Several years ago I wrote a piece for Slate that ran under the headline “Monomoney mania”. Looking at the state of affairs in Argentina now, weshould reverse the title. Now it's money monomania; and it's a sad sight.
I haven't posted anything to my web site in a while, but the Argentine situation demands comment. My New York Times readers are, I hateto admit, not as interested in Argentina as they should be, so I am placingit here. I hope someone sees this, and that it is of some use.
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. Nowlook 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 currencypeg.
At this point defending the currency board seems to have become a sortof monomania. Domingo Cavallo - whom I have known since we were both graduatestudents, who is a good man of great accomplishments - has lost sight ofthe 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 recentpronouncements.
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 boardto fail eventually, with the scenario for failure looking more or lesslike what we actually see today. But in the last year I've hesitated aboutsaying that too forcefully, precisely because I did not want to be accusedof setting off speculation against the currency. Now the government hasimposed exchange controls, and in any case the bankruptcy of the currencypeg is obvious. At this point a collapse would be better than prolongingthe 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 exchangerate. The evidence is not complex: it lies in the fact of the prolongedrecession and the slow, grinding deflation the country has suffered. Ineffect, 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 speculationagainst the currency, but do nothing about the underlying economic problem.The only way to end the economy's pain is through some form of nominaldevaluation, 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 tradingpartner. 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 andexport composition suggest that it should emulate other southern-hemisphereprimary 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 inthe past. And other emerging markets, notably Brazil, with more recentexperiences of hyperinflation have nonetheless experienced devaluationswith 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 seriousconcern. However, the current strategy - which is essentially to achievea real devaluation through deflation - offers no solution, because deflationraises the real value of debt just as much as devaluation. (This pointis explained in Nouriel Roubini's excellent new paper on Argentina, athttp://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 byRicardo Haussman, decree that private debts, even if denominated in dollars,can be repaid in pesos - a drastic step, but no more drastic than the draconianmeasures now being taken on capital movements and bank withdrawals. Orit could use public funds to compensate debtors for their capital losses,which would be administratively difficult - but no more so than the currentcapital controls - and would cost several percent of GDP, not a large sumconsidering the situation. We need a discussion of which alternative tofollow; 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 longerworth defending. I don't doubt that drastic measures can extend the lifeof 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 timeto call an end to a failed experiment.