Dollarization – Miracle Cure, Poison Pill, or Placebo?

Dollarization

From Wikipedia: Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.

There has been a lot of consternation, confusion and general head scratching going on around Costa Rica regarding the exchange rate of the United States dollar and the Costa Rica colon.

Back in the olden days, before October 16, 2006 , you could count on the Costa Rica colon slowly losing value against the US dollar. Since then, the government has allowed the ‘free market’ to set the exchange rate… sort of. The rate is still being controlled, but not as tightly as in the ‘good (or bad) old days.’

There has been a strange phenomenon lately where the colon has actually been rising in value against the US dollar. Local business people, in particular those who deal with imports and exports, are unhappy with the unpredictability of where prices will be in the future. They would like some stability. The average Tico doesn’t pay too much attention to exchange rates. There is a psychology of expecting inflation, and local prices rise regularly. If the price they pay for imported goods goes up due to the exchange rate, they will raise their prices. If the price they pay goes down… well strangely, prices don’t seem to fall. But I guess they gotta make a buck (or colon).

The big mystery to many, including me, is WHY the dollar keeps dropping against the colon. One reason being advanced is that that Costa Ricans have cut back on imports due to the big bust in the local real estate market, among others. Another reason that has been suggested is that people are moving their investments such as CDs to colon based accounts because of the much higher return offered. When you compare the rate or return on a CD in colons to those available in the USA, and figure in the exchange rate change in the last year, the difference is staggering. Banco de Costa Rica offers 8.5% return on a 1 year CD. The best rate I could find in a US bank was a little over 2%. Now here comes the good part. Over the last year, the colon has actually appreciated against the dollar by almost 3%! If you had phenomenal timing, you could have seen an exchange rate gain of as much as 12%. Here is a little chart I did to show the fluctuations in the last year.

Out of this instability and confusion have come calls for ‘dollarization’ of Costa Rica’s currency. This would certainly end the exchange rate fluctuations, versus the dollar, at least. It would also prevent Costa Rica from printing money to pay for government expenditures. Some think this would bring Costa Rica’s ever-present inflation under control.

Not everyone agrees that this is a good idea. Sebastian Edwards, formerly the chief Latin American economist of the World Bank has said dollarization “trivializes an extremely complex situation.” Costa Rica would lose control of its interest rates and have to pay something called ‘seigniorage,’ a fee countries pay for using another country’s money.

My own opinion, uneducated as it is, is that if I were in charge, I would have nothing to do with the US dollar. The people in charge of the US dollar, the Federal Reserve Bank, along with the US Treasury department have shown themselves to be either incompetent, corrupt, or both. Take Alan Greenspan, Ben Bernanke, Henry Paulson…. PLEASE! (apologies to Henny Youngman)

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Many of the (few) people who were right about the current recession (depression?) and the housing bubble think that the only way the USA will ever pay its debts will be via hyperinflation or devaluation of the dollar. Should Costa Rica hitch its rowboat to the Titanic? I think you can guess my views.

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