This is not a technical article. It just puts together some commonly known facts and asks some questions; it also includes some thoughts.
Facts (or, shall I say, Problems?):
- Argentina’s “un-edited” (i.e. true) 2007 annual inflation rate is in the 20-25% range.
- Wage contract negotiations are presently taking place. It looks like unions are requesting wage increases starting at 30% and up.
- Although claiming that the latter contract renewals might be biannual, unions are requesting to being able to renegotiate them every six months.
- As the piece by Mark Turner (here) pointed out, the current account surplus results from (the still high) external demand; it is not due to the artificially undervalued currency.
- Jose Antonio Ocampo (here) highlights how the mentioned surplus is mainly due to capital flows instead of a trade surplus.
Given all of the above, Argentina’s authorities should be really worried (although the claim not to be.) Why? Well, not only the inflation rate is high, but it looks likely to accelerate. This can be seen by facts (1) and (2). Together they imply that unions are probably observing a reduction in the purchasing power of wages (past and future.) Since any wage negotiation in the context of an inflationary process should be both backward- and forward-looking, this means that: (i) not even “official” unions believe in the massaged official inflation rate—they understand that the true inflation rate experienced by workers have been higher that the government’s figure; (ii) they anticipate a high inflation rate for this year (probably not lower than last years’; my “gut feeling” guess in the 35-40% range); and (iii) there are reasonable chances to expect the inflation rate to accelerate, which generates the need to have a sort of “escape of clause” to re-negotiate every six months.
You do not need to be an economist to realize that a higher frequency of contract renewal is based on an expected increase in the rate of change of prices. Unions sit at the negotiation table trying to recover the lost purchasing power due to past inflation (the backward-looking component) and taking into account their expected inflation (the forward-looking component.) And like I said, the faster they expect inflation to increase, the sooner they would like to renegotiate.
Thus, and contrary to the administration’s intentions, inflation expectations are not being anchored. The more so if (as analyzed in my January 29th) we also consider the potential (intertemporal) fiscal fragility of the government.
The academic literature has shown that inflation reduces long-term growth. Even though the global economy has been growing at high rates during the last years, things seem starting to change. We could expect the “tail wind” (i.e. external demand boom) that Argentina enjoyed to slowdown (in the best case scenario.) The administration is currently trying to engineer lower borrowing rates for long-term investment projects (especially if they are export-oriented.) This is not wrong, but it arrives late. This should have been the engine of growth instead of domestic consumption in the very recent past if the goal was long-term growth. They are also differing things in the expectation of a better second half of 2008 (shouldn’t they be planning and applying contingency plans ex-ante instead of acting ex-post?)
Lower, non-increasing, and credible inflation, as opposed to the current policy, will boost long-term growth since it stimulates longer horizon investment projects and increases the expected real rate of return on those projects. Current investment is mostly driven by short run expected sales rather than long run demand. It also improves income distribution (more here). As mentioned above, the piece by Mark Turner shows how we should have expected the same current account surplus regardless of the exchange rate. The difference being the non-trivial point that Brazil obtained it at the same time that its central bank was able to dominate the domestic inflation rate (and with no observable drawbacks in terms of growth; on the contrary, but based on higher productivity instead.) Or, as the piece by J.A. Ocampo highlights, that the accumulation of reserves is mainly borrowed (and thus more unstable since as easy as they entered the country, they can leave it; and capital controls never work.) The more so in the Argentine case in which close to half the international reserves are reduced by the central bank’s domestic liabilities (NOVAC, LEBAC, etc.) And praying for the commodities’ high prices not to be the next bubble to explode…
So far what the government is doing is clearly not going to control inflation. It does not anchor inflation expectation neither with its monetary policy, nor with its exchange rate policy or its fiscal policy. On the contrary, it looks more likely to make it get worse—inflation seems to be accelerating. The median voter seems to be happy with this policy, though. But it’s the policy maker’s role to appropriately consider and internalize the future effects of the current policies and adjust its present behavior accordingly—something not seen yet with the current administration.
It could be much better if the government would focus on reducing government expenditures (not just reduce the rate of growth to be lower than the growth rate of tax revenues—which are just casually high do the unusually high commodities’ prices) to achieve not only a higher and stronger primary fiscal surplus but also to enhance its sustainability. It should also let all relative prices be really free to adjust to equilibrate demand and supply (i.e. eliminate all the price controls and any type of capital controls) and let the exchange rate float. If relative prices are let to adjust, as well as the exchange rate, they will stop the growth rate of prices (i.e. inflation) and contribute, together with a non spurious fiscal surplus to contain inflation expectations—and thus wage negotiation adjustment (in quantity and frequency.) Core inflation would then be tackled with an inflation targeting regime, letting an independent central bank focus on its only goal: to preserve the value of the (domestic) currency. As of now, it will probably be better to raise interest rates to control the inflation in the short run while the rest of the reforms are put in place (including property rights that we could believe in—i.e. proper long-term institutions.). The question is, will this government be interested in implementing these and thus pursuing long-term and sustainable growth? I truly hope it. Unfortunately, I still have my doubts.