De-dollarization: Not so soon

*This article maybe a bit too economics for some readers. Feel free to leave a comment or two below if you have any questions*

For the past few weeks, I have taken great interest in the economics of money, inflation and deflation to be more specific. Inflation can be defined as a general rise in prices across the economy whereas deflation is the exact opposite. Similarly, inflation (deflation) is a fall (rise) in the value of money. For example, if a pen initially cost $2, this implies that $1 cost half a pen (1/2 pen). If the pen’s price rose to $4, say due to extended period of power outages, then equivalently, $1 is now worth a quarter of a pen (1/4 pen); hence, the connection between the prior 2 definitions.

For this article though, my focus is not so much on inflation and deflation (we save the best for last), but on the instrument that a nation’s central bank employs to stabilize prices, namely “Monetary Policy“. This is an intriguing topic for me personally since the country from where I am has been a semi-dollarized country for a few decades now. Before we go on any further, let me make it clear that my position is strongly for “semi-dollarization”, at least for the foreseeable future. The broader picture is that semi-dollarization weakens the national central bank’s power. But, why is that a good thing?

Being able to regulate the stock and flow of liquidity (the ease of converting assets into money that can readily be used for commercial transactions) is an effective means to manage the economy. It allows a nation to better manage its short-term business cycle and stabilize long-term growth as steady positive inflation contributes to long-term steady growth. All fine and dandy, except this requires some powerful models tailored to suit a nation’s economic, political and social characteristics. The fed model, taylor’s rule, and the yield curve for instance are what have been used in the United States to fine-tune its monetary policy (google them if you are curious). Still, there are those, like the former chair of US central bank (the Federal Reserve), Alan Greenspan, who values intuition over what he referred to as ad-hoc methods (because economic modelling used to be ad-hoc and did not hold well over time). Some are also subject to its inventor’s bias. That aside, monetary policy is hard to crack. Setting an inflation target is challenging, the lag of policy’s effect is a problem, and getting things right in general even within a generous range of values requires large data (both domestic and global) and analytical prowess. Not to mention, an effective central bank also needs to be properly insulated from all political ties and influences.

While achieving the desired monetary target is of extreme difficulty, getting monetary policy wrong at the wrong time and wrong place is much much easier. This can be disastrous and it damages not only the short-term economic potentials but also rational expectation and confidence in the country’s long-term monetary stability held by both the citizens and foreign investors.

Thus, a loose grip on the control of monetary policy is not necessarily a bad thing if your country is not properly equipped and if the central bankers cannot deliberate independently without occasionally giving in to political or public will. Yes, in that sense, the democratic process, the power of the people, might even need to be divorced from the day-to-day decision making of central bankers. Democracy works wonder in general, except where it doesn’t. Monetary policy is one of those instances when the line is drawn. Why? Because monetary policy can be a tough pill to swallow. Just like medicine used to cure disease, when used to fight inflation, monetary policy is bitter in the short-run but it works in the long-run, and the problem is exactly that. We all live in the short-run. Getting rid of inflation almost always requires contractionary monetary policy that politicians and the public alike do not find appetising for the reason that tightening currency circulation or liquidity in general hurts the economy as in lowering short-run growth and inducing unemployment (please refer to Phillips Curve if you are interested in learning more). However, the public and politicians prefer monetary policy that pokes the economy causing it to run on inflation. This expansionary policy can prolong the good time, the peak of business cycle, turning it into a short burst of even better time. This is the case when the economy is booming, and politicians cannot get enough of this. In the short run, when things are artificially engineered to work extremely well at the expense of the future’s economic growth, they take the credit. When the future arrives and everything falls apart, the system is blamed and the people usually do not know the cause (they sometimes would turn towards condemning businesses for running on greed). The point is a reckless expansion of money supply that boosts short-term growth will cause the economy to crash harder and the subsequent suffering to last longer, and most of us do not mind or lack the memory capacity to remember what causes the crash in the first place. That is why we need a group of independent central bankers to exercise rational foresight for us, beat us to wake us up from the boom and then save us from the bust. In layman’s terms, someone that tells you to stop drinking when the party is still going and then gives you bitter medicine for the next morning hangover. Think of a boom in real estate (real estate bubbles) when everyone rushes to grab some plots of even the most unproductive land, only to later (maybe in a few years) find out that there is no effective demand for the land. As the expansion in real estate investment tends to use capital rooted in both assets and liabilities of firms/institutions, the burst of real estate bubble will spell doom for the entire country as it tends to drag many businesses and financial institutions down with it. So, we need independent central bankers who can effectively analyse large sets of data and devise monetary policy that works. They need to do this at the right time and this means they need to be able to predict/forecast with great accuracy (imagine trying to shoot a moving target with a gun that either fires the shot a few minutes or sometimes hours after trigger pulled). They also are required to be able to synchronise their movement with the government’s fiscal policy (now, imagine two persons trying to use that gun simultaneously). Where are they at the moment? Even for the economic powerhouses like the US and the EU, these people are rare and the institutional system that enables them to perform their tasks efficiently is still far from its ideal form. For a developing country with political instability striking from time to time, this is even rarer. This is not even half of the story. The interaction between monetary policy, capital flow, and exchange rate policy further complicates the problem (this will discussed in future articles). Monetary policy independence is thus not a always conducive to growth unless the criteria stated are sufficiently met.

While semi-dollarization does not remove all authority from the domestic central bank, the dominance of dollar in the local economy implies that the central bank can only control the interest rate (or money supply) as long as its foreign reserve in dollar denomination is sufficient. This limits the power and reach of the local central bank, which might be preferable as explained above.

One can eloquently argue for the other case, that is de-dollarization which does come with its own merits. But, until we have adequately improved our data gathering and analysing capability and the understanding of the broader economics as a science (not as an ideology as we do now), I am still more inclined towards keeping the dollar running around a tad bit longer.