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Argentina on the Brink

February 22, 2002

It is hard to exaggerate the economic and political conditions in Argentina. With the economy in the grip of a paralysis, with unemployment soaring to depression levels, and with street rioting killing 28 people just before Christmas, the country is on the brink of civil war.

It was just over a decade ago, in 1991, that Argentina seemed to make a new beginning after years of hyperinflation and "dirty wars" waged by the military against fellow Argentines. When the gross domestic product (GDP) had fallen for three successive years, with goods prices rising at four-digit rates and the "australes" currency depreciating rapidly, the government--under the leadership of President Carlos Saûl Menem, leader of the Justicialist National Movement, or, as it is also known, the Peronist Party--managed to enact a "stability and convertibility plan." It conducted a currency reform, replacing the austral with the peso at a ratio of 10,000 to one in April 1991.

The exchange rate, which was conceived by politics rather than the laws of the market, overvalued the new peso; the fear of public rejection of the new currency prescribed the rate. The reform required the Central Bank of Argentina henceforth to back all issues of currency with international reserves, that is, primarily U.S. dollars. The Menem administration also deregulated some small businesses and privatized many public enterprises. To most Argentines, the future looked bright and prosperous.

Indeed, the country prospered for a few years, with GDP rising some 8 percent in 1992 and 7 percent in both 1993 and 1994. The rates of inflation declined from 18 percent in 1992 to 7.4 percent in 1993 and 4 percent in 1994. President Menem also tried to cope with the chronic budget deficits which always had been the primary driving force for the currency debasement.

As any cut in expenditures would invite instant voter objections and political repercussions, Menem chose to raise the value-added tax from 16 percent to 18 percent and then to 21 percent, which has been the rate ever since. Moreover, against strong opposition by militant labor unions, he pressed on with the sale of some public enterprises, the proceeds of which helped to reduce his budget deficits, and managed to strike a rescheduling deal with foreign commercial banks, which restructured $23 billion in debt and $8 billion of arrears.

Although the Menem administration brought relative economic stability through monetary restraint, it could not resist the old Peronist pressures for popular transfer spending. The 1994 budget provided for a $7-billion boost in spending programs for the country's poorest regions, especially for public works projects. The provincial budget was raised by $300 million. The Social Security budget required $1.3 billion in subsidies to cover deficits flowing from retrospective pensions, ordered by judicial rulings, for 100,000 recipients. At the close of the fiscal year, expenditures exceeded revenues by some 10 percent.

In 1995, after much political maneuvering and numerous concessions to his opposition, President Menem managed to be reelected to a four-year term. He vowed to address social and environmental issues and promptly announced a five-year public works program. When the Mexican peso collapsed and sent shock waves throughout the hemisphere, the Menem program actually compounded the difficulties. The growing deficits heightened the distrust and fear that spread from Mexico and sparked a flight of capital from Argentina also. 

The economic contraction caused tax receipts to decline sharply and the deficits to soar, despite much pressure on the Menem administration by Argentina's great creditor, the International Monetary Fund (IMF), to control growth in public expenditures as a condition for obtaining additional credits. But unable to reduce its expenditures significantly, Menem preferred to extract more revenue: he managed to impose a new tax on interest payable in order to equalize the cost of capital with the high costs of labor. Because most corporations were suffering losses and consequently paying no income taxes, the Menem government, upon IMF urging, invented a new tax: a presumptive income tax which was levied on the assets of every corporation. As any economist and businessman would surmise, both new levies greatly aggravated the recession, thwarting new capital investments throughout Argentina and creating more unemployment.

The Asian financial crisis of 1997 and 1998 cast more shadows on Argentine finances. When the government proposed budget cuts to meet the targets agreed upon with IMF and to underpin investor confidence, the president's support from organized labor crumbled. When it proposed measures designed to provide some labor-market flexibility, the unions answered by staging massive general strikes, protesting Menem's pursuit of what they reviled as free-market principles that left at least 17 percent of the workforce without jobs. When the Menem administration sought to curb expenditures through cuts in school funding, it brought student strikes and protest resignations of school officials.

The country's slide into recession accelerated when Argentina and Brazil managed to get involved in an ugly trade war. Brazil fired the first shot when it suddenly devalued its currency. Fearing a flood of cheap Brazilian imports, Menem imposed protectionist measures on Brazilian shoes and textiles. Brazil retaliated by imposing restrictions on 90 percent of Argentine imports. In both countries, production fell precipitously and unemployment continued to rise. Both countries managed to secure more loans from the World Bank, the International Monetary Fund, and the Inter-American Development Bank. It was left to Fernando de la Rúa, who won the Argentine presidency in October 1999, to calm the waters and reduce the frictions with Brazil.

The new president led an alliance of the Radical Civic Union and a new Solidarity Party, a splinter of the Peronists. The Peronists remained in control of the senate and the judiciary. Having inherited a huge deficit from the Menem administration, the new president responded with new tax levies and some spending cuts. His first policy initiative was a significant tax boost which raised not only the sales tax on many consumer goods and services but also the income tax rates for wealthy individuals. Very wealthy Argentines earning $3,500 a month, or $42,000 a year, suffered a 200-percent increase. 

Under great pressure from the IMF to cut expenditures in order to receive fresh funding, de la Rúa took special aim at wasteful expenditures by the provinces whose debts exceeded $18 billion, with the federal government as guarantor. The new president's strategy for lowering the 15-percent unemployment rate was to reduce the fringe costs of labor. A labor code passed during the 1950s provided for a 30-day probation period with lower costs and fewer restrictions for new workers. A new code extended the conditions to six months in larger firms and twelve months in smaller businesses. The payroll tax on new hires was reduced from 17.5 percent to 12 percent.

With the country in the grip of economic stagnation, unending budget deficits, and rising foreign debt, by now exceeding $120 billion, the costs of servicing the debt soon rose to 15 percent. But again the World Bank and the Inter-American Development Bank came to the rescue, pledging $40 billion in new loans. The terms for the assistance were simple: reducing the 2001 budget by $700 billion, lowering taxes on corporations, trimming public-sector salaries by 12-15 percent, slicing pensions, and privatizing some pension funds.

While Argentina's creditors were pointing toward genuine solutions, the Argentine public showed a growing weariness about the prospect of ever more "austerity." Led by the media, militant union leaders, and vocal civil servants, they often marched and demonstrated in protest. When the unions called general strikes, millions of workers paralyzed the economy, blocking highways, disrupting transportation, closing schools, and damaging business property. Unemployment continued to soar, and underemployment soon affected nearly 50 percent of the workforce.

Shortly before Christmas 200,1 popular anger finally boiled over when the government froze all bank accounts to protect the banks from failure. They had lent the money to the government, which had defaulted in its obligations, and to businesses, which were about to fail under the burden of losses and new tax levies. The Argentine banking crisis obviously is the consequence of debtor insolvency. Yet, all banks, domestic as well as foreign, applauded the government for the freeze and chose to fight the depositors who demanded the return of their property in the currency in which it was deposited. 

Buenos Aires erupted. While most people demonstrated peacefully, some revolutionaries clashed with the police, leaving 28 people dead. It drove Fernando de la Rúa from the presidency after just two years in power. In his place, the Argentine Congress installed Adolfo Rodriguez Saa, who resigned after just eight days in office. Congress promptly replaced him with Eduardo Duhalde, a representative of Peronism's powerful political machine. He is to revive the economy, stem the tide of violent protests, and save the political system.

* * * * *

Great crises call for extraordinary measures that redress the causes of the evil. The Argentine crisis presents not only great dangers to the country's political and economic order but also an opportunity for a new beginning. Attempts at reform, when they fail, aggravate the situation, as the numerous attempts by the Menem and de la Rúa administrations so clearly demonstrate. They merely hacked at the branches of the evil; they did not strike at the very root, which is a pervasive entitlement ideology--that is, the common conviction that everyone is entitled to economic benefits at the expense of others.

This is clearly visible in the chronic inability of government officials to balance their budgets. In boom and recession they are unwilling to live within their means. And it is visible in their loud protests against "austerity," that is, against any reductions in deficit spending. They could always count on the support by the International Monetary Fund, which could be persuaded to extend old loans and grant new funds. It provided the backing for more issues of pesos used to finance the budget deficits.

Few foreign loan funds reached the business investment market. The dollars and pesos caused Argentine prices to rise faster than foreign prices, which led to chronic balance-of-payments deficits. In time the central bank ran short of dollars, which prompted the government to suspend all payments and seize private accounts. In good times, government may lower its exactions; in bad times, it will raise them; and in moments of crisis, it may seize whatever it needs.

The financial world is doubting Argentina's viability. It is ever fearful of looming political turmoil and the chronic risk of government profligacy. Indeed, it is difficult to have confidence in the country's political leadership that is managing the people's economic affairs. Argentina is merely paying for mistakes similar to those many other countries are making or have made in the past. Proud and overconfident people seldom learn from the mistakes of others; they are convinced that they face special problems of their own.

Argentina's new administration faces two ghastly problems that drive the increasingly violent protests. It must tackle the problems of its chaotic money and banking and solve the explosive issue of unemployment and underemployment, which by now affects one-half of the population. The future of Argentina's political economic order, as well as Duhalde's own political fate, depends on the solution of these problems.

The most pressing financial issue is the future of monetary management, in particular, the future of the peso that was pegged to the dollar at parity. Related issues are the freeze of dollar deposits imposed by Duhalde's predecessors, and the default in meeting foreign dollar obligations. At the beginning of February 2002, Duhalde sought a solution by returning to the currency system of the past: the floating peso, which, left to the market, immediately fell substantially. A low rate, he argued, would be Argentina's best way out of recession and the best protection against foreign disruption. Other big emerging countries, such as Brazil and Mexico, now have floating exchange rates.

While economists always favor a return to market pricing, which reflects the people's true valuations and choices, they dread the fact that the fiat peso is the wanton creation of spendthrift politicians and government officials. In their hands, it is bound to be depreciated and ultimately destroyed like all other issues before it. And to conceal the gradual destruction of the peso, the same politicians and government officials will enmesh the people in countless regulations and controls which surely will create economic chaos and give rise to a brutal command system.

The immediate cost of the float is insolvency for countless debtors--individuals, businesses, and banks alike--as most debts are denominated in dollars while most incomes are in pesos. Two-thirds of bank deposits are in dollars as are most loans. U.S. dollar deposits are converted to pesos at the rate of 1.4 pesos to 1 dollar. As the banks suffer an instant loss of 0.4 peso on every dollar conversion, they are to be compensated with government bonds. 

In the money markets of the world, the peso actually fell to 2.15 pesos to the dollar, which conveys the full loss of all dollar depositors. They are likely to lose more in the future as the peso continues to depreciate and the restrictions on the withdrawal of dollar deposits continue in effect. Dollar debtors owing pesos to domestic creditors do profit from the conversion as the peso depreciates. Dollar debtors to foreign creditors may be crushed by the conversion; their debt has doubled in terms of pesos. Many corporations with foreign-dollar obligations, which the Argentine government cannot convert, may face bankruptcy.

The peso float has special ramifications for big Argentine banks, many of which are foreign-owned. They can be despoiled like all other financial institutions, but foreign banks may also leave the country and seek redress and compensation for contract violations in foreign courts of law. These may even seize Argentine government and corporate property and distribute it to the plaintiffs. A chronic debtor who continually depends on foreign assistance is ill-advised to shortchange his creditors. Yet the Argentine government may seek and receive support from the agencies of other governments.

Throughout its financial difficulties, Argentina always has had the advice, guidance, and support of the IMF, whose funds come mostly from the treasuries of wealthy countries. The IMF helped to build the mountain of debt until it crushed the debtor. It carries a large share of the responsibility for the Argentine crisis. Naturally, it denies all and points to the debtor. The Argentina experience raises agonizing questions about the existence of such an international institution.

IMF officials are working toward an international arrangement that would provide prompt relief for insolvent debtor governments such as Argentina. They are lobbying for measured, uniform reductions of creditors' claims, which would reduce the debtors' reliance on IMF resources and rescue and shift some of IMF's chronic losses to member governments. While IMF officials are hard at work, it is unlikely that such a rescue operation will be adopted in time to benefit Argentina.

The Duhalde administration will have to present a believable economic program to the IMF, that is, another austere budget and another fiscal reform, which will allow it to resume its support. Duhalde will have to negotiate with various debtor groups of governments and banks for moratoria permitting temporary suspension of payments or some reductions of debt. Of course, such creditor favors impede the reputation of the debtor and raise substantially his future interest costs.

Reform must come from within; it cannot be imposed by a creditor. A genuine change for the better requires the support of the people; without it, nothing can succeed. Someday the Argentines may be ready for a reform that regenerates and revitalizes the economy. They may demand freedom in all monetary matters: the freedom to enter into any currency contract of their choice, whether it be U.S. dollars, the euro, the peso, or even gold.

In a free and unhampered contract system, creditors and debtors, banks and depositors would soon come to reasonable and fair agreements about their contractual relations. A contract system would call for no new taxes, not even compensation for harm done by law and regulation. It would reopen all banks and allow them to meet their obligations to the best of their ability. It would expect the government to honor its peso obligations and manage the peso as it pleases. But it would demand that government cease and desist from any more regulations, new outlays, new taxes, and new disruptions of any kind. The Argentinnes need time and a period of peace for recovery.

There is transcendent power in honesty and integrity. Argentina can reform itself and lead the way. Perhaps it can offer a valuable example by setting its people free in all matters of money and credit; toward that end, no international assistance is needed, not even from the International Monetary Fund.

* * * * *

The Duhalde administration also faces the severe problem of mass unemployment, which is as explosive as the financial situation. While middle-class victims may be demonstrating in front of their banks that are barred from releasing their savings, unemployed workers may be rioting in the streets and ransacking public and private property. Therefore, the curse of chronic unemployment needs to be lifted forthwith.

The economic and monetary policies of both the Menem and de la Rúa administrations obviously caused the mass unemployment. They aggravated the chronic maladjustment of the costs of labor and the productivity of labor. It is conceivable to have stable money and yet suffer rising unemployment. Under certain conditions, even a country with a gold-coin standard can experience rising unemployment, if labor costs rise faster than labor productivity, if the least-productive labor becomes loss-inflicting labor and is made unemployable. Labor productivity may decline for any number of reasons, but the costs of labor may not decline or may decline at a lesser rate than productivity, which makes marginal labor unemployable.

The decline in labor productivity may not be the fault of the labor that is discharged, although it is always the least-productive labor that is let go first. Labor productivity tends to fall in a recession when business must readjust to market conditions; or, it may fall as a result of trade disruptions and trade wars with trade partners; or, it may fall on account of new government intervention by way of economic laws, regulations, or taxation. Business capital may be consumed through government deficit spending that preempts the capital coming to market, or the fear of future intervention may cause business capital to escape to safer employment or safer harbors abroad. Whatever affects the productivity and costs of labor affects the employability of labor. In Argentina, all these causes were at work to increase the army of unemployed.

Mass unemployment such as that in Argentina and several other countries around the world is conceivable only in countries with regulated labor markets. Millions of workers may be prevented from freely marketing their labor, which then condemns them to chronic unemployment and dependence on their fellowmen. In a world of need and scarcity, with human labor the scarcest of all factors of production, millions of poor people walk the streets in idleness and despair. It is one of the great economic and moral evils of our time.

Little notice is taken of a little evil, but when it reaches the proportion of mass unemployment, it calls for confrontation. Perhaps evil cannot be totally extirpated from the world where it resides in human nature, but perhaps it can be ameliorated where it springs from ignorance and inexperience. Mass unemployment, this writer sincerely believes, is the inevitable consequence of erroneous economic notions and theories. These can be exploded, discarded, and replaced with correct explanations that may provide guidance in avoiding the evil.

Both the Menem and de la Rúa administrations made several meek attempts at adjusting labor costs to labor productivity by reducing some fringe costs or imparting a measure of market flexibility. Yet, the rising rates of unemployment clearly reveal that labor productivity soon fell faster than the reduction in labor costs, which made marginal labor loss-inflicting. Every such attempt met vocal opposition from individuals called upon to adjust by suffering reductions in income and benefits.

Government cannot conquer economic principle which springs from human nature; it cannot legislate full employment. To reform the body politic, the laws and regulations of which cause mass unemployment, is a difficult and tedious task. Any effort to reform must ever be mindful of Solon's advice that "no more good must be attempted than a nation can bear."

To achieve full employment but being unable to move the body politic, this economist, therefore, would call for no reduction in pay or benefit, no reduction in vacations or pensions, no increase in effort or labor time, nor even a cut in taxes. He would merely allow all unemployed individuals, male and female, old and young, to accept employment solely under contract conditions which they alone determine. Individuals walking the streets in idleness obviously would suffer no reduction in pay or benefits by accepting employment under their own conditions. And government would suffer no loss in revenue by allowing them to work without immediately imposing a 17.5-percent payroll tax. Such action would give them latitude, which is also the freedom for all individuals to work as they see fit, so long as they do not inflict harm on others. It is an economic necessity and a moral imperative.

It is time for Argentines to cash in their experience with government power, government law, government regulation, government money, and government care. They attended a hard school and paid high tuition. It taught all who cared to learn that, after every conceivable political device has been tried and found wanting, there remains freedom. When political minds are unable to concoct yet another law or regulation, another scheme or another care, there always is freedom. It is the very last hope, short of despair.


Hans F. Sennholz, emeritus professor of economics at Grove City College, is an adjunct scholar of the Mises Institute. Send him MAIL. See also his Mises.org Articles Archive and his Personal Website.


Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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