The Destruction of Convertibility
My good friend and fellow student at Chicago, Michael Mussa, has just relieved Argentine society of its greatest concern: the search for a scapegoat for the current crisis. In his recent work: "Argentina and the Fund: from Triumph to Tragedy", this former IMF official has outlined a fiscal view of the Argentine crisis, according to which Convertibility collapsed under the weight of sharp growth in public spending, the fiscal deficit and public debt levels during the 90s.
I agree with Mussa that public spending was high, tax evasion was also high, there was no flexibility in wages, etc. I think that I contributed significantly to the debate on these topics during my two years in the government in 1996-98. The matters were in the public domain and the object of study by specialists. The government of the Alianza received no surprises when it took over on December 10, 1999.
The economic policy followed during the 90s was simple and known by all, so much so that it began to be said that the economy was running on "automatic pilot". If the policy was wrong, the economy should have blown up far sooner. However, it did not. Something happened that was not foreseen or anticipated by the markets. It was this surprise event that destroyed Convertibility and immersed Argentina in the worst crisis in its history.
Mussa's mistake was to consider the Argentine economic process as one of steady deterioration, eventually leading to the current crisis. This causes him to state that if Menem were to have tightened the fiscal belt during the boom years in 1996-1998, then De la Rúa would not have had to take the drastic and incorrect measures that he took. I think that the basic error in the analysis performed by Mussa lies here: he has ignored the surprising demonstration of technical incompetence and intellectual poverty of the Alianza government.
In my opinion, the Alianza were going to destroy whatever they inherited, however good it might have been. If they had been allowed to govern Switzerland, they would have destroyed the Swiss economy. The sad role played by Chacho Alvarez, the return of Alfonsín to power, the cosmetic ethics of Fernández Meijide and the autism of De la Rúa were the real unexpected shocks affecting the markets that generated the process that destroyed Convertibility. Pandora's box was opened on December 10, 1999.
The Alianza tried to justify its incapacity to the media by appealing to the terrible inheritance received from the decade of the 90s. In reality, Consolidated Primary Public Spending as a percentage of GDP increased not at all between 1991 and 1998 (according to Ministry of Economy figures published during Cavallo´s administration). In 1999 it only increased by 1% of GDP, in spite of the sharp fall in GDP provoked by the international financial crisis and the Brazilian devaluation. Industrial production was rising sharply during the second half of 1999 and on December 10 the country risk premium had fallen to 610 basis points. The new government received a public spending to GDP ratio that was almost identical to that of a decade earlier, an economy in the process of recovery and a country risk premium 10% lower than the average for the countries in the region.
Three years after the change in government authorities, the country risk premium has increased tenfold. GDP is falling at an annual rate of 15%, unemployment has risen by 50% and available international reserves have been exhausted (the few that remain are mostly borrowed). All these misfortunes, in spite of the fact that primary public spending has been cut by 2% of GDP and payment of the foreign debt has been halted.
If the Menem administration had left behind a lighted fuse, why didn't the country risk at December 10 reflect the danger, and why did industrial output grow 14% between July and December 1999 (an annualized rate of 37%), according to the deseasonalized Monthly Industrial Estimator published by the INDEC? If public spending was high and at odds with the stability of the financial system, how was it possible for large international banks to pay fortunes to buy domestic banks and thus be able to take a position in an economy that was showing dynamic growth? It is easy to find an indicator after the event to blame for everything that happened, but it is also possible to err by making simplistic interpretations.
I remember that when were studying with Mussa in Chicago in 1970 the Theory of Rational Expectations was just being developed, according to which the effects of all past known events are incorporated to current economic indicators: country risk premium at December 10, 1999 incorporated all information available on public finances in the 90s. If the country risk premium increased tenfold subsequently, it must have been because new information had arisen: for example, a change in the rules of the game that resulted in truly bad economic policies as from December 10, 1999.
It was the change in the rules of the game that destroyed convertibility, and it was carried out almost purposely by an irresponsible group who failed to calculate the very grave economic and social consequences of their actions. Machinea (backed by Alfonsín), seeking to make up for the debacle in 1989, invented the matter of the inheritance received, exaggerating it to the point of condemning everything that had been done in the 90s. He fell prey to his own invention and was forced to compensate for so much inherited "fiscal poverty" by introducing an ill-fated major tax package, applauded at the time by the IMF.
The tax package, the condemnation of market policies and the return to popularity of "active policies" of intervention acted as a red light for investors. The incipient recovery was aborted and capital began to flow outward. Paradoxically, public spending fell but the economy and finances did not recover. The same happened in 1988-89 during the Alfonsín debacle. However, it is one thing for spending to decline because of a political decision and quite another for spending to go down because there is no money to pay with!
In the midst of a tax debacle and a run on banks, Machinea wisely decided to resign and was replaced on the stage by Domingo Cavallo, who for some time had been waiting in the wings, all made up. Cavallo was also looking for a second chance, after having been dismissed by Menem in 1996. The economic system that Cavallo had helped to build in 1991-95 was so effective that it was able to continue to function without Cavallo as from 1996. Cavallo's ego found this hard to forgive, and he dedicated himself to destroying it (charitably, he probably did not do so deliberately).
His first measure was to declare that the ideal for Convertibility was a free float, and then he turned on the President of the Central Bank (the only remaining member of the economic team that replaced him in 1996). The attack on Convertibility and the autonomy of the Central Bank laid the basis for a serious financial crisis and aggravated the decline in the real sector. In desperation, Cavallo accentuated his abandoning of the market economy and the return to active, discretional policies by means of the competitiveness programs. His messianistic approach led him to try to personally control all aspects of the country's economic and political life. In this he was helped by the incapacity and confusion of De la Rúa and the remaining politicians in the Alianza. From these black days of our recent past we can recall the superpowers granted, zero deficit targets and the intangibility of deposits.
The banking restrictions known as the Corralito are unprecedented in the economic history of nations and marked the end of Cavallo and the Alianza , which came about by means of another unprecedented event: the bringing down of a government by popular "saucepan" protests. In the end, the abominable Alianza policies implemented by Machinea and Cavallo achieved the notoriety they so dearly sought, placing Argentina on the front pages of the world's press.
The fall of De la Rúa opened the doors to government by lobbies and populism. Debt default, devaluation and asymmetric conversions into pesos are horrors that could easily be foreseen, given the systematic destruction of the socio-economic fabric perpetrated during the previous two years.
Once Pandora's Box was opened, no-one was able to close it.