Argentina just got a $5 billion lesson in the Laffer Curve

Recently, and in the short span of 4 trading days, Argentina's peso suffered a 10% drop, leaving it down 30% vis a vis the dollar over the past year. The Central Bank spent some $5.5 billion of its reserves trying to stem the latest decline, which was arrested only after the central bank hiked short-term rates to a punishing 40% and the government promised to cut spending.

The catalyst for the latest peso decline appears to have been a new 5% income tax on non-residents' holdings of central bank debt (Lebac). This tax, which was part of a comprehensive—and mostly positive—tax reform passed late last year, took effect on April 25th, the very same day that the central bank suddenly was faced with significant outflows of foreign capital. It would seem that foreigners were unhappy paying a tax of 5% of their 30% Lebac coupons. In effect, some $5.5 billion of Lebac was unloaded by foreign investors, converted—thanks to the central bank's sales of its foreign reserves—to dollars, and then shipped out of the country. This was equivalent to the exodus of almost 10% of Argentina's precious foreign reserves. And all because of a 5% tax that might have generated, in the best of cases, about $0.5 billion per year. Ouch. As Art Laffer tells it, "when you tax something more, you should expect to get less of it." Less, in this case, being foreign capital, which Argentina desperately needs to jump-start its economy.

Most observers blame Argentina's ongoing problems on its inability to reign in government spending and tame its 25-30% inflation rate. I think the problem is simpler. As I noted 18 months ago, Argentina has been addicted to money-printing for a long time. Its monetary base has been growing about 30% per year for the past 9 years. Money printing has been and continues to be a major source of financing for the government's deficits. In the U.S., federal deficits are financed almost entirely by the sale of government debt. In Argentina, however, if the government can't finance its deficit by selling debt, then it simply resorts to asking the central bank for money, in exchange for an IOU. The U.S. spends money it borrows from the market, but the Argentine government spends money created out of thin air by its central bank.

Argentina has two ways to proceed if it wants to get things under control. One, reign in government spending in order to reduce the deficit (no more taxes, please!). Two, establish enough credibility with foreign investors so that government deficits can be financed with debt sales. Nothing wrong with doing both, of course, while at the same time eschewing money-printing.

Chart #1

Chart #1 documents Argentina's primary problem: massive money printing. For the past 9 years, the central bank has allowed a 30% annual expansion of the monetary base (two-thirds of which is currency in circulation). Not surprisingly, inflation has been running around 25-30% per year. Inflation, as Milton Friedman famously noted, is a monetary phenomenon. Inflation happens when the supply of money exceeds the demand for it. And in this case, a ten-fold increase in the money supply over 9 years clearly and by far outpaced money demand, so the value of the peso plunged and prices in turn soared.

Chart #2

Another problem that has plagued the country off and on over the years is the government's attempts to manage the peso's exchange rate. If the peso's decline can be slowed, as government bureaucrats typically argue, then that will reduce inflation pressures (thus conveniently shifting the blame from money printing to the foreign exchange market). Notably, the Macri administration, which began in late 2015, wisely abandoned the "official" rate and allowed the peso to float freely (this is shown in Chart #2 where the red and blue lines converged). That restored confidence, and the peso slowed its decline for the next year or so even though money printing continued apace, because demand for pesos improved with improved confidence.

Chart #3

But they have reverted to type of late, by selling $5.5 billion of their forex reserves in order to keep the peso from plunging, as seen in Chart #3. Since that didn't work, their only choice was to jack up short-term interest rates in order to bolster demand for the central bank's debt. Higher interest rates can work in the absence of a decline in money printing (note the similarity to the Fed's use of IOER to bolster banks' demand for bank reserves in the presence of an abundance of excess reserves), but that's not a lasting solution nor will it inspire long-term confidence.

In the end, the math is compelling: since mid-2009, the monetary base has expanded ten-fold, and the peso has lost 83% of its value. The culprit is money printing, and it has got to stop. Any other "fixes" will only prove temporary. Short-term interest rates on Lebac are only effective if they offer investors after-tax compensation for the expected depreciation of the peso. With money printing running at 30% and the peso down 30% in the past year, the after-tax coupon on Lebac needs to be well above 30% to avoid further capital outflows. (Thus it's no surprise that with Lebac rates today at 40%, the peso appears to have stabilized.)

Argentine President Mauricio Macri is, like Donald Trump, a successful businessman who has pledged to restore prosperity to his country. Macri has done a lot of good to date, but this recent peso problem is an unfortunate blemish on his record. I'd like to think that he will take the appropriate steps to get things back on track. So far he's made serious inroads on government corruption and red tape, and the economy's fundamentals have improved measurably (in dollar terms, the Argentine stock market is up 33% since Macri took over). It would be a crime if he didn't set a better course for monetary and fiscal policy. Please, Mr. Macri: cut government spending, pledge to honor Argentina's commitments, get rid of unnecessary taxes, and instruct the central bank to reign in the growth of the money supply.