Argentina Is No Turkey

This essay originally appeared in The Wall Street Journal.
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The collapse of Turkey’s pegged exchange rate — like similar events before it in Mexico, Thailand, Korea, Indonesia, Russia and Brazil — was yet another textbook case of the inherent instability of pegged exchange rates. The events in Turkey are generating many negative comments about “convertibility,” Argentina’s fixed exchange‐​rate system. This amounts to nothing more than guilt by false association. Pegged exchange‐​rate systems have little, if anything, to do with Argentina’s currency board‐​like arrangement.

Currency‐​board arrangements are dramatically different from pegged exchange rates. With currency‐​board rules, a monetary authority sets the exchange rate, but has no monetary policy — monetary policy is on autopilot. The monetary authority can’t increase or decrease its monetary liabilities by buying or selling government debt. Changes in net foreign reserve assets, which are required to back monetary liabilities one‐​for‐​one, exclusively drive changes in monetary liabilities.

In other words, with an exchange‐​rate system like Argentina’s, changes in the monetary base are determined solely by changes in the balance of payments. Conflicts between the exchange‐​rate and monetary policies can’t materialize and balance‐​of‐​payments crises can’t spin out of control because market forces act to automatically rebalance financial flows. This explains why currency boards weather storms and why Argentina’s peso has continued to trade at a one‐​for‐​one rate with its anchor currency (the dollar) since convertibility was adopted 10 years ago. No other South American country can touch that record.

Pegged rates, such as the system employed in Turkey, require authorities to manage both the exchange rate and monetary policy. The monetary base contains both domestic and foreign components because both net domestic assets and foreign reserves on the monetary authority’s balance sheet can change and these changes cause its monetary liabilities to fluctuate.

Pegged rates invariably result in conflicts between exchange‐​rate and monetary policies. For example, when capital inflows become “excessive” under a pegged system, a monetary authority often attempts to sterilize the effect by reducing the domestic component of the monetary base through the sale of government bonds. And when outflows become “excessive,” the authority attempts to offset the changes with an increase in the domestic component of the monetary base by purchasing government bonds. Balance‐​of‐​payments crises erupt as a monetary authority increasingly offsets the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradiction. This is exactly what happened in Turkey.

Many commentators who insist on a negative spin for Argentina also suggest that convertibility has failed to serve Argentina well. Not so.

In 1989 and 1990 — the two years preceding the adoption of convertibility on April 1, 1991 — Argentina’s annual inflation rate was 4,929% and 1,345%, respectively. Today Argentina’s consumer price index is falling gently, at a 1.5% annual rate. And even though the economy is presently slumping, gross domestic product per capita measured in dollars has registered a strong increase of 76.7% in the 10 years since the inception of convertibility. This decade of growth puts Argentina at the top of the Mercosur trading bloc’s growth chart, far outdistancing Brazil, which has realized only 8.2% growth in GDP per capita over the past decade.

But this hasn’t stopped convertibility’s critics. Over the past few weeks they have talked up the desirability of either exiting or modifying convertibility. The chattering classes’ most popular exit strategy would allow the peso to float, a strategy that would no doubt produce an immediate drop in the peso value and new inflation and would wreak havoc in the debt and equity markets.

The cognoscenti are also toying with a modification strategy that would switch the peso’s transparent anchor from the dollar to a basket of currencies made up of dollars and euros. This switch would do nothing more than provide cover for a devaluation. It would also invite no end of mischief because the dollar‐​euro weights in the basket could be changed at any time, producing a change in the exchange rate.

There has been more than idle speculation. There have been calls in Buenos Aires to replace the governor of the central bank, Pedro Pou, with someone who might look more favorably on a modification of or an exit from convertibility. This would be a disaster because a devaluation would mean certain default for a great deal of Argentina’s debt.

The real problem in Argentina is not convertibility. Most Argentines know that convertibility is the only institution that disciplines Argentina’s unruly politicians. That’s why Argentines almost universally support it. Argentina’s problem is the low level of confidence in the government and its ability to retain sound money and push forward with reforms. A big bang is the only way to restore confidence.

My counsel: Dump the peso and adopt the greenback. That would eliminate, once and for all, any further speculation about an exit from convertibility. It would also bring Argentina’s interest rates down to U.S. levels, a confidence‐​building headline‐​grabber.

The second leg of the big bang is supply‐​side reform. The tax code should be simplified and tax rates reduced. Argentina’s unemployment rate has been trending upward since the mid‐​1980s (it’s now 15%) because the tax bite is so large and labor laws so rigid. Deregulate the health care system, labor markets and utilities. This would allow prices and the economy to become more flexible and competitive, as in Hong Kong.

Fiscal reforms would constitute the third leg. Government spending has increased by an average of 10% a year since 1991. It must be slashed, and the government must follow New Zealand and produce an annual balance sheet and income statement. This would provide for transparency and reduce corruption.

Foreign capital would immediately start flowing in. And with a dollarized monetary regime, it would cause the M3 measure of broad money to soar to an annual growth rate of between 20% and 30% from its current anemic 3.2%. Economic growth would rapidly match, or surpass, the 7% rate realized in the 1996–97 period, when M3 growth peaked at a 28.5% rate.