In January, President Menim of Argentina proposed strengthening his country's commitment to monetary stability by replacing the peso with the U.S. dollar. Dollarization leaves Argentina without a lender of last resort, but the Federal Reserve's current operating procedure combines with existing Argentine arrangements to mitigate this drawback.Argentina ; Monetary policy - Argentina ; Currency boards

David E. Altig

Owen F. Humpage

English

Research Papers in Economics

By almost any objective measure,
Argentina surely stands as one of the
outstanding economic success stories of
the past decade. Throughout the 1980s,
inflation plagued the Argentine econ-
omy. By the end of that decade, price-
level growth reached hyperinflationary
rates: In June 1989, the Consumer Price
Index was 1,471 percent above the pre-
vious year’s level.1 By March 1990, the
index had advanced 20,266 percent over
the prior 12 months. By the end of that
year, real gross domestic product per
capita was 23 percent below its 1980
level, reflecting the wastefulness of pro-
longed and extreme inflation.
In response to these clearly unsustain-
able circumstances, Argentina embarked
on a series of reforms in the late 1980s
and early 1990s that included fiscal
restraint, privatization, trade liberaliza-
tion, and various structural improve-
ments. At the heart of the reforms was
the 1991 Convertibility Law (discussed
below), a program designed to distance
money creation from politics. The law’s
key feature was a currency board with a
fixed, one-for-one exchange rate be-
tween the peso and the U.S. dollar. 
The results have been impressive. In
1992, the annual inflation rate in
Argentina was 25 percent. In 1998, the
price level rose 1 percent. Over the same
period, real output per capita grew at an
average annual 4.6 percent rate, offset-
ting a significant fraction of the contrac-
tion suffered over the 1980s.
Despite the apparent success of its
currency-board arrangement (and the
collection of coincident reforms), finan-
cial markets have not afforded the Argen-
tine government full credibility. Risk pre-
mia—measured by the spread between
peso- and dollar-denominated assets—
continue to be large and volatile. Follow-
ing the onset of the Asian financial crisis
in summer of 1997, and then again fol-
lowing the Russian ruble devaluation in
August 1998, risk spreads spiked into the
neighborhood of 400 basis points.
Although the reaction to the depreciation
of the Brazilian real in January of this
year was muted, the spreads between
short-term peso and dollar loans remain
around 60 basis points. 
These differences persist, even though
the Argentine and U.S. inflation levels
have nearly converged, and dollars com-
pletely back the peso monetary base. To
further strengthen monetary credibility,
many (including Argentina’s President
Menem) advocate dollarization—the
complete replacement of the Argentine
peso with the U.S. dollar. 
The proposal raises several intriguing and
important questions that go to the heart of
monetary theory and the design of opti-
mal currency institutions. Central to most
discussions is the presumed trade-off
between enhanced credibility that can be
bought with dollarization and the loss of
options that are inherent in monetary sov-
ereignty. Of particular concern is the pos-
sibility that dissolution of a nation’s cen-
tral bank makes the country particularly
susceptible to shocks that require the
September 15, 1999
Federal Reserve Bank of Cleveland
Dollarization and Monetary
Sovereignty: The Case of Argentina
by David E. Altig and Owen F. Humpage
In January, President Menem of
Argentina proposed strengthening his
country’s commitment to monetary
stability by replacing the peso with the
U.S. dollar. Dollarization leaves Ar-
gentina without a lender of last resort,
but the Federal Reserve’s current
operating procedure, together with
existing Argentine arrangements,
mitigates this drawback.
ISSN 0428-1276presence of a lender of last resort. This
concern underlies the preference of many
for dollarization only with access to the
Federal Reserve’s discount window.
We contend that this trade-off is over-
stated. Argentina’s existing currency
board and the Federal Reserve’s operat-
ing procedure already provide mecha-
nisms to meet the liquidity needs of 
Argentine financial institutions. These
mechanisms considerably strengthen
the case for dollarization, even without
direct access to the Federal Reserve’s
discount window. 
The arguments that follow pertain to the
case for dollarization given the existence
of an operational currency board. We
assume that the trade-offs inherent in
moving from a floating-exchange-rate
regime to a fixed-rate system have
already been accepted, and argue that
dollarizing to enhance monetary credi-
bility does not impose costs beyond
those of a strictly observed currency-
board arrangement. 
    The Problem with Fiat Money 
The impulse for dollarization springs
from the same source as the impulse for
the creation of currency boards. Although
governments generally understand the
long-term benefits of stable money, they
have strong incentives to generate infla-
tion. Through expansions of the money
supply, governments gain revenues—
without the consent of the public as ex-
pressed through a legislative process.
Budget problems are typically at the root
of blossoming inflation.2
Seigniorage, the revenue that govern-
ments gain from printing money instead
of issuing interest-bearing debt, ac-
counted for approximately 54 percent
of total Argentine government revenues
between 1985 and 1990, reaching a
period high of 86 percent in 1987.3  The
Argentine public, not wishing to hold 
a depreciating monetary asset, shifted
out of pesos and into U.S. dollars. To
protect its revenue base, Argentina’s
government resisted unofficial dollar-
ization, but often the form of the resist-
ance—capital controls, for instance—
compounded the inefficiencies asso-
ciated with monetary instability.
To restore the economy’s long-term
growth potential, Argentina needed to
re-establish confidence in the purchasing
power of its money. With its reputation
for price stability in shambles, the task
was not an easy one. If the public once
again held and used Argentine money,
what would prevent the government
from inflating anew? The answers came
in the form of a currency board.
    The Convertibility Law 
In 1991, Argentina established a cur-
rency board that fixed a one-for-one
exchange rate between pesos and the
U.S. dollar.4 To guarantee free conver-
sion at this rate, the Convertibility Law
that established the currency board
requires Argentina’s central bank to
back the peso monetary base fully with
reserves dominated in U.S. dollars or in
currencies easily converted into dollars.
The central bank holds these reserves as
dollar-denominated deposits or other
interest-bearing instruments. 
Although the new monetary institution
created by the Convertibility Law is not a
pure currency board, such an unadulter-
ated arrangement is a useful benchmark
from which to begin thinking about
Argentina’s monetary structure. The
monetary base of a country with a pure,
dollar-backed currency board can change
in response to adjustments in U.S. mone-
tary policy, to shifts in overall demand
for dollars, or to swings in the worldwide
distribution of dollars. Holding all else
constant, for example, a U.S. monetary
expansion would raise the U.S. price
level relative to the Argentine price level
and put downward pressure on the peso
price of dollars. To defend its peg, the
Argentine currency board would trade
pesos for dollars, effectively expanding
its own monetary base in concert with
the change in the supply of dollars. 
Though not a pure currency board,
Argentina’s arrangement ties its mone-
tary policy to that of the United States.
By 1995, its inflation rate approached
U.S. levels. By adopting a currency
board, Argentina traded monetary inde-
pendence for the credibility associated
with Federal Reserve policies. 
    The Currency Board: 
ACross of Gold?
The costs of lost policy discretion are
substantial. If this were not so, the
United States and other large industrial-
ized countries might forgo fiat money
and return to a system based on gold or
some other commodity. But the costs of
low confidence and uncertainty about
the exchange value of a currency can
also be large. If this were not so, each of
the European Monetary Union states
would not have agreed to forgo issuing
its own currency under its own indepen-
dent monetary policy. 
Virtually every issue raised in contem-
plating the fundamental trade-off pre-
sented by the adoption of a currency
board—credibility and discipline
versus discretion and flexibility—
descends directly from the historical
debates that have fashioned modern
monetary institutions. In fact, a cur-
rency board ties the hands of the adopt-
ing country’s policymakers in exactly
the manner of a gold standard. 
Perhaps the most famous—or infamous
—political attack on rule-bound mone-
tary regimes in U.S. history was William
Jennings Bryan’s 1896 “cross of gold”
speech. Vehemently arguing for the
adoption of a bimetal (gold and silver)
currency standard as a way to relax the
monetary stricture of the gold standard,
Jennings warned that:
No private character, however pure, no
personal popularity, however great, can
protect from the avenging wrath of an
indignant people a man who will declare
that he is in favor of fastening the gold
standard upon this country, or who is
willing to surrender the right of self-
government and place the legislative
control of our affairs in the hands of
foreign potentates and powers.5
With only minor changes in language
and context, one can easily imagine
modern-day opponents of dollarization
uttering these sentiments. 
What consequences would justify such
dire warnings, such an impassioned plea?
Dollarization opponents often presume
that real economic activity becomesmore vulnerable to shocks in the absence
of the option to expand or contract the
domestic money supply. Under a cur-
rency peg, the exchange rate cannot act
as a buffer against economic shocks.
Necessary adjustments, which must rely
on domestic price movements, often
entail unemployment and lost output if
those price adjustments are slow. Argen-
tine output losses following Mexico’s
devaluation in 1994 reflect this problem.
In addition, dollarization or a pure
currency-board arrangement supposedly
precludes a “lender of last resort.” The
government would be unable to inject
liquidity rapidly enough to stave off
panic during periods of financial distress.
In discussing the transition to dollariza-
tion from a currency board, we ignore the
adjustment problems inherent with fixed
exchange rates and focus on the lender-
of-last-resort problem. 
    Argentina’s Almost Pure
Currency Board 
Argentina contemplated these problems
when instituting its monetary reforms
and, in contrast to a pure currency board,
elected to retain some latitude for discre-
tionary policies. The central bank may,
for instance, hold up to one-third of its
reserves in dollar-denominated Argen-
tine government bonds, but it may not
increase its holding of these bonds by
more than 10 percent over the previous
year’s average (except in emergencies
and then only with congressional
approval). Although the government has
never used this provision, transacting in
Argentine government debt allows the
central bank to alter the monetary base. 
In 1996, Argentina also established the
Contingent Repurchase Facility, which
offered a temporary source of funds to
illiquid banks, thus establishing a limited
lender-of-last-resort capacity.6 The facil-
ity gives Argentina an option to sell
bonds to a group of international banks
under a repurchase agreement. The facil-
ity contains numerous protections for the
banks, but the most important invalidates
the agreement if Argentina defaults on
any international debts. Argentina could
also finance bank loans with the dollar
reserves held in excess of the amount
necessary to back peso monetary base.
(Currently, Argentina’s foreign-exchange
reserves equal $24 billion, compared to a
monetary base of 14.5 billion pesos.) 
Ironically, the Mexican currency crisis of
1994–1995 suggests that such flexibility
might enhance the credibility of the
exchange-rate peg, because it offers an
alternative to devaluation in the face of
financial crises. Mexico’s devaluation in
December 1994 strained the credibility
of Argentina’s currency board and led to
withdrawals from Argentina’s banking
system and international capital flight.
Banks raised interest rates and restricted
lending; the monetary base fell by 2.5
billion pesos. Nonperforming loans at
banks, particularly provincial and state-
run banks, rose sharply. Real gross do-
mestic product per capita fell 5.3 percent. 
Rather than abandoning convertibility,
Argentina adopted measures designed to
contain the financial crisis. The central
bank lowered reserve requirements,
thereby reducing the contractionary
impact of the banking crisis on the
money stock. On March 14, 1995, the
government revealed plans to borrow up
to $7 billion, primarily from the Interna-
tional Monetary Fund, the World Bank,
and the InterAmerican Development
Bank. These funds provided a limited
source of credit to facilitate a restructur-
ing of the banking system. Bank privati-
zation and consolidation accelerated.
    Does Dollarization Equal
Rigidity?
Although substantial, these sources are
finite; a traditional central bank can the-
oretically create unlimited amounts of
bank reserves. Nonetheless, they provide
Argentina’s central bank with some lee-
way over domestic money growth.
Would dollarization then return Argen-
tina full circle to the type of “inelastic
currency” regime that eventually gave
rise to today’s fiat money standards and
their associated risks? 
If dollarization is to enhance credibility
further, it certainly must inhibit
Argentina from easily exercising mone-
tary policy discretion. (Although presum-
ably difficult, de-dollarization is not
impossible.) Nevertheless, an economy
operating under a fiat money standard—
even one that has no direct influence over
its money stock—is not directly compa-
rable to an inelastic regime—like the
gold stand—in which the aggregate
money stock evolves relatively slowly. In
this respect, the dollarization of
Argentina (or any other country) bears at
least one important similarity to the dol-
larization of Ohio or New York or North
Dakota.7 In all of these regions, the sup-
ply of dollars automatically adjusts to
accommodate any changes in the
demand for dollars. Even though Argen-
tine financial institutions may not have
direct access to the American federal
funds market, they will almost surely
have correspondent relationships with
institutions that do have such access.
Indirectly, then, shocks to the demand for
dollar assets originating in Argentina
would be satisfied through a fairly com-
mon chain of interbank arrangements.
Moreover, under its current federal funds
targeting procedure, the Federal Reserve
automatically accommodates aggregate
money demand shocks through its open
market desk. Accommodating aggregate
changes in the demand for money that
emanate from developments in Argentina
will not adversely affect either country’s
inflation rate. 
As for a lender-of-last-resort function,
nothing inherent in dollarization pre-
cludes the continuation of the Contin-
gent Repurchase Facility. In fact, the
facility is dollar based. Similarly,
Argentina can still hold dollar reserves
for emergencies under dollarization.8
Dollarization is therefore entirely irrele-
vant to the mechanisms that already
exist to resolve acute stress in Argentine
financial institutions. 
    There Is No Such Thing 
as a Free Lunch. 
But Is Dollarization Close? 
In the end, dollarization imposes no
costs on Argentine monetary policy be-
yond those resulting from its currency-
board arrangements. The desirability of
dollarization depends on whether aban-
doning the Argentine peso makes the
abrogation of monetary discipline less
likely than maintaining a system in
which the peso circulates but is backed
by dollars. This is not a particularly diffi-
cult question to conceptualize, but that is
not the same thing as saying it is an easy
question to answer.     Footnotes
1. All data are from the International Mone-
tary Fund’s International Financial Statistics. 
2. See William C. Gruben “Banking Struc-
tures, Market Forces, and Economic Free-
dom: Lessons from Argentina and Mexico,”
The Cato Journal, vol. 18, no. 2 (Fall 1998),
pp. 263–74. 
3. We estimate seigniorage in Argentina as
the year-to-year change in the monetary base. 
4. Steve H. Hanke and Kurt Schuler’s 
“ADollarization Blueprint for Argentina,”
Cato Institute Foreign Policy Briefing, no. 52
(March 11, 1999) provides an excellent
review of the Convertibility Law (available
at: http://www.cato.org/pubs/fpbriefs/
foreignbriefs.html). 
5. The “cross of gold” reference comes from
the last passage of Bryan’s speech: “You shall
not press down upon the brow of labor this
crown of thorns, you shall not crucify
mankind upon a cross of gold.” 
6.  For a good description, see Hanke and
Schuler, op. cit. 
7.  Although the federal government does not
exert direct influence over its short-term
monetary policy decisions, the Federal
Reserve is ultimately accountable to the
American public through the political
process. Obviously, Argentines, unlike citi-
zens of Ohio, New York, and North Dakota,
do not have the access to this system. 
8.  In theory, the Argentine central bank
could still expand and contract reserves in
response to economic shocks. With a suffi-
cient build-up of such reserves, which would
require that Argentina run an overall surplus
in its current and private capital accounts, the
monetary authorities could exercise a sort of
bounded discretion.
David E. Altig is a vice president and econ-
omist and Owen F. Humpage is an eco-
nomic advisor at the Federal Reserve Bank
of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the
Federal Reserve Bank of Cleveland or of
the Board of Governors of the Federal
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Dollarization and monetary sovereignty: the case of Argentina

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