What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a currency peg it has has sworn to be eternal and unbreakable?
Several European countries are in this position today, but there is nothing really new about it. It’s all happened before, most recently in Argentina in the winter of 2001-02. So what became of Argentina? Are there any lessons there for today’s Europe?
Argentina introduced what it called its “convertibility plan” in April 1991 as a way of stopping its latest episode of recurrent hyperinflation. Rather than opting for outright dollarization, as Ecuador would do a few years later, Argentina introduced a new version of own currency, the peso, and pegged it to the U.S. Dollar at a 1-to-1 rate.
The peg was underpinned by a currency board arrangement, which required the central bank to hold sufficient dollar reserves to back the entire monetary base (paper currency in circulation plus bank reserves) and to exchange pesos freely for dollars.
At first it worked. A fixed exchange rate can be a powerful tool to stop run-away inflation. As inflation came down, Argentina experienced a few years of good growth. However, it was not long before the fixed exchange rate showed its negative side: inflexibility in the face of external shocks. The Mexican “tequila crisis” and a devaluation of the Brazilian real, among other things, left Argentina with an overvalued currency, a big trade deficit, and excessive dependence on foreign borrowing. In addition, Argentina had a hard time mustering the fiscal discipline needed to live with a fixed exchange rate. By the end of the 1990s, Argentina was again in crisis. With IMF encouragement, it first tried fiscal austerity, and when that did not work, more radical measures, including a freeze on withdrawals of bank deposits. “This buries whatever hypothesis may exist that we will devalue,” said Finance Minister Domingo Cavallo, speaking, in December 2001, of the banking freeze. But just a month later devalue they did, and defaulted too.
What happened next is very interesting. Devaluation and default did not bring the end of the world. Hyperinflation did not return. The peso, when floated, did not go into free fall, but instead settled into a range between 3 and 4 to the dollar, where it remains to this day. Most importantly, the real economy recovered strongly. Since 2003, Argentina has grown more rapidly even than neighbouring Brazil (NYSE:EWZ), widely touted as a developing-world success story. One of my students dubbed Argentina’s recovery the “Nike effect” because of the resemblance between a graph of Argentine GDP growth and the shoe company’s famous “swoosh” logo.
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