Argentina: From the peso crisis to the dollar curse

The International Monetary Conference in Brussels in 1920 officially called for nations to set up central banks to finance reconstruction after World War I, moving away from gold reserves being used to define the wealth of countries or at least much of their creditworthiness.

The US Federal Reserve was already up and running by then. It was founded by an act of Congress in 1913 and soon faced political attacks for inaction during the Great Depression, which began in 1929 and lasted for a decade.

In 1932, Congressman Louis Thomas McFadden called it "one of the most corrupt institutions the world has ever known" and an "evil institution [that] has impoverished and ruined the people of the United States; has bankrupted itself; and has practically bankrupted our government".

Speaking at a session in the House of Representatives to evaluate the Fed's performance, McFadden pointed to "defects of the law under which it operates, through the maladministration of that law by the Federal Reserve Board, and through the corrupt practices of the moneyed vultures who control it."

There have been similar claims ever since, alongside more measured comments.

Milton Friedman, the 1976 Nobel laureate for economics and one of the discipline's best-known thinkers, once said:  "Money is far too serious to be left to central bankers." But he agreed the Fed "was largely responsible" for the 1929 crisis as "it presided over a decline in the quantity of money by one-third from 1929 to 1933."

Poor record with a core purpose

And he notes the frequent failure of central banks to live up to their core purpose: monetary stability. "They increased their money supply faster than production growth, which contributed to the emergence of bubbles in the prices of real estate, assets, and securities", Friedman points out, as shown by the last three major crises: the internet bubble in 2001, the real estate-led financial crisis of 2008, and the COVID-19 crisis in 2020.

The economist Barry Eichengreen has said this record leaves central banks "in the dock" and under suspicion for a role in any crisis with financial repercussions, calling for investigations to be undertaken.

For Milei, the jury is already back with a guilty verdict, with the failure of Argentina's central bank proved by runaway inflation and the tumbling peso. And the sentence is the bank's closure.

It is not the first time the financial world has heard calls for such drastic action.

The 1988 Nobel economics laureate – France's Maurice Allais – argued that central banks often lack proper independence from governments, clearing any financing requests.

He suggests that it can be better to shut them and move responsibility for issuing currency to state treasuries or ministries of finance, where at least there is more direct accountability and oversight for the stability of currencies, which should be a human right.

What would dollarisation mean for Argentina?

Milei does not want to phase out the peso. He wants to adopt the dollar immediately and thoroughly and close the central bank. He is not the first person to suggest it. In 1999, Argentina's President Carlos Menem also called for dollarisation.

One country adopting the use of another's currency is known as xenomonetisation. Such a move need not just be to the dollar; it could involve any major global currency, although it would most likely involve one known for stability, such as the euro, the Swiss franc or the pound sterling.

It usually involves small countries, although there are exceptions. They include Ecuador, El Salvador and Guatemala in South America, which use the dollar as their official currency.

Argentina would be the biggest to dollarise, and if Milei delivers it, the whole policy landscape of the entire American continent would be transformed.

It will undoubtedly hit plans at the BRICS+ bloc of nations to reduce the dollar's global dominance amid talk of the group setting up a shared currency along the lines of the euro.  

Argentina was among six countries invited, with the support of the Brazilian president, to join the group during the recent summit in South Africa. If it is now on the verge of adopting the dollar, it would amount to a move in the opposite direction.

The top four benefits

Milei sees the four most prominent benefits of dollarisation as follows:

First: Removing the risk of exchange rate crises and speculative attacks on the peso, alongside reducing the risk premium and high interest rates the currency's instability creates.

Second: The reduction of inflation, transaction costs of money transfers, and foreign currency hedging, which will enhance trade and financial integration, making trade with the US and other dollar-denominated countries easier.

Third: Developing the Argentinian banking sector by strengthening its link with US financial institutions and their laws and regulations.

Fourth: Monetary stability would help prevent debt crises and bring about more vital fiscal discipline and more reliable institutions, which would help with a return to confidence.

The dangers

Dollarisation would not come without significant drawbacks. Any nation using another's currency loses control of its monetary policy. Argentina would become subject to the decisions of the Federal Reserve.

Unlike the euro – designed to be a shared currency, with every member nation represented at policy meetings – monetary matters covering the dollar are run solely at the behest of the US, for the US alone.

In effect, Argentina would inherit the impact of decisions made via US economic indicators covering inflation, growth rates, and other factors without regard for the broader consequences.

Argentina would also be without some of the benefits a falling currency can bring, making its exports more competitive and increasing the buying power of foreign currency holders. Neither will it be protected from the dollar fluctuations on global currency markets. A stronger dollar would hit Argentina's exports and increase the price of imports from countries outside the "dollarzone".

There will be expenses incurred to purchase the foreign currency to replace the local currency held by banks and other economic agents. These extra dollars will be circulated by drawing on existing foreign currency reserves or through external loans. Argentina would, therefore, deprive itself of income from these reserves or bear the cost of borrowing.

Dollarisation would also remove the "lender of last resort" function that central banks have, which, along with their ability to create money, is a crucial means of easing crises in the regular banking sector.

This would curtail the country's ability to stop bank runs. Some experts believe that the greater discipline this brings to the sector makes bank runs less likely.

A problematic peg

And the country knows what damage bank runs can do. It used a Currency Board to peg the peso to the dollar between 1991 and 2001, a halfway move toward full dollarisation, which aims to maintain stability by defending a fixed exchange rate.

It proved disastrous. The list of reasons why it failed was long. It included a lack of discipline in the public budget, an exaggeration of the real exchange rate, a high level of credit to non-export sectors, and persistent gaps between savings and investments in the long term in the public and the private sector.

And the peso peg prevented a weaker currency from offsetting the impact. It led to widespread bank failures, sovereign default, a drop in economic growth, and an inevitable drop in the pegged exchange rate. Social and political crises followed.

Full dollarisation could prove to be different. But it will also be a test for Milei, showing if this libertarian populist lives up to his mandate and maybe even that El Loco nickname.