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. Last Updated: 07/27/2016

'Dollarization': Is It Irreversible?

Russians today may be in love with the dollar, but new research by two International Monetary Fund economists suggests that the country will have to take some extraordinary and perhaps even destabilizing measures to break up the romance.

The researchers say that countries awash in dollars might have to lower their inflation rates below the U. S. rate of about 3 percent in order to restore confidence to their domestic currencies.

The implications of the research for Russia, where inflation has been running at about 2, 000 percent, are twofold: First, the fact that the ruble has temporarily stabilized is not in itself enough to make the ruble attractive again. The second is that, barring a massive austerity program in Russia or exceptionally high inflation in the United States, five to 10 years of serious inflation fighting might be needed before the ruble returns in Russia as the currency of choice.

Last year, President Boris Yeltsin said he would ban the dollar, but economic officials later said that this would not happen until the ruble stabilized. Such a ban, given the inflation rate, would do little but drive the dollar economy back underground.

Classic economic thinking has dictated that to fight what economists call "dollarization" of an economy, a country must reduce inflation to a "livable" level and stabilize its money supply.

Russians have switched to dollars as a safe haven for their earnings and savings against raging inflation and the wanton printing of rubles.

So if high, sustained inflation is what made people switch to dollars, then reducing inflation should bring people back to their own currency, according to the standard approach.

Not exactly, according to Pablo E. Guidoti and Carlos A. Rodriguez, the Argentinian researchers whose findings were summarized in the IMF Survey, a biweekly publication of the fund. Their research shows that movement back to the national currency is not so easily achieved.

The researchers studied the relationship between dollarization and inflation between 1972 and 1988 in four Latin American economies: Bolivia, Mexico, Peru and Uruguay.

They found that dollarization occurs not because inflation increases, but because it stays that way over a long period of time. Even when inflation was reduced in the Latin American economies, dollarization did not drop.

Over time, some parts of an economy become permanently married to the dollar.

"Dollarization can be irreversible", the article said, unless inflation dips below the U. S. level.

The reason is that it costs money to change currencies. People will avoid switching back to the old currency unless they have significant incentive to do so.

"Reductions in the inflation rate might not achieve any significant increase in the demand for domestic currency", says the article. Governments "may need to reduce inflation to a level even lower than that of the competing foreign currency".

The researchers acknowledge that such stringent inflation-fighting measures could hurt other efforts to stabilize the economy, signaling that living with the dollar could be the lesser of two evils for Russia.