Central Banking Quite Harmful for Emerging Countries: The Case for (first) Dollarization and (then) Free Banking
A sound banking system is a necessary component of economic prosperity. The mainstream view on banking is that a central bank must prevail. In the case of emerging countries however, an alternative market-friendly monetary system involving a fixed exchange rate (sometimes coined dollarization) is by far a preferable outcome. This article will first describe the free banking era in South Africa prior to World War I, then the dollarization experiences in South America, and finally describe the advantage of a free banking system over a central banking system.
Free Banking in South Africa
Saville et al. (2005) described the free banking in South Africa before World War I as being successful due to having a branch system with 7 issuing banks by 1910. It was observed that, for the interest of the banking system as a whole, the stronger banks often came to the help of the weaker, a behaviour consistent with Selgin’s (1988) theory of free banking. Bader & Spindler (unpublished) recount the case of the banking crisis of 1890, in which the Standard Bank intervened in the run on the Cape of Good Hope Bank. The issued notes were backed by paid-up capital and gold reserves, and were convertible into gold specie. This free banking system however was “dollarised” in the sense that South African commercial banks linked the notes they issued to Britain’s pound sterling.
How the free banking there ended is no different than what happened to almost all countries which enjoyed a truly competitive note issuing banking system without any panics at all. Dowd (1992, pp. 31, 36-37, 40-45) explained that most countries moved toward central banking, because of the World War I, in order to control the money supply as a tool of government finance. The Great Depression was the nail in the coffin. In the case of South Africa, its economy accounted for almost half of the world’s gold output. For this reason the Bank of England made arrangements with South African gold mining companies to ensure control of gold production during the war years (Saville et al., 2005) and to pull South Africa away from the US sphere of influence (Bader & Spindler, unpublished). But during the war, Britain abandoned the gold standard by suspending convertibility, the Sterling devalued and South Africa experienced a significant outflow of specie. The South African commercial banks, which were forced to redeem notes into specie at a lower value than their cost of replenishment, lobbied government for the right to issue non-convertible notes. As a result, the central bank (SARB) was established in South Africa in 1920.
Interestingly, a representative of the gold mining industry opposed to a central bank system since, according to him, it would have inflationary effects as in the case of the Federal Reserve Banks (Bader & Spindler, unpublished). Indeed, later on the SARB had troubles fighting inflation.
Dollarization vs. central banking in emerging countries
Saville et al. (2005) argue that the central banking model requires the reserve bank to act as a smooth functioning absorber of economic shocks but that economic shocks cannot be anticipated with great accuracy. As a consequence, banks tend to respond to shocks with a lag, and this tendency often delays and sometimes prevents economies from making appropriate long-run adjustments. Alternative monetary systems, such as dollarization and free banking, should be considered.
Dollarization, a temporary measure which entails substitution of the domestic currency with a credible currency by establishing a fixed rate of exchange, can be especially beneficial to economies who suffer chronic inflation and do not have a credible currency such as Latin America. This implies lack of monetary sovereignty, i.e., no control on the quantity of money, which means market forces determine the quantity of money, and monetary adjustment occurs automatically with excess money being invested outside of the economy. Thus dollarization promotes monetary and price constancy by importing economic stability. Moreover, dollarization replaces the central bank as lender of last resort by harnessing the international banking system as lender of last resort. The IMF can fill this role. Financial supervision is conducted by the international private banking sector through the purchase of government bonds, with investment ratings inferred from this pricing activity. Saville et al. (2005) further mentioned that the most important benefit of dollarization is that it prevents governments from expropriating wealth through price inflation and foreign exchange controls. Cachanosky et al. (2023) noted that these countries benefit from a positive institutional shock that can create the political space and incentive to implement other needed structural reforms.
Empirical evidence abounds. Gwartney et al. (2001) compared the performance of countries with and without central banking system between 1971 and 1998. Their Table 2 shows that developing countries with central banking exhibit by far the worst performance. Their mean rate of economic growth is 1.8% without central banks and 1.1% with central banks. The median rates of inflation are 8.7% and 10.8%, respectively. For inflation, the median is chosen here instead of the mean because it is less affected by outliers.
Cachanosky et al. (2023) showed that the dollarized economies in Latin America such as Panama, Ecuador and El Salvador weathered the Global Financial Crisis (2008-2009) better than non-dollarized economies such as Argentina.
Cachanosky et al. (2023) focused on Ecuador and Argentina due to their similarity in left-leaning populist regimes and economic indicators. They both benefited from the cycle of commodity prices, and defaulted on their sovereign debt. For two decades, they experienced similar domestic and external shocks but they differed in how they escaped their economic crisis at the turn of the century. Argentina abandoned convertibility and by 2011 entered a new inflationary cycle, while Ecuador had low inflation despite growing fiscal deficits and having a sovereign default owing to not having eliminated its central bank. It is to prevent any attempt to circumvent dollarization, as was the case of Ecuador, that Cachanosky et al. (2023) concluded that dollarization should be implemented with the suppression of the central bank, as exemplified by Panama. Saville et al. (2005) consider Panama as the best case of successful dollarization. Bader & Spindler (unpublished) believe that “One of the key success of Panama’s bank liberalisation was that it occurred during a period of economic calm, so although it “sharply increased market competition and financial integration, [it] did not produce a macroeconomic crisis, as financial liberalisation did in Chile in 1980-82 and Mexico in 1994” (Moreno-Villalaz, 1999, 427).”
Hanke (1999, 2003) informed us that Argentina did not have at the time a truly dollarized system. Although its central bank from 1991 to 2002 employed a currency board, which is a dollar-pegged exchange rate system, it did not abide by the classic rules because it always attempted to offset the inflows of foreign assets by its own domestic assets. The consequence is that the peso-dollar interest rate spreads deviates subtantially from zero. Hanke (2003) further noted that the critics of dollarization attacked a straw man, in the case of Argentina, just as they attacked a straw man in criticizing the gold standard. In the past, the countries in a relatively weak position were also transgressing the “rules of the game” by the breakdown of their gold standard whenever the market tendencies were not desired by these countries.
The above findings concur with Hanke’s (1999) observation that countries which opted for a truly fixed exchange rate experienced faster growth rate of per capita GDP. The explanation as to why floating rates do not perform well in developing countries is because those countries usually have weak monetary authorities and histories of monetary instability. Gwartney et al. (2001) also argued that fixed exchange rates make sense only for countries where the credibility of monetary policy is very low or countries where the political desire to avoid devaluations is unusually high.
Dollarization is also effective at reassuring investors. Vieira et al. (2012) employed a generalized method of moments (GMM) to identify the cause of the persistence of financial dollarization over time for a group of 79 economies at different development levels over the period 1991-2006. GMM estimations were made using current and one-period-lagged variables of public debt to GDP, investment/speculative grade, inflation measures (including volatility and acceleration), minimum variance portfolio (MVP), rule of law, etc., along with the one-period-lagged dollarized deposits as the dependent variable. They found that increases in debt to GDP and investment grade are associated with increased dollarization. In a preliminary analysis, they found that a decline in inflation was associated with increased dollarization. Overall this means that highly public indebtedness generates investor’s expectations of a government default, which leads to future inflation expectation even in a currently low-inflation environment. Another implication is that dollarization is a rational response to high public indebtedness.
Analyses of African economies are rare. Pasara & Garidzirai (2020) used an Auto Regressive Distributive Lag (ARDL) to investigate growth in Zimbabwe, during 2000-2014, a country which experienced hyperinflation during 1998-2008 but improved its monetary stability thanks to dollarization in 2009. ARDL models are regressions that have lags in both the independent and dependent variables (see their Eq. 2). Their model include income per capita, interest rate, dollarization, trade openness and Gross Domestic Investment as independent variables. They found a strong long-run positive relationship between economic growth and dollarization. Such result is consistent with Noko’s (2011) earlier observation that dollarization improved many economic indicators quite early (e.g., business confidence, policy consistency and predictability, revival of financial sector services) without the need of the lender of last resort.
What after dollarization? The case for free banking
The success of dollarization sparks question about the optimal strategy to adopt when (or if) these countries finally emerge. As noted by several observers, such as Cachanosky, dollarization must be transitionary. A third alternative then is a privatized currency that will arise in a free banking system. According to Selgin (2005), currency privatization bears a minimal risk of devaluation that is more or less identical to that of a dollarized system. Selgin (2005) further argues that while a monopoly supplier of currency (i.e., currency board) generates its own seigniorage and dollarization loses its seigniorage by sending it abroad, a privatized currency will simply “get rid of seigniorage—a monopoly producer’s surplus—altogether, transforming it into consumers’ surplus, while also eliminating the “deadweight loss” associated with any monopoly to the extent that the monopoly earns monopoly rents.” The major advantage of such a system under a free banking is to be much less vulnerable to business cycles (Dowd, 1992; Selgin, 1988). The self correcting feature of free markets will find the optimal policy for each different bank, an outcome impossible under central banking. A very enlightening comment from White (2013) reads:
The wrong tactic for enhancing antifragility is to have a central authority impose uniform rules, for example, one uniform set of “optimally risk-weighted” capital requirements. This is why the Basel I capital accords failed, the more complex Basel II failed, and the even more complex Basel III will also fail to reduce fragility.
This free market solution is relevant to the situation of South Africa (Bader & Spindler, unpublished; Saville et al., 2005). The SARB adopted a floating exchange rate, and still has it today. But as observed by Gwartney et al. (2001), a floating rate is deemed to fail in emerging countries and has in fact often failed in developed countries. This is because even among developed countries, some currencies such as the French franc or Italian lira are clearly less credible than the German mark. Because South Africa still did not learn from South America’s experiences of dollarization, and despite the SARB being relatively open and transparent, monetary stability won’t be established yet.
References
Bader, M., & Spindler, Z. A. (unpublished). Toward Market-Oriented Money and Banking in South Africa.
Cachanosky, N., Ocampo, E., & Salter, A. W. (2023). Lessons from Dollarization in Latin America in the 21st Century. Available at SSRN 4318258.
Gwartney, J., Schuler, K., & Stein, R. (2001). Achieving monetary stability at home and abroad. Cato J., 21, 183.
Hanke, S. H. (1999). Reflections on exchange rate regimes. Cato J., 18, 335.
Hanke, S. H. (2003). The Argentine straw man: A response to currency board critics. Cato J., 23, 47.
Pasara, M. T., & Garidzirai, R. (2020). The boomerang effects: An analysis of the pre and post dollarisation era in Zimbabwe. Economies, 8(2), 32.
Saville, A., Bader, M., & Spindler, Z. (2005). Alternative monetary systems and the quest for stability: can a free banking system deliver in South Africa?. South African journal of economics, 73(4), 674-693.
Selgin, G. (2005). Currency privatization as a substitute for currency boards and dollarization. Cato J., 25, 141.
Vieira, F. A., Holland, M., & Resende, M. F. (2012). Financial dollarization and systemic risks: New empirical evidence. Journal of International Money and Finance, 31(6), 1695-1714.
White, L. H. (2013). Antifragile banking and monetary systems. Cato J., 33, 471.