Which is better, a fixed exchange rate or a flexible one? No question in economics has been debated more fiercely or more inconclusively. The reason is that neither system is without its flaws, and nobody has been able to quantify the trade-off.
Nor, usually, is history much of a guide, because one never sees a controlled experiment: if the world economy was more stable during the fixed-rate era from 1950 to 1973 than during the floating-rate era that followed, who is to say that the instability did not originate in the real economy and spread to exchange rates, rather than the other way around?
Over the past six months, however, we have seen what looks like an unusually clear-cut test between fixed and floating rates in Latin America. On the face of it, a rigid commitment to a fixed rate has won hands down. But the test is not over yet; a come-from-behind victory for floating rates is still a possibility. Until late last year, Mexico and Argentina were often discussed by economic analysts in the same breath. After seven lean years of debt crisis, both had emerged through a combination of market-oriented reforms and an abrupt return to the favor of international capital markets. Both had brought down inflation, largely through the use of a strong peso as a signal of their commitment to price stability. And both had resumed growth after years of stagnation.
The difference between the two nations' economic policies, it seemed, was a matter of detail. Mexico had followed a strong peso policy, but without committing itself to a fixed exchange rate. Argentina, on the other hand, had tied itself to the mast with a policy borrowed from the colonial past: not only was the government constitutionally committed to a one-peso-one-dollar policy, but every peso in circulation was backed by a dollar of foreign exchange reserves.
Then came the crisis. In December, under the pressure of speculative capital flight, Mexico wavered: rather than defend the peso by whatever means necessary, the country devalued its currency. As it turned out, the devaluation was enough to shatter the government's credibility but not enough to satisfy the speculators, and the half-measures quickly turned into a rout that drove the Mexican peso to half its previous value. Eventually the currency stabilized, but only after interest rates had been increased to 60 per cent.
The shock quickly spread to Argentina; but that country refused to contemplate any change in its exchange rate. For a time it looked as if the drain of pesos out of the banking system would lead to financial collapse. But, with a lot of help from Argentina's friends, that crisis seems to have been surmounted.
For those who believe that nothing good can come out of devaluation, it all seems like an object lesson. Mexico gave in to the pressure to devalue; Argentina did not; and so far Argentina has had much the better of it.
But the story is not yet over.
The pressures that led to the Mexican devaluation were not, ultimately, financial. Rather, they came from the real economy. Mexico's strong peso policy brought down inflation, but not all at once. By the time inflation was nearly down to US levels, many Mexican exports had been priced out of US markets. Meanwhile, the combination of the strong peso and trade liberalization had brought on an import surge. The result was that the massive inflows of capital during the good years brought surprisingly little growth in the domestic economy, and no growth at all in employment. It was the mounting pressure to do something to improve this performance - helped by internal political unrest - that eventually made financial markets wonder whether the peso would remain strong, and brought on a currency crisis.
The point is that with the peso devalued, however messily, those have become problems of the past. Mexico's domestic economy may be prostrate; but it is already running a trade surplus and exports are surging. Within two or three years, we may be marveling at how Mexico has, at last, become a fast-growing, export-oriented economy.
Meanwhile, Argentina has weathered the immediate storm; but the problems of a severely overvalued peso, which have made Buenos Aires one of the world's most expensive cities and hobbled attempts to develop new exports, remain unresolved. They will be unresolvable as long as the credibility of the government is bound up with one peso, one dollar.
So round one has ended, and old-fashioned monetary virtue is leading on points. But I will still bet that by the end of the bout we will see, once again, that things are not that simple.
Originally published, 6.13.95