in dollars. People have good reason to find more stable foreign currencies.
Unofficial dollarizations usually involve an ongoing battle between a country’s central bank, which tends to keep its currency overvalued, and the black or parallel market — such as Argentina’s Blue dollar market — in which people value the currency less than what the central bank declares. Milei’s proposal would end the high inflation and much of the parallel market activity.
The key benefit of an official dollarization, then, is that you import another country’s inflation rate. Typically, it also carries a significant cost: a government’s loss of revenue gained from issuing its currency, known as seignorage. But in Argentina’s case, seignorage was exhausted long ago. So, on net, dollarization seems like a good idea.
But there’s a caveat: Official dollarization addresses the inflation, while fiscal reform that increases tax revenues and reduces spending addresses Argentina’s growing debt. Politics, however, can derail such reforms.
After experiencing the second-worst hyperinflation in history roughly 15 years ago, Zimbabwe — which has had a much weaker fiscal capacity than Argentina — instituted a dollarization and well-planned fiscal reform. Former Finance Minister Tendai Biti’s retrospective account of what went wrong before and after his 2009-2013 tenure explains how a promising reform agenda can be derailed by those politically opposed to it.
By way of background, Zimbabwe’s hyperinflation was sparked by fundamentally fiscal issues: declining tax and bond financing revenues and no access to aid. That left the Reserve Bank of Zimbabwe (RBZ) to essentially print currency to fund spending.
Spending included so-called quasi-fiscal activities, which arise when a monetary authority undertakes actions that a fiscal authority would normally undertake through transfers and subsidies.
As the hyperinflation worsened, Zimbabweans increasingly turned to black market foreign exchange activity to preserve purchasing power. Sound familiar? Meanwhile, RBZ staff operated both sides of the foreign exchange market illegally, as some staff would give access to foreign currency through bribes, and the RBZ allegedly used runners to acquire back foreign exchange in the black market with freshly printed Zimbabwe dollars.
By late 2008, the RBZ extracted virtually all of the seignorage revenue that it could as the purchasing power of Zimbabwe dollars plunged. President Robert Mugabe’s regime and opposition leaders entered a power-sharing arrangement in 2008.
By early 2009, now under a power-sharing agreement brokered in the emergency between Mugabe and opposition leaders, Zimbabwe officially dollarized by allowing people to pay taxes in six different currencies, including the U.S. dollar, the British pound, the euro and the South African rand. The rate of inflation fell almost immediately.
Now lacking any mechanisms to collect seignorage, the new government instituted a reform aimed at making tax revenue collections more efficient. It ran surpluses and began paying down the debt and the economy began recovering.
However, the power-sharing arrangement ended in 2012. Since then, Zimbabwe’s political and inflationary environment has been unstable as its debt has been rising and the government has sought to reinstitute a new variant of the Zimbabwe dollar.
In short, dollarization can end Argentina’s high inflation, but it will not address fiscal problems. Whatever monetary institution policymakers ultimately choose, reform efforts — some of which are already underway — should also come with efforts to end the rampant government deficits problem by increasing tax revenues and cutting spending.
Stephen Matteo Miller is a senior research fellow with the Mercatus Center at George Mason University.