ARGT - A Chainsaw For Argentina?

2023-11-17 07:30:28 ET

Summary

• After decades of economic decline, crisis, defaults, and bouts of high inflation, Argentina is facing crucial elections which could short-circuit some vicious cycles.
• In theory, it's not hard to put the economy on a sound footing, closing the (moderate) deficit and making the central bank independent would be a good place to start.
• But peculiar dynamics that created a number of vicious cycles in the interplay of economics and politics make this a lot harder in practice.
• We think that more dollars coming in next year and the necessity of change are causes for guarded optimism.

In theory, Argentina should be a wonderful place for investors. It has fertile land from here to eternity, abundant natural resources, beautiful cities and dramatic landscapes, world-class wines rivaling those of the French, and a creative population largely of European descent, and it could still be called a successful multicultural society.

Yet the country, a century ago one of the richest in the world, has fallen into economic decadence for decades that has almost made the word Argentina synonymous with default and economic crisis.

One of these economic crises has been hitting again, with rapidly rising inflation (now well into triple-digit territory), rising poverty, and stagnant production.

We weren't surprised therefore (in fact, we predicted it) that Javier Milei, a somewhat eccentric libertarian economist with no experience in political office or running government, won the first round of the elections (the so-called PASO).

There is clearly a case to be made for radical change, and it rarely gets more radical than the change Milei is proposing. This Sunday is the final and decisive run-off between Milei and the present Economy Minister Sergio Massa, and it's running neck-and-neck.

Outsiders might wonder how an Economy Minister presiding over severe economic problems can be competitive in a national election.

One reason is that he was brought in at a relatively late stage and has a really unusual capacity on the campaign and in TV debates to almost completely dissociate himself from the government or even his party, posing as a well-tempered moderate problem solver who will open the door to a new Argentina through presiding over an as of yet unspecified 'unity' government.

He is also cashing in on fear about the personality and policies of his opponent and has been liberal with pre-election state handouts ("plan platito") that dressed him up as a benefactor of the poor and the retired, his main constituencies (especially in the capital suburbs known as Gran Buenos Aires).

Not even some spectacular political scandals plaguing his party in the last couple of months seem to have dented his image and his opponents were hapless in exploiting these.

What's wrong with Argentina?

There are more structural reasons why Massa's party is still competitive (Massa might very well win after a particularly poor last TV debate showing of Milei, we conceded), and these go to the heart of what ails Argentina, a particular economic dynamic driven by economic instability that has set in motion a set of self-reinforcing feedback loops.

The saying goes that there are four types of economies, developed countries, developing ones, Japan, and Argentina, the last two are clearly outliers on opposite parts of the spectrum.

Between 1950 and 2022 the country has experienced 18 recessions, which must be a world record, and many of these recessions have not your average garden variety sort but deep crises plunging people into poverty.

It's the macroeconomic instability that is the main (albeit not the only) problem of Argentina setting in motion several self-reinforcing feedback loops:

• Cycles of boom and bust dramatically shorten the investor horizon and therefore act as a big deterrent to investment. Over decades this has changed the economy from one of the richest in the world to a troubled one with a 40%+ poverty rate.
• Where Japan is able to run enormous public deficits and carry mind-boggling amounts of public debt (250% of GDP, thereabouts), much of it absorbed by endless asset buying of the BoJ without this apparently affecting people's trust in their bonds or currency, Argentina has the opposite problem, having developed a sixth sense for impending doom that leads people run from the peso (into the US dollar) at the first whiff of peril, setting in motion a self-reinforcing feedback loop that tends to end badly.
• Cycles of boom and bust worsen the dependency cycle as generally only half of those from the middle class who lost their shirt during a crisis tend to make it back during the subsequent recovery and many companies that have gone bust never recover (a phenomenon known as hysteresis in economics). The swelling ranks of the dispossessed clamor for state assistance which one part of the political spectrum is happy to provide, ballooning the state and the tax burden on the active in the process. Each new cycle worsens this dynamic.
• In order to be seen as doing something to relieve economic pressure from the poor, governments (more especially Peronist governments) tend to introduce a host of market distortions to plaster over the problems (import controls, a bewildering number of different exchange rates, taxes on agricultural exports, price interventions, etc.) that only worsen the economy structurally over time.

How to fix Argentina

In theory, the Argentinean economy isn't hard to fix, even if the above-described dynamics and the political complexity make this hard in practice. Three simple and straightforward propositions would do most of the heavy lifting:

• Close the budget deficit
• Make the central bank independent
• Liberalize the labor market and other distortions

Budget deficit

Given the history of defaults, nobody in their right mind would lend the Argentinean state any money. Given a paucity of domestic savings, this leaves monetary finance as the default option.

This lies at the root of the lack of trust in the currency, which is now so ingrained in the psyche that people sell pesos at the first whiff of danger, often setting in motion self-fulfilling prophecy-producing cycles of macroeconomic instability which we signaled above.

Solving this dynamic can't escape eliminating the budget deficit. Without a deficit, there is no need for money printing and a major source of macroeconomic instability will be eliminated as well.

It will take a long while (think a decade or more) for confidence in the peso to improve structurally, so they will have to keep at it. There are some favorable circumstances that will help:

• Vaca Muerta, the immense shale oil and gas field in Neuquen provide which is set to change the country's energy balance.
• Lithium demand is taking off with Argentina having enormous potential.
• A severe drought that plagued Agricultural exports last harvest and greatly added to the dollar shortage isn't likely to repeat this year.

Lithium and Vaca Muerta can produce a current account surplus and sound public finances will gradually improve the capital account together these have the potential to reduce economic instability and lengthen investment horizons, which has the potential to turn the negative dynamics into positive ones.

No reform program will be successful without addressing public finances, it's the essential part of beginning to create some credibility and hence stability.

Central Bank independence

The libertarian contender for the Presidential elections this weekend, Javier Milei, proposes to abolish the central bank altogether and dollarize the economy.

It's noteworthy that his recent article in The Economist only explains the advantages, completely leaving out the two main disadvantages:

• Argentina would lose exchange rate and monetary policy, one might want to ask people in Italy and Greece how that worked for them in the last decade.
• There are no dollars to dollarize the economy (even importers have rapidly rising bills to pay in unavailable foreign currency).

While doubling down on the proposal in the last TV debate in rather abstract terms, he's been short on specifics and time frames, but in any case, it's not going to happen as there is a large majority against it and it entrails a host of practical problems that seem insurmountable (there is a rapidly growing mountain of central bank peso liabilities with short maturities, to mention one).

In any case, the combination of a balanced budget and central bank independence (and a law prohibiting the CB to finance public deficits) is a superior alternative for tackling the root cause of macroeconomic instability and reducing inflation.

This works for almost any other economy, and it should work for Argentina as well, although it will take a long time for some confidence in the peso to return, which is why we can see the attractiveness of dollarization at least in theory as it would be a quick-fix for the confidence problem.

Market reforms

Liberalizing the labor market will make have to make hiring and firing easier and (notoriously complex and expensive in Argentina) less costly and time-consuming, which would help create jobs.

As the economic literature (perhaps surprisingly) shows, the advantages should not be overestimated. The labor market is no ordinary market, and there are often additional ways to produce the necessary flexibility.

For instance, Japan has a notoriously rigid labor market where it is difficult to fire people, but it gets its flexibility from increasing/decreasing pay bonuses and a wide latitude in job descriptions.

Other countries have created flexibility through the creation of temporary jobs (Spain's notorious dual-labor market), and part-time jobs (the Netherlands), for instance.

But we would still argue it's a necessary element of any reform package in Argentina as it would help get more people into the formal sector and hence broaden the tax base. With over half the economy in the informal sector, there is a lot to win here.

Milei's chainsaw

While we acknowledge the Argentinean tax burden is very high, slashing these will either need slashing public expenditures and/or running deficits, neither of these will be helpful at present.

Slashing public spending is necessary, but mainly to get public finances in order as we explained above. To go beyond that in order to cut taxes isn't urgently needed and could very well deepen the economic crisis, as well as throw even more people into poverty.

Milei's chainsaw, which he wielded at election campaigns and has condensed into proposals slashing public expenditures by 15% of GDP and reducing the number of ministries to eight, is a huge overkill at the moment.

Businesses invest when they can look years ahead with confidence and expect stability and economic demand for years to come. While low taxes help, business investment is actually surprisingly inelastic with respect to cost factors (like interest rates).

So cutting taxes on business would be a longer-term objective, but it's not really necessary today. What is necessary is to bring the budget into balance.

As one can see, it's not an insurmountable problem but much of it is political:

• More than half the population receives some kind of government assistance, well over three times the number of people with employment in the private sector.
• While public pensions have seen substantial purchasing power declines, the costs have nevertheless been ballooning as eligibility has greatly expanded in the past couple of decades. A full 55% of pensioners have contributed nothing (like housewives and people working in the informal sector).
• One in five Argentinians work in the public sector, in 13 out of 23 provinces this exceeds employment in the private sector.
• There are large subsidies for public transport (without which many would not be able to go to work or it wouldn't pay) and energy.

This great state dependency creates one of the vicious cycles described in the beginning of the article which makes it both hard to reform and especially urgent.

But a chainsaw is likely to do more harm than good, certainly in the short-term, and drastic measures that put scores of people over the edge aren't necessary to eliminate the fairly modest public deficit.

There are a host of other possible reforms, Argentina reminds us of Italy or Greece when the euro straightjacket made reforms essential, as it suffers from many of the ills of these countries

A Byzantine and notoriously slow judiciary is one they have in common, for instance, as is the need for simplification of the process of setting up new businesses.

Conclusion

While we have a particular aversion to ideologically driven politicians like Milei, as this puts rose-tinted glasses that filter out inconvenient facts or otherwise lead them to explain these away, our practical disposition of looking at the Argentinean figures nevertheless points to a pretty firm conclusion; what they have been doing so far isn't working, it's time for something else.

While one can have serious questions about Milei's experience, preparedness, temperament, and even democratic credentials, he is likely to be severely circumscribed by the lack of a majority for his party and quite a few of his most radical proposals (like dollarization).

If there is any country in the world where a whiff of libertarianism could shake up the economy in a positive way it's Argentina, as long as it's not the chainsaw variant of Milei which in undiluted form would run the considerable risk of creating a bloodbath post-election.

On the other hand, Massa could surprise us by actually putting his professed moderation into practice, forced by economic necessity and helped by more dollars getting into the country from agriculture, energy, and mining next year. But after decades of mismanagement, could you forgive the Argentinean people for not counting on that?

Argentina could be a wonderful place to invest, with boundless opportunities in agriculture, mining, energy, and a creative workforce. Once investors sense that a new government is serious about producing sustainable public finances some of the vicious cycles described above could turn into virtuous ones, even if it will take a long time for confidence to really take hold.

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