Why Panama Dollarized

Notes Towards Caribbean Dollarization (Part 2 of 17)

Panama has been dollarized since 1904. Its constitution prohibits the creation of non-convertible paper money. In any discussion on Caribbean Dollarization, Panama is a necessary element. But its monetary system is poorly understood — especially from a historical perspective. I’ve found it challenging to find a concrete explanation of how Panama developed its curious monetary jurisprudence or even how precisely it became dollarized so long ago. In this post, I will provide answers to both of those questions.

This post is Part 2 of a planned multi-part series explaining the benefits of Caribbean Dollarization and dissolving the relevant counterarguments. These public notes aim to compile the best arguments for a larger project. In Part 1, I introduced the main arguments supporting the policy proposal that all Caribbean countries should retire their local currencies and adopt USD. As always, comments are open.

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Note: Most of this post's hyperlinks lead to Spanish sources.

It is generally assumed that the US thrust dollarization upon Panama because of the Panama Canal Zone. But that is not true. The real history is far more interesting. The post is divided into two broad sections:

1. Why Panama Constitutionally Prohibits Paper Currency

2. Why and How Panama Made USD Legal Tender

First Part - Why Prohibit Paper Currency

Panama separated from Colombia in November 1903. A few months later, in February 1904, the new Panamanian constitution was promulgated—with remnants of Colombian economic jurisprudence. As should be expected, you need to understand a bit of late 19th-century Colombian monetary history to understand why Panama is the way it is today.

Utopia In A Bank

In the mid-1800s, Colombia’s political landscape had (broadly) two ideological factions. The Federalists pushed for increased decentralization — the States Rights Libertarians of their time. After successive uprisings, they gained power and created the United States of Colombia in 1863. This rendition of Colombia comprised several autonomous states, Panama being one of them. However, more factional civil uprisings continued, and by 1880, Rafael Núñez, leader of the Centralists faction, won the Presidency. He was ardently opposed to federalism. Núñez led a movement known as La Regeneración (the Regeneration) under the motto of "Una Nación, un Pueblo, un Dios" (One Nation, One People, One God). It was an ideology of unification, centralization, and control.

He moved quickly to centralize the state of Colombia by transforming all previously autonomous states into departments of Colombia, managed from Bogotá (the capital). Núñez, along with Miguel Antonio Caro, his vice-president who led many government operations, wanted to institute several state-driven developmental projects. But at this time, Colombia’s economy was primarily organized around free banking principles, and the private banks did not think it was prudent to lend large sums to the Núñez government. So Congress was called upon to create a new state bank (Banco Nacional) and a national paper currency.

Many Colombians were skeptical of the new paper currency pesos. To assuage doubts, Núñez essentially went on a speaking tour to convince people to embrace the state-issued paper currency. However, business communities continued to campaign against the Banco Nacional paper currency.

In 1886, the Núñez government of Colombia instituted a monetary rule known in the literature as Dogma de los 12 Millones (Dogma of the 12 million) to instill confidence in the paper currency. This principle was intended to safeguard against excessive currency issuance, capping it at three times the national revenue. The county’s revenue at the time was 4 million pesos, so the new monetary policy stipulated that the paper currency issuance of Banco Nacional should not surpass 12 million pesos.

Of course, this monetary rule was not respected. Political factional fighting continued and intensified, culminating in the Guerra de los Mil Días (Thousand Days War) from 1899 to 1902. The printing press went burr…

As is commonly the case, the government financed the war by creating excessive money.

Colombian economic historian Enrique Caballero Escovar in Historia económica de Colombia estimated that from 1899 to 1903, over 831 million pesos were created, a blindingly high number far beyond the intended 12 million. Inflation increased to 15.2% in 1899, 66% in 1900 and 389% in 1901. It averaged 120% until 1903.

At the end of the Civil War, the new Colombian administration promulgated Decree 217, which stated the intent to abolish the issuance of paper money (“por el cual se suprimen las emisiones del papel moneda”). Monetary stability was successfully achieved after Congress eventually passed a bill based on that Decree in July 1903, officially prohibiting the issuance of paper money by the central government.

Birth Trauma

Panamanians were stridently opposed to the centralizing of the Colombian state under Núñez’a La Regeneración. Panama was the most prosperous state in the United States of Colombia since the mid-19th century, partly because of the Panama Railway Company. It served many travelers journeying from the east coast of the USA to California via Panama (which was shorter than going overland). However, when the USA built the first transcontinental railroad, the number of passengers via the Panama route dramatically reduced. Moreover, Núñez’s policy was to extract more money from the Department of the Isthmus (Panama) via increased taxes and control of its fiscal surpluses. Inevitably, this caused great discontent.

The exploitation exacerbated by the Thousand Days War (also with the USA “nudging”) led Panama to separate from Colombia in November 1903. At the birth of this new nation, the people there had inflationary trauma fresh in their minds. The new state kept Colombia's legal prohibition on state issuance of paper money.

Interestingly, Colombia’s constitution, until 1910, still prohibited issuing paper money, but it was subsequently reformed (poorly, by US money doctors—a topic for a future post). Panama has maintained the original Colombian prohibition principle to this day.

Accurately Interpreting Constitutional Terms

Now that we understand the origin of the prohibition clause in Panama’s constitution, we need to understand what it says exactly. Almost everything you read, including Panamanian journalists and politicians, gets this point wrong. This is one of the most misunderstood and abused aspects of Panama’s monetary foundations.

Let’s start with the original 1904 constitution. In it Article 117 states that there ‘shall be no obligatory tender paper currency in the Republic’ (“No podrá haber en la República papel moneda de curso forzoso”).

The term “curso forzoso” (obligatory tender) is not straightforward and needs to be explained carefully.

Firstly, Economists and the general population routinely misuse the term “legal tender.” In a short, helpful article, Dror Goldberg (whom I interviewed last year on my podcast) explains what “legal tender” really means. Legal tender laws are designed to aid the adjudication of debt contracts in cases where the medium of exchange was not mutually agreed upon.

For a basic example, suppose you live in Mexico, and you contract the services of a house maintenance company to repair your house next week. You are the Buyer, and the company is the Seller.

A week later, the service is complete, and you attempt to pay the Seller 50 Mexican Pesos, but the Seller says, “No, I wanted Filipino Pesos,” and you refuse. The Seller then sues you for not fulfilling the contract terms by discharging the debt.

In this instance, the Court will side with you, the Buyer, because the contract did not specify a medium of payment. Since all of the business was conducted in Mexico, the legal tender laws of that country will apply. This means that the Court will allow you to offer (tender) your Mexican Pesos to the Seller, which will constitute a discharge of your debt. It is up to the Seller to accept, but you are off the hook.

If, however, both the Buyer and Seller had specified in the contract that payment should be made in Filipino Pesos, then legal tender laws would not apply because the contract specified a medium of payment. The Buyer could also discharge the debt via the agreed-upon medium even though the contract was made in Mexico. Generally, a contract can be made with any media of payment once another law does not outlaw that media.

Returning to the constitutional terms of Panama. When “curso forzoso” (obligatory-tender) is correctly interpreted, it has two parts. First, it means that the currency in question has liberatory power (referred to in local jurisprudence as el poder liberatorio), which is the power granted by law to discharge debts. Second, it means that the currency is not a claim on underlying silver or gold and cannot be substituted for such. Remember that in 1904, “true” money was silver or gold metal. So, obligatory-tender paper money should be considered non-convertible paper money.

For a paper currency to be convertible means that it is backed by underlying assets (often in those times silver or/and gold), and if you wanted to, you can return the paper currency to the issuer and receive the underlying gold or silver.

So, to be absolutely clear, the constitution does not prohibit all paper currency, only non-convertible paper currency.

If Panama wanted to create a paper currency, it would need to be fully convertible into silver or gold. It cannot be backed merely by the government's good faith. In the early 20th century, most paper currencies that retained confidence were backed by gold - including the United States Dollar. These currencies were not considered “obligatory-tender paper currency” because they were fully convertible. An example of a non-convertible paper currency would be the Colombian paper pesos created during the Núñez administration, which caused extreme inflation during the Thousand Days War, as discussed above.

Also, I'd like to emphasize that the Constitution specifies paper currency. It does not prohibit the government from creating metal currency (coins). Panama has had their own silver coins from the beginning until today.

Importantly, this original Article 117 of the 1904 Constitution has been retained in every successive Panamanian Constitution, even after various military coups and dictatorships. The current constitution, which has been in force since 1972 (with amendments), retains the original principle and prohibition now under Article 262.

ARTICULO 262. No habrá en la República papel modena de curso forzoso.
1972 Constitution of Panama

Unit of Account

In Panama, there is a separation between the unit of account and the medium of exchange. The Balboa unit is another aspect of confusion that arises when learning about Panama’s monetary system.

Usually, the principle of ‘one country, one currency’ implies that all of the characteristics of monetary interaction are expressed in the same units.

That is, if USD is your country’s money (and legal tender) then the thing-that-measures-your-bank-account is USD and the thing-that-you-exchange-for-goods is also referred to as USD. This also holds if you are in France with Euros. But this need not be the case.

The “unit of account” is a standardized measurement unit similar to centimeters, kilometers, etc. Simply, it is the measurement unit of the value of your monetary account.

If someone asks you for the length of a table and you respond by merely saying “20,” that does not actually give a clear answer. You need to include a measurement unit: “20 meters,” “20 inches,” “20 centimeters,” and so on. This gives a concrete answer. Similar to money, identifying an account as “20 grams of fine gold” or “20 USD” gives a concrete answer of its value in a known unit.

In Panama, the legal unit for valuing monetary accounts is called the Balboa (with the symbol B/. or PAB). This has been the case since the country's founding, established in Law 84 of 1904. This illustrates that it does not matter what you name a measurement if the underlying parameters are concretely defined.

Historically, a Balboa was dual-defined as having a weight of fine gold and equivalent to a United States dollar (which was also defined by a gold measurement) at the time. If you travel to Panama today, you may become confused by this point. In Panama, they have local silver coins (as they always had) called Balboas. There was a linguistic shift over the century to refer to the silver coins as Balboas. But don’t let this confuse your understanding of the historical development. But curiously, if you speak to Panamanians in more rural areas, they will often still refer to the current coins as pesos.

Another point of information is that Panama’s constitution does not mention the legal tender status of the USD. Only Article 1171 of the Código Fiscal enumerates that the United States Dollars (USD) are legal tender in Panama—not the constitution. More of this later.

Artículo 1171. La unidad monetaria de la República de Panamá, será el Balboa, o sea una moneda de oro con un valor de novecientos ochenta y siete y medio miligramos (0.9875) de peso ochocientos veintinueve milésimos (0.829) de fino, divisible en centésimos (100/100). El actual dólar de los Estados Unidos de América y sus múltiplos y divisiones serán de curso legal en la República, por su valor nominal e la moneda panameña respectiva.

Article 1171 of the Tax Code of Panama

The Seven Days Bills

The curious tale of the Arias bills is instructive to underscore the point about convertibility being the correct jurisprudential interpretation. For a very brief period in 1941, Panama had its own paper currency. President Arnulfo Arias Madrid came to power in 1940 and was the quintessential jingoistic Latin American Caudillo (an appropriate English term might be Populist).

He advanced a political ideology of Panameñismo that blamed many social ills of the country on the Gringos and Jamaicanos (Americans and West Indian black people). This included the heinous policy of taking away Panamanian citizenship from the children of Chinese and West Indians whose original language was not Spanish. (You might remember the Dominican Republic's decision in 2013 to strip away citizenship from children of foreign-born parents going back to 1929(!) that affected primarily Haitians. It’s the same idea).

As part of his general Panameñismo policies, he declared that Panamá should have its own paper currency. This was made official in the Decree No. 6 of 1941, published in September of that year. Then on the 2nd of October, the first bills were issued.

This was a landmark decision in Panama's monetary history. The obvious question here is whether this issuance was constitutional. And it was! Because the paper currency issued by Arias was fully convertible.

In Article 4 of the Decree stated:

“For each balboa issued in paper currency put into circulation by the Bank, the Bank must maintain an effective reserve of nine hundred and eighty-seven and a half milligrams of gold…, or one balboa in national silver coin, or its equivalent in the currency of the United States of America…”

These bills were not “obligatory-tender” paper currency since they were fully backed essentially by gold or gold currency (USD). As the previous section's interpretation explained, they could be issued constitutionally. If they were not convertible into gold or silver or if they were not clones of USD, then that would be a more shaky territory for constitutional soundness.

However, seven days later, on October 9th, President Arias was deposed in a coup, and the new transitional regime immediately halted the circulation of the paper currency. For this reason, the Panamanian paper currency is referred to as “billetes de siete días.”

Later that year in December, the new President Adolfo ordered that all the issued Arias bills should be burned. (Some survive as collectors’ items today. You can purchase them from an art dealer I know in Panama). This episode underscores the entrenched cultural sentiment against creating and circulating local paper currency in Panama.

I’ve described why Panama does not have its own paper money today and the legal foundations of USD circulation in the country. But a question immediately follows: why USD at all and not some other sound foreign currency? To understand why Panama uses the USD, we need to know about the creation and politics of the Panama Canal Zone.

Second Part — Why and How Panama Made USD Legal Tender

Shortly after Panama separated from Colombia, the United States “acquired” the rights to a portion of Panama's territory to build a transoceanic canal. The details of this transaction are astounding and horrifying, and I will write about them soon. But for now, let’s settle with this: it happened in 1903.

A Zone of Stable Money

The Panama Canal Zone (La Zona del Canal de Panamá) was a ‘sovereign territory’ of the United States. People born in La Zona (pejoratively referred to as Zoniano or Zoneíta by Panamanians) had a direct line to become citizens of the United States. The well-known former US Senator John McCain was born in the Panama Canal Zone.

The project of building the canal and managing the Canal Zone was overseen in the US by the Isthmian Canal Commission, which was set up by the US government and formed part of the portfolio of the Secretary of War — who at the time was William Taft (yes, the future President Taft). Taft was the Governor of the Philippines (then also a US territory) from 1901 until he resigned in 1904 to take up the post of Secretary of War.

It is usually assumed that the United States government forced the Republic of Panama to make the United States dollar legal tender. The populace, academics, and literati in Panama also generally believe this. But that’s not what happened. The initial request to make dollars legal tender in Panama actually came from the Panamanians.

The usual starting point for understanding how dollarization came about is the document known as El Convenio Monetario, referenced in a Decree made by the President of Panama in 1904 (Decreto 74 de 1904). It is held up as the defining legal basis for the United States' monetary imposition on Panama.

But rather than being a detailed legal agreement, it is actually just a very short two-page memo issued by Secretary Taft in 1904, which imposes nothing. The true starting point should have been months prior. Let’s dissect this.

A Fiscal Commission Travels North

In June of 1904, Secretary Taft was notified that a Fiscal Commission from Panama was in New York on official government business, and they also wanted to meet with him. The Fiscal Commission consisted (most importantly) of two Panamanians, Ricardo Arias and Eusobio Morales, and an American lawyer, William Nelson Cromwell, their Counsel. When the US “acquired” the land rights for the Canal Zone, around $10M (1903 $) was paid to the new Panama state. The government of Panama decided to invest around $6 in US investment banks. The Fiscal Commission was in New York to find suitable institutions to invest the money into securities.

In addition to this investment mission, the Commission was also authorized by the President of Panama to meet with the U.S. government official in charge of the Panama Canal Zone to discuss monetary arrangements. And so they met with Secretary Taft.

When the Commission met with Secretary Taft, Admiral Walker (Chairman of the Isthmian Commission, which was overseeing the building operations of the canal) and Mr. Conant (a financial expert who worked with Taft in the Philippines) were also present. All of them had a conversation regarding monetary matters in Panama.

I know these details because a stenographer recorded the meeting, and later, the transcript was entered into the record at a U.S. Senate Hearing in 1906.

The conversation was revealing. The Panamanians had started creating new monetary laws as part of their state-building process. Remember that Panama had just separated from Colombia, and all the elements of a state needed to be built almost from scratch.

The stenographically recorded conversation explicitly states that the Panamanians already made this decision and are now seeking confirmation. The lawyer for the Fiscal Commission was clear on this point:

Mr. Cromwell: (speaking to Secretary Taft). This subject has been very deeply considered by these gentlemen; not only by the gentlemen present, but by distinguished men in the Isthmus. It was considered by their [Constitutional] Convention; and a bill has been prepared by the Government, submitted, and is under consideration. That bill is very intelligent. I suggest Mr. Arias read and explain to you the measure pending. The Convention is standing ready; the bill is here; if this form is acceptable it will be cabled there and probably passed. In other words, we have the measure on the table, and this conference may put it in shape where it will be adopted.

The discussion in these records is interesting for many reasons. We can see Secretary Taft as being genuinely concerned about the monetary stability in the Canal Zone and Panama, more generally.

The post-separation transitional government in Panamá wanted to avoid a situation where the economic activity of the Canal Zone placed severe pressure on the monetary capacity of the new Republic. (Remember, finite metal coins were the norm—not infinite digits on a screen.) The increased demand for metal coins to pay imported labor would put a great strain on Panama’s capacity.

This was indeed highlighted in the Taft meetings when Taft asked Admiral Walker how much money he expected to require for paying wages to the Canal workers:

Secretary Taft: Admiral Walker, how much do you suppose your going in there would add to the demand for the peso?

Admiral Walker: Well, it would add considerably. We should use it. We would pay our men with it.

The Isthmian Commission did not have the idea to create a new currency within Panama. They thought that would be wholly impractical. It was necessary that Panama's money would remain stable relative to the US gold dollar which they would need to use concurrently.

Secretary Taft: Would you pay all your men in the peso [Panama silver coins]?

Admiral Walker: Yes; we should pay in that way probably all the people we employed down there. The people sent down from here we should pay once a month in gold or in United States currency, but the laborers and the people of the Isthmus would go on the silver roll and be paid every two weeks.

To emphasize the point of the Panamanian origin of dollarization, the lawyer of the Fiscal Commission stated in the recorded transcripts that a version of the same bill was voted on in Panama a few weeks prior, but it failed because the 32 voters ended up in a tie, 16 were pro, and 16 were against. They hoped that this agreement with the US would push it over the mark to instill confidence in the plan to get it approved in Panama.

Another key feature of the monetary agreement Taft made with Panama is woefully under-examined. The Isthmian Commission (and, therefore, the US government) agreed to help stabilize the Panamanian silver currency by loaning its own money to Panama to backstock a depreciation in the exchange rate between the silver peso and US gold money. This arrangement by Taft was unprecedented in many ways. Remember that the United States Federal Reserve did not yet exist.

Moreover, it could not have been an imposition by the US government on Panama because the US government was not involved in its contemplation per se. Secretary Taft acted unilaterally.

He did not seek permission from the US Congress before agreeing to these terms. In fact, the Senate hauled Secretary Taft up for giving such strong assurances without first asking permission from Congress.

This resulted in a Congressional hearing at which most of this information was revealed. Thank you, Library of Congress digitization services! The full title being: Hearings before the Finance Committee of the United States Senate on the Monetary Agreement between the Secretary of War and the Government of Panama 1904.

The Senate questioned and challenged Taft because it was unclear if he had the power to commit the US to such terms with Panama. Again, how can it be claimed that the US government imposed the dollar on Panama if the US government questioned how Taft himself could take this action?

During the Hearings, Taft based his defense on the point that he:

“… considered in this matter that it was as if the [Isthmian] Commission were making a financial arrangement with a view to securing a proper medium in which to pay their men.”

It's a clever framing. I want to remind readers that after Taft’s Presidency, he was also appointed Chief Justice of the US Supreme Court. The only person to have held both positions. But why did Taft even do this?

The risk of a monetary crisis in Panama was clearly fresh in the minds of the Panamanians. But it was also, more surprisingly, present in the mind of Secretary Taft. In the Hearings, he recounted that monetary stability was crucial in the Canal Zone because he saw the economic and administrative harm that occurs from monetary instability firsthand when he was the Governor of the Philippines:

Secretary Taft: I ought to add on the question of motive that what led be to take this action in respect to the currency and advise the President to confirm it was our experience in the Philippines in the same matter — while I was there silver fluctuated from less than 2:1 to 165:1 — and the difficulties that we had in paying our employees and the just complaints that we met at one time when we had accounts in three different currencies.

Taft was right. I believe this historical episode could have gone differently if Taft had not been the Secretary of War in charge of the Panama Canal construction, and for that matter, if Taft had not been the Governor of the Philippines immediately prior to his appointment. He represents a precarious hinge point in the history of dollarization in Panama.

Accordingly, the monetary agreement was approved by the US Congress and President, and later, the President of Panama confirmed its contents in Dreceto 74 de 1904, in which the President officially declared, “Apruébase en todas sus partes la Convención acordada Washington…”. (Funny enough, I had to visit the National Library in Panama to find readable copies of the full documents in the Gaceta Oficial in the early 1900s.)

Recap and Look Forward

Panama did not dollarize because of a macroeconomic crisis. Dollarization was part of Panama’s initial state-building process. The state leaders' monetary ideology was based on their recent experience of an inflation spiral caused by excessive paper money creation in Colombia. They wanted to avoid this entirely in their new country, so they chose the dollarization path.

It was a coincidence that the Secretary of War at the time was William Taft, who had first-hand experience with currency mismanagement in the Philippines. Taft knew the best way forward was to agree to the idea of the Panamanians to adopt USD as a legal tender in Panama. And he entered this agreement even though he was unsure if he had the power to do so by Congress. Yet, it worked. And today, Panama has the most stable monetary system in Latin America.

In the next post, I will discuss how Panama’s financial system currently functions under dollarization, where money is primarily digital. I will also explain the beneficial macroeconomic effects of full financial integration in Panama.

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