Download davies on argentina

Michael Davies
ECO 460
Professor Malamud
Final Paper – Q #14.6
Argentina’s One-Handed Reform:
The Limits of Fixed Exchange Rate Systems1
This week, as I begin to write on Argentina’s currency reform conundrum, The
Economist recounts President Truman’s frustration over two-handed economists. “All my
economists say, ‘on the one hand…on the other hand2.’” As Argentina entered the 90’s,
they faced the choice to maintain control over monetary policy, but risk run away
inflation and capital flight on the one hand, or on the other they could establish a fixed
exchange rate to create greater stability and certainty but lose policy flexibility. Enter
Domingo Cavallo, the one-handed economist. In effect, his bold initiative (the currency
board) reproduced the gold standard. Fixed exchange rates, at the cost of lost monetary
policy options, appeared to solve Argentina’s economic ills; however, the chosen solution
later became the Achilles heal of the Argentine economy. By 1995, the limits of the
Currency Board, the body charged with maintaining the fixed exchange rate, were being
stretched. By 2001 it completely collapsed.
What was Cavallo’s bold initiative? Does it explain the subsequent boom? Does it
also explain the ultimate bust? It appears as though Argentina’s troubled political heritage
sets the stage for chosen economic reforms. Therefore, following a brief overview of
Argentina’s political history is an outline of the initiatives established to control run away
inflation and stabilize prices. Next is a look at the short-lived boom period. Inevitably,
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Subsequent footnotes follow no particular format.
Qtd in The Economist, “Face Value: The One-handed Economist.” Nov. 15, 2003; p 62
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these policy choices came up against challenges and eventual collapse. Last are a few
notes to summarize the process in terms of economic theory. Ultimately, this paper
suggests that fixing an exchange rate is at best a short-term solution. Argentina chosen
solution may not have been a mistake of choice so much as a mistake in not developing a
timetable and exit strategy.
By the 1989 election of Carlos Menem as Argentina’s President, Argentina had
limped through four decades of protectionism, monetary abuse (printing money for shortterm objectives), and extreme structural inefficiencies. In addition, “the bloodiest military
government in recent South American history held power in Argentina from 1976 to
1983.”3 Although democracy returned to Argentina in 1983, the macroeconomic
mismanagement continued. In the 1980’s Argentina suffered two bouts of hyperinflation
separated by periods of high inflation.
In 1991, Menem brought in Domingo Cavallo as economy minister to develop the
strategy that would later be praised, but later vilified. Cavallo appeared to respond to
deep Argentinean, more specifically - possibly his own, distrust of government’s ability
to exercise restraint with respect to monetary policy. His solution was to create a
Currency Board, which fixed Argentina’s peso (previously called the austral) to the
American dollar. By eliminating the government’s ability to play with the money supply,
the fixed exchange rate killed inflation, stabilized prices. In addition, increased
confidence in the predictability of the peso’s future value encouraged capital inflows. In
one move, Cavallo seemed to have solved Argentina’s greatest problem.
Within the broader picture of fiscal and structural reforms such as removing
barriers to trade, privatization, and deregulation, the Currency Board appeared to lead to
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The Economist, “A Full Stop Removed.” September 6, 2003; 33
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an economic boom. Despite giving up the flexibility of monetary policy options, from
1991 to 1995 the Argentine economy grew at 8% per year with rapid increases in
productivity and foreign investment.4 In addition, the fixed exchange rate allowed for
magnified returns to expansionary fiscal policy. Expansionary policy that put pressure on
the exchange rate to appreciate was offset by the Currency Board’s sale of domestic
assets. This prevented Argentine prices from becoming less competitive while increasing
demand for goods and encouraging further output.
Cavallo and Menem were hailed as heroes and Argentina appeared to be a model
for Latin American economic reform. However, soon the recovery began to hint of a
house of cards. The Mexican financial crisis and plummeting peso lead investors to
speculate that Argentina was within the range of this contagion.5 Fearing collapse of the
Currency Board and devaluation of the Argentinean peso, investors began trading in their
pesos for foreign reserves; 18% of bank deposits fled the country. This capital flight
drove up interest rates, and subsequently GDP fell 4%.6 In 1998, Russia decided to
default on its loans. Again, investors feared Currency Board collapse and peso
devaluation. Capital flight ensued, however, the Currency Board survived. Despite facing
the shortcomings of the Currency Board system, Argentina continued to cling to the fixed
exchange rate dogma.
Almost immediately after the Russian default, Brazil devalued its currency
(1999). Brazil is Argentina’s largest trading partner. Now, with a fixed exchange rate,
Argentina’s goods became less competitive relative to Brazil’s. Possibly the final blow
The Economist, “Keeping Reform Alive.” October 10, 1999. www.economist.com
Krugman, Paul and Obstfeld Maurice, International Economics: Theory and Policy. Addison Wesley:
Boston 2003; p 685
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The Economist. “Argentina’s Collapse,” February 28, 2002. www.economist.com
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came in 1999 to 2001 when the US dollar appreciated forcing the peso to appreciate and
making Argentine goods even less competitive. Now, in addition to an incredibly
weakened banking system, Argentinean prices were that much more uncompetitive.
A fixed exchange rate means Argentina’s currency is unable to respond to
external shocks, in particular to sudden shifts in commodity prices (farm products). If the
currency had been floating, the exchange rate would adjust to shocks. However,
Argentina’s fixed exchange rate meant that wages and prices had to adjust. In the absence
of adjustments, goods to became less competitive. Falling exports means that Argentina
is taking in less foreign currency, which makes repayment of foreign debt difficult. This
leads to a “liquidity squeeze” exacerbated by capital flight.
During this period, Argentina was unable to prop up its currency through
monetary policy. Their desperate clutch on the fixed exchange rates dogma is likely the
legacy of decades of governmental abuse under floating and pegged rates. Therefore, they
feared adopting a floating exchange.
However, on April 28, 2002 Argentinean banks allowed the peso to trade freely.
Immediately the peso dropped to about 2:1 relative to the dollar. This comes with great
costs. Not only was there rapid inflation, but also an environment of uncertainty and
investor panic. In addition, most contracts, leases, and saving accounts were denominated
in US dollars. Repayment had become extremely expensive.
The new monetary religion as advocated by the IMF that displaced the old dogma
of fixed exchange rates is “inflation rate targeting.” Argentina will maintain a target
inflation rate, with the money base as a monetary anchor, in the context of a floating
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exchange rate regime.7 The primary benefit to gaining monetary policy flexibility is the
ability to adjust to the external shocks that have plagued Latin American countries. The
irony is that taking this step may create long-term confidence that the exchange rates and
Central Bank can adjust, respond, and survive inevitable external shocks.
In light of the last two decades, one cannot help but ask whether it was a mistake
to have adopted the fixed exchange rate strategy. Despite the sacrifices of giving up
control of monetary policy, a country in the extreme condition that Argentina found itself
may gain greatly from fixing the rate. Prices desperately needed stabilizing and
confidence needed developing. The mistake may not have been fixing the exchange rate
so much as it was to cling to it beyond its usefulness. Evidence from the Gold Standard
era allows us to predict the long-term outcome. Cavallo’s bold one-handed strategy was
effective in the short-term. Unfortunately, he did not have exit strategy. Of course, this
introduces the difficult question regarding how long a country can safely adopt a fixed
exchange rate. If Argentina’s experience is any indication, a country needs to get out
within a few years. On the other hand, maybe they can skip this difficulty by directly
baptizing themselves in the new religion of inflation rate targeting.
IMF. Argentina – Letter of Intent, Memorandum of Economic and Financial Policies, and Technical
Memorandum of Understanding. Buenos Aires, Argentina. September 10, 2003. www.imf.org
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