A short note on Argentina's depreciation, inflation and possible dollarization

That Argentina is in for a major crisis is, I think, pretty clear and well-known. I won't delve too much on the political aspects of what Finchelstein refers to as wannabe Fascistic tendencies of the new president.  Today a major protest should take place, and the same people that suggested that Peronists groups forced the recipients of social transfers to participate (something that was never proved) under threat of being cutoff, are threatening to cutoff those that participate. You know, because they defend individual liberties and all.

First of all, the economic plan (and many heterodox authors had been calling for what exactly done) was simply maxi-depreciation, of 100 percent, of the official exchange rate, to try to close the gap with the parallel market (or blue) rate, and the announcement of a massive fiscal adjustment, supposedly of about 5 percent of GDP. As discussed here several times, the effects of these policies are certainly a significant acceleration of inflation, and a massive recession. These are well-known effects of a maxi-depreciation. Prices will adjust to the massive increase in the cost of imported inputs, and the increase will reduce real wages (that, by the way, is one of the main reasons for the measure), and have a contractionary effect on spending, that will be compounded by the fiscal adjustment.

Two brief technical things. The adjustment may not per se improve the fiscal accounts, since the economic collapse will reduce revenue too. It is a well-known rule that consolidations (reductions of debt and of deficits, the results of policies) tend to be more successful with a growing economy, and without a massive adjustment (reduction in spending and/or higher taxes, the direct policies).* Second, the reduction in the exchange rate premium (the gap between official and parallel rates) is not an indication that things are better, if it is done, as it was, by depreciating massively the official rate. In particular, the question is what will happen with the parallel premium in the near future. The official exchange rate will be on a crawling peg, if the announcement of the new minister is believable. And the premium has been very high, because of the interest rate differential between returns in pesos and in dollars, adjusted for risk (see figure below, which shows the interest rate in pesos compared to the actual depreciation of the currency, plus the US rate and the EMBI from JP Morgan). The remuneration in dollars is always higher.

The government has also announced a plan to essentially transform the central bank bonds (Leliqs) into treasury bonds. And the interest rate on the central bank bonds were kept low, presumably to get everybody into the treasury ones. However, the treasury bonds will have to pay a very high rate, since the the expected depreciation is large, and the government announced it will continue. That suggests that they are expecting people to continue to go to dollars, and that might actually lead to a persistence or increase of the exchange rate premium. In particular, if there is significant wage resistance, to be expected after this massive depreciation, and inflation accelerates.

In the absence of dollars, there is little chance of a stabilization. The government may very well be trying to accelerate inflation to create the conditions for a dollarization later on.

* Most economists confuse adjustment and consolidation of fiscal accounts. In part to cloud the fact that consolidation does not require adjustment. The US reduced its massive debt accumulation during World War II, without adjustment, by growing fast in the post-war era, in which the government did run deficits frequently and the welfare state was actually expanded, particularly in the 1960s.

SSCRER this!

The acronym stands for Sustainable and Stable Competitive Real Exchange Rate. It has been an important contention among heterodox, and not so heterodox groups alike, that a depreciated exchange rate leads to higher levels of economic growth. This has been also based to a great extent on the comparative experience of Latin America and Asia. So far so good.

Depreciation, of course, protects local industry and leads to a boost to domestic production, and also, by leading to an increase in exports, reduces the external constraint of the economy. But it is important to note at least two things that heterodox economists used to know, but apparently have since forgotten (or at least some have).

One is that depreciations are inflationary, in particular because they affect costs (not demand). Yes pass-through effects are smaller, but not negligible, and they tend to be larger when wage resistance is relatively strong. In that case, if you want a more depreciated exchange rate, you must be prepared to accept higher levels of inflation, and to deal with cost-push inflation.

The other factor is that depreciation may very well be contractionary. One way in which this works out is that depreciation (everything else constant) reduces wages, increases the profits of exporters, and leads (yes, the economy is wage-led) to a reduction in spending and lower levels of activity (Diaz Alejandro dixit; classic paper by Krugman and Taylor here; subscription required). In this case, a depreciation does help reduce your external constraint, but by leading to a contraction. That, by the way, was one of the reasons why heterodox authors were against the traditional IMF package, devaluation (or wage reduction) and fiscal contraction; it was simply contractionary.

I am more concerned then, when this view of a SSCRER seems to be used to replace every other policy tool available. That seems to be the positions of some people at least in another Heterodox conference in Latin America held last week (link here). In particular there seems to be a peculiar notion that monetary and fiscal policies must be always checking the excess spending caused by the external demand obtained with the SSCRER (in this view all inflation is demand-pull), or as explained in one of the papers presented at the conference by Roberto Frenkel:

“the monetary and fiscal policies required to accompany the adoption of a SSCRER target must also have special features: the permanent expansionary stimulus that is part and parcel of the SSCRER heightens the importance of the restraining role to be played by fiscal and monetary policies.”

I remain skeptical that a SSCRER alone produces that much growth (“permanent expansionary stimulus,” wow that’s nice!). It is a peculiar reading of the Asian experience. Industrial policy, the patterns of trade integration with the main markets (in the US), and the ability to expand domestic markets with the expansion of wages, seem to play no part on the process of development in Asia. Does this mean that China has a depreciated currency, and compensates by having monetary and fiscal restraint? Really? That’s news to me!

Also it must be noted that the idea that monetary and fiscal policy must restrain excess demand implies that inflation is always a demand phenomenon, which is again peculiar among heterodox authors. The idea that devaluation is inflationary because it is expansionary (it used to be contractionary not so long ago), and so much that it leads to growth beyond capacity, and has nothing to do with costs is certainly odd.

Don’t get me wrong, I do favor in general a more depreciated exchange rate, to reduce the external constraint, but because devaluation is inflationary (on the cost side) and there often is wage resistance, one must be moderate. Also, the way to deal with inflation would be with income policies (and I mean price controls, not reduction of wages!). And because devaluation is contractionary, through its effects on income distribution, fiscal and monetary should be expansionary (check the post here; to see what fiscal adjustment has done in Brazil).

And one last thing, in Greece because they cannot devalue the ECB and the IMF have asked the equivalent thing (deflation and wage reduction) also with monetary and fiscal restraint. How is that working out for them?