The global economy is not looking promissory for 2008. The U.S. is either going to experience a slowdown or a recession. The Fed is expected to cut interest rates further while the government pencils the details of its fiscal stimulus package. These measures point to soften the downturn of the business cycle. Over time, however, these will add to the inflationary pressures on the U.S. economy above the current effects caused by commodities’ price increases. In the medium-term, the Fed will need to focus on the domestic price increases and will probably start increasing interest rates again.
The euro and the pound have been appreciating. Jointly with the U.S. contractionary effects, we shouldn’t be surprised by a slowdown in the European economy. In turn, all of the above are likely to contribute to a reduction in growth rates in Asia. Potentially, the Chinese economy could be affected too—thus potentially de-activating the so-called “decoupling effect.” The Chinese trade balance is already showing signs of deterioration regardless of the U.S. cum European potential slow downs. Eventually, the euro and the pound will need to revise their valuation back to fundamentals—and interest rates cuts are eventually likely to occur. The latter will dampen the effects of the current global credit problems on the financial sector. It will also smooth the real sector through currency depreciation. Thus, a reduction in Chinese growth rates does not sound impossible—and probably benefiting Chinese authorities in combating domestic overheating and inflation.
Argentina’s fiscal revenues are in a substantial part based on export taxes. If from the above statements we infer that Argentina’s exports will decrease, the fiscal balance is likely to deteriorate. We can also add the credibility problems due to the non-transparent “editing” of the inflation indices computation, the high inflation, and the future fiscal financing needs; the overall credibility of the government looks not very encouraging.
Given that the economy is still expanding at high rates, a strong fiscal contraction might be the correct policy to implement, and with a perfect timing. This will improve not only the current fiscal stance, but also, and especially, the future path of fiscal balances. Just to have a broad sense of the present situation we can look at the following. The growth rate in 2007 was close to 8.5%. The official inflation rate marked approximately another 8.5%. Fiscal expenditures grew at rates close to 60%, eventually “decreasing” to “only” 35%. Thus, the share of government expenditures in GDP is increasing. Even if we pose a more “realistic” inflation rate in order of 20% we still observe an increase in the ratio of public expenditures to GDP. It is true that fiscal revenues increased by close to 33%. But again, most of this revenues come from export taxes as well as consumption (e.g. VAT), thus largely explained by prices. With an annual inflation rate above 20%, the real increase in revenues is markedly reduced.
But a deeper analysis requires an intertemporal approach as well. And in this case the picture does not look as promising as the authorities suggest. Just to cite an example, the fiscal surplus is partly based on computing the flows of the future retirees that decided to switch to the state-based pension fund as current income. And the amounts of these monthly flows were somewhat arbitrarily decided to make the flow fiscal surplus look stronger than it really was. More importantly, these are only considered as (current) assets without taking into account the future liabilities that they generate—which are not trivial and increasing over time. Given the current international events, the stock variable (intertemporal sustainability) is as important as the flow variable (the fiscal balance—i.e. liquidity.) Looking at the entire picture Argentina might be fiscally much more fragile than it seems. In turn, this is made worse off by the fact that the current financial program includes borrowing from these accumulated funds of future retirees to finance current expenditures!
Therefore, given the state of the global financial and real economy this might probably the best moment for the Argentine authorities to engineer a strong reduction in government expenditures. Some of the benefits of such a policy follow.
By lowering fiscal expenditures the government not only increases its current surplus and reduces its (intertemporal) fiscal fragility, but also contributes to reducing inflationary expectations. Given the high revenues, this tends to increase public saving (until the inflation rate is reduced.) The latter involves something like a one-time windfall of resources to the government. Until revenues stabilize (progressively) due the reduction in the inflation rate while the expenditures are instantaneously reduced, the government will “receive” a temporary excess of resources.
The more so if, as it is usually claimed, the intention of the government is to have a “competitive” real exchange rate, since these extra savings could be used to absorb dollars—thus enabling the central bank to concentrate on inflation instead of artificially maintaining a depreciated exchange rate. It is well known in the academic literature that reducing government expenditures depreciates the real exchange rate.
Alternatively, the public savings should be channeled to increasing the so-much needed (and never actually formally implemented) counter-cyclical fiscal fund. For the present high growth rates are likely to be reduced—hopefully not to become negative. In either case, it could be good to save for a rainy day when things are still good. For when things start to look more gloomy it is politically more complicated to make the necessary fiscal corrections. Argentina has experienced this once and again. This is a good opportunity not to make the same mistake as many times in the past.
A by product of lower expected inflation will be lower interest rates, as the governments wants. This will help expanding investment—at the expense of current consumption. Thus, it reduces present inflation. Also, devoting current resources to the production of future goods reduces expected (future) inflation as well. In other words, reducing fiscal expenditures contributes to anchor inflation expectations.
Additionally, reducing fiscal fragility encourages capital flows from abroad. This is non trivial since during 2007 Argentina experienced an increase in capital outflows. Flight to quality might eventually re-appear if, as expected, global financial markets continue with high volatility. This, in conjunction with a truly flexible exchange rate will also contribute to maintain the inflation rate under control and increase the investment rate.
On the other hand, the academic literature has proved that under fiscal fragility contractionary fiscal policies end up being expansionary—the big fear of the current administration—but not inflationary. Thus, it not only helps long-term growth, but also improves the fiscal balance (liquidity and intertemporally) since it increases tax revenues jointly with decreasing expenditures.
There are other motives for now being a good timing for contracting government expenditures. As a consequence of the implicit price-regulations that have been taking place in Argentina since 2002 many relative prices are not in equilibrium. The longer it takes to let relative prices adjust, the harder the price adjustment will be. This will impact on the inflation rate and inflation expectations much harder as well. The more so if, as it is the case nowadays, the exchange rate is in a certain extent pegged to the U.S. dollar. Since the dollar is currently depreciating, “imported” inflation adds to the domestic mismanagement. This will also be the case if Argentina pegs to the euro, since eventually it will start to depreciate too—as the ECB cuts its interest rates and the euro returns to its long run value.
Related to all the above, we should consider provincial fiscal imbalances. Many provinces—some of a relevant size in terms of GDP—show deteriorating fiscal balances; some are already running a substantial deficit. Since ultimately the federal government is a “payer-of-last-resort”, it would be worth paying attention to this point. The mentioned deficits occur despite the continuous high growth rate in the last couple of years. They result, in part, from the current revenue structure of the country—a non-trivial amount of the revenues collected by the central government are not instantaneously distributed to provincial governments (the so-called “co-participation law.”) This generates political pressures on local authorities—especially if they want to receive funds from the federal government. Thus, the provincial fiscal balances should also be incorporated in to the intertemporal fiscal analysis of the country.
A similar comment should be made in regards to “fiduciary funds.” These funds are mostly not included in the fiscal budget. They are used to finance a big amount of fiscal expenditures. What about the potential liabilities they might generate for the fiscal authorities?
The crossed-subsidy system used to (try to) reduce inflation (mostly favoring middle-class families) causes another problem. On the one hand, these types of subsidies are relatively simple to establish but very difficult to cut. Take for example the transportation subsidies. Early this year the government allowed increases in transportation fares (averaging 20 %.) The increases were supposed to enable reducing the subsidies. Now these subsidies seem non-removable. Likewise, the money spent on subsidizing energy could have been used to build energy-generation plants. All in all, the government should be not interfering with relative prices, as it causes them not be in equilibrium—implying wrong incentives for individual’s consumption and firm’s investment decisions—while spending tax-payers money worthlessly.
Finally, not only the level of fiscal expenditures seems to be in opposition to long-term growth, but also its composition. Investing in human capital is as important as investing in physical capital. The country not only needs more and better infrastructure. It desperately needs better education and health care. The latter are fundamental for long term growth. Higher human capital also contributes, all else equal, to lower present and future inflation, as it increases productivity and growth—and consequently higher fiscal revenues too.
Argentina is watching a one-in-a-lifetime opportunity. Hopefully the current authorities are really looking forward to leave a better country to their children, and act accordingly. Argentina, unfortunately, is full of fiscal adjustment “after the fact.” Most of them resulted from previous excesses during expansions. Given that the economy is still expanding, the government has the chance to put the country into a long term growth path. Now is the time not to repeat prior mistakes; tomorrow it might be (again) too late.