Argentina's Financial Crisis: Floating Money, Sinking Banking

Introduction

and summary The recent and still developing Argentine crisis has already generated a heated debate among proponents of alternative explanations, each emphasizing different factors as the main underlying drivers. Feldstein (2002), for example, argues that the crisis was due to exchange rate overvaluation that could not be easily corrected and to an excessive amount of foreign debt. From a different perspective, Calvo, Izquierdo, and Talvi (2002) claim that a sudden stop in capital flows following the Russia crisis created a major real exchange rate misalignment and fiscal problems in Argentina that were difficult to address given the country's widespread currency mismatches, high indebtedness, and relatively closed economy. Perry and Servén (2002) find the origins of the crisis in multiple vulnerabilities (deflationary adjustment under the hard peg, high public debt and fiscal fragility, and hidden weaknesses in the financial sector), neither of which was decisive by itself. But all these factors reinforced each other in a perverse way under the post-1997 shocks, leading to a major overvaluation of the real exchange rate and pessimistic expectations regarding growth prospects. The economy thus entered a vicious circle from which it was very hard to pull out, particularly considering rigid and insufficient policy instruments, as well as faulty policy decisions. Mussa (2002), by contrast, emphasizes that, given the decision to adhere to convertibility, the post-1997 external shocks (including the appreciation of the U.S. dollar and the devaluation of the Brazilian real), and labor market rigidities, the "fundamental cause of [the] disaster […] was the chronic inability of the Argentine authorities to run a responsible fiscal policy," which led to a fast rise in the ratio of debt to GDP during the 1990s and up to the outburst of the crisis. In this paper we argue that the relation between the currency board and the financial system—that is, the link between money and banking—is key to understand the unravelling of the Argentine crisis. In particular, it is crucial to explain the manner in which the crisis unfolded, its timing and severity, and the complications in managing and resolving it. This is because the currency board was not just a simple peg but rather a central part of the Argentine social contract that enjoyed deep political support, given its success in bringing about stability. Convertibility was also a "core" or "master" contract, in the sense that it underpinned a wide range of contracts across the whole economy. It was clear that, from the point of view of Argentina's trade and productive structure, a rigid peg to the dollar was highly inconvenient.1 But convertibility was not chosen in view of trade considerations. It arose in response to hyperinflation and against the historical background of repeated episodes of debasement of the domestic currency. As a result, the function of money as a store of value (and, hence, the confidence in, and sound functioning of, the financial system) as well the contracting function in the economy (and not just in regard of financial contracts) became inextricably intertwined with convertibility.download