Economics 201

Case of the Day: Money and Inflation in Argentina

Some history

From the end of World War II until the 1990s, Argentina vied with other South American countries and a few countries in other parts of the world for the dubious honor of having the highest inflation rate in the world. As is always the case with rapid inflation, the price increase in Argentina was fueled by rapid expansion of the money supply. The seigniorage earned from monetary expansion served the needs of the government as a method of taxation that was difficult to avoid and politically easy to enact.

Argentina, like many other chronic-inflation economies, went through repeated cycles of hyperinflation followed by attempts at stabilization. A typical cycle in such an inflationary economy begins with acceleration of money creation to accommodate the government's budgetary needs. As inflation accelerates, political pressure to reduce inflation builds, leading to an eventual "monetary reform." Such reforms usually include the introduction of a new currency (which is convenient since inflation has usually moved the nominal prices of goods and services into the thousands, million, billions, or even trillions of units of the old currency) and promises on the part of the government (which is in charge of the budget) and the central bank (which is in charge of issuing money and is often under direct control of the government) to follow rules leading to slower monetary growth in the future.

These rules often take the form of monetary rules, under which the central bank promises to keep the growth rate of the money supply within specified limits. Alternatively, countries sometimes promise to keep the foreign-exchange rate (the amount of the domestic currency it takes to buy one dollar in the foreign-exchange market) stable under a so-called exchange-rate rule.
A major difficulty that plagues anti-inflation reforms is credibility. Once inflationary expectations have become ingrained in a society, people become very skeptical of government and central-bank promises to keep inflation under control. This skepticism leads them to maintain "defense mechanisms" against the effects of inflation and the inflation tax.

One such defense mechanism is keeping wealth in forms that are not affected by inflation. Holding U.S. dollar assets is one common way that people in high-inflation countries protect their wealth from inflation. Wealthy members of these societies often deposit funds in American banks or hold stock in U.S. firms (this is called "capital flight"). Less wealthy citizens often hold $100 bills. Real assets that are not directly related to the financial sector are another form of "inflation hedge." Many residents of high-inflation economies keep wealth in durable goods such as houses, gold, or even rice, rather than holding financial assets such as bank deposits.

Another common defense mechanism is the indexation of contracts and payments. This involves writing into the contract an inflation-based adjustment of all nominal payments to compensate for changes in the price level. Although the presence of indexation is extremely valuable in helping an economy live with high inflation, it can contribute to an inertia that makes it more difficult for the central bank to reduce inflation. Under some forms of indexed contracts, wages (or whatever payment is provided for in the contract) may continue to rise for some period after inflation has stopped. This causes wage costs to continue rising and forces firms to continue to raise prices even after the monetary growth that was the root cause of inflation has stopped.

By 1990, Argentina had been through almost a dozen cycles of hyperinflation and reform. None of the reforms kept inflation low for more than a couple of years before a combination of fiscal pressure and lack of credibility forced the central bank to abandon monetary restraint and crank up the printing press yet again. The public's attitude combined a desperate wish that inflation could be eliminated with a deep-seated cynicism about the prospects for effective anti-inflationary policies.

In 1990, the government of president Carlos Menem and economics minister Domingo Cavallo embarked on a truly radical anti-inflationary reform: They adopted a straitjacket monetary system called a currency board. Under a currency board (which was also used routinely to manage the money supply of Hong Kong), every unit of the domestic currency (the peso, in Argentina's case) is backed by a corresponding number of units (one, for Argentina) of dollars or other foreign currencies in the central bank's vault. Only when more dollars flow into the central bank's coffers (as, for example, when the country runs a trade surplus) is the central bank allowed to expand the money supply. This eliminates the possibility of expanding the money supply for fiscal reasons. The Argentine central bank committed itself to exchanging dollars for pesos on a one-for-one basis; anyone who brought in a peso could receive a dollar in exchange.

A currency board eliminates any ability of the central bank to issue money voluntarily. Its main drawback is that it is impossible for monetary policy to respond to conditions in the domestic economy such as recession or banking crises. However, as long as it remains in force, the currency board makes sustained inflation impossible.

The following excerpts are from an article by Domingo Cavallo entitled "Lessons from the Stabilization Process in Argentina, 1990-1996," published by the Federal Reserve Bank of Kansas City in the proceedings from its 1996 symposium Achieving Price Stability.

The stabilization plan

In 1990, the government began to completely overhaul the organization of the Argentine economy. It included (a) comprehensive liberalization of foreign trade and capital movements, (b) the privatization of public enterprises and the deregulation of the economy, (c) reduction of the bureaucratic apparatus of the public sector and the reconstruction of the tax system, and (d) the creation of a new monetary system.

Government expenditure fell drastically from 35.6 percent of GDP in 1989 to 29.8 percent in 1990, and continued to fall to 27 percent of GDP by 1995. The fiscal deficit also decreased sharply from 7.6 percent of GDP in 1989 to 2.3 percent in 1990, and from 1991 onward, it fluctuated around 0 percent, accompanying the economic cycle.
The prices of goods and services began to be freely determined in competitive and open markets. As of April 1991, the public could freely choose the currency used in all financial and commercial transactions. Among the alternatives was the convertible peso, which came with the transformation of the central bank into a virtual currency board. The central bank must back each peso in circulation with an equivalent amount or gold or foreign exchange, permitting holders of pesos to exchange, at any moment, one peso for one American dollar.

The same law that created this monetary system included the prohibition of indexation clauses or any other monetary alterations in the terms of contracts. Wage agreements resulting from collective bargaining had to be accompanied by agreements on productivity.

The disinflationary process was continuous and sustained: Inflation fell from 1,344 percent in 1990 to 84 percent in 1991, 17.5 percent in 1992, 7.4 percent in 1993, 3.9 percent in 1994, 1.6 percent in 1995 and 0 percent in the twelve-month period between June 1995 and June 1996.

The new monetary system encouraged a strong increase in the external reserves that back the monetary liabilities of the central bank. Reserves went from $3.8 billion at the end of 1989 to $17.9 billion at the end of 1994. This trend was reversed when the fall in the level of confidence following the devaluation of the Mexican peso led to capital flight from Argentina: by the end of March 1995, reserves had fallen to $12.5 billion. But the policies adopted to face the crisis reestablished confidence. By the end of June 1996, reserves had already surpassed $20 billion.

Between 1991 and 1994, GDP grew at an average annual rate of 7.7 percent. However, due to capital flight, after the second quarter of 1995 the economy entered a period of recession. The recession lasted a year and in the second quarter of 1996, the economy was already showing signs of a recovery at an annual rate of 3 percent.
Exports, virtually stagnant in the previous decade, grew vigorously during the period of the stabilization. Imports, which had grown much more than exports until 1994, shrank during 1995 with the onset of the recession.

Despite the strong increase in the GDP, employment grew relatively slowly, and suffered a decline during the recession that began in 1995. The poor performance of the economy in relation to employment is explained by the substantial increase in worker productivity, which by mid-1996, had reached the level of 1980. The rapid growth of the economy during the period permitted the transformation of numerous low-productivity or unproductive activities that had been artificially created during the decade of the 1980s into productive efforts. However, this was not sufficient to employ all of the growing labor force. Thus, beginning in 1992, the unemployment rate increased and reached a peak of 18.4 percent of the active population in May 1995. Since then, there has been a slight decrease in unemployment. The survey of May 1996 recorded a rate of 17 percent, still three times higher than that of the 1980s.

The percentage of households below the poverty line (an average of 26 percent in the late 1980s, which had risen to 29 percent in the period of hyperinflation) fell to 13 percent in 1994 but went up to 17 percent during the recession of 1995. . . .  

Lessons of the Argentine disinflation

The main lesson of the Argentine stabilization experience is that the elimination of inflation is possible even when an economy has been flogged by that disease for decades. It is not true that in Latin American economies it is necessary to accept annual inflation rates of around 10 percent, even after many years of searching for stability.

Another important conclusion of the Argentine experience is that the fiscal adjustment, understood as a reduction of the government expenditure, as well as the reduction and the elimination of budget deficits are the keys to stabilization after decades of instability, the origins of which are mainly found in the monetary financing of persistent fiscal deficits.  

Table 2. The Argentine Stabilization in Numbers
(decade of the 1980s and 1989 through 1996)

 Sources: Secretaría de Programación Económica, B.C.R.A

For a society in economic chaos due to inflation, the imposition of basic discipline on both the private and public sectors is of special importance. External and internal competition--achieved through the opening of the economy, deregulation, and the privatization of public companies--is an excellent disciplining mechanism for the private sector. The budget is the disciplining mechanism for the public sector. In order to achieve the transparency necessary for the markets and the budget to function efficiently, the monetary system is the key.

The success of stabilization in Argentina is neither due to the quantitative control of the national currency, nor due to fixing its value in terms of the dollar because, in a strict sense, these two monetary policy rules were not applied. What the government offered the public was freedom to choose the currency to be used in its transactions and for its savings. In practice, the choice was given between the American dollar, that the public had already transformed into its currency during hyperinflation, and the convertible peso that began to be offered by the central bank. In accordance with the Convertibility Law, this currency should be at least as stable as the dollar. For this reason, from the outset its creation was limited to the quantity that could be backed by the gold and foreign currency reserves in the central bank. Freedom of choice of the currency to use, not necessarily limited to the peso and the U.S. dollar, sustained the prohibition on monetary corrections or indexation clauses in contracts. This was very important to the elimination of all vestiges of inflationary inertia in the system.

Stability in the value of the peso in relation to the dollar was not an obstacle for a healthy expansion of exports, much greater than that of the previous decade when the Argentine currency had been grossly undervalued. And it was not necessary to devalue the peso in order to reduce the deficit in the current account of the balance of payments, which, in 1994, reached 3.3 percent of GDP but fell drastically to just 0.9 percent in 1995.

The stability of the peso was vital to encouraging public officials as well as private entrepreneurs to pay greater attention to the real determinants of external competitiveness: economically distorting regulations and taxes, as well as factor productivity.
The increase in the rates of investment and productivity explain the impressive economic growth during the stabilization period. The increase in the unemployment rate could not have been avoided by allowing higher inflation. With the exception of the year of recession, aggregate demand was constantly expanding and tending toward an overheating of the economy. The causes of unemployment can be found in the institutional rigidities in the labor market and the low levels of productivity of the 1980s. In the case of both problems, the transparency attained with price stability creates a much more adequate environment conducive to improving the quality of the public policy debate and of the labor negotiations that are necessary to overcome them.

Everything didn't turn out to be rosy

The original case study above was written in 1998. Shortly after that, Argentina's financial system began to crumble. The banking system had suffered a crisis in early 1995, following unrelated difficulties in Mexico that nonetheless caused a loss of confidence in Argentina. Some key Argentine banks were in trouble, and the currency board system precluded any corrective action by the central bank, such as serving as a lender of last resort or engaging in a general mometary expansion.

Then in early 2002, a combination of bank difficulties and rising government debt induced a national economic crisis as severe as America's Great Depression. While the currency board was not the cause of this crisis (government fiscal irresponsibility was the chief culprit), it tied the central bank's hands in helping to ameliorate the crisis. Since the main emphasis in this case is on beating inflation, we are not going to focus on the later crises, but if you want more information, you might look at this article from the March 2, 2002 issue of The Economist for a blow-by-blow account of the downturn.

After the crisis, Argentina has reverted to some of its former populist policies. Inflation has not exploded, but it has run at considerably higher rates than during the currency board period. A more recent comparison of Argentina and Brazil's economic policies and outcomes is here.

Questions for analysis

1. What costs did Argentina's high and variable inflation prior to 1990 have on the "real" side of its economy? What parts of society lost the most? Were there any gainers?

2. If everyone agrees that hyperinflation is bad, why does it happen? There is some evidence that countries in which central banks are independent of the elected government tend to have less inflation. Why might this be?

3. What is the major advantage of a currency board system in establishing anti-inflation credibility? Why is credibility critically important?

4. When the Mexican currency crisis occurred in 1995, some international speculators pulled their money out of Argentine pesos as well as other South and Central American currencies because they feared that the peso would depreciate against the dollar. Explain why this peso currency depreciation could not happen as long as Argentina stuck to its currency board policy.