The Broader Market

Much has been said about the lack of monetary tools available to the Greeks in their fight to remain a solvent sovereign. While not entirely similar to the Greek situation, Argentina’s currency board regime in the 1990s is a good example of the importance of independent monetary policy. This cautionary tale goes as follows:

After an inflationary period in the late 1980s, Argentina created a currency board arrangement in which the Argentinean peso was pegged to the U.S. dollar. During the peak periods of hyperinflation, Argentineans had begun to reject the peso and demand the U.S. dollar instead. The currency board arrangement constrained the Argentinean Central Bank to keep its dollar reserves at the same level as the cash in circulation. Thus, in pegging the peso to the dollar, the Argentinean currency board tamed inflation by restoring the function of money as a store of value. However, in 2001, a decade after its creation, Argentina’s currency board collapsed amidst a run on the currency and a broader financial crisis.

The question, therefore, is what caused an effective inflation fighting mechanism to suddenly collapse? The answer: inherent features of the mechanism itself; the currency board arrangement allowed Argentina’s nominal exchange rate to become substantially overvalued. To understand this point, it is necessary to understand Argentina’s trade structure.

Argentina had a relatively diversified trading pattern with nations whose currencies fluctuate against the U.S. dollar. In pegging the peso to the dollar, only trade with the United States gained price stability. However, other important trading partners, such as Brazil, saw prices fluctuate. Thus, when the Brazilian real depreciated in the late 1990s and the U.S. dollar appreciated, Argentina’s exports became uncompetitive to many of the country’s major trading partners. This in turn hurt the export sector in Argentina and its total output. For this reason capital inflows began to decline in 1999 and foreign exchange reserves started to decrease.

Typically, to emerge from such a period of weakened economic activity, a country needs to engage in fiscal expansionary policy that stimulates demand. The problem was that Argentina did not possess a substantial amount of foreign reserves to continue to engage in deficit spending. The only other policy option that would have been available to the Argentineans had also been taken away; the currency board arrangement itself precluded Argentina from making requisite changes to monetary policy. This meant that both fiscal and monetary policy, under the currency board arrangement, were practically impossible.

Ultimately, in January of 2002, Argentina halted its decade old currency board arrangement to devalue its peso and set it to $.71. This devaluation ultimately deteriorated the balance sheet of the banks, as liabilities grew (due to the depreciated exchange rate), while their asset values decreased due to a surge in non-performing loans as borrowers struggled to pay back dollar denominated debt (which had become a whole lot more expensive).

The currency board arrangement made it practically impossible for Argentina to make discretionary changes to monetary policy. A floating exchange rate could have effectively responded to external shocks, correcting for overvaluations of the Argentinean peso. An exit from the currency board in the mid-1990s, after inflation had been tamed, would have provided Argentinean monetary authorities the requisite tools to more effectively react to the appreciating nominal exchange rate. The point is that the basic ability to make discretionary changes in the nominal exchange rate would probably have reduced the likelihood of crisis and a currency run.

So, that is the Argentinean story. While it differs markedly from the problems associated with Greece, it presents the central theme that central banks need to have the tools to respond to economic problems. Both countries tried to participate in an optimum currency area whereby monetary policy was imported. In the case of Argentina, policy was imported from the US; the Greeks have been importing policy from the European Central Bank since the establishment of the Euro area. The former certainly didn’t work, the latter doesn’t seem to be either.