THE deepening crisis in Argentina is more than just the latest emerging-market meltdown. The country's troubles come with a twist. A decade ago Argentina fixed its currency, the peso, against the dollar in an unusually binding way. This arrangement worked fairly well, promoting stability and growth for much of the 1990s. Now it is being blamed for Argentina's plight.
A currency board fixes Argentina's exchange rate. The central bank maintains foreign reserves to back the (narrowly defined) money supply in full, implicitly promising to convert all local currency into dollars if need be. This makes the peg as credible as it can be, short of outright dollarisation. In principle, it should immunise the economy against the sorts of speculative attacks that plagued South-East Asian countries in 1997-98.
In the 1990s, currency boards were widely regarded as a good solution for economies troubled by high inflation and financial instability. Steven Hanke of Johns Hopkins University, for one, travelled the world urging poor countries to adopt the method. A few successes—Hong Kong (pegged since 1983), Bulgaria and Estonia—supported currency boards' reputed stabilising powers. Argentina had suffered a decade of rising inflation, and two bouts of hyperinflation, when the economy minister, Domingo Cavallo, introduced a currency board in 1991. At first the results were impressive, but now the economy is in a hole. Where does this leave the currency-board debate?
Rudiger Dornbusch of MIT, not shy of contrarian positions, has published a new defence of currency boards. He argues that, Argentina notwithstanding, boards have virtues that can outweigh their drawbacks*.
As Mr Dornbusch concedes, currency boards involve costs, from the political to the practical. First, countries must swallow their pride and abandon their “monetary sovereignty”: henceforth, interest rates are set not locally but, in effect, in Washington, DC, or Frankfurt. Second, currency boards require the government to give up seignorage—the implicit profits from printing money. Third, the fixed exchange rate can get badly out of line with those of trading partners. A strong dollar has hurt Argentina, while its neighbours have devalued to boost their economies.
Yet the benefits are great, too. One is lower inflation. Another, which Mr Dornbusch emphasises, is that currency boards help to curb wasteful government spending. The inability to rely on printing money to finance deficits focuses minds wonderfully. In the five years after the introduction of the currency board, Argentina pruned spending and subsidies dramatically. This did not happen at the expense of economic growth: the economy grew on average by 6% a year during 1991-96.
According to Mr Dornbusch, the causes of Argentina's current troubles are deeper than its overvalued peso. They include the legacy of high debt and earlier deficits, trade unions that have consistently thwarted reform, and obsolete industries producing goods so shoddy that they would be uncompetitive at almost any exchange rate.
In fact, it is wrong to separate all these issues from the currency-board debate. Argentina's notoriously intransigent unions were always likely to make it harder to get good results from a fixed currency. And although the currency board stopped the government from printing money, it enabled excessive borrowing from abroad—a big part of the crisis now. Still, Mr Dornbusch's main point, that it is wrong to blame the currency board for all of Argentina's ills, is surely right.
Today, currency-board sceptics point to Brazil. Like Argentina, it struggled with years of high inflation before taking its own reform path. It chose to manage exchange rates after introducing a new currency, the real, in 1994. Arminio Fraga, in charge of Brazil's central bank (and a former student of Mr Dornbusch), managed to convince the markets that this was the better approach—notably in January 1999, when a speculative attack forced a devaluation in the real. Then, Brazil saw only a blip of inflation and a relatively brief pause in growth.
Does the comparison between Brazil and Argentina settle the matter? Not really. Brazil has been fortunate to have a skilled and convincing central banker, and a government dedicated, for a time, to fiscal prudence. (Lately, this commitment has waned, and inflation is rising.) All Brazil and Argentina really prove is that no currency regime is a cure-all, and that there is no substitute for sound fiscal policy.
If Argentina breaks its dollar peg, as now seems likely, it will be wrong to declare currency boards a menace under all circumstances. For many countries—especially if they are small, open to trade and lacking a central bank with inflation-fighting credibility—they may be the best insurance against hyperinflation. For larger countries, such as Argentina, the choice of foreign-exchange regime is bound to be more difficult. Thanks to the currency board, Argentina cut inflation and held it down. And Argentina has suffered plain bad luck in the recent, possibly anomalous strength of the dollar.
If, a decade ago, Argentina had known what it knows now, would it have chosen a currency board? Probably not. But even as default looms, it would be wrong to conclude that Argentina's policy has been an unmitigated disaster, or that, regardless of circumstances, a currency board is always the wrong solution.
*“Exchange Rates and the Choice of Monetary-Policy Regimes”, by Rudiger Dornbusch. American Economic Review, Volume 91, Number 2. (Mr Dornbusch's paper is posted with a different title at the above link.)
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