[A-List] Argentina on the Brink, an Austrian School Analysis

[Anne Williamson]

Argentina on the Brink

by Hans Sennholz


It is hard to exaggerate the economic and political conditions in Argentina.
With the economy in the grip of a paralysis, with unemployment soaring to
depression levels, and with street rioting killing 28 people just before
Christmas, the country is on the brink of civil war.

It was just over a decade ago, in 1991, that Argentina seemed to make a new
beginning after years of hyperinflation and "dirty wars" waged by the
military against fellow Argentines. When the gross domestic product (GDP)
had fallen for three successive years, with goods prices rising at
four-digit rates and the "australes" currency depreciating rapidly, the
government--under the leadership of President Carlos Saûl Menem, leader of
the Justicialist National Movement, or, as it is also known, the Peronist
Party--managed to enact a "stability and convertibility plan." It conducted
a currency reform, replacing the austral with the peso at a ratio of 10,000
to one in April 1991.

The exchange rate, which was conceived by politics rather than the laws of
the market, overvalued the new peso; the fear of public rejection of the new
currency prescribed the rate. The reform required the Central Bank of
Argentina henceforth to back all issues of currency with international
reserves, that is, primarily U.S. dollars. The Menem administration also
deregulated some small businesses and privatized many public enterprises. To
most Argentines, the future looked bright and prosperous.

Indeed, the country prospered for a few years, with GDP rising some 8
percent in 1992 and 7 percent in both 1993 and 1994. The rates of inflation
declined from 18 percent in 1992 to 7.4 percent in 1993 and 4 percent in
1994. President Menem also tried to cope with the chronic budget deficits
which always had been the primary driving force for the currency debasement.

As any cut in expenditures would invite instant voter objections and
political repercussions, Menem chose to raise the value-added tax from 16
percent to 18 percent and then to 21 percent, which has been the rate ever
since. Moreover, against strong opposition by militant labor unions, he
pressed on with the sale of some public enterprises, the proceeds of which
helped to reduce his budget deficits, and managed to strike a rescheduling
deal with foreign commercial banks, which restructured $23 billion in debt
and $8 billion of arrears.

Although the Menem administration brought relative economic stability
through monetary restraint, it could not resist the old Peronist pressures
for popular transfer spending. The 1994 budget provided for a $7-billion
boost in spending programs for the country's poorest regions, especially for
public works projects. The provincial budget was raised by $300 million. The
Social Security budget required $1.3 billion in subsidies to cover deficits
flowing from retrospective pensions, ordered by judicial rulings, for
100,000 recipients. At the close of the fiscal year, expenditures exceeded
revenues by some 10 percent.

In 1995, after much political maneuvering and numerous concessions to his
opposition, President Menem managed to be reelected to a four-year term. He
vowed to address social and environmental issues and promptly announced a
five-year public works program. When the Mexican peso collapsed and sent
shock waves throughout the hemisphere, the Menem program actually compounded
the difficulties. The growing deficits heightened the distrust and fear that
spread from Mexico and sparked a flight of capital from Argentina also.

The economic contraction caused tax receipts to decline sharply and the
deficits to soar, despite much pressure on the Menem administration by
Argentina's great creditor, the International Monetary Fund (IMF), to
control growth in public expenditures as a condition for obtaining
additional credits. But unable to reduce its expenditures significantly,
Menem preferred to extract more revenue: he managed to impose a new tax on
interest payable in order to equalize the cost of capital with the high
costs of labor. Because most corporations were suffering losses and
consequently paying no income taxes, the Menem government, upon IMF urging,
invented a new tax: a presumptive income tax which was levied on the assets
of every corporation. As any economist and businessman would surmise, both
new levies greatly aggravated the recession, thwarting new capital
investments throughout Argentina and creating more unemployment.

The Asian financial crisis of 1997 and 1998 cast more shadows on Argentine
finances. When the government proposed budget cuts to meet the targets
agreed upon with IMF and to underpin investor confidence, the president's
support from organized labor crumbled. When it proposed measures designed to
provide some labor-market flexibility, the unions answered by staging
massive general strikes, protesting Menem's pursuit of what they reviled as
free-market principles that left at least 17 percent of the workforce
without jobs. When the Menem administration sought to curb expenditures
through cuts in school funding, it brought student strikes and protest
resignations of school officials.

The country's slide into recession accelerated when Argentina and Brazil
managed to get involved in an ugly trade war. Brazil fired the first shot
when it suddenly devalued its currency. Fearing a flood of cheap Brazilian
imports, Menem imposed protectionist measures on Brazilian shoes and
textiles. Brazil retaliated by imposing restrictions on 90 percent of
Argentine imports. In both countries, production fell precipitously and
unemployment continued to rise. Both countries managed to secure more loans
from the World Bank, the International Monetary Fund, and the Inter-American
Development Bank. It was left to Fernando de la Rúa, who won the Argentine
presidency in October 1999, to calm the waters and reduce the frictions with
Brazil.

The new president led an alliance of the Radical Civic Union and a new
Solidarity Party, a splinter of the Peronists. The Peronists remained in
control of the senate and the judiciary. Having inherited a huge deficit
from the Menem administration, the new president responded with new tax
levies and some spending cuts. His first policy initiative was a significant
tax boost which raised not only the sales tax on many consumer goods and
services but also the income tax rates for wealthy individuals. Very wealthy
Argentines earning $3,500 a month, or $42,000 a year, suffered a 200-percent
increase.

Under great pressure from the IMF to cut expenditures in order to receive
fresh funding, de la Rúa took special aim at wasteful expenditures by the
provinces whose debts exceeded $18 billion, with the federal government as
guarantor. The new president's strategy for lowering the 15-percent
unemployment rate was to reduce the fringe costs of labor. A labor code
passed during the 1950s provided for a 30-day probation period with lower
costs and fewer restrictions for new workers. A new code extended the
conditions to six months in larger firms and twelve months in smaller
businesses. The payroll tax on new hires was reduced from 17.5 percent to 12
percent.

With the country in the grip of economic stagnation, unending budget
deficits, and rising foreign debt, by now exceeding $120 billion, the costs
of servicing the debt soon rose to 15 percent. But again the World Bank and
the Inter-American Development Bank came to the rescue, pledging $40 billion
in new loans. The terms for the assistance were simple: reducing the 2001
budget by $700 billion, lowering taxes on corporations, trimming
public-sector salaries by 12-15 percent, slicing pensions, and privatizing
some pension funds.

While Argentina's creditors were pointing toward genuine solutions, the
Argentine public showed a growing weariness about the prospect of ever more
"austerity." Led by the media, militant union leaders, and vocal civil
servants, they often marched and demonstrated in protest. When the unions
called general strikes, millions of workers paralyzed the economy, blocking
highways, disrupting transportation, closing schools, and damaging business
property. Unemployment continued to soar, and underemployment soon affected
nearly 50 percent of the workforce.

Shortly before Christmas 200,1 popular anger finally boiled over when the
government froze all bank accounts to protect the banks from failure. They
had lent the money to the government, which had defaulted in its
obligations, and to businesses, which were about to fail under the burden of
losses and new tax levies. The Argentine banking crisis obviously is the
consequence of debtor insolvency. Yet, all banks, domestic as well as
foreign, applauded the government for the freeze and chose to fight the
depositors who demanded the return of their property in the currency in
which it was deposited.

Buenos Aires erupted. While most people demonstrated peacefully, some
revolutionaries clashed with the police, leaving 28 people dead. It drove
Fernando de la Rúa from the presidency after just two years in power. In his
place, the Argentine Congress installed Adolfo Rodriguez Saa, who resigned
after just eight days in office. Congress promptly replaced him with Eduardo
Duhalde, a representative of Peronism's powerful political machine. He is to
revive the economy, stem the tide of violent protests, and save the
political system.

* * * * *
Great crises call for extraordinary measures that redress the causes of the
evil. The Argentine crisis presents not only great dangers to the country's
political and economic order but also an opportunity for a new beginning.
Attempts at reform, when they fail, aggravate the situation, as the numerous
attempts by the Menem and de la Rúa administrations so clearly demonstrate.
They merely hacked at the branches of the evil; they did not strike at the
very root, which is a pervasive entitlement ideology--that is, the common
conviction that everyone is entitled to economic benefits at the expense of
others.

This is clearly visible in the chronic inability of government officials to
balance their budgets. In boom and recession they are unwilling to live
within their means. And it is visible in their loud protests against
"austerity," that is, against any reductions in deficit spending. They could
always count on the support by the International Monetary Fund, which could
be persuaded to extend old loans and grant new funds. It provided the
backing for more issues of pesos used to finance the budget deficits.

Few foreign loan funds reached the business investment market. The dollars
and pesos caused Argentine prices to rise faster than foreign prices, which
led to chronic balance-of-payments deficits. In time the central bank ran
short of dollars, which prompted the government to suspend all payments and
seize private accounts. In good times, government may lower its exactions;
in bad times, it will raise them; and in moments of crisis, it may seize
whatever it needs.

The financial world is doubting Argentina's viability. It is ever fearful of
looming political turmoil and the chronic risk of government profligacy.
Indeed, it is difficult to have confidence in the country's political
leadership that is managing the people's economic affairs. Argentina is
merely paying for mistakes similar to those many other countries are making
or have made in the past. Proud and overconfident people seldom learn from
the mistakes of others; they are convinced that they face special problems
of their own.

Argentina's new administration faces two ghastly problems that drive the
increasingly violent protests. It must tackle the problems of its chaotic
money and banking and solve the explosive issue of unemployment and
underemployment, which by now affects one-half of the population. The future
of Argentina's political economic order, as well as Duhalde's own political
fate, depends on the solution of these problems.

The most pressing financial issue is the future of monetary management, in
particular, the future of the peso that was pegged to the dollar at parity.
Related issues are the freeze of dollar deposits imposed by Duhalde's
predecessors, and the default in meeting foreign dollar obligations. At the
beginning of February 2002, Duhalde sought a solution by returning to the
currency system of the past: the floating peso, which, left to the market,
immediately fell substantially. A low rate, he argued, would be Argentina's
best way out of recession and the best protection against foreign
disruption. Other big emerging countries, such as Brazil and Mexico, now
have floating exchange rates.

While economists always favor a return to market pricing, which reflects the
people's true valuations and choices, they dread the fact that the fiat peso
is the wanton creation of spendthrift politicians and government officials.
In their hands, it is bound to be depreciated and ultimately destroyed like
all other issues before it. And to conceal the gradual destruction of the
peso, the same politicians and government officials will enmesh the people
in countless regulations and controls which surely will create economic
chaos and give rise to a brutal command system.

The immediate cost of the float is insolvency for countless
debtors--individuals, businesses, and banks alike--as most debts are
denominated in dollars while most incomes are in pesos. Two-thirds of bank
deposits are in dollars as are most loans. U.S. dollar deposits are
converted to pesos at the rate of 1.4 pesos to 1 dollar. As the banks suffer
an instant loss of 0.4 peso on every dollar conversion, they are to be
compensated with government bonds.

In the money markets of the world, the peso actually fell to 2.15 pesos to
the dollar, which conveys the full loss of all dollar depositors. They are
likely to lose more in the future as the peso continues to depreciate and
the restrictions on the withdrawal of dollar deposits continue in effect.
Dollar debtors owing pesos to domestic creditors do profit from the
conversion as the peso depreciates. Dollar debtors to foreign creditors may
be crushed by the conversion; their debt has doubled in terms of pesos. Many
corporations with foreign-dollar obligations, which the Argentine government
cannot convert, may face bankruptcy.

The peso float has special ramifications for big Argentine banks, many of
which are foreign-owned. They can be despoiled like all other financial
institutions, but foreign banks may also leave the country and seek redress
and compensation for contract violations in foreign courts of law. These may
even seize Argentine government and corporate property and distribute it to
the plaintiffs. A chronic debtor who continually depends on foreign
assistance is ill-advised to shortchange his creditors. Yet the Argentine
government may seek and receive support from the agencies of other
governments.

Throughout its financial difficulties, Argentina always has had the advice,
guidance, and support of the IMF, whose funds come mostly from the
treasuries of wealthy countries. The IMF helped to build the mountain of
debt until it crushed the debtor. It carries a large share of the
responsibility for the Argentine crisis. Naturally, it denies all and points
to the debtor. The Argentina experience raises agonizing questions about the
existence of such an international institution.

IMF officials are working toward an international arrangement that would
provide prompt relief for insolvent debtor governments such as Argentina.
They are lobbying for measured, uniform reductions of creditors' claims,
which would reduce the debtors' reliance on IMF resources and rescue and
shift some of IMF's chronic losses to member governments. While IMF
officials are hard at work, it is unlikely that such a rescue operation will
be adopted in time to benefit Argentina.

The Duhalde administration will have to present a believable economic
program to the IMF, that is, another austere budget and another fiscal
reform, which will allow it to resume its support. Duhalde will have to
negotiate with various debtor groups of governments and banks for moratoria
permitting temporary suspension of payments or some reductions of debt. Of
course, such creditor favors impede the reputation of the debtor and raise
substantially his future interest costs.

Reform must come from within; it cannot be imposed by a creditor. A genuine
change for the better requires the support of the people; without it,
nothing can succeed. Someday the Argentines may be ready for a reform that
regenerates and revitalizes the economy. They may demand freedom in all
monetary matters: the freedom to enter into any currency contract of their
choice, whether it be U.S. dollars, the euro, the peso, or even gold.

In a free and unhampered contract system, creditors and debtors, banks and
depositors would soon come to reasonable and fair agreements about their
contractual relations. A contract system would call for no new taxes, not
even compensation for harm done by law and regulation. It would reopen all
banks and allow them to meet their obligations to the best of their ability.
It would expect the government to honor its peso obligations and manage the
peso as it pleases. But it would demand that government cease and desist
from any more regulations, new outlays, new taxes, and new disruptions of
any kind. The Argentinnes need time and a period of peace for recovery.

There is transcendent power in honesty and integrity. Argentina can reform
itself and lead the way. Perhaps it can offer a valuable example by setting
its people free in all matters of money and credit; toward that end, no
international assistance is needed, not even from the International Monetary
Fund.

* * * * *
The Duhalde administration also faces the severe problem of mass
unemployment, which is as explosive as the financial situation. While
middle-class victims may be demonstrating in front of their banks that are
barred from releasing their savings, unemployed workers may be rioting in
the streets and ransacking public and private property. Therefore, the curse
of chronic unemployment needs to be lifted forthwith.

The economic and monetary policies of both the Menem and de la Rúa
administrations obviously caused the mass unemployment. They aggravated the
chronic maladjustment of the costs of labor and the productivity of labor.
It is conceivable to have stable money and yet suffer rising unemployment.
Under certain conditions, even a country with a gold-coin standard can
experience rising unemployment, if labor costs rise faster than labor
productivity, if the least-productive labor becomes loss-inflicting labor
and is made unemployable. Labor productivity may decline for any number of
reasons, but the costs of labor may not decline or may decline at a lesser
rate than productivity, which makes marginal labor unemployable.

The decline in labor productivity may not be the fault of the labor that is
discharged, although it is always the least-productive labor that is let go
first. Labor productivity tends to fall in a recession when business must
readjust to market conditions; or, it may fall as a result of trade
disruptions and trade wars with trade partners; or, it may fall on account
of new government intervention by way of economic laws, regulations, or
taxation. Business capital may be consumed through government deficit
spending that preempts the capital coming to market, or the fear of future
intervention may cause business capital to escape to safer employment or
safer harbors abroad. Whatever affects the productivity and costs of labor
affects the employability of labor. In Argentina, all these causes were at
work to increase the army of unemployed.

Mass unemployment such as that in Argentina and several other countries
around the world is conceivable only in countries with regulated labor
markets. Millions of workers may be prevented from freely marketing their
labor, which then condemns them to chronic unemployment and dependence on
their fellowmen. In a world of need and scarcity, with human labor the
scarcest of all factors of production, millions of poor people walk the
streets in idleness and despair. It is one of the great economic and moral
evils of our time.

Little notice is taken of a little evil, but when it reaches the proportion
of mass unemployment, it calls for confrontation. Perhaps evil cannot be
totally extirpated from the world where it resides in human nature, but
perhaps it can be ameliorated where it springs from ignorance and
inexperience. Mass unemployment, this writer sincerely believes, is the
inevitable consequence of erroneous economic notions and theories. These can
be exploded, discarded, and replaced with correct explanations that may
provide guidance in avoiding the evil.

Both the Menem and de la Rúa administrations made several meek attempts at
adjusting labor costs to labor productivity by reducing some fringe costs or
imparting a measure of market flexibility. Yet, the rising rates of
unemployment clearly reveal that labor productivity soon fell faster than
the reduction in labor costs, which made marginal labor loss-inflicting.
Every such attempt met vocal opposition from individuals called upon to
adjust by suffering reductions in income and benefits.

Government cannot conquer economic principle which springs from human
nature; it cannot legislate full employment. To reform the body politic, the
laws and regulations of which cause mass unemployment, is a difficult and
tedious task. Any effort to reform must ever be mindful of Solon's advice
that "no more good must be attempted than a nation can bear."

To achieve full employment but being unable to move the body politic, this
economist, therefore, would call for no reduction in pay or benefit, no
reduction in vacations or pensions, no increase in effort or labor time, nor
even a cut in taxes. He would merely allow all unemployed individuals, male
and female, old and young, to accept employment solely under contract
conditions which they alone determine. Individuals walking the streets in
idleness obviously would suffer no reduction in pay or benefits by accepting
employment under their own conditions. And government would suffer no loss
in revenue by allowing them to work without immediately imposing a
17.5-percent payroll tax. Such action would give them latitude, which is
also the freedom for all individuals to work as they see fit, so long as
they do not inflict harm on others. It is an economic necessity and a moral
imperative.

It is time for Argentines to cash in their experience with government power,
government law, government regulation, government money, and government
care. They attended a hard school and paid high tuition. It taught all who
cared to learn that, after every conceivable political device has been tried
and found wanting, there remains freedom. When political minds are unable to
concoct yet another law or regulation, another scheme or another care, there
always is freedom. It is the very last hope, short of despair.


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Hans F. Sennholz, emeritus professor of economics at Grove City College, is
an adjunct scholar of the Mises Institute. Send him MAIL. See also his
Mises.org Articles Archive and his Personal Website.


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