Macroeconomic Dynamics and (Present and Future) Income Distribution in Argentina: a Lucas’ Critique View

The export tax law that Argentina’s president submitted to Congress ended as a complete failure for the current administration—the more so since it was finally rejected by the negative vote of the vice-president. However, I look at the episode as the best outcome possible for the current administration. It actually gave the government the ability to start afresh. The vice-president rejection actually enabled the president to obtain an elegant way out of an economic mistake—with potential social unrest. Will the president take advantage of this? Although I truly hope that “words” will actually be contradicted by “facts”, as of today I am inclined to think the answer is not—details follow.

As per the information available it seems that in order to re-boost the high inflation-low growth direction that the economy is taking the government is planning to increase the after-tax wage of middle-income families—and, at the same time, to try to partially re-gain some political support (currently close to 20%). Supposedly, the government intends to provide a fiscal stimulus: increasing the gross income level at which employees start paying income taxes, increasing net wages. That would not surprise any economist if the economy is slowing down to below full-employment. But this is not the case of Argentina. This looks even worse once we factor in an inflation rate in the 30-35% range.

On the contrary, such a policy will more likely end up being the worst of all medicines—potentially killing the patient. For, this will accelerate the (already high) inflation rate, as middle-income people consume more—but firms are unlikely to increase employment. The more so since this policy will probably trigger distributional tensions, as unions will press for further, more frequent, and greater wage increases.

Why do I think that this fiscal stimulus will exacerbate the inflationary pressures? Among many other reasons, I can mention: inflation expectations could jump, aggregate demand could increase due to consumption increasing (but not because of investments as high inflation and interest rates, plus uncertain exchange rate market and property rights call for firms’ caution), and the worsening of the present and future fiscal position. Add to this a global slowdown, more stringent international credit markets (the more so for Argentina), and the fact that the current administration is financing present expenditures that become permanent with transitorily high revenues.

On the latter, we can not only consider the lower real revenue (inflation can compensate partly, but not when demand is going down at an increasing rate), but more importantly this will accelerate the already huge bill that subsidies to the middle- and higher-income represent. And most of these subsidies (energy, gas, public transportation, etc.) benefit relatively more to relatively higher income people—thus it represents a transfer from poor to rich people. It has been suggested that some of these subsidies will be reduced by letting prices increase. This would be great news—if enacted. For, some couple of months ago some of the previously “frozen” prices were permitted to increase a little bit. However, and contrary to what was stated by the authorities at the time, subsidies were not reduced at the time—they actually kept on increasing.

So all in all, this represents a current transfer of resources from poor to reach people. But, it represents a much higher future transfer in the same direction. Eventually the economy will need to be aligned back to trend. This will require a drastic adjustment in government expenditures, interest rate hikes, (real wages contractions?) and, in general, a strong contraction of the economy to correct all the accumulated and increasing resource misallocation and misaligned relative prices (and the exchange rate…?). And the adjustment will need to be greater the longer it takes to be internalized.

Therefore, what I observe is a variety of the classical Lucas Critique problem. The government is planning (again) to pump up (private consumption) domestic aggregate demand not realizing the future effects of these policies. By not internalizing the present and future impact of its own present public policy—thus lacking any medium and long term strategy—it might lose another chance; in this case shifting from economic instability to political instability. Unless they want the political instability to emerge—so as not be made responsible for its own mistakes.

And the worst of all these consequences it the present and future income redistribution (from poor to rich) that this supposedly “popular” (I would say “populist”) administration is generating will do nothing but worsening even more the standards of living of those in the lower income brackets.

Hopefully the available information is wrong and the president figured out that the rejection in the senate has turned into her best chance to achieve the best for the country. We’ll see.

4 Responses to "Macroeconomic Dynamics and (Present and Future) Income Distribution in Argentina: a Lucas’ Critique View"

  1. Vitoria Saddi   July 21, 2008 at 10:33 am

    Nicolas,Great piece! Do you think that the fact that the farmers’ strike is over change your scenario about the intertemporal transfer and the fiscal stimulus in Argentina?

  2. Nicolas Magud   July 21, 2008 at 11:50 pm

    Hi Vitoria,Thanks for your comments. Honestly, unless the government changes its policy 180 degrees, I doubt it. On the contrary, now the government has lower expected tax revenues and higher (and increasing) expected expenditures (subsidies), thus worsening the situation even more. Unless the government launches a serious and credible anti-inflationary plan–part of which should include a sharp decrease in present and future expenditures–I am quite skeptical. Adding the global situation, and the low ability of Argentina to obtain reasonable financing (in good times due to its own mismanagement, the more so in bad times to come), it is like the administration not only does not factor in the future effects on its current policies; I would be tempted to say the government is decoupled of the events taking place abroad: they have not realized what the global economy situation looks like and how in might likely be next year–and thus it has not internalized the impact of the external economic environment into its policy-making.

  3. mangy cat   July 22, 2008 at 8:32 am

    do you feel a weakened govt can push through a massive tax crunch to replace the missing farm tax revenues?is it a 180º shift, at the risk of tipping over the apple cart, or skilled helmsmanbship to change direction?

  4. Nicolas Magud   July 22, 2008 at 10:48 pm

    Hi Mangy,My sense is that the government, whether weak or not, has not too much of a margin but to start "behaving" with respect to its fiscal accounts. The more so since not only it is supposed that on top of what I mentioned in my post, minimum wages are probably given increases and other wage raises will likely happen–to compensate for a higher than considered (and reported) inflation (Lucas’ critique one more time). However, will this not be in one way or another transfered to prices? …