SYNOPSIS: How a small Latin country will prove Currencies right or wrong

Ecuador is a small, faraway country of which most Americans probably know nothing. (Hint: it's on the equator.) Last week, amid the hoopla of the AOL-Time Warner deal, one suspects that few noticed the surprise announcement by President Jamil Mahuad that he would abolish his nation's currency and replace it with the U.S. dollar. But there is an important story behind that story, which is not so much about Ecuador as about the great financial crisis that swept Asia in 1997-98, and the continuing debate over what to do when the next crisis strikes.

Everyone agrees that the Asian crisis was, in the first instance, a case of financial panic: basically, after enthusiastically putting hundreds of billions of dollars into Asia in the years before 1997, investors suddenly lost their nerve and began pulling out all at once, with catastrophic consequences. But there is a sharp difference of views over what could have prevented or at least mitigated that crisis.

Broadly speaking, one view holds that in times of panic the normal rules of business should be suspended -- that investors should be persuaded, or if necessary forced, to keep their money in place while the authorities get things under control. In the oddly euphemistic jargon of international finance, this is known as "burden-sharing," or even more obscurely as "private sector involvement."

The other view holds that the way to deal with panic is to try to reassure investors that their money is absolutely secure -- and that one way to do that is to offer an ironclad guarantee that their holdings of Korean won, or Indonesian rupiah, or Ecuadorian sucres, will not lose their value in terms of dollars. This can be done by establishing a "currency board," which holds dollar reserves large enough to back the entire national money supply; it can be done even more decisively by "dollarizing" -- that is, abandoning the national currency and using dollars instead.

It is an unresolved debate, because neither approach was given much of a trial. Hong Kong has a currency board, but was never itself the object of investor panic -- it just happened to be living in a bad neighborhood. Malaysia imposed controls on investors, but only after the worst of the panic was past.

And that's where Ecuador comes in. The small Latin nation has the dubious distinction of having plunged into crisis just as Asia climbed out; and as a result it has become a sort of guinea pig for economic nostrums. It is by no means an ideal choice as a clinical model. After all, at the beginning of 1997 Asian economies looked robustly healthy, with their government budgets balanced or in surplus; their crisis came, as it were, out of a clear blue sky.

Ecuador, by contrast, has always been more or less a mess; its plunging currency is only the outward sign of an inward disgrace, of a bankrupt banking system that cannot be rescued by an equally bankrupt government. But nonetheless, Ecuador is the test case we have, and its experience is likely to have a disproportionate effect on how the next big crisis is handled.

Indeed, the tiny nation has already done much to discredit the notion of "private sector involvement." Last September Ecuador decided, with more or less explicit encouragement from the International Monetary Fund, to temporarily suspend payment of some of its foreign debt. The experiment was a failure: while some investors found their money locked up, others continued to flee Ecuador, and the economy's tailspin continued.

Now its government has swung to the other extreme, and is trying to restore confidence in the currency by abolishing it. Observers say that this could work if it is accompanied by extensive domestic reform -- which is a bit like the old line that you can kill someone with witchcraft, if you also give him plenty of arsenic. But if it works, it will do much to make dollarization likely elsewhere (Argentina, for example); if it fails, as is much more likely, it will give dollarization a bad name.

And the outcome matters. Sometime -- almost surely sometime this decade -- there will be another great financial crisis like the ones that struck Mexico in 1994 or Asia in 1997. What will we do about it? Believe it or not, Ecuador may determine the answer.

Originally published in The New York Times, 1.19.00