Dollarization: the immediate solution to Venezuela’s monetary problem?

The phenomenon of dollarization is not new in Latin America, there are certain countries in the region that have given up on maintaining their own currency. Panama, El Salvador, and Ecuador are the most important examples in the region, they all decided to give greater stability to their economies by managing a strong foreign currency. Now Venezuela announced a currency exchange, it will transition from the Sovereign Bolivar to a currency (which still has no name) with six 0 less.  The  Venezuelan streets are already trading with the dollar (and even the Colombian peso and Brazilian reals). So isn't it better to officially dollarize in a country where the de facto dollarization is already 67% in payment of services and goods ?

The answer has 2 aspects. The economic and the political. Obviously, in the political sphere, and while Chavismo is in power, it will be very difficult for them to adopt a foreign currency as it represents a loss of sovereignty. But from an economic point of view, the discussion is deeper.

Also read: New Economic Failure: Venezuela Changes Its Currency Again

Advantages

IMF economists Andrew Berg and Eduardo Borensztein highlighted several advantages of adopting the dollar .

For example, it reduces the risk of a strong devaluation; it generates stability in debt payments; lower interest rates; greater foreign investment; ease of integration; and lower tax costs.

Disadvantages

There are several risks when assuming the dollar or another foreign currency. For example, in the face of international crises or changes in the market, there is no way for the National Government to take monetary measures that are adapted to the characteristics of the country.

Collection is lost in seigniorage taxes (currency exchange benefits); there may be a fall in the national currency at the time of the change and the local economy is exposed to the interests of the issuing country at the time of market turmoil.

Experts believe that dollarization provides stability, but with a social cost. This phenomenon can make the country more expensive for its own people, almost always the least favored and the most vulnerable.

Dollarization could also be the way for severe Latin American countries with currencies that are becoming more volatile, affecting wages, pensions, and trade.

It is not the first time that Venezuela has changed its currency to remove the zeros, its hyperinflation has almost forced it to do it routinely.

The Impossible Trinity

For international economists, there is an unbreakable law: the impossible trinity. This law suggests that no economy can have these 3 characteristics: a fixed exchange rate; a free trade in capital; and an autonomous monetary policy.

This means that if a country wants to have a free flow of capital (without any type of controls or obstacles) and a fixed exchange rate, it must renounce its monetary policy. This is, similar to what happens with the Eurozone or with dollarized countries. When you give the autonomy of your currency to another country, you will have a fixed exchange rate (1 dollar = 1 dollar), and you will have free circulation of currency.

Another strategy used by most Latin countries is to try to have a free flow of capital and an autonomous monetary policy, this causes that they cannot have a fixed exchange rate. This is why inflation occurs and today the soles, pesos, bolivianos, etc., are constantly devalued by stronger currencies.