Argentina Financial Crisis An Assessment

ARGENTINA FINANCIAL CRISIS

Argentina Financial Crisis

In the year 2001, Argentina had a financial crisis that sent the South American nation into what could only be described as a political and economic tailspin. This text seeks to present some factual information as to what really happened and how this could be tied to events in the 17th century England.

Discussion

From the onset, it would be prudent to note that according to Rodrik (2003), the move by Argentina to fix its currency to the US dollar was born out of the country’s belief that it could swiftly attain rich country income levels by reducing sovereign risk. Thus, in the words of the author, there was hope that it “would be rewarded with a sharp reduction in ‘Argentina risk’, leading to large amounts of capital inflows and rapid economic growth” (p. 17). In Argentina, new sources of revenue were highly desired. This had been the very same scenario that was experienced under the Stuarts (North and Weingast, 1989).

According to Rodrik (2003), it would be difficult for a country to access foreign capital without the removal of sovereign risk. The only way to remove this particular risk, as the author further points out, is to undertake a commitment that other people’s funds will not be played around with. To a large extent, Argentina was determined to convince all those who mattered that its commitment was not only binding, but also real. It is important to note that as North and Weingast (1989) point out, “reputation has long been noted as an important factor in limiting a sovereign’s incentive to renegade, and this approach has recently been formalized in the elegant models of modern game theory” (p. 807). Otherwise, there is nothing that would prevent the sovereign from acquiring a loan and renegading on an agreement to repay. In the very same way, Argentina was keen on building its reputation. In honoring its commitments, the country would be able to have access to additional funds in the future. This is what North and Weingast (1989) refer to as the ‘long arm of the future.’

As Rodrik (2003) further points out, the linchpin of the plan of action in the case of Argentina was the currency board regime’s straitjacket. More specifically, in the words of the author, “by linking the value of the peso one-for-one to the US dollar in 1991, and putting monetary policy on automatic pilot, the regime sought to counteract the effects of more than a century of financial mismanagement” (Rodrik, 2013, p. 17). This was, as it would turn out, the wrong course of action. Indeed, as Gartner (2004) observes, currency board arrangements are often associated with a wide range of risks. According to Gartner (2004), at the time, the overvalued peso severely constrained the growth of the Argentinean economy. Further, it is important to note that as the author points out, the fixed-exchange rate’s credibility was effectively undermined by several other factors including, but not limited to, high borrowing costs in the context of increased borrowing appetite on the part of the government. The country had limited options. It is because of the situation recounted herein that “Argentina had arguably little choice but to stick to the currency board” (Gartner, 2004). To a large extent, there was little in terms of checks and balances to prevent the government of the day from embracing this course of action.

North and Weingast (1989) are of the opinion that in the context of free markets, there is need to have restrictions that are credible and effective in place so as to ensure that economic rules are not manipulated by state in a manner that disadvantages certain parties. Thus, in the words of the authors, there is need to ensure that favorable economic performance is “accompanied by institutions that limit economic intervention and allow private rights and markets to prevail in large segments of the economy” (North and Weingast, 1989, p. 808). If such measures had been in place in the case of Argentina, the country would not have placed itself in the position that it did. The currency board arrangement would not have seen the light of day. In this case, however, the country faced no significant constraint. One other country that has made a similar mistake in the past, according to North and Weingast (1989), is Spain. In the absence of rigid and effective restrictions (mainly constitutional), “early modern Spain created economic conditions that retarded long-term economic growth” (North and Weingast, 1989, p. 808).

In the case of Argentina, the adopted course of action appeared viable and even practical. In addition to the sustained inflows of capital in the earlier periods of the 1990s, there was an unprecedented expansion of the economy. However, as fate would have it, the country encountered a number of external shocks between 1995 and 1999. The said external shocks were inclusive of, but they were not limited to, the 1999 Brazilian devaluation and the 1997/98 Asian crisis. According to Rodrik (2013), the 1999 Brazilian devaluation was particularly detrimental to Argentina. This is more so the case given that it left the country’s economy acutely exposed and unable to compete against that of Brazil. It was downhill for Argentina from this point onwards – with the country’s risk increasing rapidly in relation to that of the likes of Brazil and other markets categorized as emerging. Attempts to salvage the situation using a wide range of strategies did not bear fruit. The financial markets (which Rodrick refers to as ‘fair-weather friends’) read the ‘signs of the times’ and the inevitable happened. In this case, there was an inevitable collision between domestic constituencies’ needs and foreign creditor demands. According to Rodrik (2013), when there is such a collision, it is foreign creditors’ demands that yield to domestic constituencies’ needs. Mass riots and protests broke out, causing the prompt resignation of both de la Rua and Cavallo.

In both instances, there was instability (in the form of a civil unrest) in the end – that ushered in a new era of governance. In the case of 17th Century England, the egregious behavior of the Crown was fixed after the opposition seized power. The most important changes on this front revolved around the reform as well as modification of institutions. Long-term prosperity and success was, however, still elusive following the civil war. According to North and Weingast (1989), soon, it became apparent that the excesses of the Crown could only be kept in check following the resolution of the financial problems at the time, amongst other things. Towards this end, “the Glorious Revolution ushered in fiscal revolution” (North and Weingast, 1989, p. 815). To a large extent, the Glorious Revolution, as North and Weingast (1989) further point out, had effects that could only be described as profound. This is more so the case when it comes to matters related to public finance.

Are there any lessons that we can learn from the Argentina Financial Crisis of 2001? There are indeed plenty of lessons to be learnt here. One crucial lesson, in my opinion, is that the relevance of fiscal discipline cannot be overstated. As a matter of fact, as Gartner (2004) points out, “with rigid labor markets, a lack of fiscal discipline and the absence of a natural anchor currency, Argentina was never a strong candidate for a hard peg” (p. 680). A currency board arrangement such as the one that the country had in place cannot be sustainable in the long-term. As has been highlighted in this text, the move to promote the exchange rate’s peg was rather effective in the short-run, and indeed appeared practical and viable. However, in the long term, this resulted in excessive borrowing on the part of the country’s public sector – effectively increasing the final collapse’s cost. Countries ought to have in place fiscal policies that are consistent. Debt should also be kept at manageable levels. Failures on these two fronts is what, arguably, resulted in the demise of this once-prosperous nation. North and Weingast (1989) assess and highlight various institutional reforms that made it possible for early modern England to achieve economic growth. It would, however, be prudent to note that the said reforms were largely forced. Their occurrence was not natural. There are various parallels that could be drawn between the Crown (prior to the Glorious Revolution) and Argentina’s situation. In both scenarios, the financial system was largely a source of expediency. In both instances, there were fiscal needs that, in retrospect, appear to have advanced an agenda of government arbitrariness.