Putting all your 401(k) eggs in one basket

It is dangerous to elevate a currency as a political emblem if the need for other economic reforms is obscured, says Amity Shlaes.

Currencies are in the news. In Argentina, the story is the death of the dollar-linked peso and any confidence in the state. In Europe the story is the birth of the euro, which is then supposed to yield confidence in Europe's political future.

These have been treated as entirely separate events but they raise common issues. The Argentina saga shows that no currency, however virtuously conceived, can alone save a people or an economy. Reform aimed at increasing competitiveness and reducing the size of government relative to the economy must attend it. And it is dangerous to elevate a currency as a political emblem while putting off the problem of competitiveness.

In 1991, after a generation of wild inflation, the government of Carlos Menem flamboyantly launched a new currency as the basis of future economic stability. "Each peso is a contract between the government and the peso holder," declared Domingo Cavallo, the finance minister. Mr Cavallo made an ill-fated return to office last year in a vain attempt to shore up that contract.

Because Argentina's monetary record had been one of the worst in the world, the Menem government promised voters that they could convert their pesos to dollars whenever they liked. This plan, known as a currency board, was as important to Argentina as the euro is to eurozone countries. Argentina was in effect chopping off its monetary arm, ceding control of interest rates and inflation to the US.

The sponsors of Argentina's convertibility programme sought to send the same message to voters that the euro's backers seek to send to their constituents now: trust us. Greater political good will flow from this currency. In the short term, Argentina's currency bet paid off. The dollar link gave the nation's middle class - those who had been robbed blind by inflation - the confidence to continue there. It pulled in foreign investors. By the mid-1990s, Argentina was an emerging market wunderkind.

But while the currency board produced stability, it could not succeed indefinitely without reforms to increase competitiveness. This, after an impressive start, its governments failed to deliver.

They failed to liberalise trade enough to expand exports dramatically. They failed to change restrictive labour laws. They raised taxes above US levels. The result was that Argentina was not enough of a contender to withstand external shocks, or count on future investor confidence.

It is sad to report that Argentina's international advisers and its backers at the International Monetary Fund and in Washington were inconsistent about their wunderkind. To be sure, they poured in cash by the tens of billions. But this had the effect of convincing Argentina that bail-outs could always be counted on.

What is worse, these advisers mostly looked away when, in the second half of the 1990s and later, the government allowed provinces to expand debt via unsustainable programmes. Examples included a folly of a canal in La Rioja, Mr Menem's home province, and the growth of social commitments. When they did look, they concentrated too much on fiscal balances and too little on competitiveness.

Last, rather than defend the dollar link, some of the country's advisers advocated breaking it to save things that had earlier been subordinated to the sanctity of the currency contract: budget commitments, the banks and the state. In this newspaper Ricardo Hausmann, formerly of the Inter-American Development bank, backed a plan that would de-link the peso from the dollar, in effect allowing devaluation.

The result is the uprising we see today. "They defrauded me," an Argentinian woman told La Nacion, the Buenos Aires newspaper. If the general economic problems angered voters, the fear that the Menem government's currency contract was about to be betrayed led to riots.

Argentina contains a message for the eurozone, which also has fiscal work before it, albeit of a less urgent variety. The euro, however glorious an innovation, is not enough. Europhilia will become dangerous if it is allowed to obscure other reforms.

ABC News reported recently that "in rural Portugal, where people tend to put their trust in the Church and not the government, priests are part of the euro education campaign". Did southern Europe's priests also tell citizens that painful employment reforms were needed if the euro was to be a strong currency?

But the saga of the currency board has implications for places beyond Argentina or Europe. Citizens in poorer parts of the world will argue that the devaluation makes the wealthy north into a currency hypocrite. Developed nations, they will point out, talk a lot about stable currencies for themselves but they helped to create the conditions for a currency break down in Argentina by backing unsustainable policies.

This is the moral hazard of international intervention in economies. America is seen to be backing a stable currency and then reneging - giving a dollar and then taking it away. One can argue that nothing other than devaluation was possible. Or that, by supporting the currency board and a hard and stable currency, I have proved myself captive to outdated gold standard theology.

The point is not to defend the currency board, although I would do that, but to note that a monetary promise is about the most serious a government can make. Honouring it entails more than governments often acknowledge.

As the Portuguese story reminds us, monetary regimes have an aspect of the Church. By failing to push harder for changes that could have sustained Argentina's currency board, and then failing to defend the board when it was challenged, the world's economic leaders have breached faith.

© Copyright 2002 Financial Times

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To book Amity Shlaes for a speaking engagement, contact Jamie Brickhouse at the Red Brick Agency, 646.281.9041.
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