The Pandemic Depression
The Global Economy Will Never Be the Same
BEARISH IN BUENOS AIRES
Several years ago, during the heyday of Argentina's market restructuring, a prominent local economist was interviewed about the country's long-term prospects. Despite a backdrop of rapidly expanding output and low inflation, he was surprisingly pessimistic. "Argentina has always been a country with mediocre growth, believing that spectacular growth and riches are right around the corner," he warned. "And when a good year comes, Argentines say, 'Ah, here comes the life we've been waiting for and so deserve.' "
The good life seems to have eluded Argentina once again. Unable to shake a deep recession triggered by Brazil's currency devaluation in January 1999, a country that once enjoyed emerging-market status is looking more like the same old underachiever. Three years of recession have led to an unemployment rate of nearly 17 percent, adding misery to a labor force already hard hit by deep economic adjustment in the early 1990s and rising joblessness after Mexico's 1994-95 currency crisis.
Despite bailouts from the International Monetary Fund (IMF) -- comprising a $40 billion package in December 2000 and an $8 billion package last August -- acute financial stress is the order of the day. An external debt of nearly $130 billion is looming, and the central bank's cash and gold reserves have fallen by 25 percent since June 2001. Although the worst of the crisis hit in July, when government-bond yields tripled, bond-rating services are still predicting a 30 percent chance of default. The resulting liquidity crisis has slammed the door on Argentines trying to secure new loans and prompted a new wave of desperation among pension-fund managers and investors with deposits in the country's banks.
Meanwhile, the political situation is chaotic. President Fernando de la Rœa has switched economics ministers and policy directives to little effect. Voters are increasingly angry over rising inequality, falling job prospects, and failed adjustments. Adding spice to the mix are tales of spectacular corruption. Most dramatic has been the case of former President Carlos Menem, now under house arrest for his role in various arms-smuggling schemes that fueled civil conflicts in Ecuador and Croatia. It is a plot worthy of Latin America's literary tradition of magical realism. But the consequences for both the international financial system and the Argentine people are sadly far more real than magical.
What has gone wrong? After all, Argentina won over international investors in 1991 by launching its "Convertibility Plan," which tied the peso to the U.S. dollar under a currency board and ushered in a new era of economic prosperity and price stability. The country then weathered the fallout from the Mexican peso crash by creatively loosening reserve requirements, tightening fiscal policy, and revamping its banking system.
In part, the illusion of macroeconomic stability under the Convertibility Plan turned out to be just that. Moreover, international approval of Argentina's avid commitment to market reforms actually masked a series of unresolved problems within the economy itself. To understand the choices facing Argentina, it is necessary to revisit the recent chain of events that led it into this quagmire.
ANATOMY OF A CRISIS
Like other emerging markets in Latin America, Argentina pursued a dual strategy of macroeconomic stabilization and deep market restructuring in the 1990s. The central twist in the Argentine case was the Convertibility Plan, which tied the peso to the dollar like the gold standard once tied the value of local moneys to precious metals. Despite some hiccups along the way, the program brought quick relief, reducing annual inflation from nearly 5,000 percent in 1989 to less than 5 percent in 1994. From 1991 to 1994, annual economic growth averaged nearly 10 percent.
Although the macroeconomic story dominated the headlines, President Menem also pursued ambitious policies of liberalization, privatization, and deregulation. The government began to negotiate the creation of Mercosur, a "Southern Cone" common market that would bolster Argentine trade and investment by integrating its economy more closely with those of Brazil, Paraguay, and Uruguay. With Argentina's future seeming bright, foreign capital poured in.
Mexico's crisis presented the first major challenge to the currency board. In 1995 alone, Argentina suffered a capital outflow of some $6 billion. But its policymakers rose to the challenge in almost heroic fashion. They overhauled the banking system and tightened fiscal policy, while multilateral agencies came forward with generous support for stabilization. Together, these steps helped hold the exchange rate steady. The boost in domestic and international confidence in Argentina's new capacity to keep economic promises was palpable.
Argentina's credibility was further reinforced by its handling of the Asian and Russian financial shocks in 1997-98. Again, Buenos Aires quickly pulled together the kinds of measures that were necessary to fend off financial contagion and preserve dollar-peso parity. Although the country was hard hit, its capital outflows and rising interest rates did not compare with Mexico's in 1995. Moreover, because most of the market restructuring had been completed, Argentina looked like a stellar reformer compared to the other emerging-market bunglers taking center stage. It was the first developing country to return to international capital markets in the wake of Russia's 1998 default. From all appearances, the Convertibility Plan was still on track.
The only catch was that the Argentine peso had appreciated considerably over the course of the stabilization process. With devaluation precluded by the very rules of the Convertibility Plan, pressure on the country's trade balance continued to build. In turn, the stronger peso made Argentine exports more expensive and helped produce a boom in imports. Through the 1990s, Argentina was fortunate that Brazil had also pegged its currency, the real, to the dollar as an anti-inflation strategy. This move helped shift the bilateral exchange rate more favorably toward Argentina during the Mexican fallout and maintained Argentina's competitive edge in that market. But tying one's fate to Brazil -- a country prone to its own ups and downs -- was hardly a prescription for success. The problems inherent in that strategy became painfully apparent when the real's value dropped 40 percent during Brazil's financial crisis in January 1999.
In contrast to the Mexican, Asian, and Russian crises, the Brazilian devaluation hit Argentina not through its financial flows but through trade. The peso's value was stable against the dollar, of course, but this stability provided little help for Argentina's trade balance; U.S. markets account for less than 12 percent of Argentine exports, whereas close to 30 percent are destined for Brazil and almost 20 percent go to Europe. Further fanning the fire, the Argentine peso rose against the euro by more than 20 percent between January 1999 and late 2000, tracking the rise of the dollar to which it was fixed. The combination of an unattractive exchange rate and slumping regional economies sharply reduced demand for Argentine exports in 1999 -- particularly those headed to Brazil, where their sales fell by nearly 30 percent.
Straitjacketed by the peso peg to the dollar, Argentina's competitiveness could be improved only through vigorous gains in efficiency and productivity. Yet little had been achieved on this front during the long period of market restructuring in the 1990s. Labor productivity grew robustly during the early part of that decade, but that increase relied heavily on downsizing and business failures that cut redundant workers. Although efficiency gains had occurred in services and finance -- partly because a strong peso and the privatization of state-held firms made these sectors more attractive to international investors -- those areas usually do not lead to significant growth in jobs or exports.
Furthermore, Argentina had made few inroads into markets for more sophisticated products, where price might be less critical. For example, nine of the country's top ten export products are primary commodities such as grain and meat. The only "dynamic" industrial sector is auto parts, which is precariously hitched to the Brazilian economy and vulnerable to periodic tariff hikes by Brazilian policymakers coping with their own adjustment headaches. This is a world apart from Mexico, where government policy and regional integration in the 1990s fostered a dramatic expansion in the manufacture of more technologically advanced goods for export.
Argentina could have tried to redress the situation by making its labor market more limber. A golden rule for a rigid monetary regime such as Argentina's dictates that if one price (the peso exchange rate) is fixed, another price (say, wages) must be flexible. Moreover, when sweeping economic liberalization occurs, as in Argentina, job mobility is essential for relocating workers of differing skills into more productive and efficient endeavors. But Argentine labor markets are anything but flexible -- hardly a competitive advantage. For every two pesos that an employer pays out in wages, he or she must add an additional peso to cover the "Argentine cost" of doing business (payroll taxes, benefits, and severance pay); in most other industrialized countries, that ratio is only three to one.
PATHS NOT TAKEN
The reform record in other Latin American emerging markets, such as Chile or Mexico, shows how policymakers can deal with similarly disruptive external blows by implementing reform packages that include exchange rate adjustments and other policies to make their exports more attractive abroad. Why did Argentina so adamantly resist currency devaluation during the shakeouts of 1995 and 1999? Why have its policymakers dragged their heels for so long in formulating measures that could enhance the country's competitive position in regional and foreign markets?
One reason is the Convertibility Plan's official prohibition of currency devaluation -- it would literally take an act of Argentina's Congress to change the peso's value. But Argentina's reluctance to abandon the currency board also has deep historical roots in the chronic macroeconomic crises and hyperinflation that predate the 1990s. Considered the ultimate guarantor of external credibility, the currency board helped trigger the longest period of high growth rates that the country had seen in some 50 years.
With the devaluation path thus ruled out, action in fiscal and labor policies remained the other option. But the Menem administration, elected on the Peronist ticket in 1989 and in power until 1999, was never fond of such measures. Like Carlos Andres Perez in Venezuela and Alberto Fujimori in Peru, Menem surprised his traditional base of working-class support and implemented an ambitious program of deep market reforms. In so doing, he changed the very face of the Peronist party from a sectarian and socially divisive political force to a modern organization that attracted middle-class voters, intellectuals, and even some business interests. Yet these new alliances were not cheap -- and after Menem announced his intention to seek reelection in 1995, he needed the support of traditional constituencies all the more. Although labor markets had become more flexible in piecemeal fashion -- often through informal arrangements and the creation of a "temp worker" market -- the Peronist bloc in the Congress continually managed to thwart far-reaching reforms. The same applied to the Argentine provinces, where a majority of Peronist governors were needed to deliver votes at election time.
During the Convertibility Plan's early years, tight fiscal adjustments in Buenos Aires gave the impression that policymakers had taken the currency board's imperatives to heart. Yet once the dust settled after the Mexican crisis, it became clear that these adjustments were offset by fiscal expansion in the provinces. By sparing cuts in provincial spending until 1995, Menem appeased his regional cronies, who handed him a second term. But the lag in streamlining finances in the hinterland contributed much to the current fiscal strain. Policymakers are still struggling to reverse these deals made years ago.
Menem also had to appease the private sector, whose investment and support was essential to sustain the market reform effort. Big players in the market made out especially well with privatization, which early on became clouded by charges of corruption. Although privatization made some sectors (such as electricity) more competitive, others (such as telecommunications) were a travesty. And as large Argentine companies assumed higher levels of dollar-denominated debt in the 1990s, they became the Convertibility Plan's most loyal lobby; if the peso were to fall against the dollar, these firms feared, their dollar debt would become untenable.
In the end, Menem's strong pro-market rhetoric simply meant that the losers in the domestic market -- the smaller firms that lacked the affordable credit and technical know-how to survive the competition -- had to bite the bullet. For the winners, the state was still there to lend a helping hand by granting access to lucrative contracts and assets and offering generous concessions with high investment returns.
Menem succeeded beyond all expectations in implementing market reforms, particularly the stabilization and liberalization policies adopted during his first term. When he began lobbying the Congress to amend the national constitution so that he could run for reelection in 1995, Menem promised voters that he would fine-tune the reform effort in a more competitive and equitable direction. Voters clearly believed him, as he was reelected. But as Menem's second term drew to a close in 1999, his failure to reduce sizably the costs of doing business or to rationalize fiscal policy in line with the Convertibility Plan's stringent requirements was coming home to roost.
TRY AND TRY AGAIN
Menem's inability to catalyze further reforms and smooth out his original program's rough edges is not a unique story. Other renowned Latin American reformers, such as Mexico's Carlos Salinas or Peru's Fujimori, also failed to deliver on similar promises. Those setbacks prompted new politicians to challenge and replace the incumbents by promising to pursue a "second generation" of market reforms. In Argentina's case, the challenger was the former Buenos Aires mayor and Radical Party candidate, de la Rœa.
By 1997, voters were increasingly unhappy with rising unemployment and tales of government corruption. That year the Peronists were given a wake-up call with the midterm elections, when they lost control of the lower house of the Congress. By 1999, de la Rœa's more centrist Radical Party had joined ranks with a center-left party, Frepaso, to form the Alliance for Work, Justice, and Education. The alliance's pledge to cleanse the government, modernize the judicial system, and implement the necessary fiscal, labor, and competition policies was a winning message. And since the alliance was not beholden to the same interests as the Peronists, voters assumed, it would have more freedom to maneuver with a fresh approach.
Yet the electoral success of the alliance's broad coalition never translated into a cohesive platform for governance. De la Rœa quickly encountered a lack of policy consensus within his own coalition and could not impose the necessary party discipline to move his program forward. His first vice president, the leader of Frepaso, resigned in protest over the government's slow pace in rooting out corruption. Since then, other Frepaso leaders have debated whether to depart from the alliance altogether. The Peronists' continued control of the Congress' upper house has also not helped. Making matters worse, a scandal exploded over the administration's attempts to bribe an opposition legislator to support a long-awaited labor reform package.
Meanwhile, Argentina's economy has heard only the steady drumbeat of bad news. Investment, which began to plummet in mid-1998, fell 25 percent between the first quarter of 1999 and the first quarter of 2001. The household poverty rate in Buenos Aires, around 13 percent in 1993, hit nearly 21 percent in October 2000. Conditions worsened even further in March 2001, when de la Rœa replaced his economics minister with a free-market ideologue, Ricardo Lopez Murphy. The new minister announced sharp budget cuts that garnered the confidence of creditors but prompted the resignation of three cabinet members and Frepaso's exodus from the government. In the ensuing political crisis, de la Rœa dismissed Lopez Murphy and summoned Domingo Cavallo to the position of economics minister -- the third person to hold that position that month.
A charismatic former policymaker who had engineered the original Convertibility Plan, Cavallo arrived amid great expectations -- and with the same arrogance that had always rendered him controversial in Argentine policy circles. Hoping to resurrect his initial triumph, he promised to restore growth and downplayed any mention of austerity. He started by passing a new "Law of Competitiveness" that seemed like a partial reversal of liberalization. Although it pushed through some new deregulation and streamlining measures, eliminated tariffs on capital goods, and reduced certain business taxes, the law also imposed new tariffs on finished goods as well as a new tax on financial transactions.
Cavallo then tried to tackle the exchange-rate dilemma without abandoning the sacred dollar peg. The reasons for retaining the peso's connection to the dollar were partly ideological and partly practical. In a financial system in which 70 percent of debt is dollar-denominated, a standard depreciation of the peso would raise the price of servicing dollar-denominated loans and possibly trigger default by consumers and businesses. Hence Cavallo proposed to keep the peso fixed to the dollar while implementing a convoluted scheme that would peg it to a combined euro-dollar rate once those two currencies reached parity (an event that lay entirely beyond Argentina's control). For the interim, Cavallo raised tariffs on certain imports and suggested that exporters receive subsidies to offset the dollar's high value.
Neither Argentines nor international financial markets have been impressed by this complicated "quasi-devaluation" scheme, which has only further raised fears of a real devaluation to come. By the summer of 2001, the IMF had begun to run out of patience and became increasingly concerned with the country's growing fiscal deficit. Argentina had managed to postpone painful fiscal adjustment in 1999 by selling off parts of its state-owned oil company. But thanks to Menem's privatization legacy, the country now has few assets left to sell. Moreover, public support for privatization, which was as high as 52 percent in 1989 (when the state's delivery of public goods had virtually collapsed), is now below 20 percent. Most Argentines today associate privatization with soaring utility prices and monopolistic abuses. In short, Cavallo has few real options other than the most painful ones: raising taxes and cutting spending.
There is one potential route out of crisis that was originally proposed by Menem in the wake of the Brazilian shock in 1999: Argentina could take the Convertibility Plan one step further and actually "dollarize" the Argentine economy. Although there were serious exchanges with U.S. financial officials in early 1999 about moving toward full dollarization, powerful nationalistic forces continue adamantly to oppose all such proposals. After all, adopting the dollar would strip Argentina of any remaining semblance of autonomy in monetary policy. Moreover, even if such a measure could reduce financial risk, it would not necessarily increase competitiveness. Argentine goods, priced in dollars, would still be too expensive for Latin American or European markets. For these reasons, the dollarization option has been pushed onto the back burner during the current crisis.
Argentine officials have also quietly contemplated tinkering with trade policy. Indeed, Cavallo's decision to unilaterally reduce taxes on imported capital goods goes against the multilateral spirit of the Mercosur pact. But the nation's reliance on trade with Brazil -- a country with an unstable economy and similarly erratic swings in trade policy -- has made any regional trade-based solutions problematic. A more appealing route for Argentina would be to increase trade with the United States, the one market where currency swings have no effect under the Convertibility Plan. But Washington continues to drag its feet on negotiations for a Free Trade Area of the Americas (ftaa). With the joint challenges of fighting terrorism and reviving a U.S. economy in recession, the ftaa option remains at best long-term. For now, Mercosur leaders have proclaimed their intentions to forge ahead with deepening their customs union -- the only sensible position left to take in light of the sudden onset of recession across the western hemisphere.
As a result of the lack of better options, policymakers have channeled their energy toward cleaning up the country's finances. In July, with the stock market falling 20 percent, Cavallo promised to begin balancing the budget on a monthly basis. To great fanfare, de la Rœa announced that he would give his "life for this plan." But state employees and retirees will suffer the most: their incomes will be reduced by as much as 13 percent so that the government can meet the interest payments on its debt. This latest program places another set of frightening constraints on the Argentine economy. A recession that reduces tax revenues requires spending cuts, which in turn exacerbate the recession. Performing this exercise on a monthly basis is sure to whipsaw the economy. But since policymakers are now down to their last few choices, an option that was once rejected as too onerous has apparently gained appeal.
In the view of some economists, Argentina will eventually have to default; the only questions now are when and to whom. The country faces three main financial strains: the deficits run by the provincial governments, the bonds held by domestic lenders, and the external debt owed to foreign institutions. Reining in spendthrift local entities is no doubt better than bankrupting local pension funds and certainly better than failing to pay holders of bonds or damaging one's international credit rating. But de la Rœa has made remarkably little progress even on provincial retrenchment.
This failure is partly due to the fact that local officials hold a powerful card: their key role in collecting taxes for the government. Politics are also a variable. Peronist governors are reluctant to sacrifice their budgets to support adjustment. The dire threat of a full-blown crash eventually led the recalcitrant governors to offer support for Cavallo's program of deficit reduction. But this year's provincial deficits are nonetheless estimated to top $3 billion, and slow progress on spending cuts has left the markets still expecting a default.
Furthermore, there is a larger concern for the rest of Latin America. Even though the IMF provided Argentina with $8 billion in August to stave off a financial meltdown, its officials have openly suggested that shaken investors may be reluctant to provide the capital flows needed by emerging markets in other regions. The brokerage houses have taken this assessment to heart: recognizing that Argentina accounts for around a fourth of all traded emerging-market debt, they have warned of contagion and cautioned clients to sit out most Latin American equity markets for now. For its part, the Bush administration has sought to downplay the role of the U.S. economic slowdown in exacerbating emerging-market volatility. Instead, Washington has attributed the problems to the individual countries at hand. President Bush did express support for de la Rœa during the July crisis, but he foreclosed initially any chance of the kind of assistance that President Clinton assembled after the Mexican peso crash. Although the Bush administration did get involved in Argentina's recent negotiations with the IMF, pushing for a voluntary debt component as part of the deal, its leadership role has been modest by past standards.
This is new terrain for a Latin American emerging market. Domestic policy reform was key to resolving the Mexican and Brazilian crisis. Both countries abandoned fixed exchange rates, tightened monetary and fiscal policy, aggressively promoted exports, and recovered much sooner than market analysts had ever imagined. But the combination of significant U.S. and international support was also crucial in calming nerves and providing the necessary breathing space for adjustment. Now, it appears, Argentina has to go it alone.
International support may be important for another reason. If Argentina is unable to face down its domestic trouble, a contagion effect is indeed possible. The Brazilian real and the Chilean peso have already suffered due to the Argentine drama. Brazil seems poised for another dramatic slowdown despite its own $15 billion package from the fund. If private capital flows to emerging markets react by drying up, that could make life difficult for other Latin American leaders as well, including Mexican President Vicente Fox, whose economy is slated for a sharp slowdown in tandem with the U.S. recession. Finally, one impact for the region will have global repercussions: the unraveling of an experiment that was feted in international financial circles as a model of reform.
In Argentina as elsewhere, politicians and policymakers have found that there is no simple path to promote efficiency, productivity, or competitiveness. Market reform remains a work in progress, an endeavor that requires as much political skill as economic expertise. Some observers would argue that the Argentine experiment does not reflect badly on liberalization, privatization, or the rest of the market package; rather, it offers evidence of another failure to pursue adequately tough change. After all, its budget issues were never fully addressed, particularly with regard to provincial cuts; labor-market flexibility, hampered by Argentina's obstinate unions, has never approached U.S. standards. But lamenting that the real world does not fit the market model is a futile exercise. Argentina's experience has painfully shown that the trick is to make reform work in the context of political and social realities.