PESO REAL: YOU WILL CRY BECAUSE OF ME, ARGENTINA

As if it were not enough both Argentina and Brazil struggling with their weak economies, there seems to have been discussed a monetary union between them. A single currency with a working name of peso real reveals that the lessons of 60 years of economic literature on monetary unions and eight years after the Eurozone crisis, an episode that revealed fragilities due to monetary arrangements in the old continent (fragilities that remain untouched, by the way), did not teach our policymakers that before we even consider such a thing, we should integrate the economies in a way that faces not only severe political hurdles, but also questionable economic outcomes. Let’s see what peso real would mean for both countries.

The first pillar we will address traces back to Robert Mundell`s work on optimal currency unions: production factors mobility. Imagine there is a negative shock, let’s say in Argentina. With a floating exchange rate regime, we may have a currency depreciation to adjust competitiveness of exports and bring relative prices to a new equilibrium, accommodating the initial output fall with a positive impact on the current account. Now, imagine the same shock, but without the nominal exchange rate to adjust. In order to restore relative exports competitiveness, prices in Argentina should fall (or increase less than in Brazil). This not only takes time, but evidence on nominal rigidity of prices (specially downwards) would call for an adjustment in quantities: unemployment would rise, so real wages could fall, removing pressure on firms costs and then the real exchange rate would boost net exports. In Portugal and Spain that meant a 50 percent young unemployment rate and a lot of suffering.

In both cases, Argentina would be poorer. However, the mechanism would differ. In the first scenario, it would be because of the exchange rate depreciation. In the second, because of unemployment. What do you prefer? (The exercise works for Brazil as well).

The second pillar for a monetary union is fiscal transfer within the currency area, so let’s summon Ronald McKinnon’s work. How the aforesaid shock could be accommodated without the nominal exchange rate? Well, if there were unemployment benefits financed for Brazilian workers when problems arise in Argentina (or the other way around, if the problems were in Brazil), this would help to accommodate the recession, so aggregate demand in the troubling country would not fall a lot (the so-called automatic stabilizers would prevail within the whole union). Would both countries be willing to do these arrangements with their current unemployment rates?

The last pillar is unified bank supervision. The Brazilian financial system is a role model on bank supervision. Would Argentina tight its regulations (amid a recessive dynamics) or would Brazil soft them? The former imposes (another) negative shock in the short-run for Argentina, the latter would create medium run risks, unless, of course, this is different.

An implied necessary (but as we discussed above, not sufficient) condition would be a positive and strong correlation of business cycles between Argentina and Brazil, so the shocks would not be asymmetric (if they are, the adjustment takes too much time due to the thing we have discussed before). But let’s go back to Argentina’s convertibility plan in the 1990s: the benefits of the fixed exchange rate regime were not used wisely. Monetary expansion baked a crisis in 2001. Or, let’s see how earmarked credit expansion in the recent past ended in Brazil.

Fixed exchange rates have the benefit of predictability. So, we can predict that it would go wrong.