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Living and Dying with Hard Pegs:
The Rise and Fall of Argentina's Currency Board
Argentina's currency board was a textbook model of a rigid exchange rate regime for more than ten years. The subsequent collapse of the financial system yields important lessons for the debate on exchange rate regimes for developing countries. 1 As expected, the Argentine case has already generated much debate on the causes and policy implications of the crisis. 2 Current explanations, however, concentrate too much on the last years of the experiment and do not pay enough attention to the underlying logic of the currency board and its implications for the financial system and the economy at large.
In this paper, we study the Argentine experience from a perspective that links money (in its function as a store of value) and financial intermediation. This approach has important advantages. By organizing the discussion of the different intervening factors around a main motive, it allows us to balance the breadth of a comprehensive survey with the focus needed to [End Page 43] extract lessons. This approach also enables us to highlight the role played by the currency board in the development of the financial sector during the 1990s and in the genesis of its collapse. In particular, Argentina fell into a currency-growth-debt (CGD) trap in the late 1990s, which eventually led to a currency and bank run and a devastating economic crisis.
The Argentine experience suggests that the benefits of hard pegs have been much overstated. To be sure, a credible hard peg ensures nominal stability and boosts financial intermediation by providing savers with the dollar as the store of value, either directly under dollarization or via the peg under currency boards. Even if credible, however, a hard peg does not automatically lead to the emergence of alternative nominal flexibility (particularly in wages, fiscal spending, and financial contracting) to compensate for the loss of the nominal exchange rate as a policy instrument. This is particularly problematic in the case of hard peg countries that, like Argentina, do not meet the classical conditions for an optimal currency (dollar) area. Partly as a result, hard pegs per se do not induce fiscal or even monetary discipline. The monetary framework of a hard peg, although typically protected by a heavy legal and institutional armor, can be dismantled more easily than is usually thought by the emergence of quasi-monies. These arise, in turn, from extreme budgetary pressures stemming from insufficient nominal flexibility in fiscal spending and public sector wages. Moreover, because the credibility of a hard peg is a positive function of its exit costs, a hard peg creates powerful incentives for the government to raise exit costs further (redouble the bet) when the hard peg is under pressure. Hard pegs endogenously raise exit costs by fostering dollarization—including dollarization of the liabilities of debtors in the nontradables sector—since the government would rather not explicitly adopt measures to discourage dollarization for fear of undermining the credibility of its commitment to the hard peg.
Exiting a hard peg is inherently very painful, but some ways of exiting can be more disastrous than others. The Argentine experience offers lessons on alternative exit strategies. With the benefit of hindsight and the caveats of any counterfactual analysis, we argue that the forcible pesification of existing financial contracts (stock pesification) was the most costly choice, for it was bound to cause excessive destruction of property rights with long-lasting consequences for financial intermediation. It was also likely to rekindle the deposit flight and exacerbate the exchange rate overshooting by creating a massive peso overhang in the midst of a currency [End Page 44] run. By contrast, an early (before 2001) exit into full dollarization (of both financial contracts and money in circulation) might have averted the bank run, thus protecting financial intermediation and the payment system, but it...