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Even the more resolute, on any occasion of disgust or disappointment hereafter, might falter in purpose, and, getting possession of the vessels, abandon the enterprise. The best chance of success was to cut off these means. He came to the daring resolution to destroy the fleet, without the knowledge of his army. . . . The destruction of his fleet by Cortés is, perhaps, the most remarkable passage in the life of this remarkable man. History, indeed, affords examples of a similar expedient in emergencies somewhat similar; but none where the chances of success were so precarious, and defeat would be so disastrous. . . . The measure he adopted greatly increased the chance of success.

—William H. Prescott, History of the Conquest of Mexico

Why should a country adopt a foreign currency as its legal tender? Leaving aside the trauma of losing its national symbol, what are the disadvantages and advantages of substituting domestic currency for a hard currency? These questions are becoming increasingly relevant as several countries in Latin America are either adopting (for example, Ecuador and El Salvador) or considering (as in Argentina) the U.S. dollar as the legal tender.

This paper explores these questions by analyzing the case of Panama, one of the largest countries currently using the dollar as its legal tender. Panama has had a dollarized economy for more than ninety years. This allows us to verify some of the predictions of the theory on the costs and benefits of full dollarization. The limits of this strategy are well known: it is difficult to separate the effect of full dollarization from the effects of many other idiosyncratic characteristics of Panama. The paper controls for some of these effects by comparing Panama with the rest of Latin America, in particular with Costa Rica (which is also a relatively small economy) and Argentina (which uses a currency board).

The theoretical debate on the benefits and costs of dollarization covers three sequential subjects. The first subject is whether a fixed exchange rate is relatively more advantageous than a more flexible regime. The literature on this issue is vast, in particular in the context of the optimal currency area. Second, once the relative costs and benefits of a fixed exchange regime are laid down, one can analyze which type of fixed regime is more appropriate, for example, a simple parity versus a more rigid regime such as a currency board. Finally, the third subject encompasses the marginal benefits and costs that apply exclusively when a country decides to abandon its currency and adopt a hard currency. Here issues like completely renouncing the associated seigniorage revenues are relevant.

The main issues discussed in the paper are the following: whether dollarizationgenerates sufficient gains in credibility to reduce spreads on sovereign external bonds and also on domestic interest rates; whether the gains on lower inflation offset the cost of losing seigniorage revenues and the ability to use monetary policy to offset external and internal shocks; whether dollarization promotes fiscal discipline; and whether dollarization improves the efficiency of financial markets. In the process of exploring these points, the paper reviews several aspects of the Panamanian experience. First, the paper compares Panama's long-term macroeconomic performance with that of other Latin American countries, concentrating on the effect of different exchange rate regimes. Second, the paper describes Panama's macroeconomic experience in detail, highlighting its low inflation, the growth performance of its gross domestic product (GDP), and its peculiar real exchange rate depreciation trend. Third, the paper evaluates the effect of full dollarization on domestic interest rates and sovereign spreads in Panama. Fourth, the paper analyzes whether the exchange rate regime has induced fiscal discipline in Panama. Fifth, the paper evaluates Panama's performance during the Asian and Russian crises. Finally, the paper studies the effects of external confidence and world production shocks in Panama relative to Costa Rica and Argentina, using a vector autoregressive analysis.

The main conclusions drawn from the case of Panama are that, on one hand, dollarization does not guarantee fiscal discipline, and the elimination of currency risk does not preclude default risk or the high volatility of sovereign...