In 2000, Ecuador Adopted a Full Dollarization, and El Salvador Announced Its Determination to Follow the Same Course

The number of independent countries has almost tripled since World War II: in 1946 there were 76 independent countries; today there are 193. Until recently, most countries had their own currencies. Hence, the expansion of the number of countries led to a proliferation of the number of currencies. More recently, however, the identification of currencies with countries has weakened, and the discussion has shifted toward one of desirable forms and sizes of currency unions. Roughly 60 small countries or territories have for some time been members of currency unions or have used a large country's money. Examples are the 15-member African Financial Community (CFA) franc zone in Africa, the seven-member Eastern Caribbean Currency Area, the use of the U.S. dollar by Panama and several smaller countries, the use of the Belgian franc by Luxembourg, the use of the Swiss franc by Liechtenstein, and the use of the Israeli shekel in the West Bank and Gaza. In the future, currency unions will surely be more prevalent among large countries, as is clear from the recently formed union of the 11 European countries that use the euro. Greece will join soon, and several other countries may sign on later, although Denmark has said no, and the debate in the United Kingdom is intense. Dollarization has been contemplated by several countries in Latin America, including Argentina, Peru, and much of Central America. Argentina went part of the way toward dollarization through its adoption of a currency board linked to the U.S. dollar in 1991. Currency boards that lock local currencies to the dollar or the euro also exist in Hong Kong, Estonia, Bulgaria, and Lithuania. In 2000, Ecuador adopted a full dollarization, and El Salvador announced its determination to follow the same course. We seek in our analysis to understand the forces that favor and oppose currency unions; that is, we extend the classic analysis of optimum currency areas from Robert A. Mundell (1961). One consideration, not touched on in Mundell's economic analysis, is that individual currencies are sometimes valued simply out of national pride. One would have expected these nationalistic concerns to be more intense for language than for money, yet most countries willingly use the language of another country, typically the one of a former colonial ruler. Given this acceptance of transplanted language, it is surprising how often people reject currency unions (which sometimes involve the use of another country's currency) simply on the grounds that important countries are supposed to have their own money. From an economic standpoint, the strongest argument that Mundell identified for individual money is that it allowed a country to pursue its own monetary policy. In theory, if the country operates with a flexible exchange rate, the monetary authority can design a countercyclical policy that responds optimally to its own economic disturbances. In contrast, under a fixed exchange rate, monetary policy has to be subordinated to the maintenance of the exchange rate. Fixed-rate regimes include a peg to another currency, which may or may not be permanent, and the more serious commitments represented by currency boards and dollarizations (by which we mean one country's use of another country's money, which may not be the U.S. dollar). In Mundell's framework, the main force that favors a common currency is the transactionscost benefit. The use of the same money facilitates trade in goods and services and also in financial exchanges. The expansion of world trade, or globalization, has made this consideration increasingly important. Globalization and two other factors seem to explain why the world has been moving away from the doctrine of one-country/one-currency and toward multi-country currency unions. The first additional factor is the already noted * Department of Economics, Harvard University, Cambridge, MA 02138. This research is supported by the National Science Foundation.