L RANDALL WRAY

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Still others peg the exchange rate to a foreign currency, but hold less than 100 per cent reserve backing. In practice, this is a very risky proposition if the exchange rate is fixed and conversion on demand is permitted. Hence, the behaviour of a prudent government operating with less than 100 per cent reserves would not be much different from one operating with 100 per cent reserves, because any policy that might provoke a “run” on the currency would force it to default on its promise to convert. Even a 100 per cent reserve backing will not be sufficient if the government issues non-money liabilities (for example, treasury securities) to borrow dollars. As a result, countries that peg their currencies also constrain “capital flows” by limiting currency conversion and imposing other capital controls, and by trying to achieve a current account surplus. This in turn generally means domestic policy is biased toward austerity: high interest rates (to attract capital flows) and fiscal restraint (to keep inflation and imports low). Because policy must focus on maintaining the exchange rate, it subordinates other policy goals – most importantly, full employment and domestic growth and development.

We will first examine Argentina’s experience with a currency board that led to a crisis. We then analyse in detail why currency sovereignty generates the conditions required for policy independence. We will see how Argentina in the aftermath of crisis put in place policies that allowed it to recover, concluding with implications for India.

Argentina’s Experience witha Currency Board

In 1991, Argentina adopted a currency board based on the dollar – a last ditch effort to constrain inflation. From that point forward it surrendered currency

Economic and Political Weekly May 13, 2006 sovereignty as it became a user of a currency rather than an issuer. The creation of the currency board, as well as various structural reforms that included rapid privatisation of state assets and downsizing of the national government did appear to bring major benefits. Exports plus imports as a per cent of GDP grew well over 7 per cent annually during the first half of the 1990s, boosted by US demand, as the economy was opened and trade was liberalised. Federal expenditures fell from more than 27 per cent of GDP at the end of the 1980s to about 20 per cent during the 1990s; the federal budget achieved a balance during the first half of the 1990s (even a surplus in 1994). Inflation fell from nearly 100 per cent at the beginning of the 1990s to nearly zero for the rest of the decade (until the currency board collapsed). It is no wonder that those who promoted the Washington Consensus viewed Argentina’s experiment as a nearly unqualified success.

The problem was that the policy package lent a slow-growth bias to the economy by constraining fiscal policy. Unemployment remained high, and inequality rose, throughout the currency board experiment. Growth relied on nongovernmental spending – either domestic consumption and investment or a trade surplus. However, pegging to the dollar made Argentinian exports less competitive whenever its competitors devalued. Dollar and, thus, peso appreciation caused imports to rise more quickly than exports so that a persistent trade deficit arose after 1992. With a trade deficit, Argentina could obtain needed dollars only by borrowing or by selling assets. Moreover, as deflationary forces built up (with negative inflation-adjusted GDP growth every year from 1999 onwards), tax revenue growth fell off so that the federal government began to run a persistent deficit by the mid-1990s, and provincial governments (and the private sector) accumulated big debts.

In an attempt to slow the growth of its own deficits, the federal government cut transfers to regional governments, forcing

Economic and Political Weekly May 13, 2006

interest rates remained on par with those of its neighbours after creation of the currency board, indicating that market assessment of default risk substituted nearly perfectly for reduced currency risk), federal debt service payments grew fairly rapidly (by 2000, interest costs alone were about 17 per cent of national government spending). Hence, the combination of slow economic growth and high government borrowing rates ensured a vicious cycle of pressures on the treasury to increase fiscal austerity, which hindered growth, raised unemployment, and increased fiscal pressures as taxable income fell. Federal governmental default was inevitable, as was the extreme social unrest that normally comes when unemployment reaches 20 per cent.

In conclusion, even if it is accepted that dollarisation brought initial benefits, it put Argentina in an unsustainable situation. The whole package came crashing down by Christmas 2001 as Argentina defaulted on its dollar debts, abandoned the currency board, refused to convert pesos to dollars, and floated the currency. Street protests brought down a series of governments. However, little more than a year later, Argentina began to mount a strong recovery. This was accomplished by the combination of floating the currency, defaulting on external dollar debt payments, and creating a job guarantee. We will return to the successful implementation of this package of policies after examining in detail how sovereign currencies work.

Currency Sovereignty

A nation like the US (as well as countries like Japan and Turkey, and Argentina after it abandoned the currency board) creates a currency for domestic use (and ensures its use primarily by demanding payment of taxes in that currency, although some go further by adopting legal tender laws). The government, itself (including the treasury and the central bank – the Fed in the case of the US), issues and spends high powered money (HPM – cash and reserves at the central bank) as its liability. The US government does not promise to convert its HPM to any other currency, nor to gold or any other commodity, at any fixed exchange rate.1 The flexible exchange rate is key to maintaining fiscal and currency independence – what I call sovereignty, although governmental sovereignty certainly has other dimensions as well. But there is more to it than a flexible exchange rate. The sovereign government spends (buys goods, services, or assets, or makes transfer payments) by issuing a treasury cheque, or, increasingly, by simply crediting a private bank deposit. In either case, however, credit balances (HPM) are created when the central bank credits the reserve account of the receiving bank. Analogously, when the government receives tax payments, it reduces the reserve balance of a bank. Simultaneously, the taxpayer’s bank deposit is debited. While we commonly think of a government needing to first receive tax revenue, and then spending that revenue, this sequence is not necessary for any sovereign government. If a government spends by crediting a bank account (issuing its own IOU – HPM) and taxes by debiting a bank account (and eliminating its IOU – HPM), then it is not as a matter of logic, “spending” tax revenue. In other words, with a floating exchange rate and a domestic currency, the sovereign government’s ability to make payments is neither revenue-constrained nor reserveconstrained.

This fundamentally simple point is difficult for some to grasp because we are used to thinking about government as if it were not sovereign. It is the non-sovereign government that must obtain money before it can spend; for the most part, it obtains money by taxing and borrowing (governments also sell services, assets, and some commodities to obtain money). For example, state governments in the US are non-sovereign in the sense in which I am using the term. They really do spend tax revenue. When state taxes are paid, bank deposits of taxpayers are debited and those of the state governments are credited. These governmental deposits are then used when state governments spend, leading to debits to their accounts and credits to the accounts of those receiving state government cheques. When tax revenues fall, states have to cut spending, raise taxes, or borrow to finance their spending. However, state borrowing is ultimately limited by market assessment of default risk. Thus, states are forced to act in a pro-cyclical manner in recession, cutting spending and raising taxes and thereby exacerbating the unemployment problems.

In the US it is the federal government (the sovereign) that ultimately has the responsibility and the means to maintain full employment – not the individual, nonsovereign states. Logically, this is implied by the fiscal arrangements. As the sovereign issuer of the currency, only the national government is able to spend without regard to revenue. Fiscal transfers (mostly from the US treasury, although the Fed can also play a role) from Washington to the states can help counter the pro-cyclical behaviour of states. Note that when Argentina adopted the currency board, it put itself into a situation that is much like that of US states. If Washington had stepped in to provide sufficient transfers to the non-sovereign Argentina, it could have prevented a fiscal, economic, and social crisis. Unfortunately, such a policy would have had little political support in the US.

When a household or non-sovereign government borrows, it issues an IOU and obtains a bank deposit that it needs in order to spend. The sovereign government, on the other hand, has no need to obtain a deposit before it spends its own currency, crediting a private bank account. It sells a security, not to finance its expenditures but to reduce the outstanding stock of HPM, merely offering to substitute one of its interest-paying liabilities (the security) for a non-interest-paying liability (the HPM that is debited from bank accounts). This is really an interest rate management operation (known within the US Federal Reserve as offsetting operating factors) – reducing bank reserves in order to eliminate (non-interestearning) excess reserves that would otherwise place downward pressure on overnight interest rates.

The final point is that the interest rate paid on sovereign securities is not subject to normal “market forces”. The sovereign government only sells securities in order to drain excess reserves to hit its interest rate target. It could always choose to simply leave excess reserves in the banking system, in which case the overnight rate would fall toward zero. When the overnight rate is zero, the treasury can always offer to sell securities that pay a few basis points above zero and will find willing buyers because such securities offer a better return than the alternative (zero). This drives home the point that a sovereign government with a floating currency can issue securities at any rate it desires – normally a few basis points above the overnight interest rate target it has set. There may well be economic or political reasons for keeping the overnight rate above zero (which means the interest rate paid on securities will also be above zero), but it is faulty reasoning that leads

Economic and Political Weekly May 13, 2006 to the belief that the size of a sovereign government deficit affects the interest rate paid on securities.

For a real world example, one need only look at the current case of Japan, which has long had the largest government deficit (relative to GDP – reaching to 8 per cent) as well as the all-time largest outstanding government stock of debt (over 150 per cent of GDP) of any major developed country. However, Japan long maintained interest rates on government securities at a few basis points above zero (and sometimes, for technical reasons, even below zero!). It recently announced that it will finally raise rates above zero – as a policy, not as something imposed upon it by markets. The US accomplished the same feat during the second world war, when short-term treasuries paid 3/8th of 1 per cent even as the deficit-to-GDP ratio reached 25 per cent of GDP – three times higher than Japan’s current ratio! This indicates that a sovereign nation with a floating exchange rate can choose interest rates on government debt as low as it wants. By the same token, the sovereign government could have interest rates above 100 per cent if it so desired. All it needs to do is set the overnight rate target at 100 per cent and then sell securities whenever excess reserves placed downward pressure on that rate. This drives home the point that the interest rate is exogenously set in any sovereign nation. Whether the base rate will be zero or 100 is a monetary policy matter, not subject to market determination.

A non-sovereign government faces an entirely different situation. In the case of a “dollarised” nation, the government must obtain dollars before it can spend them. Hence, it uses taxes and issues IOUs to obtain dollars in anticipation of spending; unlike the case of a sovereign nation, this government must have “money in the bank” (dollars) before it can spend. Further, in contrast to the sovereign nation, the nonsovereign government promises to deliver third party IOUs (that is, dollars) to service its own debt (while the US and other sovereign nations promise only to deliver their own IOUs). Because of this, the interest rate on the non-sovereign, dollarised government’s liabilities is not independently set (whether it is a US state or an Argentina). Since it is borrowing dollars, the rate it pays is determined by two factors. First, there is the base rate on dollars set by the monetary policy of the US (the issuer of the dollar). On top of that is the market’s assessment of the non-sovereign government’s creditworthiness. A large number of factors may go into determining this assessment. The important point, however, is that the non-sovereign government, as user (not issuer) of a currency cannot independently set the interest rate. Rather, market forces determine the interest rate at which it borrows.

When Argentina abandoned the currency board, it gained policy independence: its exchange rate was no longer tied to the dollar’s performance. Its fiscal policy was no longer held hostage to the quantity of dollars the government could accumulate and its domestic interest rate came under control of its central bank. One of the first policy initiatives taken by newly elected president Nestor Kirchner was a job creation programme that guaranteed employment for poor heads of households. Within four months, the ‘Plan Jefes y Jefas de Hogar’ had created jobs for two million participants – equal to 13 per cent of the labour force. This not only helped to quell social unrest by providing income to Argentina’s poorest families, but it also put the economy on the road to recovery. Conservative estimates of the multiplier effect of the increased spending by ‘Jefes’ workers are that it added a boost of more than 2.5 per cent of GDP. In addition, the programme provided needed services and new public infrastructure that encouraged additional private sector spending. Without the flexibility provided by a sovereign, floating, currency, the government would not have been able to promise such a job guarantee.

Argentina also benefited from currency flexibility that was made possible by dropping the peg to the dollar, as her exports became competitively priced. The US expansion as well as the worldwide rise of commodity prices have helped Argentinian exports. To be sure, there is some precariousness inherent in reliance on export-led growth. Argentina realises it must also continue to develop its domestic markets so that it won’t be so reliant on US growth. Currency sovereignty allows the nation to use fiscal policy (and monetary policy) to continue to create jobs in the private and public sectors.

Like Argentina, India is enjoying rapid growth of GDP, currently fuelled by favourable export conditions. India is also in the process of implementing a limited job guarantee, in part to deal with very uneven economic performance across regions. However, resolving India’s unemployment and poverty problems may require a greater fiscal commitment than its government is prepared to undertake. India is rightly concerned with the financial and exchange rate crises suffered not long ago by Asian and Latin American nations, triggered by large external debts, declining foreign currency reserves, and market expectations that exchange rate pegs could not be held. However, it must be recognised that these nations had adopted (formal or informal) pegs to the dollar. By contrast, a nation that adopts its own floating rate currency can always afford to put unemployed domestic resources to work. Its government will issue liabilities denominated in its own currency, and will service its debt in its own currency. Whether its debt is held internally or externally, it faces no insolvency risk. Further, the floating currency gives domestic policy an additional degree of freedom. This does not mean that the nation will necessarily ignore its trade balance or movements of its exchange rate, but it does mean that it can put domestic employment and growth at the top of its policy agenda.

In a subsequent issue, we will examine Argentina’s experience with its Jefes programme for lessons that might help India to implement its own job guarantee. However, currency sovereignty – that requires a floating rate – is the first step to ensuring policy flexibility to guarantee full employment.

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Email: WrayR@umkc.edu

Note

1 The US government holds reserves of various foreign currencies, and may occasionally use its foreign reserves to buy dollars, or may sell dollars to obtain foreign currencies. This is done not only to facilitate foreign transactions by domestic residents, but also to influence exchange rates of the dollar against foreign currencies. Still, the US operates a “dirty” floating exchange rate regime, rather than a fixed exchange rate. A rapidly falling dollar would probably generate official action by the US and other major players to cushion exchange rate movements. However, it would not financially constrain the US government from making timely payment on any and all dollar-denominated liabilities precisely because the US does not guarantee any particular conversion rate.