Currency Pluralism and Currency Substitution
29 January 2009
Finance Minister Patrick Chinamasa of the Zimbabwean government has announced that Zimbabweans will be allowed to conduct business in other currencies in addition to the Zimbabwe dollar, “In line with the prevailing practices by the general public”. Formerly only licensed businesses could legally deal in banknotes other than those issued by the Zimbabwean government. The Finance Minister acknowledged that the South African rand, US dollar, Botswana pula, euro and British pound were all in use within Zimbabwe, and that “the use of multiple foreign currencies for business transactions alongside the Zimbabwean dollar” was now government policy.
Zimbabwe is, in essence, creating a free market in currencies within its borders, although the market is free only in so far as exchange is concerned. The exchanges in fact will be subject to severe constraints. To date, very few people have had access to foreign currencies. These have been the privilege of elites and the wealthy with assets outside Zimbabwe. But if the experiment is allowed to run its course (which is highly unlikely), and progressively greater quantities of non-Zimbabwean banknotes begin to circulate in the Zimbabwean economy, these currencies will be in competition and subject to the laws of supply and demand like any other commodity.
While I am sympathetic to the agony of the people of Zimbabwe, from a strictly economic perspective this is an interesting development. Zimbabwe is embarked on an experiment that might be called currency pluralism. I call this “currency pluralism” for lack of a better term. Perhaps economists already have a term for it. Indeed, the situation has precedent (and therefore may well have an established term for the condition), as a situation of currency pluralism prevailed in the American colonies and in the first states in the Union after independence before the US set up a central bank and issued a currency in which people had faith. One of the big questions of the early American republic was whether the government would assume Revolutionary War debt (mostly bought up by speculators) run up in worthless Continental currency.
Also, I don’t know if economists have a term for another concept or not (if there isn’t a term for it we need to coin one) but we need a word to describe the situation when nation-state x abandons its currency and, instead of producing another currency of its own, opts to adopt the currency of nation-state y. “Dollarization” is the word for this situation when the currency adopted is the US dollar, but the currency pluralism of Zimbabwe demonstrates the need for a term independent of the US dollar. For lack of another term, I will here call this “currency substitution”.
It is not widely known (except among travelers and economists) that Ecuador began to “dollarize” its economy starting in the spring of 2000. When I was in Ecuador in 2001 all bills in circulation were US banknotes, though the coins were all Ecuadorian minted coins. In Quito there many street vendors selling old Ecuadorian banknotes as souvenirs (now I am sorry that I didn’t buy any at the time). Thus Ecuador’s dollarized economy has had almost a ten year run. Dollarization in Ecuador has had consequences both intended and intended. One interesting news story from the previous year was that, when the US dollar reached a low point, citizens of Colombia were crossing into Ecuador in large numbers in order to purchase goods and services.
The possibility of dollarization immediately suggests currency substitution with currencies other than the US dollar as the target currency for adoption. It is easy to imagine the smaller and poorer economies of central and eastern Europe opting for a program of “Euroization”, with or without the cooperation of the European Currency Union.
The most obvious problem with currency substitution is that the substituting nation-state (or other political entity, which could well be a non-state actor) loses control of its monetary policy. A relatively small economy could pursue currency substitution without the cooperation of the target currency’s issuing authority. In practice, one assumes that there is some degree of cooperation involved in most currency substitutions to date. Cooperation in adoption implies a certain level of cooperation in monetary policy, though it will obviously be the case that the strong nation-state with the strong currency will dictate policy. The most a currency substituting entity could hope for would be a role of consultation and suggestion.
Ultimately, in the long term, currencies could evolve in a way not unlike languages. Successful currencies will spread and gain users, while less successful currencies will become marginalized, and perhaps even become extinct, as seems to be the likely fate of Zimbabwean banknotes. In fact, the US dollar is already a default currency around the world. I have personally met travelers who, although they were not themselves US citizens, were not traveling to the US, and were not traveling from the US, had nevertheless chosen to change their currency into dollars for the ease of exchange throughout the world.
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