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.