Why Dollarization Works in Ecuador

A discussion with Francisco Zalles on The Rasheed Griffith Show

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Show notes

Francisco Zalles, Ecuadorian Economist and Professor gives us an in-depth account of Ecuador’s journey to dollarization.

A series of unfortunate events
The economic crisis of the late 1990s, marked by a banking collapse due to external shocks (El Niño triggered the underperformance of the banana industry), poor fiscal policies, and mismanagement by the Central Bank, paved the way for drastic monetary reform in Ecuador.

A good policy is a good policy
President Jamil Mahuad's sudden decision to dollarize in 2000, at a time of extreme political and economic instability, was a last-ditch effort to save his administration. Despite limited planning, and many efforts to undermine sound monetary governance, the policy gained immediate popularity and stabilized the economy by halting inflation and restoring confidence.

Dollarization means development
Francisco sees dollarization not only as a stabilization mechanism but as a tool for institutional reform. It anchors private property rights over money, minimizes political interference, and enhances productivity by reducing inflationary uncertainty.

There is no more democratic private property than money. And building institutions is a long-term process. Dollarization is a very fast and efficient way to introduce an inclusive institution. - Fancisco Zalles

The future
Francisco’s dream? The closure of the Central Bank of Ecuador. This would solidify the benefits of dollarization. He underscores its potential as a safeguard against populism and a driver of sustainable economic growth.

Francisco Zalles via X

Recommended

• Ecuador: All You Need is Dollars: La Recuperación del Ecuador - Francisco Zalles

• The Inside Story of Dollarization in El Salvador — Manuel Hinds - The Rasheed Griffith Show

• How to Dollarize Argentina, Exactly - Nicolás Cachanosky - The Rasheed Griffith Show

• Dollarization: A Solution For Argentina with Emilio Ocampo - The Rasheed Griffith Show

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Full Transcript

This transcript was automatically generated by AI and lightly edited by our team. We don’t catch every error, so if you spot one, send us a message/email via shem@cpsi.org.

Rasheed: So Francisco, thank you so much for joining me on the podcast live in Madrid.

Francisco: You're welcome. Well, thank you very much, Rasheed I'm very happy to be here, yes, in Madrid. I just got back from the Canary Islands where I filmed my courses for Universidad de las Hespérides and I gave the inaugural lecture this year. It was a huge honor. So thank you for having me. I've always been a big fan of your podcast and I'm very happy to be here.

Rasheed: So we are going to do a deep dive into dollarization in Ecuador and this comes up constantly when you bring up Dollarization anywhere in the world.

There are so few countries that have done it. So the models that have done it, people tend to even not know that much about it in any really sophisticated way. And that's why I want to fill in this episode. Even though there are lots of details about the dollarization process that I'm not aware of in Ecuador; I am happy to finally get a chance to ask someone who was there and part of the plan.

So that's where I want to start. How did you get involved with the idea and process and just the essential idea promoting dollarization in Ecuador?

Francisco: So I was a very young economist. But there was only one liberal think tank, and I was associated with it. It's called the Instituto Ecuatoriano de Economía Política, still run by Dora de Ampuero.

When I showed up there as a young economist Dora put Mises and Hayek in my hands for the first time and really changed my life because I'd come from a very formal economics background and was very not happy with it. There was something lacking. So I'd been working with the  Instituto Ecuatoriano de Economía Política and there was a major banking crisis.

I was also working for a bank and it was a member of the economic committee of the private banking association. So I was looking for solutions and we were looking for solutions out of the  Instituto Ecuatoriano de Economía Política and Franklin Lopez and I were working on a variation of Simmon's Banking, Fractional Reserve, etc, etc.

Which was, I thought, the way to sterilize the excess money that was coming into the system. Then, Jose Luis Cordeiro, a friend and also a liberal, came to Ecuador and he wanted to re-issue his book on currency boards for Venezuela in Ecuador. So he asked me to revise and actualize it. But at the time, we're talking about 1998, there was already a lot of noise on the Argentine convertibility, which was not a currency board, but most people absolutely have no idea how different they were.

So Ecuador was already in dire straits going into a banking holiday basically. We ended up in a banking holiday. And and I just thought it was a really bad idea to try to sell currency boards at the time. Ecuador had already looked at the currency boards in 1995. That was my first exposure to them really.

So I just thought, look, there's got to be a better way. And someone at the table and I think it was most likely Dora, said, "Well, why are we using a currency board? Why are we proposing a currency board that actually gives power to the central bank still, when we could just take the reserves and give them to the people?"

And a sort of light bulb went off and everybody said, and he said, yes. And as a result, I was the coauthor of the first book that came out of dollarization, with Jose Luis Cordero. And then I was, my research was also used in Franklin Lopez's book, which came out a few months later, which is "How to Dollarize Ecuador."

How did I get involved? Through liberal ideas, through finding ways to make sure that the people had the power and not the government.

Rasheed: So the banking crisis in Ecuador that essentially accelerated the push towards dollarization is pretty infamous now but we were talking earlier, why did this crisis come to a head at this time?

Francisco: It's incredibly important. Thank you Rasheed for that question because unfortunately the narrative has been completely overtaken by, I'm going to say, Correa. That's the narrative out there because they have insisted forever and they still do. They bang the table on the corrupt bankers.

Correa's expenditures and money proficiency, profligacy, whatever the word is, it's actually magnitudes larger than the banking bailout if you consider it a banking bailout, cause banks actually lost. But anyway, getting to your point in 1998 Ecuador suffered a very strong El Niño. Banks had a major concentration of loans in the commodity sector because Ecuador is a major commodity exporter.

However, here's an interesting point. Ecuador has a price control on bananas. So the government, through price control on bananas, actually created an incentive for an excess of banana production, which the banking sector loaned into. So there's a huge concentration of loans in the banana sector and bananas and shrimp collapsed during the Niño because of an external shock.

This created a liquidity pressure on the banks. Simultaneously, Ecuadorian banks were streamlining into the Basel Accords. It was the only time that Ecuadorian banks had ever been under international norms of banking. In order to take banks that had normally been running wild and putting them into real courts, also puts pressure on the balance sheet.

So as pressures on the balance sheet were taking place because bad banks or weak banks were having to fess up on a whole bunch of stuff that they were free to do before, the Niño falls. And various banks have started asking for emergency loans from the central bank.

So the central bank during 1998 actually loaned up to a significant amount of the GDP. I forgot the exact number, but there were emergency loans out in 1998. So it was a lot of liquidity that had been printed and sent. So the central bank wanted to soak up that liquidity somehow. The existing banks had a lot of pressure because interbank rates had gone through the roof.

The government wanted to finance itself at the same time because it was experiencing a lot of fiscal pressure. So the government decided and passed a law to change taxation they actually got rid of income tax and substituted the income tax with a tax on financial transactions; 1% tax on financial transactions.

So if you went and you deposited money, 1% was taken off. If you took your money out, even through an ATM, 1% was debited from your balance. Now how does that work? As you as an economist understand, for money to multiply itself, for M one to turn into M2, we need loans and deposits.

So if you put a tax on transactions, on loaning and depositing, you're contracting the money supply, you're de-multiplying the money supply. So this law came into effect in early December but would be applicable 1st of January. What the central bank did was increase reserve requirements. It doubled reserve requirements on dollar deposits on December 18th.

And on January 18th, it increased reserve requirements in Sucres by 33%. Keep in mind that interbank rates were already in triple digits. So the central bank basically, caught a small smoldering fire and threw three gallons of gasoline on it. So by March, by 8th March, there was a banking holiday.

Rasheed: What was the rationale for the central bank to increase the reserve requirements?

Francisco: To this day, we don't know. I've had conversations with friends of mine who were working in the central bank. I almost lost a lot of friendships because of this. Once I heard about that, I picked up the phone and I got very upset at them and I raised my voice at them. And I told them very clearly, "You will be responsible for the downfall of the Ecuadorian banking system."

And they were like, "Well, you can't raise your voice at me like that." And we're still friends. We've become friends. And they've said that I was right, but of course, that's not any consolation because 100% of the banking sector was frozen.

Deposits were frozen for over a year. And this created a very serious condition for Mahuad who became highly unpopular. So they started unfreezing deposits as quickly as they could, but every single time that they unfroze deposits, the Sucre's at the time would pressure the exchange rate.

So the exchange rate started creeping up and they could not control it. Central Bank had zero credibility, and couldn't control the interest rates or the FX rates. So the economy was really in a tailspin.

The only thing that was keeping the economy, if you want to call it keeping the economy, was the fact that the whole economy was frozen for nine months. But that's essentially the genesis of the Ecuadorian financial crisis. It was caused by poor coordination and very bad policies from the government and from the Central Bank.

Case in point, the superintendent of banks at the time, Jorge Egas was impeached. And I'd already floated this theory. I'd already written about the fact that it was the central bank's fault. So he asked me to write the defense for his impeachment, and he was exonerated.

So to this day, if you think about the Ecuadorian banking crisis historically, there is no responsible party. The narrative is that the bankers were at fault. But if the bankers were at fault where is the evidence? Where are the supervisory authorities that should have been on top of it? Why are they not at fault? Now I'm not trying to excuse the banks. There were bad apples. There was especially one really bad apple in the Ecuadorian financial system. And this is called Banco del Progreso and the owner was Fernando Aspiazu. And what he tried to do, is to use and exacerbate regional tensions between the highlands and the lowlands. And the government was from the highlands, Quito. And Guayaquil is where most of the banks were affected by the external shock and the commodities. They were the most affected.

So there was this tension that was historical in Ecuador between the capital and was used as well by this bank. As a matter of fact that bank, which was the largest bank in Ecuador at the time was not intervened directly. He shut his doors.

He placed himself into a receivership of his own. It was only later that the government actually took over the accounts. And sure enough, his bank had concentrated loans into his own companies that exceeded the permitted amounts by five times.

So the rest of the Ecuadorian financial system had been complying with the Basel Accords and had been reducing their exposure to related companies significantly. They had better capital adequacy ratios than Peru, Panama, Colombia, and most of their peers. So the Ecuadorian banking system was complying and was getting better. But was hit by an external shock. Then of course you can't compete against the Central Bank and the fiscal authorities just throwing a dumpster fire on you.

So that is the genesis of the Ecuadorian Banking holiday. It's Central Banker irresponsibility combined with fiscal irresponsibility

Rasheed: The crisis continued And the president at the time, Jamil Mahuad, wasn't particularly responsive to dollarization at the beginning, and then it was a shock.

He came to TV to announce dollarization quite suddenly. Why do you think he decided to Hail Mary his presidency by dollarization? If that's a fair categorization.

Francisco: Absolutely. His popularity when he announced dollarization was 7%.

The whole country and this is in the memoirs of the central bank, bureaucrats that actually worked with him after dollarization, et cetera. Everybody expected him to resign. So why did he hail Mary? Because that was his only option. And that was because we'd done a significant amount of legwork convincing people.

There was also Joyce de Ginatta who recently passed away. She had this political platform that we were able to capitalize on in order to convince the population that this was a solution. And how we did that was very methodical. Both Franklin Lopez and I would go to every single university, and every single opinion maker, and instead of having a one-on-one publicly, we'd have one-on-ones privately.

And we'd say, "Look, we're not here to confront you. We're here to say, this is our idea. What is yours?" It was a Socratic method that basically convinced people. We created this coalition of left, right, and center that eventually would publish and we'd put press releases saying this is what Ecuador needs to do to get back on track. So his Hail Mary was because fundamentally he was up against the wall. He had absolutely no other options. And this was already popular. This was already ingrained in the people. People were telling him, "dollarize, why don't you dollarize?"

We had sent him various proposals to dollarize. So he was hearing it from the people. He was hearing it from inside his cabinet. But he'd been very not favorable to it. As a matter of fact, I think I showed you, that there's a famous Telex sent to the financial system of Ecuador on the 5th of January saying dollarization is completely off the table. Well, dollarization took place four days later. So why did he Hail Mary? Well because he wanted to survive politically. A president with 7% popularity announced the intention to dollarize the economy. There was absolutely nothing but an intention. The spontaneous order worked so fast, and this is in all the memoirs. It caught everybody off guard how fast it worked. By the next morning when banks opened, there was absolutely not a single call to the Central Bank to buy dollars.

Lines on the banks were over. Interest rates started dropping. Jamil Mahuad was kicked out of office 12 days later. There was a coup 12 days later. By then his popularity had risen to 17%. That's how fast dollarization worked in his favor. But what I want to illustrate here is that 12 days later, Ecuador was still dollarized even though all that was sustaining it was the announcement by a president with 7% popularity.

That's not the government working, that's the spontaneous order working. And that's the strength of dollarization. It returns the power of money and the value of savings back to the individual. It takes it away from the politicians

Rasheed: When you were discussing and promoting the idea of dollarization what kind of group of person was most opposed to it?

And who was more receptive to it?

Francisco: Oh, obviously the central bank. The central bank was opposed to it. The IMF was opposed to it publicly. There were two economic think tanks that were very opposed to it. And of course, there were extreme left-wing political organizations that were opposed to it.

However, I had public debates with them. I still respect these people a lot because I don't respect Correa. I don't respect his people because they're a different breed, but the true Marxists, the true believers, some of them are very academically honest. And when people are academically honest, you can hold a conversation and we would literally go to auditoriums and have a one-on-one debate and they were against it and we were for it. So they were clearly against it, but their arguments were weak. Why? Because there was a massive financial crisis. So the obvious question was, "This is a solution. What's yours?"

And there was no answer on the other side except more of the same and more of the same is just not acceptable. I don't say it's easy. We went to each university and talked to opinion makers and talked to professors and we got published manifestos in the Ecuadorian paper where you look at the names and it's funny because it's a complete coalition of people left, right, and center saying "This is a solution. The government should consider it." So it's the only time in Ecuador that really leftist economists have actually proposed market-friendly measures. It was the fact that there was this banking holiday, this major crisis, and there was this void of ideas to get us out of it.

Rasheed: So you mentioned just now that the only thing that really sustained the dollarization early on was just an announcement. There was no law, there was no regulation, and there was nothing besides this statement by a very unpopular president. But how then did it stabilize?

Francisco: So he did issue a decree. But he was out of the office 12 days later.

How did it stay in place? It was because it was so popular. There was a poll the day after he dollarized. It was already 52 percent popular. So it already had a majority. Although most people were uncertain about what this was. Within one week, interbank interest rates went from 151% to 25%. Within a week.

The remunerated deposits in the central bank, and liabilities in the Central Bank went from 91% to 9%. The equivalent of T-bills we would say. So deposit rates, which were high, started to come down. Loan rates went from 73 percent to 16 percent in a month. So this is what maintained it.

What maintained it was that it was just working, that it was just fantastically popular because everybody could breathe a sigh of relief finally. And there was another additional I think factor. The banking holiday had frozen deposits in Sucres and every time that the FX rate went up those deposits in Sucres lost value. So if you dollarize the economy those frozen deposits were dollars by then so everybody was it was in favor of it. The indigenous population of Ecuador had already risen up in arms against Jamil Mahuad because even before the banking holiday, or when he declared the banking holiday, he took away some subsidies in gas and fuel because he really wanted to have an accord with the IMF.

He was begging the IMF to give him money. This was the way for him to get out, to tie himself to the IMF, which we didn't do. We went through dollarization and they were very much against dollarization. But if you read Stanley Fischer's speech six months after dollarization, he says, we were shocked and surprised at how well it has worked. But had they asked us, we would have said no." And informally, we know that they asked them and we know for a fact that they said no, because the representative in Ecuador, his name was Jeffrey Franks, whom I actually had lunch with afterward. And as Jeffrey Franks was leaving the country, I asked him, "Well, what are you going to do next?"

And he says, "Well, I'm going to go dollarize countries." Why did it stay? Simply because it worked 12 days afterward. So who really throws Mahuad out of power is this indigenous coalition that marches in Quito. But of course, they were against the gas subsidies being lowered, against Mahuad. Then my watt decides the dollarize 9th January.

So the whole manifestation turned into, "We're also against dollarization." So 12 days later when he's thrown out of office, one of the cries is, "Down with dollarization." So of course there's a president with zero credibility who's just been thrown out of office by a coup and the coup promoters are saying no against dollarization.

Still, interest rates stayed stable. Still, there was no pressure on the central bank. So the incoming vice president who had already seen 12 days of stability understood that everything was okay and was getting calls from everybody saying "Don't move this, don't move this."

The only people that are against this are the indigenous uprising. He said, no, we're keeping it. And the uprising left. They fizzled out as they normally do, and dollarization stayed. Now, dollarization's popularity has increased significantly every single year. By 2015, it was 85%. The latest polls put it at 88.9% popularity.

Rasheed: So I'm going to fast-forward a bit, you might come back also, but I'm going to fast-forward a bit because I want to spend some time talking about Rafael Correa.

Francisco: Oh, gosh.

Rasheed: So, Rafael Correa, former president of Ecuador, he's a trained economist. He was an economics professor, and he was the minister of finance before he was president, and from the beginning, he was anti-dollarization.

Francisco: Yes, quite strongly.

Rasheed: I was recently preparing for the interview when I saw a paper he wrote in 2004. He was, I think he was just still a professor at that time, not in government at all. And he was talking about how it's very bad for Ecuador, how we need to get past it. And Rafael Correa, he was I guess one could say the most popular politician in Ecuador, in recent memory.

And he wanted to get rid of the dollarization, but he couldn't do it either. So, I want to spend some time on this. Why is Correa so anti-dollarization? And then, later, why couldn't he get rid of it?

Francisco: Well, I met Correa when he was a professor. I was dollarizing and he was already an anti-dollarizer and as I said, I'd already had various open auditorium debates with anti-dollarizers.

So I asked him to have a debate. Now that he's been ex-president he's very insulting, but he comes after me on Twitter. And I keep on saying, and if he's listening, let's have a debate, Correa. Why is he anti-dollarization? Because he's a strong believer that monetary policy can be used to increase social spending.

He believes that dollarization only benefits the richest in the economy. He's an anti-capitalist. He does not believe in the market. And he did absolutely everything to undermine dollarization. For dollarization to work optimally, you would have an open economy.

You would let dollars flow in and out without trying to trap them. This is the Panamanian model. What he did was the opposite. He tried to close the economy and close capital flows in Ecuador. He installed capital controls and he also very wildly, immediately after he assumed office, declared a default, even though he had significant petroleum income.

So, Ecuador's default under Correa was merely to shut Ecuador out of capital markets. Then he installed a whole bunch of mercantilist policies. He changed the constitution. The Constitution is a blueprint for the socialism of the 21st century. It's not a constitution. It's 444 articles that give the president and a whole bunch of power.

The government basically runs all of Ecuador. There is no possibility. For instance, Ecuador is under blackouts right now. But the only investor in electricity generation in Ecuador, by law, is the government. This was put in, in the 2008 constitution. So Correa is, is, is a believer, or I think he's more politically expediently believes that he could maintain his political, clientalist you know, populist, Political agenda if he had money to spend and he did.

He had the petroleum and he spent all of the petroleum. As a matter of fact, for the first eight years of dollarization, Ecuador had surpluses. As soon as Correa gets into power, he turns those surpluses into chronic deficits. Why did we have surpluses amongst other things? Because we passed, a fiscal responsibility law.

I think it's absolutely necessary. It's definitely a great idea that if you're going to have a monetary anchor, you should have a fiscal anchor with it. So we passed 2002, the first fiscal anchor law, and actually I wrote it. The fiscal anchor law provided for a stabilization fund.

So surplus petroleum above what the petroleum price was budgeted at would go to this sovereign fund and that sovereign fund would help fund whatever. First of all, it would bring down debt up to a level of 40%, and then it would help with deficit volatility and what was left over would help social spending in the economy. But of course, if you can maintain a 40% debt level, then there's a tremendous amount of availability for social spending, once you've stabilized the patient. Correa immediately, when he was in 2005 when he was finance minister, first thing he said that that was ridiculous because what needed to be emphasized and prioritized was social spending and social spending and social spending. And nobody's against social spending, but you need to be, you need to be able to pay for it. So Korea got immediately into trouble with the World Bank in 2005, when he was shortly lived as a minister of finance because, amongst other things, he went around this fiscal responsibility law and the World Bank withheld payments on their next loan. That got him chopped off. That cost him the Ministry of Finance. And two years later, he was a candidate, and by 2008 he took away the fiscal responsibility law and Ecuador went from surpluses to chronic deficits, to the largest deficits in Ecuadorian history. The deficits are caused in order to promote his populist agenda and to leave and saddle the next generations and the next politicians with such a burden of debt that Ecuador is not able to crawl out of it.

So, first of all, he installs a default to close off the country from foreign financing. Then he installs capital controls. He starts a capital control tax for foreign transactions. He says it's temporary. It's going to be a spot 5%.

It's at 5 percent now. So Correa did absolutely everything. As a matter of fact, once he ran out of petroleum revenue, once petroleum was corrected in 2014, he actually found a way to take reserves out of the central bank. There's a study by the IMF that says that the amount of money that he took out of the central bank was equivalent to 10 percent of the GDP of Ecuador.

The guy did absolutely everything in his power to destroy dollarization. But dollarization is so, so popular that he knows. He'd come out and say, dollarization is the worst thing in the world, but we're not going to get rid of it. Because he couldn't, because it would cost him political votes.

And it has. None of his candidates after his presidency, after, it came to light that he had been dipping into the Central Bank which made him more unpopular, have actually won the presidency.

So there is evidence that people are rejecting his model more and more because the dollarization put guardrails on him.

Rasheed: So, I'm going to tap into that. But, before I do that, Mahuad, would you consider him a liberal or a free market person in some way?

Francisco: That's a hard question to answer. I would say he's a social democrat and a weak social democrat at that, which is probably the worst combination that you can have in a politician in Ecuador. Because it's yes some market reforms, but not really. And therefore when they fail, they get completely identified as free marketers when they're not really.

I do think that he has, that he's smart enough to know that you can't go against the market and that there are prices that have to be. And he did do some very pro-market friendly measures like, for instance, attempting to get rid of the gas subsidies that have saddled Ecuador with an incredible burden for many years.

And by the way, a lot of the subsidies, a lot of the subsidized gas actually gets sold in Peru. It goes over the border to subsidize Peruvian consumption. So I think he does have a market-friendly attitude, but he's your typical social Democrat. Let me put, give a more recent example- Macri in Argentina.

They're trying to balance way too many variables by trying to stay popular. At the end of the day, you need to make some serious decisions and you need to ideologically align yourself with one or the other. You're either going to go full market or you're going to go full Marxism.

The reason why political parties in Latin America, and Marxist political parties in Latin America have been so successful is because they're so clear with their ideologies. Most social democrat parties like Mahuad's are wishy-washy. They're not fully committed to a path and therefore they end up failing and when they fail, they get wrongly associated with Truly market- they're market-oriented, if you will, but they're not really market convinced.

Rasheed: And Correa, obviously, who is a socialist, it is interesting because, you know, the Ecuadorian population voted for Correa. They really liked him. He was so popular they were able to change the constitution. But that same population was always also very pro-dollarization. So usually people always tend to think, oh, it's a very free market ideology dollarization, but you can't really say Ecuador is a free market ideology.

Francisco: Not at all. Not at all. And it's historical. Dollarization is an exception to Ecuador's history. However, it has lasted longer than any constitution in Ecuador's history. Ecuador is a very volatile and completely adolescent politically. Dollarization is liked, but it's not understood at all.

Ecuador has been a highly mercantilist economy since the fifties. The government, it's fundamentally a socialist economy. It's socially planned. It's centrally planned. It's mercantilist. It's protectionist. What Correa did was just exacerbate that, add populism, add authoritarianism, and deepen the protectionism and the closing of the borders.

His argument was very deceiving. What he told the people was an economy needs money to run. Which is correct. In his case, it was Ecuador needs dollars to run, but the true argument is any economy needs money to run, right? So that's a tautological statement and people bought that, of course they bought. But then he built that into a logical fallacy and said therefore we need to lock the dollars in We can't let the dollars out.

And so people were like, okay, the one thing makes sense. The other thing makes sense too. Instead of saying we need to open the economy so more dollars can flow into it. This is what he did. So he convinced people that we had to close the economy in order to save dollarization. He really convinced them that what he was doing was the best thing for dollarization.

And unfortunately, he drowned out many, and all of us, everybody. By then every single economist understood that dollarization was a good thing, except Correa and his followers. So absolutely, Rasheed, Ecuador is not, by any stretch of the imagination, a market-friendly economy or a population that is steeped in the fundamentals of the market because they've not ever been exposed to it.

And what they've been sold consistently is that capitalism is an exploitation theory. They still believe in the expectation theory of the capitalist. And one of the reasons that that has been so ingrained is precisely because of the banking crisis that you just mentioned. For over 20 years, they've been talking about the financial crisis, how the bankers were corrupt, and how the bankers took everybody's money.

When really the bankers went broke and all the money was put back in the depositors’ pockets. So they've managed to take over the narrative. We've seen this in many other places. This is crony politics that takes place everywhere. But as a population, the average Ecuadorian citizen is not aware, has never been aware that Ecuador has never privatized a single institution.

Not a single one. It's never experienced the true openness of an economy. So they don't even know what they're against. They're just accustomed to this. And therefore they're extremely socialist in their organizational thought structure. And it's a hard thing to get through.

Rasheed: One of the strong arguments usually used for pro-dollarization is that dollarization creates a fiscal straight jacket on the government so they can't overspend in the economy. But you had mentioned that Correa found a way to still spend in dollarization.

Could you explain how that happens? Okay.

Francisco: So we call dollarization a pre-commitment strategy, right?

This is why it's so strong because it prevents the current politicians and the future politicians from being able to spend. And the reason I bring this up is because of IEEP's current strategy. Not a strategy, but we're starting a campaign to close the central bank of Ecuador.

What we did in Ecuador was we took away the capacity to print money, but we didn't close the institution where you can create money. Central banks can still create money, even though they don't print money when they expand their balance sheet. And this is what Correa did. You can even think of it as a modified quantitative easing. By telling the government-owned banks to say, "Well, why don't you issue a promissory note and I'll just buy it from you?"

And so he kept on pumping money into the government-owned banks, based on his social spending agenda, and this expanded the bank. And then of course you deposited in the central bank. So the central bank increases its assets and increases liability simultaneously. So accounting-wise, it looks, it looks balanced, but the truth is that once people start using that money, the balances of the reserves in the central bank start dropping. So he consumed the reserves of the central bank. By 2014 he dropped the whole "I'm doing this through government banks" facade, and he passed a new monetary law by which the central bank started financing the Ministry of Finance directly, starting financing the deficit directly. Where does the central bank get the money from? From the reserves. Where are the reserves coming from? Amongst other things, they're coming from the bank's deposits. Because he closed the economy, he forced the banks to bring any deposits that they were holding abroad back into the country.

So he tapped into the money of the depositors indirectly in order to keep financing his political agenda. So Central Banks are a very pernicious institution. They are run by a few privileged individuals who have the capacity to destroy your life. We saw that in the banking crisis.

The banking crisis was created or exacerbated by a few very wrongly taken decisions by a few people, they created a banking holiday. They destroyed the Ecuadorian banking system. Then you have the Central Bank under dollarization. A very, very, very dangerous institution to have. As a matter of fact, the only institution that can de-dollarize an economy is the Central Bank.

We have a history in Ecuador where Correa was already able to abuse the central bank. We know that this is the weakest link within any dollarized economy. We've started a campaign saying, "Look, if you really like dollarization, which you do the best way to strengthen it, It's to get rid of the central bank." And getting rid of the central bank, once again, going to pre-commitments just strengthens the pre-commitment. It strengthens the pre-commitment and gives the individuals more certainty that it will never go away.

Rasheed: How, how would you close a Central Bank in Ecuador?

Francisco: It'd be rather easy. John Greenwood, Steve Hanke and I published a paper in November, proposing the closing of the Central Bank of Argentina.

It's an issuing bank. It's harder than closing the Central Bank of Ecuador, which is a dollarized bank. Once the bank is dollarized, it fundamentally acts like any other depository institution. And you can just wrap it up.

There are two quirks that I would say, or three quirks that I've already dealt with in the book that's going to be published by March I deal with a very detailed account of how to close and why we should close the central bank of Ecuador. But there are three things and getting into the weeds with it a little bit, Ecuador still issues coins. So you'd have to take the coins out. Liability would have to be passed on to the private sector.

This can be done in the same way that Hong Kong issues currency through banks. So that little quirk has to be taken care of. It's a minor quirk in Ecuador. And there are various ways that historically something like that has been taken care of. The Hong Kong Monetary Authority doesn't issue coins.

It's a standard charter bank that issues coins. So we could easily pass that liability onto the private sector. Then there's the fact that the Central Bank is the major depository institution for the Ecuadorian government. It's called the treasury account.

It receives all the deposits from petroleum exports. It's the one that pays off the local governments, et cetera. So we just have to pass all those activities to the private sector. If it's politically unviable to give it to the true private sector, you could even use a coalition of private sector and government-run banks.

But the idea would be that there wouldn't be one bank where all of these activities are centralized. And then the last part of it would be the relationships with multinationals, like the IMF, the IDB, and the BISD, et cetera. So those could be easily passed onto other entities within the Ministry of Finance, et cetera.

As a matter of fact, what we are suggesting in our proposal is that Ecuador needs to beef up its financial supervision. So all of the talent that exists in the Central Bank, they're not all bureaucrats. There are people. There are, there are public servants there that are talented, which are being wasted completely today.

Their talent is being wasted on an entity that has no real value, adds no value, and doesn't reduce transaction costs in the economy of Ecuador. So if we could take that talent and also coalesce a lot of the very poor institutions that Correa left over in terms of banking supervision we should be able to set up a much stronger banking supervision authority to prevent crises, not to be reactive to crises. Now, the other curious thing about dollarization is that one of the things that we predicted as well is that the banks would self-police themselves. Ecuadorian banks have much larger liquidity ratios than their peers all over South America because they know that there is no lender of last resort.

However, the population has been sold the idea that there is a lender of last resort. This is one of the reasons we need to get rid of the Central Bank.

Rasheed: The Panama comparisons are quite useful here in that it is one of the other things where the information on how Panama works it's so hard to find. People don't discuss Panama that much because it's over a hundred years dollarized very open market but yet people don't know the integrity of how things work. But in Panama, they never had a central bank But the Banco Nacional, the national bank, essentially does some of the essential banking functions like managing coins and things like that.

They also manage in conjunction with the private sector, like Bano General in particular, the RTGS, and so on in Panama. So clearly this can work in reality like in Hong Kong the example that you mentioned. So one of the other things that I want to ask about is the brief Correa policy of the CBDC, the central bank digital currency, that Correa had tried to implement, was it 2008 or oh 09, a while ago by now? What was his intention behind that?

Francisco: The intention was to de-dollarize. The man behind that is Andrés Arauz. He was his vice presidential candidate at one point. He was the presidential candidate for Correa.

He is deeply left and his theories are very, very flawed. He was behind the Central Bank digital currency. The whole idea was that they could issue currency in a dollarized economy and that this currency would trade at equal value to the dollar and therefore they could maintain government spending. By that time the law allowed the Central Bank to finance the month, the Ministry of Finance directly. So they could just create a digital currency, pass this digital currency to the Ministry of Finance and then the Ministry of Finance could pass the digital currency on to social spending and to local governments and things like that.

And then those local governments would use that digital currency to be able to purchase real goods and services. It was an absolute flop. There was no issuance whatsoever. Nobody accepted it amongst other things because it was immediately aware. The population was immediately aware that this was not a real currency.

There was immediate backlash to them. And this was across the board. So it died. It was stillborn. There was no acceptance of the digital currency. This is a society that has very low internet penetration. That is not technologically very advanced. So for you to try to install a Central Bank digitalized currency in a country that does not have, internet penetration... Although we've seen in Africa, people can use phones. So that was part of the idea. We could use phone money, right? The fundamental reason why it flopped immediately was because it was flagged as a currency that would compete against the dollar and nobody wants anything but the dollar. It died within a year.

Rasheed: So dollarization, usually again, in the common ways discussed, it's taught as a stabilization tool, it's taught as a fiscal commitment tool, but it's not usually discussed as a developmental tool. And in Ecuador, there's some data that you were explaining to me earlier. But could you get into how we should think about dollarization as a developmental tool and apply it to some of the situations in Ecuador, a real-world example?

Francisco: Rasheed, thank you for that question. That's exactly where I've been. I've been writing and developing most of my research in dollarization for the last few years. It has transcended a monetary anchor. It is an institutional anchor. It institutionalizes the private property of money.

Money is an important institution in any economy and it should be held by the individuals. Its value should not be manipulated by a third party. This really transmits power to the individual and takes it away from the politician. That's why it's a development tool because it truly transmits the running of who is the boss of the economy, the citizen, and not the government. And that changes the dynamic significantly.

What we've seen in Ecuador is that, for instance politically, any candidate that speaks out against dollarization, like Arauz, will lose an election. The power of institutionalizing or reinstitutionalizing money is extremely important. And the reason why dollarization should be considered a significant tool for development is because it's easy to implement.

You can't change institutions overnight. You can't make courts less corrupt overnight. But you can change money overnight. And when you change money overnight and you absolutely give the private property its proper place in society, then the dynamic changes significantly. And that's what's been happening in Ecuador.

The citizen knows. Even though there are deeply committed Correa followers in Ecuador, they like the dollar. They don't want to get rid of the dollar. So we think that it's going to be easier to convince those people that what we've actually done is privatized currency. So if we privatize currency and you like it, then why can't we privatize other parts of the economy and you can also get good results for them?

There is no more democratic private property than money. And building institutions is a long-term process. Dollarization is a very fast and efficient way to introduce an inclusive institution.

What institutional drift tells us is that if there is a sufficiently strong, inclusive institution there can only be two results. Either the political extractive institutions will corrupt it or they will have to adapt to it. Dollarization in my belief is incorruptible for various reasons. I've studied how to de-dollarize countries, obviously, very deeply.

And the conclusion that I've reached is that it's almost impossible to de-dollarize. I say almost because Zimbabwe did it. But it's almost impossible to de-dollarize, not because of ideological, or political reasons, but because simply it is logistically impossible. Once the currency in circulation in people's pockets is the dollar, if you were to announce a de-dollarization, what would happen to daily transactions?

They would collapse completely. Like dollars would disappear. And unless you have a stock of money to replace the stock of money that exists then all of the economy would collapse rapidly. After First World War Germany, cities had to issue script in order to be able to function.

First World War Germany was a much different economy than today's economies. So the mere impossibility of substituting whatever papers are in circulation rapidly, overnight, makes de-dollarization impossible.

So I would say dollarization is a cure for populism. Dollarization is truly a recipe for development. Amongst other things, it installs a highly inclusive institution that cannot be corrupted by political extractive institutions. And Ecuador is a great example of this.

You can throw anything at it. But eventually, the politically extractive institutions will have to adapt to it.

Rasheed: I think that's probably the most powerful analysis one could think about dollarization in Ecuador. Because the constitution changed, and yet they couldn't change dollarization.

Francisco: You've got to understand that the constitutional change in Ecuador changed all of the institutionality of Ecuador.

Every single institution is subordinated to central planning. The whole economy is centrally planned. The private sector is subordinated to the public sector. The regulations are just stifling. Taxes are stifling. If you could think of all the conditions that would make dollarization really hard, you have Ecuador. That's why Ecuador is such an interesting example. Because you have to study it from the point of view of "how tough is dollarization where there's Ecuador?" Ecuador has every single institution and the whole political and economic landscape of Venezuela.

It shares exactly the same constitutional basis. It has petroleum revenue, et cetera. But you compare Ecuador to Venezuela and Ecuador is a thousand times better. Its GDP has grown at 150 percent of Venezuela's annually over the last 20 years. Of course, you then compare Ecuador, a dollarized economy, to Panama, where Panama doesn't share the same institutionality of the socialism of the 21st century, but it also has the dollar.

And Panama does a lot better than any other Latin American institution. So you can say that Panama Dollarization will save you from Venezuela but it won't save you from the socialism of the 21st century. It will stop it. It will help you maintain certain amounts of economic calculus.

What ended up happening in Ecuador, for instance, and I showed you some statistics before we started, is that dollarization helps decouple the private sector from the private sector. When you have a devaluation inflationary economy, you spend a lot of your time worrying about what a politician is going to do to affect your pocket. I ask this of the Argentines all the time. I just say "What percentage of your time are you spending worrying about the interest rate?"

And they're like, "Oh my god, 10%, 20%." Imagine if you could spend time on being more productive. We're talking about GDP and potential GDP going up overnight. So the deterioration of, or the elimination of this exogenous risk allows for economic calculation. And that's the basis of the economy.

That's productivity. That's how you get unemployment down. It's through productivity. And so the other thing that they throw against dollarization is the rigidity of the currency will make you not competitive. So let's take the private sector of Ecuador, which has been castigated by poor institutions, by corrupt courts, and by crowding out from the government. Anything you can think of has been thrown at the private sector of Ecuador. But shrimp exports have grown so rapidly, so well that now in today's world, one out of every four shrimp you consume comes out of Ecuador.

However non-traditional exports and non-petroleum exports in Ecuador are significantly larger than petroleum exports are. All of Ecuador's balance of payments historically was based on petroleum. Now petroleum is less important than private-sector exports. All of that is possible because economic calculation can take place by the private sector.

This is what stability gives you, and you need stability to be long-lasting. Dollarization is long-lasting. It's a pre-commitment that is so strong that eventually, all institutions will have to submit themselves to the openness that it requires. Even though Ecuador has been closed and shut off from foreign exchanges.

Anybody that has money in Ecuador will take it out, pay the tax, and don't want to bring it back in.

Rasheed: Right.

Francisco: Why? Why would you pay a tax to bring money back in? Why would you put it at risk of all these regulations and crony capitalism, all these things that unfortunately a bad government and a socialist and planned economy bring with it?

So dollarization is truly a recipe for development. If Ecuador has been able to grow under the conditions, the really, bad conditions that have been set in place, imagine how well Ecuador will grow once they give it the right and proper fertile conditions for the private sector to thrive.

And that's what we're hoping for in Argentina.

Rasheed: Earlier you mentioned that there was a team of experts, or a particular expert that Correa had brought in to design some new fiscal laws in Ecuador, or monetary laws.

Francisco: No, no. What I think you're referring to once Mahuad announced dollarization, they needed some sort of way of justifying that the spontaneous order had worked so well, but they were perplexed. They were like, "Oh, but we need a law. We need a law to make this work." This is interesting because one of the lessons of Ecuador is that it works so well and so rapidly that they've not done the rest of the homework. And this goes to the Central Bank, to getting rid of the Central Bank, to make sure that there are fiscal anchors, to making sure that money can freely float in and out; that you have a well-regulated banking system so that there's no real risk.

Like Panama, you should integrate with the rest of the world. Once you dollarize, it's the private sector that dictates how much money is in the economy and therefore you should just let the market decide. You should not start messing with the monetary mass, cause you're going to get into trouble.

And this is what the Ecuadorian government has done. It's created this hybrid of dollarization on the one hand, but still a discretionary monetary policy on the other hand, through fiscal means. So what ended up happening was that dollarization worked within hours. But since there's this legacy of having to legislate, of having to create government around things, they called in these, all these, experts, so-called, I'm going to put them on quotes because they never called Kurt Schuller, they never called Steve Hanke, they never called Larry White, they never even consulted with us, the locals that had been promoting and writing laws. And they never even called us to help with what's called the Dollarization Law.

Now the Dollarization Law only has about 12 articles that really deal with dollarization. It was a law that had been cooked before as a potentially modernizing law. But it didn't do anything. It didn't do anything, it was ridiculous. One of the experts that was called in, and was paid for by the IDB, was a Frenchman. And one of the things that they had to do, and this is typical of bureaucracies, they just have to justify themselves. The largest part of the articles and clauses in the new law that was passed in March had nothing to do with dollarization.

The largest part of the dollarization clauses has to do with installing a new accounting system for the central bank, which is fundamentally an accounting system that is used in all colonial currency boards. So there's nothing new to it, but the bureaucracy that came in justified themselves by saying, "Oh, we have this thing that will really help."

And all it really does is create a new type of accounting. But if you know how to read a balance sheet sort of gobbledygook that was also violated by Correa.

Rasheed: So I have this book here. Published by

Mahuad, in 2001 or 2002 I believe.

Francisco: 2020. Cause the whole premise is that 20 years later...

20 years after dollarization, he comes out to finally say, this is how we did dollarization.

Rasheed: Okay. I would say I bought it in 21, so that's the real issue. He attempts to describe what he says is the process where he dollarized Ecuador.

The title is essentially, this is how we dollarized Ecuador. You're a bit critical of this interpretation.

Francisco: I'm not a bit critical. I'm a hundred percent critical. I was an actor. I was part of it. I saw it. I lived it day to day. And if you read the book, it's absolutely sad in the sense that 20 years later, it's completely demonstrable that he still doesn't understand how dollarization works. So he chose the exchange rate.

He arbitrarily decided that Ecuador would dollarize at 25,000 and that's been highly criticized. We criticized it the day after. The day after he announced we said "Look we're happy you did it But you could have done it a lot better and you should have followed what we told you months ago." There is a market-friendly way to dollarize and it is to tell the country that you are going to dollarize within a certain number of days.

And of course, you freeze any monetary expansion during that time. Hanke did it in Montenegro. This is nothing that we're making up. That's the way to do it. Because you need to establish the most informed rate, the most informed market rate in terms of supply and demand. Because once you get the rate wrong, you're causing friction, you're causing problems.

So what the Mahuad did was establish a rate that was extremely high, which resulted in 91 percent inflation under dollarization. And just a little side note, this is precisely the concern we have in Argentina now, that the rate is so revalued that if it were to dollarize at these rates, like if they were to say a la Mahuad this is the rate, it would create a problem on the other end of the spectrum.

You need the market to establish exactly what the demand and supply is and what is the proper rate. I'm just using this as an example, because 20 years later, Mahuad writes in his book and he says, "I can justify I can absolutely, with all certainty, tell you that I made the right decision based on the studies that we had, which have never surfaced. The 25,000 sucrase to the dollar, which is the rate we dollarized was the correct rate. And the reason is. We were able to substitute, we were able to take out of circulation all the dollars."

Well, yeah, you had an excess of reserves! That's the whole purpose of dollarization, to buy every single Sucre in existence. What he's attempting to say is that there was not a single dollar left in the Central Bank before after he dollarized. That would have been a perfect calculation that would have been like, "Wow you really got it down to the cent. That there was not a single dollar left in the Central Bank. When you bought out your existing money in circulation."

Every single Sucre in circulation was taken out by dollars and in the Central Bank, and there was not a single dollar left in the Central Bank, then you got that calculation absolutely correct. But that's totally what did not happen.

There were over 300, 400 million left in the Central Bank. And we're talking about a monetary base of only 800 million. So he really screwed the pooch. And in his announcement, "he said, our studies indicate that 25, 000 is the correct rate, and inflation next year will be 10%."

Inflation next year was 91%. So the studies that he mentions in his book, which he never publishes, even though it's like a thousand-page book. Where is the link to this study? Nobody has ever seen this famous study. We did studies. In the private sector, we had all the studies.

We drafted laws that we sent to them. They never took us into consideration. And so these studies that he says 20 years after the fact that they had are bunk, they didn't exist. Why did he choose 25,000? Let me explain this quickly. Dollarization took place on a Sunday, the 9th of January.

31st of December, when all fiscal accounts close, is when we take stock of what happened. And the exchange rate was at 18,400, more or less. In five days, between then and the 5th of January, the exchange rate went to 25,000. So it lost 7,000 out of 18,000 basically in value very rapidly.

We were going into a hyperinflation. The rate that he chose was the spot rate after a massive spike. Instead of even thinking the market has overreacted here, which is normal he took the spot rate. That's it. That's what he did. And he has no justification for it. And it was a mistake. That mistake cost Ecuador dearly because inflation did not come back down to single digits after, until two years after dollarization.

But here he comes 20 years later with the most important institution in Ecuador's history, and of course, he wants to jump on the bandwagon. As a matter of fact, if you talk to a lot of Ecuadorian economists today, they keep on saying, "Well, I was part of dollarization" Well, no, you weren't. It is such an important institution in Ecuador's history, of course, everybody wants a piece of it. I can demonstrate just how many fallacies are in this book. And it's upsetting, quite frankly, that, even the title, he says, "This is how WE dollarize Ecuador." Well, you didn't. Thank you though. You took the decision. I mean, he could have gone the other way.

He could have created another banking holiday and could have taken away people's deposits. So in that sense, I think we should give him due praise for the fact that he made the right decision. But he didn't take it because he had this study and he knew exactly what he was doing.

No, he took it because it was a political lifesaver for him. He was kicked out 12 days later. He's been declared a pariah. He's been sued. He can't go back to Ecuador. This is very sad because I think he should be allowed to go back to Ecuador and face the court of public opinion and defend his position. But this is his defense for dollarization.

It is the weakest defense I've ever seen. It proves beyond a shadow of a doubt that even 20 years later, he doesn't understand how dollarization works or that his exchange rate, his choice of exchange rate was wrong. And that's pretty telltale.

Rasheed: You mentioned that you're working on a book yourself about a proper interpretation of the dollarization process in Ecuador.

Francisco: So, the IEEP, the Instituto de Economía Política, has not, over the last 25 years, published our version of the history of dollarization. We've been cautious about reading other people's interpretations and waiting for the right time. So dollarization turns 25 on the 9th of January.

The longest-lasting constitution in all of Ecuador's history did not turn 23. It lasted from 1906 to 1929. So it is absolutely clear now that dollarization is the most important institution in Ecuador's history. So it is important that other countries understand this and see this because, with that evidence, it cannot be underestimated as a tool for development, as an institutional anchor that can truly change a country.

And this is what we're going to publish. We wanted to publish it earlier, but we think it's going to come out in March. Steve Hanke has a chapter, Kurt Schuller has a chapter, Larry White has a chapter. And of course, all the important economists who helped with dollarization in Ecuador; Dora, Pablo Lucio Paredes, Franklin Lopez, myself. We have chapters in the book. And of course, I've written the historical part. We look at dollarization as an event study, too. We try to make it, we try to make it as, as objective as possible in terms of the data that we present as to how dollarization took place.

We give a lot of references. We inject our analysis. We show what the Central Bank of Ecuador did, this hasn't been published before. We believe it's a very important tool for students of dollarization and I have a chapter there where I propose the closing of the central bank and I put a very detailed plan on how to do that. Because we think that if dollarization has been the most important institution of Ecuador's history and you want to strengthen it Then this is the single most important thing to strengthen the pre-commitment of dollarization.

So look out for that book coming out. We don't have a title yet, but I think we're gonna call it something like "Dollarization a Vaccine Against Populism" or my favorite which is a book that I had when I've been writing for a long time, I've incorporated into this: "Dollarization: A Recipe For Development."

The strength of what's happened in Ecuador, the evidence of what's happened in Ecuador just cannot be overlooked. And unfortunately, it has been. Most people don't know about Ecuador and have never heard of Ecuador, but it is the first country in the world that voluntarily gave up its currency that had been in circulation for over a hundred years and said, "We're done with you, Central Bank.

You have not provided us with a service that has brought down transaction costs. You have only increased transaction costs in this economy. And you have created winners and losers. And you've made a lot of people rich, not by productivity, but by inflating currency, by creating devaluation. So we're done with you, Central Bank. Give the power to the people."

This is an important step. This had not taken place before in monetary history. So what we're missing now is to close the central bank. And I hope to have the next podcast with you as the liquidator of the Central Bank of Ecuador.

Rasheed: Francisco, thank you so much for joining me on the podcast today.

Francisco: It's been my pleasure, Rasheed. I mean, honestly, thank you very much for all your work on dollarization. I think that there are a lot of things that we still have left to talk about. Maybe we can have another one sometime soon. But dollarization and money are the most important institutions in society, and we need to pay more attention to them.

And especially in countries that have low institutionality, we need to get rid of the Central Bank, which is basically a factory for misery. Right?

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