Received Ideas

This article appeared in Forbes on May 13, 2004.

Military History Is Written By The Victors.Economic history is written, to a degree,by central bankers. In both cases you haveto take official accounts with a large doseof salt.

You thought you knew that the Duke ofWellington whippedNapoleon at the Battle ofWaterloo. But according to the experton Waterloo, Peter Hofschröer, Wellington’s army of 68,000men was locked in a bloody stalemate with Napoleon’s force of73,140 until late in the afternoon of June 18, 1815. That’s whenField Marshall Blücher’s 47,000 Prussian troops entered the fieldof battle and turned the tide.

The Iron Duke’s officialaccount has Prince Blücher failingto arrive until early eveningand with only 8,000 troops.Somehow 39,000 Prussians sim​ply​van​ished​.As they say, the restis history — history literally aswritten by Wellington.

Doctored accounts oftengain wide circulation in thesphere of economics, too. In2002 Argentina devalued thepeso, defaulted on its debt andwas engulfed in economic chaos.Why? Most commentatorspointed their accusatory fingersat Argentina’s monetary regime. For example, Paul Krugmanrepeatedly used his New York Times column to castigate theArgentinean convertibility system.

Krugman (and the rest of the herd) claimed thatArgentina’s monetary setup was governed by currency boardrules.Accordingly, from April 1991 until Jan. 6, 2002, the centralbank’s hands were tied and domestic monetary policy was ver​boten​.In addition, he claimed that the peso’s one‐​to‐​oneexchange rate with the dollar was overvalued, rendering Argentineanexports uncompetitive. Does this story hold water?

A currency board issues a domestic currency convertibleinto a foreign reserve currency at a fixed exchange rate. Toensure convertibility, it holds foreign reserves equal (orslightly greater) in value to its monetary liabilities. It thereforeoperates as an exchange house with a balance sheet thatcontains only foreign reserve assets and domestic monetaryliabilities. Consequently the domestic money supply automaticallyfluctuates in a one‐​to‐​one correspondence withchanges in a currency board’s foreign reserves.

Unlike a currencyboard, Argentina’s central bank could accumulate foreignreserves in excess of itsmonetary liabilities and couldhold domestic assets. These featuresallowed it to engage in discretionarymonetary policy andto break the link betweenchanges in its foreign reservesand the domestic money supply.

During the period when thecentral bank operated under theconvertibility law of 1991, it aggressivelyused its discretionary powers. Indeed, it neutralized viaopen market operations 59% of the changes in its foreign reserves​.In 2001 neutralization was dramatic. Foreign reserves fell by $12billion, but the central bank more than offset this dramatic declineby issuing peso liabilities and purchasing domestic assets.

The Argentinean monetary regime’s reputation as a currencyboard represents a classic case of mistaken identity. The centralbank’s hands were anything but tied, allowing it to practice ahyperactive monetary policy. That was the system’s fatal flaw.The peso overvaluation/​uncompetitiveness story also fails.If that story were true, exports would have been sluggish ordeclining during the 1991 – 2001 period. In fact the volume ofexports was relatively robust when the peso was linked to thedollar. The average annual export growth rate (measured byvolume) was a brisk 7.8%.After the devaluation export volumeshave grown at only a 3% annual rate.

So much for received ideas. Where does all this leave ustoday? Argentina finally bounced off the bottom. In the lastquarter of 2003 the real gross domestic product was 11.3%higher than in the same period in 2002. As a result of its recentgrowth spurt, Argentina’s real GDP is now where it was at theend of 1996. Can sizzling growth be sustained?

To answer that question we have to go back to the devaluationof 2002. It was not a garden‐​variety devaluation. Whatmade Argentina’s monetary regime unique in the predevaluationperiod was its explicit redemption pledge. Each personwho owned an Argentinean peso was guaranteed the right toconvert a peso for a U.S. dollar. When the redemption pledgewas revoked, the government confiscated $17.8 billion of centralbank reserves that had been the property of people whoheld pesos. Talk about a bank robbery!

As a result of that bank heist and the embrace of neopopulistpolicies, the rule of law in Argentina remains in shambles. Thosewho expect a sustained boom will, therefore, be disappointed.Argentinahas a long way to go to make amends for its past sins.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute.