Link to US dollar has hurt Argentina

Events in Argentina, where the government is caught between devaluing the Argentine peso and turning entirely to the United States dollar as a currency, provide an object lesson in what bad monetary policy can do.

Through the postwar period, Argentina has lived through long periods of economic mismanagement punctuated by short periods of economic crisis. A culture of Peronism sought economic self-sufficiency, without accepting that this demanded that the country turn its back on trade. Its emergence, since the late 1980s, as a trading nation ranks as a powerful national achievement.

Since 1991, Argentina has managed its currency by making its peso fully convertible to U.S. dollars, at par. It adopted the policy following a disastrous episode of hyperinflation in the early 1990s, when the central bank allowed the money supply to grow without restriction. Prices changed by the hour, people rushed to spend their un-indexed paycheques, and the central bank lost all credibility.

At first, the new policy, managed by a currency board independent of the government, was highly successful. The currency policy had the luck to hit a long period of international economic growth, which meant healthy inflows of foreign exchange, and the gurus of international finance held the country up as a shining example of what monetary discipline could do. (Their usual counter-example was Brazil, which they found a dangerously lax economy deeply beholden to entrenched interests, unlike their golden boy.)

People whose measure of recession is the performance of the Standard & Poors 500 Index often prove to be unaware of this, but global recession started in 1997, not in the first quarter of 2001, and it was the Asian currency crises that brought it on. The mining industry knows this, from unhappy experience with commodity prices.

That recession hit the Argentine economy hard, because, even though highly industrialized, it has a significant commodities base. Argentina’s neighbour and principal Mercosur trading partner, Brazil (the same Brazil the financial commentators found wanting), freed its currency to find a new (and much lower) level against the U.S. dollar, and its trade deficit shrank. Argentina, tied to the fixed-rate regime, could not, and its trade surplus has dwindled.

As economist Samuel Brittan has pointed out, the only meaningful definition of a country’s “competitiveness” is its exchange rates, which at least can be measured numerically. And competitiveness, so defined, is an undervalued currency. Argentina became uncompetitive, particularly in Mercosur, precisely because the Argentine government had given up its ability to manage its own monetary policy.

(This was a shame. There is good reason to believe the government would have followed sound monetary policy, because it had been a model of fiscal rectitude. With a deficit of less than 3%, and a total debt of less than half of its gross domestic product, it had done better than a number of G7 countries.)

Inevitably, the crunch came. This summer, whispers of portended default pushed up long-term interest rates. The government did what it could with the tools to hand — it tightened the public belt and covered its expenses by raising taxes, to avoid pushing the country further into a debt trap. But it had no ability to devalue, and no floating rate to do the devaluing for it; and tight fiscal policy contributed to the recession.

The bond markets, in applying heavy discounts to Argentina’s government bonds, have obviously decided the U.S. dollar peg cannot be maintained; and in the self-fulfilling way of markets everywhere, the discounts will themselves make it impossible for the Argentine currency board to defend the fixed exchange rate.

(It is also worth noting, at this point, that the currency board, however independent it may be of government control, still relies on government holdings to provide the foreign exchange reserves that allow it to defend a dollar peg. Spending someone else’s money, particularly the taxpayers’, is nice work if you can get it.)

Argentina may default, or it may find a way to devalue that, in effect, unilaterally rewrites its debt obligations. Neither choice is attractive, but whatever Argentina does, there is a lesson in its situation for Canadians, who are again being lectured about the wonders of dollarization.

We have a currency that has fallen considerably against the U.S. dollar in the past four years, and has steadily shrunk in U.S. dollar terms since the mid-1970s. Our nominal gross domestic product, per capita, has gone from being nearly equal to that of the United States to just over three-quarters of it. This has led a number of economists, policy wonks, and related talking heads to pronounce that now is the time for the adoption of either a “common” North American currency or for Canada to exchange its own money supply for U.S. dollars. Significantly, newspaper pollsters — the agents provocateurs of economic policy — found strong support for dollarization among business people.

Yet we see in Argentina what can happen when monetary policy — or, to be precise, non-policy — takes no account of a nation’s unique economic circumstances. Had Canada wanted a severe recession when the Asian tiger markets collapsed in 1997, we could have had one, either by defending a fixed exchange rate or by pure dollarization. Instead, the central bank let the dollar fall, and we avoided recession until 2001. That bought three years of improving government finances: our public debt is now below half of the gross domestic product, too, and it was economic growth, not fiscal austerity, that got us there. It bought a cushion of personal savings that is helping the economy ride out the current slowdown.

Support in the business community for economic quackery is not new. But to keep coming back for more of it when a cruel counter-example tells you all you need to know begins to look like purblindness.