Argentina was once the darling of investors, a large emerging market graced with stability and transparency. Now, it has defaulted on $132 billion in debt, its banking system is in turmoil, the value of its currency is uncertain, and middle-class Argentines have rioted through the elegant squares of Buenos Aires.
How did this happen? One of the main suspects is the Convertibility Law that Argentina adopted in 1991, a modified currency board system that pegged the peso to the dollar one to one. At first, it succeeded in taming Argentina’s runaway inflation, but many economists believe it eventually became a severe drain on the economy.
The currency board system, however, has supporters. One of the strongest is Prof. Steve H. Hanke of Johns Hopkins University. Professor Hanke agreed to answer questions about Argentina’s travails but insisted on responding by e-mail because of what he called the complexity of the issues.
Q. The currency board system was supposed to ensure economic stability. What went wrong?
A. In our 1991 book, ”Banco Central O Caja de Conversion?,” Kurt Schuler and I proposed an orthodox currency board for Argentina. Instead of the real thing, the Argentines opted for a convertibility system in April 1991. In October 1991, we warned that convertibility would evolve from a currency-board-like system into something closer to a central banking system. And that it did. Last year, for example, the ”pure” foreign reserves in the convertibility system fluctuated wildly from a high in February of 193 percent of its monetary liabilities to a low in December of 82 percent. If Argentina would have employed an orthodox currency board, those reserves would have always been 100 percent of the system’s monetary liabilities.
If that wasn’t bad enough, Domingo Cavallo meddled with convertibility shortly after he was reinstated as Argentina’s economic czar in March 2001. In April, he announced that the peso’s anchor would eventually change from the dollar to a basket of 50 percent dollars, 50 percent euros, and in June he announced a preferential exchange rate for exports. These changes moved convertibility further from currency board orthodoxy and caused interest rates to skyrocket. The lessons are clear: deviations from currency board orthodoxy cause problems— big problems. In Argentina, they resulted in a tightening of monetary conditions in the middle of a slump.
And to add insult to injury, the de la Rua government increased tax rates on three occasions during the past two years. These rate hikes put Argentina’s tax rates well above comparable U.S. rates. Not surprisingly, the tax-increase packages caused the economy to slump further and tax revenues to collapse.
Q. So the currency board is not to blame? Only the way Argentina tinkered with it?
A. There is nothing wrong with the currency board system concept. Indeed, the I.M.F. has concluded that the currency boards installed in the 1990’s, as well as Hong Kong’s, have strengthened fiscal discipline and the banking systems, have motivated reforms and have been the linchpins for growth. And until it began to meddle with convertibility, that was the case in Argentina. Indeed, Argentina’s real G.D.P. grew by more in the decade of convertibility than in any other decade in the 20th century.
Q. The currency board system seems to be unprepared to deal with external events that can cause unforeseen problems — for example, Brazil’s 1999 devaluation, which severely hurt Argentina’s exports to Brazil. Isn’t this a major flaw in the system?
A. You are alluding to the allegation that by linking the peso to the strong dollar, the peso became overvalued and Argentina became uncompetitive. The claims about Argentina’s lack of competitiveness are nonsense. A classic sign of uncompetitiveness caused by an overvalued currency is declining exports. But Argentina’s exports increased every year in the past decade except 1999, when Brazil, its largest trading partner, suffered a currency crisis. Exports during the first 11 months of 2001 were about 3.2 percent ahead of exports during the same period in 2000. Considering that the real growth in world trade was only 0.9 percent last year, Argentina’s export performance was relatively strong. Indeed, the export sector has been one of the few bright spots in the Argentine economy.
Q. What will happen next in Argentina?
A. Since the central bank was established in 1935, until 1991, the peso depreciated against the dollar by a factor of three trillion. With central banking and a floating peso, I am afraid Argentina’s problems have just begun, again.
Q. Isn’t the currency board discredited even if it did not contribute to Argentina’s crisis?
A. No. Argentina’s meltdown occurred after the convertibility system was officially abandoned on Jan. 6 and is still in progress. The only reason Argentina was able to hold its head above water before then was the convertibility system, with all its flaws.