Until recently, stable money and sound banking were the two pillars of an otherwise weak Argentine republic. As Argentina confronts its fourth year of recession and finds itself bankrupt, many are now blaming its monetary regime, which delivered that stability and soundness.
In fact, it's government tinkering with the monetary regime and the banking system, coupled with antigrowth policies, that spawned economic chaos. These experiments on an unwilling patient, if they continue, will prove fatal.
To put an end to monetary mischief and rein in hyperinflation, Argentina established an unorthodox currency-board system in 1991. Argentines call the system "convertibility." Like all currency-board arrangements, convertibility has maintained a fixed exchange rate between the peso and its anchor currency, the U.S. dollar. The system has checked inflation: The consumer price index today is about where it was in 1994. In addition, it has imposed a hard budget constraint on the banking system, forcing banks to clean up and strengthen their balance sheets.
As Kurt Schuler and I have pointed out, there is a problem with the convertibility law: It allows the Central Bank to behave more like a traditional central bank than a true currency board. Each quarter the Central Bank of Argentina publishes a "Bulletin of Monetary and Fiscal Affairs," and each issue contains a long list of measures that have been taken by the Central Bank. If the Central Bank was operating as an orthodox currency board, these pages would be blank. For all its warts, however, convertibility has been the key to Argentine economic survival over the past decade.
If convertibility is not the problem, then what is? During the glory days of economic and structural reform (1990-94), President Carlos Menem maintained a unified command of the political scene. The reforms -- which were developed without the IMF's guiding hand -- were simple and implemented with speed in large packages. The results in the 1990-94 period were spectacular. GDP per capita measured in dollars increased by 72.8 percent.
In the wake of the 1995 Mexican peso devaluation, Argentina's reform agenda lost momentum. Even though the country pulled out of the crisis and GDP grew at a 7 percent clip in the 1996-97 period, it never regained its former vigor. When Fernando de la Rua became president in December 1999, things went from bad to worse. His administration's new economic plan, the brainchild of the IMF, was supposed to lower interest rates and produce a boom by raising taxes, which was meant to reduce the government's deficit. Its timing was awful.
World interest rates in December 1999 were on the rise. So Argentina's rates rose with the rest and the economy slumped further into recession. Argentina was headed for a crisis of confidence, one that would plunge the economy into a deeper recession and cause debt-servicing problems. The rest is history, almost.
>From there the De la Rua administration would commit a steady stream of policy errors that would undermine the successful reforms of the early 1990s: stable money and sound banking.
Domingo Cavallo became Argentina's economic czar in March 2001, and these errors were engineered on his watch, despite the fact that he had implemented the original reforms. The undermining of convertibility started with what appeared to be a banking scandal. Two banks with relationships with Citibank stood accused of involvement with money laundering. Pedro Pou, the governor of the Central Bank, found himself at the center of the firestorm. Mr. Pou's enemies wanted a replacement that would loosen convertibility's straitjacket. Without support from the president, Mr. Pou was ousted, and, yes, without him, the Central Bank has further undermined convertibility.
In June, Mr. Cavallo introduced a dual-currency regime. Under this setup, all exports (excluding oil) take place with a devalued peso; all imports with a revalued peso. All other transactions take place at a peso-dollar rate of one-to-one. Then a law was passed in which the peso's anchor will switch from the dollar to a basket of 50 percent euros and 50 percent dollars once the euro reaches parity with the dollar.
The markets viewed these changes by Argentina as moves to eventually abandon convertibility. They were not reassured when, on July 9, Agence France Presse quoted Mr. Cavallo as saying that Argentina "will leave the peg one day." External drains of the Central Bank's reserves picked up speed and interest rates shot up in anticipation of an exit and a devaluation. The economy continued its slump and Argentina's ability to service its debts was thrown further into doubt.
As recently as Nov. 16, Mr. Cavallo has attempted to assure the markets by stating that, if things got much worse, Argentina would adopt either the dollar or the euro. The euro? That specter has kept the devaluation flame alive, stimulated more speculation against the peso, increased external drains from the Central Bank, and increased interest rates.
And what about those sound banks? They have not escaped. To reduce the government's debt servicing costs, Mr. Cavallo has engineered a "voluntary" debt swap. As part of their patriotic duty, the Argentine banks have agreed to swap high-yielding for lower-yielding bonds. This put a dent in their balance sheets. Depositors have continued to pull out their funds, pushing up interest rates, a further blow to the economy and its ability to generate taxes to service government debts.
On Monday, in order to check interest-rate hikes, the Central Bank introduced mechanisms to average down interest rates offered by the banking system to depositors. Under a currency-board arrangement, these price controls are a strict no-no because they undermine the automatic adjustment features of the system. Why would a depositor keep funds in a bank that isn't paying for the risks involved? Interest-rate caps promise more internal drains from the banking system.
Short of official dollarization, it might be too late to head off a full-blown financial meltdown. But no matter the outcome, the facts of the case should be preserved and advocates of sound money must not allow revisionists to prevail. The convertibility law brought Argentina stable money and sound banking. An inept government that assaulted convertibility and the banking system and embraced antigrowth policies produced the crisis.