If you heard a giant sucking sound recently, it might have been the gurgle of the Argentine economy going down the drain again. With it may go an economic idea, the currency board, which has enjoyed much popularity among economists. And it is not good news for any eventual Free Trade Area of the Americas.
Let’s start with history in a nutshell. Argentina, one of the world’s richest countries in 1900, has experienced recurring economic difficulties since World War II. These difficulties were especially severe in the late 1980s, when annual inflation exceeded 3,000 percent on occasion. In 1991, early in the administration of President Carlos Menem, Finance Minister Domingo Cavallo introduced a currency board that effectively tied the value of the Argentine currency to the U.S. dollar.
The plan took control of the money supply away from the central bank and gave it to a new body with a mandate to issue only one Argentine peso for each U.S. dollar in Argentina’s foreign exchange holdings. Pesos could be converted to dollars on demand.
This measure soon reduced inflation to single digits, though not necessarily to such low levels as in the United States. Menem’s government also launched a program of privatizing state industries, notably the national petroleum company and telecommunications. It also began halting reforms of a federal taxing and spending system that chronically had produced large budget deficits. Together with neighboring Brazil, Uruguay and Paraguay, it launched Mercosur, the most ambitious free trade area ever attempted on the continent.
Inflation-weary Argentines welcomed stable prices, and the economy experienced good growth in several years. But problems soon surfaced. Fiscal reform proceeded much more slowly than privatization. Labor markets remained highly regulated. Higher inflation in Argentina than in the U.S. and the increasing strength of the U.S. dollar compared to other world currencies meant that the dollar-linked peso became increasingly overvalued. Argentine exports thus became less competitive.
The 1991 stabilization and privatization plans attracted substantial capital from other countries. But such investment was skittish, falling or reversing on news of financial problems elsewhere in the world. This led to a “tequila effect” crisis in Argentina after the Mexican economy collapsed in 1994 and problems when numerous Asian countries and Russia were buffeted in 1997-99.
These problems might have been more manageable if Argentina’s largest trading partner, Brazil, had not followed radically different policies. Brazil introduced a new currency, the real, in 1994. Initially it was worth slightly more than the dollar. But Brazil created no currency board. The real’s exchange value hung solely on a policy commitment by Brazil’s Banco Central .
That held until early 1999. Since then, the value of the Brazilian real has fallen by more than 50 percent against the dollar. With the Argentine peso welded to the dollar, the Brazilian real thus also declined by more than half against the currency of its southern neighbor.
This is straining Mercosur immensely. Even five years ago, Argentine exports to Brazil were strong. Now even Argentine wheat is being priced out of Brazil. And as the De la Rua administration, which succeeded Menem’s, has struggled with stagnating output and rising unemployment, the credibility of the dollar peg has become increasingly weak.
Earlier this year, there was a flurry of changes of heads of the central bank and finance ministry. Domingo Cavallo, the old warhorse who instituted the currency board 10 years ago, was brought back in to run things. He said the currency board is irrevocable but proposed changing the link to an average of the dollar and euro, rather than just the dollar. And this past week, Argentina instituted a separate exchange rate of 1.08 pesos for each dollar in import and export transactions.
Cavallo’s brave talk sounds increasingly like whistling in a graveyard. The odds of a maxi-devaluation increase daily. But it is hard to see how such a devaluation could take place without throwing Argentina’s economy into even deeper chaos. And the new exchange rate for trade is correctly seen by Brazil as an implicit import-tax and export subsidy, contrary to the Mercosur treaty. Beleaguered lame-duck President Cardoso faces a recession himself and is unlikely to do much to accommodate Argentina’s plight.
So how does this affect the United States? First, it must be sobering to the small platoon of economists who have advocated currency boards as a panacea for developing countries’ monetary woes. Yes, a currency board can halt hyperinflation, but if not accompanied by more difficult fiscal reform, it simply functions as a Band-Aid over a suppurating wound.
Second, if both Argentina and Brazil end up in deep recession, U.S. exports to the region will suffer. And the devaluation that has already taken place makes wheat, soybeans, iron ore and steel from these two countries cheaper in world markets. Brazilian farmers will get twice as many reals for each bushel in their 2001 soy crop as in 1999, and their production costs have not increased nearly that much.
Finally, if these problems deal a mortal wound to Mercosur, the Bush administration will find increasing resistance to plans for a FTAA. If four countries with similar income levels cannot make a free trade area work, how will 25 plus with dramatically different incomes and economic policies succeed?
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.