photo/GdeFon.ru
photo/GdeFon.ru

Following further devaluation of the Argentine peso in recent weeks, analysts now suspect that Argentina’s GDP has fallen to the fourth largest in South America behind emerging regional powerhouse Columbia. This is just the latest in a string of setbacks for the nation, which was considered one of the world’s strongest economies just a century ago.

The problem, according to many analysts, stems from a combination of declining output and high inflation. On the production front, Argentina, once famous for its beef production, has now fallen behind neighbor Uruguay’s annual output of beef. Unfortunately, the struggles of the beef industry are joined by slumping world prices for commodities that Argentina produces, like soy.

Yet, the falling GDP figures are due to more than falling output and prices. Argentina’s skyrocketing inflation, which the Economist predicts could hit as high as 55 percent this year due to compounding, decreases the value of Argentine products compared to the world market. While inflation is not the sole cause of Argentina’s economic woes, it must be controlled before the nation can become competitive in regional and international markets again.

Traditionally, the go-to measure to combat inflation for central banks around the world has been to increase the federal funds rate. An increase in the federal funds rate raises interest rates, reduces inflation, and stabilizes the economy. This approach works when monetary policy is predictable and when currency values are validated by reserve currency stockpiles held in national coffers.

Argentina, however, is unable to control inflation through traditional means because the nation has had erratic monetary policy and has printed currency while simultaneously spending reserve currency stockpiles to pay off debt. This combination has led to high inflation rates, averaging between 25 percent and 30 percent a year, and a devaluing of the Argentine peso, which has lost over 75 percent of its value compared to the dollar since 2007.

The irresponsible  monetary policy of Argentina’s central bank, El Banco Central, has led to economic downturn and high inflation, causing the nation to lose the confidence of domestic and international firms alike. These firms fear investing in Argentina because of the peso’s instability. Therefore, the Argentine central bank must resort to creative policy alternatives to stabilize the currency and regain investor confidence. No option is more practical and can yield better results than tying the health of the peso to the U.S. dollar through a fixed exchange rate.

The benefits of such a strategy are twofold. First, tying the peso to the dollar through a fixed exchange rate will depoliticize monetary policy in Argentina. Columbia’s recent surge in GDP, which allowed it to surpass Argentina’s output figure this week, is due to what Finance Minister Juan Carlos Echeverry calls “predictable and boring” monetary policy. Argentine President Cristina Fernández de Kirchner, whose policies have led to economic uncertainty in the nation, and El Banco Central President Katya Daura, who is directly responsible for printing non-backed money, will no longer influence the monetary policy. Instead, monetary stability will be tied directly to the world’s foremost depoliticized reserve currency, the U.S. dollar.

Second, tying Argentina’s peso to the dollar will encourage foreign investment in Argentina. Investors around the world trust the stability of the dollar, so a fixed exchange rate between the peso and the dollar would increase investor confidence in Argentina and lead to a resurgence in the nation’s economy. Investors would no longer worry that profits made in Argentina could be lost to extreme exchange rate fluctuations or to poor Argentine fiscal management.

A similar measure was adopted by Belize in the late 1800s, which led to increased trade with the United States and Canada, a stabilization of the nation’s currency, and an increase in Belizean business performance. Today, international financiers, especially those interested in real estate, invest large sums of money in the Belizean market, helping the nation keep a healthy GDP. A similar inflow of foreign capital stemming from currency stabilization would go a long way toward jumpstarting the Argentine economy.

Even if El Banco Central decided to tie the health of the peso to the dollar, Argentina would still face an uphill battle in reviving its economy. However, the resulting fall in inflation and increase in foreign investment in the country would be a significant step toward reviving its faltering economy.

Image courtesy of Julia Suber