[If this either/or scheme is true, Ecuador's pain will be the rest of the developing world's gain]
New York Times
January 19, 2000
RECKONINGS / By PAUL KRUGMAN
Dollars and Desperation
Ecuador is a small, faraway country of which most Americans probably
know nothing. (Hint: it's on the equator.) Last week, amid the hoopla
of the AOL-Time Warner deal, one suspects that few noticed the
surprise announcement by President Jamil Mahuad that he would abolish
his nation's currency and replace it with the U.S. dollar. But there
is an important story behind that story, which is not so much about
Ecuador as about the great financial crisis that swept Asia in
1997-98, and the continuing debate over what to do when the next
crisis strikes.
Everyone agrees that the Asian crisis was, in the first instance, a
case of financial panic: basically, after enthusiastically putting
hundreds of billions of dollars into Asia in the years before 1997,
investors suddenly lost their nerve and began pulling out all at once,
with catastrophic consequences. But there is a sharp difference of
views over what could have prevented or at least mitigated that
crisis.
Broadly speaking, one view holds that in times of panic the normal
rules of business should be suspended -- that investors should be
persuaded, or if necessary forced, to keep their money in place while
the authorities get things under control. In the oddly euphemistic
jargon of international finance, this is known as "burden-sharing," or
even more obscurely as "private sector involvement."
The other view holds that the way to deal with panic is to try to
reassure investors that their money is absolutely secure -- and that
one way to do that is to offer an ironclad guarantee that their
holdings of Korean won, or Indonesian rupiah, or Ecuadorian sucres,
will not lose their value in terms of dollars. This can be done by
establishing a "currency board," which holds dollar reserves large
enough to back the entire national money supply; it can be done even
more decisively by "dollarizing" -- that is, abandoning the national
currency and using dollars instead.
It is an unresolved debate, because neither approach was given much of
a trial. Hong Kong has a currency board, but was never itself the
object of investor panic -- it just happened to be living in a bad
neighborhood. Malaysia imposed controls on investors, but only after
the worst of the panic was past.
And that's where Ecuador comes in. The small Latin nation has the
dubious distinction of having plunged into crisis just as Asia climbed
out; and as a result it has become a sort of guinea pig for economic
nostrums. It is by no means an ideal choice as a clinical model. After
all, at the beginning of 1997 Asian economies looked robustly healthy,
with their government budgets balanced or in surplus; their crisis
came, as it were, out of a clear blue sky.
Ecuador, by contrast, has always been more or less a mess; its
plunging currency is only the outward sign of an inward disgrace, of a
bankrupt banking system that cannot be rescued by an equally bankrupt
government. But nonetheless, Ecuador is the test case we have, and its
experience is likely to have a disproportionate effect on how the next
big crisis is handled.
Indeed, the tiny nation has already done much to discredit the notion
of "private sector involvement." Last September Ecuador decided, with
more or less explicit encouragement from the International Monetary
Fund, to temporarily suspend payment of some of its foreign debt. The
experiment was a failure: while some investors found their money
locked up, others continued to flee Ecuador, and the economy's
tailspin continued.
Now its government has swung to the other extreme, and is trying to
restore confidence in the currency by abolishing it. Observers say
that this could work if it is accompanied by extensive domestic reform
-- which is a bit like the old line that you can kill someone with
witchcraft, if you also give him plenty of arsenic. But if it works,
it will do much to make dollarization likely elsewhere (Argentina, for
example); if it fails, as is much more likely, it will give
dollarization a bad name.
And the outcome matters. Sometime -- almost surely sometime this
decade -- there will be another great financial crisis like the ones
that struck Mexico in 1994 or Asia in 1997. What will we do about it?
Believe it or not, Ecuador may determine the answer.
Copyright 2000 The New York Times Company