Opinion: Dollarization (part 1)

POSTED: 06/20/11 1:10 PM

The topic of dollarization has resurfaced and I believe the citizens should have proper knowledge so that they can contribute fruitfully to a debate that should be forthcoming before a final decision is made. Even though I am not a proponent of dollarization I will give unbiased information so people can decide for themselves which would be a better choice given our circumstances.

Before going further it is my belief that you cannot talk about money without understanding the purpose for which it was created. Money was supposed to serve two primary purposes namely it greatly alleviated bartering and it was suppose to represent the value of labor about in the economy.  One might argue that it also should represent the raw materials (commodities) that go into production but these are negligible because commodities were not created by man; man applies labor to them to create further raw materials or products that are used in the production cycle. In other words, matter cannot be created nor destroyed (by man at least) but can only be transformed from one form to another, according to physics.

Now if money was suppose to alleviate bartering while at the same time representing labor about in the economy, have you never questioned why there is so much unemployment or why is it people can’t find jobs when obviously the supply of labor (number of persons willing to work) is abundant? One of the answers will be addressed in this article and the other in a future article.

The intended purpose of money has since evolved into a speculative game where economics 101 principles apply. Supply and demand is the basic foundation of economics 101. The four basic laws of supply and demand are: If demand is high and the supply remains unchanged, price value goes up. If demand is low and supply is unchanged, price value goes down. If supply is in excess and demand remains unchanged, then the price value goes down. If the supply is limited and demand remains unchanged, the price value goes up.

However, at least two assumptions are necessary for the validity of this standard model: first, that supply and demand are independent; and second, that supply is “constrained by a fixed resource”. In a scarcity environment these assumptions apply but with the development of technology these assumptions have become outdated. Also, in the case of mass production, both the assumptions of supply and demand being independent and constraints on supply are not applicable. I would also add that demand and supply laws should represent mostly non basic goods (includes energy) and services.

Well as you may or may not know, these four basic laws held up reasonably well in the period before the 1900’s where the context was different in that scarcity and growth was perfectly valid throughout the world. Therefore controlling the supply and demand of money to match scarcity and growth in such an environment made sense. Today however, the context has changed drastically. This is why the gold standard, which served its purpose and time well, would not have held up indefinitely. Unlike precious metals, mankind has the ability to multiply in leaps and bounds. Hence to limit the amount of money that can be created by gold would mean at some point the gold convertibility price of money would have had to continue increasing as the population grew. A bigger population means more money is needed in order to represent labor about in the economy. In other words money should not be the limiting factor but labor availability, natural resources, and the carrying capacity of an area should.

 

Today however we find that monetary policy is out of synch with the reality of an emerging world. Money is being deliberately kept scarce in order to maintain its value and as a consequence unemployment keeps rising. Now one might ask if the Federal Reserve in America has turned on the printing press how is it possible then that money “seems” scarce?  As this is an in-depth topic of itself I will summarize and say that there are two main reasons: the money creation process better known as the fractional reserve banking system inherently creates scarcity. Central banks don’t create money and give it to the people. They create the money but deposit it into commercial banks, which are private institutions, with the intention for these commercial banks to create credit or loans to people and thereby increasing money or debt in the society.

Remember I said these institutions are private and private means that profit is the primary focus. Hence often times the persons who are in dire need of funds are the ones who cannot meet commercial banks requirements hence the economy becomes unbalanced where a widening of the haves and have nots become the order of the day. Secondly, when one pegs one currency to another it means that sufficient reserve currency of the currency that one has chosen to peg against must be available to keep the exchange ratio between the national currency and the reserve currency.

In our case the guilder is pegged to the dollar at 1.79. So if we have Naf 100,000,000 (one hundred million guilders) in circulation then we would need to in turn have USD 55,865,922 in reserve to keep our currency at the peg of 1.79. Part of the role of the Central Bank is to maintain this ratio within a small band above or below the pegged ratio.

But what happens if our USD reserve starts to decrease like what is happening now? So for example what happens if the USD reserve drops to USD 50,000,000? In order to keep the peg ratio we would need to have 50,000,000 times 1.79 which is Naf 90,000,000. As per example there is Naf 100,000,000 so the Central Bank will need to find a way to reduce our national currency by Naf 10,000,000 in order to maintain the peg.  They can do a number of things to ensure this.

They can sell guilders for dollars, they can increase the interest savings/time-deposits rate on guilders, they can issue bonds denominated in guilders at attractive interest rates, or any of the combinations just mentioned. Now obviously this sort of activity can be out of harmony with the realities within the society and economy. For example a growing population would need access to more money/credit/debt. But if the printing of more money is limited by the maintenance of the peg ratio requirement then we will develop a mismatch issue with all of the consequences. Stay tuned for part two.

Emilio Kalmera

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