Arnold Kling


Arnold Kling, Great Questions of Economics
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The crisis in Argentina begs for a post-mortem. In particular, the role of a "currency board," in which Argentina pegged its exchange rate to the dollar, is controversial. In a letter to the editor of Financial Times, Columbia University economics professor Edmund Phelps writes,

Lenders and investors may have mistaken the construction of the currency board as a signal that a creative, vibrant capitalism was also under construction.

What Phelps is saying is that the currency board increased investor confidence in Argentina. Up to a point, this was a good thing. But investors became overconfident, and they allowed Argentina to borrow excessively. Because Argentina's economy had structural weaknesses, it became insolvent.

Conceptually, there are three types of crises that put pressure on a country's currency.

  1. A liquidity crisis.

    In this case, a country simply needs a loan in order to fend off a speculative attack on its currency. In Brad DeLong's new macroeconomic textbook, he describes the crises of Mexico and Asia in the 1990's in a way that makes them sound like liquidity crises. The best solution in such cases is an international loan to the country suffering the speculative attack.

  2. A balance of trade crisis.

    In this case, the problem is that the country's goods cost too much in world markets. The simplest, fastest way for a country to cut its prices is for its exchange rate to depreciate.

  3. A solvency crisis.

    In this case, a country has borrowed more than it can hope to repay. Some of the debt has to be written off. The country's standard of living is bound to decline.

In any currency crisis, some criticisms are inevitable. The left always complains about any increase in interest rates, and the right always complains about any currency devaluation. However, as DeLong states forcefully in his textbook, these are consequences that are impossible to avoid.

Another favorite whipping boy is the International Monetary Fund. The IMF is designed to handle a liquidity crisis. However, in a solvency crisis, the initials IMF could stand for "Impossible Mission Fund." That is because critics blame the IMF for what is an inevitable decline in the standard of living in the insolvent country.

Discussion Question: If a borrower is illiquid but not insolvent, you should lend more to that borrower. If the borrower is insolvent, you should not lend to that borrower. Will borrowers tell you that they are insolvent? How can a lender make a determination of whether the borrower has the capacity to repay a loan, particularly when the borrower is a foreign government?

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