Many eminent economists — Olivier Blanchard, Michael Bordo, Sebastian Edwards, Martin Feldstein, Ricardo Hausmann, Paul Krugman, Allan Meltzer, Michael Mussa, Joseph Stiglitz, Thomas Willett and John Williamson –- told us that dumping convertibility would work wonders in Argentina. Indeed, they trotted out every half‐truth or non‐truth under the sun to bolster their claims that the source of Argentina’s problems was convertibility and that a floating peso, and pesofication of contracts and financial liabilities and assets were just what the doctor ordered.
Under the Convertibility Law, the peso and US dollar legally circulated at a one‐to‐one exchange rate. The owner of a peso had a property right to a dollar and could freely exercise that right by converting pesos into dollars. That redemption pledge was credible because the central bank was required by law to hold foreign reserves to cover fully its peso liabilities. It doesn’t take a rocket scientist to conclude that the floating peso and pesofication have left the patient at death’s door. What went wrong?
It turns out that the medicine they prescribed required contracts to be broken and property rights to be destroyed. The resulting chaos should serve as a grim testimonial to all those, including the International Monetary Fund, that advocated a floating peso and pesofication.
If Argentina hopes to reemerge from its current chaos, its fiscal regime must be fully subordinated to its monetary regime. The only way to do this is to dismantle the central bank, liquidate the peso, completely dollarize the economy and prohibit the issuance of quasi‐monies, the bonds provincial governments issue to finance their budget deficits. Dollarization would not only ensure fiscal subordination and solve Argentina’s currency problem once and for all. It would also give it a much‐needed confidence shock and reverse the dramatic decline in the government’s tax revenues. This medicine would work in Argentina. After all, it delivered a positive confidence shock to Ecuador, a country that was in the grips of economic chaos before it dollarized in 2000. Now Ecuador’s economic growth tops the charts in Latin America and its non‐oil tax revenues are growing at over 40% per year.
It is important to stress, however, that dollarization is a necessary, but not sufficient condition that must be satisfied before Argentina can reach its potential. More broadly, the rule of law must be respected. No country can prosper if it fails to recognize the sanctity of contracts, which are the foundation of all private morality and the indispensable condition of every sane social order. This point about the rule of law cannot be stressed enough. The government of President Eduardo Duhalde has focused its efforts — much as the Bolsheviks did in Russia — on abrogating private contracts. For example, it has done away with the Convertibility Law, embraced the corralito and pesofied the economy, to name but a few gross infractions of contract law.
Dollarization would, by definition, solve Argentina’s currency problem. But what about banking? Given Argentina’s history, the banking problem will be a tougher nut to crack. A bifurcated banking system coupled with dollarization might just do the trick.
Generating Paper Money
Banks that are unquestionably solvent should be allowed to issue their own notes (paper money), denominated in dollars. In the current context, the only banks likely to qualify would be foreign banks whose head offices promised to support them in full. People holding these bank‐issued dollar notes could demand payment in notes issued by the US Federal Reserve or in an electronic form acceptable to note holders, such as Fed funds. Bank‐issued notes would be much like bank‐issued traveler’s checks. People would accept the notes if they had confidence in the issuer and reject them if they lacked confidence. They would always have the option of continuing to use dollar notes issued by the US Federal Reserve.
Allowing banks to issue dollar‐denominated notes and repealing the central bank’s power to issue pesos would have a powerful effect in making monetary policy “looser,” by reducing interest rates. Monetary policy is much “looser” in the United States, Panama, and Ecuador than in Argentina because the perceived risk of devaluation is absent.
Allowing banks to issue dollar‐denominated notes would help them increase their supply of reserves on hand by “capturing” some of the Federal Reserve notes now held by Argentines and replacing them with bank‐issued notes. Allowing banks to issue dollar‐denominated notes would reduce banks’ demand for reserves by reducing their need for Federal Reserve notes as vault cash. The boost to confidence that would result from eliminating the peso could lead depositors to bring back the deposits that have flowed out of Argentina’s banking system in recent months. A similar thing happened in Ecuador after it dollarized in 2000.
Allowing banks to issue their own notes might seem far‐fetched or at least novel, but it is neither. Many financial firms already issue paper travelers’ checks, which resemble currency although they cannot pass from hand to hand without being endorsed. Before the 20th century, commercial banks issued their own notes in most financially advanced countries of the time, nearly 60 countries in all. Multiple brands of notes need not confuse people any more than multiple brands of traveler’s checks now do. Governments took over note issuance from commercial banks not because the private sector was doing a bad job, but because governments wanted the profits for themselves. The record of private issuance of notes was generally good. In some countries bank failures caused losses to note holders, but the losses were small compared to the losses inflicted by the central banks that later took over note issuance.
Argentina was one of the countries that had note issuance by commercial banks in the 1880s. Argentina had a rather unhappy experience because it made a number of mistakes. One was that rather than being redeemable in gold, bank notes were redeemable in government‐issued pesos, a depreciated fiat currency, rather than in an international unit such as gold or the pound sterling. Another mistake was that as a condition for issuing notes, banks were required to hold specified Argentine government bonds.
Argentina’s default on its foreign debt in 1890 triggered a currency and banking crisis. It was not the banks, but the government that created the crisis. Even so, the government responded by ending note issuance by banks and establishing the Caja de Conversión in 1891. In 1902 the Caja began to operate as a currency board, and continued to do so, providing Argentina with one of its few periods of monetary stability, until the First World War broke out in 1914.
Nothing in Argentina’s constitution stipulates that it must have a central bank or a nationally issued currency. In fact, because the constitution has roots in the 19th century, when note issue by multiple banks was widespread around the world, the constitution contemplates the possibility of multiple issuers. Article 75, paragraph 6 of the constitution gives the Argentine Congress the right to “establish and regulate both a federal bank with the ability to issue money, and other national [that is, federally chartered] banks”. However, the constitution explicitly contemplates the possibility of multiple note issuers in article 126, which states that “provinces may not coin money or establish note‐issuing banks without the authorization of the federal Congress”. By implication, the federal government may itself authorize banks to issue notes, or it may authorize the provinces to charter private or government‐owned banks that issue notes.
Argentina’s Law on Financial Institutions does not mention note issuance as a permitted power of commercial banks or other financial institutions. The Organic Law of the Central Bank gives the central bank power to issue notes but does not state that the power is a monopoly. It may be possible to give commercial banks the freedom to issue notes through administrative decisions, without changing any existing laws. But it would be desirable to eliminate any role for the central bank as an issuer of currency, which would require amending the Organic Law of the Central Bank.
Breaking A Monopoly
Allowing banks to issue notes would broaden the reach of solvent banks into an area currently monopolized by the government. Another reform would be to convert the immediately salvageable part of banks of doubtful solvency into so‐called narrow banks, to preserve a role for them in the payments system. Narrow banks would be deposit‐taking banks that operated as money‐market mutual fund banks (a modified form of 100% reserve banking). Depositors in these banks would no longer have to live in fear of being unable to withdraw their deposits because banks would have the liquid reserves to cover the withdrawals.
Another important advantage of money‐market mutual fund banking is the fact that these banks would need very little equity capital to cover the small risks associated with the matching of their assets and deposits. Finally, to make both the note‐issuing and money‐market mutual fund banks safe from the grabbing hands of the authorities, they should be free to operate offshore.