SYNOPSIS: Excellent Piece on Argentina's currency board -- highly recommended

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, we should 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 hate to admit, not as interested in Argentina as they should be, so I am placing it 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. Now look 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 currency peg.

At this point defending the currency board seems to have become a sort of monomania. Domingo Cavallo - whom I have known since we were both graduate students, who is a good man of great accomplishments - has lost sight of the 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 recent pronouncements.

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 board to fail eventually, with the scenario for failure looking more or less like what we actually see today. But in the last year I’ve hesitated about saying that too forcefully, precisely because I did not want to be accused of setting off speculation against the currency. Now the government has imposed exchange controls, and in any case the bankruptcy of the currency peg is obvious. At this point a collapse would be better than prolonging the 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 exchange rate. The evidence is not complex: it lies in the fact of the prolonged recession and the slow, grinding deflation the country has suffered. In effect, 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 speculation against the currency, but do nothing about the underlying economic problem. The only way to end the economy’s pain is through some form of nominal devaluation, 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 trading partner. 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 and export composition suggest that it should emulate other southern-hemisphere primary 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 in the past. And other emerging markets, notably Brazil, with more recent experiences of hyperinflation have nonetheless experienced devaluations with 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 serious concern. However, the current strategy - which is essentially to achieve a real devaluation through deflation - offers no solution, because deflation raises the real value of debt just as much as devaluation. (This point is explained in Nouriel Roubini’s excellent new paper on Argentina, at http://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 by Ricardo Haussman, decree that private debts, even if denominated in dollars, can be repaid in pesos - a drastic step, but no more drastic than the draconian measures now being taken on capital movements and bank withdrawals. Or it could use public funds to compensate debtors for their capital losses, which would be administratively difficult - but no more so than the current capital controls - and would cost several percent of GDP, not a large sum considering the situation. We need a discussion of which alternative to follow; 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 longer worth defending. I don’t doubt that drastic measures can extend the life of 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 time to call an end to a failed experiment.

Originally published on Krugman's Official web site on 12.01