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Don’t Devalue in Argentina

Matt Craighead

In the aftermath of Argentina’s economic collapse, there is no shortage of blame being thrown around. The forces opposed to globalization argue that we have witnessed a failure of “neo-liberal economics.” Others say this is a reason for us to hand over more of our money to the International Monetary Fund (IMF) to bail out such countries. And some have taken this opportunity to push the economic snake oil of “devaluation.”

Argentina’s most immediate problems are twofold. First, the country has a $150 billion debt and is unable to make its interest payments. Second, it has been in a deep recession for several years. Fernando de la Rua, president up until his recent resignation, did his best to handle the debt, but his actions worsened the recession. He raised taxes repeatedly to try to cover the budget deficit; yet the deficit grew instead of shrinking as the economy suffered under the oppressive tax burden. He tried to implement “austerity” packages (in short, government spending cuts), but opposition politicians blocked even the most necessary cuts. In the meantime, he and his economy minister, Domingo Cavallo, begged for assistance from the IMF, in the form of loans from wealthy countries.

When the IMF recently refused a badly needed loan package, the house of cards collapsed. Without cash on hand, the country was unable to make payments on its debt. Raising taxes would be equivalent to squeezing blood out of a stone, and as President de la Rua attempted to implement a bare-bones budget to keep the country alive, the mob took to the streets. In the ensuing violence, he and his entire cabinet resigned.

Many say that the only solution for Argentina is a combination of a devastating default and a massive currency devaluation. On the matter of the default, I agree -- there is no alternative. Argentina simply cannot service its debt. Indeed, the recession, not the debt, is the real problem. If Argentina’s economy were healthy, the budget could be balanced easily. But default solves only some of the problems.

Argentina’s currency, the peso, is currently linked to the dollar at a one-to-one ratio via an arrangement known as a “convertibility system.” Cavallo and former President Carlos Menem conceived the convertibility system in the early 1990s as a solution to Argentina’s chronic hyperinflation, and it succeeded. Whereas inflation in Argentina was at least 90 percent every year from 1975 to 1990, once the peso and dollar were linked, inflation essentially disappeared.

If you believe the sophistry of such columnists as Paul Krugman of The New York Times, the convertibility system is Argentina’s problem. Krugman, among others, believe that the peso must be devalued to make Argentina’s export businesses competitive. Whereas today the government will exchange one dollar for one peso, after devaluation it might only give a dollar in exchange for 1.4 pesos. Then, products made in Argentina will appear at first to be 40 percent cheaper for foreign buyers.

The key words being “at first.” Such an analysis ignores the many downsides of devaluation. There are four major problems. First, though exported goods may be 40 percent cheaper, imported goods will now be 40 percent more expensive. Second, economic arrangements made under the presumption that the dollar and peso remain linked will be heavily disrupted. Third, devaluation constitutes an immediate confiscation of 40 percent of the wealth of every Argentinean by the government -- a massive breach of property rights. And finally, Argentina’s debts are denominated in dollars and thus are 40 percent larger, making things worse, not better.

Indeed, the claim that exports will become more competitive is itself not necessarily true. For example, if a company in Argentina made a product whose cost was primarily composed of imported goods, the cost of production in pesos would become 40 percent higher, and the price of the product in foreign markets would not decrease at all. On the other hand, if the cost of production were primarily made up of domestic labor costs paid in pesos, workers would realize that their wages had suddenly dropped by 40 percent and would demand pay increases. If such pay increases were widely granted, then exports would be no more competitive; if they were not, then Argentina’s standard of living would drop.

Devaluation is little more than a shell game. However it is accomplished, it simply transfers wealth from some people to others. Many of the measures recommended by supporters of devaluation to cushion some of its negative side effects make this clear. For example, Paul Krugman (who claims he is opposed to a default) says that Argentina should redenominate its national debt in pesos rather than dollars prior to devaluing; yet such an action is itself a default! Others have suggested that all bank deposits and loans in Argentina, not just those of the government, be converted as well; this would cripple the banking system, eviscerate private property rights, and forever destroy savers’ confidence that their money is safe in Argentinean banks.

If Argentina is not competitive in world markets, the only real solution is increased productivity. First, the government should make it clear that it is not interested in the devaluation shell game by implementing full dollarization, at a rate of one peso to one dollar. This will demonstrate to all Argentineans that their money is safe and eliminate the specter of currency risk that hangs over the country, discouraging investment of all kinds.

Second, it must embark on a comprehensive plan of tax reform and tax cuts, while at the same time cutting back on wasteful spending to keep the budget in check. President de la Rua’s tax increases have caused nothing but trouble. Finally, the government must vigorously renew efforts to liberalize its economy, efforts that stalled in the mid-90s; especially in its calcified labor market, and by enforcing property rights and opening its borders to more trade. Only then will true competition and economic recovery come to Argentina.