Does Argentina's "Nike Effect" Hold Lessons for Europe?

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Does Argentina’s Nike Effect Hold Lessons

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Posted Dec. 14, 2010 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Argentina and Europe

What happens when a country faces forced austerity, a banking crisis, a risk of sovereign default, and pressure to abandon a fixed exchange rate it has sworn to be eternal and unbreakable?

Several European countries are in that position today, but they are not the first. It has all happened before

Are there lessons for Europe in Argentina’s similar crisis in the winter of 2001-2002?

Map source: Wikimedia commons



Argentina’s Convertibility Plan

Argentina introduced its “convertibility plan” in 1992 to stop its most recent outbreak of hyperinflation

The plan featured a fixed 1-to-1 exchange rate between the peso and the U.S. dollar

The fixed exchange rate was underpinned by a currency board arrangement that obligated the central bank to maintain sufficient reserves to fully back the monetary base and exchange pesos freely for dollars



Early Success, later problems

At first the plan worked to slow inflation and restore growth, but there was a downside

The fixed exchange rate made Argentina vulnerable to external shocks like the 1994 Mexican “tequila crisis” and the 1998 Brazilian devaluation

In addition, Argentina did not have the fiscal discipline needed to live permanently with a fixed exchange rate


The Crisis of 2001-2002

By 2001, Argentina was again in crisis

With support from the IMF, it first tried to restore order with a stringent austerity program

When that failed, it tried more radical measures, including a freeze on withdrawals of bank deposits

Despite these measures, in January 2002, the country was forced to devalue and default on its external debt

"This buries whatever hypothesis may exist that we will devalue."

Argentine Finance MinisterDomingo Cavallo,

speaking in December 2001about the banking freeze

Photo source: Televisión Pública Argentina. Canal 7. Cadena Nacional, http://commons.wikimedia.org/wiki/File:Cavallo.ogv


The Nike Effect

The devaluation and default were not followed by the disaster that officials had warned of

Instead, the Argentine economy began a period of steady growth

Hyperinflation did not return After the initial devaluation, the peso

steadied to a range of 3 and 4 to the dollar, where it remains to this day

A student dubbed the recovery the “Nike effect” because of the resemblance of Argentine GDP growth to the famous Nike “swoosh.”


Lessons for the Euro Area

What lessons, if any, does the Argentine experience hold for Europe?

For stressed members of the euro area like Ireland, Greece, Spain, and Portugal?

For new member states like Latvia, Lithuania, and Bulgaria, whose currencies are pegged to the euro with currency boards or similar arrangements?

Image source: ECB, http://commons.wikimedia.org/wiki/File:Euro-Banknoten.jpg


Lesson 1: External shocks

Lesson 1: A fixed exchange rate makes it

difficult to adjust to external shocks Argentina in the 1990s was affected

by contagion from the Mexican and Brazilian crisis

Ireland, Spain, Latvia and other EU countries were affected by shocks in the form of real estate bubbles and volatile financial flows

Housing under construction in Calahonda, Spain, 2005Photo source: http://commons.wikimedia.org/wiki/File:Construction_site_in_Calahonda,_Spain_2005_3.jpg


Lesson 2: Real Exchange Rate Misalignment

Lesson 2: A fixed nominal exchange rate does

not protect a country from misalignment of real exchange rates

During the boom of the mid-2000s, countries like Ireland, Spain, and Latvia experienced strong real exchange rate appreciation compared to Germany, the core economy of the euro area

Technical Note: Inflation and the Real Exchange Rate

The competitive position of a country’s exports depends not only on the nominal exchange rate, but also on the rate of inflation

When a country experiences inflation while its nominal exchange rate remains fixed, its exports lose competitiveness and its exchange rate appreciates in real terms

Financial inflows chasing housing bubbles caused inflation and real appreciation in peripheral EU countries during the boom of the mid 2000s

Let—

H = nominal exchange rateh = the real exchange ratePf = foreign price levelPd = domestic price level

Then

h = H (Pf/Pd)

Note: The formula above defines the bilateral real exchange rate between two countries. The graph on the preceding page shows real effective exchange rates, which are weighted averages of the bilateral real exchange rates with all of a country’s trading partners



Lesson 3: The Unthinkable is Sometimes the Best Option

Lesson 3: When all options are bad, the unthinkable

may be the least bad The orthodox prescription for real

exchange rate overvaluation in a fixed-rate country is “internal devaluation” through austerity and deflation

The alternative of devaluation is “unthinkable” because it is likely to require default on sovereign debt and cause a banking crisis

In some cases, however, the unthinkable option may lead to a faster recovery

Headquarters of the International Monetary Fund, Washington, D.C.The IMF has often favored austerity and internal devaluation over nominal devaluation and default for countries to which it offers financial assistancePhoto source: http://commons.wikimedia.org/wiki/File:IMF_HQ.jpg


The Bottom Line

The Bottom Line: A fixed exchange rate is not for everyone

Some countries are structurally unsuited for a fixed exchange rate

Some countries lack the fiscal discipline needed to maintain a fixed exchange rate

A country locked into a fixed exchange rate for which it is not suited is like a spouse locked in a bad marriage—divorce may be painful, but it is an option that should not be taken off the table

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Does Argentina's "Nike Effect" Hold Lessons for Europe?

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