Monday, May 7, 2018

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.


Peter said...

Hello Scott. Thank you for another great article. Is Japan not in the same situation as Argentina now with the JCB buying all the debt refinancings?
And new debt for that matter?



Scott Grannis said...

Peter: Unfortunately I know a lot more about Argentina than I do about Japan. So I just don’t know the answer to your question. But I would add that Japan obviously does not have an inflation problem like Argentina’s so I would have to guess there are no obvious parallels between what the two central banks are doing.

Benjamin Cole said...

One of the exasperating aspects being a layman who likes macroeconomics is that there always seems to be another highly intelligent expert with another point of view.

John Cochrane's latest blog is another example of what he calls the fiscal theory of monetary policy.

In shorthand, it is too-large federal deficits that ultimately lead to crippling inflation.

Cochrane has been suggesting that the US is already deep into the zone that will lead to higher inflation.

Scott Grannis said...

Benjamin, re John Cochrane: Cochrane argues that large deficits ultimately lead to high/crippling inflation because most governments with huge deficits inevitably resort to money-printing as a way to deal with their deficits. Print lots of money, create lots of inflation, and the real value of all the debt they have incurred plunges. It's called inflating your way out of debt.

In my opinion, the U.S. deficit, currently just under 4% of GDP, is a long way from the inflation danger zone. U.S. federal debt, which is currently about 77% of GDP, is uncomfortably but not dangerously high. Both may worsen, to be sure, but there are many variables involved and there is no guarantee that disaster awaits us.

Unknown said...

It is my understanding that a major purchaser of US federal debt is its Central Bank, leading directly to expansion in broad money supply. Therefore the distinction between virtuous dealing in the global debt markets by the Treasury and profligate use of the Argentine printing press is weakened considerably, no?

Scott Grannis said...

Unknown, re Fed printing money like Argentina: There is a world of difference between what the Fed has done and what the Argentine central bank has done. I've been discussing this many times over the years, and you can find an extensive discussion from 5 years ago here:

Although the Fed has indeed purchased large amounts of Treasury debt, this has not resulted in unusually fast growth in the US money supply. Why? Because when the Fed purchases Treasury debt they don't use "money" in the traditional sense; they credit banks with 'bank reserves' which cannot be spent anywhere. Banks can use those reserves to expand their lending (and thus expand the money supply), but they have chosen to hold on to the bulk of those reserves because they are substitutes for T-bills.

In contrast, when the Argentine central bank "lends" money to the government in exchange for IOUs, they actually credit the government's bank account with spendable money. So they really are "printing money."

Tell-Tale Investor said...

Scott, Thanks for all your posts. I've been reading them for years. This post was very helpful. By the way, I worked for Dr. Laffer for 5 great years. Now I have an economic research firm and a hedge fund. I have been invested in Argentina for almost 2 years and this has taken me a bit by surprise. I have a couple of questions.

Are they going to reverse the capital gains tax? In your opinion, is this crisis going to pass or is the Argentina opportunity over for now? MSCI is expected to announce whether Argentina will be upgraded to emerging market in June as I'm sure you know. Does this crisis effect those odds?

Scott Grannis said...

Tell-Tale: Given today's action (May 15), Argentina has survived this latest crisis. The peso had fallen to 25, and has now rallied by to less than 24. The peso was cheap enough and Lebac rates were high enough that the market was able to clear.

I keep going back to the one thing that has caused all this instability and uncertainty, and it is the fact that the money supply has been growing 30% per year for many years. I'm preplexed that no one is talking about this. The government seems to act as if the only thing that is important is the exchange rate. But clearly, with 30% money supply growth every year there is no way the peso will ever stop falling.

Regardless, 30% money growth is not all that terrible compared to Venezuela. There's no reason for the peso to plunge to absurd levels. 22-24 seems about right to me, but at some point over the next 12 months or so it will likely drop to 28-30. Unless of course they manage to reign in the money supply growth.

I would to see Argentina cut some more taxes, especially taxes on foreign capital. The country can't bootstrap itself to prosperity; foreign capital is essential. Treat capital well and you can prosper. Tax it and you won't.

I wouldn't be surprised to see Argentina upgraded, and that would certainly be a good thing.