1. What was the impetus for Argentina's currency board system?
2. How successful was Argentina's currency board?
3. What led to the downfall of Argentina's currency board?
4. What lessons can we learn from the experience of Argentina's currency board?
Argentina, once the world's seventh-largest economy, has long been considered one of Latin America's worst basket cases. Starting with Juan Peron, who was first elected president in 1946, and for decades after, profligate government spending financed by a compliant central bank that printed money to cover the chronic budget deficits had triggered a vicious cycle of inflation and devaluation. High taxes and excessive controls compounded Argentina's woes and led to an overregulated, arthritic economy. However, in 1991 after the country had suffered nearly 50 years of economic mismanagement, President Carlos Menem and his fourth Minister of Economy, Domingo Cavallo, launched the Convertibility Act. (The first Minister of Economy, Miguel Roig, took one look at the economy and died of a heart attack six days into the job.) This act made the austral (the Argentine currency) fully convertible at a fixed rate of 10,000 australs to the dollar, and by law the monetary supply had to be 100% backed by gold and foreign currency reserves, mostly dollars. This link to gold and the dollar imposed a straitjacket on monetary policy. If, for example, the central bank had to sell dollars to support the currency, the money supply automatically shrank. Better still, the government could no longer print money to finance a budget deficit. In January 1992, the government knocked four zeros off the austral and renamed it the peso, worth exactly $1.
SOLUTION
1. Argentina had suffered for decades from a vicious cycle of inflation and devaluation. The currency board system was an attempt to break that cycle and help stimulate economic growth. It would also ensure that the government could no longer print money to finance a budget deficit. By effectively locking Argentina into the U.S. monetary system, the currency board system mandated by the Convertibility Act had remarkable success in restoring confidence in the peso and providing an anchor for inflation expectations.
2. The object of the currency board was to end the inflation-devaluation cycle that had plagued Argentina for some 50 years. From that standpoint, the currency board succeeded. It spurred rapid economic growth, led to a rock-solid currency, and ended hyperinflation. The peso was fixed at one dollar and inflation plummeted, falling from more than 2,300% in 1990 to 170% in 1991 and 4% in 1994. By 1997, the inflation rate was 0.4%, among the lowest in the world. Argentine capital transferred overseas to escape Argentina's hyperinflation began to come home. In response to the good economic news, stock prices quintupled, in dollar terms, during the first year of the plan.
3. The downfall of Argentina’s currency board stems from a series of external shocks and internal problems that were suffered by the Argentine economy and that the economy was unable to adapt to. External shocks included falling prices for its agricultural commodities, the Mexican peso crisis in late 1994, the Asian currency crisis of 1997, and the Russian and Brazilian financial crises of 1998-1999. The financial shocks led investors to reassess the risk of emerging markets and to withdraw their capital from Argentina as well as the countries in crisis. The devaluation of the Brazilian real in early 1999–which increased the cost of Argentine goods in Brazil and reduced the cost of Brazilian goods to Argentines–hurt Argentina because of the strong trade ties between the two countries. Similarly, the strong appreciation of the dollar in the late 1990s, made Argentina’s products less competitive, both at home and abroad, against those of its trading partners whose currencies were not tied to the dollar. Internal problems revolved around rigid labor laws that make it costly to lay off Argentine workers and excessive spending by the Argentine government. In a decade that saw GDP rise 50%, public spending rose 90%. Initially, the growth in government spending was funded by privatization proceeds. When privatization proceeds ran out, the government turned to tax increases and heavy borrowing. The result was massive fiscal deficits, a rising debt burden, high unemployment, economic stagnation, capital flights, and a restive population. Simply put, Argentina’s bold currency experiment unraveled amidst political and economic chaos brought about by the failure of Argentine politicians to rein in spending and to reform the country’s labor laws. In effect, forced to choose between the economic liberalization and fiscal discipline that was necessary to save its currency board and the failed economic policies of Peronism, Argentina ultimately chose the latter and wound up with a disaster.
4. The most important lesson from Argentina’s failed currency board experiment is that exchange rate arrangements are no substitute for good macroeconomic policy. The latter takes discipline and a willingness to say no to special interests. The peso and its currency board collapsed once domestic and foreign investors determined that Argentina’s fiscal policies were unsound, unlikely to improve, and incompatible with the maintenance of a fixed exchange rate. Another lesson is that a nation cannot be forced to maintain a currency arrangement that has outlived its usefulness. As such, no fixed exchange rate system, no matter how strong it appears, is completely sound and credible.