Argentina’s Monetary Mess

CAMBRIDGE: Efforts to make the world safe for investment bankers are underway once again. The IMF is preparing a bailout estimated at $20 billion to keep Argentina from defaulting on loans to foreign investors. As usual, investors will get repaid, while Argentina sinks deeper into crisis.

The story goes back decades. Argentina was seriously mismanaged from the 1940s to the early 1990s. Military and civilian governments alternated in irresponsible monetary and fiscal policies, and in trade protectionism that cut Argentina off from world markets. That combination produced massive foreign debt, a low level of exports relative to the size of the economy, and high inflation.

In the early 1990s, President Carlos Menem and Finance Minister Domingo Cavallo took drastic actions, reducing budget deficits and ending protectionism. To battle inflation, however, they resorted to a trick. They fixed the exchange rate of the Argentina Peso at a value of one Peso per US dollar, and promised that the exchange rate would never change. This system is known as a “currency board” arrangement.

Irrevocably fixing the exchange rate was at best a gamble, at worst a blunder. The exchange rate is a safety valve: when an economy becomes uncompetitive – say, if international demand for its products declines, or domestic costs rise above other countries – a decline in the currency’s value can restore demand for the nation’s output, and so help preserve employment. If the exchange rate is irrevocably fixed, that safety valve disappears. The economy can remain uncompetitive for years, causing chronically high unemployment and slow growth.