Drawing the Wrong Conclusions from Argentina

By Desmond Lachman *

Last week, in a commendable act of self-criticism, the IMF issued a report evaluating the important role that the IMF played in the Argentine economic debacle of the last few years. In that exercise, the IMF drew many valuable lessons that should allow it to improve its performance in handling future emerging market crises. However, it has to be regretted that the IMF failed to draw the most basic of lessons from that sorry episode, especially given its supposed expertise in exchange rate matters. That lesson should have been that an emerging market country like Argentina should not lock itself into the most rigid of exchange rate regimes if it does not minimally satisfy the conditions for successfully doing so.

Larry Summers once famously quipped that judging by the IMF’s general approach, the letters IMF must stand for “It is Mostly Fiscal”. The IMF’s Argentina evaluation report will do much to reinforce that belief. For its main finding was that the Argentine crisis resulted from the failure of Argentine policy makers to take necessary corrective measures early, particularly in the consistency of fiscal policy with their choice of exchange rate regime. According to the IMF evaluation report, the IMF’s main fault was to support Argentina’s inadequate fiscal policies for far too long with unduly generous loan disbursements.

In the IMF’s evaluation, if only the Argentine government would have followed a more restrained fiscal policy in the economic boom years of the mid-1990s, it would have been able to successfully use fiscal policy in a countercyclical manner in the wake of the August 1998 Russian economic crisis. If only the IMF would have been consistently tougher on Argentine fiscal policy, Argentina would have had the wherewithal to withstand the series of shocks that hit it in1999.

The shocks, which hit the Argentine economy following th e August 1998 Russian crisis, were large by any standards. Those shocks included the floating and subsequent collapse of the Brazilian currency in January 1999, which resulted in a roughly 50 percent depreciation of the Brazilian real against the Argentine peso; the significant raising of US interest rates that immediately impacted Argentine interest rates through its fixed exchange rate system; and the plunge in international grain prices that substantially reduced foreign exchange receipts from Argentina’s principal export earner.

There is to be sure a certain amount of truth in the IMF’s assertion that things might have worked out differently had Argentina pursued a more consistently orthodox fiscal policy. However, this conclusion ducks the deeper question about Argentina’s choice of a currency board arrangement. Could a currency board possibly have been the right long-term exchange regime for a country with Argentina’s particular economic characteristics?

For after all, Argentina satisfied few of the optimum currency area criteria that Professor Robert Mundell taught us in the 1960s were necessary for a currency board’s success. Specifically, Argentina lacked wage flexibility, it did not enjoy labor market mobility, it could not have been economically more different from the United States to whose currency it was now pegged, and it did not enjoy a system of fiscal federal transfers with the United States. Should the IMF not have known that it was only a matter of time before the Argentine currency system would have been subjected to sufficiently strong asymmetric shocks that would have torn it asunder regardless of how good Argentina’s macro-economic policies might have been?

If this view of the world is correct, Argentina’s basic mistake was not so much that it did not support its currency regime with a sufficiently orthodox fiscal policy as the IMF now contends. Rather, it was that Argentina did not exit from its currency board arrangement in the mid-1990 s when favorable external conditions and a buoyant domestic economy might have allowed it to do so without economic dislocation.

The IMF must bear responsibility for not having leant on Argentina to move to a more appropriate exchange rate regime when the opportunity to do so presented itself. It should also be taken to task for having continued to lavishly bankroll a fatally flawed exchange rate system long after it had served its initial purpose of establishing domestic price stability. If this lesson is not fully internalized by the IMF, one must fear that it will repeat the same mistake of supporting for too long a fixed exchange rate regime in inappropriate circumstances with some other hapless emerging market economy.

Brazilian policymakers must consider themselves fortunate for not having succumbed during the 1990s to the seductive allure of a currency board arrangement to wring inflation out of the economy. Indeed, mindful of the dangers that a fixed exchange rate system might pose, Brazilian policy makers had the good sense to respond to the August 1998 Russian crisis by floating the currency in early 1999 within the context of an inflation-targeting regime.

Brazil’s success since 1999 in reducing inflation, while at the same time strengthening its external accounts, offers a valuable lesson to other emerging market economies. It shows that a fixed exchange rate arrangement, let alone a currency board system of the Argentine variety, is not necessary for attaining financial stability. One has to regret that the Argentine policymakers had to learn this lesson by their own bitter experience rather than by learning from their neighbors.

* American Enterprise Institute (U.S.)

Source: American Enterprise Institute