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. Last Updated: 07/27/2016

NEWS ANALYSIS: Economists Ponder Dollar Zone

QUITO, Ecuador -- Even in the rest of Latin America, this country of 12 million has never been regarded as much of an economic leader. But by deciding to replace Ecuador's currency with the U.S. dollar, President Jamil Mahuad has thrust his nation onto center stage of a heated, continent-wide debate about monetary policy and economic relations with the United States.

Mahuad's unexpected gambit, announced Jan. 9 amid a political crisis that threatened to topple him, is a textbook example of what economists call "dollarization," and provides the test case long sought by advocates of that policy, once considered as much a fringe notion across the hemisphere as the flat tax still is in the United States.

So for the next few months, both the administration of U.S. President Bill Clinton and its trading partners from Canada to Chile will be watching Ecuador's experiment intently - and with a healthy dose of skepticism.

At the moment, the only country in Latin America that uses the dollar as its currency is Panama, which took that decision almost immediately after breaking away from Colombia in 1903. Because Panama is so small and was so closely linked to the United States by the Panama Canal Zone, the rest of Latin America has traditionally viewed it as a unique and not especially attractive case in which national sovereignty was traded for stability.

But the trend toward regional trading blocs, including the possibility of forming a Free Trade Area of the Americas as early as 2005, has forced a re-examination of that attitude. The success of the euro, especially as it affects the mother countries of Latin America, has also made the notion of a single currency for the hemisphere more plausible and attractive.

Economists and government officials in the region say the nations that would be most tempted to follow Ecuador's example are those of Central America, which already conduct the bulk of their trade with the United States. In El Salvador, for instance, dollar remittances from Salvadorans in the United States are now the principal source of foreign exchange.

In reality, many other Latin American nations already rely on dollars, to one degree or another. In many supermarkets in Peru, for example, the bills given to shoppers are calculated both in U.S. dollars and Peruvian soles. Customers can pay in either currency.

Other Latin American countries, most notably Argentina, have formally adopted mechanisms that tie the exchange rate of their pesos to the dollar and made the two currencies fully convertible at that fixed rate. And beyond Latin America, only Liberia in Africa and a few tiny island nations in the Pacific have embraced dollarization, although Hong Kong has followed an approach similar to that of Argentina and its currency board since 1983.

Indeed, the consistent strength of the currency in world markets has meant that most U.S. dollars can be found in other countries. The Federal Reserve estimates that about $580 billion is in circulation globally, two-thirds outside of the United States.

"Most countries have a large amount of their debt in dollars, maintain a large percent of their reserves abroad in dollars and write contracts indexed to the dollar," a World Bank official said.

"In a country like Argentina, a lot of the costs of dollarization have already been incurred, so the step to full dollarization would not be that great."

Those who advocate formal adoption of the U.S. dollar argue that it would also benefit countries in which wage earners are used to seeing their purchasing power eroded by high inflation and a weak currency. Indeed, some analysts even suggest that dollarization could be a tool to lessen income inequality.

The U.S. position on the issue is one that former Treasury Secretary Robert Rubin once described as "agnostic."

"We would never put ourselves in a position where we envisioned actions that we would take would be of assistance to the rest of the world but to the detriment of the United States," Alan Greenspan, the chairman of the Federal Reserve, told a congressional panel last year.

To Latin American economists, that meant Washington is unwilling to extend the safety net of the Federal Reserve system to any dollarized countries that get into economic trouble.

One clear benefit to the United States would come from "seignorage" fees that would have to be paid by countries that abandon their own currency. Though it costs only pennies to manufacture paper bills, those notes would be sold at face value to countries adopting the dollar, resulting in a substantial profit for the U.S. Treasury.

"By acquiring dollars for use in their domestic economies, dollarizing countries would be extending an interest-free loan to the United States," Treasury Secretary Lawrence Summers told the Senate Banking Committee last year.

If the entire region were to adopt the dollar, that would amount to several billion dollars a year, unless treaties waiving such fees could be negotiated, which Latin American countries have said they would want.

In Washington on Friday, Summers said there is no likelihood of a monetary treaty or any other kind of official accord with Ecuador regarding its dollarization.

Creating a dollar zone would also be likely to accelerate the integration of Latin American economies with the United States and create trade opportunities for U.S. companies.

But Clinton administration officials have made it clear that, given the region's long history of political and economic instability, they worry the relationship could become too close. Dollarization in the Americas stands in sharp contrast to the experience of Europe, where a group of countries at similar levels of economic development created a new currency and established a new common central bank to manage it.

"The Federal Reserve would be buying the problems of places like Colombia and Argentina" if those countries were to give up their own monetary system and adopt the dollar as currency, said a senior official of an international lending agency. "They don't want that headache. Their attitude is 'use your own aspirin.'"