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Pros and cons of official dollarization in Eastern Europe.

Article Excerpt
Abstract

The balance of payments barrier is the biggest obstacle to growth in Eastern Europe. This problem stems from the existence of individual national currencies which dynamically increases the risk associated with capital inflows. Capital inflow leads to both domestic growth and domestic currency real appreciation, reducing net exports to a level insufficient to service international debt obligations stemming from capital inflow. To avoid losses when capital flows are reversed, high domestic interest rates are required to stem capital outflow. Result is the decline of domestic economic activity. Adoption of foreign currency eliminates the need for net exports as the source of revenue needed to service debt obligation, hence it renders the balance of payments as an obstacle to sustained capital flows and economic growth irrelevant. (JEL O50)

Introduction

The stated ambition of almost all East European countries (the area between the European Union and Russia) is to join the European Union. All countries hope that such a union will bring increases in the standard of living, economic growth, political stability, and an increase of international security.

The likelihood that at least some countries will realize this dream is relatively high, even if the time-frame of the accession remains highly uncertain. The obstacles remain on both sides. The decision-making structure of the European Union (EU) today is simply not suitable to handle more countries, especially if perspective new members are relatively poor and backward. The institutional reinvention of EU has to take place coincidentally with the structural shift to a new paradigm economy in the core EU countries. This is necessarily a contentious process. It will be resolved, but a time is obviously required.

On the side of the East European candidates, it appears that necessary reforms of the legal system, fiscal policy, financial sector, and to a some degree agriculture are more difficult to implement. The main reason is that required reforms have a negative, albeit a rather short term impact on significant groups of population. That makes an implementation of these reforms politically difficult, especially in the contentious political scene of most East European countries.

The process of the EU expansion is, indeed, asymmetric. Existing members are at best lukewarm. Among the candidate countries, attitudes differ. But one can clearly identify rising wave of national chauvinism and the anti-EU isolationism. (Pronouncements of V. Klaus in the Czech Republic are the best example of this trend.)

However, joining the EU is, in essence, the only hope for East European countries. In the era of globalization, small national states are at best anachronism, both politically and economically. But can East European countries institute policies that will bring them closer to EU and hence closer to the global economy of 21st century? This question is relevant given the above mentioned difficulties of the expansionary process stemming from political realities on both sides.

This paper discusses one such possible policy, the full official dollarization of East European economies. In essence, what are the pros and cons of East European economies abandoning their own currencies and adopting the euro? (The term official dollarization is commonly used in economic literature to describe the situation where one country officially adopts the currency of another country, even if the adopted currency is not necessarily the U.S. dollar.) Such a step can be taken unilaterally, without actually joining the EU. But will such a step accelerate processes needed for East European countries to formally join EU?

The discussion proceeds in several steps. In the next section, the choices of currencies, national versus foreign money, are discussed in general. The following section concentrates on problems that hinder economic performance of the most advanced East European countries (Poland, Hungary, and the Czech Republic) up to date. The next section then evaluates the expected impact of the replacement of domestic currencies in those countries by the euro, and the final section concludes.

The Currency Choice: National Versus Foreign

The 20th century was a century of national currencies. Often seen as a symbol of national sovereignty and independence, almost any time a new political entity was created a new national currency was created as well. Economists inquired into the rationality of such a behavior, after all, money...

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