As elections are approaching, it seems that the good equilibrium (as per my posting on March 26) is more likely. The market has not—so far—reacted running against central bank’s reserves. This is good news.
The purpose of this update is to elaborate on why this equilibrium resulted and what could be expected after the elections. Regarding the latter, however, I will put more emphasis on the medium/long run as opposed to most of the opinions that I have recently seen—which focus on the short run.
As per the polls and various reports it seems that the Kirchner administration is almost sure to lose its majority in Congress. Furthermore, Nestor Kirchner himself, running in the Province of Buenos Aires, seems to be losing the election—or wining by a narrow margin at best. Lack of a strong victory is precisely a relevant factor in explaining the observed equilibrium. For, had Kirchner led in the polls for an ample difference, the bad equilibrium was much more likely. It would have jump-started expectations of a wave of stronger populism. On the contrary, the election is very likely to result in the need for the Kirchners to govern in consensus with Congress—and powerful provincial governors. This makes the market expect a more orderly and progressive way out of the current populism. This still belongs to the good equilibrium.
Complementary, the central bank (BCRA) has been slowly allowing the peso to depreciate—partly on purpose, partly because it couldn’t stop it. More importantly, almost all forecasts point to a much more depreciated peso toward H2 of 2009 and much more for 2010. If any, the BCRA was smart enough to signal the same. By not denying these projections it has been implicitly validating them, thus calming financial markets. (Surprisingly, the implicit support contributed to contain expectations by not increasing the degree of uncertainty.) This strategy might pay off to the government—not to the reputation and long run credibility and independence of the BCRA that should be focused on reining in inflation and inflation expectations. It is still absurd not to see the BCRA letting the exchange rate float and implement inflation targeting. Brazil, Chile, and Peru—among others—are example to look at. This would help the BCRA rebuild its reputation and will likely reduce the pass-through effect. It will also give the BCRA a higher degree of freedom to implement counter-cyclical policies.
Luckily, net reserves are still at a decent level. But there are never enough international reserves if a speculative attack is triggered.
The US—and to a lesser extent other developed countries’—prompt and aggressive response to the international financial crisis helped substantially in controlling the collapse of international financial markets. The latter have started to stabilize. Even though some more bumps are quite likely to happen it looks as if the worse has passed or is about to be passed. That does not imply that real effects will not drag way into 2010 at least—best case scenario. The recovery will be slow and we might need to hope for 2011 to see some real bright recovery—not necessarily spectacular though. This clearly affects Latin America and Argentina in particular. Since Argentina implemented populist policies during “good times” I would expect a much slower recovery when compared with those countries that did their “homework.”
All of the above refers to the good equilibrium. One more time, unfortunately, a bad equilibrium could arise. It can result out of a political problem though: e.g. if, after the elections, the Kirchner administration decides not to govern in coordination with Congress and instead chooses to strengthen the populist policies. This will likely generate an implosion of the economy—and could be a quite sudden collapse. Potentially, it could also be implicitly “forced” by the Kirchners so as to blame the market for their own wrong macro policies. In any case, however, the recession will continue and probably deepen—it will be protracted with downside risks in regard to its recovery. It is part of the natural correction to the long macro and micro mismanagement. Unfortunately, this seems not to help reducing the true inflation rate and depicts upside risks to amplify and propagate to provincial governments. The latter have fragile fiscal positions and are very pro-cyclical and dependant on the central government.
Overall, and contrary to most opinions, I do not anticipate a collapse after the elections—unless the Kirchners irrationality exacerbates it as described in the previous paragraph. The big problem is that such a long populist policy has degraded the Argentine economy not only in the short run but, more importantly, in the medium and longer run. Institutions have been degenerated and their recovery will take much longer than their destruction.
Long term investment has strong downside risks and will thus be scarce: private investment due to the lack of credible property rights and correct long term incentives; public investment will be constrained due to fiscal stringency as a result of the pro-cyclicality of expenditures exacerbated during the tail-wind years.
The resulting medium/long term equilibrium is more likely that of a stagnant economy for years to come. Sadly, this seems to be the long–term “good” and stable equilibrium.
Is there still hope for a “better” equilibrium? I believe the answer is yes. But it will take a substantial change in policy—and a very long to-do list. Not only regarding free markets, but also transparent data, solid and reputable central bank policy making, fiscal responsibility (conditional on which, a policy for income redistribution, education, and health services should be designed), respectable long term institutions that enforce property rights and the rule of law, an open economy that stimulates long–term investments without messing with exchange and current and financial account controls, incentives for R&D, much lower corruption (including bureaucrats and union leaders—the latter which should stop playing political roles), and rational foreign policy, among many other things.
Above all, we should look at our neighbors like Brazil, Chile, Mexico, and Peru. These countries learnt not to condition the political economy to politics. Argentina suffers very volatile economic business cycles in big part due to political volatility. (Everything that the previous government did should be wrong, by definition, so the argument would go.) Only after Argentina learns to separate the design of economic policy from politics will a true GOOD equilibrium be achieved. That would imply graduating to a really developed country, and that is the initial condition required to successfully implement the correct long term economic policies mentioned above.