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Argentina’s Economic Policy in a Time of Crisis: Don’t Throw the Baby Out With the Bathwater

Santiago Capraro, Guest Blogger

“Our definition of the concept of “monetary regime” had two parts to it: it is (a) a system of expectations governing the behavior of the public, and (b) a corresponding set of behavior rules for the policy-making authorities that will sustain these expectations.”

- A. Leijonhufvud, “Inflation and Economic Performance,” WP No. 223, UCLA, 1981.

In the first three months of 2014, the Argentine peso suffered a nominal devaluation of 20% (an annual rate of over 60%) and the real interest rate jumped from zero to around 10-15%. Argentina’s government has wanted to stop the fall of the Argentinean Central Bank’s (BCRA) international reserves. The drop in reserves has three origins:

First, growing current account deficits (see Figure 1). Argentina does not have access to international markets to finance these deficits. (Since the default in 2001-2002, there remain issues to be resolved. These include solutions to the holdouts of foreign debt and Paris Club Debt— the last IMF  “Article 4 Consultation” with Argentina was in 2006—and the expropriation of the Spanish petroleum company Repsol’s shares of the Argentine company YPF. The government has been trying to solve these problems: For example, in March the government agreed to pay $5 billion to Repsol as compensation for its shares in YPF.) As a result, the current account deficit must be financed with international reserves.

Figure 1. National Public Sector Financial Deficit (% of GDP) and Current Account (millions of dollars)

Second, in 2011, BCRA decided to use the nominal exchange rate as the “nominal anchor” of the economy, in an attempt to limit increases in inflation. The continuous real appreciation of the peso due to rates of inflation on the order of 20-25% since 2007 created the expectation that BCRA would have to devalue the peso. The result has been that speculators and other agents in the market saw the semi-fixed price of the international reserves as too low, and bought as many dollars as they could.

Finally, the real interest rate in 2011-2013 was negative, and as a result the dollar seemed a secure and simple way to save. The cost of these policies was a loss of $21 billion in BCRA’s international reserves between 2011 and 2013 (see Figure 2).

Figure 2. Argentinean Central Bank’s (BCRA) Stock of International Reserves

The crisis has thus led to both a deprecation of the peso and an increase in interest rates. The increases in the interest rate and the exchange rate are contractionary in the short run. Nevertheless, the devaluation could be expansionary in the medium run, partly as a result of the shrinkage of real wages. In this so-called best case scenario, workers will have paid the adjustment of the economy, which is not fair. But this adjustment might not even occur. Unions are fighting now to increase nominal wages by 30%, which implies that a large proportion of the nominal devaluation won’t become a real one. Indeed, the Buenos Aires state teachers union sealed the bargaining process with an increaseof 34% in the nominal wage; this amount could become a benchmark for others unions.  In addition, the government announced that will rationalize subsidies on utilities, which means that after ten years subsidy programs will start to distinguish between poor and rich, trying to target the people who need support. Although this is something that must be done, it will aggravate the economic situation because it will increase the rate of inflation, putting the economy at the door of stagnation.

Maybe these policies could control the current account deficit and stop the drop of international reserves by detonating a recession. Nevertheless, the increase in the nominal exchange rate could accelerate inflation because it will have a direct impact on prices and then wages, determining changes in the real exchange rate at some lag, and then a further impact of the increase in the real exchange rate on prices and wages, creating an inflationary spiral. The uncertainty related to inflation is huge; nobody knows if it will accelerate this month or even within 2014.

The control of a double digit rate of inflation, as faces Argentinian government, is a complex task. The government needs to control the expectations of different agents. To do that, it will have to present a plan for the medium run, but so far it has presented neither a plan nor a clear goal in terms of inflation. The lack of transparency and accountability regarding monetary and economic policy raises unions’ and capitalists’ inflation forecasts. The government must win the confidence of economic agents by presenting a plan explaining the consequences of the policies that it has just put into practice (nominal devaluation, increase in the interest rate, and decrease in subsidies on utilities), declaring what rate of inflation policymakers expect for 2014, and guaranteeing that the policy package will be neutral in terms of the income distribution. Whether citizens believe the government’s plan or not is a key element in stabilizing the economy. If the government cannot get the confidence of the public, it will have to apply additional contractionary monetary and fiscal policies to avoid an acceleration of inflation.

Last, but not least, President Cristina Fernández is betting her political strength on these policies. If they do not solve the economic turmoil, she is counting on the lower and middle classes believing that the problem is the application of the policies and not the government’s general economic strategy. This strategy is the development of the national market through an increase in real wages, a redistribution of income in favor of labor, and the development of national industry that can be globally competitive.

In 2015, belief in this model will be put to the test in presidential elections, and it is important that voters understand that an implementation error does not mean that everything is wrong, but rather that the current government made some mistakes and they have to be solved. The alternative macroeconomic model, based on export-led growth and inflation targeting with an independent central bank, could be more stable, but with a cost in term of the welfare of the working class. We have to learn from the 1980s, when “Washington Consensus” (neoliberal) policies completely wiped out the import substitution industrialization (ISI) strategy. This time, we don’t need to throw out the baby with the bathwater.

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