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Why Jamaica Should Dollarize

While Jamaican officials have recently applauded their own ability to raise 11.5 billion Jamaican dollars from an investment debenture offering last week, others see no reason to celebrate and believe that the debenture provides the latest evidence that the Caribbean nation of 2.7 million people should consider replacing its currency with the US dollar.

On the surface the 11.5 billion raised in Jamaican dollars may look impressive but it came with an especially high price tag as the government was forced to offer a 21% interest rate for the 18-month debenture.

The high interest rates are the result of inflation and a lack of confidence in the Bank of Jamaica - two problems that have plagued the country since 1961 when its central bank was established.

In effect the Jamaican government has been forced to use high-interest rates as a bribe to persuade investors to pour financial capital into the country. And while investors are attracted to the high interest rates as was the case with the recent debenture, the drawbacks to high-interest rates so outweigh the benefits that eventually they produce the opposite of their objective - they actually drive down domestic and foreign demand for Jamaican dollars as investors recognize the manner in which the Jamaican economy is stifled by high lending rates and inflation.

In the last 15 years the inflation rate in Jamaica has varied from 8 to 80 percent while the inflation rate in the US has varied from 1.9 percent to 5.4 percent, as measured by consumer price indices. Interest rates have had to keep pace with the rate of inflation just to compensate Jamaicans for their decreased purchasing power over time.

In 2000 real interest rates were a stifling 18%, down from a stunning 24% in 1998. Over the last two decades, Jamaica has had some of the highest interest rates of any country in the world.

And the high rates have had a devastating impact on capital formation, entrepreneurial development and overall economic growth in Jamaica. And it is hard not to see why.

Think of all of the business enterprises and economic development projects in Jamaica that are able to generate anywhere from an 8 to 18 percent real profit. These would make for profitable ventures, but because the cost of borrowing inside of Jamaica is so high, that business that would be profitable, if it were advanced credit in the US, is unprofitable in Jamaica. As a result new businesses are not started, existing businesses are starved for working capital and new workers are not brought intro the workforce leaving unemployment rates at high levels, with Jamaica's unemployment rate approaching 16 percent in 2000.

In recent years the Jamaican dollar has steadily depreciated against the US dollar with 35 Jamaican dollars exchanging for 1 US dollar in 1995, 41 Jamaican dollars exchanging for 1 US dollar in 1999 and with a current exchange rate of 45 Jamaican dollars to 1 US dollar.

Since 1996 Jamaica has kept the Jamaican dollar from dramatically decreasing in value but only by raising interest rates, perpetuating an environment that strangles economic growth.

Johns Hopkins Professor of Applied Economics, Steve Hanke, who has advised members of Jamaica's private and public sector on economic matters in recent years describes a pyramid of problems that have been built because of the dismal state of the Jamaican dollar and the Bank of Jamaica's strategy of using high interest rates to both finance the country's public debt and to create an artificial demand for Jamaican currency.

A four-year old book, Alternative Monetary Regimes For Jamaica, which Hanke co-authored with Kurt Schuler, describes the dilemma faced by Jamaica,

"High real interest rates also create problems for government finance. Real interest rates persistently higher than the rate of growth in taxes imply that the Jamaican government must devote more and more revenue to repaying the debt and less and less to other activities. Ultimately that creates a crisis in which the government has three choices: further reduce spending on everything except repaying the debt, default, or create inflation. Further reducing spending is typically unpopular. Default is unnecessary because the government can make the Bank of Jamaica print all the money it needs to pay its bills. Consequently, inflation has been the usual result in the past, and threatens to occur in the future should real interest rates remain high. Monetary policy in Jamaica today faces a dilemma that may last for quite some time. On the one hand, high real interest rates for Jamaican dollar loans are stifling business activity and economic growth. They also imply a future crisis for government finances, which would sow the seeds for further high inflation."

And Hanke's analysis has proven to be correct, as Jamaica has accepted the options of reducing spending and creating inflation in order to compensate for its fiscal shortfall. Jamaica's government finances are in a crisis, with 40% of its budget going toward debt servicing.

In addition due to the absence of economic growth and the presence of high rates of unemployment many Jamaicans have turned away from the formal economy in order to earn a living. According to the IMF this has resulted in an estimated 50% of Jamaica's economy activity taking place in the informal sector, further denying the island nation of badly needed tax revenues and ensuring yearly budget deficits. This has forced the government to move further along the path of inflation and oppressive and unproductive debt as the Bank of Jamaica has enabled the Jamaican government to finance its yearly deficits through increased borrowings at high rates of interest. Today, Jamaica's total public debt is 144% of its GDP.

In addition, since 1977 Jamaica has had over 10 agreements with the IMF that have only compounded the country's problems as the IMF has placed demands upon Jamaica to reduce spending in key areas and to reduce its budget deficit by raising taxes. This type of fiscal austerity has not only failed at closing Jamaica's budget deficit but it has contributed to and reinforced the environment of inflation and high interest rates that has made economic growth next to impossible.

In light of this myriad of problems Jamaica needs to address its problems by taking a dramatic new course in monetary regimes. We suggest that Jamaica replace its currency, the Jamaican dollar, with the US dollar - unofficially or officially, in order to reduce its debt burden, lower its interest rates and encourage risk-taking and entrepreneurial development.

In order to implement dollarization Jamaica should first declare a fixed exchange rate between the Jamaican dollar and the US dollar. After the exchange rate is fixed between the Jamaican and US dollar, the monetary base should only be allowed to increase to the extent that the Bank of Jamaica obtains more US dollars. So if the exchange rate were established at the rate of 40 Jamaican dollars to 1 US dollar that would mean that the Bank of Jamaica would not be able to increase the Jamaican monetary base by 40 Jamaican dollars unless it had an additional US dollar. After this has been done, the Jamaican dollar monetary base should be replaced with US dollars as quickly as the Bank of Jamaica's foreign currency (US dollar) holdings increase. This would complete the currency change over aspect of the dollarization process, as US dollars would eventually replace all Jamaican dollars in circulation and in bank reserves.

The last step would involve changing the role of the Bank of Jamaica from a financial institution, lender of last resort and currency issuer to that of a strictly regulatory institution.

The switchover to the US dollar would not come as a shock to Jamaicans among whom the US dollar is enormously popular and already used in economic transactions. Today in Jamaica, at any major intersection, vendors will gladly exchange beer, cigarettes and soft drinks for US dollars. Hanke told, " The Jamaican economy is practically dollarized already - they use the American dollar in their daily transactions and price goods and services in terms of US dollars, its use is enormously popular there."

And while dollarization could be done officially or unofficially, there may be an added incentive for Jamaica to officially dollarize.

Last year, legislation was formulated in both houses of the US Congress that would have allowed for the US Treasury to share 85% of the profits it would obtain from the issuance of the additional currency necessary to help nations dollarize with the very countries that were dollarizing. This profit is called seigniorage and to the extent that the dollar displaces other currencies around the world, the United States increases these seigniorage earnings while other countries decrease theirs.

The legislation did not get out of the Banking Committee of the House of Representatives but is certain to be reintroduced in the current session of Congress. If the bill is passed it could mean tens of millions of dollars in extra revenue for Jamaica over a 10-year period.

Hanke believes that passing the seigniorage law is the right thing for the United States to do and would go a long way toward promoting economic growth in Jamaica.

Hanke says, "If you really want to help Jamaica and other countries this is the way to do it. Sharing the seigniorage with countries that dollarize is the best form of foreign aid that I can think of. I would especially hope that the US Congress and particularly the members of the Congressional Black Caucus would recognize the positive impact that dollarizing and sharing seigniorage profits would have on Jamaica and the Caribbean nations".

If Jamaica would dollarize its economy, it would benefit from decreased borrowing costs and inflation and if the dollarization took place over a two-year period it would entail no start-up costs. This would certainly be true if the US Congress passed seigniorage-sharing legislation within that two-year period, which is possible.

By importing US monetary policy Jamaica can accomplish what it has not been able to in 40 years of an independent central bank guiding its monetary affairs. And that is produce economic growth in an environment of low inflation and low interest rates.

As a safety provision, if the country decides to officially dollarize, Jamaica should include a provision that allows it to switch to the use of other currencies in the event that the US dollar dramatically inflates or deflates relative to the price of gold or against a basket of gold, the yen and the euro.

If Jamaica were to compliment a new dollarized economy with tax cuts and increased personal exemptions that enabled wage-earners to keep more of their income and which unleashed the productive capacity of the Jamaican people, it could generate an economic boom that would solve the nation's chronic unemployment, inflation and deficit problems.

Cedric Muhammad

Thursday, January 25, 2001

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