Jeffrey Frankel: Let me begin by expressing my admiration for the industriousness of Ilan Goldfajn. At LACEA in Rio de Janeiro he hosted one of the smoothest-running large meetings I have ever attended, presented two authored papers, and changed jobs, all at the same time.
From the viewpoint of the United States or Brazil, Panama looks like a small country. We must necessarily look at small countries, however, if we are to examine the historical experience with official dollarization. Indeed, as Goldfajn and Olivares point out, Panama has until recently been the largest dollarized country. The research strategy represented in this paper is therefore exactly the right one.
First, consider the origins of a country's decision to adopt the dollar as the national currency. Does the decision follow extraneous political currents or the recommendations of economic theory? If the latter, which theory? Does it reflect traditional optimum currency area (OCA) criteria—country characteristics such as small size, openness, dominance of internal disturbances, symmetry of shocks, and labor mobility? Or does it reflect modern criteria, many of which were designed to explain Argentina's popular adoption of the convertibility plan in 1991 despite its poor qualifications for a fixed exchange rate under the traditional OCA criteria. These modern criteria, which have more to do with stabilizing investor confidence than stabilizing the business cycle, are as follows:
—a strong (even desperate) need to import monetary stability, due to a history of hyperinflation, an absence of credible public institutions, or an unusually large exposure to nervous international investors;
—a desire for further close integration with the United States (which has the added advantage of enhancing the political credibility of the commitment, if such integration is indeed politically popular); [End Page 141]
—an economy in which the dollar is already widely used; and
—access to an adequate level of reserves.1
Panama adopted the dollar at independence almost one hundred years ago. At first glance, the original decision to dollarize fits the traditional OCA criteria: Panama is small, and it trades extensively with the United States. The Central American countries, in general, qualify fairly well.2 At second glance, the decision also fits a political explanation: Americans were active in encouraging the onetime province of Colombia to break away in 1904, so that they could build the Panama Canal. At third glance, the modern criteria also hold. Panama had recently been the victim of a hyperinflation in Colombia's currency (the so-called War of 1000 Days), so that a desire for monetary stability was a perfectly good motive for switching to the dollar.
Every country that uses the dollar or some other foreign currency as its national currency has employed the regime at least since independence.3 The only major cases in which a country has fully given up its currency while remaining politically independent are two very recent ones. First, in 1999, eleven European countries entered a monetary union for reasons that do not fit the modern criteria, but rather follow traditional OCA criteria, unless one wants to explain the decision as serving purely political goals. Second, Ecuador opted for full dollarization in 2000; this small, open economy could fit the traditional OCA criteria, but it was the desperation of its economic circumstances that made dollarization seem the [End Page 142] only choice, which corresponds to the modern criteria. Most relevant data for the European Monetary Union and Ecuador will not be available for some time, so we must return to Panama.
The distinction between average performance in the long run and volatility in the shorter run is important. Computations suggest that Panama has generally performed better than countries with more flexible exchange rate regimes. It is by now well known that countries with less flexible exchange rate regimes tend to have lower inflation rates, not just in theory but empirically as well. This is particularly true of currency boards, whose enhanced monetary stability seems to come with average real growth rates that are higher, not lower, than other countries. The paper shows that Panama, the only fully dollarized economy of reasonable size, has had a substantially lower inflation rate than most...