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May 2002, Volume 50, Number 5
Why the Peso Melted
by Joseph T. Salerno
The monetary situation in Argentina is a glaring example of confiscatory deflation. In 1992, after yet another bout of hyperinflation, Argentina pegged its new currency, the peso, to the US dollar at the rate of 1-to-1. In order to maintain this fixed peso/dollar peg, the Argentine central bank pledged to freely exchange dollars for pesos on demand and to back its own liabilities, consisting of peso notes and commercial bank reserve deposits denominated in pesos, almost 100 percent by dollars.
Unfortunately this arrangement—which inspired confidence in international lenders because it was approved by the IMF and therefore carried its implicit bailout guarantee—did not prevent a massive and inflationary bank credit expansion. As investment dollars flooded into the country, they found their way into the central bank, enabling it to expand the amount of reserves available to the commercial banks. As fractional-reserve institutions, commercial banks were able to inflate bank credit in concert by multiplying bank deposits on top of each new dollar or peso of reserves.
As a result, Argentina’s money supply (M1) increased at an average rate of 60 percent per year from 1991 through 1994. After declining to less than 5 percent for 1995, the growth rate of the money supply shot up to over 15 percent in 1996 and nearly 20 percent in 1997. In 1998, with the peso overvalued as a result of inflated domestic product prices and foreign investors rapidly losing confidence that the peso would not be devalued, the influx of dollars ceased and the inflationary boom came to a screeching halt as the money supply increased by about 1 percent and the economy went into recession. Money growth turned slightly negative in 1999, while in 2000, the money supply contracted by almost 20 percent.
The money supply continued to contract at a double-digit annual rate through June 2001. In 2001, domestic depositors began to lose confidence in the banking system, and a bank credit deflation began in earnest as the system lost 17 percent, or $14.5 billion worth, of deposits. On Friday, November 30, 2001, between $700 million and $2 billion of deposits—reports vary—were withdrawn from Argentine banks. Even before that Friday bank run, the central bank possessed only $5.5 billion of reserves ultimately backing $70 billion worth of dollar and convertible peso deposits.
President Fernando de la Rua and his economy minister, Domingo Cavallo, responded to this situation on Saturday, December 1, announcing a policy that amounted to confiscatory deflation to protect the financial system and maintain the fixed peg to the dollar.
Specifically, cash withdrawals from banks were to be limited to $250 per depositor per week for the next ninety days, and all overseas cash transfers exceeding $1,000 were to be strictly regulated. Anyone attempting to carry cash out of the country by ship or by plane was to be interdicted.
Finally, banks were no longer permitted to issue loans in pesos, only in dollars, which were exceedingly scarce. Depositors were still able to access their bank deposits by check or debit card in order to make payments. Still, this policy was a crushing blow to poorer Argentines, who did not possess debit or credit cards and who mainly held bank deposits not accessible by check.
Predictably, Cavallo's cruel and malign confiscatory deflation dealt a severe blow to cash businesses and brought retail trade to a standstill. This worsened the recession, and riots and looting soon broke out that ultimately cost twenty-seven lives and millions of dollars in damage to private businesses. These events caused a state of siege to be declared and eventually forced President de la Rua to resign from his position two years early.
By January 6, the Argentine government, now under President Eduardo Duhalde and Economy Minister Jorge Remes Lenicov, conceded that it could no longer keep the inflated and overvalued peso pegged to the dollar at the rate of 1- to-1, and it devalued the peso by 30 percent, to a rate of 1.40 pesos per dollar. Even at this official rate of exchange, however, it appeared the peso was still overvalued because pesos were trading for dollars on the black market at far higher rates.
The Argentine government recognized this, and instead of permitting the exchange rate to depreciate to a realistic level reflecting the past inflation and current lack of confidence in the peso, it intensified the confiscatory deflation imposed on the economy earlier. It froze all savings accounts above $3,000 for a year, a measure that affected at least one-third of the $67 billion of deposits remaining in the banking system, $43.5 billion in dollars and the remainder in pesos.
Depositors who held dollar accounts not exceeding $5,000 would be able to withdraw their cash in twelve monthly installments starting one year from now, while those maintaining larger deposits would not be able to begin cashing out until September 2003, and then only in installments spread over two years. Peso deposits, which had already lost one-third of their dollar value since the first freeze had been mandated and faced possible further devaluation, would be treated more liberally. They would be paid out to their owners starting in two months, but this repayment would also proceed in installments. Mr. Lenicov openly admitted that this latest round of confiscatory deflation was a device for protecting the inherently bankrupt fractional-reserve system, declaring, "If the banks go bust nobody gets their deposits back. The money on hand is not enough to pay back all depositors."
Unlike the bank credit deflation that Lenicov is so eager to prevent, which permits monetary exchange to proceed with a smaller number of more valuable pesos, confiscatory deflation tends to abolish monetary exchange and propel the economy back to grossly inefficient and primitive conditions of barter and self-sufficient production that undermine the social division of labor.
Meanwhile, unlike the deflation-phobes in academia, the media, and supranational bureaucracies who have turned a blind eye to confiscatory deflation or hailed it as a responsible “austerity measure,” many of its unfortunate Argentine victims have recognized it for what it essentially is: bank robbery by the political elites.
Ramona Ruiz, a retired textile worker, railed at an empty ATM machine, "That is my money inside that bank, mine!" Another, unidentified woman yelled at a government spokesman: "How dare you take my savings.” Jose Valenzuela, an Argentine salesman, stated, "It's as if while I am talking to you I’m swiping the change from your pocket." More poignantly, an Argentine businessman lamented, “It is trampling on our liberties. . . . I feel my civic rights, my private rights, have been violated." Finally, Argentine union leaders incisively denounced the policy as “the hijacking of a nation’s savings."
Unfortunately, things were to get even worse for hapless Argentine bank depositors. After solemnly pledging when he took office on January 1, 2002, that banks would be obliged to honor their contractual commitments to pay out dollars to those who held dollar-denominated deposits, Duhalde announced in late January that the banks would be permitted to redeem all deposits in pesos. Since the peso had already depreciated by 40 percent against the dollar on the free market in the interim, this meant that about $16 billion of purchasing power had already been transferred from dollar depositors to the banks.
Happily for bank depositors, Argentina's Supreme Court struck a heroic and stunning blow in favor of property rights on Friday, February 1, 2002, when it ruled unanimously (five to zero with three abstentions) that the banking freeze was unconstitutional, arguing that it was "irrational" and that it "annihilated" constitutional rights to private property, in effect opening the door to a much-needed bank credit deflation.
After a shaken Duhalde went on television on Saturday, February 2, to decree that the banks would stay closed on the following Monday and Tuesday in blatant defiance of the Court’s decision, the disgusted and enraged middle class took to the streets banging pots and pans and chanting "out, out, all the politicians out" and "give us our money." Duhalde quickly recovered, however, and on Monday he defiantly issued an executive decree suspending for 180 days all judicial challenges of the freeze on bank deposits; he also goaded his allies in Congress to accelerate the process of impeaching the recalcitrant Supreme Court justices for "alleged corruption and improprieties."
The only equitable and efficient solution at this point is for the Argentine government to recognize and adjust its policy to the reality of property—and the reality is that bank deposits are no longer (and really never were) par value property titles to fixed quantities of pesos and dollars. These currencies do not exist in the fractional-reserve banking system in anywhere near the quantities needed to pay off depositors.
In economic reality, a bank's deposits are claims on its loan and investment portfolio, including its cash reserve. Therefore, every bank should be immediately handed over to its depositors, that is, transformed into a managed mutual fund. The ownership titles or “equity shares” in each mutual fund would be prorated among the former depositors in accordance with their share of the predecessor institution’s deposit balances.
The result would be a bank credit deflation that would result in a swift and sharp, one-shot contraction of the money supply down to the level of the monetary base, which is equal to the amounts of peso and dollar currencies held by the public plus the peso and dollar reserves held by the banks.
While nominal prices and wage rates would have to be readjusted sharply downward, the value of the peso would rise commensurately, monetary exchange and calculation would be restored, and the allocation of resources and distribution of property titles would once again be determined by market processes.
Joseph T. Salerno, senior fellow of the Mises Institute and editor of The Quarterly Journal of Austrian Economics, teaches economics at Pace University (firstname.lastname@example.org).