Wednesday, October 19, 2011

Argentina's lessons for today

I first visited Argentina in 1970, when I spent my summer there visiting my soon-to-be wife. The country has intrigued, fascinated, and frustrated me ever since. Though I have been spending most of my research time on the U.S. and Europe this year, a brief dip back into the Argentine statistics today proved quite rewarding, yielding lessons that are relevant to several of today's most pressing problems.

We lived in Argentina for four years, 1975-79, during which time inflation averaged about 7% per month, if I recall correctly. During that time, the disastrous government of Isabel PerĂ³n was overthrown by a military coup, and martial law was imposed. (I recall several instances when I was stopped at roadblocks and saw soldiers all around with rifles pointed at me.) After a few years of relative stability under a military dictatorship, things began to deteriorate about a year or two after we returned to the States. (Our timing couldn't have been better.) By the  late 1980s, Argentina was spinning out of control, as its annual inflation rate peaked at over 20,000%. But inflation subsequently fell to zero by the mid-1990s, thanks to the government's decision in 1991 to peg the peso at 1-1 to the dollar.

Here's where the lessons of Argentina have relevance to the eurozone sovereign debt crisis: As the dollar appreciated against other currencies, it carried the peso along with it to levels that created severe deflationary pressures beginning in the late 1990s. Falling prices collided with huge deficit-financed government spending increases to produce one more collapse, in which the currency "floated" from 1-1 to almost 4-1 against the dollar in 2002, and the government converted all dollar-denominated deposits into pesos at a fraction of their former value. As if stealing the life savings of many of its citizens were not enough, the Argentine government subsequently defaulted on some $130 billion of its debt to foreigners, eventually restructuring the debt at about 30 cents on the dollar. (This reminds me a lot of Greece's current predicament: being tied to the euro made it easy for the Greek government to finance huge increases in spending by issuing mountains of euro-denominated debt at relatively low interest rates. Greece's now-inevitable default will have to result in the impoverishment of its citizens, whether through reduced salaries, seized wealth, or a devalued currency. That will come on top of the loss to Greece's creditors, but that is a loss that is reflected today in the market value of Greek bonds, which are trading at about 35 cents on the dollar.)

Although the Argentine economy has since recovered—after several years of extremely painful adjustment—Argentines are once again enjoying a measure of prosperity. I know, because the number of Argentina visitors to our house has increased by an order of magnitude in the past two years. Sadly, however, the government is now engaged in new tricks which promise the return of another collapse. One of those tricks involves a blatant effort to under-report consumer price inflation, beginning in early 2007. The objective was to avoid reporting a budding surge in inflation, and to keep reported inflation low to minimize public dissent in the runup to this weekend's presidential election, which current President Fernandez is almost sure to win. Keeping reported inflation low also helps the government because it also reduces the cost of inflation-adjusted pensions and healthcare benefits. In a vain attempt to deflect criticism of its CPI tinkering, the government has resorted to imposing stiff fines on any private forecaster who dares report that inflation is at least two or three times higher than the official number, which is currently about 10%.

The first chart above shows the "official" consumer price inflation rate, which has been suspiciously flat at about 10% since early 2007. Fortunately, while its not too hard for the government to game the CPI, it is almost impossible to game the overall rate of inflation which is used to calculate the economy's real growth. The true inflation rate is revealed in the GDP deflator, which is shown in the second chart. According to the deflator, inflation is now at least 30% (through June '11). No wonder everyone laughs at the government's CPI data.

All of this leads up to the third chart, which compares the level of the deflator and the CPI to the peso/dollar exchange rate. International monetary theory says that prices inevitably follow the path of currencies; if country A's currency doubles in value relative to country B's currency (for example, if country B devalues its currency by 50%), then prices in country B will eventually double also. Argentina may be a disaster as a country, but it serves as a valuable laboratory for economic experimentation: we now see that with the dollar more than quadrupling in value relative to the peso since 2001, prices in Argentina have also more than quadrupled. Q.E.D. The tinkered-with CPI, however, is woefully lagging, and now understates true inflation by about 35%.

There are several lessons here: One, a currency cannot depreciate relative to other currencies without there being a corresponding rise in inflation in the fullness of time. If the dollar continues to decline relative to other currencies, U.S. inflation will perforce increase. If the principles behind the gold standard have any validity, then the dollar's decline relative to gold almost guarantee the inflation will accelerate in the years to come. Two, controlling the value of one's currency can be an extremely effective method of controlling inflation. This has important implications for China, since it has pegged its currency to the dollar for the past 18 years, thus tying its price level to that of the U.S. It is thus quite unlikely that the yuan is significantly undervalued relative to the dollar. Three, massive sovereign debt defaults, while very likely to cause serious economic disruption, need not spell the end of the world as we know it, although they are extremely painful for many. Four, for those Argentines who worry that the peso is overvalued today relative to the dollar, yes it is. It is almost exactly as overvalued today as it was at the end of 2001, with one important difference: in late 2001 the dollar was quite strong relative to most other currencies, whereas today it is quite weak. Bottom line: although the peso is still strong relative to the dollar—and still appreciating, since the peso is falling at the same rate as prices are rising—it is weak relative to most other currencies and to commodities, so the Argentine economy is likely to suffer from continuing inflationary pressures.


Anonymous said...

Interesting stuff. Two things I've learned in following economic issues over the years:

1. You should never peg your currency to the value of another nation's currency. China might be getting away with this, but only because they've gradually been loosening the peg.

2. Similarly, nations should never share a currency. Friedman was prophetic, the problems he forecast with the Euro are playing out exactly as predicted.

An interesting thought experiment would be, How would Argentine economic history have played out if they never pegged the peso to the dollar?

As for the US dollar itself, it's hard to escape the fact it's in a secular decline. Even the Fed's raising of interest rates in 2004-06 had little, if any, effect on its value. World markets simply want the dollar to fall - this is the likely reason why.

If there's not much we can do about it, might as well look on the bright side. 1978 is infinitely preferable to 1933.

Colin said...

Scott, speaking of Argentina did you see this WSJ column?

Benjamin Cole said...

I agree with Mr. Unknown that the decline of the dollar seems to have only some connection to US monetary policy. The dollar is in decline for secular reasons, one being the huge dollar overhang built up over decades. The dollar has been declining since 2002.

Inflation has been more than tame in this time frame--of late it has been deader than Jimmy Hoffa. For the three years ended in August, running at 1 percent a year.

An even lower dollar is likely and desirable. We will export more goods, and attract more tourists and probably foreign capital into US manufacturing plants and real estate.

If the Fed will target nominal GDP, I see a huge boom in the USA.

We will do a Japan, if the Fed can't get over its fixation and unhealthy obsession with inflation. This peevish tunnel-vision is the biggest threat to American security and prosperity going.

Benjamin Cole said...

Structural Reality-The Sinking Dollar

That something is structural. There are two tectonic forces at work.

There is a global dollar overhang that is being unwound. This is not a result of the U.S. monetary policy of the past 10 years, but rather the legacy of the last 60 years when liquid wealth across the planet had only one currency choice: the U.S. dollar. In the wake of WWII, as global trade increased, global wealth grew, and precautionary financial buffers got fatter, the global demand for dollars soared. We are now witnessing the backside of that slope.

The decline of the dollar started in 2002 largely because this is when the paradigm shift in emerging markets began to take hold and people across the world began, slowly, to trust their home currencies. The financial deepening of foreign markets everywhere supported this process, as did the decline in transactional demand for the dollar (hotel bills in India and Brazil are now, for example, in local currency, not dollars).

Anonymous said...

"We will do a Japan, if the Fed can't get over its fixation and unhealthy obsession with inflation. This peevish tunnel-vision is the biggest threat to American security and prosperity going."

I repeat (and repeat what Scott repeated in another article): We will not do a Japan, because during the time of Japanese stagnation their currency was rising. Ours is falling. This makes a huge difference. We may get a repeat of the 70's sometime in the next 10 years, but we will *not* get a repeat of Japan any time soon for the aforementioned reason. If we stagnate like Japan, it will be a stagnation with high inflation, not one with deflation. You just don't get deflation with a falling currency.

Anonymous said...

Oh I forgot - and that has nothing to do with the Fed. The Fed can make little difference at this point as far as I'm concerned. As I pointed out before, even when the Fed raised interest rates in 2004-06, it did nothing to stem the decline of the dollar. Look at the chart of DXY going back to 2000, and you can barely notice the Fed raised interest rates in the middle of the decade at all.

Gus said...

Interesting post -- a few questions/comments.

You write: ". . . for those Argentines who worry that the peso is overvalued today relative to the dollar, yes it is."

By what measure do you reach this conclusion?

If we are talking about "overvalued" in terms of the price of goods, how do you distinguish between the effect of the exchange rate and the other policies that impact the price level, mainly the various protectionist schemes (e.g., licencias no automaticos), flood of ultra-cheap credit for the short term (e.g., cuotas sin interes), pro-consumer political games (e.g., lcd para todos), anti-industry practices that destroy supply (e.g., price caps and export restrictions on staples like beef), and the general instability that encourages consumption over investment?

And, paradoxically, while I would agree that Argentina is rapidly becoming less competitive due to its increasing cost structure, that the currency is overvalued in dollar terms is belied by the fact that the price of goods are exorbitant relative to local incomes. Imagine how expensive goods would be relative to local incomes at 5-to-1 (where we're almost at in the informal market, and where we'll soon be officially with the K victory out of the way) or even 6-to-1? We're already looking at iPhones that cost 7000 ARS (or, say, about 10% of the annual salary of a reasonably well-paid professional).

My point is that, yes, there obviously is inflation in Argentina, costs are high, and a few years back (2003 through 2006, maybe 2007) the peso seemed undervalued against almost all major currencies, but I don't think it necessarily follows that the peso is overvalued against the dollar. Nor do I think that
the "Argentina case" supports the argument that there exists a necessary causal connection between a cheap and/or declining currency and future inflation. Rather, there are a host of other factors, both internal (e.g., protectionist policies) and external (e.g., demand for soy from China), that impact whether an economy will experience inflation. Thus, concluding from the "Argentina case" that inflation in the US is just around the corner seems, in my view, to be a tad simplistic.