Argentina Has a Chronic Problem with Monetary-Policy Failure
Argentina suffered yet another so-called “currency crisis” last week. On Thursday and Friday the Argentine peso (ARS) depreciated 9% against the U.S. dollar (USD), falling from roughly 20.50 ARS per USD to 22.25 per USD. To stem the slide of the peso, Argentina’s central bank increased its target interest rate (the 7-day repo reference rate) from 30.5% to 40% over the course of two consecutive days. This came on the heels of a rate boost of 3-percentage points the previous week during which the bank also sold $5 billion in reserves. The central bank also boldly announced that it would use “all the tools at its disposal” to reduce inflation — which clocked in at 25% year over year in March — to its 2018 target rate of 15%. Politicians got into the act with the finance minister declaring at a press conference that the government had cut its target for its budget deficit from 3.2% to 2.3% of GDP.
Following these policy moves and proclamations, the peso ceased its decline and recovered 1.7% of its value against the U.S. dollar. For now, the markets have been calmed and, according to media commentators and financial analysts (here, here and here), the crisis has been at least temporarily resolved. As I pointed out in a post on an earlier Argentine currency crisis, however, the depreciation of the peso is not a crisis in itself that requires remedial treatment. A currency crisis is a salutary warning sign like the rising mercury column in a medical thermometer. Selling reserves and reversing short-term capital flows by incrementally raising interest rates in order to suppress rising prices of foreign currencies is like submerging the thermometer in ice water, which does absolutely nothing to address the patient’s underlying disease.
The true crisis that Argentina suffers from is a chronic and deep-rooted monetary policy failure. This has not even been hinted at in the standard media accounts of the most recent peso depreciation. It has been taken for granted that since the supposedly “pro-business” Mauricio Macri became president in December 2015, Argentina has been on a righteous path to deregulation, deficit reduction, and disinflation. But nothing could be further from the truth. However one gauges Macri’s success in achieving the first two goals, he has been as bad as, if not worse than, his left-wing populist predecessor on the inflation front. We need only look at two indicators to substantiate this claim: the USD/ARS exchange rate and the growth rate of the Argentine money supply (M2) since Macri took office.
As Ludwig von Mises pointed out at the beginning of 20th century, the most sensitive indicator of relative price inflation is the exchange rate. As we can see from Chart 1 below, the price of a dollar rose from roughly 13 pesos in late 2015, when Macri terminated exchange controls, to 22 pesos today, a depreciation of the peso by 70 percent against the dollar.
The only cause of price inflation and currency depreciation is, as Mises also taught, the expansion of the money supply by the government or its central bank, which monopolizes the issue of currency and bank reserves. Budget deficits and low interest rates are not causes of inflation but only the leading reasons why governments and central banks adopt expansionary monetary policies. Charts 2 and 3 below show that under the two-plus years of Macri’s administration, the year-over-year growth rate of the money supply never fell below 25% per annum and for the first three quarters of 2017 exceeded 45% per year.
Neither a reduction in budget deficits nor higher interest rates will prevent future currency crises. Budget deficits can be financed by non-inflationary borrowing from foreign investors. Carefully orchestrated increases in interest rates by central banks are useless because, unless credit markets are left free to discover the “natural” interest rate that equates the supply and demand for voluntarily saved funds, the money supply will continue to expand willy-nilly. Prices will therefore continue to rise and the currency will depreciate in fits and starts.
So forget interventions into foreign exchange markets! Forget interest rate manipulations! Forget inflation and deficit-reduction targets! If the Argentine government is serious about ridding the country of the (alleged) scourge of currency crises, all it has to do is order the central bank to cease all open market and lending operations. This would effectively freeze the amount of bank reserves and currency in the country (aka, “the monetary base”) bringing a halt to further expansion of the money supply and allowing the interest rate to find its natural level. Recession and a further depreciation of the exchange rate may initially ensue as malinvestments are liquidated and prices, wages, and production are readjusted to comply with consumer preferences. Eventually, however, this hard-money policy will cause the peso to appreciate on foreign exchange markets. At this point policymakers may have a discussion about implementing a more permanent anti-inflation policy such as abolishing the central bank and the peso itself and “dollarizing” the economy. Or they may consider abolishing all legal barriers to paying and contracting in gold, silver and foreign currencies to provide competition with the peso.