MASSIMO RICOTTILLI

O

Every first year undergraduate taking a macroeconomics course knows that the narrowest definition of money comprises banknotes and deposits on current accounts with the commercial banking system. Money is a monetary institution’s liability that can be legally claimed on demand in exchange for central bank money, the prime means of transaction and legal tender of which banks must hold sufficient reserves. On that fatal and beleaguered day, Argentinians were hot on their heels to rush to their banks’ counters to claim back their current account deposits. There was an extraordinary reason. Normally, if current account holders lose trust in their banks and claim central bank money, the former can draw on their reserves, and if in want of these, the latter can always issue, albeit in distress, further balances to rescue them or to force them to fail with as little harm to the public as possible. But Argentinians had a further legal claim: the law allowed them to trade in their peso balances in exchange for US dollars at the central bank, on request. In the weeks preceding that day, rumours had spread, and in the early hours it had become a certainty that the central bank was not in a position to honour its legal liability. As a consequence, the exchange rate, that had been kept fixed for a decade, was to be devalued by a large amount.

Everybody ran for his or her money, but there was not enough.

Political Backdropand Economic Theory

The end of the 1980s had brought with it the scorching experience of soaring inflation; it was, in fact, a hyperinflation that had reached the mind-boggling rate of 5,000 per cent on a yearly basis. It was an excruciatingly painful event that threatened to, and indeed did, gnaw into people’s purchasing power. Life was turned into a bitter struggle in which everybody tried to scrape his or her way to relative safety by seeking a hedge to safeguard daily income as best as they could. Prices increased sizeably from morning to evening and no one could be sure that his or her real income would be maintained; everybody had literally become a speculator in search of protection through anything that could be reputed a viable alternative to holding money balances. Inflation had to be tamed if the country were to remain a democracy. The memory and legacy of the military junta with its trail of human tragedies were still fresh and temptations to settle political and social problems by a coup d’état, a frequent occurrence in Argentina, still ran high when president Raoul Alfonsin met his demise, shifting executive power to Carlos Menem, a poncho wearing, long sideburned chieftain from the distant sub-Andean province of La Rioja. Menem was a member of Peron’s Justicialista Party. Yet, whilst he stuck to the traditional populist rhetoric, he embraced ultraliberal, right wing policies, supported by much of the predominant theory. This attitude needs some explaining.

It may possibly be rather glib to assess the full extent of US ideology and cultural ascendancy on the Latin American ruling élites and upon public opinion in general, but it is certainly an undisputed fact that nowhere else in the whole world did the assertions and prescriptions of the so-called Chicago school of economics gain such a deep root as amongst Argentinian academics and policy-makers.Some observers have gone as far as stating that it was the presumed and debatable success of the economic advisors to Chile’s Augusto Pinochet, many of whom took wide renown as the “Chicago boys”, that firmly established the doctrine as a benchmark of excellent theory and crucial reference for policy-making. Basically, the following are the tenets of the theory that became widely accepted political currency, especially after Menem took office.

In a truly market driven environment, financial capital and goods flow freely in and out of a country determining an equilibrium exchange rate. Any trade deficit is automatically a capital surplus. In this context, monetary policy and demand management must only accommodate growth, but in no case steer the economy away from its natural path and its natural rate of unemployment and natural activity level, since rational expectations forestall, aside from temporary oscillations, attempts to veer away from fundamental equilibrium. Policy tools that interfere directly with supposedly smoothly working markets such as sectorally targeted industrial and credit policies, and subsidies, even if directed to the very poor, should be banned from the dictionary of policy-making.

We must now dwell on what this meant in Argentina in the decade of the 1990s. By following this orthodox prescription, capital movements were allowed to flow unhindered in and out of the country, given

Economic and Political Weekly May 13, 2006 that they were assumed to merely chase the best profit opportunities. Accordingly, a balance of payments current account deficit was thought to matter little if not at all in this context since, provided that the interest rate were a market rate orienting investment opportunities, it would neatly be offset by an equal amount of capital inflows. Thus, the exchange rate would not be perturbed by a trade imbalance. Subsidies and government provided incentives rapidly became blasphemous swear words and their supporters were treated with haughty contempt by those, having studied in the seminaries of orthodox theory, claimed to know better. This view contrasts, of course, even with the less fundamentalist neoclassical views, according to which imperfectly functioning markets, asymmetries of information and less than perfect foresight make current account deficits and debt stock signposts of the path that the exchange rate is likely to follow.

One may wonder why it is that such a theory became the leading beacon of so much policy-making in a country like Argentina. Whilst academics were under the spell of Nobel Prize winning theorists and saw it as a great intellectual challenge of being able to follow in the foot steps of world acclaimed economists and a key to a bright university career, it is less obvious why an entire society accustomed more to populist politicking and to bartering votes for patronage would accept the rigour of a highly constrained ultra liberal policy. The explanation lies with the inflationary process that plagued the country in the aftermath of the military dictatorship and that had bored deeply into the trust and certainties of the vast majority of the population.

When he was elected, president Menem was widely considered by many to be the clan head of a province where political horse-trading and widespread corruption were the norm. In spite of this very traditional and century honoured habits, he called upon a Harvard trained economist, Domingo Cavallo, to tame the four digit inflation that had ridden the country for several years. The most important measure in the policy packet that was introduced soon after his inauguration was the so-called convertibility law (‘Ley de Convertibilitad’). This law reintroduced the peso and commanded an irrevocably fixed exchange rate of one Argentinian peso for one US dollar. Cavallo was well aware that legislating a fixed exchange rate meant nothing without the backing of necessary rules constraining monetary authorities. To ensure that this was indeed the case, the law mandated the central bank of Argentina to convert on demand any amount of pesos into dollars. In practice, if the latter was to have sufficient backing for the peso quantity of money in circulation, it had to keep a nearly equal amount of dollar reserves. Argentina had, therefore, chosen a currency board and relinquished its monetary sovereignty. What the law implied was that the growth of the money supply was to be entirely determined by the net inflow of capital, boosting the financial systems holdings of dollar reserves. This meant that the central bank was to monitor the reference interest rate in order to keep it aligned with the US Federal rate plus, it is important to note, the perceived country risk. Hence, it is true to say that the peso was almost equivalent to the US dollar but not quite the same: the degree to which they actually differed could be measured by agents’ evaluation of the risk of holding peso denominated liabilities. It also meant that the central bank had to strictly monitor the trading and commercial banks’ reserve requirement in order to keep the overall quantity of money redeemable in US currency on demand. This, in turn, meant seeing to it that deposits on current account and their endogenous determination through bank credit were kept strictly within the closed bounds of a credit multiplier not very different from one.

It is important to stress that an effective currency board, especially if the anchor currency is an international reserve currency, requires unfettered capital movements. Thus, the growth of the money supply depends on the net inflow of anchor denominated capital and on the reserve currency country’s monetary policy. Since the latter was the US, this also depends on the willingness of the US Federal Reserve system to render liquidity available to the domestic and international markets. It is also important to remark that this dependency, although less binding than in the case of a stiff currency board, also applies to economies allowing free capital movements. In a world where there are very few recognised reserve currencies, it is the latter that set the reference real rate of interest thus constraining all other currencies to comply if the exchange rate is to remain relatively stable. In turn, this constraint is more or less binding according to how financial markets form their expectations. Without resorting to any strong rational expectation assumptions, it seems to be a fairly well established fact that operators do target some fundamental benchmark to forecast the likely behaviour of a given currency. As the 1997 east Asian crisis has shown, debt growth, especially the shortterm one, and the current account deficit that feeds it may likely rouse devaluation expectations and thus capital flight leading to an actual devaluation. In this context, the real exchange rate that is judged to maintain balance becomes another constraint for a free capital movement economy, whence the requirement that the rate of inflation be kept fairly strictly within the range of the one prevailing in the reserve currency country. This is why wage moderation and less intrusive trade unions are often advocated to discipline such an economy, implying a trade off between international discipline and policy sovereignty.

The Menem government made sure that capital movements were indeed free to move. Markets were liberalised and most state owned companies were sold, mostly to foreign firms, especially to Spanish interests following the neo-Atlantic mood taken by Spain towards its erstwhile overseas colonies. This outright sale took place by underpricing assets, thanks to kickbacks that are still being investigated by Argentinian courts. All industrial policies were scrapped, subsidies cut back and public expenditure restructured in favour of patronage and against public utilities: schools and public universities, for example, were starved of funds whilst letting their private counterparts flourish.

Consequences

Inflation was stopped abruptly. The change over to the new currency was quite smooth, even if real adjustment had been severe. In 1992-93, inflation was a thing of the past. Had policies changed then and become less rigid, Argentina might have been spared the tragedy that was to come. Yet, apparent good results, academic pressure to pursue orthodox recipes and, above all, the interests of rent-seeking classes of societies who thrived on overvalued financial wealth conjured to convince the Menem government to stick to its one peso one dollar currency board policy. Its dire consequences showed up without delay: an overvalued peso caused a deficit in the

Economic and Political Weekly May 13, 2006

trade balance and then in the current account that mounted year after year, according to a very predictable time pattern. Manufacturing industries became non-competitive and thus pushed out of international markets, especially those with neighbouring ‘Mercosur’ countries and, above all, with the major trade partner, Brazil. The only sectors that remained competitive were resource based, normally capital intensive industries that were the main actors on international dollar priced markets and many of which had been purchased by foreign corporations. Yet, not even the capital inflows generated by the latter were sufficient to offset the deficit implied borrowing requirement. As long as interest rates remained high enough to cover a slowly increasing country risk, foreign capital kept entering Argentina’s financial system. This fact was seen as a triumph of the market principle. In the first part of the 1990s growth remained buoyant, led first by pent up consumption spending and then by an inter-industry restructuring away from manufactures to the benefit of financial, service and resource based sectors. Productivity statistics were excellent but concealed the fact that much of the growth was actually due to the closing down of many manufacturing firms whose efficiency, if measured by international standards, was less than good and that had been able to survive under the protection of high tariffs. Nevertheless, these firms were the backbone of Argentina’s industrial sector, provided a large share of overall employment and were the custodians of considerable technological capabilities, skills and knowhow. They had a problem, of course, but the problem was of enhancing their performance and bringing them up to the standards of international competitiveness, not to close them outright. There were two indicators, however, that told a different story. The first was seen as a mild puzzle: the rate of unemployment never dropped, even in the years of high growth, below 14-15 per cent. The second was almost entirely ignored: the Gini coefficient measuring inequality steadily grew across social classes and between thriving urban and decaying provincial populations. This outcome of Menem’s policy stance could have been entirely foreseen. There was, indeed, a major flaw even with the currency board chosen. If one has to be chosen for any period of time it is crucial to determine the country’s trade orientation and the pattern of direct investment flows that are likely to bolster capital movements. This is clearly very important since if the domestic currency must follow the ups and downs of its anchor, it must not lose competitiveness in relation to trade partners lest the current account start to generate offsetting debt. This was clearly never the case for Argentina, given that its major trading partner within Mercosur was and still is Brazil, a country that had chosen a flexible exchange rate policy, and that the one outside was Europe. Thus, in spite of a very low inflation rate, when during the decade of the 1990s the US dollar steadily appreciated against the euro, and indeed against other reserve currencies (mainly the Japanese yen), so did the Argentinian peso.

Harsh Conundrum

Under the currency board arrangements, the growth of the money supply was constrained by net capital inflows and credit was rationed: small and medium sized enterprises had to pay rates that bordered on usury. As a consequence, the banking system continuously sought to expand its dollar assets on which its leverage depended to avoid the likelihood of a monetary crunch. This was the harsh conundrum: keeping convertibility on a par with the US dollar implied a rising debt or a credit squeeze since the economy was not sufficiently competitive at the fixed and steadily appreciating exchange rate.

On the side of public finances, theory demanded that the budget be balanced and practice required that the government keep a deficit as small as possible. As it has been mentioned, however, unassisted unemployment remained above 15 per cent. No democratic government can sustain such a high rate for long and certainly not one that still had a strong populist penchant, especially in outlying provinces where most of it was concentrated. In spite of appalling inefficiency, pressure rose for the public sector to offer the remedy by creating much needed compensating employment. In a country with a feeble tax base like Argentina, this meant rising peripheral governments’ budget deficits that the federal one had to offset by transfers. A balanced budget became wishful thinking and its financing increasingly problematic. Given the traditional general public’s distrust of government bonds, underwriters were to be found either within the financial sector or directly abroad. Banks bought government bonds but, given the currency board rationing of reserves, they had to sell them on the international market in exchange for dollar balances for which there was a high demand because of a high current account deficit. Buying dollar denominated public liabilities in exchange for pesos and then selling them abroad for actual dollar balances closed the gap, transforming private international debt into a public one making it expedient to place issuances directly abroad. Towards the end of the decade, government deficits increased as a consequence of a deep downturn and debt accordingly rose to unbearable heights. It is interesting to note that deficits and debt were a consequence of the deep imbalances engineered by the policies that had been undertaken since the inception of the Menem’s administration and not their cause. All the symptoms of a pending financial crisis were then gathered: (i) an overvalued exchange rate, (ii) a structural current account deficit, (iii) a large external debt increasingly contracted on a shortterm basis, (iv) a high public deficit.

What happened then followed a very classical pattern. Increasing borrowing requirements demanded the support of the International Monetary Fund, an institution that changed its attitude from praise to reprimand. Predictably, the root of external disequilibrium was seen in the excessive absorption originating from the government deficit and the onus of adjustment was accordingly placed on cutting public spending at a time, especially after 1998-1999, of a deepening recession. Compliance with this ill-advised measure brought about still lower activity levels, even more unemployment, falling tax receipts and, finally, larger fiscal deficits that required further external borrowing: the economy was thrown into a vicious circle. In 2000, Menem finally lost the general elections to an indecisive politician, Fernando De La Rua, who would not take the ultimate step of unhinging the currency from its dollar straitjacket, fearing an upper and middle class backlash that held dollar deposits and debt contracts (mostly mortgages). Menem left a poisoned legacy: on the strength of a political and public opinion blinded by international pressures and prominent economists’ advice that entirely espoused the IMF belief in the orthodoxy of a balanced budget, a law was pushed through Congress mandating the government to legislate a zero budget deficit. De la Rua had his hands tied.

All the cards were laid out for a grand slam. In 2001, expectations ran high that

Economic and Political Weekly May 13, 2006 the situation had become unbearable: foreign corporations who had replaced the state as a monopolist began to repatriate large peso balances, speculators and rich rentiers who had always kept their wealth placed abroad, i e, the US financial market, stepped up capital flight. Dollar reserves were, accordingly, drained and reached an all time low much more rapidly than the money supply could be lowered to match whilst markets were no longer ready to buy any Argentinian liability. Capital flows were all outgoing and none incoming.

In December 2001, fears that devaluation would take place reached a feverish height and people from all walks of life began to withdraw their deposits to change them into dollars. But there were not enough dollars. As Christmas day neared, everybody sought to outpace his or her neighbour. On the morning on December 21, a run on the banks occurred. The government and monetary authorities had no choice: they had to let the currency float and declare all deposits unclaimable, for a temporary period, but long enough to cause incredible distress. Argentina has now painfully recovered, but it was left in a shambles amongst unprecedented misery and with a poverty line that rose to embrace more than 50 per cent of the population.

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Email: ricottil@economia.unibo.it

Economic and Political Weekly May 13, 2006