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No Tears for Argentina

January 9, 2002

Tags Big GovernmentBooms and BustsCorporate WelfareThe FedFinancial MarketsU.S. EconomyBusiness CyclesInterventionismMonetary TheoryMoney and Banking

Argentina's default came as no surprise. The amazing thing is not that the collapse of the Argentinean economy finally occurred, but the length of time it took to happen. Why have private and public lenders extended loans for so long a time? Why have they continued doing so even when all warning lights were flashing red? How did Argentina manage its run into default, and why was it that the International Monetary Fund continued to provide bailout packages even when it became obvious that Argentina's currency regime had become unsustainable?

Only weeks before the default, the Argentinean government declared that the economy was fundamentally sound. Given that the statement came from government, one may not worry too much about it if this declaration was based on ignorance or an outright lie. But what about the International Monetary Fund with its statement, also only a few weeks before the default, that Argentina, while being confronted with a short-term fiscal problem, does not have a fundamental economic and currency problem? What do we make of an international public organization that makes us ask whether it is totally ignorant or whether it is practicing the art of deception?

As is so often the case in economic affairs, the most superficial answers tend to become the most commonly held. According to the popular versions, Argentina is not in default because it squandered the money it got and ruined the industrial base of its economy, but because the International Monetary Fund and the U.S. government failed to provide new loans in a timely manner. The IMF itself will justify its way of action by pointing to the failure of the Argentinean government to overcome its short-term fiscal problem, while the Argentinean government is blaming both the IMF and the U.S. government for not extending new loans and is accusing the Brazilians for having unduly devaluated their currency. But blame should be put on the International Monetary Fund or the U.S. government, not for letting Argentina go into default, but for supporting this country's irresponsible economic policies for such a long time.

Argentina's default is not a mere accident brought about by adverse circumstances such as the devaluation of the Brazilian currency in 1999. The unpleasant truth is that Argentina has been living beyond its means for decades, and during the 1990s, the government of President Menem elevated this feat to new heights. The trap set up for international lenders was the introduction of a so-called currency board in 1991. Establishing a new monetary regime by making the Argentinean peso convertible to the U.S. dollar at a fixed rate of one to one and linking the monetary base to international reserves provided the basis for the illusion that in Argentina, international lenders could earn higher rates of return without any currency risk. While scarcely a serious investor would have trusted the Argentinean government per se, the bait was thrown in by the IMF when this institution gave its backing to the Argentinean currency board regime.

With the implicit bailout guarantee by the IMF in place, the floodgates to credit inflow were opened. Protected by the IMF as their apparent guardian, international investors felt safe when earning the higher yields on Argentinean bonds. At home in Argentina, it was the government, which got hold of the cash that poured in. President Menem was all too ready to assume the role of the big spender. Most of the government expenditure was allocated for salaries to government employees. Public-sector employment--already excessively high by tradition--grew higher in number, with salary rates set way above that of the private sector. It was a feast to be an Argentinean--as long as you worked in the public sector or were in other ways linked to the system of privileges. High income with little work or the chance to earn superior profits due to government connections was not the only kick. There also was the "strong currency"--with the peso apparently as good as the U.S. dollar--that allowed the beneficiaries to buy the best import goods, to travel extensively abroad, and to invest overseas in hard currency for private accounts.

The flow of money that came from foreign investors got first into the hands of the government, which in turn would exchange the dollars for home currency at the central bank. In due course, internal money circulation rose with international reserves like those prescribed by a currency board regime. The government then would allocate the funds for its clientele in the capital city and across Argentina's provinces. Once in private hands, the largest part of the funds was spent for foreign goods, services, and investment. The foreign exchange that was brought in by the government flowed out through private channels. This way the foreign exchange at the central bank was transferred back overseas. When foreign exchange reserves accordingly fell, new foreign loans or the money obtained by privatizations would come in to fill up reserves again, and another round could be initiated. Seen from a purely macroeconomic and stability framework, everything seemed in equilibrium. But while the internal and external monetary balances seemed stable in terms of reserves and internal money circulation, external debt doubled during the past decade, along with government spending, which ran far ahead of economic growth.

At first, external credit and government spending as well as favorable expectations made the economy boom, thereby attracting more external funding. But in the second half of the 1990s, the economy entered into a recession. It was then that the real trouble began. As a true believer in the doctrine of curing a recession with more deficit spending, the government accelerated debt accumulation, while the economic downturn became deeper. In 2001, the Argentinean economy was in its fourth year of recession. Government debt had accumulated to $155 billion in U.S. dollars, $135 billion of which was dominated in foreign currency. The current account deficits had been running at around 4 percent for years. The official unemployment rate had reached 18 percent.

With the public debt almost exclusively in foreign currency, and the largest part of the private debt and many longer-term contracts also dominated in dollars, the government ruled out a devaluation of the peso. Instead, the government continued to cling to the established way of trying to overcome economic problems by spending more and accumulating more debt. When private investors had turned reluctant to continue financing in 2000, the IMF stood ready to arrange a $40-billion loan package, and when this proved to not be enough, this institution took care to provide $8 billion more. But toward the end of 2001, the government was again without external funds. Without new loans from abroad, the government could no longer service its foreign debt.

The Argentinean currency board regime, which was pivotal in attracting funds from abroad, became a trap to the inventor once the inflow of external flows dried up. Then the monetary regime began to exert deflationary pressures in the midst of a deepening recession. With the currency board, Argentina had also introduced a price level similar to that of the United States and thus provoked a situation that was totally incompatible with the needs of a highly indebted country.

The functioning of the currency board as it was being practiced in Argentina had become totally dependent on foreign exchange inflows at an accelerating pace. When this inflow began to slow down, the squeeze in international reserves automatically contracted the internal money circulation. However, it was not the currency board which caused the default of Argentina, but the instrumental character that this regime was given by the Argentinean government as a way to attract foreign funding.

In the early 1990s, the Argentinean currency board served as the trick to bring price stability without outright pain to the economy. The regime was set up to become creditworthy in the eyes of foreign investors, and with the availability of foreign exchange, imports could be financed that in turn subdued the internal price level. With the internal credit growth by the private sector mainly done on dollar basis as well, the structural insufficiency of national internal savings did not seem to matter. The major burden of this kind of macroeconomics fell on the country's small- and medium-sized businesses and within the industrial sector on its export industries.

Under the rule of President Menem, by propagandizing some isolated acts of economic liberalization and a seemingly strong and stable currency, the Argentinean government deceived international investors about the true nature of the system, while the IMF stood at its side quietly watching as the funds were squandered and the industrial base of the country was pushed into degeneration.

The overstaffed and overpaid bureaucracy represents Argentina's power center, and the top of this hierarchy rules the country by deriving its legitimacy from its capability to aliment its clientele. This system is largely immune to the needs of the business sector. By its very nature, the bureaucratic elite rapidly learned the lesson that it is much easier trying to get money from abroad via external loans in a direct way than by strengthening internal production and the competitiveness of the export sector.

With a higher export share for both Europe and the rest of Latin America than for the United States in the early 1990s when the currency board was established, the peg to the dollar was a paradoxical scheme right from the beginning. With the strength of the U.S. dollar against the European currencies and the devaluations that occurred in Latin America and in Southeast Asia in the second half of the 1990s, the system turned into an absurdity. Here too, however, the main problem was not the currency board by itself, but the fact that it served as an instrument to accumulate external debt. The huge public- and private-debt burden in foreign currency hampered the adjustment of the internal price level and blocked the change of the system.

To make matters worse, official IMF approval continued to add support to the inflow of private external funds, even at a time when it should have become clear that the Argentinean practice of its monetary regime was unsustainable. As long as foreign money continued to flow into the country, however, there was little need for the government to abandon its monetary regime--the more so as implicitly, and later on by deed, the IMF stood ready to jump in as the lender of last resort.

Argentina's history to live beyond its means and to default on its foreign obligations--a tradition that goes back to the early nineteenth century--became the institutionalized ideology of the country under Juan Domingo Perón, who first ruled the country from 1946 to 1955. In its modernized version, this ideology has guided the transformation of Argentina into a system of "techno-bureaucratic clientilism," which is primarily oriented at providing privileges to those who are employed in or linked to the public sector. At the top of the bureaucratic hierarchy is a technocratic elite whose function is to take care of the funding of its clientele, primarily by obtaining foreign loans.

In its relations with the bureaucrats of the International Monetary Fund, Argentina's power elite used to feel like brothers in mind. In various respects, the ideology of "el peronismo" shares a number of similarities with the IMF's view of how economic policy should be handled. Both are in agreement when assuming, first, that an economy should be run by them, i.e., a bureaucratic elite; second, that an economy must be stabilized, controlled, and managed by government intervention; and third, that it is primarily the demand side which matters. Both are in agreement by assuming that the attainment of macroeconomic figures as given by some specific statistical aggregates would imply sound economic policy.

It came as a profound shock to the Argentinean political establishment when the government proved unable to get new loans from the IMF in December 2001. An implicit contract between the IMF and Argentina had fallen apart. Therefore, it came as no surprise that the economic and financial crisis turned into a profound political crisis. In Argentina, the legitimacy of a government is closely tied to its capability to aliment its clientele. When the government of De la Rúa and Domingo Cavallo had to admit that it could no longer fund the system, it became certain that they would have to dismiss. The interventionist fury in the second half of 2001 and, later on, the bloody turmoil in the streets--as well as the confusion at the governmental level, with five presidents in just about a month--demonstrated that Argentina's system of legitimacy was about to fall apart.

The collapse of Argentina signifies the breakdown of an economy as much as the end of a political system. But the default of Argentina also shows the failure of an economic model which presumes that economic growth and development can be achieved by accumulating external debt. Argentina represents another case in the long chain of economic collapses brought about by excessive external credit accumulation. The fall of Argentina is also a case in the long chain of the failures of the doctrine which holds that economies should be managed, stabilized, and controlled by bureaucrats.

By not paying out the credit tranche of $1.3 billion in U.S. dollars in December 2001, the International Monetary Fund probably did the best thing in decades. The alternative would have implied the continuation of financing an inherently corrupt system. By not providing further loans, the IMF may have triggered reconsideration and change, not only in Argentina, but also in other highly indebted countries that suffer from similar structures, as they exist in Argentina. In these countries, the authorities have long given up serious efforts to strengthen their productive systems, concentrating instead on getting funds from abroad--or, more specifically, formally adhering to the IMF policy targets as their intermediate economic policy goals. In these countries, the national financial sector, the government, and those connected to the public sector via a more or less subtle system of privileges have formed a symbiosis in combination with the international creditors and the International Monetary Fund, which, during the past two decades, has degenerated its prime function into holding this wasteful system together.

In its original meaning, "crisis" signifies a turning point that can either lead to improvement and recovery or to more severe deterioration. In the case of Argentina, with the future of the Argentinean people in mind, one must hope for the abandonment of its interventionist economic system with its reliance on a bureaucratic apparatus and its self-chosen dependency on foreign credits. But there is always the risk that, due to biased analysis, the wrong lessons will be drawn from a crisis. It would be another tragedy in the making if opinion should prevail that it was the currency board per se that lay at the basis of the default and that a dismantling of this regime, along with a devaluation of the peso, would be enough to put Argentina on the road to prosperity.


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