SYNOPSIS: Argentina is stuck in a bind, and politics are making its salvation tricky

In the 1990's Argentina staged a dramatic recovery from decades of economic mismanagement, and in the process became an icon of the new world order. But last week the Argentine government found that it could roll over short-term debt only by offering a 14 percent interest rate, five points higher than a month earlier. And the buzz on Wall Street is that the question about an eventual Argentine debt default is no longer whether, but when.

Both the markets and the Argentine government are treating the issue as mainly one of deficit spending. Indeed, in a desperate effort to regain market confidence, President Fernando de la Rúa has called for draconian spending cuts.

But Argentina's fundamental problem isn't fiscal; it's monetary. Ten years ago Economy Minister Domingo Cavallo, the nation's economic hero, introduced a much- acclaimed monetary system, the nation's "currency board." Now he finds his handiwork threatened by that system's tragic flaw.

First, a word about the dire budget numbers you may have heard. Argentina, we are told, has a public debt equal to 45 percent of its G.D.P.; it has a budget deficit of more than 2 percent of G.D.P. Gee — the budget numbers are almost as bad as they were in the United States when the elder George Bush was president!

Why does a level of debt and deficits that caused only tut-tutting here create panic in Argentina? To some extent it's a vicious circle: because investors believe default is likely, they demand usurious interest rates that may well push the country into default. But the main answer is that behind a mildly troubled budget lies a deeply troubled economy.

Argentina's economy surged between 1990 and 1998, but it has been steadily contracting ever since. Unemployment, which stayed high even during the good years, has risen above 16 percent. This dismal performance contributes to the budget problem in at least three ways. A depressed economy means low tax receipts; it's hard to slash spending or raise taxes when the populace is already feeling a lot of economic pain; and it's hard to convince lenders that you will grow out of your problems when your economy is, in fact, shrinking. It's easy to criticize Argentina's political leadership for its inability to eliminate the budget deficit. But when did you last see our own leaders raise taxes and cut spending in the face of a nasty recession?

So why is Argentina's economy depressed? Basically it comes down to the currency board, which pegs the value of the peso at one dollar and ensures (technicalities aside) that each peso in circulation is backed by a dollar in reserves. When it was introduced this system offered a welcome guarantee that hyperinflation would not return, and contributed to a stunning economic recovery. Now, however, the system's fatal flaw has become obvious. Argentina's international competitiveness has been undermined by devaluation in neighboring Brazil and by the weakness of the euro; domestic demand has fallen as consumers and companies lose confidence; but because the currency board allows no flexibility in monetary policy, policy makers cannot respond, Greenspan-style, by opening the monetary spigots.

Mr. Cavallo, whom I know and admire (though I can't claim to have a sense of his soul) understands this very well. Yet he is understandably unwilling to abandon his creation. It would be a humiliating blow to his and his government's credibility. Also, because much of the debt of Argentina's private sector is in dollars, any devaluation of the peso would risk major financial disruption.

Yet if the latest desperate round of belt-tightening does not succeed, something will have to give.

Some Wall Street analysts believe that the Argentine government will default but try to keep the peso pegged at one dollar. Maybe — but that would be a bizarre strategy, choosing the worse of two evils. Advanced countries — the status to which Argentina aspires — regard default on debt as a mortal sin, but a sliding currency as at most a mild embarrassment. And default without devaluation, while easing Argentina's budget pressures, would do nothing to help its economy.

Meanwhile, the opposite strategy worked for Argentina's biggest neighbor. Two years ago Brazil was forced into a devaluation that many predicted would lead to economic ruin. It didn't. I hate to suggest that Argentina should emulate Brazil; indeed, I have been reluctant to say anything that would make Mr. Cavallo's job harder. But he and his country are rapidly running out of options.

Originally published in The New York Times, 7.15.01