Politicians are often accused of promising what cannot be delivered. In Argentina, economists sold politicians on two dreams that could not be fulfilled.
Their failure plunged the country into its deepest political and financial crisis in decades. President Fernando de la Rua was brought down by riots that left 29 dead. Citizens, facing unpaid salaries, frozen bank accounts and unemployment of 20 percent, are suffering the consequences of two grand economic illusions.
ILLUSTRATION: YU SHA
The first concerned the supposed restorative powers of a currency board. Call it the magic wand illusion. When in 1991 Argentina tied the peso to the dollar and prevented its central bank from printing pesos freely, the world applauded -- with good reason. The new policy ended decades of high inflation and currency debauchery. But the currency board was not just a monetary system; it was also a reform strategy. That overreach began Argentina's undoing.
Unreformed
The country had not reformed previously -- the theory went -- because it did not need to. If unions bid up wages too high, a devaluation could fix the problem; if provincial governments spent a little too much, a quick round of peso printing would save the day. Inflation was the grease that had kept the wheels of Argentine politics going.
Shut off the peso spigot -- economists counseled -- and politics would fix itself. Without an inflationary cushion labor markets would have to be modernized, and peso wages would fall to the point were the country could compete internationally.
Fiscal policy would also be straightened out because the central bank was no longer the lender of last resort. Local banks and corporations would never again over-borrow, knowing that no safety net would catch them when they fell. Even politicians liked this theory, since they could blame the monetary straightjacket for some of their unfulfilled promises.
The magic wand illusion was not invented in Argentina. Like many things in that country, it was imported from Europe.
Adopt a common currency, many a Continental economist had promised, and fiscal laggards such as Italy and Greece would shape up. In Europe, the combined carrot of northern transfers and the stick of northern reproach did the trick. Most southern European nations today display public finances that are Lutheran in their prudence.
In Argentina the currency board did the trick -- at the start. In the early-to-mid 1990s budget deficits turned into surpluses, bank and financial supervision tightened and labor market reform was repeatedly attempted (if never achieved). Argentina was briefly Wall Street's darling. Then came Mexico's crisis, and Russia's, and Asia's. The world economy turned sour for emerging markets. At that point Argentina fell victim to the second false promise -- call it the golden child illusion.
The world economy will help you as long as you help yourself, policy gurus told Argentina's politicians. If you suffer a shock, just turn the other cheek. If you need to borrow for liquidity, world market will supply those funds at reasonable interest rates. No matter what, don't touch the currency board, the linchpin of your credibility.
Until late in the game, Argentina did as it was told. President de la Rua countered the terms of trade and interest rate shocks from abroad with domestic tax increases, even as the economy contracted. Contrary to conventional wisdom, the government did not go on a spending binge. Despite the temptation to spend its way out of slump, Argentina's non-interest expenditure remained roughly constant. In 2000 the nation ran a budget surplus of 1 percent of domestic output, which became a total deficit of 2.4 percent once interest payments were added in. Public debt stood at a moderate 45 percent of output.
In short, it did as much as the once-golden child in the class could have been expected to. World capital markets did not reciprocate. Spreads charged on loans to Argentina went from huge to obscene. Interest payments drove up the deficit, which spooked investors who demanded even higher spreads, enlarging the deficit even more. Most governments forced to pay 40 percent a year or more on dollar loans would eventually run out of money and stop paying. This is what has happened to Argentina.
In the endgame, the consequences of a policy based on illusions reared their ugly heads. The temporary discipline imposed by the currency board had masked the absence of crucial reforms. The weakest link was the fiscal regime tying the federal government and the rest of the country together, which remained discretional and full of loopholes. As the budget situation deteriorated, transfers from Buenos Aires to provincial governments became a matter for day-to-day political bargaining. The lack of a fiscal framework hindered credibility.
Unrepentant
Cut off from credit, Argentina entered a deflationary spiral. Never mind that Cavallo promised a zero-deficit policy, spending only what the government took in. Budget cuts reduced demand and output, which caused revenue to collapse, making additional budget cuts inevitable. The lesson would have been obvious to Keynes: with monetary policy immobilized by the currency board, and with fiscal policy immobilized by lack of financing, the economy could only go down. The shock absorbers that were dismissed as unnecessary for a golden child (world capital markets, remember, were supposed to finance your way out of a slump) turned out to be crucial.
In defending the currency board and trying to avoid a default vis-a-vis those who hold pesos in their pockets, Argentina ended up defaulting against everyone else: its public employees, whose salaries were either never paid or arbitrarily cut; its provinces, who have not received the transfers accorded them by law; its depositors, who can no longer withdraw their funds freely from the bank; and, crucially, its democracy, with the mandate of a popularly elected president cut short by rioting and looting.
Now is the time to cut free of these two illusions. Since no one will save Argentina, Argentines must save themselves. A necessary step is to abandon convertibility and let the peso float, while transforming outstanding obligations to pesos so as to prevent the devaluation from wrecking the balance sheets of local banks and corporations. The moratorium on foreign debt payments announced by incoming President Rodriguez Saa's will help cushion the blow.
With the currency at a level that makes Argentina competitive again, reconstruction can begin. With no currency board to instill a false sense of discipline, real institutional reform will have to be tried.
Provincial finances will finally have to be cleaned up. It will be a long, painful road. But this time Argentina will not travel under the illusions fostered by economic scribblers, both dead and alive.
Andres Velasco is a professor of economics at Harvard University. Copyright: Project Syndicate
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