Don't Cry for the IMF, Argentina
The Gazette (Canada), May 21, 2001
Knight-Ridder/Tribune Media Services, May 17, 2001
How many times can the most powerful financial institution in the world -- the International Monetary Fund -- make the same mistake? The answer seems to be: as many times as it wants to. As Argentina teeters on the brink of defaulting on its $150 billion foreign debt, and finance minister Domingo Cavallo jets all over the world trying to convince the financial markets that the inevitable is not going to happen, there is an eerie familiarity to the whole sequence of events.
Think back to November 1998: Brazil's currency was highly overvalued and most economists expected the peg -- its fixed exchange rate against the dollar -- to collapse. Enter the IMF, arranging a "rescue" package of $42 billion in loans, and its usual application of leeches to bleed the patient: sky-high interest rates and budget cuts, guaranteed to slow the economy and put the burden of "adjustment" on the poor.
Within two months the Brazilian real had collapsed anyway, leaving the country with nothing to show for the IMF plan but a pile of foreign debt and a stagnating economy.
Argentina may be headed for a similar fate. The Argentines pegged their currency to the dollar a decade ago, and the move is widely credited with helping to end an era of high inflation.
But there are disadvantages to a fixed exchange rate, and Argentina has come to see the worst of them in the last few years. As the US dollar rose in value the Argentine peso had to rise in step with it. When the Fed raised interest rates in the United States, Argentine interest rates had to go up too, even with their economy already in a slump. When Brazil's currency collapsed, it made Argentina's exports to that country inaccessibly expensive.
It all adds up to a finance minister's worst nightmare: an overvalued currency and a fixed exchange rate that many investors believe cannot hold. The country must borrow at ever higher interest rates, because of the increasing risks of both currency collapse and default on the foreign debt. And as the country borrows more, these risks increase. Argentina now has debt service that is approaching its total export earnings.
The IMF's role in Argentina, as in similar situations, is not helpful. First, they act as "enabler" for the loan-addicted government, providing enormous loans to prop up the currency. Some of the better-connected and wealthier investors are thus able to get their money out before the inevitable collapse, or even worse, to make a fortune by speculating against the domestic currency.
The IMF argues that to let the currency fall would risk a return to hyperinflation. But no such thing happened after the Brazilian real collapsed. And for the Russian ruble in 1998, where the Fund also wasted billions and bled the economy in order to prop up an overvalued currency, the result of the currency's collapse was even more favorable. Not only was the ensuing inflation easily manageable, the economy has since registered its highest real growth in two decades.
All this is consistent with standard economic theory. We would not expect terrible inflation from a currency devaluation in a country where imports are a relatively small fraction of the economy (about 11 percent in Argentina, 7 percent in Brazil). A devaluation of the domestic currency is often the best solution in these situations: it makes the country's exports cheaper and its imports more expensive, thus improving the trade balance and stimulating growth.
The Fund also plays another destabilizing role in these crises, by setting targets that the country's government must meet in order to "reassure financial markets." But these targets may be politically difficult to meet -- as well as unnecessary or even harmful to the economy.
And when the country fails to do what it is told, the crisis worsens. In Argentina's case the government budget deficit target for 2001 has been increased from less than 1 percent, to now 2.3 percent of GDP. These are very tight constraints for an economy in the midst of a long recession: for comparison, the US ran a budget deficit of 4.6 percent of GDP during our last recession (1991), and 6.1% coming out the previous, deeper recession (1983).
One year ago the Meltzer Commission, a bi-partisan Congressional panel appointed to review the IMF's practices, recommended a number of steps to downsize this institution, and reduce the likelihood of these repeated and often disastrous economic failures. Maybe it is time to put some of these reforms in place.