A proposal of monetary reform for Argentina: flexible dollarization and free banking.

Author:Cachanosky, Nicolas

Any system which gives so much power and so much discretion to a few men that mistakes--excusable or not--can have such far reaching effects is a bad system.... Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an "independent" bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers.

--Milton Friedman, Capitalism and Freedom

The Need for Institutional Reform

Once again Argentina is experiencing a serious institutional and economic crisis. A centerpiece of the economic imbalance is the weakness and untrustworthiness of its monetary institutions, manifested by high inflation and currency devaluation. We acknowledge that the economic and social problems currently affecting Argentina extend beyond monetary policy. The monetary reform that we offer here should not be understood as a sufficient measure to end the recurrent economic problems in Argentina but as a useful step in that direction.

Our plan is an update of the monetary reform for Argentina proposed by Steve Hanke and Kurt Schuler (in Hank and Schuler 1999a, 1999b; Hanke 2001; Schuler and Hanke 2002), with insights from George Selgin's proposal for the United States (1988, chap. 11). Briefly, our proposal, which closely follows Hanke and Schuler's, is that the central bank be eliminated as the monetary authority and that the Argentine peso (ARS) be eliminated as the country's national currency. The central bank should change all ARS into U.S. dollars (USD), but no restrictions should be imposed on the use of other currencies to negotiate contracts. Hence, the term flexible dollarization: the country would not be tied to the USD but freed from the ARS. In other words, Argentina should unilaterally dollarize rather than enter into a bilateral agreement with the U.S. Federal Reserve. In addition, commercial banks should be allowed to issue their own banknotes. As discussed later, this second aspect of the reform has financial and macroeconomic benefits.

The fact that the Central Bank of the Argentine Republic (BCRA) is unable or unwilling to efficiently manage the supply of currency is--or should be--undisputed. Argentina currently has one of the highest inflation rates in the world, yet the highest-ranking authorities of the BCRA and national government publicly deny that mismanagement of the money supply is the cause of prices increasing at annual rates of 25 percent or higher. (1) In addition, in 2012 the representatives of Congress approved a reform to the Carta Organica, or BCRA Law, that freed the central bank from its responsibility to preserve the Argentine currency's purchasing power; instead, the BCRA's new mandate is to promote, to the extent of its ability and within the bounds of national government policies, monetary stability, financial stability, employment, and economic development with social fairness. (2)

Politicians' disdain for the inflation issue (and their fear of political consequences if they openly admit responsibility) is not limited to the BCRA. The National Institute of Economic Census (INDEC) has supplied unreliable inflation estimates since at least 2007, which in turn has affected the calculation of other key economic indicators, such as gross domestic product (GDP) and poverty. The World Bank and The Economist are two examples of reputable institutions that have stopped publishing economic data from Argentina. A ruling class that is uncommitted to basic monetary management should not be permitted to maintain a central bank that allows itself to be a political tool of government officials.

The present monetary weakness in Argentina is arguably a reflection of the country's history of monetary mismanagement. From the BRCA's foundation in 1935 to 2013, Argentina had a compounded equivalent yearly inflation rate of 50 percent. This means that 4.58 x [10.sup.14] ARS in 2012 had the same purchasing power as one ARS in 1934. (3) This is not the result of hyperinflation in the late 1980s; rather, it is the result of a chronic inflationary problem. During the seventy-seven years of monetary management by the BCRA, Argentina's inflation rate has been lower than 10 percent in only twenty-three years and lower than 5 percent in only seventeen years. An inflation rate lower than the 2 percent level--which any serious central bank would consider to be an acceptable benchmark--was achieved in only eleven years. (4) For twenty-one of those years, inflation was higher than 50 percent. Argentina has removed thirteen zeroes from its unit of account through various currency denomination exchanges since the foundation of the BCRA.

We think that the absence of strong and sound monetary institutions in addition to the lack of interest by policy makers in defending the BCRA's independence are compelling reasons to consider a radical reform of Argentine monetary institutions. We also believe that the argument that Argentina should not surrender its central bank and monetary-policy "sovereignty" because a "better policy can be put in place" is, in light of Argentina's historical performance and policy makers' behavior, an exercise in wishful thinking.

The proposal presented here does not address all of the small and technical details that would be necessary for the implementation of monetary reform. Rather, it addresses the general themes, problems, and objections relating to flexible dollarization and free banking in Argentina.

It is worth mentioning that there is no such thing as the perfect monetary institution, and every monetary arrangement suffers from shortcomings. The proposal presented here is no exception. However, it is unwise to make the inevitability of imperfections the enemy of improvement. If imperfections were enough to dismiss any monetary institution, then the BCRA should be rejected with much more urgency than our proposal.

We present our proposal as follows: the first section discusses the pitfalls of the convertibility law put in place between 1991 and 2002 and presents an overview of the present economic situation; the second section discusses the need for a balanced budget as a prerequisite of monetary reform; the third section discusses the various aspects of our proposal; the fourth section responds to potential objections to our proposal; and the final section offers concluding remarks.

Recent Argentine Economic History: Was the BCRA a Currency Board during the Convertibility Era (1991-2002)?

Although some describe the convertibility of the ARS between 1991 and 2002 as a currency board system, a distinction between orthodox (strong) and heterodox (weak) currency boards should be made. An orthodox or strong currency board ties the central bank's hands to avoid monetary policy mismanagement, whereas a heterodox or weak currency board leaves room for the central bank to conduct monetary policy. During the convertibility era, the BCRA was under a weak currency board regime. For instance, the BCRA was allowed to have as little as 66.5 percent of monetary liabilities in foreign reserves (this amount was later increased to 90 percent). Under an orthodox currency board, the BCRA would have been required to keep between 100 and 110 percent of monetary liabilities in foreign reserves. Unlike an orthodox currency board system, in which the monetary base's behavior mirrors that of foreign reserves, the convertibility law provided enough leeway for the BCRA to continue practicing monetary policy.

During periods in which this weakness was actively exploited, "speculative attacks" against the ARS occurred. Hanke (2008) shows the deviation from an orthodox currency board with a plot like the one shown in figure 1. The graph shows (1) the reserve pass-through (the change in the monetary base divided by the change in net foreign reserves) and (2) the net reserves as a percentage of the monetary base. An orthodox or strong currency board would have a reserve pass-through of 100 percent. As the graph shows, the BCRA cavalierly exploited the loopholes of the heterodox currency board. The plot shows a dotted line at 90 percent and 110 percent; net foreign reserves as a percentage of the monetary base rarely fall within this region. (5)

During the convertibility era, Argentina was under neither a strict currency board regime nor masked dollarization. Accordingly, the 2001 crisis in Argentina could not have been due to an orthodox currency board regime because that regime was never actually implemented; rather, the crisis was due to an unsustainable level of public debt driven by fiscal deficits. Therefore, the mistakes and problems that led to the 2001 crisis are not valid arguments against the proposal we offer here and are not illustrative of how our proposal would work.

It is often argued that Argentina's monetary crisis occurred as a result of Brazil's devaluation in 1999. (6) However, although Brazil is certainly an important trading partner of Argentina and the Brazilian crisis obviously had an impact on the Argentine economy, Argentina's own fiscal problems were the root cause of its monetary crisis. Convertibility collapsed when international funding to Argentina became unavailable. Argentina's deep fiscal imbalances and high foreign debt would have been unsustainable regardless of the Brazilian crisis.

Although Brazil is Argentina's largest trading partner, it does not offer a currency that is as stable and solid as the USD. Brazil also has a history of high inflation (until recently), which makes the Brazil real a weak choice to peg the ARS if the objective is to curb inflation. (7) In addition, because our proposal does not fix Argentina to any specific currency, the market can shift to the Brazilian real if the real proves to be a better choice for economic agents. In...

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