Brazil’s and Argentina’s Proposal for a “Latin American Euro”

Creating a common currency between Brazil and Argentina, with Venezuela appears to be wanting to join, is the latest craze of renewed 21^st century socialism.

The purpose of this article is to determine whether a monetary union between Argentina and Brazil, with the possible incorporation of other countries, makes sense.

Why a Common Currency Might Be a Good Idea: Eliminating Transaction Costs

Let us begin by enunciating a monetary maxim that in a twist of fate concurs with our 21^st century socialists: sharing currency between different economic areas is incredibly coordinating or efficient from an economic point of view. Here, the underlying argument is that the alternative to a common currency, that is, having different currencies constantly fluctuating (“floating”) between each other, limits the geographical division of labor. Technically, we would argue that specialization patterns is constantly being altered due to monetary noise introduced by free-floating exchange rates.

Sharing a currency, on the other hand, avoids the always cumbersome calculation of businessmen who sell products into foreign markets. He must take into account the potential losses caused by sudden and unexpected changes in the exchange rate.

Another way of looking at the same problem is that there are financial derivatives that allow you to protect yourself from exchange rate risk, but of course, such financial derivatives come at a cost. Therefore, if a company makes a sale abroad today, but payment is due in another currency in a month, the seller must bear a potential loss due to fluctuations in the exchange rate. Alternatively, the same company would have to bear the cost of covering its foreign exchange rate risk with a currency swap (one of the derivatives that allows you to protect yourself against exchange rate risk). Sharing a currency avoids these unnecessary costs for businessmen. In economic terms, we would say that sharing a currency among several countries avoids transaction costs. By reducing trade barriers, the exchange of goods and services increases, and profits derived from such trade increase as well.

When trade increases, economic integration occurs: this causes changes in the productive structures or patterns of the economies involved. The division of labor expands, and produces changes in specialization patterns. Economists correctly argue that such changes bring large benefits in terms of efficiency, benefits that positively impact people’s lives. The result would be that more things, more goods and services, are produced with the same or even less effort. That is basically how wealth creation works. In other words, a monetary union contributes to, although not necessarily creates, wealth.

In the case of Brazil and Argentina, a common currency could help Argentinians and Brazilians to have a true common market and trade between the two countries would become much more important than it is today. Of course, if more countries were included in this monetary union, the greater would be the integration of their respective economies and the more efficient would be the patterns of productive specialization.

Despite all this, and as practically anyone even without any background in economics can quickly attest to, a common currency between Argentina and Brazil is a terrible idea, or even a potential disaster.

A Common Currency Only Makes Sense When Trade Is Free

The first reason why it makes no sense to create a currency between countries with the self-proclaimed leaders of 21^st century socialism is that their idea of economic integration is different from us mere mortals.

21^st century socialism involves a high degree of economic intervention. Perhaps the area of economic integration that best characterized the ideas of 21^st century socialism was the now practically extinct ALBA. In ALBA, countries rather than people trade. They do not even allow trade between companies that hold some kind of government permit, but only allow State companies to trade. In other words, trade (if you could still call this “trade”), in this attempt of economic integration, was completely controlled by governments.

Neither Argentina nor Brazil was directly part of ALBA, but the ideology that inspires their current rulers is practically identical to the one that inspired the establishment of ALBA back in 2004, which is none other than 21^st century socialism. Brazil and Argentina are part of Mercosur, an common economic area in which trade of goods and services is not free either and is still usually subject to heavy tariffs. Whichever way you look at it, free trade doesn’t seem to be the goal.

Therefore, we can affirm that the Brazil’s and Argentina’s rulers seek to direct their economies along the path that they themselves trace. This entails a direct intervention in the specialization patterns of the economy. But if the great advantage of a monetary union is to eliminate precisely such transaction costs in order to obtain specialization patterns based on the competitive advantages of each country, a common currency directly clashes with the interventionist intentions of Brazil’s and Argentina’s rulers. In other words, the advantage of having a common currency is lost almost instantly as soon as the true intentions of the rulers who propose it become apparent.

In the case of Argentina and Brazil, having a common currency could imply that a part of the Argentine automotive industry would move to Brazil and that a part of the Brazilian agricultural production would move to Argentina (or vice versa). Once transaction costs are removed, the less competitive industries in an area will have a hard time and may have to reconvert into other industries. This process of economic reconversion is politically very costly, since time passes while industries are being rebuilt and people lose jobs. It is also possible that many people will experience a reduction of their human capital, since their particular skills might have very little value after an economic reconversion. They might have to re-learn another profession (and at certain ages this becomes complicated, so additional political pressure arises to maintain the status quo).

The popular discontent derived from the necessary productive reconversion is very difficult to navigate politically. If we add this to the fact that the current governments of Brazil and Argentina have a predilection for intervening in markets, it is likely that trade barriers will be erected for the national industries that are being threatened. Such barriers can be many things, from import quotas, additional tariffs, import regulations, and a very long “etcetera”.

Sharing a currency align specialization patterns with underlying economic conditions. Political power intervening in the market process implies the precise opposite; it favors wasteful and inefficient specialization patterns.

Therefore, the raison d’être of a common currency such as one between Brazil and Argentina falls apart as soon as we analyze the rhetoric, ideology, and actions of the governments that propose it. For this reason alone, the common currency lacks a sound justification. The real problems that the potential Latin American common currency would bring about are much more serious.

A Common Currency as a Source of Political Problems

The bitter experience of the euro reminds us of the problems common currencies have in today’s highly intervened financial and monetary system.

The euro has proven to be a sound currency as far as European specialization patterns are concerned. European economies have never been so economically integrated since the period of the classical gold standard (gold was the only world currency the world really enjoyed, sadly the experiment was cut short in 1914 with World War I).

But the political problems stemming from the euro have also been monstrous, which leads us to the question: how is a common currency able to cause political problems?

The answer has to do with the way in which money is produced under the current monetary regime. Historically, base money was a commodity (gold or silver, for example) and close monetary substitutes were produced in the form of debt (bank notes or deposits). Those monetary substitutes in the form of debt were promises, more or less credible, to pay gold, silver or any commodity base money.

However, in the current monetary system, all money is based on debt. The monetary base is debt and close monetary substitutes are debt. Specifically, the monetary base consists of government debt. Central banks issue currency and use government debt as collateral or backing. Monetary substitutes in the current monetary system take the form of private bank debt such as checking deposits. In this article, and for didactic reasons, we are going to leave out of the analysis the monetary substitutes that the private banking system produces.

Central bank operations are relatively easy to understand. The government runs deficits, that is, it spends more than it earns. It covers its deficits by issuing government debt, and part of that debt is purchased by the central bank. This process is called debt monetization. Monetizing debt simply means that the central bank buys the debt by issuing new currency. It is called monetizing because explicit government debt goes out of circulation, since the central bank accumulates it and issues new currency instead. In this sense, the new currency, the new euros or dollars or whatever, are nothing more than a form of debt.

Therefore, the monetary base, the apex of the monetary system, is backed by a country’s debt. This creates an “advantage” for the State as it produces a significant demand for their public debt. It implies, however, a great disadvantage for the general public, since this mechanism can be abused and, usually when it is abused, the currency begins to become worth less and might be gradually rejected by the public. When this occurs, an inflationary processes is triggered that seems incurable. When the process of monetary abuse in the form of public debt monetization accelerates, we observe countries with out-of-control inflation. One example of countries that chronically suffer from out-of-control inflation is Argentina, and, not long ago, Brazil was another of those countries.

A Common Currency Only Makes Sense with Restrictive Fiscal Arrangements

Therefore, under the current financial system, a common currency between various countries only makes sense if there exists some type of fiscal arrangement. In other words, since the central bank is going to purchase public debt of various countries, no country should be able to fiscally exploit other countries through the debt monetization mechanism.

This is the reason that when the euro was established, quite strict fiscal rules were established for member countries. At this point, it is of little use to mention the specific fiscal rules that involve the euro, but the idea that the architects of the euro masterfully understood that a currency is a form of debt and that it can be (ab)used by member countries to finance their excess spending. When that happens, every user of the currency is hurt by the onset of inflation. Therefore, countries needed to be fiscally disciplined and avoid committing fiscal misbehaviors that would have a negative impact on the rest of the countries that also use the common currency.

Despite the fact that the architects of the euro fully understood the potential problems and devised a reasonable set of rules, politicians will always be politicians, and the most irresponsible leaders found justification for repeatedly flouting the euro’s fiscal rules. This has caused enormous political tensions. The countries of North and South-Europe are constantly exchanging accusations of all kinds. The European common currency, no matter how common it might be, has served to spark conflict between the countries of the old continent.

A Common Latin American Currency: What Can We Expect?

If the euro has created so many political problems due to the fiscal irresponsibility of some governments, what can we expect from a Latin American currency?

In Europe, the euro has faced the fiscally irresponsible countries of southern Europe, with special mention of Greece, Italy and Spain (in that order) with the most fiscally responsible countries such as the Netherlands, Germany or Finland.

In Latin America, financially responsible countries are much less common than in Europe (even in Europe they are not abundant). The problem then is that creating a common Latin American currency is similar to creating a euro with exclusively southern European member states. If we all prey on each other monetarily, the common currency would soon be destroyed and rejected by the public in a heartbeat. The Latin American currency project is similar to the euro, except that all countries resemble Greece (or are even more financially irresponsible than Greece).

Brazil and Argentina: Why a Common Currency?

Taking into account the enormous problems that might arise, why are Brazil and Argentina launching into an almost utopian project of creating a common currency?

Argentina is currently close to an unfortunate milestone of 100% annual inflation, a figure that merely the world champion of inflation, Venezuela, can surpass. It is not surprising that Venezuela is another candidate member for this odd monetary union. Argentina is almost completely financially isolated from the world. It has a practically unpayable debt with the IMF and its capital markets are practically closed. Its central bank barely holds any monetary reserves in dollars, and a black market for dollars is yet again thriving. Therefore, it makes all the sense in the world that the Argentinian ruling class wishes to monetarily prey on the citizens of other countries, since theirs are already being squeezed as much as they can well bear.

Yet, the Brazilian case is much more complicated to understand. Brazil has achieved remarkable monetary stability in recent years. Its inflation rate is in line with that of the rest of the world. Brazil has large monetary reserves and the country’s financial health seems guaranteed. Why would Brazil want to create a common currency with partners that are much more irresponsible than itself?

The answer is twofold: one involves monetary policy and another involves “general” policy:

• Monetary politics

Brazil’s president, Lula, has already announced that the central bank’s inflation target must be raised to allow for a greater margin for his government to act. Of course, “to act” implies a clever sleight of hand since it means that it simply wants to force the central bank to purchase a larger amount of public debt than before. Essentially, the Brazilian government is announcing that it cares little about Brazil’s monetary stability. The Brazilian government intends to increase public spending, the fiscal deficit and public debt, and does not mind squandering the monetary stability that the country has achieved. The Brazilian government is openly announcing that it will swindle its citizens. Why not try to do the same with the citizens of other countries? This is where the possibility of a common currency comes in.

• “General” policy

Another reason for Brazil to create a common Latin American currency is that the Brazilian president seeks to be a new beacon of 21st century socialism. Brazil is a country large enough and developed enough to exercise regional leadership with left-wing policies that confront the free market in general and the United States in particular.

One way to deal with the United States is by creating parallel payment systems. In today’s monetary world, countries exchange with each other in dollars. The dollar is the world’s reserve currency. Common currencies create large areas of trade and movement of capital that do not use the dollar.

Therefore, the strictly political objective of the Brazilian government is twofold with this common Latin American currency: on the one hand, Lula seeks to be the new self-styled Latin American leader and, on the other hand, he seeks to confront the United States.

Conclusion

The Latin American common currency promoted by Brazil and Argentina does not make any economic sense. If the project manages to see the light, which is highly doubtful, it will only produce a currency as strong as the currency of the weakest member of the monetary union. You cannot create a sound currency with spendthrift and fiscally irresponsible governments.

The common Latin American currency only makes sense as part of a more far-reaching political project, a political project that Lula da Silva is launching as a “renewed version of 21st century socialism”, of which Brazil is already a formal part.

Legal disclaimer: the analysis contained in this article is the exclusive work of its author, the assertions made are not necessarily shared nor are they the official position of the Francisco Marroquín University.

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