Argentina: Economic Problems and Solutions

CRS Report for Congress
Economic Problems
and Solutions
October 26, 2001
Gail Makinen
Specialist in Economic Policy
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Argentina: Economic Problems and Solutions
After a long history of high inflation, Argentina decided in 1991 to link its
currency rigidly to the U.S. dollar and replaced its discredited central bank regime
with a monetary arrangement known as a currency board. With this change, peso
currency became backed by the U.S. dollar and inflation was brought to an end. The
United States derives revenue, called seigniorage, from this use of the dollar.
With the establishment of a currency board Argentina tied itself to the American
currency area as if it were California or Vermont. The theory of optimum currency
areas suggests that this was not a wise choice. First, little trade takes place between
the U.S. and Argentina (in 1999, imports from and exports to the U.S. were between
1.0% and 2.0% of Argentina’s GDP) while a large amount of American output is used
internally. Theory suggests that the two such regions should be linked by flexible
exchange rates. Second, there are mechanisms that enable the American currency
area to work smoothly in the face of negative shocks that are not available to
Argentina. These include the ability of American labor and capital to move from areas
strongly affected by negative shocks to areas less affected, the integration of the
nation’s financial system that makes possible the financing of regional trade
imbalances, and fiscal transfers that target areas of high unemployment. The United
States also relies on flexible exchange rates to cushion external negative shocks, and
if the shocks have a wide effect, monetary and fiscal policy can be used to combat
them. Argentina cannot avail itself of these mechanisms and must deal with negative
external shocks primarily through deflation. Given the well documented downward
rigidity of wages and prices in the short run, this can be a very difficult path to follow.
Argentina has had to follow this path in the face of four negative shocks: the
appreciation of the dollar, the fall in world commodity prices, the depreciation of the
Brazilian real, and the increase in real interest rates in the United States. In addition,
Argentina has also had to cope with a debt problem.
A currency board imposes substantial constraints on fiscal policy. Fiscal deficits
can no longer be financed by central banks. Thus, Argentina’s fiscal behavior was
going to have to approximate that of an American state. This has not happened. The
fiscal deficit of the consolidated public sector has been in excess of 4% of GDP,
unlike the behavior of American states. These deficits have added substantially to the
national debt, raising concerns that Argentina will default on its debt. Speculators
have attacked, thus far unsuccessfully, the Argentine peso several times over the past

3 years.

Argentina has dealt with its burgeoning debt through efforts to lengthen its
maturity and pay off existing debts with loans from international financial institutions,
banks, and others. The debt problem will continue until the fiscal deficits end.
Argentina has dealt with its macro problem by imposing multiple exchange rates on
exports and imports. In addition, when the dollar and the euro reach parity, the peso
will be linked to both currencies. Dollarization and altering the exchange rate have
also been discussed. They pose a number of serious problems. This report will not
be updated.

An Overview of the Argentine Economy..............................1
The Monetary Regime, Anti-Inflation Policy, and the Consequences.........2
The New Monetary Regime....................................2
The Anti-Inflationary Policy....................................3
The Argentine Fiscal Regime...................................4
The Consequences of the Monetary Regime........................5
The American Currency Union.....................................6
The Shocks to the Argentine Economy...............................8
Dollar Appreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8
Rising U.S. Interest Rates.....................................9
Falling Prices of Exportables...................................9
The Devaluation and Subsequent Depreciation of the Brazilian Real.....10
Argentina’s Solution to Its Economic Problems........................11
Macroeconomic Instability....................................11
Debt Buildup..............................................12
Policy Options for Argentina’s Macroeconomic Problems................12
Changing the Exchange Rate..................................13
Dollarization .............................................. 13
Summary and Conclusions........................................14
Appendix: The Dual Currency Board................................16
List of Tables
Table 1. Selected Economic and Financial Indicators: 1990-2001. . . . . . . . . . . . . 2

Economic Problems and Solutions
For much of the post-World War II era, when the financial press focused on
Argentina, it was to highlight bouts of very high inflation and failed stabilization
efforts.1 Argentina again commands the attention of the financial press, but this time
inflation is not the issue. Not only has Argentina had 5 years of stable prices, but over
the past 2 years, the price level in Argentina has actually fallen. Thus, it is now
speculated that Argentina may have to change its monetary regime not because of
inflation, as had been perennially the case, but to combat falling income, rising
unemployment and a possible default on its national debt. How did Argentina come
to this end? In large measure it is the consequence of the method chosen to deal with
the chronic tendency of Argentine public finance to produce inflation. To a lesser
degree, it is due to the government’s failure to recognize that the method chosen to
control inflation also placed constraints on fiscal policy, and to two unavoidable
economic shocks that reduced the price of Argentine exports and made Argentine
products uncompetitive in Brazil, Argentina’s largest trading partner.
An Overview of the Argentine Economy
Very high inflation rates, failed stabilization efforts, and a long period of
economic stagnation are noticeable features of the economic history of Argentina in
the post-World War II era. A compelling case can be made that the history of chronic
inflation is a product of the public finance practices of the Argentine government. In
1990, Argentina was once again in the midst of a serious inflation. Prices for the year
rose on average between 2000% and 3000%. In 1991, the government engineered
yet another stabilization effort, the so-called Convertibility Plan. A unique feature of
this program was the linkage of the Argentine currency to the U.S. dollar on a rigid
one-to-one basis.
The data in Table 1 show that the plan was successful in bringing an end to
inflation. Argentina has enjoyed at least 5 years of stable if not falling prices (and
compared to the 1980s, a decade of stable prices). However, price level stability has
not gone hand-in-hand with low unemployment and an end to the business cycle.
Rather, unemployment has been high and has also shown a tendency to rise; and
economic growth, while initially strong, has recently turned negative. While economic
growth began to slow in 1998, an actual contraction of income began in 1999 and
this has continued through 2000 and into 2001 (although the data for both years

1 This paper is based on an earlier, now archived study, CRS Report RS20796, The Troubled
Argentine Economy: The Role of the Monetary System and the Exchange Rate Regime, co-
authored with M. Angeles Villareal. Her contribution to this collaborative effort is gratefully

remain incomplete). The current account of the balance of payments has been in
deficit since the Convertibility Plan was implemented, indicating that Argentina
continues to borrow abroad. Argentina has had a fiscal deficit over this same period2
that, since 1996, has been large relative to GDP. The cumulative budget deficit since

1993 has increased the national debt by about 20%.

Table 1. Selected Economic and Financial Indicators: 1993-2000
1993 1994 1995 1996 1997 1998 1999 2000
Real GDP (1993236.5250.3243.2256.6277.4288.1278.3276.9
Real GDP Growth 5.8 -2.8 5.5 8.1 3.9 -3.4 -0.5
Unemployment Rte. 9.1 11.7 15.9 16.3 NA 14.1 15.5 NA
Inflation CPI (%) 10.7 4.1 3.4 0.2 0.5 0.9 -1.2 -0.9
Current Acct. Bal. -8.0 -11.0 -5.0 -6.5 -12.0 -14.3 -12.2-10.8
(US $b)
Current Acct. Bal. 3.4 4.3 1.9 2.4 4.1 4.8 4.3 3.8
(% of Nominal
Fiscal Deficit 0.7 0.7 0.6 1.9 1.5 1.4 2.9 *
(% of Nominal
Source: IMF. International Financial Statistics.
* Through the first three quarters of 2000, the fiscal deficit averaged 1.8% of GDP.
The Monetary Regime, Anti-Inflation Policy, and the
The New Monetary Regime
An important part of the 1991 Convertibility Plan was to fix the exchange rate
of the Argentine peso to the dollar on a one-to-one basis. This in itself, however,
could not guarantee a low inflation rate since it was not an effective constraint on the
issuance of money, the key to controlling inflation. To control the issuance of money,
the Argentines abandoned their central bank based monetary regime, which they felt
lacked credibility, and set up a monetary arrangement known as a currency board.
Under this arrangement, currency could be issued only if the currency board had an

2 The budget deficit reported in Table 1 is for the central government. The consolidated public
sector deficit for 1997 through 2000 as a percentage of GDP is, respectively, 2.1%, 2.1%,
4.2%, and 3.6%. It is expected to be 3.1% in 2001. The deficit is accounted for by interest
payments on government debt which has risen from 2.3% of GDP in 1997 to an estimate of
4.7% of GDP in 2001. If it were not for interest payments, the remainder of the consolidated
budget would be in surplus for this period except for 1999.

equivalent amount of dollars. Each Argentine peso note was thus backed by an
American dollar (no additional dollars, no additional pesos). This 100% backing did
not apply to any of the deposits supplied by Argentine financial institutions (such as
checking deposits) that for most developed economies are the principal part of their
money supply. Nevertheless, Argentine banks have been willing to supply dollar-
denominated deposits. By the middle of 2001 about two-thirds of all deposits were
dollar denominated.3
While the currency board guarantees only that the currency is backed by dollars,
this guarantee also constrains how many loans banks can make and the amount of
deposits they can accept since deposits are convertible into currency on demand and,
hence, into dollars. That this constraint is effective is evidenced by the low inflation
rate experienced in Argentina since the institution of the currency board. This new
monetary regime linked Argentina to the United States currency area. In an economic
sense Argentina’s relationship to the U.S. currency area is now much like that of any
state such as Wisconsin or California.4 As explained below, this linkage did not
ensure that Argentina would enjoy access to the mechanisms that make the American
currency area function smoothly.
The Anti-Inflationary Policy
The fixed exchange rate and the currency board were designed to ensure that
Argentina would have a low inflation rate, one similar to that in the United States.
To see why this is so, suppose that Argentina had a higher inflation rate than the U.S.
The people of Argentina would now see prices in Argentina that were higher than
comparable goods and services that were available from the United States and
elsewhere. They would thus tend to switch their spending from home country goods
and services to the now cheaper substitutes available from the United States or
elsewhere in the world. Similarly, non-Argentineans would find Argentina an
increasingly expensive country to buy from and they would switch their purchases to
cheaper sources of supply. This would result in a growing trade deficit for Argentina.
Under a currency board and fixed exchange rates this trade deficit would have to be5
covered by a loss of currency and shrinkage of the money supply. The reduction in
money supply and money spending in Argentina would then bring the rate of inflation6

in Argentina into line with that in the United States and keep it there.
3 See Thomas J. Trebat. Salomon Smith Barney (July 10, 2001). Mr. Trebat cites the Central
Bank of Argentina.
4 Because all the states in the United States use a common currency, they are in essence linked
to one another by rigidly fixed exchange rates. The dollars that circulate in Wisconsin will
buy a dollar’s worth of goods and services in New York or any other place in the U.S.
common currency area.
5 It is possible in the short run for Argentina to receive an inflow of foreign capital that could
forestall the shrinkage in the money supply and money spending. The inflow of foreign capital
could thus finance the growing trade deficit. This might continue for some time.
6 This does not mean that Argentina will have exactly the same rate of inflation as the United

Important to the anti-inflation program is that the currency board cannot issue
currency based on any domestic asset such as Argentine government bonds. Currency
issues must be based on the possession of foreign assets. In the case of Argentina,
these are dollar-denominated assets. In the past, the Argentine central bank was used
as the engine of inflation since it was forced to purchase government bonds in
exchange for currency, the means used to finance the large fiscal deficits.7 What is
seldom appreciated about fixed exchange rates and a currency board is that they are
not only a monetary regime, but also a fiscal regime, and they impose a great deal of
restraint on governments. In particular, this monetary regime forecloses the option
of monetizing government budget deficits by central banks. Governments are forced
to finance budget deficits by selling interest-bearing debt to domestic banks and the
public or to foreigners.
The Argentine Fiscal Regime
The single most important reason for the long inflationary history of Argentina
has been unbalanced government budgets. Large budget deficits have been financed
by the expedient of printing money and this has fueled inflation (the classic case of too
much money chasing too few goods and services). Given that history, one might
have expected that when Argentina changed monetary regimes in 1991, it would also
have embraced a very conservative fiscal regime. Yet, this appears not to have been
the case. The data in Table 1 show that Argentina has had a budget deficit since the
stabilization was implemented.8 In 1999, the last year for which complete data are
available, it reached nearly 3% of GDP.9 The national debt of Argentina is now
estimated to be about $150 billion dollars or about 50% of GDP. Some portion of
this debt is owed to foreigners. What the Argentine government appears to have

6 (...continued)
States. Each economy has a large non-tradeable goods sector, and prices in this sector enter
the price index and make it possible for the recorded rates of inflation in the two countries to
be somewhat different.
7 Argentina does not have a classic currency board. The Argentine currency board legislation
does permit some holding of government bonds. But these holdings must be purchased at
market prices, cannot exceed 33% of total reserves, and cannot increase by more than 10%
in any one year. Many observers regard this departure from a classic currency board as
minor. See, for example, Francois R. Velde and Marcelo Veracierto. “Dollarization in
Argentina.” Economic Perspectives. Federal Reserve Bank of Chicago. First Quarter 2000.
8 While budget deficits are projected for the current and near term fiscal years, it should be
noted that Argentina has recently enacted drastic fiscal measures to achieve a zero deficit.
There is, however, an important question about the degree to which the budget projections
provide unambiguous information about the fiscal position of the Argentine government. This
is because the government either owns or guarantees the operation of various enterprises. It
is thus contingently liable for these businesses. In the current economic downturn,
contingencies could become realities, substantially increasing the realized budget deficits.
Those who speculate against the Argentine peso are likely to base their assessments on the
degree to which these contingencies can become realities.
9 This is the deficit of the central government as a percentage of GDP. The deficit of the
consolidated public sector reached 4.2% of GDP.

overlooked is that even though Argentina is a sovereign state, when it pegged it
currency to the dollar, its fiscal behavior was going to have to be similar to that of a
large American state. This has not happened. As noted in Table 1, its recent budget
deficits have been upwards of 2% to 3% of GDP. No state in the United States has
had this fiscal experience (most have constitutionally mandated balanced budgets).
If they had, there is little doubt that they would have had a problem marketing their
state debt.
The continuation and worsening of the budget deficit and the growth of the
national debt appear to give rise to the expectation that Argentina will be unable to
achieve fiscal balance in the foreseeable future. This fuels speculation that it will be
forced to default on its debt. The Argentine government has had great difficulty
rolling over its maturing debt and has been forced to pay upwards of 14% interest to
get the public to renew maturing issues.10 It does not take long for interest rates of
this magnitude to make a major contribution to any fiscal imbalance and make a debt
default a real possibility.
The Consequences of the Monetary Regime
Argentina adopted a currency board and fixed its exchange rate to the dollar in
order to bring to an end its chaotic history of high inflation. As noted above, this
objective has been achieved. But did this medicine come with adverse side effects?
A compelling case can be made that it did.11 In particular, it can be argued that the
basic, if not the only, mechanism within the current monetary regime that is available
to deal with negative economic shocks is deflation. That is, in the face of a negative
shock, money wages and prices must fall absolutely to restore full employment. Why
is this so?
When Argentina adopted a currency board based on the dollar, it placed itself in
the position of a U.S. state such as Wisconsin or California. Common consensus
holds that America as a single currency area works quite well in the sense that output
in the United States has, for substantial periods, been able to grow along a full
employment path or, at least, experienced long periods of positive growth. Indeed,
the period from 1995 through mid-2000 was quite spectacular. GDP growth was
high and the unemployment rate fell to a 30-year low. All parts of the United States
enjoyed this prosperity. Argentina did not. Its GDP contracted 3.4% in 1999 and
another 0.5% in 2000. The contraction appears to be continuing in 2001 although
data are not yet available to measure the extent of the fall. Its unemployment rate has
also risen.

10 At the Treasury auction held on July10, 2001, the Argentine government paid 14% on
$827.7 million of 3-month bills and 15.96% on $22 million of one year bills (these were peso
denominated securities). See Jonathan Fuerbringer. Economic Troubles Worsen in
Argentina. New York Times. July 11, 2001.
11 The discussion to follow draws heavily on literature related to “The Theory of Optimum
Currency Areas.” The seminal paper in this literature, cited in the award of the Nobel Prize
in Economics to its author, is Robert A. Mundell. A Theory of Optimum Currency Areas.
American Economic Review, vol. 51, September 1961, pp. 657-665.

Why did Argentina fail to prosper as did the American states? There are
mechanisms that make the American currency area work smoothly that are not
available to those countries that opt through currency boards or dollarization to join
the area. It is worth a short digression to see what these mechanisms are for they bear
on how Argentina got into its present dilemma, and whether dollarization is good for
it or for any country.
The American Currency Area
The United States is subject to a variety of economic shocks that affect both
demand and supply. These shocks do not always affect the entire country uniformly.
Some are specific to an industry, sector of the economy, or geographic region. To
see how America deals with these shocks, consider a case in which the American
public suddenly prefers to own foreign cars (a change in taste). The public switches
from buying U.S. cars to foreign cars. Economic theory predicts several
consequences from this shift. On the aggregate level, a trade deficit would tend to
emerge. This would be eliminated through a depreciation of the dollar which would
tend to stimulate additional exports and cause some Americans to switch expenditures
from imports to domestically produced substitutes. These additional purchases would
tend to be spread across the economy and would be unlikely to offset the decline in
U.S. car sales and output and the increase in unemployment in the automobile
industry. Moreover, the automobile producing areas of the country would
undoubtedly suffer a “trade deficit” with the rest of the country. If wages and prices
were completely flexible within the U.S., car prices would fall, as would wages, until
the unemployment was eliminated. This would also tend to eliminate any regional
trade deficit. However, this adjustment would be unlikely to happen because wages
and prices display substantial downward rigidity in the short run. Other factors or
mechanisms would come into play to reduce unemployment and deal with the regional
trade imbalance that can be regarded as substitutes for wage and price adjustments.
First, the financial system in the United States is highly integrated, meaning that
many stocks and bonds are highly substitutable in the portfolios of financial
institutions (including banks) and private individuals. This substitutability is aided by
the fact that many of these assets can be sold in national markets to which financial
institutions and individuals have ready access. Thus, if a region has a trade deficit, the
banks in that region can finance it by selling their assets. If the adverse shock is
transitory, financing a trade deficit is an effective substitute for wage and price
decreases. A highly integrated financial market also has the advantage that monetary
changes engineered by the Federal Reserve will be felt throughout the U.S. A
common pattern of interest rates will also prevail throughout the American economy
(or currency area). Financial integration is encouraged by a common legal system.
Second, and arguably, the most important way that regional imbalances are
adjusted in the United States, is for labor and capital to move from areas where
demand for them weakens to areas where it is stronger. And it is this “factor
mobility” which tends to iron out regional imbalances. In the example above, this
means that unemployed automobile workers would move to other industries or parts
of the country where demand is stronger (in export or other import competing

industries). U.S. labor has shown itself to be highly mobile and this mobility is aided
by a common legal system and language and such things as portable pensions.
Third, fiscal policy in the United States can be used as a means for automatically
transferring income to regions hit by adverse shocks. The federal government has
historically targeted various pockets of high unemployment for special treatment. For
example, the duration during which unemployment benefits have been paid has been
extended and the formulas for allocating and/or triggering federal expenditures often
contain an unemployment rate component. Federally funded job retraining is also
available. Moreover, such programs as farm price supports and social security help
maintain a net income flow into adversely affected areas. Should the shock be
economy wide in its effect, federal tax cuts or expenditure increases have also been
used to reduce unemployment. This type of fiscal expansion can actually have a
negative effect on countries who link their currencies to the dollar. This occurs in the
following way. Fiscal expansion tends to raise U.S. interest rates. In an open
economy, with international capital flows that are sensitive to interest rate
differentials, an increase in U.S. interest rates will draw in foreign capital and this will
lead to a stronger dollar (the dollar will appreciate). Dollar appreciation will then lead
to a larger trade deficit and it will also have a negative effect on demand in countries
whose currency is linked to the dollar as the foreign price of their goods and services
increases to reflect the stronger dollar.
Finally, monetary policy can be used for shocks that are spread across the whole12
economy and this is an advantage of a central bank monetary regime. Interestingly,
monetary expansion in the United States will be felt in those countries whose currency
is linked to the dollar even if the financial systems of those countries are not
integrated with the U.S. financial system. This occurs through the effect of changes
in U.S. interest rates on the international flow of capital and the exchange value of the
dollar. To the extent that this effect is strong, it places a premium on countries having
business cycles that are synchronized with U.S. cycles. If they tend not to be, U.S.
monetary and fiscal policy could destabilize these countries.
When Argentina linked the peso directly to the dollar, it could not avail itself of
these mechanisms that tend to substitute for wage and price rigidity to ameliorate
negative shocks. For example, the Argentine and U.S. financial systems are not highly
integrated. Many of the assets owned by Argentine banks and other financial
institutions are not saleable in the United States and, hence, cannot be used to finance

12 It should not be overlooked that the case for a single currency area is strengthened if the
trade in that area is largely internal. Dividing such an area into subareas linked by floating
exchange rates brings with it an element of exchange rate instability which, in turn, leads to
price level instability. And price level instability tends to discourage the use of money and for
that reason leads to inefficiency in exchange. Trade within the U.S. economy is largely
internal even though the U.S. economy is becoming increasingly open. For example, during
the 1960s, the sum of U.S. exports and imports as a percentage of U.S. GDP varied between
8% and 10%. During the 1990s, this had increased to 20% to 25% of GDP. Very little trade
takes place between Argentina and the United States. In 1999, imports from and exports to
the U.S. were, respectively, about 1.8% and 1.0% of Argentine GDP. Thus, the case for a
fixed exchange rate between the two countries, viewed from the perspective of the theory of
optimum currency areas, is weak.

an Argentine trade deficit. Recent data suggest that Argentine liabilities to American
banks are only $11 billion. The unemployed in Argentina are not free to move to
America (this is not true for Argentine capital) because of immigration controls. The
U.S. Congress is unlikely to target American fiscal policy on problem areas in
Argentina. Finally, Federal Reserve policy is geared to economic conditions in the
United States, not to those in Argentina. To the extent that the business cycle in
Argentina in terms of type, periodicity, and magnitude, is different than in the U.S.,
both U.S. fiscal and monetary actions could actually destabilize Argentina.
Since these ameliorating substitutes are unavailable to Argentina, negative
shocks to the Argentine economy must be dealt with primarily by wage and price
deflation. And this is the specter that now faces Argentina. It is the consequence of
having fixed its currency rigidly to the dollar.
The Shocks to the Argentine Economy
The Argentine economy has over the past 5 years been affected to one degree
or another by four external shocks: the rising value of the dollar, higher U.S. interest
rates, falling prices for its exports, and a devaluation and subsequent depreciation of
the currency of its leading trading partner, Brazil. A discussion of each follows in
order to demonstrate how the Argentine economy has had to adjust to each shock.
Dollar Appreciation
Between mid-1995 and 2001, the dollar rose in real or inflation adjusted terms
by about 33%.13 It is widely acknowledged that the appreciation was due in large
measure to the desire by foreigners to buy American assets. To do so, they bought
dollars. This increase in demand raised the price of the dollar and this, in turn, led to
a trade or current account deficit. The trade deficit was the means by which foreign
capital (or the inflow of foreign saving) came to the United States.14 Dollar
appreciation has caused a problem for some American industries (primarily those
producing exports and substitutes for imports). Offsetting this have been the lower
interest rates (lower than they would otherwise have been) made possible by the
inflow of foreign capital and this has expanded the demand for the output of other
American industries. Overall the net effect on the United States economy has been
small because as the trade deficit grew, the American unemployment rate fell.
The effect of dollar appreciation on Argentina, however, has been substantial.
The rising value of the dollar has had the same effect on Argentine export and import
competing industries that it had on similar industries in America. But because the

13 As measured against 26 currencies of the leading trading partners of the United States on
a trade weighted basis as compiled by the Board of Governors of the Federal Reserve.
14 For a more comprehensive discussion of the cause of the U.S. trade deficit, see CRS Report
RL30534, Marc Labonte and Gail E. Makinen. America’s Growing Current Account Deficit:
Its Causes and What It Means for the Economy.

financial systems of the two countries are poorly integrated, the relatively lower
interest rates the capital inflow made possible in the United States were not
experienced to the same degree in Argentina.15 Argentina was left with a trade deficit
that it had to finance by borrowing abroad and losing dollar assets held by its currency
board. This put deflationary pressure on Argentina. To some degree the Argentine
government tried to deal with rising unemployment by running a fiscal deficit. It
would appear, however, that it hoped that the rising unemployment would lead to a
fall in wages and prices so that Argentine goods would once again be competitive in
world markets. Falling prices are a sign that this part of the adjustment mechanism
is working. Notice that the mechanisms that substitute for deflation are not working
for Argentina. The unemployed in Argentina cannot move to the United States and
the U.S. Congress does not consider them in making fiscal policy.
Rising U.S. Interest Rates
The United States enjoyed a robust, booming economy during the last half of the
1990s. The boom featured a substantial rise in productivity that increased the real
rate of return on capital. This, in turn, increased investment and led to higher interest
rates. In addition, the Federal Reserve raised interest rates between mid-1999 and
mid-2000 in an attempt to reign in the boom lest the economy overheat.
These interest rate increases were felt directly to some degree in Argentina even
though the financial markets of the two countries are not highly integrated. And they
were indirectly felt through the effect these interest rate hikes had on the appreciation
of the dollar. In addition, following the Asian crisis, investors demanded higher
interest rates for lending in emerging market countries. In part this was to
compensate for additional fears of default and currency devaluation. And these
interest rate increases, by decreasing spending on capital goods, only curbed
aggregate demand growth in Argentina – they were, in effect, another negative
economic shock.
Falling Prices of Exportables
Commodities are an important component of Argentine exports and commodity
prices took a tumble on world markets during the late 1990s as world demand16
declined following the Asian crisis. If Argentina had a floating exchange rate, its
currency would have depreciated to smoothly transmit this fall in world demand and
prices to the Argentine economy. Since this channel is not available under a currency

15 Financial integration has a number of attributes. It can be affected by law, administrative
procedures, inability to adequately assess risk in lending to foreign countries, etc.
16 This shock must be thought of as separate from the shock that came from dollar
appreciation. The latter would have been spread across all Argentine exports. This shock
only applies to raw material exports and should, more appropriately, be thought of as a
negative terms-of-trade effect. That is, the fall in commodity prices means that Argentina
must now give up more exports for each unit of imports. In effect, commodity prices got a
hit by a double shock.

board, Argentine prices and wages must fall. Since price stickiness prevents this in
the short run, Argentina faces recession and unemployment. This fall in commodity
prices did exert a small downward pressure on the exchange value of the dollar,
however, because it reduced world demand for dollars. Little of this benefitted
Argentina because it is a relatively small part of the overall output of the dollar
currency area. Thus, the decline in Argentine export earnings would not have been
matched by a commensurate fall in outlays for imports. As a result, Argentina was
faced with a trade deficit that had to be financed. Some of the deficit was financed
by a the sale of currency board assets and this put additional deflationary pressure on
Argentina (another source of financing was borrowing abroad).
The Devaluation and Subsequent Depreciation of the Brazilian
Brazil is the largest trading partner of Argentina. Over the period 1993-1999,
about 25% of all Argentine exports were destined for Brazil. These exports averaged
about 2% of Argentine GDP. The exchange rate between the two countries is thus
important to trade and Argentine income growth. For a number of years in the 1990s
the exchange rate between the two countries was fixed. Because Brazil had a higher
inflation rate than Argentina, the fixed nominal exchange rate between the two
countries implied a real rate that gradually cheapened Argentine products in Brazil
and priced Brazilian products out of the Argentine market. In January 1999, in the
face of capital flight, Brazil devalued its currency, the real, and then let it float
against all currencies. The devaluation and subsequent depreciation more than17
compensated for the differential rates of inflation in the two countries. In inflation
adjusted terms, Brazilian products now became relatively cheaper in Argentina and
the latter’s goods became expensive in Brazil. This would put downward pressure
on Argentine export earnings and tend to increase outlays for imports. As a result,
it would tend to aggravate any existing trade deficit and this had to be financed.
Again, the loss of currency board reserves would put downward pressure on money
spending and this reduced output and caused unemployment to rise.
These four external shocks have had a major deflationary effect on the Argentine
economy. Between 1995 and 1997-98, the deflationary pressure from the balance of
payments deficit was masked or offset by the ability of Argentina to borrow abroad.
Foreign capital did come to Argentina. This came to an end with the East Asian
financial crisis of 1997 and the Russian default in the summer of 1998. Foreign
lending to Argentina dried up and the full deflationary effects of these shocks tended
to be felt. Because nominal wages and prices in Argentina have shown marked
downward rigidity, the initial response to deflation has been falling output and rising
unemployment. Argentina has been thrown into a recession.
It is not always clear why currencies become vulnerable to speculation. The
Argentine peso has come under speculative attack several times over the past few

17 After devaluation in 1999, the real, like other currencies, depreciated against the dollar and,
hence, against the Argentine peso. At this point, the discussion above on dollar appreciation
becomes relevant.

years, most recently late in 2000. Undoubtedly, one factor influencing speculators is
how long the continued policy of deflation will be politically acceptable. The longer
it continues and the higher the unemployment rate climbs, the more reasonable is the
view that politicians will bring the deflation to an end with a currency devaluation,
i.e., that the peso/dollar exchange rate will be changed. This will invite speculation.
Argentina’s Solution to Its Economic Problems
Argentina has two economic problems to deal with: macroeconomic instability
characterized by falling income and rising unemployment and a growing national debt.
These problems are not separate, but inter-related. Falling income has increased the
fiscal deficit and this has increased the national debt. Argentina has responded both
actively and passively to these problems.
Macroeconomic Instability
Argentina has faced the contraction of income and the rise in unemployment in
three ways. First, it has allowed its fiscal deficit to grow. Its fiscal behavior, unlike
that of any state in the United States, has given rise to a fear that the government will
have to default on its debt. Second, since the exchange rate has not been changed,
Argentina must hope that the fall in income and rise in unemployment will put
downward pressure on wages and prices. If wages and prices fall enough, exports
will again become competitive and the people of Argentina will buy cheaper domestic
substitutes for imports. Both of these will expand domestic demand. Of course,
downward rigidity in wages and prices could make this a prolonged process. A more
activist policy has also been pursued.
In December 2000, legislation was passed to alter the currency board
arrangement. The law now specifies that when the euro and the dollar reach parity,
the Argentine peso will be pegged to both currencies. The intent of the legislation is
to curb any tendency of the peso to appreciate as it has when pegged only to the
dollar. Since this scheme has not yet come into effect, an evaluation of it is confined
to the Appendix.
To expand demand, the government in March of 2001 unveiled a scheme to
subsidize exports and penalize imports. To this end, it rewards each dollar earned
abroad by exchanging it for 1.07 pesos. Dollars to be spent abroad for imports can
be acquired only by paying 1.07 in pesos. While this may have a small effect on the
trade deficit, it is a very inefficient way to stimulate demand, as it will lead to all sorts
of devices to make it appear that dollars were earned abroad and few dollars are to
be used to acquire imports. Multiple exchange rate schemes have a dismal record for
accomplishing any macroeconomic goals. Instead, they have a good record in
encouraging criminal behavior.

Debt Buildup
The approach to the debt problem has been different. Until recently, there was
much debate in the government about reducing the budget deficit, the source of the
increase in the debt. Very little happened as the political factions could not agree on
the distribution of the burden inherent in deficit reduction. The required reduction
grew quickly as interest rates rose. Thus, the debt continued to grow. This changed
dramatically in July 2001 when the government committed itself to the zero deficit
plan. Nevertheless, the government has been faced with the problem of rolling over
the existing debt and finding new lenders to acquire the new debt. The existing debt
is denominated both in pesos and several foreign currencies such as dollars, euros and
yen. One approach was to try to lengthen the maturity of the debt coming due thus
postponing the problem to a future day. Finding new lenders, especially foreign, to
acquire a growing debt posed additional problems. Some observers point out that
Argentina is unlikely to acquire a balance of payments surplus in the foreseeable
future. Thus, it is unlikely to have the foreign exchange to service the debt
denominated in foreign currencies. This increases the chance of default and increases
the reluctance of foreigners to buy Argentine debt. An additional approach is to line
up lines of credit with such international lending institutions as the International
Monetary Fund (IMF), foreign governments, and various international banks. The
most recent effort by the government to deal with the debt was in December 2000.
A $39.7 billion support package was provided by the IMF, the Inter-American
Development Bank (IBD), the Spanish government, and other lending institutions.
It includes a $13.7 billion line of credit from the IMF, $5 billion in loan commitments
from the World Bank and IBD, and $1 billion from the Spanish government. The
remainder consists of nonbinding commitments from Argentine banks and foreigners18
to roll over their existing loans. About $25.4 billion of the $39.7 billion support
package will be available by the end of 2001, which covers almost all of Argentina’s
debt payment requirement for that year.19 Other negotiations have continued
throughout 2001 aimed at debt extension and additional support. While these aid
packages can help alleviate the funding burden temporarily, they do nothing to alter
the effects of the four external factors that caused Argentina’s current macroeconomic
Policy Options for Argentina’s Macroeconomic
Two options to lift Argentina out of the economic doldrums have been
proposed: depreciating the peso by changing the exchange rate to the dollar and
replacing the currency board by formally adopting the dollar as the legal tender of the
country. Both of these medicines come with potentially serious side effects.

18 See Washington Post (Dec. 19, 2000, pp. E1-2) and the IMF Statement (Dec. 18, 2000).
19 The Economist Intelligence Unit Ltd., Argentina Economy: $39.7 Billion International Aid
Package, Dec. 12, 2000.

Changing the Exchange Rate
Argentina has always had the option of changing its exchange rate rather than
deflating its economy in response to an appreciating dollar. Thus, it could for
example give 1.5 pesos for each dollar and this would cheapen its goods abroad and
increase the price of imports in Argentina. This would increase the sale of exports
and cause individuals in Argentina to switch from buying imports to substitutes
produced in Argentina. Both would increase demand in Argentina and put people to
work (reduce unemployment).
While the solution sounds simple, it does not come without major costs. First,
it would remove the credibility of the fixed exchange rate as a constraint on inflation.
Individuals would reason that if the rate could be changed once, it could be changed
again and again. In effect, Argentina could be back in the old inflation cycle and this
could undermine the desire of foreigners to invest in the country. Second, and more
important, devaluation could wreck havoc on the financial system. This is because
Argentina has become increasingly dollarized since the 1991 reform. Banks, for
example, have substantial dollar liabilities. If the peso were devalued, the peso value
of those liabilities would rise. Account owners could withdraw substantially more
pesos after devaluation than before. Where could the banks obtain these additional
pesos? If their assets were denominated in dollars, they might be able to force those
who owe these assets to pay more in pesos (for example, homeowners could find
themselves with larger mortgages). If not, the banks would be in serious difficulties.
And this is also true for other financial institutions. Thus, changing the exchange
value of the peso to the dollar to stimulate demand is likely to run the risk of wrecking
financial ruin on the financial system. It may be for this reason that there is not much
support for this option in Argentina even among the opposition parties.
The Argentine economy is now heavily dollarized. U.S. currency circulates
widely in the country. All of the peso denominated currency is effectively backed by
dollar denominated assets. About two thirds of all bank accounts are expressed in
terms of dollars. The only thing that is lacking from complete dollarization is that the
U.S. dollar is not legal tender in Argentina. Those who advocate dollarization do so
on the grounds that it would lower real interest rates in Argentina and this would
encourage spending by consumers and businesses on such things as durable goods and
housing. They cite as evidence the fact that yields on Argentine government debt are
higher than on comparable U.S. Treasury debt. The yield differential, they argue, is
due to two factors: fear of debt default and fear that the peso/dollar exchange rate will
be altered (i.e., the peso will be devalued). The yield differential is held to
compensate for these additional risks. While this argument has some merit, it is based
on the questionable proposition that if these risks were not present, the yield on
comparable Argentine and U.S. Treasury debt would be the same. For this to be true,
the financial systems in both countries would have to be highly integrated. And this
is simply not the case. Thus, the argument neglects the fact the Argentina is currently
financing a growing budget deficit while the U.S. has been disposing of a budget
surplus. However, if the exchange rate risk is important, dollarization could reduce

real interest rates. It should not be forgotten that dollarization would bind Argentina
more completely to U.S. currency than does the present currency board and, like the
latter, Argentina would continue to be excluded from the cushioning effects that
moderate the recourse to deflation that U.S. states enjoy to deal with macroeconomic
imbalances. 20
There is one tangible benefit that might come from dollarization. Since there
would no longer be any risk of devaluation, it might stop, if not reverse, any capital
flight from Argentina that has occurred.
All agree, however, that there is one shortcoming of dollarization: the
government would forgo the seigniorage (or profit) that it currently gets from the
currency board system.21 To minimize this loss, Argentina might be able to negotiate
a treaty with the United States to give it the seigniorage accruing to the dollars
circulating in Argentina. If that is not possible, the loss of seigniorage, it is argued,
is a small price to pay for the gain in demand stimulus that should come from lower
interest rates.22
Summary and Conclusions
Argentina decided in 1991 that a chronic tendency to inflation was harmful to
economic growth and well being. To achieve price level stability, the government
rigidly fixed the exchange rate of the peso to the U.S. dollar and, to control the money
supply, adopted a currency board to replace the largely discredited central bank
regime. Under a currency board, the peso currency is backed 100% largely by U.S.
dollars. With a minor exception, new peso currency can be issued only if the currency
board acquires an equivalent sum of dollars. While checking accounts and other bank
deposits are not backed 100% by dollars, the fact that they are convertible into peso
notes constrains the ability of banks to supply them.

20 Recently provincial governments in Argentina have taken to issuing their own “money” in
the form of interest-bearing notes which they pay to civil servants and others who supply
services to the government. In some cases these notes are legal tender. They are similar to
scrip issued by municipalities in the United States during the 1929-1933 depression. In the
1990s, the state of California resorted to a similar experiment when it ran out of funds. It is
well to remember that the issuing authorities get only a short term gain from this expedient.
When the scrip is returned in the payment of taxes or other dues, it provides no revenue to the
issuing government. For a discussion of this development, see Anthony Faiola, “Hard Times
Tarnish a Sterling Symbol,” Washington Post, August 30, 2001.
21 Seigniorage is the profit that government gets from issuing money. Under the currency
board system, seigniorage is represented by the income the currency board derives from the
assets it holds as backing for the peso. If the peso were abolished and Argentina adopted the
dollar instead, the seigniorage would accrue to the United States.
22 Omitted from this list is the hope that the Federal Reserve continues to lower interest rates
in the United States. Even though the financial markets of Argentina and the United States
are not well integrated, lower rates are better for Argentina than higher rates. At least they
may bring about some depreciation in the value of the dollar.

With this new monetary regime, Argentina achieved price stability, if not
deflation. This medicine did not come without side effects. The most important of
them is that the road back to full employment in the presence of negative economic
shocks is largely through deflation or absolute declines in wages and prices. This
occurs because the monetary regime makes Argentina a part of the U.S. currency area
and the mechanisms that enable the U.S. to cope with such shocks are, in general, not
available to Argentina. These include flexible exchange rates, monetary policy of the
Federal Reserve, federal fiscal policy, the highly integrated nature of the U.S. financial
system, and the ability of Americans to migrate freely from areas and industries where
demand is weak and unemployment high to areas and industries where demand is
stronger and unemployment lower. In addition, a great deal of U.S. trade is internal
and this strengthens the case for a common currency area. U.S.-Argentine trade is
very small and this strengthens the case for linking the two countries by flexible
exchange rates.
In the second half of the 1990s, Argentina was hit by four negative external
shocks: the appreciation of the dollar, high real American interest rates, the fall in the
price of the Brazilian real, and the decline in price of raw materials. Because the
adjustment mechanisms integral to the U.S. system are not available to Argentina, the
country has been forced into a serious contraction of income and an increase in
unemployment. The decline in the price level during the past 2 years is the primary
way Argentina has to restore income, trade, and employment.
In addition, the new monetary regime has placed a major constraint on Argentine
fiscal policy. Argentina should have conducted its fiscal policy as if it were another
U.S. state. This it has failed to do and the long string of fiscal deficits has greatly
added to the country’s national debt. The prospect that it can service this debt or will
attempt to get out of its economic problems by altering the peso/dollar exchange rate
has led to speculation against the peso.
Argentina has dealt with its macro problem by running a budget deficit,
subsidizing exports and taxing imports. The exchange rate of the peso has been
linked to both the dollar and the euro, but this will only come into effect when the
linked currencies reach parity with each other. Its debt problem has been dealt with
by efforts to lengthen its maturity (postpone the problem) and borrow from a variety
of international agencies to meet maturing obligations. Recently, discussions have
centered on dollarization as a way to reduce domestic interest rates. Some have
proposed that the peso/dollar exchange rate be altered. Both of these solutions have
inherent problems.

Appendix: The Dual Currency Board
When Argentina set up its currency board, it linked the peso only to the dollar
as its reserve currency. This exposed Argentina to all of the shocks that affect the
international exchange value of the dollar. Of particular importance has been the
strong appreciation of the dollar in the period since 1995. This appreciation has had
a major deflationary effect on Argentina. To prevent this from happening in the
future, Argentina decided to reduce its dependency on the dollar as a reserve currency
by linking the peso to both the dollar and the euro. The change will take effect
whenever the euro reaches parity with the dollar on the international exchange
markets. At that point, the peso will be set equal to one dollar or one euro. That is,
the holder of an Argentine peso will be able to go to the currency board and exchange
it for either a dollar or a euro – one for one. This shift to dual currencies, while
conceptually simple, accomplishes quite a number of changes. To make the following
discussion manageable, the operation of the system will be described first.
To see how the new system works and how it avoids the shock that comes from
appreciation of a single reserve currency, assume that the euro reaches parity with the
dollar and that on that date, the Argentine currency board converts half of its dollar
assets into euros (the proportion converted into euros is immaterial to the example).
Further, assume that shortly thereafter, for some reason, the dollar suddenly
appreciates such that in the market, one dollar exchanges for 1.5 euros. Since the
market ratio now deviates from the currency board ratio, it becomes profitable for
individuals (including the currency board) to engage in arbitrage. In this instance,
individuals would take pesos to the currency board, exchange them for dollars and sell
the dollars for euros in the market. The euros would then be taken to the currency
board and converted into pesos on a one-for-one basis. The net result is a .5 euro
profit for each peso purchased.23 This could continue until the currency board is
stripped of all of its dollar assets.24 At this point, its assets would all be denominated
in euros. (Nothing would prevent the currency board itself from doing the same
Once the currency board no longer holds dollars, the Argentine peso would only
be convertible into euros, the depreciated currency, and no one would have any
incentive to bring dollars to the currency board for conversion into pesos (because the
currency board undervalues the dollar). In effect, the Argentine peso is linked only
to the euro and it becomes the sole reserve currency. Of great importance, the prices
of Argentine goods and services will not effectively rise in terms of the euro even

23 Those familiar with monetary history will recognize this situation as analogous to that
occurring from the operation of a bi-metallic monetary standard in which both gold and silver
money are used and the official or mint exchange ratio of the two currencies deviates from that
dictated by the market.
24 Essential to this discussion is that the currency board runs out of dollars. Notice that by
supplying dollars for euros, the currency board’s action tends to drive the market exchange
ratio back to the currency board ratio. If this occurs before the currency board loses all of its
dollars, then the discussion to follow in the text will not occur.

though the dollar has appreciated.25 In fact, not only will the appreciation of the
dollar not have a negative effect on the Argentine economy, it will actually stimulate
demand for Argentine goods and services.
To see why this it true, consider the case of an Argentine good that costs 100
pesos. As the dollar appreciates, the market price of the good might be expected to
rise to 150 euros and this should discourage individuals in the euro area (or any other
country whose currency rises in value with the dollar) from purchasing the good (the
essence of the exchange rate shock). However, this won’t happen. The euro price
of Argentine goods will not rise because the currency board will still convert euros
into pesos on a one-for-one basis. Since the price of the good in Argentina remains
100 pesos, it only costs 100 euros to the purchaser in the euro area for with 100
euros, 100 pesos can be obtained from the currency board. Thus, the appreciation of
the dollar does not translate directly into an increase in Argentine prices for those
holding euros. Hence, with a dual currency board, an appreciation of the dollar (or
the euro) would impose no adverse shock on Argentina. Quite the contrary. The
appreciation of the dollar will stimulate demand for Argentine goods for all dollar
holders (and for those in countries whose currency has risen in value with the dollar)
since in the market, one dollar will now command 1.5 pesos and the peso price of
Argentine goods will fall in terms of dollars (and for all other currency holders whose
currency rises in value with the dollar).26 Should the reverse occur, and the market
exchange value of the euro rise above the dollar relative to the currency board ratio,
the currency board would be hit by the opposite phenomenon and its assets would
tend to shift from being all euros to all dollars.
The analysis above suggests that despite having a dual currency board, the
Argentine peso is likely to be linked to either the dollar or the euro, but not to both
simultaneously, for the market ratio of the two currencies is seldom going to be the
same as the currency board ratio and the assets of the currency board are unlikely to
be large enough to make this possible. Thus, shocks that lead to an appreciation of
one or the other of the two reserve currencies will expand demand in Argentina, not
cause it to contract.
Another implication of the dual currency board system is that Argentina will
switch from being in the dollar area to being in the euro area every time the peso
becomes linked only to one currency. While the theory of optimum currency areas
suggests that Argentina should not be linked to the dollar, it may not be true for the
euro. The euro area is, for example, Argentina’s second largest trading partner.
Thus, there may be a number of efficiency losses when the peso link is forced from
one currency to the other and then back again as the market ratio of the two
currencies departs from the currency board ratio.

25 This is also true for all currencies whose exchange rate for the euro remains unchanged
during the period of dollar appreciation.
26 Of course, the increased demand for Argentine goods and services is likely to put upward
pressure on their peso prices. Domestic price increases should be expected to affect demand
both domestically and internationally.

Does this change to a dual currency system come with any other adverse side-
effects? It may. First, shocks to the dollar or the euro are unlikely to coincide with
the Argentine business cycle. By having a link to two currencies, Argentina may be
exposing itself to many more shocks than if it was linked to only one currency. While
this could be stabilizing, it is more likely to be destabilizing. Second, the currency
board is likely to hold very short term assets to facilitate the shift in preferences
between the dollar and the euro whenever the market exchange rate deviates from the
rate set by the currency board. Since short term assets typically yield less than longer
term assets, this arrangement is likely to reduce the seigniorage earned by the
currency board. It is conceivable that the currency board would yield no seigniorage
at all.27 Third, the dual system may discourage foreign investment in Argentina.
Would international investors want to invest either dollars or euros in Argentina when
there is some probability of being paid in a depreciated currency when the time comes
to repatriate either the principal or earnings? This would add an additional element
of risk to the investment and require some additional interest to compensate for it.
Similarly, Americans may be less eager to trade with Argentina since they may not
know if their transactions will be settled in dollars or euros. Fourth, the dual system
could discourage international contracts for at least one of the parties could be in the
position of not knowing what the contract would cost. This will not be a problem as
long as the market ratio and the currency board ratios are the same. When they are
not and the peso shifts from being pegged to one to the other, the cost of the contract
could become greater or less than intended.
Thus, while the dual currency board may shelter Argentina from adverse shocks
due to an appreciation of a single reserve currency, it is a medication that does not
come free of adverse side effects, some of which may be serious.

27 The reader may wonder if the currency board will suffer a loss each time individuals shift
from wanting to hold dollars or euros or vice versa because the market exchange rate deviates
from the currency board rate. A simple answer is “no” in an accounting sense. The assets
of the currency board are always valued in Argentine pesos at the currency board exchange
rate of one-to-one. Thus, no matter whether the assets are all dollars or all euros or some
combination of the two, they are always converted into pesos at a one-for-one rate. Losses
could be incurred is the assets were to be valued in terms of the market ratio of the two
currencies, but this is not how it is done. A more sophisticated answer, however, is that losses
(or gains) are possible as the assets are shifted from those denominated in one currency to the
other. This depends on the relationship of the interest rates that prevailed when the assets
were acquired versus those prevailing when they are sold. Should the rates rise, losses could
be incurred. Should the rates fall, gains could be made.