Argentine Dollarization Is a Great Idea, but It Requires Limited Purpose Banking to Work
Dollarization means no central bank means no lender of last resort means the financial system needs to be bank-run proof making Limited Purpose Banking the key
Argentina’s newly elected President Milei has pledged to dollarize the Argentine peso. This reform and many more are decades overdue. As MIT economist, Ivan Werning, just conveyed on the Markus Academy (Princeton economist, Markus Burnnermeier’s, excellent podcast series), Argentina’s current annual inflation rate is 140 percent! The country’s spending has been rising like mad along with its deficit.
Werning, a stellar economist, is Argentinian. He takes his audience through Argentina’s troubled economic past and emphasizes the difficulties and pitfalls of trying to eliminate the peso overnight. (Warning: his talk is pitched to academic economists.) But Werning’s reasonable concern about shock therapy, whose cure could be fatal to the patient, doesn’t rule out a gradual and fully successful dollarization strategy.
Gradual refers to accumulating, over time, the dollars needed to purchase all outstanding pesos. It also means curing the Argentine financial system of its addiction to lender-of-last-resort bailouts from the Argentine Central Bank. This is the same drug on which financial systems worldwide are hooked — a drug whose potency is, thanks to the speed of digital transactions, rapidly declining. Silicon Valley Bank’s overnight vaporization last March makes this clear.
But back to Argentina’s crazy inflation rate, which has one cause — the government’s making money to make money. What’s the seignorage payoff from this act of macroeconomic malfeasance? It’s 5 percent of GDP. Seignorage is the hidden/implicit tax governments collect from printing money, physically or electronically, and spending it. The tax arises from the attendant increase in prices. The extra inflation waters down the purchasing power of Argentinians’ pesos and peso-denominated assets. Hence, printing money transfers spending power from the public to the government.
Running a massive inflation because you can’t raise 5 percent more of GDP in tax revenue or can’t cut spending by 5 percent of GDP is testimony to the magnitude of Argentina’s current economic status and political dysfunction. But Milei’s landslide election signals public willingness to fix things — once and for all — despite the pain that doing so entails.
Hence, Milei’s challenge is not just reforming economic policy, but doing so for good. Recall, his symbol was taking a chain saw to existing government policy and institutions. Unfortunately, Argentina’s economic history is discouraging. The country’s per capita GDP fell from roughly 85 percent of the U.S. level in 1920 to roughly 15 percent today. Corruption has played a big role. But every reasonable policy step forward was followed by two policy steps backward.
The last time things were fixed once and for all was the Argentine Miracle under President Menem. The architect was my former classmate and close friend, Domingo Cavallo. Domingo served as Menem’s Economics Minister from 1991 to 1996. His policy agenda was no less courageous than Milei’s. Domingo pegged the peso to the dollar — 1 to 1, which brought inflation to an end. And he privatized an array of government-owned enterprises, promoting something Argentina had long been missing — tough competition. This and other outstanding major reforms lead to rapid growth.
But in 1996, after Domingo publicly denounced government corruption, he was fired. And, wouldn’t you know it, things headed back down hill. By 2000, the financial system was beginning to implode. Domingo was reappointed Economics Minister, but it was too late. A run on the banks forced the government to abandon the peso-dollar peg. Why? To print pesos to shore up the banking system.
The lesson here is that when a country’s financial system is collapsing, it has no option but to try and save it. That’s the fundamental weakness in pegging your currency to another country’s. If you can’t print the other country’s currency and your commercial banks, insurance companies, mortgage companies, investment banks, credit unions, etc. experience a run — a run that can be due simply to panic — the entire financial system can melt down and do so overnight.
By the way, do you want to view a banking panic in colorized living color? If so, watch or rewatch It’s a Wonderful Life this holiday season and then read my book, Jimmy Stewart Is Dead. You’ll understand the my unusual choice of the book’s title.
Mind you, in a financial crisis, the Federal Reserve could print dollars and gift or lend them to Argentina to save the day. But unlike Greece, which is a member of the EU and in the Eurozone, the U.S. is not in a political union with Argentina and surely wouldn’t bail out its financial system. Moreover, Greece, like others in the Eurozone, can print its own euros under what’s called the T2 arrangement.
Now you see Milei’s dilemma. He can dollarize. But he can’t print dollars. So, how can he keep himself or a future President from printing pesos if everyone starts to run on the banks? Again, they could run simply because they believe everyone else is running and someone they have never met will grab their money before they get a chance to retrieve it.
This is the soft underbelly of Milei’s dollarization plan unless he reforms the financial system such that no one ever runs on a bank (henceforth, shorthand for all financial corporations) again because banks don’t owe anyone anything. If I known that the assets I have in a bank can’t be handed to someone else to repay a bank I.O.U. because banks can’t issue I.O.U.s, I have no reason to run.
Making banks fail-proof is remarkably simple. All that’s needed is to transform all banks (i.e., all financial corporations) into mutual fund companies that offer an array of individual mutual funds all of which are 100 percent equity financed. A financial system that has no debt is a financial system that can never go bankrupt and, thus, can never experience a bank run.
In the Great Recession, the U.S. had some 7,000 equity-financed mutual funds marketed by mutual fund companies including big boys like Fidelity, Vanguard, and TIAA. Not a single one of the 7,000 of these, in effect, equity-financed banks failed. Failing means not making payments you are legally obligated to make. But equity-financed mutual funds don’t have such financial debts. Equity financed means they have zero leverage.
Yes, money market mutual funds ran aground in the Great Recession. But they were leveraged. They had financial obligations they couldn’t meet due to their backing participants’ investments to the buck. Such backing-to-the-buck is, with minor exceptions, no longer permitted. This equity-financed, mutual-fund banking plan is called Limited Purpose Banking. I developed the plan starting in 2008. It’s summarized in this March 22nd substack article.
As you’ll hear in a podcast I’ll be posting shortly, which features Minister Cavallo and another grad school buddy — President Sebastian Pinera, who just stepped down from his second term as Chile’s President, Limited Purpose Banking has high-level support. Both Minister Cavallo and President Pinera believe transforming Argentina’s financial system to Limited Purpose Banking is President Milei’s crucial first step before dollarizing.
Doing so can, by the way, be done in a manner that doesn’t disrupt existing bank business, but simply keeps banks from continuing to play their standard game — borrowing to invest at risk, taking the upside when the risks pay off and forcing taxpayers to cover the downside when things go south.
Under Limited Purpose Bank, banks would not be gambling with our money. Instead, they’d sell shares to a wide range of open- and closed-end mutual funds that they’d establish. Some mutual funds would specialize in mortgages, others in small business loans, others in real estate, others in commercial bonds, others in domestic stock, others in foreign stock, others in foreign bonds, others in government bonds, etc. All of these specialized mutual funds are already available in the U.S.
Cash mutual funds is a key mutual fund that would replace checking accounts. Cash mutual funds would hold one thing and one thing only — cash. They’d charge a fee to investors. You’d invest your cash in one of a huge number of cash mutual funds that would be established, and have access to your cash by using your debit card with merchants or at the ATM. You’d also be able to write as many checks as you want against your cash mutual fund balance.
President Piñera, Minister Cavallo, and I all believe President Milei must move quickly in reforming Argentine economic policy. But dollarizing overnight is not the answer. Buying up all outstanding pesos with dollars will, at the current exchange rate, cost $40 billion. That’s far too expensive for a country that needs to get back on its economic feet.
The better way to dollarize is to immediately declare the dollar legal tender, meaning Argentinians can pay their taxes in dollars. This plus setting a declining path of money printing followed by a shuttering of the central bank will bring inflation down gradually.
A gradual decline in inflation is vital. Otherwise, borrowers will be forced to repay loans that carry huge nominal interest rates because everyone expected inflation to water-down the repayment. Eliminating inflation overnight would turn 100 plus percent nominal interest rates into 100 plus percent real interest rates and cause massive bankruptcies — including massive bank failures.
Overtime, the government can accumulate foreign reserves, buy up outstanding pesos, and use them for landfill. The peso will be gone. But getting rid of the peso for good is the real prize. Doing so will require President Milei to immediately transform Argentina’s banking system to Limited Purpose Banking, which will instantly make it the safest financial system on the planet. This, by itself, will drive massive foreign investment into Argentina and help produce a permanent Argentine miracle.