In the early 1990s, Argentina stopped increasing the money supply and fixed the
ID: 1168376 • Letter: I
Question
In the early 1990s, Argentina stopped increasing the money supply and fixed the exchange rate of the Argentine austral at 10,000 to the dollar. It then renamed the Argentine currency the "peso" and cut off four zeros so that one peso equaled one dollar. Inflation slowed substantially. After this was done, the following observations
were made. Explain why these observations did not surprise economists.
1.The golf courses were far less crowded.
2.The price of goods in dollar-equivalent pesos in Buenos Aires, the capital of the country, was significantly above that in New York City.
3.Consumer prices--primarily services--rose relative to other goods.
4.Luxury auto dealers were shutting down.
Explanation / Answer
Hyperinflation exploded in 1989. It was the final stage of a chronic inflationary process that began in 1945 and lasted forty-five years. From the beginning of the century until the end of World War II, Argentina had been characterized by stable prices. Internal prices only reflected fluctuations related to events in the world economy, such as the two world wars and the Great Depression of the 1930s. After 1945, the combination of industrial protectionism, redistribution of income based on increased wages, and growing state intervention in the economy touched off the inflationary process shown in Table 1. After so many years of inflation, there is a general consensus among economists about the mechanics of this process. A persistent fiscal deficit, increasingly financed by monetary emission, caused more and more frequent devaluations of the local currency. The acceleration of inflation resulted from the demonetization of the economy as the public tried to avoid the inflation tax. During the last decade of this period of chronic and growing inflation, the social and economic costs of inflation became evident. In the 1980s, the economy, increasingly disoriented by inflation, declined at a rate of 1 percent per year. Employment continued to grow 1.6 percent per year but the 2.6 percent average annual decline in the productivity of the employed was the clearest evidence that only unproductive activities were expanding. This was especially the case of the public sector but it also existed in the private sector,which continued to be strongly protected from foreign competition and involved in financial speculation. Government expenditure during the 1980s represented, on average, 33 percent of GDP, while the fiscal deficit was about 5 percent of GDP. . . . The year 1989 was catastrophic. Government expenditure reached 35.6 percent of GDP and the fiscal deficit climbed to 7.6 percent of GDP. From December to December, inflation almost reached 5,000 percent; at the peak of March 1989 to March 1990, it was over 20,000 percent. Gross domestic product fell more than 6 percent and imports fell 21 percent that year. The government could not ignore the strong public demand for the price stability that had been absent for forty-five years.
Table 1. Argentine Inflation by Decade (Annual rates of change in the consumer price index)
Period
Average
Maximum
Minimum
1920-1929
-1.7
17.1
-15.9
1930-1939
-0.3
13
-13.9
1940-1949
10.6
31.1
-0.3
1950-1959
30.3
111.6
3.7
1960-1969
23.3
31.9
7.6
1970-1979
132.9
444
13.6
1980-1989
750.4
####
87.6
The stabilization plan
In 1990, the government began to completely overhaul the organization of the Argentine economy. It included (a) comprehensive liberalization of foreign trade and capital movements, (b) the privatization of public enterprises and the deregulation of the economy, (c) reduction of the bureaucratic apparatus of the public sector and the reconstruction of the tax system, and (d) the creation of a new monetary system.
Government expenditure fell drastically from 35.6 percent of GDP in 1989 to 29.8 percent in 1990, and continued to fall to 27 percent of GDP by 1995. The fiscal deficit also decreased sharply from 7.6 percent of GDP in 1989 to 2.3 percent in 1990, and from 1991 onward, it fluctuated around 0 percent, accompanying the economic cycle.
The prices of goods and services began to be freely determined in competitive and open markets. As of April 1991, the public could freely choose the currency used in all financial and commercial transactions. Among the alternatives was the convertible peso, which came with the transformation of the central bank into a virtual currency board. The central bank must back each peso in circulation with an equivalent amount or gold or foreign exchange, permitting holders of pesos to exchange, at any moment, one peso for one American dollar.
The same law that created this monetary system included the prohibition of indexation clauses or any other monetary alterations in the terms of contracts. Wage agreements resulting from collective bargaining had to be accompanied by agreements on productivity.
The disinflationary process was continuous and sustained: Inflation fell from 1,344 percent in 1990 to 84 percent in 1991, 17.5 percent in 1992, 7.4 percent in 1993, 3.9 percent in 1994, 1.6 percent in 1995 and 0 percent in the twelve-month period between June 1995 and June 1996.
The new monetary system encouraged a strong increase in the external reserves that back the monetary liabilities of the central bank. Reserves went from $3.8 billion at the end of 1989 to $17.9 billion at the end of 1994. This trend was reversed when the fall in the level of confidence following the devaluation of the Mexican peso led to capital flight from Argentina: by the end of March 1995, reserves had fallen to $12.5 billion. But the policies adopted to face the crisis reestablished confidence. By the end of June 1996, reserves had already surpassed $20 billion.
Between 1991 and 1994, GDP grew at an average annual rate of 7.7 percent. However, due to capital flight, after the second quarter of 1995 the economy entered a period of recession. The recession lasted a year and in the second quarter of 1996, the economy was already showing signs of a recovery at an annual rate of 3 percent.
Exports, virtually stagnant in the previous decade, grew vigorously during the period of the stabilization. Imports, which had grown much more than exports until 1994, shrank during 1995 with the onset of the recession.
Despite the strong increase in the GDP, employment grew relatively slowly, and suffered a decline during the recession that began in 1995. The poor performance of the economy in relation to employment is explained by the substantial increase in worker productivity, which by mid-1996, had reached the level of 1980. The rapid growth of the economy during the period permitted the transformation of numerous low-productivity or unproductive activities that had been artificially created during the decade of the 1980s into productive efforts. However, this was not sufficient to employ all of the growing labor force. Thus, beginning in 1992, the unemployment rate increased and reached a peak of 18.4 percent of the active population in May 1995. Since then, there has been a slight decrease in unemployment. The survey of May 1996 recorded a rate of 17 percent, still three times higher than that of the 1980s.
The main lesson of the Argentine stabilization experience is that the elimination of inflation is possible even when an economy has been flogged by that disease for decades. It is not true that in Latin American economies it is necessary to accept annual inflation rates of around 10 percent, even after many years of searching for stability.
Another important conclusion of the Argentine experience is that the fiscal adjustment, understood as a reduction of the government expenditure, as well as the reduction and the elimination of budget deficits are the keys to stabilization after decades of instability, the origins of which are mainly found in the monetary financing of persistent fiscal deficits.
Table 1. Argentine Inflation by Decade (Annual rates of change in the consumer price index)
Period
Average
Maximum
Minimum
1920-1929
-1.7
17.1
-15.9
1930-1939
-0.3
13
-13.9
1940-1949
10.6
31.1
-0.3
1950-1959
30.3
111.6
3.7
1960-1969
23.3
31.9
7.6
1970-1979
132.9
444
13.6
1980-1989
750.4
####
87.6