Argentine Endgame: Couple Dollarization with Free Banking

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Argentina's currency board, which hasmaintained a fixed exchange rate with thedollar since it was created in 1991, hasworked well to eliminate inflation andestablish monetary stability. But the currencyboard has not been trouble free,because the system has deviated fromorthodox currency board rules. There hasbeen speculation that the governmentmight abandon the peso. As a consequenceof the exchange-rate risk created, interestrates have soared.

Those problems have put an otherwisesound banking system under stress asdeposits and reserves have fallen. The resultingfall in reserves has reduced bank lending,worsening Argentina's ongoing recession.

To avert a financial crisis and spur economicgrowth, Argentina should officiallydollarize its economy by replacing the pesowith the dollar. It should also allow banksto issue their own dollar-denominatednotes. Dollarization combined with competitivenote issue by private banks--or freebanking--would eliminate the risk of devaluationof the peso and capture seigniorage,the profit from issuing notes, that wouldotherwise accrue to the U.S. government.

By ending currency risk and increasingreserves, a policy that allowed free bankingand eliminated the peso would result in aloosening of monetary policy and greaterconfidence in the banking system. Bank-issuednotes are nothing new, and historyshows the advantages of free banking overcentral banking for Argentina. Under freebanking, inflation would continue to be lowand the banking system would be stable.

There are no constitutional barriers toArgentina's dollarizing and allowing freebanking. Because monetary policy alonecannot sustain growth, the country mustalso introduce a range of fiscal, legal, andsupply-side reforms.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at Johns Hopkins University in Baltimore, Maryland; chairman of the Friedberg Mercantile Group of New York; and a senior fellow at the Cato Institute.