Argentina’s empirical contribution to monetary theory…

(Photo Credit)

A few weeks ago talking to Nick Hubble, I told him what happened in Argentina when several provinces and the federal state issued quasi-currencies. He was interested and asked me to write a piece for “The Road to Freedom,” the newsletter that MoneyWeek and the Austrian Economics Center publish for this year’s Free Market Road Show. Please find below what I wrote (and don’t forget to subscribe to “The Road to Freedom” clicking here).

Competing money supplies à la Argentina

by Federico N. Fernández*

One of the most groundbreaking ideas of Friedrich von Hayek and the Austrian School of Economics is free banking. By this, they mean a system in which money would be privately offered by certain institutions and different currencies would compete for the favour of the consumer. The Austrians believe that a free banking system would bring more stability and accountability to the monetary system. Legal tender laws and the presence of the Central Bank of Argentina as a lender of last resort have very harmful consequences.

Among many criticisms that are put forward against free banking, a main one is that it would be completely impractical. How would people deal with the different suppliers? How to select “the right one”? People would be completely lost in this scenario of multiple currencies and total chaos would arise.

The literature refuting this apocalyptic picture is abundant. However, instead of referring to that I would like to tell you a story of something that happened in my beloved Argentina between 2000 and 2003.

Let’s start with some history

In 1989 and 1990 Argentina had a total economic breakdown and two hyperinflation crises. Public services did not work. Supermarkets were looted. There were shortages of basic goods. The state could not guarantee the provision of electricity — and its provision was rationed to certain hours.

This catastrophe forced our politicians to fight inflation in ways they’ve never done in the past five decades or so.

Enter “convertibility”

Domingo Cavallo (Photo Credit)

In 1991 a law was passed by Congress that established a monetary convertibility (also known as a currency board). This law said that for every peso (our local currency) that was circulating in the economy there should be a US dollar stored in the central bank. Thus, the capacity to print money out of thin air was abolished. And with it, the horrible fear of inflation that Argentina had suffered so much.

The effects of convertibility were almost instant. Inflation stopped and a country that was used to inflation since the 1950s entered a period of stable prices and economic growth.

As one of the ministers of that time put it: “With the convertibility regime we locked away the money printing presses and threw away the key.”

One can easily see that a system like convertibility basically forbids the government to make monetary policy. For every new peso you want to print, you need to deposit first a dollar at the central bank. Therefore, when the government needed to pay its bills it couldn’t just “create” the money. They had to get it from somewhere. These sources of revenue could be taxes and debt. And the Argentine government started to abuse both of them. By the end of the 90s the economy was in recession and sovereign debt had skyrocketed. Nonetheless, our spendaholic politicians weren’t thinking about balancing the budget and reducing spending. That would be something completely exotic for them.

The situation they were facing included:

  • Impossibility to print money due to the convertibility regime
  • Taxes already very high and economy in recession
  • Huge deficits
  • International credit getting more expensive and restrictive due to the (very real) fears of sovereign debt default

So, what was their alternative solution? Start issuing their own money!

Around the year 2000, several Argentine provinces and even the federal government started issuing quasi-currency to pay for state salaries, public projects, etc. These new currencies were technically IOUs that the different administrations committed to redeem in the future. Their face value was to be considered as if they were pesos. For instance, the province of Buenos Aires (our biggest province) issued IOUs named “patacones”. 100 patacones were supposed to be accepted and traded as if they were 100 pesos. But this was hardly the case…

Competition begins

(Photo Credit)

Argentine people in those years weren’t staunch Hayekians nor supporters of the Austrian School of Economics, believe me. However, that great mechanism which is the market started to work. Consequently, a series of very interesting things could be observed.

Firstly, only the “national” IOU, the one issued by the federal government, was accepted nationwide at approximately face value. This is because people thought this was the only one that had good chances of actually being redeemed someday.

Secondly, exchange rates started to reflect the preferences of the population. No IOU was taken at peso parity. All of them were taken at a discount. How big that discount was basically depended on how broke any given province was. Thus, the bonds from the provinces of Corrientes and Entre Ríos — both in terrible financial shape — were taken at just 30 or 40% of their face value. The ones from the province of Buenos Aires — which actually promised a premium — and the ones from the federal government scored much better.

Thirdly, with the exception of the IOU issued by the federal government, none of these quasi-currencies were accepted outside of their province of origin. There could of course be certain speculative trades, but generally no business from one province took the IOUs of another one. Moreover, the bonds issued by the provinces that were completely bankrupt were repudiated even by their own citizens. In many cases they were forced to take them (public employees, for example). However, they spent them as soon as they could and the exchange rate against the peso was very low.

A magnificent experiment, but…

What happened to these IOUs? Some provinces honoured their commitments after convertibility fell by the end of 2001. That meant that they paid pesos that bought fewer dollars (from 1 to 1 the exchange rate went to 3 pesos per dollar). Other provinces couldn’t do it, and eventually the federal government redeemed these IOUs that were still in circulation. This happened around 2005.

The experience in Argentina was very different from what Hayek and the Austrians think competitive money supply would be like. However, in spite of all its degenerate features, I believe it helps us to shed some light into how different currencies could compete. And the result is not chaos, but an effective way to sort the better ones from the rotten apples.

It was indeed a magnificent experiment of currency competition. I just regret I had to live through it.

* Federico N. Fernández is senior fellow of the Austrian Economics Center (Vienna, Austria), and vice president of Fundación Bases (Rosario, Argentina).

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