Recipe for Disaster: The Rise and Fall of Currency Boards in Argentina

Recipe for Disaster: The Rise and Fall of Currency Boards in Argentina
Richard Carew

Released: 01/13/02

The resignation of Fernando de la Rua and the financial disaster that he leaves to his successor Aldolfo Rodriguez Saa have left Argentina in a state of crisis. Looting and national strikes have left the developing nation's economic system crippled. The events of recent days share an eerie similarity to the resignation of Raul Alfonsin in 1989. The economic collapse of 1989 and 2001 are two sides of the same coin. In both cases, the economy of Argentina was rattled by monetary phenomenon. Interestingly enough, there can be a direct link drawn between the two collapses: protection against hyperinflation following the 1989 crisis has directly led to the 48 month long depression which finally brought the Argentine government to its knees this week.

Overcorrection seems to be a historical tendency as governments and international agencies seem only able to remember the latest crisis at the expense of all other potential problems with a policy. Such is the case with Argentina's currency board regime. The currency board regime was created to tame the rampant hyperinflation of the later 1980s. It's chief goal was to end the high rates of inflation that had destroyed wealth and created uncertainty Argentina's businesses, workers, and would-be foreign investors. The currency board does a very good job of limiting inflation. Actually, it does too good of a job. The currency board has led to the recent unemployment levels upwards of 18%. By tying the Argentine peso to the movements of the U.S. dollar, as a solution to hyperinflation, another problem was created, economic recession. All of these problems were caused by the accidental correlation of international events, which understandably make Argentineans so frustrated at the recent budget cuts and other austerity measures.

Argentina chose to create a currency board to make the peso convertible to dollars (effectively tying it to the dollar's movements) because the U.S. had a low inflation rate in the early 1990s. The Argentine government hoped by making its currency convertible into dollars, it would be able to make the peso a sound currency with low inflation. It achieved this goal astounding well as U.S. inflation rates continued to fall to new lows and Argentina's inflation rates followed. So low that Argentine prices are actually falling; consumer prices fell by 1.6% in November. However, unforeseen was the movements of the U.S. dollar in foreign exchange markets. The U.S. dollar has maintained extremely high valuation on international markets throughout the late 1990s, perhaps because of the desirability of U.S. financial assets such as stocks and bonds to international investors. Resulting from this the U.S. has run an extremely large trade deficit.

What does this have to do with Argentina? Well remember with the peso convertible into dollars, it should follow the exchange rate of the U.S. dollar. This is the problem. The exchange rate regime kept the peso at an abnormally high valuation, which made Argentina's exports expensive and imports inexpensive. While the U.S. was in the midst of a technological boom and had extremely high growth rates upwards of 4%, Argentina did not fair nearly as well. The uncompetitiveness of Argentina's exports has had a serious drag on Argentina's growth and has led to drops in tax revenues. Argentina posted a current account deficit of $8.4 billion dollars in the 2nd quarter of 2001, meaning that it imported more goods and services than it exported, the opposite of what a country in recession should be doing. Without the flexibility of a floating currency, which would allow the peso to decline and promote exports, Argentine businesses and consequently workers have suffered from the loss of exports and increase in imports. Tax revenues have fallen with the economic decline and to meet its debt obligations which have reached 43% of GDP, Argentina's government has been forced to cut wages and spending programs. The decision was extremely unpopular and brought down the government of President de la Rua. Argentina was forced to reschedule debt in order to stave off defaulting, but now the new president of Argentina has declared that they will not repay the foreign debt it owes until it can get its domestic situation in order. The frustration at the international community because of the austerity measures it has forced upon the government is certainly understandable, but the approach is wrongheaded. It would be smarter for the new President Saa to attack the currency board that leading economist from the U.S. and international organizations proposed as a solution to hyperinflation. However, he has also maintained his support for the currency board regime. This contradiction and poor policy choice will certainly doom the economy's growth and Argentina's workers.

The international community has had a hand in the problem too. The IMF has been all too willing to restructure debt to delay the inevitable collapse of the currency board. The IMF maintains they are upholding a policy of avoiding interference with the sovereign decisions of nations on their monetary and exchange rate regimes. Many outside of Washington have portrayed the IMF motives as less genuine, calling the policy a method of avoiding blame in cases of regime collapses.

Economists willing to offer solutions have cited several options. One is to completely dollarize the economy, making all contracts required to be in U.S. dollars and refinancing the international debt. This would seemingly worsen the problem, but would relieve the government of the responsibility of maintaining foreign exchange reserves. However, this does not directly address the problem. Another option, with far better prospects is to allow the Argentine peso to float and get rid of the currency board in place. Now, at this point many observers point to the crisis of 1989 and sneer that history would repeat itself and hyperinflation would reappear. But is it legitimate to fear high levels of inflation when a country is currently experiencing negative inflation rates? I would argue that it is not. Perhaps even a little inflation would be good for the economy if it were accompanied by growth. What is obvious is that a solution must be found to quell the public unrest and provide stability and growth to one of Latin America's largest economies. Argentina's new President Saa has chosen a far different path from either of these options. He has chosen to forego budget cuts and ignore changes to the exchange regime. He chose instead to halt the repayment of international debt until growth revives. Argentineans will hopefully realize sooner rather than later that growth will not magically appear nor will debt magically disappear, for if history teaches us anything, it hasn't for Argentina.

-Richard Carew
Economic Analyst
theshortrun.com