Argentina’s attempt to swap some $40 billion in domestically-held debt for lower-interest bonds is a welcome admission that its current balance sheet is unsustainable. Had this been acknowledged a year ago, much misery might have been averted.

It is good news, yet also troubling because it falls short of a resolution of the current crisis. To achieve that, the government should shore up currency stability and carry out a simultaneous global restructuring of all its debt. Provided such a plan is accompanied by economic restructuring--rapid trade liberalization, and spending and tax cuts--it would lift a cloud of uncertainty that is inhibiting private investment and growth.

It is often argued that Argentina suffers from an overvalued currency and that a devaluation would realign the peso and therefore spur an economic recovery. But devaluation would produce financial collapse, since Argentine debt is largely denominated in dollars and would be even harder to service with a devalued peso. A proposal for the government to revoke dollar contracts by decree would be even more destructive, as it would end foreign interest in supplying private-sector capital.

The antidotes to currency overvaluation are increased labor productivity and falling wages. Wages have already fallen and will continue to decline, particularly since the government is now paying some employees with the new federal scrip, Lecop, which has limited use as money. But growth in labor productivity requires a resumption of capital inflows. This, in turn, depends on resolving the debt problem and passing reforms conducive to private capital imports and domestic financial stability. Dollarization would restore currency credibility and also encourage private capital inflows.

Argentina must resolve its debt crisis without destroying its banks. Over the past several months, Argentine banks have been forced to absorb government debt, placing the financial system at great risk, as indicated by the recent accelerating outflow of deposits. Nevertheless, in an orderly and rapid restructuring, I estimate that the write-down that banks (and other debt holders) will suffer will not exceed 50%, which will not bankrupt the banking system. This is particularly true since a properly managed write-down would immediately improve government creditworthiness and produce a fall in interest rates, boosting banks’ net worth.

To that end it would be best if all debts (foreign and domestically held) were restructured at the same time and if the IMF would facilitate the process by creating liquidity in the market for defaulted debts by the means I describe below. Neither of these ingredients is part of the current restructuring plan, but fortunately both are still possible.

The government’s current intent is to swap domestically held debt first. This will be harmful to local financial institutions because they will be forced to take a write-down before market interest rates decline (as they would following a full restructuring of debt). Thus the market value of domestically held restructured debt will be unnecessarily depressed unless and until foreign-held debt is restructured. And, notwithstanding promises to back the new debt with dedicated tax revenues, the relatively long maturity of the new domestic instruments will effectively subordinate this debt to debt that matures sooner, resulting in a further loss in market value.

Moreover, a prior restructuring of the domestically held debt will reduce the chance for a speedy restructuring of the foreign-held debt. In military matters, one divides to conquer, but the opposite holds in debt restructuring. The use of agreements called “exit consents,” which change the covenants in existing bond contracts and are signed by debt holders who agree to swap, can encourage other creditors to swap. But exit consents are only useful as a threat against holdouts if a large proportion of creditors choose to restructure. If all debts are restructured at once, domestic institutions (which hold roughly half of bond debt and are more amenable than foreign creditors) will be able to encourage foreigners to exchange debt. But if domestic claims are swapped first, foreign-creditor holdout problems could prove more difficult.

Despite the fact that a misguided two-tier restructuring is already underway, universal debt restructuring is still possible. The government has announced that domestic debt swappers will retain the option to participate in any subsequent international swap. If a global swap of all debt can be arranged quickly, then much of the harm from a two-tier structure can be avoided. This should now be a priority for the Argentine government.

Moreover, the IMF can play a constructive role in minimizing the fallout from default. Economists Adam Lerrick and Allan Meltzer have devised a simple means for the IMF to place a floor under the market price of defaulted bonds during the restructuring--at a significant discount to their expected post-restructuring exchange value. Doing so would prevent a temporary collapse in the market for these bonds, thus avoiding a run on banks. A floor on bond prices would also ensure liquidity to the market by making defaulted bonds valuable as collateral for borrowing. Messrs. Lerrick and Meltzer have conducted simulations of a debt-exchange auction with market participants, and have found that the mechanism works.

For over a year, senior IMF officials have opposed Argentine default. They mistakenly believed that default would necessarily result in devaluation, that the contagion effects would be catastrophic, and that a restructuring would be protracted and difficult to arrange. So instead they agreed to a string of doomed “rescue” packages for Argentina that delayed the resolution of the debt problem and contributed to economic decline, the weakening of the financial sector, and the poisoning of the domestic political climate.

Now Argentina has one last chance to resolve its debt burden in an orderly fashion and begin rebuilding its economy. The IMF, which is supposed to be in the business of helping stabilize international financial markets, can play an important role. Let’s hope that this time it chooses the right course of action.