THE ARGENTINE STRAW MAN: A RESPONSE TO CURRENCY BOARD CRITICS

THE ARGENTINE STRAW MAN: A RESPONSE TO
CURRENCY BOARD CRITICS
Steve H. Hanke
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 fac-
tual errors.1 The most oft-repeated and egregious errors are the fol-
lowing:
• Argentina employed a currency board from April 1, 1991, until
January 6, 2002, that rendered the central bank, the Banco Cen-
tral de la República 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 devalu-
ation, “pesofication” of the economy, and a freely floating ex-
change rate would reinvigorate the economy.
Cato Journal, Vol. 23, No. 1 (Spring/Summer 2003). Copyright © Cato Institute. All rights
reserved.
Steve H. Hanke is Professor of Applied Economics at the Johns Hopkins University and a
Senior Fellow at the Cato Institute. The author thanks Kurt Schuler for his comments and Matt
Sekerke for research assistance.
1Not all of the works on the Argentine crisis suffer from these egregious errors. See Calvo,
Izquierdo, and Talvi (2002), Powell (2003), and Schuler (2003) for a sampling of that
literature. As for the faulty literature, I will limit the citations to a sample of writings that
are most representative.
47

---

CATO JOURNAL
• 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, re-
spectively, 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 exis-
tence, 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 be-
tween 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 do-
mestic assets (Hanke 2002a: 210). The offsetting was especially dra-
matic 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 con-
siderable discretion, especially after 1994. In that period, the BCRA’s
2Key economic and financial indicators for Argentina from 1989 to 2002 are collected in
Schuler (2003: Table 1).
3For an early appraisal of the convertibility system’s central bank-like features and the
problems that might (and did) ensue, see Hanke, Jonung, and Schuler (1993: 72–76) and
Hanke (1991).
48

---

THE ARGENTINE STRAW MAN
net domestic asset position was more than six times more volatile than
that of Chile’s central bank, which clearly has an independent mon-
etary 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 re-
quirements, 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 exac-
erbated 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 signifi-
cant upward leaps in the peso risk premium began on April 25, 2001,
when Cavallo began his attack on convertibility. After ousting Gov-
ernor 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 cur-
rency 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” (Eichen-
green 2002: 112). Paul Krugman (2001a), in particular, lamented:
“Because the currency board allows no flexibility in monetary policy,
policymakers cannot respond, Greenspan-style, by opening the mon-
etary spigots.”
If the currency board critics had bothered to read the BCRA’s
charter, examine its balance sheet, and recognize the flood of regu-
lations pouring from the pens of the central bankers, they would have
concluded that the convertibility law did not create a true currency
board. Instead, what Argentina really had was a central bank with a
pegged exchange rate and a domestic monetary policy, distinguished
by the unique feature of the convertibility of pesos into dollars on
demand. And like most central banks employing a pegged exchange
49

---

CATO JOURNAL
rate, the Argentine system proved vulnerable to conflicts between the
peg (the exchange rate policy) and domestic monetary policy (Hanke
1998). A proper examination of the convertibility system would have
led any informed and objective observer to conclude that the rules of
the game contained in the BCRA’s charter were flawed and that
garden-variety missteps by the authorities led to the system’s eventual
demise.
It is worth noting that F. A. Hayek concluded in 1932 that critics
of the gold standard also attacked a straw man:
There has been much talk about the breakdown of the gold stan-
dard, particularly in Britain where, to the astonishment of every
foreign observer, the abandonment of the gold standard was very
widely welcomed as a release from an irksome constraint. However,
it can scarcely be doubted that the renewed monetary problems of
almost the whole world have nothing to do with the tendencies
inherent in the gold standard, but on the contrary stem from the
persistent and continuous attempts from many sides over a number
of years to prevent the gold standard from functioning whenever it
began to reveal tendencies which were not desired by the country
in question. Hence it was by no means the economically strong
countries such as America and France whose measures rendered
the gold standard inoperative, as is frequently assumed, but the
countries in a relatively weak position, at the head of which was
Britain, who eventually paid for their transgression of the “rules of
the game” by the breakdown of their gold standard.
That the otherwise conservative managements of the central
banks deviated in a relatively lighthearted manner from the tradi-
tional rules of monetary policy can be attributed to the influence of
new ideas on monetary policy, propagated by the academic frater-
nity, which obtained wide circulation during the postwar years
[Hayek 1999: 153].
Hayek stressed that under a classical gold standard, as with a currency
board, the money supply should vary in a one-to-one correspondence
with changes in the monetary authority’s net foreign reserves. As
sterilization of foreign currency inflows or offsetting of outflows was
an anathema for Hayek, so too are they for advocates of currency
boards.
The Overvaluation Canard
Currency board critics assert that the peso’s one-to-one link with
the dollar under convertibility left the peso overvalued and made
Argentine exports uncompetitive, contributing to a general economic
malaise. Krugman (2000), for example, declared “Argentine producers
50

---

THE ARGENTINE STRAW MAN
find themselves priced out of world markets.” Martin Feldstein
(2002) agreed: “Because the exchange rate was fixed at too high a
level, Argentina exported too little and imported too much.” Thomas
Willett (2002: 52) also concluded that Argentina’s recession was deep-
ened by the overvalued peso and the “inability of producers to com-
pete at home and abroad.”
Does their story withstand examination? Argentina’s exports in-
creased every full year during convertibility except 1999, when Brazil,
its largest trading partner, suffered a currency crisis. Even during
the first 11 months of 2001, exports were about 3.2 percent ahead
of exports during the same period in 2000 (Liskey 2001). Argentina’s
export performance was relatively strong, outpacing a mere 0.9 per-
cent real increase in world trade. Indeed, the export sector was, at
the time, one of the few bright spots in the Argentine economy. If the
rest of the economy had been growing as fast as the export sector
during 2000 and 2001, Argentina would not have experienced a re-
cession.
In attempts to demonstrate the peso’s overvaluation, some observ-
ers asserted (on the basis of taxi rides from the airport or other casual
impressions) that prices were high in Buenos Aires, and that high
prices were evidence that the peso was significantly overvalued
against the dollar. A Union Bank of Switzerland survey of prices in 58
of the world’s largest cities found that for a weighted basket of 111
goods and services—including three categories of house rent—
Buenos Aires ranked 22nd, about midway between the most expen-
sive city, Tokyo, and the least expensive, Bombay. The survey also
found that taxi rides that were so expensive in Buenos Aires cost
about 8 percent less than in Rio de Janeiro (Union Bank of Switzer-
land 2000: 6, 19).
There are other indicators that contradict the overvaluation story,
too. For example, The Economist’s Big Mac Index indicates that the
peso, before its devaluation, was 2 percent undervalued. Although the
Big Mac Index, as well as more sophisticated estimates of equilibrium
exchange rates, should be treated with skepticism, a recent study
using data from 1993 to 1999 indicates that the peso was always
within 6 percent of its so-called fundamental equilibrium real ex-
change rate (Hristov 2001).
To determine whether claims about the overvaluation of the peso
before the abandonment of convertibility were justifiable, I computed
an equilibrium exchange rate for the peso on the basis of the relative
movements of prices in Argentina and the United States. First, I
recentered producer price indexes from Argentina and the United
States so that the index number for April 1991 (the beginning of
51

---

CATO JOURNAL
convertibility) would be 100 for each index.4 The ratio of the index
numbers multiplied by the base period exchange rate (in this case, 1)
gives the equilibrium exchange rate for any subsequent date. I then
subtracted the actual exchange rate (in all cases, 1) from the equilib-
rium exchange rate prediction to obtain the peso’s hypothetical de-
viation from its equilibrium exchange rate.
I then used the same method to compute an equilibrium exchange
rate on the basis of consumer price indexes in both economies.5 The
results from the consumer price indexes tell a much different story
from that told by the producer price indexes. But to use consumer
price indexes for an equilibrium exchange rate calculation is to com-
mit a serious analytical error. Because international arbitrage is re-
sponsible for bringing an exchange rate into line with its purchasing
power parity level, the relevant prices to consider in a equilibrium
exchange rate calculation are those of traded goods. Consumer price
indexes include a number of nontraded goods that are exempt from
the forces of arbitrage, whereas traded goods generally account for
the lion’s share of producer prices condensed into an index. Accord-
ingly, the predictions made using producer price indexes more closely
reflect an equilibrium exchange rate. The results of my calculations
are displayed in Figure 1. It is clear that, using the producer price
indexes, there is no merit to the overvalued peso story.
The Devaluationists
Having conjured up news of a fire, the devaluationist bucket bri-
gade set out to douse the flames. For them, a peso devaluation,
pesofication of the economy, and a floating exchange rate would save
the day.
Ricardo Hausmann (2001) took the lead, advocating “first, de-
dollarization of the foreign debt, the financial system and the domes-
tic contractual environment; second, a floating exchange rate an-
chored by strict inflation targets.” Michael Mussa (2001) and Paul
Krugman (2001b) concurred. And while Martin Feldstein (1999)
once observed that Argentina had “stayed competitive because its
domestic producers lowered the cost of Argentine goods by increasing
4The Argentine producer price index is from the Ministry of Foreign Relations; the U.S.
producer price index is from the Bureau of Labor Statistics (index of all manufactured
goods).
5The Argentine consumer price index is from the Ministry of Foreign Relations; the U.S.
consumer price index is from the Bureau of Labor Statistics (CPIU, all urban consumers,
all items).
52

---

THE ARGENTINE STRAW MAN
FIGURE 1
PERCENTAGE OVER/UNDERVALUATION OF THE ARGENTINE
PESO, LIFETIME OF CONVERTIBILITY
productivity,” he now wrote, “A market-determined floating exchange
rate is the only way to avoid these [competitiveness] problems” (Feld-
stein 2002).
Needless to say, the bucket brigade’s water turned out to be gaso-
line. President Duhalde chose to abandon the convertibility system by
decree on January 6, 2002, “pesofy” the economy and bank balance
sheets asymmetrically, and float the peso on February 12, 2002. It is
important to stress that the Duhalde devaluation was more than a
garden-variety devaluation because he violated the convertibility law’s
redemption pledge—the government’s legal obligation to redeem 1
peso for 1 dollar. Even though the Argentine courts subsequently
ruled, in September 2002, that the pesofication of the economy and
devaluation were illegal, a confiscation of peso holders’ property (i.e.,
the central bank’s dollar reserves of $17.8 billion) occurred in January
2002 (Hanke 2003).
The devaluation did indeed push Argentina’s trade account into
surplus—making imports three times more expensive will do that.
53

---

CATO JOURNAL
Exports fell in dollar terms by 4.5 percent from 2001 to 2002, while
imports imploded, shrinking by 55.7 percent over the same period.
Before the suspension of internal convertibility (the corralito) and
the asymmetric pesofication of bank balance sheets, the Argentine
banking system was robust. Extensive foreign ownership, regulations
that required a high level of capital, and prompt action to close
insolvent banks made the banking system much stronger than it was
when the tequila crisis hit in 1995, rendering it one of the healthiest
in Latin America (Powell 2003: 16, n. 24). The Duhalde administra-
tion, however, reversed all that when it decreed the asymmetric pe-
sofication of bank balance sheets. Under the terms of pesofication,
dollar reserves were seized from banks and converted into pesos at
the rate of 1.4 pesos per dollar. Bank loans made in dollars were
converted into pesos at one peso per dollar in a populist move to
reduce consumers’ personal debt service cost. Finally, bank deposits
made in dollars were converted into dollars at the 1.4 peso per dollar
rate. Unable to withdraw their deposits, Argentines have seen the
losses on their deposits fluctuate with each new decree and proposal
for bailing out banks and depositors. The impact of those measures on
the banking sector was considerable. The windfall loss from the mea-
sures immediately following their implementation exceeded the capi-
tal of the consolidated banking system.
The confiscation of private property and the collapse of the banking
system (and ensuing credit crunch) have decimated the economy.
Indeed, industrial production fell by 10.6 percent during 2002, and
consumer confidence reached an all-time low. And that is not the end
of the story. In the interest of promoting its often-neglected strategic
engagement with Latin America, the Bush administration urged the
IMF to bail out Argentina in January 2003. The IMF complied by
rolling over $6 billion in Argentine debt.
By turning a blind eye toward the Duhalde government’s theft and
the utter collapse of the Argentine economy, which has sent millions
into abject poverty, the Bush administration jettisoned the principle
of property rights—a principle whose importance was clearly stated in
the 2003 Annual Report of the Council of Economic Advisers. Chap-
ter 6, “A Pro-Growth Agenda for the Global Economy,” states: “In-
stitutions that protect property rights are central for economic
growth” (Council of Economic Advisers 2003: 237). Moreover, it
states that countries that fail to enforce the rule of law and private
contracts will fail to qualify for U.S. bilateral assistance through the
President’s new Millennium Challenge Account.
The Argentine economy is beginning to show superficial signs of
recovery, but those short-term benefits have been achieved at the cost
54

---

THE ARGENTINE STRAW MAN
of future growth. Neopopulist policies have promoted capital con-
sumption. In 2002, depreciation exceeded investment by 6.5 percent
of GDP, and is expected to do so by at least 4.5 percent of GDP this
year (Mondino 2003: 44). While capital consumption might give tem-
porary relief, it portends a more comprehensive future collapse
(Hayek 1984).
The Case for Dollarization
The case for dollarization—the liquidation of the central bank and
replacement of the peso with the dollar—is stronger today than ever.
Dollarization, combined with off-shore banking, could give Argentina
the confidence it so desperately needs. Argentina has never had a
stable central bank-issued currency (della Paolera and Taylor 2001).
Since the central bank was established in 1935, the peso has depre-
ciated against the dollar by a factor of about 9,000,000,000,000. Un-
derstandably, Argentines do not trust the peso. Indeed, Argentines
continue to dollarize the economy spontaneously and unofficially at a
rapid rate. In 2001, the greenbacks circulating in Argentina totaled
$28 billion, and in 2002 the total grew to $35 billion. This $7 billion
increase exceeded the dollar value of new peso base money emitted
over the same interval. To eliminate the possibility of more Argentine
monetary mischief and restore confidence, the central bank should be
liquidated, its power to issue currency should be repealed, and private
Argentine banks should be allowed to issue U.S. dollar-denominated
notes (Hanke 2003).
Critics, however, have dismissed dollarization as a viable alterna-
tive. Willett (2002: 59) argues that the “debate over dollarization was
like a discussion about alternative types of cosmetic surgery while the
disfigured accident victim was bleeding to death.” Anne Krueger of
the IMF, when asked about the dollarization option for Argentina at
a press briefing on January 11, 2002, responded, “Well, my under-
standing at the moment is that [dollarization] is technically unfeasible.
So I don’t think the authorities are thinking about it; I don’t think we
are thinking about it” (Krueger 2002). The IMF crushed the possi-
bility of dollarization with its bureaucratic weight and made a sham of
its declared policy to foster local ownership of economic policies.
Yet, the facts did not support the IMF’s position. On January 10,
2002, the central bank had “pure” foreign reserves equal to $14.75
billion and 3.93 billion pesos in overdrafts and rediscounts to banks
that were fully collateralized by publicly traded securities assessed at
market value. Unless the central bank was cooking the books—or the
IMF knows something that we don’t—those two categories of assets
55

---

CATO JOURNAL
would have been more than adequate to cover the central bank’s
17.92 billion in outstanding peso liabilities at the one peso–one dollar
exchange rate, making dollarization a feasible option (Hanke 2002b,
2002c).
Conclusion
The Argentine crisis was not caused by the failure of a currency
board, but by its absence. Currency board critics attacked a straw
man. What Argentina needs is stable money and limited government;
those goals can best be achieved through dollarization coupled with
free banking, protection of property rights, and fiscal accountability.
References
Calvo, G.; Izquierdo, A.; and Talvi, E. (2002). “Sudden Stops, the Real
Exchange Rates and Fiscal Sustainability: Argentina’s Lessons.” Inter-
American Development Bank, 11 March (www.iadb.org/res/publications/
pubfiles/pubS-146.pdf).
Council of Economic Advisers (2003) “The Annual Report of the Council of
Economic Advisers.” In Economic Report of the President. Washington:
Government Printing Office.
della Paolera, G., and Taylor, A. M. (2001) Straining at the Anchor: The
Argentine Currency Board and the Search for Macroeconomic Stability,
1880–1935. Chicago: University of Chicago Press and NBER.
Eichengreen, B. (2002) Financial Crises and What to Do About Them. New
York: Oxford University Press.
Feldstein, M. (1999) “A Self-Help Guide for Emerging Markets.” Foreign
Affairs 78 (March/April): 93–109.
(2002) “Argentina’s Fall.” Foreign Affairs 81 (March/April): 8–14.
Hanke, S. (1991) “Argentina Should Abolish its Central Bank.” Wall Street
Journal, 25 October.
(1998) “How to Establish Monetary Stability in Asia.” Cato Journal
17 (3) (Winter): 295–301.
(2002a) “On Dollarization and Currency Boards: Error and De-
ception.” Journal of Policy Reform 5 (4): 203–22.
(2002b) “Questions the IMF is Obliged to Answer.” Financial
Times, 17 January.
(2002c) “Questions Remain Unanswered.” Financial Times, 6 Feb-
ruary.
(2003) “A Dollarization/Free-Banking Blueprint for Argentina.” In
J. Dean, D. Salvatore, and T. Willett (eds.) The Dollarization Debate,
387–400. New York: Oxford University Press.
Hanke, S. H.; Jonung, L.; and Schuler, K. (1993). Russian Currency and
Finance. London: Routledge.
Hausmann, R. (2001) “A Way Out for Argentina.” Financial Times, 30 Oc-
tober: 23.
56

---