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Argentina and Brazil propose a strange common currency

Aargentina is running out of the vault. With annual inflation nearing 100%, local banks are making room for ballooning peso stocks as the central bank prints bills to fund the government’s fiscal deficit. Officials have tightened capital controls. Imports are at a standstill.the government is working with International Monetary Fund to avoid the tenth sovereign default since independence in 1816. Yet on January 22, Brazilian President Luiz Inácio Lula da Silva and Argentinian President Alberto Fernandez announced that they would begin preparations for a common currency, potentially leading to a full monetary union that would bring South America’s largest economy is tied with one of its worst.

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The idea has a history. The first was the “gaucho,” a currency intended to replace Brazil’s cruzado and Argentina’s austral until the concept was abandoned in 1988 during economic turmoil.This was followed by a proposal by members of the trade union Mercosur for a common currency, and sucrose, a Venezuela-led experiment with ambitions to reduce the continent’s reliance on the U.S. dollar. Since it was easy to sell foreign exchange reserves to prop up the peso, Argentina was always short of dollars to repay loans and pay for imports. A joint currency would create alternative reserves and make it easier for neighboring countries to trade. Brazil is Argentina’s largest trading partner. By backing Lula’s ideas, as Mr Silva knows, Lula is seen to have reinvigorated regional cooperation, thereby gaining a reputation boost.

At least, that’s the idea. The arguments against it are daunting. A complete union with a joint central bank would surely collapse. Economists use a measure of economic similarity devised by Canadian economist Robert Mundell to judge how well countries would fit within a currency union. Typically, central banks adjust rates for individual economies; in unions, one rate must apply to all. The difference between policy rates in Argentina and Brazil is a staggering 61 percentage points. Their business cycles are wildly out of sync, as their main exports – agricultural and industrial commodities, respectively – are affected by different global headwinds. Argentina’s problems have made its recession deeper and its boom shorter and shallower.

Another condition set out by Mundell is that people and money should flow smoothly across borders, as a means of adjustment when a shock hits one country but not another. In Europe, farm workers hop between jobs and countries, while poor infrastructure in South America makes travel cumbersome, and capital controls in Argentina make cross-border payments nearly impossible. Artificially high wages could spark inflation in parts of the union if workers don’t end up working where they are most productive. Moreover, as long as Brazil commits to a joint currency, it will be forced to bail out its southern neighbor. Armed with this knowledge, Argentina will have good reason to continue spending irresponsibly.

Brazil has backed off. Officials stressed that the new currency will be a complement to, not a replacement for, the two national currencies and that it is a long-term project. Other countries are not racing to join. Lula and Mr Fernandez offered South American leaders the chance to do so at a news conference on January 25: so far no one has taken them up.

This discounted alliance would still push Argentina’s problems to Brazil’s door. There needs to be a monetary policy maker, either a currency board or a full-fledged central bank, to oversee the exchange rate.this International Monetary Fund, Argentina owes $72 billion, and would be less willing to prop up the peso if Argentina had another fiat currency. On top of that, Lula will have to ignore his independent central bank, which has already spoken out against the idea. Brazil’s finance minister, Fernando Haddad, hinted just 24 hours after the big announcement on Jan. 23 that the idea would only come to fruition in the form of a credit note backed by Argentine commodities. That’s not currency at all. But that would be more borrowing, which Argentina intends to avoid.

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