The downside of dollarization

In 2001, El Salvador abandoned its own currency for the US dollar. Business Week has a good article describing how turning over your monetary policy to the US Federal Reserve Board may not be such a good idea. Here is an excerpt:
Yet El Salvador may still be in for a dollar-induced shock. That's because the government has effectively forfeited control of its monetary supply to the U.S. Federal Reserve. While the Fed was busy cutting rates to stimulate growth after September 11, that proved to be a boon. But with U.S. rates rising, dollarized nations like El Salvador are at risk for a credit crunch....

Of course, higher rates will help counter inflation from rising energy costs. And a moderate rise in interest rates is unlikely to sink El Salvador's economy, since two-thirds of its trade is with the U.S. A potentially far greater threat is the loss of a safety lever in the form of currency devaluation. Since El Salvador uses the dollar, it can't devalue to export itself out of a slump -- or issue debt in its own currency. That could come to haunt the country by making its exports more expensive -- and imports cheaper -- when neighboring countries' currencies depreciate against the dollar.

Not being able to use money supply to stimulate growth is a problem, since the switch to dollars has done little to boost gross domestic product. GDP growth has averaged 1.9% over the past five years -- the most sluggish of any Central American country. What's more, dollarization hasn't improved the lot of the poor. Half of El Salvador's population still lives in poverty, leaving many exposed to hardship if the economy stalls. "For poor people like me, dollarization hasn't worked at all," says Samuel Renderos, a 70-year-old retired bus driver. "Basic necessities all got more expensive when we moved to the dollar."

Economists say El Salvador needs to gird its economy by improving education and worker training, and encouraging more private investment in basic infrastructure projects. "Dollarization was a vehicle to broaden their integration with the global economy, but additional reforms have to be deepened," says Mario Garza, the International Monetary Fund's chief of mission for El Salvador. Only then, he says, will dollarization make a difference for ordinary Salvadorans.

NOTE -- Click on the comments link for an extended discussion about dollarization and poverty.


Anonymous said…
Nothing has failed the working peolpe of El Salvador, and Latin America, more than capitalism. This travesty has appeared over the last 50 years in to prevailing forms. First, the tragedy, in the 1960's and 70's with the brutal model of statist capitalism. Second, the farce, from the 1980's to present with the neo-liberal model that necessitated the weakening of the state to facilitate the free flow of capital across the globe. The people of El Salvador have been living this tradegy for so many years. Now, to hear the "economists" suggest that the people must suffer even deeper cuts into their humanity, because they need to further privatize their social infastructure, makes my head spin. Soon, one of these capitalist devils will realize that they have suck all the living blood out of the people of Salvador, and like Gogol so eloquently detailed long ago, capital will simply begin creating a market for their souls. Oh yes, profit, the market, to capitalize, to exploit, to valorize greed and acquisition, to turn a human being into an empty decimal in the ebb and flow of the capitalist market, and Christ weeps.
Tim said…
I agree with the sentiments which motivated your comments. I suspect that we might disagree on what that means for concrete steps to improve the plight of the poor in Latin America and elsewhere.
Anonymous said…
The fact that dollarization would lead to increased prices is taken for granted in El Salvador. However, I haven’t heard any good explanations as to why this should be the case. Presumably, sellers try to get as much for their products as they can regardless of the currency.

Many prices have indeed gone up. I don’t have the data to determine if these price increases have anything to do with dollarization, but I’ll speculate anyway. It may have just been a convenient time to make an inevitable price increase, i.e. prices may have been below the market equilibrium prior to dollarization and sellers believed that the currency change would lessen psychological impact of the inevitable price increase.

An important point to make is that these types of price increases in prices are not always a bad thing. It’s the prices of locally produced necessities, not luxury manufactured goods that are going up. Pupuseras are certainly working class and deserve a fair price for their product. Increased bus fairs may reduce overcrowding and reduce air pollution. Increased water prices will promote conservation and reduce the daily water shut-offs most poor Salvadorians are subjected to.

If anyone else has a better explanation that ties rising prices to dollarization, I’d love to hear it.
Anonymous said…
Let's make it simple. Higher prices means that with that 5 dollar a day person makes now he can not buy as much basic utilities like food, clothing etc. When you have 5 in your hand to feed a family what do you care if the buses are less crowded? or if the daily water shut off are decreasing? What I'm trying to say is that we have to see the problem on the short medium and long term. Priorities first. Food on the table for everyone is first.
Tim said…
The questions of why the poor have the experience of higher prices following dollarization was explored in Socioeconomic Implications of Dollarization in El Salvador Latin American Politics and Society, Fall 2004, by Towers, Marcia, Borzutzky, Silvia.

The article is much more detailed than the Business Week article I quoted and concludes that, on balance, dollarization has not benefited El Salvador and has harmed the poor. Inflation experienced by the poor in the informal economy comes from "rounding up" is one of the article's conclusions.

I agree that a priority must be placed on eliminating the extreme poverty in El Salvador and putting food on tables. To date, the Salvadoran government has devoted too little attention to addressing poverty and instead focused on a policy that says "if it's good for business, then eventually there will be economic growth which will improve the situation of Salvadorans." So far that policy has only led to greater extremes of wealth and poverty.
Anonymous said…

Whose livelihood are you looking out for? The pupuseras (i.e. people who make pupusas for a living) in my extended family make less than $5 per day. Do you really want them to sell at below market prices? Don’t pupuseras deserve “food on the table” too?

The water going off causes people to keep pilas full of water. This helps breed mosquitoes, spreading dengue. Surely you are not proposing that we ignore public health and all other needs except “food on the table.”

I think the priority of everybody reading this board is to relieve poverty. The real question is how to go about this.
Anonymous said…
Tim, thanks for the reference.

The rounding up explanation makes sense for 1 cent increases in price, but that is not what I hear people in El Salvador complaining about. The article quotes someone referring to informal venders "some people take advantage of the change, and for what used to be seven Colones they now charge a dollar." This is the range of price increase I hear complaints about. I have two points to make about this.

First, the article also states that 75% of microbusiness owners earn less than minimum wage, so the winners of this price increase are likely to be as poor as the losers.

Second, raising prices 24% above market prices in the informal sector is simply not possible. I know the competitiveness of these markets well. If venders are charging that much, someone will quickly offer to sell for 95 cents and prices will fall to Colon levels. I can’t vouch personally for the competitiveness of the middlemen, but if anyone believes that their revenue suddenly went up 24% without any changes in costs, I’d say you have found yourself a get rich quick scheme. How hard can it be to buy and sell rice and beans?

Ultimately, the debate about dollarization is really between the Cafeteleros, who like devaluations, and the financial elite, who hate devaluations. What does this have to do with the poor? In the 1980s, the Salvadorian left decried devaluation. Now we waste our efforts protesting a dollarization whose primary purpose is to make devaluations impossible. The real success of the oligarchs has been to distract the left on an issue that has little relevance to the poor. Until the Salvadorian left and its international allies come up with a coherent story for our economic concerns, we will be condemned to a political life as fringe rejectionists.

What we need is a positive agenda that both strikes a cord with the poor and cannot be discredited with objective social science. How about a campaign to eliminate the charges for “public” schools (I have been told these are $10 per month, but I’ll check this figure)? It’s realistic, it strikes at a legitimate complaint of the poor, few of the benefits will accrue to the upper classes since they sent their kids to private schools, and it would encourage people to do something that is socially desirable (sending kids to school) rather than encouraging waste (which is the effect of many other policies supposedly targeted at the poor such as water and electricity subsidies).
Tim said…

Thanks for your thoughtful comments.

Dollarization is a complex topic, and I think the Towers, Borzutsky article does a good job of exploring it. I think you would agree that it is not helpful just to have a knee-jerk reaction that "since dollars come from the United States, it must be part of an imperialist plot." The rhetoric of the left often seems to go no farther than this. On balance, I happen to think it was a bad idea to dollarize for the reasons the article lists, but dollarization is not the cause of poverty in El Salvador.

With respect to a program which makes sense, Tony Saca's "Red Solidaria" which he proposed at the beginning of March, and which included direct subsidies to families living in poverty with children, if they made sure the children went to school, could be a good concept if there is commitment, resources and follow-through. I fear that with all the financial strains caused by the flooding, this program may not proceed.

Because there is no social safety net in El Salvador, I think you need to be careful about advocating policies which would have bus fares, water prices, and other necessities rising in price as a way to encourage more efficient use of resources. Doesn't all of the increased "efficiency" come from the poor going without?
Anonymous said…
Thanks for your reply. For some time I have wanted to let you know how much I appreciate your blog. I no longer have time to follow events in El Salvador as closely as I would like and your blog is one of my prime ways to keep up.

I certainly agree that we need to be careful about advocating policies that increase prices. The only proposed policy in this thread that would increase prices is Business Week’s suggestion that El Salvador might want to engage in competitive devaluations with its neighbors. While such a policy might stimulate employment (this effect is a zero-sum-game; any gains to El Salvador = losses to other poor countries), it would also increase prices.

Even if the “rounding up” did occur, I don’t think anyone believes vender’s would “round back down” if El Salvador switched back to the Colon. For the record, I opposed dollarization back in 2001 for technical reasons better articulated by Paul Krugman than myself (and included in the Towers, Borzutsky article). I certainly did not mean to imply that I support dollarization as a way to increase prices. I just don’t think dollarization has much to do with poverty one way or the other.

I think the flip side of your point that we must be careful about policies that increase prices is that we also have to be careful about policies that decrease prices. We are on the side of the poor, not consumers in general. Not all consumers are poor and many producers of beans, corn, and pupusas are. Thus, for example, price controls on these products have tended to worsen poverty where they have been tried. There are more targeted policies to improve nutrition that are probably appropriate for another thread.

As for subsidized prices for water and electricity, to my knowledge there are none in El Salvador. Yes, I would oppose such policies because; 1) in absolute terms, the rich gain more than the poor (they use more water and electricity) and 2) they encourage waste and environmental decay. I think some environmental concerns do have immediate impacts on the poor and refer readers to the link related to the causes of the floods found in Tim’s September 25 blog entry.

The program Tim mentions has merit and is far better than what I would expect from the current administration. The problem I see is in identifying the poor in the context of mass remittances. I don’t know if the government has the capacity to identify remittance income. If not, some well-off remittance receivers will unfairly receive benefits. Even if the government does take remittances into consideration, we still have the philosophical question of who is poorer (and thus more deserving of payments) - the person who works long hours at the maquila for minimum wage or the person who receives a little less than minimum wage in remittances, but has time to stay home with the children, cook, wash clothes, etc (having one parent half-way across the world for years at a time could be considered a manifestation of poverty as well). Thus, I think the policies where beneficiaries self-identify themselves as poor through their actions (e.g. by sending their kids to public school or by purchasing a basket of subsidized, simple but nutritious basic grains) are preferable to explicitly means tested payments. However, if Saca actually follows through on his plan, I’ll be the first to give him due credit.