Dollarization

Dollarization used to be a "hot topic" around 10 years ago in Guatemala. Nowadays one hardly hears about it either among economists or in the media. In a previous post I looked at some economic indicators of Central American countries. The performance of Panama stands out. Dollarization took place in Panama in the early twentieth century (1904) -- other countries have recently followed: El Salvador (2001), and Ecuador, in South America (2001). 

Does dollarization explain recent growth of Panama? This is a hard question. To be sure the relative economic success of Panama is explained by many factors: large fiscal incentives that attracts foreign investment, relatively peaceful social environment (historical absence of civil wars to the extent of other countries in the region), a strategic geographic location, and the Canal. Panama is also much more secure in terms of crime and violence than other countries in Central America and Colombia (although this is slowly deteriorating due to drug trafficking). Of course not everything is rosy. But dollarization plays its role particularly because it reduces transaction costs. 

In 2003 Sebastian Edwards wrote:

In this paper I investigate the historical record of countries that have lived under a 'dollarized' monetary system. As it turns out, this is a very small group of counties, most of which have operated under very special circumstances, and for which there are very limited data. The results reported in this paper suggests that, when compared to other countries, the dollarized nations have: (a) have had significantly lower inflation; (b) grown at a significantly lower rate; (c) have had a similar fiscal record; (d) have not been spared from major current account reversals. Additionally, my analysis of Panama's case suggests that external shocks result in greater costs - in terms of lower investment and growth - in dollarized than in non-dollarized countries.

During the recent economic crisis, for the Central American region at least, there isn't clear evidence that dollarized economies have slower recoveries. 

In 2011 Andrew Swiston analyzed the effect of dollarization in El Salvador, he argues:

This paper examines El Salvador’s transition to official dollarization by comparing aspects of this regime to the fixed exchange rate regime prevailing in the 1990s. Commercial bank interest rates are analyzed under an uncovered interest parity framework, and it is found that dollarization lowered rates by 4 to 5 percent by reducing currency risk. This has generated net annual savings averaging 1⁄2 percent of GDP for the private sector and 1⁄4 percent of GDP for the public sector (net of the losses from foregone seigniorage). Estimated Taylor rules show a strong positive association between Salvadoran output and U.S. Federal Reserve policy since dollarization, implying that this policy has served to stabilize economic activity more than it did under the peg and more than policy rates in Central American countries with independent monetary policy have done. Dollarization does not appear to have affected the transmission mechanism, as pass- through of monetary policy to commercial interest rates has been similar to pass-through under the peg and in the rest of Central America.

The economic situation of the United States doesn't look good, and it is risky to rely in the dollar given the current debt crisis. On the other hand, El Salvador and Panama are doing relatively well.