Sound Macroeconomic Policies: Better Hurry or it will be TOO Late (or how Fiscal, Monetary, and Exchange Rate Policies are Running Behind the Curve)

This post appeared on RGE-Monitor on March 22nd, 2008.

I always tell my students: “If you observe inflation picking up, something is wrong with that economy; it is like a fever.”

The Argentine government has a high inflation problem. Instead of applying sound macroeconomic polices to stabilize inflation it is just using income polices—like price controls and export constraints.

On the contrary, since this is a long-run inflationary problem, the government should recognize its irresponsibility in conducing macroeconomic policy and work to correct its mistakes. For the longer they take to put things in order, the larger the correction will be. Among those problems is the simple fact that the administration has used these ineffective macroeconomic policies while the economy was still in a reasonable growth path. By avoiding the right policies in “good” times the government led the country’s inflation rate to separate—from above—from the international inflation rate. Yes, inflation rates have been higher the last year in most countries; but Argentina’s has been even higher. The problem then becomes: What will happen when things get worse (e.g. a negative external demand shock? By the way, the latter looks more likely as the international financial crisis is developing…

The true problem is that the government did not control inflation during the global expansion. Now that things are looking gloomy, will the government have some, if any, room to put the economy back in the right path? I have my doubts, unless the administration is willing to press the brakes quite abruptly—and the longer they take, the more abrupt the stop will need to be. In other words, Argentina decided not to correct the imbalances by using the correct policy toolkit when it was feasible to put the economy in a low volatility long run growth path with minor—may be no—real effects. To do it now, the adjustment will probably not be as smoothed as it could have been if the authorities would have understood the problem correctly. Argentina, one more time, chose a business cycle with potential big amplifications instead of a smoother path; it chose short run high growth rate levels instead of a longer horizon low volatility path—as. e.g. Brazil did.

Let me be slightly more specific. By sound macroeconomic policy I mean, among other things:

n letting the currency float

n a central bank devoted to truly control inflation—which now implies applying a contractionary monetary policy which ill appreciate the currency and reduce the excess aggregate demand

n a strong contractionary fiscal policy to reduce aggregate demand—and partially helps in controlling the real exchange appreciation so as not hurt exporters.

Notice that, as I mentioned in several previous postings, it does not imply a reduction in the growth rate of government expenditures—to rates lower than the tax revenue—but an actual targeted reduction. This is non trivial. Why? Because tax revenues, based especially on exports taxes and inflation taxes are the first ones that could be affected. For if external demand contracts plus, as likely, commodities’ prices lower returning to fundamental—instead of its high speculative component derived form the flows that are trying to avoid losses in other financial markets, the previously so called “savings glut”—export tax revenues will contract. Since also exporters’ income will be lower, so will aggregate demand—through the standard multiplier process. Note that the two main sources of aggregate demand impulses have been government expenditures and exporters high transitory incomes!

This is precisely the point to consider the need for a reduction in expenditures. Tax revenues are likely to be reduced. The government seems to ignore and thus fail to internalize this fact. If so, fiscal sustainability will start flashing a red light. On the contrary, reductions in public expenses will not only generate a flow fiscal surplus today, but also will be able to keep in “bad times.”[1]

Another thing to add is that an inflation target would have been a much better tool to provide the central bank with for it to focus on inflation. Problem is that inflation targets should be implemented in good times, not bad times—and I hear a tic-toc here…

Also note that since one of the main tools that the government has been using to control the inflation rate is subsidies—with no mayor effect—, as the inflation rate remains out of control, the amount (volume and quantity) of subsidies keeps on increasing. And it will rather continue growing the way things currently look. If so, they eventually—in the limit—become unmanageable, thus potentially reaping up the entire tax revenue. Again, the longer it takes for these subsidies to be removed, the greater their inflationary impact when liberalized.

Finally, what if the external demand shock ends up generating a stagflation-like situation? What will the government do in such a case? What if, on top of it the primary balance, it shows a deficit? What about the provincial governments’ deficit?

One more thing. Argentina did not had it easy to get international financing in global capital markets in these “good times.” Will it get it in the future if the situation becomes gloomier, as I presume? I doubt it. In this case, everything that I mentioned above can only get worse. As an example of this, FDI increased substantially in the later times in Latin America. But in Argentina? Hmm…

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[1] On the contrary, the government is seriously considering increasing its debt in almost U$S 4billion to finance a “bullet train” whose profitability analysis looks rather nonprofitable.

Argentina’s Way of Putting a Cap on Inflation: High Inflation ruled–out by Definition?

The following piece appeared in RGE-Monitor (Latin-America) on Mar 7, 2008

Argentina’s authorities are working on the design of the new Consumer Price Index—as if the previous one had problems, other than its “ex-post editing”.

The (almost official) information available (clarin) suggests that some elements of the new computation of the CPI could include:

1. Seasonal products: only the cheapest will be considered
2. Not computing
1. goods that experience price increases greater than 15% (assuming people won’t buy them)
2. health insurance payment other than “co-payments” (which are relatively few)
3. travel abroad
4. Private education expenses
3. Lower number of consumption goods in the consumption basket: it will be mostly focused on the basket of goods and services of lower-middle class families which:
1. could potentially be modified at discretion
2. it will be mainly based on food prices that are in one way or another under price controls
4. The weights in the consumption basket could be modified on a monthly basis
5. Giving more importance to the goods sold by supermarkets (as opposed to small stores). The latter, in turn, could be based on price-controlled goods and could be based on the reported prices rather than the true selling prices.

If the information above is true (to be seen) not only Argentina will increase the degree of default on its debt (a huge share of the debt is indexed by CPI). Argentina, by definition, will be ruling out high inflation—not least hyperinflation. Why? See (2)(a) above!—and not taking into account that the faster prices rise, the more (instead of less) of the goods would be purchased. The more so if one takes into account that for this methodology to be viable we would need to know the price elasticities of these goods. This is an experimental methodology in the U.S. where the amount of information and consumer surveys can support it. Because of this, this price index is reported along with a regular CPI, PPI, core inflation, etc. In Argentina, on the contrary, the plan seems to be to report this new index as the only CPI…

Some long-run implication of the above: around 50% of the pension funds firms’ assets are indexed by CPI. Then, the default also affects future retired people. On the contrary, instead of letting these firms (AFJP’s) invest their funds freely to maximize the expected profits of its to-be-retired people, the government wants AFJP’s to finance investment. It is the government’s role to set up the long-run institutions and sound macroeconomic policy for investment to increase, not force it. This partly results from the decrease in FDI that Argentina is experiencing—as opposed to our neighbor countries.

Actually, the opposite is being done. Argentina’s inflation is separating more and more from international inflation. This strongly reduces the incentives for long-term investments.

So far, consumption has been growing. This is partly due to the expansionary policies of the government and the crossed subsidy system—so people are paying for the higher prices anyway. It is also resulting (more and more over time) from the acceleration of the inflation rate. Argentines are unfortunately very knowledgeable of high inflation. When it accelerates, demand for goods increase to anticipate future higher prices, reducing the demand for money.

We also have to hope that commodities markets continue as they are. However, the debate has already started: is this a long-term effect or just a bubble where the savings glut has been propelling commodities’ prices (see RGE-Monitor, March 6^th)? If the latter were the case: will that be a yellow light, or a red light altogether?

However, could stagflation be knocking Argentina’s door in 2009? This is cannot be ruled out—and it’s in part conditional on commodities markets and the global effects of the current U.S. recession/slowdown. If so, we have to start internalizing a big future problem. For 2009 is an election year. This government is extremely biased to pump up aggregate demand through fiscal policy; the more so with a faltering consumption. But with high inflation already in place…

Argentina’s authorities would claim that the recent economic growth has not been seen for 100 years. This is not false. But it is also true that the rest of the world economy has been growing at high rates for last 5 years (say the China-India effect if you want to). On the contrary, I would claim that Argentina the later has helped Argentina grow despite the highly mismanaged macroeconomy. Argentina has been in front of a once-in-every-100-years chance to make a big step to long-run growth. We could be missing the opportunity, though.