“Devaluing the peso would require Argentina to flout the rule of law and abrogate property rights. It would be both irrational and immoral.”
With five presidents in the short span of two weeks, Argentina is mired in a deep political crisis. And, since 1999, it has also been in the grip of a downward economic spiral.
According to the chattering classes, most of the blame should be laid at the feet of Argentina’s currency regime. To rid the country of hyperinflation and give it a confidence shock, Carlos Menem’s government installed a convertibility system on April 1, 1991.
The Convertibility Law fixed the peso’s exchange rate at par with the U.S. dollar and required the peso to be fully backed with dollar reserves. Under convertibility, the owner of a peso had a property right in a dollar and could freely exercise that right by converting a peso into a dollar.
The pundits assert that by linking the peso to the strong dollar, convertibility has rendered Argentina uncompetitive. This, they assert, is at the heart of Argentina’s economic crisis. Consequently, a peso devaluation and a floating exchange rate are necessary.
As the Jan. 4 editorial in The New York Times put it: “… a devaluation, though politically difficult, is needed to make the country’s exports more competitive.”
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 10 months of 2001 were about 4% ahead of exports during the same period in 2000. The export sector has been one of the few bright spots in the Argentine economy. If the rest of the economy had been growing as fast as the export sector during the last two years, Argentina would not be in a recession and the government would not be bankrupt.
In an attempt to bolster their overvaluation claim, many assert, on the basis of taxi rides from the airport or other casual impressions, that prices are high in Buenos Aires, and that high prices are evidence the peso is significantly overvalued against the dollar. A recent Union Bank of Switzerland survey of prices in 58 of the world’s largest cities found that for a basket of 111 goods and services, weighted by typical consumer habits — including three categories of house rent — Buenos Aires ranks 22nd, about midway between the most expensive city, Tokyo, and the least expensive, Bombay. The survey also found those taxi rides that are allegedly so expensive cost about 8% less than in Rio de Janeiro.
Like the assertions about uncompetitiveness, the idea of floating the Argentine peso suffers from a disregard for economic realities. The history of independent monetary policy and a floating exchange rate in Argentina is not just bad; it is one of the worst in the world. Inflation was never below 90% a year from 1975 until the convertibility system was established. Over a still longer period, from the time the central bank was established in 1935 until the convertibility system began in 1991, the peso depreciated against the dollar by a factor of three trillion.
If devaluation and floating were the elixirs for Argentina, the country would have long ago been one of the most competitive, booming economies in the world.
If not the convertibility system and the peso, then what? Argentina’s acute political and economic crises have resulted from an interrelated set of self‐inflicted Argentine blunders.
Blunder 1: In the 1990s, Argentina failed to carry out comprehensive free market reforms. Contrary to claims by Eduardo Duhalde, Argentina’s new president, the neo‐liberal economic model was never implemented or, if it was, it was half‐baked. The fiscal system is a mess and tax rates are sky‐high. Over half the working age population in many provinces is employed by the government. The Mussolini‐style labour laws and the public health‐care and social security systems remain unreformed and in need of modernization.
Blunder 2: In 1999, former president Menem failed to replace the peso with the dollar as he promised. This has left the peso vulnerable to meddling by the always unreliable Argentine politicians.
Blunder 3: In 1999, Argentina’s voters elected a weak left‐wing government. It was led by President Fernando de la Rua. Although a decent man, he remained distant and removed from the economic realities of Argentina and tone deaf to Argentina’s politics.
Blunder 4: In 2000 and 2001, the de la Rua government introduced three large tax increase packages on the recommendation of the International Monetary Fund. These pushed the top tax rates in Argentina to very high levels. Consequently, the top tax rates in Argentina are much higher than those in the United States. Not surprisingly, these tax increase packages forced the economy to slow rapidly and total tax revenues collapsed. As a result, Argentina was unable to service its debt.
Blunder 5: In March, 2001, Domingo Cavallo was appointed Minister of the Economy. Cavallo’s economic principles were subject to constant change and as fluid as the assets in a well‐managed bank. This fact, combined with his hyperactivity, was a deadly cocktail.
Blunder 6: On April 25, 2001, President de la Rua replaced the president of the central bank, Pedro Pou, with Roque Maccarone, a man who was inclined toward meddling with the rules governing the peso‐dollar exchange rate.
Blunder 7: On June 19, 2001, Argentina introduced a multiple exchange‐rate system. Under this set‐up, exports (excluding oil) take place with a devalued peso; imports with a revalued peso. All other transactions take place at a peso‐dollar rate of one‐to‐one. This was the beginning of the end because Argentina abandoned the convertibility rules. Consequently, external drains of foreign reserves out of Argentina accelerated.
Blunder 8: On June 25, 2001, a law was put into effect in which the peso’s anchor would switch from the dollar to a basket of 50% euros and 50% dollars once the euro reaches parity with the dollar. This constituted another breach of the Convertibility Law and gave rise to further external drains of foreign reserves.
Blunder 9: In early December, 2001, Argentina imposed an interest rate ceiling on interest paid in pesos. Consequently, bank runs and internal drains of deposits out of Argentina’s banks accelerated.
Blunder 10: Then, in an attempt to slow the external and internal drains in Argentina’s money and banking system, exchange controls were imposed. These totally abrogated the property rights people had been granted under the Convertibility Law. Argentines viewed this as theft and went to the streets.
Blunder 11: On Dec. 26, 2001, interim President Adolfo Rodriquez Saa proposed the issuance of a parallel currency, the Argentino. Whenever Argentina has found itself in a tight pinch in the past, it has resorted to the printing of more fiat paper money. Since these experiments have always ended badly, the public responded by rioting and the Argentino never saw the light of day.
Blunder 12: Now the Duhalde government is on the verge of turning back the clock in Argentina. Indeed, by scrapping the Convertibility Law and devaluing the peso, as it proposes, it would engage in theft. Consequently, President Duhalde’s days in power will be numbered.
What should be done? The only way to re‐establish confidence and get the economy moving is to do what Ecuador did in 2000: The Argentine peso should be liquidated and the economy should be dollarized. The turnaround would be just as rapid as in Ecuador. In two short years, that country has pushed growth to the top of the South American charts, unemployment has fallen from 15% to 9% and 30‐day interest rates on deposits have fallen from almost 60% to 3.65%.
Dollarization is desirable, but is it feasible? In a word, yes. As of Dec. 27, 2001, the monetary base (monetary liabilities) of the central bank were 17.771 billion pesos. The central bank’s “pure” foreign reserve assets (in U.S. dollars) were worth 14.608 billion pesos, or 82.2% of the monetary base. In addition, the central bank holds 15.138 billion pesos of domestic assets valued at market prices which could be sold to acquire U.S. dollars. Consequently, the central bank could easily honour the peso holders’ property rights by liquidating its outstanding peso monetary liabilities (monetary base) and dollarizing the economy at the current official exchange rate of one peso to one U.S. dollar.
If Argentina should devalue the peso, it will be the first time to my knowledge that a monetary authority devalued its currency when the market value of its foreign exchange reserve assets exceeded the value of its monetary liabilities. Indeed, it would be an extremely rare event, one that would be irrational, if not immoral. After all, the law governing the peso is the Convertibility Law of 1991 and the official exchange rate under the law is one peso equals one U.S. dollar. Since the asset‐liability position of the central bank makes adhering to the law feasible, there is no reason for Argentina to flout the rule of law and abrogate the property rights enshrined in the Convertibility Law.
Argentina does not have a currency problem. Rather, it has a banking problem. In addition, Argentina has a political problem, manifested by the fact it has had five presidents in less than two weeks. Let’s hope the Argentine authorities come to their senses and honour the rule of law. If they fail to do so, expect more troubles — big troubles — in Argentina.