Nice article, but I never got why dollarization was such a good idea. If an overvalued currency had caused a recession, ¿the solution was a better overvalued currency? Instead of the quadruple D, the solution was the triple D, devaluation, debt writedown and default. It worked fine so far.

Hey, that was a good article.

One snippet caught my eye in the context of Bush's SS reform:

"But the problem with the [Bush] strategy ... is that the current government cannot commit future governments, nor can it commit the electorate."

Bush promises that benefits to current seniors would not be cut, but carving out a third of SS funding for private accounts would force future governments to borrow extensively to keep paying traditional SS benefits.

Anyone expecting to collect any traditional SS benefits in the next 45 years (the timeframe in which transitional borrowing to finance private addon accounts would continue to exceed the cost of "doing nothing" every single year) has plenty of reason to be skeptical whether future governments and electorates would continue to be bound by Bush43's rhetorical committments.

I think one factor which made the crisis intractable is not mentioned here. The Argentinian federal system doesn't work the same as in the US. At the time of the crash Argentinian states could borrow money without control by the central govt that the central govt was obliged to pay back. A reference is here:

http://www.yale.edu/leitner/pdf/PEW-SW.pdf

(See p. 15).

States had large obligations to pay public employees and pensioners, and were issuing payment in scrip (termed "patacones", after a cartoon's money).

I followed the Argentine crisis closely. Read the BBC news website daily and participated in the Argentine forum at the Financial Times online service. One of the most popular and heavily visited topics. The article by Eichengreen is interesting but readers should know that the IMF has a standard solution to any economic crisis which is fiscal austerity. It is totally rigid and unvarying in its approach so no matter what the subject country faces unless the IMF prescription fits the economic conditions, the result will be a steady worsening of the economy. This was the situation in Russia in the summer of 1998 until Yeltsin was finally ousted and replaced by Primakov and later Putin who then proceeded to ignore the IMF advice and restore the country's economy.

http://www.pkarchive.org/

July 15, 2001

A LATIN TRAGEDY
By Paul Krugman - New York Times

...Both the markets and the Argentine government are treating the issue as mainly one of deficit spending. Indeed, in a desperate effort to regain market confidence, President Fernando de la Rúa has called for draconian spending cuts.

But Argentina's fundamental problem isn't fiscal; it's monetary. Ten years ago Economy Minister Domingo Cavallo, the nation's economic hero, introduced a much- acclaimed monetary system, the nation's "currency board." Now he finds his handiwork threatened by that system's tragic flaw.

First, a word about the dire budget numbers you may have heard. Argentina, we are told, has a public debt equal to 45 percent of its G.D.P.; it has a budget deficit of more than 2 percent of G.D.P. Gee — the budget numbers are almost as bad as they were in the United States when the elder George Bush was president!

Why does a level of debt and deficits that caused only tut-tutting here create panic in Argentina? To some extent it's a vicious circle: because investors believe default is likely, they demand usurious interest rates that may well push the country into default. But the main answer is that behind a mildly troubled budget lies a deeply troubled economy.

Argentina's economy surged between 1990 and 1998, but it has been steadily contracting ever since. Unemployment, which stayed high even during the good years, has risen above 16 percent. This dismal performance contributes to the budget problem in at least three ways. A depressed economy means low tax receipts; it's hard to slash spending or raise taxes when the populace is already feeling a lot of economic pain; and it's hard to convince lenders that you will grow out of your problems when your economy is, in fact, shrinking. It's easy to criticize Argentina's political leadership for its inability to eliminate the budget deficit. But when did you last see our own leaders raise taxes and cut spending in the face of a nasty recession?

So why is Argentina's economy depressed? Basically it comes down to the currency board, which pegs the value of the peso at one dollar and ensures (technicalities aside) that each peso in circulation is backed by a dollar in reserves. When it was introduced this system offered a welcome guarantee that hyperinflation would not return, and contributed to a stunning economic recovery. Now, however, the system's fatal flaw has become obvious. Argentina's international competitiveness has been undermined by devaluation in neighboring Brazil and by the weakness of the euro; domestic demand has fallen as consumers and companies lose confidence; but because the currency board allows no flexibility in monetary policy, policy makers cannot respond, Greenspan-style, by opening the monetary spigots.

Mr. Cavallo, whom I know and admire (though I can't claim to have a sense of his soul) understands this very well. Yet he is understandably unwilling to abandon his creation. It would be a humiliating blow to his and his government's credibility. Also, because much of the debt of Argentina's private sector is in dollars, any devaluation of the peso would risk major financial disruption.

Yet if the latest desperate round of belt-tightening does not succeed, something will have to give.

Some Wall Street analysts believe that the Argentine government will default but try to keep the peso pegged at one dollar. Maybe — but that would be a bizarre strategy, choosing the worse of two evils. Advanced countries — the status to which Argentina aspires — regard default on debt as a mortal sin, but a sliding currency as at most a mild embarrassment. And default without devaluation, while easing Argentina's budget pressures, would do nothing to help its economy.

Meanwhile, the opposite strategy worked for Argentina's biggest neighbor. Two years ago Brazil was forced into a devaluation that many predicted would lead to economic ruin. It didn't. I hate to suggest that Argentina should emulate Brazil; indeed, I have been reluctant to say anything that would make Mr. Cavallo's job harder. But he and his country are rapidly running out of options.

December 1, 2001

ARGENTINA’S MONEY MONOMANIA
By Paul Krugman

...To get a perspective on Argentina’s situation, let’s remember what the currency board was supposed to accomplish. It was there to provide stability, and to create an environment in which free markets could flourish. Now look at Argentina today: it is anything but stable, with debt default looming. And it is surely a cruel irony that capital controls, limits on bank withdrawals, and regulation of lending are being imposed in the name of the currency peg.

At this point defending the currency board seems to have become a sort of monomania. Domingo Cavallo - whom I have known since we were both graduate students, who is a good man of great accomplishments - has lost sight of the fact that the currency board was a means to an end, not an end in itself. And it’s really sad to see him blaming foreign economists for his problems, when in fact Mussa and Haussman have shown great courage in their recent pronouncements.

Personally I don’t think it makes sense to keep quiet at this point. I think it’s fair to say that I always expected Argentina’s currency board to fail eventually, with the scenario for failure looking more or less like what we actually see today. But in the last year I’ve hesitated about saying that too forcefully, precisely because I did not want to be accused of setting off speculation against the currency. Now the government has imposed exchange controls, and in any case the bankruptcy of the currency peg is obvious. At this point a collapse would be better than prolonging the agony.

Why can’t the currency board survive? It is clear that Argentina suffers from a real overvaluation - that is, prices are too high given the exchange rate. The evidence is not complex: it lies in the fact of the prolonged recession and the slow, grinding deflation the country has suffered. In effect, the economy is “trying” to accomplish a devaluation through deflation; it is a very painful process.

Since the core of Argentina’s problem is the deflationary pressure imposed by an overvalued currency, dollarization offers no cure; it would end speculation against the currency, but do nothing about the underlying economic problem. The only way to end the economy’s pain is through some form of nominal devaluation, which ends the need for deflation.

The natural answer is to float the currency. Some have proposed an alternative - devalue, then dollarize. But it was always strange to peg the peso to the dollar, when the U.S. is by no means Argentina’s dominant trading partner. The peg made sense only as a way to provide clarity and credibility. Since that credibility will be lost anyway by devaluation, why lock the country into an inappropriate currency regime? Argentina’s location and export composition suggest that it should emulate other southern-hemisphere primary exporters, like Australia, and have a floating exchange rate.

Now comes the hard part. Isn’t it dangerous to devalue?

One risk is that hyperinflation will reappear. However, this is not a credible concern. Argentina has a depressed economy, in which prices are hardly likely to soar. Its hyperinflation is more than a decade in the past. And other emerging markets, notably Brazil, with more recent experiences of hyperinflation have nonetheless experienced devaluations with very little pass-through into prices.

The other, more serious concern, is that because of dollarized private debt a devaluation will cause financial problems. And this is a serious concern. However, the current strategy - which is essentially to achieve a real devaluation through deflation - offers no solution, because deflation raises the real value of debt just as much as devaluation. (This point is explained in Nouriel Roubini’s excellent new paper on Argentina, at http://www.stern.nyu.edu/globalmacro/).

It is highly likely that Argentina will have to do something to mitigate the effects of devaluation on internal debt. It could, as suggested by Ricardo Haussman, decree that private debts, even if denominated in dollars, can be repaid in pesos - a drastic step, but no more drastic than the draconian measures now being taken on capital movements and bank withdrawals. Or it could use public funds to compensate debtors for their capital losses, which would be administratively difficult - but no more so than the current capital controls - and would cost several percent of GDP, not a large sum considering the situation. We need a discussion of which alternative to follow; I’d vote for the simple decree, but could be persuaded otherwise.

The important thing is to accept that the fixed-rate regime is no longer worth defending. I don’t doubt that drastic measures can extend the life of the regime for a while. But as even the investment bankers are now saying, Argentina can buy time - but what will it do with that time? It’s time to call an end to a failed experiment.

Domingo Cavallo needed to drop the currency peg, but was continually urged to keep the peg as the economy first slowed, then entered a recession phase, and finally a depression. The peg had to be dropped, for Argentine currency was pricing its exports out of its neighbor countries and southern Europe. Drop the peg, but the peg was not dropped. Who can understand sacrificing a country to a depression for the sake of an arbitrary currency value.

The IMF asked of Argentina what China's leaders would rightfully never have accepted. Why did Argentina sacrifice middle and lower income households to a failing currency peg? Why not adjust? Why would the IMF not recognize the needs for adjustment? Imagine 15% and 20% unemployment for the sake of the peg. I still do not understand.

The reluctance to drop the currency peg is understandable if you see it in the context of Argentina recent history. After decades of triple digit inflation and a bout of hyperinflation, during which different governments tried unsuccesfully every anti-inflationary strategy known to man, the currency peg managed to beat inflation. Not only that, it was seen as the cause of an economic boom. For that reason, most argentine economists and politicians saw the peg in an almost fetishistic way, as a sort of talisman against inflation, unstability, poverty, etc. Also, you have to remember that most internal debt was dollar denominated. A devaluation was not costless.

Carlos

Agreed. Adjusting the peg would have a significant cost in meeting internal dollar debt. Also, remember that internal debt was significantly increased because of the privatization of the public pension scheme. But where Hong Kong had the needed surplus to keep the peg during the same period of a dramatic rise in dollar value, there was no recourse other than austerity for Argentina. Austerity in the grip of a developing depression is impossible. Brazil and Chile and Spain had depreciating currencies, and Argentina traded little with America, there was no rational choice. Hong Kong at least had substantial American trade as the American dollar strengthened.

The model for a developing country applying a peg would need to be China. Remember that China grew well through the period when the dollar was rising in value, and China was surely not about to be pushed to an austerity program to satisfy international investors. Currency controls were the protection China needed with the peg against a rising dollar. Again, though, China had a substantial trade with America but Argentina did not.

The topic and argument over the use of a currency peg in Argentina or China, or general monetary policy, is most important for developing nations. Brazil with a floating appreciating currency is rapidly growing, but now has interest rates over 19%. What of Brazil? What of South Africa or Nigeria or India? Will China continue to be successful in development with a currency peg?

I've already commented in the thread below on the very high human cost in terms of unemployment and wages of Argentina's alleged success in the 1990s, something Krugman also skates over much too blithely.

I'd add that the so-called "surge" between 1990 and 1998 needs a little qualification, in addition to the rather obvious point that it's an odd kind of surge that gives you 17% unemployment. There is a common boom-slump pattern in the aftermath of exchange rate-based stabilizations (ERBS) that is discussed here:

Ades, Alberto F., Miguel A. Kiguel, and Nissan Liviatan. Exchange-Rate-Based Stabilization: Tales from Europe and Latin America. Policy Research Working Papers Series 1087. Country Economics Department, World Bank, 1993.

and there's surely more recent literature. What differentiates Argentina is that the 1995 slump did not push them off the peg and they hung on for another half-decade, but at the cost of continued high unemployment and Ponzi finance.

Additionally, as the above-cited authors point out, the RER appreciation that happens in the initial "boom" phase of an ERBS damages one's ability to export, and I think if you did a decomposition of 1990s growth you'd find a lot of it in construction and nontraded services.

Finally, people don't realize how much a claim to hang one's "credibility" on a peg boxes in policymakers, and the "currency board" distracted a lot of people who wanted to believe it was more than just a peg plus an arbitrary monetary rule, which indeed is all it was. Part of the problem is a monetarist *political* logic that (a) insists that goverments continualy prove they are not wicked through some visible sign like an exchange rate, and (b) interprets foreign capital inflows, even under what are obviously Ponzi conditions, as evidence that gov't has credibility.

again, thanks colin. i like your perspective.

Krugman is certainly one of my favorites, but i can remember reading him while i was in argentina during the collapse, thinking, 'man he does't have any understanding of the social and political aspects of the crisis'

and by late 2001 cavallo couldn't leave his house. he was absolutely despised by the majority of the population.

People realize he ran against De La Rua in 99? while De La Rua campaigned against the sins of menem (of which Cavallo was part), 2 years later de la rua's asks cavallo to join his government. that was the end of whatever political credibility de la rua still had in the country. his days were numbered from that point on, regardless of what foreign economists prescribed as a way out of the crisis.

and never forget, it was not the foreign investors and markets that brought down de la rua. it was the argentine population. i was in the plaza de mayo on the 20th of dec. it was an incredible experience. never before had argentines "spoke out" like they did that day. truly inspirational.

if anyone is interested in seeing some stills from my doc. (ie the crisis) you can see them here:
http://stagefour.typepad.com/photos/argdocphotos/

(and contact me if you're interested in a copy- there are some comments from Argentine economists in the pic as well, also i'm not selling it, ie no cost, I just want people to see it)

my email: commonprejudice@yahoo.com.ar

Colin Danby:

- A central part of Argentine policy during the 1990s was a successful effort to reduce nominal (and, of course, real) wages, accompanied by high unemployment. Take a look at figures here:

http://www.econstats.com/IMF/IFS_Arg1_67R__.htm

It's not a pretty picture and you can't just blame it on the 1995 recession. So let's not forget the very high human cost at which the Argentine gov't "halted inflation." Might we rethink the assertion that the only thing that Argentina's gov't did wrong was to let debt rise too quickly? -

An international investment induced surge in economic growth that does not generate employment demand must be considered suspect of must be supplemented by a domestic stimulus program.

B. Hunter

Thank you :)

In addition to Colin's point that the Argentinian "boom" of the 1990's generated 17% unemployment (in fact, even at the top of the boom in late 1997/early 1998 the unemployment rate didn't fall below 12.5%) it should be mentioned that Washington Consensus-style regime of the Menem administration generated a classic privatization/capital inflow/rationalization effect that closed down many businesses and threw thousands of Argentinians per month out of work even as GDP started growing.

Under such conditions, it is very hard to engage in fiscal austerity even if the provincial government finances are under control. And Argentina's structural budget deficits were not larger than those of many neighboring countries, but were aggravated by ballooning interest rate and recessionary burdens.

In general, Argentina followed a classic political economic pattern: a country which loses a war and control of its finances during the same period slides into hyperinflation and manages to stabilize its prices only after imposing a hard currency regime. But as Colin points out, such an exchange rate based stabilization inevitably leads to overvaluation, loss of competitiveness, growing unemployment, and ballooning deficits as unemployment and debt-deflation mount up. Anyone who had made a careful study of Germany, or even Britain, in the 1920's could have predicted in 1991 the eventual fate of Cavallo's Convertibility Law without too much work. In that sense, the economic lessons of history have to be relearned by successive generations.

Re:

"An international investment induced surge in economic growth that does not generate employment demand must be ... supplemented by a domestic stimulus program."

That might indeed have raised employment. But by the logic of "credibility," an indebted, adjusting gov't is supposed to be cutting spending and raising taxes, and in general displaying its readiness to inflict pain on its population. The worst thing a gov't can be accused of in this framework is "populism." I'm still not clear how this frame differs from the clinical rhetoric of "doing things right" that Brad and Paul Krugman employ.

A comment on Brad's temporal framing: how much insight do we really generate by a focus on the last couple of years of the peg? Everything Barry Eichengreen writes is interesting, but by mid-01 the train wreck was well underway. There's a certain morbid fascination to watching the final dissolution of a Ponzi scheme, but folks should have been more critical during the so-called boom.

June 13, 1995

Monetary virtue leads two-peso tussle
By Paul Krugman

Which is better, a fixed exchange rate or a flexible one? No question in economics has been debated more fiercely or more inconclusively. The reason is that neither system is without its flaws, and nobody has been able to quantify the trade-off.

Nor, usually, is history much of a guide, because one never sees a controlled experiment: if the world economy was more stable during the fixed-rate era from 1950 to 1973 than during the floating-rate era that followed, who is to say that the instability did not originate in the real economy and spread to exchange rates, rather than the other way around?

Over the past six months, however, we have seen what looks like an unusually clear-cut test between fixed and floating rates in Latin America. On the face of it, a rigid commitment to a fixed rate has won hands down. But the test is not over yet; a come-from-behind victory for floating rates is still a possibility. Until late last year, Mexico and Argentina were often discussed by economic analysts in the same breath. After seven lean years of debt crisis, both had emerged through a combination of market-oriented reforms and an abrupt return to the favor of international capital markets. Both had brought down inflation, largely through the use of a strong peso as a signal of their commitment to price stability. And both had resumed growth after years of stagnation.

The difference between the two nations' economic policies, it seemed, was a matter of detail. Mexico had followed a strong peso policy, but without committing itself to a fixed exchange rate. Argentina, on the other hand, had tied itself to the mast with a policy borrowed from the colonial past: not only was the government constitutionally committed to a one-peso-one-dollar policy, but every peso in circulation was backed by a dollar of foreign exchange reserves.

Then came the crisis. In December, under the pressure of speculative capital flight, Mexico wavered: rather than defend the peso by whatever means necessary, the country devalued its currency. As it turned out, the devaluation was enough to shatter the government's credibility but not enough to satisfy the speculators, and the half-measures quickly turned into a rout that drove the Mexican peso to half its previous value. Eventually the currency stabilized, but only after interest rates had been increased to 60 per cent.

The shock quickly spread to Argentina; but that country refused to contemplate any change in its exchange rate. For a time it looked as if the drain of pesos out of the banking system would lead to financial collapse. But, with a lot of help from Argentina's friends, that crisis seems to have been surmounted.

For those who believe that nothing good can come out of devaluation, it all seems like an object lesson. Mexico gave in to the pressure to devalue; Argentina did not; and so far Argentina has had much the better of it.

But the story is not yet over.

The pressures that led to the Mexican devaluation were not, ultimately, financial. Rather, they came from the real economy. Mexico's strong peso policy brought down inflation, but not all at once. By the time inflation was nearly down to US levels, many Mexican exports had been priced out of US markets. Meanwhile, the combination of the strong peso and trade liberalization had brought on an import surge. The result was that the massive inflows of capital during the good years brought surprisingly little growth in the domestic economy, and no growth at all in employment. It was the mounting pressure to do something to improve this performance - helped by internal political unrest - that eventually made financial markets wonder whether the peso would remain strong, and brought on a currency crisis.

The point is that with the peso devalued, however messily, those have become problems of the past. Mexico's domestic economy may be prostrate; but it is already running a trade surplus and exports are surging. Within two or three years, we may be marveling at how Mexico has, at last, become a fast-growing, export-oriented economy.

Meanwhile, Argentina has weathered the immediate storm; but the problems of a severely overvalued peso, which have made Buenos Aires one of the world's most expensive cities and hobbled attempts to develop new exports, remain unresolved. They will be unresolvable as long as the credibility of the government is bound up with one peso, one dollar.

So round one has ended, and old-fashioned monetary virtue is leading on points. But I will still bet that by the end of the bout we will see, once again, that things are not that simple.

Colin Danby and Andres

Though Paul Krugman was not tough enough in 1995 in questioning the difference between a strong currency and a strong economy, still the difference was ominously noticed. Again, it is clearer all the time why China has taken such precautions in currency policy.

The more I consider Argentina, the more I am convinced China has used currency policy properly till now. There will come the needed change, but China has insulated itself from currency speculation, controlled inflation, allowed for steady trade growth, and avoided any austerity pressure. Infrastructure development has been significant, where Argentina would never have been able to implement such a domestic development program.

Wow, what an interesting discussion, esp to a non-economist who nevertheless tried to follow the match blow-by-blow through the nineties. And as Krugman predicted in 1995, the story ain't over yet.

Thanks Anne for the '95-vintage Krugman. One might quibble with some of his Mexico assessments, but you're quite right that he caught Argentina's fundamental BoP problems.

And thanks Andres for the reminders about Europe. One thinks of Keynes' argument against Britain going back onto gold in which he pointed out that driving down miners' nominal wages was not going to be pleasant. I wonder if anyone has traced out the effects within the Argentine economy of the lower wages.

Andres and Colin Danby

Clever posts reminding us of Keynes warning to Britain. An annoyance I have had is how easily ignored were the effective Argentine wage limitations. Wall Street Week with Lou Rukeyser was filmed in Buenos Aires late in the 1990s, and I can remember the gloating over the peg with a sneer or so at Brazil and the unreal sense that the currency peg was a revolutionary development tool. "For whom," I wondered?