Nicolas Magud | Sep 8, 2008
The pro-cyclicality of Latin American fiscal policy has been extensively documented (see e.g., Kaminsky, Reinart, and Vegh (2004), Talvi and Vegh (2005), Hausmann and Gavin (1997) among many others). The recent boom in commodities’ prices that started in the early 2000’s add one additional set of observations to extend this literature, albeit with some important differences.
Some countries internalized the temporariness of the boom in commodities’ prices and fiscal expenditures were increased accordingly. One example of the latter could be Chile, where what can be computed as the permanent component of the terms of trade shock can be spent while the transitory component has to be saved for the long-term purposes. In a way, another case can be made of Brazil were the government stimulates investment in the agricultural sector to take advantage of this boom such that that the country can obtain long run benefits of this temporary boom. The list does not end here.
However, other countries did exactly the opposite: spend permanently based on this transitory shock. Argentina, unfortunately, fits this case. Government expenditures have been increasing at very high rates—higher than GDP. Granted, tax revenues also increased substantially—the economy emerging out of one of the worse crises in its history jointly with the international boom in commodities’ prices and an increasing inflation, though (i.e., based on temporary sources).
Commodities’ prices have been (as expected) progressively reverting down—a correction to their long-run level—and this could be expected to continue. At the same time, international financial turbulence started over a year back and it is still not done. During this time period, as mentioned above, Argentina has been engaged in a spending spree that has accelerated, among other things, due to subsidizing consumption as the “anti-inflationary” strategy—along with price controls. It is not the purpose of this piece to elaborate on the causes of this explosion in government expenditures; although the main reasons seem to be political objectives matched with some misunderstanding of (short-term vs. long-term) macroeconomic management.
It’s worth mentioning that (only) some current measures seem to go into the correct. However, will that be enough? That still needs to be seen. So far, the measures look more like stray signals rather than a true and deep change in the macroeconomic policy. This is not without a cost, though. Even if the government engages in the required long term corrections, given the delay already observed, regressive income distributions could happen. History has a lot of observations that show how populist government expenditures pro-cyclicality end.
Given the observed response of government expenditures to these external shocks, some yellow lights are:
1. Fiscal fragility (and capital account?) likely to worsen. Expenditures: Will government expenditures be reign in? Actually, it looks like the opposite—as per the 2009 fiscal budget act project. The government is looking for alternative instruments to finance higher expenditures—like enabling the currently forbidden lending from the Banco Nacion (the major national public bank, where the government deposits its money), but not reducing them. The latter resembles, in some aspects, the old-fashioned (central bank’s) quasi-fiscal deficit which tends to worsen inflationary situations. Some cosmetic accounting has been used to try to show a fiscal surplus that is not really as strong as claimed (central bank transfers plus arrears)—so now even the flow balance is becoming fragile—not to mention the intertemporal stock. On the revenue front, if commodities’ prices keep on correcting and the real exchange rate appreciating (domestic inflation plus an appreciating dollar as commodities revert to long-run trend) they would tend to decrease. And what if the current account moves to a deficit (chances now increasing)? What will happen with the quasi-fixed exchange rate? Will the so-called “exchange scarcity problem” reappear?
2. Financing problems. High interest rate: lack of international lending to Argentina; that’s why the administration decided to repay to the Paris Club (in cash though, instead of through the IMF, as would have been wiser). Showing this willingness to pay is good news but not enough and probably with less impact on the country’s credit constraints than truly putting the macroeconomic policy in a sustainable path. Let’s notice that even though the repayment might (marginally) reduce the interest rate, this effect favors investment projects. Without correcting the whole macroeconomic policy-frame investments are unlikely to be many anyway. That means spending almost 15% of international reserves (close to $7,000 out of $47,000) for probably not much future return—losing reserves when the world economy will probably provide less foreign exchange to Argentina as commodities’ price decrease and the world economy slows down—increasing the chances of systemic risk. Worse, the only “benefits” would be more expansionary aggregate demand (not surprising given elections next year). The latter, jointly with any interest rate reduction will clearly not contribute to control the high domestic inflation.
3. Inflation. Domestic inflation has substantially separated from world inflation. However, so far the government seems to lack an inflation stabilization plan—other than stabilizing at the already high levels, which depresses long-term growth.
4. World economy slowdown. The U.S. seems to be headed to slower growth—in the brink of recession. Europe and Japan do not look much better. This is likely to affect Asia since the latter’s exports are mainly driven to developed countries. As a collateral effect I can not discard some effects on Brazil, a huge trade partner to Argentina which, by the way, has done the right job by tending to cool its economy to keep inflation under control. This is not without recessionary impact, as should be; thus, all else equal this would contribute to worsen Argentina’s external balance.
Notice that all of the above, among other things, involve a strong control of government expenditures as (part of) a corrective device. Reduced public spending not only increases the present fiscal balance, but also improves its future stance. It ameliorates the government financing pressures, contributes to control the inflation rate by reducing aggregate demand at the same time that frees up financing resources (and reduces interest rates) for the private sector—the old-fashioned “crowding-out” effect—and tends to depreciate the real exchange rate, thus helping the exporting sector.
All in all, it seems that Argentina needs a comprehensive macroeconomic reform to wisely take advantage of the commodities boom windfall, and stop always being behind the curve. The problem is that this external shock is currently slowing-down for good. So far, the country has only benefited from the boom’s short run externalities, discounting the long-term effects as second order. The above points just signal the lack of this type of strategy, and implies that not only has Argentina not paid much attention to the (infrequent) opportunity that the world economy has provided to catch up with the developed world—it has almost nullified its long-run positive effect. This seems to be a positive externality. However, Argentina is responding with a negative strategic complementarity…
Notice that since debt obligations involve a temporal links, fiscal policy is extremely important. Not only past and present fiscal policy matters (reflected in (1) above), but also the future effects of current fiscal policy ((1), (2), and (3)), as well as the current expectations on future fiscal policy ((1), (2), (3), and (4)). Let’s add that 2009 is an election year and the administration since 2003 has pursued aggressive fiscal expansions during election times. The more so for a politically weak government (i.e. a government with a low political capital) that does not internalize the amplification and propagation of its own policies and the world economy’s shocks into the future of the country’s volatility and growth.
On a positive note we can argue that for this to end on an economic crisis we need to observe some events with joint probabilities that are difficult to happen. On a negative note, however, although difficult, these joint probabilities seem not impossible—and the government contributes to make them more likely.
 See Izquierdo, Talvi .and Ottonello (2008) for details.