Larry Elliott Monday November 5, 2001 The Guardian
Here's a puzzle for you. With the world on full-scale recession alert, the US Federal Reserve, the Bank of England and the European Central Bank are all expected to cut interest rates next week. President George Bush admits he is worried about the waves of job cuts and has put Congress on notice to stop playing games and come up with a fiscal package that will boost investment and consumer demand.
What's wrong with that, you might ask? The answer, of course, is that there is nothing wrong with it at all. But forget for a moment about what is happening in the developed world and take a look at what is happening in one of the world's leading developing nations, Argentina. There, the economy has been in recession for four years and unemployment is 18% - as opposed to 5.4% in the US, a figure that warrants pushing the growth accelerator hard to the floor.
So, should Argentina be cutting interest rates, should it abandon the peso's peg to the dollar, should it give up budgetary tightening in favour of the sort of counter-cyclical fiscal policy that is the norm in the US or the UK? Absolutely not. The answer for Argentina, say the experts, is more economic pain to satisfy creditors to whom it owes a tidy $132bn (£90bn). In particular, the proposed remedies involve the liberalisation of labour markets, presumably so that employers can sack people twice, and budget austerity to make sure that those laid off receive no social security benefits.
The reason for this disparity between north and south America comes down to credibility. Alan Greenspan, who has presided over an explosion in private debt, has credibility with the markets; Domingo Cavallo, the hard man in charge of Argentina's economy and presiding over a mountain of public debt, does not. Cavallo is trying to win some by insisting to international investors that if they agree to a restructuring of debt he will ensure that state governors impose deflationary measures. By driving Argentina deeper into recession, Cavallo's credibility with the markets will be enhanced, thereby permitting him to cut interest rates. Credibility, in other words, means giving Cavallo a ladder to escape from the pit he is digging for himself.
Now this may seem somewhat bizarre. But the alternative to austerity is devaluation and default. And that, you guessed it, would be a terrible blow to Argentina's credibility.
Argentina has been something of a sideshow for the past couple of months. There is even some suggestion that it has ceased to be the most important patient in the IMF's intensive care ward because Turkey is seen as a crucial US ally in the war against terrorismm. But what happens in Argentina matters, and policymakers know it. "If Argentina falls, Brazil could fall, too," says Carlos Zarazaga, an Argentinian-born economist at the Dallas Federal Reserve. "If the country does default, it will mean another lost decade not just for Argentina but for the whole of Latin America." The fear is that Argentina could do in 2001 what Thailand did in 1997, and set off a chain reaction across the whole developing world.
The question is not whether a remedy should be found for Argentina's ills but what that remedy should be. It has to be said that, even if Cavallo secures the agreement of creditors for the debt restructuring he is looking for, it will be nothing more than a stopgap solution. The proposed trade-off - swap our high-interest debt for low-interest debt so we can afford the repayments and we'll sign up for another dose of fiscal austerity - will just postpone the inevitable. There is a limit to the amount of economic pain that can be inflicted without the markets becoming concerned about political fallout. When interest rates were raised to 15% in the UK on the afternoon of Black Wednesday, the stock market rallied because dealers knew the game was up. Rates at that level would have devastated the economy, and were not, and here's that word again, credible.
As we now know, Black Wednesday was great news for Britain. Lower rates and a cheaper currency meant recovery began almost immediately and expansion has not ceased since. None of the dire consequences predicted for devaluation happened. This, it might be argued, is because Britain is a first world country with a stable economic and political framework. There is something in this - even Argentina's staunchest supporter would admit it has plenty of form when it comes to bad economic management. But the sky did not fall in on Mexico when it devalued after the crisis of 1994-95, and since Russia defaulted in 1998 its economy has grown strongly, helped by higher oil prices, admittedly. Stronger growth has made the countries more attractive to investors in an environment where markets are now far less concerned about fighting inflation than with policies that promote expansion.
That's the reason the US dollar continues to outperform the euro.
For these reasons, it should be a no-brainer that what Argentina needs is a growth-based strategy. For this, there are three options. Zarazaga says one way of proving to Argentinians that liberalisation works would be a free trade area of the Americas that would allow Latin American nations access to the rich markets of the north while maintaining protective barriers for the rest of the world. The argument in favour of this is that exports are a pitifully small part of Argentina's economy, about 8% of output, and that a staged liberalisation of trade would boost growth. Argentina lacks economic dynamism and this might be a way of providing it, though it would take time. Time is one thing Argentina doesn't have.
The second approach would be the opposite, and would involve devaluation, default and an increased reliance on domestic savers rather than international capital flows to finance investment. This has a better chance of working than full-out austerity but is still fraught with risk. Argentina is not Malaysia, which could defy the orthodoxy and impose controls on capital because it had a stronger manufacturing base and ample domestic savings. A go it alone policy might lead to a controlled macro-economic expansion, but it might equally lead to the government printing money and, eventually, hyper-inflation.
Buenos Aires is no stranger to devaluation and default, and there is every indication that domestic savers are just as wary of the authorities as are international investors. For this option to work, there would have to be a rethink of what makes for sound development policies, coupled with a new set of rules for bankruptcy that would give countries the same rights as corporations.
This would be sensible but looks unlikely.
The only other option is for Argentina to dollarise its economy. Now, it has all the disadvantages of a pegged currency without any of the benefits. Importing monetary policy from the US would mean a loss of independence but a sharp drop in real interest rates. Such a move requires policymakers in Washington to be fully engaged, and at this time the US may not want to send out the message that it is running Latin America. Nothing meaningful will happen until Argentina goes belly-up. The way things are shaping, that may not be too far away.
larry.elliott at guardian.co.uk