6 months ago
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Why is inflation going down in Argentina? Because it went up massively late last year. Why might inflation rise again in Argentina? Because it has been falling in recent months.
Those are the two main conclusions of a wonderful recent paper by two Uruguayan economists. Want to figure out what is going on in a country or a household? Ask the neighbours.
To understand these two apparent paradoxes, it helps to go back a little in history. The administration of President Alberto Fernández, a Peronist who governed Argentina until December 2023, ran a large fiscal deficit, owing in part to sizeable inflation-adjusted increases in pensions and public-sector wages.
Because no one would lend to Argentina, Fernández could finance the deficit only by instructing the central bank to print the necessary pesos. And to ensure that Argentines held on to the pesos instead of exchanging them for dollars, Fernández built a wall of exchange controls. The result was a massive overhang of pesos, held reluctantly under mattresses or in local bank accounts that paid negative interest rates.
A monetary overhang is a ticking time bomb. If the pesos are spent, an inflationary spike follows. If the exchange controls are ever lifted, people rush to convert their pesos to dollars, the exchange rate collapses, and import prices soar. How Argentina would escape that danger zone was far from clear.
Enter the new president, anarcho-capitalist Javier Milei, who upon taking office liberalised prices, eliminated subsidies that had kept utility prices artificially low, and allowed the peso to be devalued by 54 per cent. The result was that the consumer price index rose by a factor of 1.7 in just three months, equivalent to annualised inflation of nearly 800 per cent.
The price surge did terrible damage to consumers’ pocketbooks. But it had a silver lining: it diminished the purchasing power of the excess pesos. Between November 2023 and February 2024, the real value of the central bank’s monetary liabilities fell by nearly 40 per cent, sharply diminishing the monetary overhang’s future inflationary potential.
The jump in prices also had budgetary consequences. In an illiquid local peso market, the central bank could fund itself by issuing notes at much lower interest rates than during the previous administration. What economists call the “quasi-fiscal” deficit began to fall.
And so did the fiscal deficit, because most expenditures – including big ticket items like pensions and public-sector wages – are set in nominal terms, so when inflation unexpectedly spikes, the real value of those expenditures falls. Add to that a freeze in public investment and a sharp cut in transfers from Argentina’s federal government to the provinces, and the net effect was a sharp drop in government spending. That is why Milei could solemnly announce, during a prime-time television speech, that in the first quarter of 2024 Argentina achieved a small fiscal surplus – the first since 2008.
In many countries, this would be a routine occurrence. In Argentina, it was treated like winning the World Cup. And there really was much to celebrate: a surplus means no obligatory recourse to monetary financing, which in turn means no new peso overhang and the potential for much lower inflation in the future.
But here is the rub: in their early success could lie the weakness of Milei’s anti-inflation plans. Monthly inflation was 25.5 per cent in December and “only” 11 per cent in March. It is expected to continue falling in the months ahead. But as inflation drops, and as unions and politicians begin to demand increases in wages and pensions, the fiscal relief brought by unexpected high inflation could be undone. Add to that the recession that Argentina will surely endure this year – the International Monetary Fund recently projected that GDP will contract by 2.8 per cent – with lower incomes translating into smaller government revenues.
Politics will also threaten the recent fiscal gains. Milei upset provincial governors by reducing transfers to the provinces. But he needs the congressional votes from some of those same provinces – over which the governors hold substantial sway – to enact his much-touted structural reforms.
Without reform, the economy will grow even less in the long run, further weakening Argentina’s public finances. But in the short run, getting those votes might require more transfers and a smaller surplus, or a return to deficits. It is the perfect example of being between a rock and a very hard place.
Complications also arise in the external sector. Since the 54 per cent devaluation in late 2023, Argentina has been allowing the official peso exchange rate to depreciate by 2.0 per cent each month. But with monthly inflation running much higher than 2.0 per cent, a growing imbalance accumulates every month.
In inflation-adjusted terms, today the Argentine peso is more overvalued than it was in August 2023, when the Fernández administration was compelled to allow a one-time devaluation. This effect can be seen clearly in the shopping malls of neighbouring Chile, mobbed with Argentine tourists who stock up on electronics, clothing, and even food products, thanks to the strength of what some are calling the “super peso”.
The future of Milei’s administration rests on its ability to deliver lower inflation and higher growth. But the super peso will threaten growth once exporters decide they cannot make money by selling abroad. It could also threaten inflation control if the central bank is pushed into a disorderly devaluation, which would immediately feed into domestic prices.
How does this all end? There is an optimistic scenario in which inflation continues to fall, but not so abruptly that fiscal gains are undone, while economic activity bottoms out in the middle of the year and growth is eventually restored. In this scenario, the central bank finds a non-traumatic way out of peso overvaluation, while gradually dismantling capital controls. The improved economic picture lightens the political mood, and Milei finds the votes to turn his temporary fiscal gains into sustainable long-term achievements.
But that is not the only scenario. There is also a path in which the government bides its time, unsure of what to do, overvaluation eventually takes its toll, and a sharp devaluation opens the door to the return of inflation. Animal spirits turn pessimistic, growth does not return, and the early shine of Milei’s administration turns to gloom.
Which will it be? It’s Argentina, so the honest answer is that no one knows.
Andrés Velasco, a former finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. © Project Syndicate 2024 www.project-syndicate.org
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