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Hoisted from the Archives (2002): Mark-My-Beliefs-to-Market Time: Argentina

Hoisted from the Archives:

Mark-My-Beliefs-to-Market Time: Archive Entry From Brad DeLong's Webjournal: I am reading Michael Mussa's brand-new very short book on the latest Argentinian financial crisis [Michael Mussa (2002), Argentina and the Fund: From Triumph to Tragedy (Washington: Institute for International Economics: 088132339X)]. In The Importance of Being Earnest, Oscar Wilde gets a laugh out of the idea that a chapter on a rupee crisis is too exciting for young ladies--out of the idea that a technical discussion of anything having to do with international finance can be anything but deadly boring. But reading this is different.

First, I'm weird: I'm an economist, which means (these days at least) that I don't even have the sparkle and flash, the willingness to take risks and go out on limbs, that accountants have. Second, the Argentine crisis is an important setback for human happiness--a much more important tragedy even than the closing of a Zambian copper mine. Plus the crisis has important lessons for international economic policy in the future.

Third, Michael Mussa--former chief economist at the IMF for a decade--is a fearless and witty guy: he (reportedly) spoke of his boss at the IMF, Michel Camdessus, as a man who was 'so optimistic he always sees the glass as half full, even when there's no glass at all'; in this book, he writes of the IMF following its standard approach when a government fails to meet the policy targets it has committed to--the standard 'three-monkeys approach: see no evil, hear no evil, speak no evil'; he writes of the proposals of the Meltzer Commission for IMF reform as '...unnecessary, unworkable... fundamentally misguided...'; and he writes of the Fund staff's spring 2001 analysis of the dynamics of Argentina's debt, '...if, if, if... if my grandmother had wheels, she would be a bus...'

Thus I had no trouble staying awake through the book.

Toward its end, Mussa calls for a thorough evaluation of the Fund's role in Argentina, an evaluation to take the broadest possible scope. He writes (p. 71) that:

.>.. it is my view that the Argentine government's basic decision to combine efforts at macroeconomic stabilization with market-oriented reforms was the right policy approach... the spectacular success of the Argentine economy throughout most of the past decade is attributable to this basic policy choice... the spectacular collapse in 2001 is due to the failure to implement this strategy sufficiently vigorously, especially in... fiscal discipline. Others... may be inclined to the view that the policies... are fundamentally wrong and were doomed form the start.... An evaluation of the Fund's role in Argentina should reflect on this broad question...

And so I have begun thinking: What if I wanted to make the argument that the neoliberal policy mix adopted by President Carlos Menem and Finance Minister Domingo Cavallo was a big mistake, that it was all doomed to failure from the beginning and should not have been undertaken, that from the moment he proposed his Convertibility Plan to stop Argentina's hyperinflation the Sunday Horse was pulling the Argentine cart down a track that led nowhere? What would that argument look like?

As I see it, such an argument would have five steps:

First, the neoliberal program pushed by Domingo Cavallo demanded free markets--the end to protectionism, the end to quantitative restrictions of all kinds, the end of limits on freedom of contract, and most importantly the end to controls on the ability of not just goods but money to flow into and out of Argentina, and the end of the government's ability to force Argentines to denominate their wealth in a unit of account--the peso--whose value it controlled.

Second, the neoliberal program pushed by Domingo Cavallo required a hard peg of the value of the peso to the dollar: nothing else would convince Argentines that the days of hyperinflation had passed, and that they no longer had to dissipate resources and waste time insuring themselves against inflation, but could trust the unit of account.

Third, Argentina is a country in which the government constantly promises the people more than it can deliver. It promises rich oligarchs that it will not collect too much in taxes. It promises workers and consumers a generous social insurance state. It promises rapid economic development, large expenditures on infrastructure, jobs for politically well-connected boys, and so forth. An unequal distribution of income and wealth, a lack of social comity between the working and the middle classes, a viciousness in politics going back to General Galtieri, the Dirty War, Juan Peron and his enemies, and even before means that claims on national product and demands that the government enforce those claims are inevitably going to mount up to more than 100% of what is available. The basic political fight over how national product is to be distributed among social classes is unresolved, and any political movement that makes only promises it can keep is doomed to rapid defeat.

Hence, fourth, in Argentina government deficits--large government deficits--are a law of nature, a fact of life. Moreover, everyone knows that large government deficits are a fact of life and a law of nature. Hence interest rates on Argentine debt will be low and reasonable only rarely and for short periods.

Fifth, points one through four mean that the neoliberal reform program in Argentina in the 1990s had exactly the same chance of avoiding disaster as one would expect if one gave a modern gene-splicing biochemistry lab to Doctor Frankenstein. The fundamental unresolved conflicts of Argentine politics mean that debt is going to mount. The fact that everyone knows that Argentine politics generates chronic deficits means that the interest payments due on that debt are likely to explode. Exploding interest payments mean that the dynamics of Argentine debt are unstable, and thus that the hard-currency exchange-rate peg cannot last. And free access to international capital markets, to dollar-denominated bank accounts, and so on, and so forth, means that when the crisis caused by the contradiction between the hard currency peg and the fundamentals of Argentine politics comes, it will be five times as bad: at least with tight controls on foreign exchange and a primitive, underdeveloped banking system, the amount of damage a government default can do to normal economic life is limited.

From this perspective, pushing neoliberal, market-opening reforms on Argentina looks as wise as giving a supply of gasoline to a bunch of pyromaniacs, on the grounds that gasoline is a very useful and powerful fuel.

My intellectual problem right now is that this argument I have just constructed--which was supposed to be a strawman that I, a card-carrying neoliberal, could easily demolish--feels too convincing.

Michael Mussa (2002), Argentina and the Fund: From Triumph to Tragedy (Washington: Institute for International Economics: 088132339X).

Bergsten, p. viii: "[Mussa's] conclusion that the Fund's last pre-crisis loan to Argentina in August 2001 was 'the greatest mistake the Fund made in my ten years there' is thus of considerable importance in the ongoing debate over this crucial and tragic case."

p. 3: " other cases... Mexico in 1995; Indonesia, South Korea, and Thailand in the Asian crisis... Brazil... a Fund-supported program was started only after the crisis was already under way. Thus, any failures of the Fund in the pre-crisis period were those of its relatively low-intensity surveillance activities. For Argentina, the failures of the Fund are clearly associated with the core of the Fund's [activities]... when it is providing financial assistance and when the policy and performance of the member are subject to the intense scrutiny of Fund conditionality..."

p.3: "The end result in Argentina has clearly been a disaster... not intended or, until recently, broadly anticipated--by the Argentine authorities, the Fund, or anyone."

p. 4: "...the Fund did make at least two important mistakes... failing to press the Argentine authorities much harder to have a more responsible fiscal policy, especially during the high growth years... extending financial support to Argentina during the summer of 2001, after it had become... clear that... efforts to avoid default and maintain the exchange rate peg had no reasonable chance of success."

pp. 5-6: "...if the Argentines had decided to move to an alternative, more flexible exchange rate and monetary policy regime that maintained reasonable monetary policy discipline, this would also have been acceptable to the Fund. Indeed, at least some in the Fund... would have welcomed serious consideration of such a move..."

p. 6: "As the crisis deepened... and the deficit targets set in the Fund-supported program were missed, the Argentine authorities sought to undertake further austerity measures. The Fund supported these efforts.... However, had the Argentine authorities decided at some time during 2000-2001 ... to pursue an alternative... debt restructuring and a possible change in the exchange rate regime, the Fund would have supported responsible efforts in this direction..."

pp. 9-10: "In sum, if things had broken more in Argentina's favor, this surely would have helped to preserve the success.... Enumerating the many things that contributed to Argentina's tragedy, however, should not obscure the critical, avoidable failure of Argentine economic policy that was the fundamental cause of the disaster--namely, the chronic inability of the Argentine authorities to maintain a responsible fiscal policy..."

pp. 15-16: "In sum, during the period 1993-1998 when the Argentine economy was performing very well [average annual real GDP growth rate of 4.1%] and the Argentina government was receiving substantial nonrecurring revenues from privatization and enjoyed other temporary fiscal benefits [that amounted to 2 percent of a year's GDP], the public-sector debt-to-GDP ratio nevertheless rose by 12 percentage points [from 29 to 41 percent of GDP]. This clearly was not an adequately disciplined or sustainable fiscal policy..."

p. 16: "Because most industrial countries have government debt-to-GDP ratios above 50 percent and some above 100 percent, it might be asked why a debt-to-GDP ratio of just above 40 percent was worrying for Argentina. There are at least five important reasons. First... Argentina has had little success in raising tax revenues (including social security contributions) of more than 20 percent of GDP.... Second... government debt denominated in foreign currency... held externally, Argentina faced the dual challenge of persuading creditors that it was capable both of raising sufficient fiscal revenues to service its debt and of being able to convert these revenues into foreign exchange with an exchange rate that was rigidly pegged to the U.S. dollar.... the ratio of external debt to exports... more than 400 percent.... Third, it is not just the level of the government debt... it is also how the debt has been behaving.... Fourth... Argentina... was potentially vulnerable to external economic shocks.... the collapse of Brazil's crawling-peg exchange rate in early 1999 had important negative spillovers... the debt-to-GDP ratio jumped from 41 percent in 1998 to 50 percent in 2000.... Fifth... Argentina was clearly vulnerable to changes in financial market sentiment... [that might become] self-fulfilling..."

p. 18: "When the actual fiscal deficit began to exceed the program targets during 1995 because of an economy that was weaker than expected, the Fund... showed unusual flexibility (by past Fund standards) in allowing an upward revision of the deficit target. In my view, this was the right approach.... Unfortunately, the Fund's flexibility... was not applied symmetrically. Starting in late 1995, the Argentine economy began three years of very rapid recovery... one would have expected that the Argentine government's fiscal deficit would have come in well below the permitted target... [but] it was just below or even slightly above.... During 1995, when the recession turned out to be steeper... there was plausible reason to grant waivers.... At other times... it is difficult to understand why the Fund did not make active use of its conditionality to press the Argentine government to maintain a more responsible fiscal policy.... And the fiscal targets were significantly less demanding than they appeared to be (even allowing for stronger-than-expected economic growth) because they conveniently ignored... government borrowing that were viewed by the Argentines as off-budget..."

p. 24: "...the fundamental choice of Argentina's monetary policy framework and exchange rate regime was a choice for the duly constituted government of Argentina. The Fund could advise.... However, the basic choice of regime is a decision of the [Fund] member--at least up to the point where the chosen regime has no reasonable chance of success.... Thus, though an independent observer might conclude that the rigidities of the [exchange rate] Convertibility Plan deserve relatively more weight, and the failures of Argentine fiscal policy relatively less weight, in the blame for the tragedy that ultimately befell Argentina, this is not the relevant perspective from which to view the role of the Fund. For the Fund, the relevant question was--given the choice of Argentina to adopt and maintain the Convertibility Plan--what other policies were necessary to make the stabilization and reform effort a success. Given the plan, failure to maintain a sufficiently prudent fiscal policy would likely prove a fatal error. The Fund, having accepted the Convertibility Plan, had the responsibility to press very hard to avoid this fatal error."

pp. 27-30: "For the Fund, the deteriorating situation in Argentina in the autumn of 2000 presented a critical challenge.... A star pupil that the Fund had praised and supported as a model of economic liberalization and reform was in danger of turning into a basket case.... One approach would have been to continue with an essentially standard Fund-supported program... [of] up to 100% of its Fund quota.... The main difficulty... was that... it was clearly inadequate. A second approach would have been to conclude that because of the continuing recession... further official [Fund] support would be available only on the condition that Argentina reach agreement with its private creditors that would substantially reduce its financing requirements in the coming years.... Necessarily, this rescheduling of private credits could not be entirely voluntary.... [A] decision by the Fund in late 2000 to press Argentina into a debt restructuring that would have amounted to a de facto sovereign default would have been a very weighty matter. The Argentine government was dead set against such action.... At the Fund... there was little enthusiasm for such an approach... the Argentine situation was not seen as without realistic hope.... The third approach... actually adopted... [was] levels of support substantially greater than in standard Fund-supported programs... the deficit target would be set so as to carefully balance the need to keep borrowing within responsible limits... against the very real economic and political difficulties of fiscal consolidation in a deepening recession. Official financing would... meet virtually all of Argentina's projected external financing requirements for 2001, assuming the program's fiscal objectives were met..."

pp. 45-8: "By August 2001... prospects for a favorable outcome were pure fantasy.... [I]nterest rate spreads... were... in the range of 1300 to 1600 basis points. This implied nominal interest rates for the Argentine sovereign... of 18 to 22 percent, with real interest rates even higher due to deflation. Economic recovery was impossible in this situation.... The Argentine government's fiscal policy... could not meet its targeted objectives.... The political consensus to raise the huge primary surplus... required to demonstrate sustainable debt dynamics... was, quite understandably, nowhere apparent.... An emergency injection of another $6 billion in cash from the Fund was urgently needed just to stave off immediate default and keep the farce going for another few months.... [A] wide range of analysts... often with differing views on many issues concluded that the game was over for Argentina. Only a fool would conclude otherwise. Why, then, did the Fund... acquiesce in this folly?... Here there was a failure of intellectual courage... and a failure of moral courage.... Argentina was not helped... assistance that was potentially far more valuable in helping to contain the damage once a de facto sovereign default had occurred was instead squandered in a futile effort to avoid the inevitable..."

pp. 60-64: "What should be the elements of the policy program...? Six elements can be delineated.

First, the program should be based on realistically optimistic economic assumptions... real GDP will likely fall 10 to 15 percent in 2002... the value of the peso at the end of 2002... 20 or 25 U.S. cents... domestic inflation... headed over 200 percent [in 2002]...

Second.. the government budget needs... the deficit... within the bounds of what can be financed without... hyperinflation.... Tax revenues are likely to be very low because of the economic collapse and very poor tax compliance... substantial costs to the government from dealing with the mess it has created in the Argentine banking system... the absolutely essential task of reining in the deficits of the provinces and terminating their discretionary authority to borrow...

Third... a reasonable framework for monetary policy... contain the initial inflationary surge from the collapse of the peso and then bring the inflation rate down to more moderate levels during the course of the next two years...

Fourth... [a] unified floating exchange rate... the peso inevitably will depreciate very substantially (from its old parity) in real terms--and even more so in nominal terms...

Fifth, something needs to be done to clean up the horrendous mess in the Argentine banking system.... Four actions of the Argentina government have made the banking system... insolvent.... (1) The government defaulted on its... own dollar-denominated debt... held by Argentine banks. (2) The government reneged on... the Convertibility Plan.... (3) The government mandated that dollar-denominated loans of Argentine banks were payable in pesos. (4) The government mandated that dollar-denominated deposits at Argentina banks be converted into pesos at a [higher] exchange rate...

The first three actions together effectively forced a massive write-down in the dollar value of [bank] assets... a write-down that was unavoidable.... The Argentine government.. lacked the political courage to tell the Argentine people... that the U.S. dollar value of their deposits... was being sharply reduced as a result of government actions. Instead, through the fourth action, the Argentina government sought to purvey the fiction that most of the dollar value of deposits could be preserved... and shift the blame for the losses of depositors from the government to Argentine banks. Now the Argentine public has, with good reason, lost confidence in the banking system and... the government.... Moreover, the owners of Argentine banks... robbed of all their invested capital... have little reason to believe any promises of the Argentine government... no incentive for [anyone]... to put in new capital to refloat the banking system... Sixth... signal their intention to pursue good-faith efforts to deal responsibly with their external sovereign debt.... [F]oreign creditors... need to recognize that... they will not be made whole, but... need to share in the enormous economic losses.... Argentine authorities must ensure that foreign investors are... not forced to accept disproportionately large losses...

p. 67: "The Fund is expected to... act both as a sympathetic social worker and as a tough cop."

"the 'three-monkeys approach' to dealing with government failures to meet policy targets that it has promised the Fund: see no evil, hear no evil, speak no evil..."

p. 71: "... it is my view that the Argentine government's basic decision to combine efforts at macroeconomic stabilization with market-oriented reforms was the right policy approach... the spectacular success of the Argentine economy throughout most of the past decade is attributable to this basic policy choice... the spectacular collapse in 2001 is due to the failure to implement this strategy sufficiently vigorously, especially in... fiscal discipline. Others... may be inclined to the view that the policies... are fundamentally wrong and were doomed form the start.... An evaluation of the Fund's role in Argentina should reflect on this broad question..."

p. 74: proposals of the Meltzer Commission as "...unnecessary, unworkable... fundamentally misguided..."

p. 78: of the Fund staff's spring 2001 analysis of Argentina's debt dynamics, '...if, if, if... If my grandmother had wheels, she would be a bus...'