Argentina's Monetary
Policy Lesson for Mexico

By RUDI DORNBUSCH

Ever since Argentina got its new currency in 1991, a dramatic change has taken place. In the 1980s Argentine output shrank almost 0.5% per year; in the past six years annual growth has been in the 5% range. Argentina is the only country that today enjoys both price stability and vigorous growth.

Over the years, Argentina has experimented with both good and bad monetary policies. Now even casual observers can see that hard money is the hands-down winner.

With this evidence, it's instructive to compare Argentina's story with the experiences of other countries in the region that have fiddled with currency experiments but, lacking the discipline brought about by a law, have not been forced to recognize the importance of fiscal and structural reform. The Argentine Convertibility Law gives the country no choice but to adjust prices and competitiveness to the currency.

"Argentineans are always in trouble about their currency," Bankers Magazine wrote in 1889. "Either it is too good for home use, or as frequently happens, it is too bad for foreign exchange. Generally they have too much of it, but their own idea is that they do not have enough. The Argentineans alter their currency almost as frequently as they change their finance ministers. No people on earth has a keener interest in currency experiments than the Argentineans."

A few years later Finance Minister Ernesto Tornquist put Argentina formally on a gold standard, limiting the issue of money to the holdings of the treasury, thus stabilizing currency. That's when Argentina became, for a while, one of the leading economies in the world.

"In consequence of this law, gold poured into the treasury in quantities which far surpassed the most optimistic anticipations," according to "Economic Development of the Argentine Republic in the Past 50 Years," published by Banco Tornquist in 1919. "The monetary circulation increased correlatively, business increased in unlooked for degree and the economic development of the country presented the notable success which has attracted the attention of the whole world."

Argentina did well with its internationalism until, in the 1930s, the light was switched off on free trade and stable money around the world. Along with the rest of Latin America, Argentina went for protectionism. That set the stage for Juan Peron to add populism and labor unions; from there it was downhill both for monetary stability and the standard of living. Per capita income stagnated; inflation increased; periodic half-hearted attempts at stabilization and reform yielded to whole-hearted moves to nationalize production and print more money. Capital fled the country; soon Argentinians paid their taxes like Italians--hardly at all--and formed unions like the British--with a vengeance. In the early 1980s, only some 3,000 people paid income tax and the big question was why so many did. Unions divided their time equally between working and striking. Hyperinflation was the inevitable last stop of this debilitating process.

Argentina's currency board-like arrangement would be ideal for Mexico, except for one small problem: credibility. Mexico remains suspect and hence must take more drastic steps.

After some half-hearted measures to stop hyperinflation failed, President Carlos Saul Menem and his uncompromising new finance minister, Domingo Cavallo, introduced the Convertibility Law in 1991. At the outset, hard money meant just recognizing the facts: The dollar had become Argentina's de facto money. The law established a firm rule: fixed parity with the dollar, the dollar as legal tender, no issue of local currency except when backed 100% by dollar reserves in the central bank, and no financing of the Treasury by the central bank.

Hard money provided the cover for the urgent reforms: privatization, restructuring of the public sector and elimination of pervasive subsidies. Moreover, the monetary regime withstood tough tests during the Mexican peso crisis.

True enough, Argentina has high unemployment--the immediate counterpart of drastic restructuring and liberalization--but no politician would dare touch the rule; in Argentina everybody understands that tinkering with the monetary rule means going back to hyperinflation. The old answer of public works is fortunately out of date. The remaining strategy involves deepening flexibility and productivity, and adopting a tax structure that favors employment rather than taxes.

Since hard money has been a political and economic success for Argentina, who is in line to emulate the experience? Believe it or not, Mexico. A move onto a fixed dollar parity would offer relief from the six-year cycle of devaluation and collapse that coincides with presidential terms. Halfway into the current cycle, the government has just spent its way to winning the forthcoming congressional elections. For the presidential election in 2000 we can expect even more politics and less economic stability. Mexico can change all that by going on a dollar-based system.

Argentina's currency board-like arrangement would be ideal for Mexico, except for one small problem: credibility. Mexico remains suspect and hence must take more drastic steps.

In order to address this, Mexico should go one step further and get rid of the peso almost completely. Specifically, the entire banking system should operate in dollars. That way any fears of junking the currency board or of yet another devaluation would become impossible. This rather radical reform would establish an unprecedented level of confidence. The argument on the other side--that this is politically impossible, nationalism won't permit it--is outdated.

Mexican per capita GDP today is still where it was in the mid-'70s. If Mexico cannot manage a competitive exchange rate, it must get rid of its exchange rate. On a dollar system, wages and prices would quickly converge to U.S. levels, the official system of wage fixing (known as the pacto) would fortunately become impossible, risk premiums in credit markets would shrink, and the credit market would come back to life. The loose cannon--the peso--would be rendered harmless.

Whatever it does in the monetary area, Mexico is on probation for years to come. The U.S. cannot do much to help Mexico along--such proposed reforms as monetary union and a Mexican seat on the Federal Reserve Board are inconceivable. But the best chance to make headway is to use a system that is known to have worked well elsewhere. As Argentina's experience shows, stable money is the beginning of economic prosperity and political stability. Mexico needs both and has the prospect of neither. After too many experiments, hard money now, before the next devaluation, is the safest way.