The Argentine straw man: a response to currency board critics.

• Author: Hanke, Steve H.

It is noticeable, on the one hand, that a large part of the best work on Money is topical. It has been prompted by particular episodes, by particular experiences of the writer's own time.

--Sir John Hicks (1967: 156)

Sir John certainly would have agreed that particular experiences prompt faulty work on Money, as well. Argentina's recent crisis is a case in point. It has spawned a deluge of commentary on alternative exchange rate regimes. The majority of this writing (aimed at both an academic and lay readership) contains elementary analytical and factual errors. (1) The most oft-repeated and egregious errors are the following:

* Argentina employed a currency board from April 1, 1991, until January 6, 2002, that rendered the central bank, the Banco Central de la Republica Argentina (BCRA), incapable of employing a domestic monetary policy.

* The peso's one-to-one exchange rate with the U.S. dollar was overvalued and made Argentine exports uncompetitive in world markets.

* The inflexible currency board and overvalued peso caused the Argentine crisis. A three-part reform consisting of a peso devaluation, "pesofication" of the economy, and a freely floating exchange rate would reinvigorate the economy.

* Replacing the peso with the U.S. dollar--"dollarization"--was and is an infeasible alternative.

The Currency Board Misnomer

To put an end to hyperinflation, Argentina inaugurated something like a currency board system on April 1, 1991, by rechartering the BCRA. Argentines called the system "convertibility." Convertibility maintained a fixed exchange rate between the peso and its anchor currency, the U.S. dollar, on the spot market. That nominal anchor checked inflation: the consumer price index at the end of 2001 was about where it was in 1994. (2)

The BCRA's charter allowed it to behave more like a central bank than a currency board in many important respects. (3) A currency board maintains a floor and a ceiling of 100 percent and 110 percent, respectively, for the foreign reserve cover of its monetary liabilities. Its net domestic assets are zero or frozen. Thus, a currency board cannot sterilize foreign currency inflows, offset outflows, or use discretionary monetary policy. The convertibility system had a floor under the BCRA's foreign reserve cover, but no ceiling, and the BCRA's net domestic assets were not frozen. Hence, the BCRA could sterilize inflows of foreign currency and offset outflows.

The BCRA used the central banking powers in its charter liberally. Indeed, in virtually every month of the convertibility system's existence, the BCRA sterilized or offset changes in its foreign reserves, and in most months after 1994, it did so aggressively. During the system's life span, there was, on average, a negative correlation between changes in net foreign and domestic assets on the BCRA's balance sheet, with 59 percent of the changes in net foreign assets being either sterilized or offset with changes in the BCRA's net domestic assets (Hanke 2002a: 210). The offsetting was especially dramatic in 2001. Foreign reserves fell by $12 billion over the course of the year. This decline was offset 122 percent by increases in the central bank's net domestic assets.

The above evidence demonstrates that, contrary to the musings of most observers, the BCRA under convertibility maintained considerable discretion, especially after 1994. In that period, the BCRA's net domestic asset position was more than six times more volatile than that of Chile's central bank, which clearly has an independent monetary policy and has had a floating exchange rate since 1999.

Under convertibility, the BCRA retained additional central banking powers, offering lender-of-last-resort facilities, adjusting reserve requirements, and regulating the banking sector. Over the lifetime of the system, the BCRA issued 1,588 new regulations via its Series A circulars--a truly staggering rate of intervention in the banking system.

The problems set in motion by Argentina's central bank were exacerbated by Argentina's economic czar, Domingo Cavallo. His policies caused convertibility to lose what little semblance it had to a currency board system. With his appointment on March 20, 2001, the peso risk premium--as measured by the spread between the 30-day Argentine interbank lending rates in pesos and U.S. dollars--jumped 50 basis points and rose in step with the confidence-defeating measures that were the hallmark of his tenure (Hanke 2002a: 210-12). The significant upward leaps in the peso risk premium began on April 25, 2001, when Cavallo began his attack on convertibility. After ousting Governor Pedro Pou from the BCRA on a pretext, Cavallo instituted forced debt swaps (property confiscations), multiple exchange rates, new legislation to change the peso's anchor from the dollar to a euro-dollar basket, and the prohibition of internal convertibility. The higher risk premium likewise reflected Cavallo's regular refrains about the beauty of a floating exchange rate. The resulting higher interest rates put Argentina's debt dynamics over the top, culminating in its sovereign debt default on December 23, 2001.

The fact that Argentina did not have a full-fledged, orthodox currency board did not stop critics, as they dissected the Argentine crisis, from pointing an accusatory finger at currency boards. Indeed, some even claimed that Argentina had a "'pure currency board"...