Eleven Years Later: What Went Wrong in Argentina

Argentina has entered a period of growth that will last far many years-perhaps decades. Two crucial factors will facilitate this continued growth. First, the rate of investment is increasing-I expect that it witt reach 22 or 23 percent of the gross domestic product (GDP) in the near future. During the 1980s, it fell to levels as low as 12 percent and has now recovered to around 18 percent. Second, productivity is also increasing. For example, the marginal relation between product and capital-the increase in productivity overinvestment-is recovering strongly... We have before us, I believe, many y ears of rapid growth like that of the Southeast Asian countries in the 1910s and 1980s. Lake postwar Germany, France, and Japan, Argentina is in the process of stabilizing and taking advantage of the opportunities the world economy offers. We witt increase our productivity and assert ourselves in the global economy. "

"Secrets of Success: Argentina's Blueprint far Economic Prosperity"

Fall 1994

As part of the innovative symposium, "Predicting the Present," I have been asked to respond to the above quotation from my interview, "secrets of Success: Argentina's Blueprint for Economic Prosperity," in the Harvard International Review, Fall 1994 issue. In 1994, when I gave this opinion, Argentina was completing four years of impressive growth and successful stabilization. At the beginning of 1995, Argentina was shocked by the Mexican Crisis that provoked a sudden stop in capital inflows and a deep recession. Nevertheless, by the beginning of 1996, Argentina was recovering very rapidly and its economy grew steadily until 1998. Overall, from 1991 to 1998, Argentina's GDP expanded at 6 percent per year, with the investment rate reaching 22 percent of GDP in 1998 and productivity growth averaging 3.8 percent per year. Inflation had disappeared from the Argentine economy. Until that time, events evolved exactly as I had predicted in mid-1994.

As it emerges from the rest of the interview, my reasoning behind this prediction was the "reform of the rules of the political game." Answering the second question in the interview, I described what it meant. "In Argentina, a country that has suffered decades of serious economic and institutional disorder, this transformation occurred at many levels. It has led into a focus on integration into the world economy. Private companies have replaced public enterprises, subjecting businesses to competition and professional regulatory agencies. The state has limited its activities to essential functions, resulting in a thorough deregulation of capital, labor, and goods and services markets."

Popular support and political leadership had been crucial. "Public support was fundamental to the success of the reforms. The dramatic hyperinflationary experience had left its mark on the people. Fearful of uncontrolled inflation, Argentines, for the first time, started to value stability. This popular support, combined with political leadership, gave us momentum for extensive reform. In three years we achieved what took Chile ten years under a dictatorship and Mexico six to eight years under the strict political control of the [Institutional Revolutionary Party]."

Made possible by the immediate success of the stabilization program know as the "Convertibility System," Argentine economic reforms included both significant cuts in government expenditure and a tax reform that would improve tax administration and remove distortions on relative prices created by some taxes. If Argentina had not created clear rules of the game for the currency and wage that remained unprotected against currency depreciation and inflation, none of the reforms could have been implemented. Therefore, the Convertibility System became the political and economic cornerstone of the overall economic reform program.

The Interplay of Domestic and External Shocks

The Brazilian Crisis of February 1999, and its predecessor, the Russian Crisis of August 1998, did not have such an immediate impact on Argentina as the Mexican Crisis of 1995 did, but their negative effects were longer lasting and much more damaging for the performance of its economy. This different response of the Argentine Economy to two very similar external shocks-the Mexican and the Brazilian shocks-originates in two circumstances that I had overstated in my 1994 analysis. One was the political support in Argentina for the fiscal discipline necessary to preserve rapid growth. The other was the opportunity offered by the integration into the world economy.

On the domestic front, after I left former Argentine President Carlos Menem's government, the President allowed the provinces to borrow from the local banking system to finance expanding current expenditures. The increasing indebtedness of the provinces started to crowd out bank credit for the private sector and generated a continuous fall in the investment rate.

On the foreign front, several factors created very adverse external conditions for the Argentine economy, including the extreme strength of the dollar until 2002 and the US recession in 2001. Consequently, domestic and foreign economic agents started to predict the collapse of the Convertibility System. This prediction affected domestic interest rates, which started to incorporate an increasing country risk component.

The government of President Fernando De la Rua, an administration that had won the 1999 Argentine presidential election by committing to defend the Convertibility System, had tried and achieved a reduction in primary government expenditures similar in absolute six-e to the expansion during the last three years of the Menem Administration. By the second semester of 2001, De la Rua had successfully engaged in an orderly process of debt restructuring, but in cutting government expenditure and trying to preserve public credit, De la Rua expended most of his initial political capital.

By the fourth quarter of 2001, the International Monetary Fund (IMF)-instead of helping Argentina reinforce the adjustment mechanisms within the existing rules of the game, as it had done until August 2001-changed its diagnostic and decided that Argentina was suffering from reform fatigue and that it was useless to support voluntary and orderly adjustments. Its new attitude, in practice, meant a shift to the side of those very indebted provincial governments and private entrepreneurs that demanded debt default and "Pesofication-cum-Devaluation" as a way to wipe out their debts and restore their solvency. This was none other than the very old and addictive mechanism that, during ten years of inflation, had helped Argentine debtors to evade and ultimately rob their creditors.

The De la Rua Government could not survive the run against the banks that accompanied the new attitude of the IMF, especially once Argentine depositors became fully aware of it. The fall of the De la Rua Government opened the door of power to Eduardo Duhalde, the former Governor of the Province of Buenos Aires who had spearheaded the expansion of provincial expenditure and indebtedness, and who had lost the presidential election in 1999.

Duhalde did not mind abandoning the Convertibility System and with it, the commitment of Argentina to the creation of an open market economy well-integrated with the world economy. He interpreted the new attitude of the IMF as a push towards default, pesofication, and devaluation, in accordance with the demands of indebted entrepreneurs and governors of the indebted provinces. He therefore decided to undertake these measures as soon as he took power in early 2002.

The immediate consequences of the decisions adopted were terrible for the Argentine people. There was a wild redistribution of wealth from the depositors in the banking system and Argentine bondholders-families from the middle classes, workers that had saved for retirements, and retirees-to a small number of entrepreneurs that owned indebted firms. It also provoked a sharp reduction in real wages, real pensions, and employment, as well as a sharp deepening of the recession during the first semester of 2002.

Duhalde used both the dictum of the IMF and the support of the local media, most of which benefited from the cancellation of debts, to endorse all these effects as necessary consequences of the previous governments, and particularly, of the "rules of the game of the 1990s." Of course, he never linked the crisis to the excessive expenditure and indebtedness of the provinces.

For the same reason he tried to shift away the blame for the negative effects of his decisions; in early 2002, Duhalde and his successor, Nestor Kirshner, were ready to accept credit for the strong recovery and re-stabilization of the economy since the second semester of 2002.

Now, by mid 2005, the Argentine economy has enjoyed 12 quarters of growth at an annual rate around 8 percent and annual inflation is again in the one-digit range after its peak in 2002. Thus, the question that naturally arises in connection with my predictions of 1994 is the following: is the Argentine Economy back to the promising growth and stability path I had then described? Unfortunately, the answer is "no."

Are 1994 predictions still valid?

As I explained in my 1994 interview, my confidence in the sustainability of the economic performance of the previous three years relied on popular support for the economic reform process, much of which was secured only after the defeat of hyperinflation and the conscious backing of the political leadership of the country. The economic reform process was pushing up the investment rate and the productivity growth, but it was the popular support and the political backing that made the "rules of the game" credible and sustainable. What is happening now in Argentina is completely different.

There are no economic reforms and even less "credible rules of the game" behind the impressive economic performance of the last three years. It is simply the rebound from a very deep and long recession that came as a consequence of the extreme and non-voluntary adjustments provoked by devaluation combined with very favorable external conditions for the Argentine economy: a weak dollar, low interest rates, booming commodity prices, and an expanding global economy.

As impressive as it looks and as favorable as the external circumstances have been, the economy is still at the same level of total GDP as it was in 1998. Therefore, much of the recovery of the last three years was possible thanks to the existing productive capacity, which originated in the investment and productivity growth processes of the 1990s.

The prospects of an increasing investment rate and additional increases in productivity that existed in 1994 today are absent. Instead, the fight for income and wealth redistribution through monetary mechanisms that fed inflation during the 40 years prior to 1991 is back and strong.

Workers, who suffered significant income losses because of the devaluation, are demanding wage increases. Industrialists and farmers are trying to maintain high relative prices for their products by demanding a weak peso. Public utility prices, which have been frozen during the past three years, will have to rise in order to prevent shortages. And as monetary policy tries to be accommodating to maintain demand expansion, the economy sacrifices the possibility of monetary brakes to curb inflation.

In an inflationary Argentina, it will be almost impossible to create a business climate favorable for long-term investment. Without long-term investment, moreover, there will be no significant productivity change.

The political leadership that emerged from the 2002 crisis does not look to popular support for reestablishing a good climate for private investment. On the contrary, the government tries to convince the public that the reforms of the 1990s-particularly those related to the privatization of public enterprises and the opening of the economy-were responsible for the stagnation of the Argentine economy.

All this happened because both the public and many political leaders were convinced by the diagnostic that made the IMF abandon Argentina in 2001: that the country had to change the rules-rules that over more than 10 years had delivered stability and economic progress. Rather than adhere to the old system, Argentina felt that it must now force adjustments through non-voluntary mechanisms, even if these mechanisms destroyed institutions and contracts.

Lessons

The most important lesson to be learned from the Argentine experience relates to the importance of fiscal policy and, particularly, of fiscal discipline during good times. In my 1994 interview, I emphasized the role of fiscal balance as a precondition for stability. However, stability requires more than just that. During periods of rapid growth and favorable external conditions, it is necessary to generate a fiscal surplus as a cushion for the negative external shocks that may show up unexpectedly at any moment. Argentina should have done this between 1991 and 1994, and again between 1996 and 1998, but it did not. Therefore, at the rime of external shocks, it depended on foreign financing precisely at a time when foreign expectations turned sour.

Another important lesson relates to the existence not only of opportunities, but also of significant risks that emerge from a closer integration of a national economy into the global economy. Instability among the major currencies, significant changes in interest rates, and wild fluctuations of commodity prices associated with global cycles may generate significant external shocks that may become very difficult to absorb in economies whose economic agents are very sensitive to currency and interest fluctuations. This is particularly important for countries that become, de facto, financially open during periods of hyperinflation.

Political leaders that are convinced that certain "credible rules of the game" are necessary to promote stability and growth should explain it to the people and not only rely on the support that comes because of success. This way, support for the economic reform process may continue also during periods of unfavorable events. If this does not happen, crisis may move power in favor of demagogues that will feed off of the public's impatience and generate changes that will destroy confidence and institutions.

International institutions, particularly the IMF, should be conscious of their importance and influence, particularly when countries are suffering a crisis of confidence. The strategy of pushing for non-voluntary adjustments that come at the expense of institutions and contracts may end up creating formidable obstacles to the rebuilding of trust in the rule of law and economic rationality. In times of crisis, the role of the IMF is not only technical, but becomes significantly political. It may unbalance power against the convinced economic reformers and in favor of political leaders that do not hesitate to produce wild redistributions of wealth and income if they can shift the blame to political opponents.