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 beforeit in Mexico, Thailand, Korea, Indonesia, Russia and Brazil -- was yetanother 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 tonothing more than guilt by false association. Pegged exchange-rate systemshave little, if anything, to do with Argentina's currency board-likearrangement.

Currency-board arrangements are dramatically different from pegged exchangerates. With currency-board rules, a monetary authority sets the exchangerate, but has no monetary policy -- monetary policy is on autopilot. Themonetary authority can't increase or decrease its monetary liabilities bybuying or selling government debt. Changes in net foreign reserve assets,which are required to back monetary liabilities one-for-one, exclusivelydrive changes in monetary liabilities.

In other words, with an exchange-rate system like Argentina's, changes inthe monetary base are determined solely by changes in the balance ofpayments. Conflicts between the exchange-rate and monetary policies can'tmaterialize and balance-of-payments crises can't spin out of control becausemarket forces act to automatically rebalance financial flows. This explainswhy currency boards weather storms and why Argentina's peso has continued totrade at a one-for-one rate with its anchor currency (the dollar) sinceconvertibility was adopted 10 years ago. No other South American country cantouch that record.

Pegged rates, such as the system employed in Turkey, require authorities tomanage both the exchange rate and monetary policy. The monetary basecontains both domestic and foreign components because both net domesticassets and foreign reserves on the monetary authority's balance sheet canchange and these changes cause its monetary liabilities to fluctuate.

Pegged rates invariably result in conflicts between exchange-rate andmonetary policies. For example, when capital inflows become "excessive"under a pegged system, a monetary authority often attempts to sterilize theeffect by reducing the domestic component of the monetary base through thesale of government bonds. And when outflows become "excessive," theauthority attempts to offset the changes with an increase in the domesticcomponent of the monetary base by purchasing government bonds.Balance-of-payments crises erupt as a monetary authority increasinglyoffsets the reduction in the foreign component of the monetary base withdomestically created base money. When this occurs, it is only a matter oftime before currency speculators spot the contradiction. This is exactlywhat happened in Turkey.

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

In 1989 and 1990 -- the two years preceding the adoption of convertibilityon 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 a1.5% annual rate. And even though the economy is presently slumping, grossdomestic product per capita measured in dollars has registered a strongincrease of 76.7% in the 10 years since the inception of convertibility.This decade of growth puts Argentina at the top of the Mercosur tradingbloc'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 weeksthey have talked up the desirability of either exiting or modifyingconvertibility. The chattering classes' most popular exit strategy wouldallow the peso to float, a strategy that would no doubt produce an immediatedrop in the peso value and new inflation and would wreak havoc in the debtand equity markets.

The cognoscenti are also toying with a modification strategy that wouldswitch the peso's transparent anchor from the dollar to a basket ofcurrencies made up of dollars and euros. This switch would do nothing morethan provide cover for a devaluation. It would also invite no end ofmischief because the dollar-euro weights in the basket could be changed atany time, producing a change in the exchange rate.

There has been more than idle speculation. There have been calls in BuenosAires to replace the governor of the central bank, Pedro Pou, with someonewho might look more favorably on a modification of or an exit fromconvertibility. This would be a disaster because a devaluation would meancertain default for a great deal of Argentina's debt.

The real problem in Argentina is not convertibility. Most Argentines knowthat convertibility is the only institution that disciplines Argentina'sunruly politicians. That's why Argentines almost universally support it.Argentina's problem is the low level of confidence in the government and itsability to retain sound money and push forward with reforms. A big bang isthe 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, aconfidence-building headline-grabber.

The second leg of the big bang is supply-side reform. The tax code should besimplified and tax rates reduced. Argentina's unemployment rate has beentrending upward since the mid-1980s (it's now 15%) because the tax bite isso large and labor laws so rigid. Deregulate the health care system, labormarkets and utilities. This would allow prices and the economy to becomemore flexible and competitive, as in Hong Kong.

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

Foreign capital would immediately start flowing in. And with a dollarizedmonetary regime, it would cause the M3 measure of broad money to soar to anannual 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 the1996-97 period, when M3 growth peaked at a 28.5% rate.