What Went Wrong in Argentina?

As Argentina's economy unravels in street demonstrations, food riots, and political tumult, conventional wisdom suggests that a lethal combination of reckless government spending and a fixed exchange rate is to blame. Large fiscal deficits, so this argument goes, pumped up domestic demand, which fueled inflation and caused the peso to appreciate in real terms, even though it was pegged to the US dollar at a nominal one-to-one exchange rate. As public debt grew, the government's only hope of paying it back was a deflationary clampdown on available money and credit--with a collapse in output, soaring unemployment, and civil disorder almost inevitable.

This line of reasoning is plausible, because exchange rate misalignment may indeed be at the heart of Argentina's problems (albeit for very different reasons that we will not explore here, one associated with a sudden stop in capital flows). But fiscal profligacy alone cannot explain Argentina's meltdown.

Throughout the 1990s, Argentina's budget deficit never exceeded 2% of GDP, with the exception of 1999, when it rose to 2.5%, before falling back to 2.4% in 2000. While public-sector borrowing pushed external debt from 28.4% of GDP in 1991 to 51.4% in 2000, this still compares favorably with countries renowned for their fiscal probity. The European Union, for example, requires its member states to cap budget deficits and public debt, respectively, at 3% and 60% of GDP. Moreover, like Argentina's dollar peg, most EU countries abandoned control over their exchange rates by adopting the euro. Yet no one suggests that Germany, France, or Italy risk sharing Argentina's fate.

One key difference between Argentina and the EU is the huge risk premium that Argentina must pay for its debt, which imposes much narrower limits on the sustainability of its fiscal deficits. Indeed, in 2000, interest payments on the public debt equaled 16.5% of Argentina's total budget revenues. Why, then, was Argentina treated so differently in 2001? Something essential is missing from the conventional story: money and banking.