Argentia Crisis Lessons Fondad Imf

The Crisis That Was Not Prevented:Lessons for Argentina, the IMF, and Globalisation

From: The Crisis That Was Not Prevented: Argentina, the IMF, and Globalisation,FONDAD, January 2003, www.fondad.org

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Forum on Debt and Development (FONDAD)

FONDAD is an independent policy research centre and forum forinternational discussion established in the Netherlands. Supportedby a worldwide network of experts, it provides policy-orientedresearch on a range of North-South problems, with particularemphasis on international nancial issues. Through research,seminars and publications, FONDAD aims to provide factualbackground information and practical strategies for policymakersand other interested groups in industrial, developing and transitioncountries.

Director: Jan Joost Teunissen


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The Crisis That WasNot Prevented

Lessons for Argentina, the IMF, and Globalisation

Edited byJan Joost Teunissen and

Age Akkerman

FONDADThe Hague


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ISBN: 90-74208-20-7

Copyright: Forum on Debt and Development (FONDAD), 2003.

Permission must be obtained from FONDAD and the contributing authors prior toany further reprints, republication, photocopying, or other use of this work.

This publication was made possible thanks to the support of the Department forDevelopment Cooperation of the Dutch Ministry of Foreign Affairs.

Additional copies may be ordered from FONDAD atNoordeinde 107 A, 2514 GE The Hague, the NetherlandsTel: 31-70-3653820 Fax: 31-70-3463939 E-Mail: [email protected]


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Contents

Acknowledgements viiNotes on the Contributors viiiAbbreviations xiPreface by Jos Antonio Ocampo xiii

1 Introduction 1Age Akkerman and Jan Joost Teunissen

An Overview of Some Studies on the Argentine Crisis 2The Studies in this Book 10The Role of the IMF 12The Politics of Crisis Prevention and Management 13

2 Argentina: A Case of Globalisation Gone Too Far or Not Far Enough? 15Dani Rodrik

The Too Simple Idea of Sovereign Risk Reduction 16An Alternative Vision 19

3 The Mistaken Assumptions of the IMF 22Jos Antonio Ocampo

Wrong Assumptions 25Lessons 27Current Conditions and Outlook 28

4 Growth, Instability and the Crisis of Convertibility in Argentina 32Jos Mara Fanelli

Structural Breaks, Volatility, and the Macroeconomy 36Asymmetries, Rigidities, and Dynamic Effects as Sources of Instability 50Concluding Remarks 61


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5 The Regional Fallout of Argentinas Crisis 68Ricardo Ffrench-Davis and Rogrio Studart

Building Up Vulnerabilities 69Investor Condence, Domestic Policies and External Support 77

6 The Puzzle of Argentinas Debt Problem: Virtual Dollar Creation? 81Bernardo Lischinsky

Composition and Evolution of the Argentine Debt 82When and Why Did the Debt Become a Problem? 93Debt in the Context of a New Development Agenda 96Argentina and Globalisation 98

7 The Argentine Drama: A View from the IMF Board 101J. Onno de Beaufort Wijnholds

Argentina and the IMF: 1980-1991 102The Currency Board 105The End Game 110Lessons from the Argentine Drama 115

8 Some Lessons from the Argentine Crisis: A Fund Staff View 120Mark Allen

Background to the Argentine Crisis 121What Were the Lessons of Previous Crises? 122Lessons from the Argentine Crisis 129How Should the Funds Role in Argentina Be Judged? 141Costs and Benets of Globalisation 146


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vii

Acknowledgements

This book is yet another result from the Global FinancialGovernance Initiative (GFGI), which brings together Northern andSouthern perspectives on key international nancial issues. In thisproject, FONDAD is responsible for the working group CrisisPrevention and Response, jointly chaired by Jos Antonio Ocampo,head of the United Nations Economic Commission for LatinAmerica and the Caribbean (ECLAC), and Jan Joost Teunissen,director of FONDAD. GFGIs main sponsors are the CanadianInternational Development Research Centre (IDRC) and the DutchMinistry of Foreign Affairs. The book has been produced in closecooperation with ECLAC.

FONDAD very much appreciates the continuing support of theDutch Ministry of Foreign Affairs. Thanks are due to thecontributing authors for their efforts, and The New Republic forpermission to include Dani Rodriks article Argentina: A Case ofGlobalisation Gone Too Far or Not Far Enough? in this volume. Aspecial thanks goes to Adriana Bulnes and Julie B. Raadschelders whoassisted in the publishing of this book


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Notes on the Contributors

Mark Le Gros Allen (1947) is deputy director of the PolicyDevelopment and Review Department of the IMF. He joined theIMF in 1974 and has successively held the positions of economist inthe Exchange and Trade Relations Department, economist in theGeneva Office, advisor, mainly on debt issues, in the Exchange andTrade Relations Department, division chief, West Africa, of theAfrican Department, assistant director, International CapitalMarkets, of the Exchange and Trade Relations Department, seniorresident representative of the IMF in Poland, senior advisor of thePolicy Development and Review Department, working mainly onIMF surveillance policy, debt and nancial crisis management, seniorresident representative of the IMF in Hungary, and nally deputydirector of the Policy Development and Review Department.

Jos Mara Fanelli (1953) is professor of macroeconomics andformer director of the Economics Department at the University ofBuenos Aires. He is former director of the Ministry of Economysgraduate programme. Since 1984 he has been senior researcher atCEDES (the Center for the Study of State and Society) and in 1999was named independent researcher at Conicet (the national researchcouncil) in Buenos Aires. Following his appointment as economicanalyst at the Ministry of Labour, he was a researcher at theArgentine Central Bank (1983-84). He was a consultant for ECLAC,IADB, G24, UNCTAD, OECD and IDRC. He has published widelyon stabilisation, structural reform and the nancial system in LatinAmerica.

Ricardo Ffrench-Davis (1936) is principal regional advisor onEconomic Policy at ECLAC. He is also professor of graduateprogrammes at the Instituto de Estudios Internacionales and theDepartment of Economics at the University of Chile. He wasformerly director of research of the Central Bank of Chile, vicepresident at the Center for Economic Research on Latin America

viiiFrom: The Crisis That Was Not Prevented: Argentina, the IMF, and Globalisation,

FONDAD, January 2003, www.fondad.org

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ixNotes on the Contributors

(CIEPLAN) in Santiago, and deputy manager of the Central Bank ofChile. He has been a visiting professor at both Oxford and BostonUniversity and at institutes in France, Italy, Spain and Sweden. Hehas published widely on international economics, developmentstrategies, foreign nancing and Latin American economies.

Bernardo Lischinsky (1950) is dean at the Department ofEconomics and Administration at Universidad Nacional de Tres deFebrero (UNTREF) in Argentina, professor at the UNTREF andUniversidad de Buenos Aires, former senior lecturer at the NationalSchool of Government, Instituto de Economa y Sociologa Rural(INTA), Universidad de Belgrano, Universidad del Salvador, andvisiting professor at Universidad de Lomas de Zamora. He hasworked as a consultant for the government, cooperatives and groupsat the national, provincial and local level, on issues of internationalnance, economic, social and environmental impact, empowermentand development. He has published on debt problems, development,poverty and project evaluation.

Jos Antonio Ocampo (1952) is executive secretary of ECLACsince January 1998. Previously, he was minister of Finance and PublicCredit of Colombia, director of the National Planning Departmentand minister of agriculture. He was a senior researcher and memberof the board of directors of FEDESAROLLO in Bogot, Colombia.He has been an advisor to the Colombian government and director ofthe Center for Development Studies at the Universidad de los Andes.His academic activities have included being professor of economics atthe Universidad de los Andes and professor of economic history ofthe Universidad Nacional de Colombia. He has served as aconsultant to the IADB, the World Bank and the United Nations. Hehas published widely in academic journals and books.

Dani Rodrik (1957) is professor of international political economy atthe John F. Kennedy School of Government, Harvard University. Hehas published widely in the areas of international economics,economic development, and political economy. What constitutesgood economic policy and why some governments are better thanothers in adopting it are the central questions on which his researchfocuses. He is affiliated with the US-based National Bureau ofEconomic Research, Center for Global Development, Institute for


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International Economics and Council on Foreign Relations, and theLondon-based Centre for Economic Policy Research.

Rogrio Studart (1961) is economics affairs officer at the EconomicDevelopment Division of ECLAC. Previously, he has been anassociate professor at the Instituto de Economia of the UniversidadeFederal do Rio de Janeiro. He has led research projects ondevelopment nance, nancial markets and macroeconomics, andhas acted as a consultant for state governments in Brazil, privatecorporations and international agencies, including the World Bankand UNCTAD. He has published widely on monetary issues anddevelopment nance.

Onno de Beaufort Wijnholds (1943) has been an executive directorat the IMF from 1994 to 2002, representing the Netherlands andeleven other countries. He was an alternate executive director at theIMF during the mid-1980s, and an assistant to the Dutch executivedirectors in the World Bank and the IMF in the early 1970s. Hestarted his career at De Nederlandsche Bank in 1968 and worked invarious departments before becoming deputy executive director in1987. In the early 1990s he was also professor of money and bankingat the University of Groningen. He has published regularly oninternational monetary and nancial issues

x The Crisis That Was Not Prevented

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xi

Abbreviations

BIS Bank for International SettlementsCEPAL see ECLACCPI consumer price indexECLAC Economic Commission for Latin America and

the Caribbean (of the UN); (in Spanish CEPAL)EMU Economic and Monetary Union (of the EU)ERSP exchange rate-based price stabilisation

programmesEU European UnionFDI foreign direct investmentFDIA International Fund for Agricultural Development

(Fondo Internacional de Desarrollo Agrcola)FONPLATA Financial Fund for the Development of the

River Plate BasinFTAA Free Trade Area of the AmericasGDP gross domestic productIADB Inter-American Development BankIMF International Monetary FundMercosur Southern Cone Common Market (in Latin

America)NAFTA North American Free Trade AgreementOECD Organisation for Economic Cooperation and

DevelopmentPPP purchasing power parityRER real exchange rateSDR special drawing rightWPI wholesale price index


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xiii

Preface

The crisis that erupted in Argentina in 2001 raises manyquestions as to what went wrong and what lessons can belearned. No one doubts now that the Argentine authorities madeserious mistakes, but the international community also bearsresponsibility for the crisis. The IMF backed Argentinas economicprogrammes with money and advice throughout the ten years thatthe convertibility regime (linking the peso to the dollar) was in place.Argentina was highly praised as an exemplary case of a countryadopting the type of structural reforms that international nancialinstitutions and private markets have been pushing over the past twodecades. Argentina opened itself enthusiastically to world nancialmarkets, which backed the country with signicant resources. Therisks involved were minimised by all these institutions and agentsuntil very late in the process.

Argentina is not the only country in Latin America that has beenaffected by the mixed results of the reform agenda that came to beknown as the Washington Consensus. Indeed, the expectationsraised by this agenda a decade ago have turned out to be a mirage.Contrary to the promise that economic liberalisation would generaterapid economic expansion, growth rates since 1990 have been half of what Latin America achieved during the period of state-ledindustrialisation. The strong recession that began in 2001 deepenedin 2002, when GDP fell in Latin America by 0.5 percent, completingwhat we at ECLAC have called the lost half-decade. Open un-employment reached 9.1 percent, a record gure in Latin Americanhistory. Over the past ve years, the poor population has swollen by20 million Latin Americans.

There are two causes for this widespread reversal. The rst is thedecision to follow the domestic reform agenda of the WashingtonConsensus, despite its serious shortcomings. The second is theeffect of the asymmetries between globalisation and the institutionalframework in which it operates. Prominent among them is thevolatility of nancial markets. Periods of irrational exuberance in


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foreign lending have been followed by irrational panics, leading toexcessively high country risk premia and net capital outows.Argentina is a case in point. New institutional frameworks at theworld level must thus complement a new domestic developmentagenda.

Fortunately, there has also been some good news in 2002. Growthin Latin America resumed in the last quarter of the year. The use ofexible exchange rates in the regions larger economies has increasedcompetitiveness and given, in some countries, room for counter-cyclical monetary policies. But undoubtedly the best news is that theeconomic debate has opened up. The dogmatism of a decade ago hasstarted to fade. In branches of knowledge as imprecise as economics,an open controversy is essential to evaluate the strengths andweaknesses of different alternatives. Thus, pluralism in the economicdebate and its reections in the political arena are creating importantopportunities for better policies.

In Latin America, the lessons learned over the past decade ofintensive reforms are the basis for a reorientation of developmentstrategies. Such reorientation should take into account three keyelements: creating room for counter-cyclical policies that seek toreduce vulnerability to external nancial cycles; adopting activeproductive development strategies that improve internationalcompetitiveness and offer greater opportunities to small rms; andimplementing aggressive social policies that help ensure that thebenets of growth reach the entire population.

At the same time, the Argentine crisis and the lost half-decadefor Latin America should be an incentive to reactivate theinternational discussion about ways to reform the global nancialsystem. The Global Financial Governance Initiatives working groupon Crisis Prevention and Response, co-chaired by Jan JoostTeunissen and myself, brings together Northern and Southern viewson how nancial crises can be avoided and better managed, as well ashow the global nancial system should be improved. This bookresults from that joint effort. I hope it will inspire those who can helptransform developing countries in more stable and prosperoussocieties for all.

Jose Antonio OcampoJanuary 2003

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1 Fondad publications bear testimony of this. For a description of Fondad books,see the list of publications on the last pages of this volume.

1

1IntroductionAge Akkerman and Jan Joost Teunissen

The nancial crises in developing countries over the last twodecades have resulted in an avalanche of studies explaining theorigins and remedies. Thousands of articles and books have beenpublished carrying a wide range of diverging views.1 Why so many,and why so diverging?

It seems that, by denition, analysts and policymakers cannotagree on the diagnosis of and response to nancial crises (andeconomic developments in general), because they are dealing with asubject matter that is the result of the politics, economics andpsychology of human behaviour. Argentinas recent crisis is noexception to that rule. There is an ongoing stream of studies that tryto detect the causes of the crisis and present possible remedies. AsDani Rodrik puts it in the second chapter of this book, ngers havebeen pointed at enough culprits to explain the Argentine crash manytimes over.

Given the large number of illuminating economic analyses thathave already been published on the lessons from the Argentine crisis,we thought it useful to highlight a few of them in the rst part of thisintroduction. For this brief overview, we have selected analyses thatwe consider of particular importance, given the quality of theirarguments and the position or reputation of their authors.

The overview includes analyses by the former chief economist ofthe World Bank, Joseph Stiglitz, the current chief economist for


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2 Stiglitz, Joseph E., Argentinas Collapse Incited the Largest Default inHistory, In: The Straits Times, January 10, 2002.

Latin America of the World Bank, Guillermo Perry, and the formerchief economist of the Inter-American Development Bank, RicardoHausmann. The opinion of IMF officials is not presented in thisoverview, because Mark Allen (IMF staff) and Onno de BeaufortWijnholds (IMF Board) are among the contributing authors. Nor isthe view of the United Nations Economic Commission for LatinAmerica and the Caribbean (ECLAC) included, since three othercontributing authors are from ECLAC, including its head, JosAntonio Ocampo.

In the second part of the introduction, we briey introduce thechapters of the book. They are written by the two experts from theIMF already mentioned (Mark Allen and Onno de BeaufortWijnholds), three experts from ECLAC (Ricardo Ffrench-Davis,Jos Antonio Ocampo, and Rogrio Studart), two Argentineaneconomists (Jos Maria Fanelli and Bernardo Lischinsky), andHarvard professor of economics Dani Rodrik. We conclude the in-troduction with two short sections, one on the role of the IMF andthe other on the politics of crisis prevention and management.

An Overview of Some Studies on the Argentine Crisis

Joseph Stiglitz

One of the most widely cited analysts of the Argentine crisis andcritic of the IMF is the Nobel Prize winning economist and formerWorld Bank chief economist Joseph Stiglitz. Shortly after the IMFsuspended its aid to Argentina in December 2001, Stiglitz wrote anarticle2 which was published worldwide. In the article, he argued thatthe IMF had made a fatal mistake in the last years, by encouragingthe Argentine government to pursue scal austerity in the belief thatthis would restore condence.

But the numbers in the IMF programme were ction, saysStiglitz. Any economist would have predicted that contractionarypolicies would incite slowdown, and that budget targets would not be met. Needless to say, the IMF programme did not full its

Introduction2



3 Stiglitz, Joseph E., Argentina, Shortchanged - Why the Nation ThatFollowed the Rules Fell to Pieces, In: The Washington Post, Sunday, May 12, 2002.

3Age Akkerman and Jan Joost Teunissen

commitments. Condence is seldom restored as an economy goesinto a deep recession and double-digit unemployment.

Since it takes two to tango, Stiglitz also looked at the mistakes ofArgentina. In his view, its main mistake was the pegging of the pesoto the dollar. This was a system doomed to failure, not because ofmistakes made by the country, but because of shocks from beyond itsborders that were caused by the volatility of international nancialmarkets. However, the IMF encouraged this exchange rate system,he observes. Argentina should have been encouraged, instead, tomove to a more exible exchange rate system, or at least a system thatwould be more reective of its trading pattern; exports to the UnitedStates never exceeded 20 percent of total exports.

Sticking to the peso-dollar peg resulted from a single-mindedfocus on ination, without a concern for employment or growth, saysStiglitz. However, Any government following policies which leavelarge parts of the population unemployed or underemployed is failingin its primary mission.

In a second article, published in May 2002,3 Stiglitz addressed thesuggestion made by many economists that the Argentine crisis couldhave been averted had Argentina followed the advice of the IMFreligiously, especially by cutting back on government expenditures(including at the provincial level) more ruthlessly. He disagrees withthis view, arguing that scal decits of below 3 percent of GDP werenot at all that large, and did not result from proigacy but from aneconomic downturn, which led to falling tax revenues. And in hisview, soaring interest rates resulted not so much from what Argentinadid but from the mismanaged global nancial crisis of 1997-98.

I believe, says Stiglitz, that in an economic downturn, cuttingexpenditures simply makes matters worse: tax revenues, employmentand condence in the economy also decline. Had Argentina morereligiously followed the austerity advice of the IMF, the economiccollapse would have been more rapid, he observes. What isremarkable about Argentina is not that social and political turmoileventually broke out, but that it took so long.

He stresses that economic reform in Latin America resulted inlow growth and disillusionment with neo-liberal style reform and



4 Weisbrot, Mark and Dean Baker, What Happened to Argentina?, Center forEconomic and Policy Research, Washington D.C., January 31, 2002.5 Cibils, Alan B., Mark Weisbrot, and Debayani Kar1, Argentina Since Default:The IMF and the Depression, Center for Economic and Policy Research,Washington D.C., September 3, 2002.

warns, Argentinas experience is being read: This is what happens tothe A-plus student of the IMF. The disaster comes not from notlistening to the IMF, but rather from listening.

Stiglitz ended his May 2002 article with an optimistic note.Argentina is a country rich in human and natural resources. Beforethe crisis, these resources, even with inefficiencies, generated one ofthe highest GDPs in Latin America. Those resources have not beendestroyed by the nancial crisis. ... we should open our markets toArgentine goods. More than anything else, it was trade with theUnited States that brought Mexico out of its crisis.

Mark Weisbrot and Colleagues

In a paper of January 2002,4 Mark Weisbrot and Dean Baker, co-directors of the Washington-based Center for Economic and PolicyResearch, took a similar line as that of Stiglitz. They emphasise thatArgentina got stuck in a debt spiral. According to them, Argentinasstory is the story of debt, inherited from the past, that was perhapsmanageable until through no fault of the debtor interest rates onthe countrys borrowing increased. Higher interest payments, notincreased spending, led to higher decits. Growing decits in turncreated doubts about the overvalued exchange rate, which pushedinterest rates still higher, creating larger decits, in a hopeless spiralthat ended in default and devaluation. ... The economy lapsed intorecession in the second half of 1998 and never recovered. Repeatedattempts to restore condence in the overvalued peso throughspending cuts, and loans arranged through the IMF including a 40billion dollar loan package in December of 2000 could not reversethe downward spiral.

In later papers and articles, Mark Weisbrot and his colleaguescontinue saying that Argentinas crisis was not the result of scalproigacy, but rather of a decline in government revenue due to therecession that began in the third quarter of 1998. In a September2002 paper,5 for example, they include a table which shows that the

Introduction4





Figure 1 Argentinas National Government Spending and Revenues (percentage of GDP)

0%

2%

4% 6% 8%

10% 12% 14% 16% 18% 20% 22%

24%

1993 1994 1995 1996 1997 1998 1999 2000 2001 Primary Spending (excl. interest) Interest Payments Total Revenue

deficit }

primary balance of Argentinas government (revenues and spending,excluding interest payments) was never negative and that primaryspending did not increase but decrease. Figure 1 represents Weis-brots table, which is based on data from the Ministry of Economy ofArgentina.

With regard to Argentinas future policies, Weisbrot and hiscolleagues suggest that the country should not submit itself to IMFpolicy conditions. An IMF loan would not necessarily restoregrowth, and could even delay or abort any economic recovery. Theystress that Argentina should have, above all, a viable economicrecovery plan of its own.

Weisbrot is optimistic about Argentinas capacity to overcome itscrisis and believes that Argentinas export sector could play a crucialrole in jump-starting a recovery. One of the great advantages thatArgentina has over other countries ... is that the country is runninglarge surpluses on both its trade and current accounts.



Guillermo Perry and Luis Servn

In a collective World Bank study of May 2002,6 led by GuillermoPerry and Luis Servn, these two authors examined whether theArgentine economy was more vulnerable to external shocks thanother Latin American economies, and whether policy mistakes of theArgentine government were the main culprit, as is often claimed.

Perry and Servn try to answer why Argentina plunged into aprotracted recession in 1999 while other Latin American countriesrecovered after the Asian and Russian crisis of 1997-98. They showempirically that Argentina was not hit any harder than other LatinAmerican countries by the terms of trade decline after the Asiancrisis, nor by the US and worldwide slowdown in 2001, nor by thecapital ows reversal and the rise in spreads after the Russian crisis.The sudden stop of new capital ows acted more like an amplierthan a primary cause of the crisis, they argue. That Argentina did fareworse than other countries must therefore, in their view, beattributed to Argentina-specic factors: either higher vulnerabilitiesto external shocks, or weaker policy responses.

Examining Argentinas specic vulnerabilities as a result of itsxed exchange rate, large public debt and possibly weak bankingsector (hidden behind a faade of strength), Perry and Servnconclude that although there were important vulnerabilities in eachof these areas, none of them were larger than those affecting someother countries in the region, and thus there is no one obvioussuspect. However, the vulnerabilities reinforced each other in such aperverse way that, when combined, they led to a much largervulnerability to adverse external shocks than in any other country inthe region.

According to Perry and Servn, the peg to an appreciating dollarplayed a dominant role in the emergence of the Argentine crisis.Because of the steadily rising dollar and Brazils devaluation in 1999,a gap developed between the real exchange rate and its equilibriumvalue, resulting in an overvaluation of the peso of about 55 percent in 2001. Since the nominal exchange rate was xed, the real ratecould adjust only if wages and prices fell. Prices did fall, but not

Introduction6

6 Perry, G. and L. Servn, The Anatomy of a Multiple Crisis: Why WasArgentina Special and What We Can Learn From It, mimeo, World Bank, May,2002.


7 Hausmann, Ricardo and Andrs Velasco, Hard Moneys Soft Underbelly:Understanding the Argentine Crisis, mimeo, Harvard University, July 2002.


enough. However, a faster deation would have been politically verydifficult, as it would have required an even deeper recession andhigher unemployment than actually witnessed in 1999-2001.

Moreover, the economic contraction made it very difficult to keepthe public debt sustainable. It would have required a dramaticallyrising primary scal surplus (excluding interest payments) that wouldhave reached 4 percent of GDP in 2000 or, ultimately, 2001. Thiswas a highly unlikely scenario, the authors argue, given Argentinasscal history and institutions. Argentinas debt dynamics thereforeincreasingly became assessed as unsustainable.

With regard to the policy response by the Argentine government,Perry and Servn observe that the dollar peg created a harshdilemma. One option was to accept a painful and protracteddeationary adjustment while keeping the Currency Board ... toretain market condence. ... The other option was a more orderlychange of the exchange rate regime during the boom years before1999. However, letting the peso devalue and oat would have led toa latent corporate, banking and scal crisis, given the dollarisedliabilities of both the public and the private sectors and the largedegree of overvaluation of the currency. A more orderly exit wouldhave required signicant structural reforms and institution building.

Perry and Servn conclude that the Argentine authorities can beblamed for instituting scal adjustment too little and too late (it shouldhave been done in the boom years before 1999), for hesitating on theultimate choice of exchange rate regime, for postponing the neededpublic debt restructuring for too long, and for precipitating a majornancial and payments crisis. In their view, a key lesson fromArgentina is that economic and political institutions are needed thatprovide incentives to face hard policy choices and facilitate timelyreforms, and in particular are less prone to amplifying economic cycles.

Ricardo Hausmann and Andrs Velasco

In a study published in July 2002,7 Hausmann and Velasco discuss,what they call, three major views on the Argentine crisis and presenttheir own analysis of what happened.




They dene the rst view as the self-fullling pessimismparadigm. According to this view, which was dominant before thecrisis, pessimism would lead to high interest rates, depressed growthand a weakening scal position, complicating debt service and thusjustifying the initial pessimism. The authors claim that the IMFshared this view, because it recommended a strengthening ofcondence through scal consolidation, believing that this wouldinitiate the opposite virtuous circle of stronger public nances, lowerinterest rates, and a recovery of economic activity.

Hausmann and Velasco examine some implications of thisparadigm with a simple simulation in which Argentina would havehad a growth rate of 3 percent between the fourth quarter of 1998and the second quarter of 2001. They nd that this would haveindeed eliminated the scal imbalance and that the public debt wouldhave remained stable. However, the current account decit wouldthen have climbed from 3 to around 5.5 percent of GDP, requiringlarge external funding and leading to the accumulation of anadditional 12 percent of GDP in external obligations.

In a second widely held view, the accent is placed on irresponsiblefiscal management . After the outbreak of the crisis, this became adominant view, Hausmann and Velasco observe, pointing to itsendorsement by the IMF, and others. The authors, however, do notbelieve that this view is supported by the facts. If one excludes thecosts that resulted from the privatisation of Argentinas socialsecurity system, the government was able to generate a primary scalsurplus in excess of 3 percent of GDP. This would have beensufficient to cover the increased cost of servicing the public debt. Infact, Argentinas primary surplus was of the same magnitude as thatof Brazil, in spite of the deeper recession. Hausmann and Velascoobserve: There is no evidence of a spending boom: as a share ofGDP, primary government expenditures remain roughly constant in1993-2001. They therefore ask: Where is the dramatic shift inscal outcomes between the time when Argentina was perceived asone of the safest emerging markets (say, in 1999) and its eventualdemise?

The authors argue that the bulk of scal problems were aconsequence, not a cause, of the overall mess. It was recession, notsimple scal misbehaviour, that prompted a worsening of expecta-tions and a rising country risk. Fiscal tightening was not the solution,nor did investors perceive it as such. Hausmann and Velasco nd it

Introduction8




striking that on the day (July 15th 2001) Domingo Cavalloannounced the zero-decit policy, implying an immediate cut inpublic sector wages and pensions of around 13 percent, Argentinascountry risk spread did not improve but rather deteriorate. It rosefrom 1200 to 1600 basis points. No country can be run on that basis,investors plausibly conjectured. Events thereafter proved them right.8

The third major view the authors discuss is the story about theoverly rigid exchange rate regime that resulted in overvaluation, thusreducing the protability of the export sector and limiting its abilityto expand supply. Here Hausmann and Velasco agree, but point tothe dilemma the Argentine government was facing. At theprevailing real exchange rate even modest growth of 3 percent couldonly be achieved at the expense of large current account decits andrising debt ratios. Argentina thus found itself in a bind: if it tried togrow it risked accumulating debt to the point of insolvency; if itchose to achieve external balance, it would have had to achievestrongly negative growth rates, which would also have imperiled itssolvency. They doubt whether one could, reasonably, have expectedthe Argentina government to nd a solution to the exchange rateproblem, given the increasingly scarce external nancing andArgentinas large private and public dollar debt.

In their own analysis of the crisis, Hausmann and Velasco focus onthe interaction between two factors: the real exchange rate and thecapacity to borrow abroad. They observe that after the Russian crisisof 1998 and the Brazilian devaluation of 1999, international investorslost some of their appetite for emerging country securities generally.But in the case of Argentina, external conditions worsened evenmore, basically as a result of its dollar peg, making the country lesscapable to export and grow. Lower export earnings limitedArgentinas capacity to repay debt, and thus limited foreign lending.The lack of external resources resulted in a fall of investment andoutput, which in turn depressed demand for domestic production.

Hausmann and Velasco conclude that three coinciding factorsexplain why Argentina was hit so hard by the crisis: the high initial

8 Barry Eichengreen observed in October 2001 that the cut in state salaries andpensions by 13 percent was, predictably, met with widespread streetdemonstrations raising doubts among investors about the sustainability of thezero-decit policy. See, Barry Eichengreen, Crisis Prevention and Management:Any New Lessons from Argentina and Turkey?, mimeo, October 2001.


debt level, the inexible exchange rate system, and the relative lowimport and export levels.

The Studies in this Book

In the second chapter, Dani Rodrik compares the Argentinegovernment, because of the pegging of the peso to the US dollar, toUlysses, pinning himself to the mast of his ship to avoid the call of theSirens. He recalls that Argentinas policies during the 1990s wereexemplary by neo-liberal standards and that no country tried harderto endear itself to the international capital markets. Argentinepolicymakers pursued austerity policies even when one worker out ofve was already out of a job.

Rodrik stresses that what sealed Argentinas fate in the eyes ofnancial markets was not what its political leaders were doing, butwhat the Argentine people were willing to accept. This shows, hesays, that when the demands of foreign creditors collide with theneeds of domestic constituencies, the former eventually yield to thelatter. In his view, developing countries should not adopt foreigninstitutional blueprints (the Washington Consensus), but seek,instead, enhanced state capacity to undertake institutionalinnovation based on domestic needs and local knowledge. Heemphasises that Argentina should rebuild the credibility of itspolitical system, not for the sake of nancial markets, but for the sakeof ordinary Argentineans.

In the third chapter, Jos Antonio Ocampo gives a succinctaccount of the incubation of the Argentine crisis. He stresses thatwith the choice of Convertibility (pegging the peso to the dollar) asthe mechanism to restore nancial stability in the early 1990s, theArgentine government placed itself in a position that left it with verylittle room to manoeuvre. He observes that the dollar peg led to astrong dependency on highly volatile external nancial ows, and toa sharp business cycle. Eventually, the recessionary effects of thesystem led to its demise. Ocampo advocates that both the Argentineauthorities and the IMF take a highly pragmatic approach and bewilling to learn as they go along.

In the fourth chapter, Jos Maria Fanelli examines specicfeatures of the Argentine economy and addresses questions such as:Why did Argentina choose an exchange rate system as rigid as a

Introduction10




currency board? Why were contracts dollarised? Why was the IMFso involved with and supportive of the countrys policies underConvertibility? He concludes with a discussion of four steps torestore macroeconomic and nancial stability, and wonders whetherthere are hidden resources to resume growth. One hidden resourcehe mentions is the large stock of foreign assets in the hands of theprivate sector in Argentina, representing roughly 100 percent ofGDP: As soon as the economy stabilises, this wealth effect canbecome a powerful incentive to effective demand.

In the fth chapter, Ricardo Ffrench-Davis and Rogrio Studartdiscuss the regional fallout of the Argentine crisis. They claim thatthe spill-over effects are related to the build-up of threevulnerabilities during the 1990s: an external liabilities overhang, afragile domestic nancial sector, and the rise of political fatiguewith neo-liberal policies. They conclude that conventional policyresponses to external shocks have become less effective, politicallyinfeasible and highly damaging to domestic nancial stability, andadvocate a policy response that would mitigate the threevulnerabilities identied.

In the sixth chapter, Bernardo Lischinsky gives a detailed analysisof the evolution and characteristics of Argentinas debt, comparing itwith that of other countries. He pays particular attention to what hecalls, the virtual dollar creation under Convertibility. He concludesthat the debt problem will not be solved rapidly, because it is notmerely a nancial problem. In his view, it can only be solved in thecontext of a different development model.

In the seventh chapter, Onno de Beaufort Wijnholds, who was amember of the IMF Executive Board from 1994 to 2002, gives hisview on why the actions of the Argentine authorities were leading toa dead end. He also explains why he did not support the IMFsdecision in September 2001 to augment the existing Fund credit by 8 billion dollars. One of the lessons he draws is that both the IMF andthe private sector paid insufficient attention to the build-up of anunsustainable external debt situation. As borrowing from the marketcontinued until a quite late stage and from the IMF beyond what wasin Argentinas own interest, the collapse was especially devastatingwhen the plug was nally pulled.

In the nal chapter, Mark Allen reviews the lessons that the IMFdrew from previous crises in Mexico, Asia and Russia, and how itviewed economic policy in Argentina in light of these lessons. He




then examines the factors that precipitated the crisis in Argentina andasks whether these were obvious to the IMF at the time. Finally, hedraws some lessons from the Argentine crisis that could help preventother countries from falling into the same traps. One such trap hementions is the (inevitable) embrace by developing countries ofglobalisation. Because of the volatility of private nancial ows, thiscan entail huge costs if not properly handled. He warns that it willbe a long way before the people of developing countries can benetfully from their integration in the global economy.

The Role of the IMF

The IMF has been strongly criticised for the role it has played bothbefore and after the outbreak of crisis in Argentina. Protesters on thestreets of Buenos Aires have pointed to the IMF as the main culprit,along with the Argentine authorities. Joseph Stiglitz and othereconomists blame the IMF for having given the wrong advice andrepeating the same mistakes it made in East Asia. However, is it fairto shift so much blame on the IMF?

In the nal chapter of this volume, Mark Allen admits that theFund has made various mistakes. For example, he acknowledges thatthe Fund failed to pinpoint the growing vulnerability of(Argentinas) economy during the 1990s (and) did not produce asufficiently clear analysis of the situation to catalyse an early decisionto restructure the debt. He also acknowledges that the Fund staffwas overly optimistic in its assessments of underlying trends inArgentina, and observes that the Fund was excessively indulgent inthe application of its conditionality during the 1990s. He stresseshowever that the Fund was basically inspired by the wish to preventthe outbreak of the crisis, and that before the crisis it was not obvioushow it could have acted differently.

Could the Fund have acted differently? Here, again, opiniondiverges. Some say that the Funds neo-liberal policies inevitably ledto disaster in Argentina, whatever greater clarity about Argentinasunderlying trends it might have had. Others argue that, by no means,could Argentina have escaped disaster. Allen seems to defend this lastview when he relates the Funds decision of September 2001 toaugment a stand-by credit by 8 billion dollars. ... it is not clear thatanother policy package at that point for example, one involving

Introduction12




either scal stimulus or the abandonment of the exchange rate peg would have helped Argentina escape disaster.

Should the IMF now agree as soon as possible with Argentina ona large nancial rescue package of similar magnitude as that ofBrazil?9 Again, opinion diverges. Some say it should rather not,arguing either that it would give the wrong signal to foreign investors(the moral hazard argument that nancial rescue leads to moreimprudent lending and additional crises) or that it would continue tostrangle the Argentine people by increasing the debt and pushing thewrong development policies (see e.g. Rodrik and Lischinsky). In thepages that follow, none of the contributing authors seems to considera huge rescue package as the main ingredient for Argentinas roadto recovery. Rather, they stress the importance of sound home-grownArgentine policies and sound international nancial policies. Thisbrings us to the last issue we want to discuss in this introduction: therole of politics in crisis management.

The Politics of Crisis Prevention and Management

Focusing on deeply enshrined historic weaknesses of Argentinaspolitical and economic structure, one may hope that longer-termbenecial effects will turn Argentinas crisis into a blessing indisguise. Meanwhile, the crisis brought unemployment and povertyfor a large number of Argentineans. So the question emerges: Couldmore have been done to prevent the crisis? The answer is, yes but...

As the preceding and following pages of this book show, the butcan be many things. For example, one could say that the Argentinegovernment was not really able to abandon the peso-dollar peg. Orone could say that neither the majority of the Argentine people northe majority of the economic experts, both inside and outside thecountry, were aware that the peg was doomed to fail and should havebeen abandoned earlier. Or, to give a last example, one could say thatthe IMF and the foreign investors continued to give the wrongsignals to Argentina. As Dani Rodrik has said, there are enoughculprits to explain the Argentine crash many times over.

The highlighted studies above and the studies that follow providea wealth of facts, arguments and policy suggestions that go far

9 On August 8, 2002 the IMF agreed to lend 30 billion dollar to Brazil.


beyond a simple search for culprits. The authors have differentfocuses and, often, draw diverging conclusions. That is not so sad.Even the most complete and rigorous economic analysis of theArgentine crisis could never answer in an undisputable manner thefundamental question: What would be the best economic policy forArgentina, or any other country?

In the end (and in the beginning), the answer to that questionremains a matter of politics, and requires a democratic debate of theideals and objectives one wants to achieve. Unfortunately, in mostcountries, including industrial countries, such a debate is hardlytaking place. Some observers argue that the political angle is evenmore important for understanding and remedying Argentinas crisisor improving the global nancial system than the economic one. Butwhatever view one takes, any serious and long-term solution forArgentinas and the worlds economic problems requires a thoughtfuland democratic discussion. This book aims to contribute to thatimportant discussion.

Introduction14




15

1 This chapter is a reprint of Dani Rodriks article Reform in Argentina, TakeTwo. Trade Rout, published in The New Republic on January 2, 2002.

2Argentina: A Case of Globalisation Gone Too Far or Not Far Enough?Dani Rodrik1

Argentinas default on its $132 billion public debt on December23, 2001 hardly came as a surprise to its foreign creditors, whohad anticipated it for many months. It had been clear to most outsideobservers that the countrys currency board regime, which locks inthe Argentine pesos value one-to-one with the US dollar, had heldthe peso at an unsustainable level vis--vis other currencies. It wasalso evident that the political system would be unlikely to deliver thebelt tightening needed to service foreign creditors ahead of domesticpayments on wages, pensions, and other obligations. So, whenPresident Fernando de la Ra and economy minister DomingoCavallo resigned and the inevitable happened shortly thereafter, fewother markets around the world moved.

As is usual after a debacle of such a magnitude, ngers have beenpointed at enough culprits to explain the Argentine crash many timesover. The Argentine political class was too shortsighted to reach acompromise on scal policy. The currency board system was toorigid to allow Argentine exporters to regain their competitivenessfollowing Brazils devaluation of its currency in early 1999. Labourunions were too unresponsive to demands for reform. Cavallo wastoo sure of himself and went for too many gimmicks to resuscitate theeconomy and lower the cost of servicing the debt. Foreign creditors



were too ckle and should not have reversed course so dramaticallyafter their rush into Argentina in the early 1990s. The IMF should have pulled the plug much sooner. The IMF should not have pulled the plug. But the tragedy of Argentina goes much deeper than any of these explanations. The collapse offers ahumbling lesson about the limits of economic globalisation in an age of national sovereignty.

Even though many in Washington would rather forget it,Argentinas policies during the 1990s were in fact exemplary by theorthodox standards that neo-liberal economists have advocatedaround the world. The country undertook more trade liberalisation,tax reform, privatisation, and nancial reform than virtually anyother country in Latin America. And no country tried harder toendear itself to international capital markets. The overvaluation ofthe peso was a nagging concern, to be sure, because of the loss ofArgentine competitiveness. But economists have long taught thatdevaluation of the national currency the common remedy toovervaluation is of little use in a country that is nancially inte-grated with the rest of the world, which Argentina surely was. Whenbanks balance sheets are dominated by dollar liabilities, devaluationwreaks havoc with the nancial system. The Argentine experimentmay have had elements of a gamble, but it was also solidly groundedin the theories expounded by US-educated economists, the USTreasury, and multilateral agencies such as the World Bank and theIMF. When Argentinas economy took off in the early 1990s afterdecades of stagnation, the economists reaction was not that this waspuzzling; it was that reform pays off.

The Too Simple Idea of Sovereign Risk Reduction

The Argentine strategy was based on a simple idea: that reduction ofsovereign risk is the quickest and surest way to reach the income levelsof the rich countries. Sovereign risk refers to the likelihood that agovernment will be unwilling to service its foreign obligations evenwhen it has the capacity to do so. In domestic nance, the distinctionbetween willingness-to-pay and ability-to-pay is much less importantbecause courts and regulators can sanction recalcitrant debtors. Butcountries cannot be sanctioned in quite the same way, because theyare sovereign hence the term.

Globalisation Gone Too Far or Not Far Enough?16



17Dani Rodrik

Sovereign risk matters because it is an important obstacle toeconomic convergence among nations. If investors had no fear thattheir lending would be expropriated, capital would move inabundance from the rich countries, where it is plentiful and yields arelow, to the poor countries, where it is scarce and yields are high. Inthe process, incomes would equalise across borders. But in reality,capital often moves in the reverse direction think of the bankaccounts in Miami and Zrich maintained by wealthy individualsfrom developing nations. Yields may not be higher, but moneyinvested in the US or Switzerland is at least safe from expropriation.

Viewed from this perspective, the challenge of economic develop-ment is reduced to three simple propositions. Economic growthrequires foreign capital. Foreign capital requires removing sovereignrisk. And removing sovereign risk requires a commitment not to playgames with other peoples money. All this made for a coherenttheory, even if it did not correspond to the actual developmentexperience of any successful country larger than a city-state. Gettingrid of sovereign risk, it would turn out, requires a lot more than com-mitment to sound money.

The overarching goal of Argentine economic policy during the1990s was to deliver this commitment, and even more importantly, toconvince nancial markets that the commitment was real andbinding. The straitjacket of the currency board regime was thelinchpin of this strategy: By linking the value of the peso one-for-oneto the US dollar in 1991, and putting monetary policy on automaticpilot, the regime sought to counteract the effects of more than acentury of nancial mismanagement. Privatisation, liberalisation andderegulation further underscored the governments commitment to anew set of rules. Like Ulysses pinning himself to the mast of his shipto avoid the call of the Sirens, Argentine policymakers gave up ontheir policy tools lest they (or their successors) be tempted to usethem to repeat the errors of the past. Their hope was that they wouldbe rewarded with a sharp reduction in Argentina risk, leading tolarge amounts of capital inows and rapid economic growth.

For a while, it looked as though the strategy might work. In therst half of the 1990s, capital inows did increase substantially andthe economy expanded at unprecedented rates. But then Argentinawas hit with a series of external shocks the Mexican peso crisis of1995, the Asian crisis in 1997-98, and most damagingly, the Braziliandevaluation of January 1999. The last left Argentinas economy



looking hopelessly uncompetitive relative to its regional rival.Economic growth turned negative in 1999, and foreign investorsbegan to worry about the repayment of the huge liabilities incurredduring the course of the decade. By the second quarter of 2001,Argentinas country risk was rising relative to that of other emergingmarkets. This despite of the return to the helm of Cavallo, thearchitect of the currency board regime, in March 2001 or as somewould say, because of it. Cavallo, with his strong credibility innancial markets, at rst looked like he might be exactly whatArgentina needed. But his efforts to engineer economic growththrough an unconventional mixture of tax and trade policies and abungled attempt to alter the currency board regime by giving theeuro a role parallel to that of the dollar were not well received bymarkets and cost him dearly.

By the end of the summer, the nancial condence game was infull play. Markets demanded a huge interest premium for fear thatArgentina might default on its debt. But with interest rates so high,default was virtually assured. The possibility that Argentina woulddefault was enough to ensure that it would.

That nancial markets make only fair-weather friends is no newsat all. That they turned so rapidly against Argentina requires moreexplanation. This, after all, was a government that had focused itspriorities not on a nondescript social agenda, but on attaining invest-ment-grade rating in credit markets and essentially little else. Thecommitment of the top political leadership to service the externaldebt could not have been, and was not, in doubt. Cavallo and de laRa were willing to abrogate their contracts with virtually alldomestic constituencies public employees, pensioners, provincialgovernments, bank depositors so as to not skip a cent of theirobligations to foreign creditors. Yet in the end, investors still woundup thinking that Argentina was a worse credit risk than Nigeria.

What sealed Argentinas fate in the eyes of nancial markets as2001 came to a close was not what Cavallo and de la Ra were doing,but what the Argentine people were willing to accept. Cavallo knewhe had to regain market condence in order to bring the crushinginterest burden on Argentine debt down. When his initial attemptsto revive the economy produced meagre results, he was forced toresort to austerity policies and sharp scal cutbacks in an economywhere one worker out of ve was already out of a job. He hadlaunched a zero-decit plan, and enforced it with cuts in govern-




19Dani Rodrik

ment salaries and pensions of up to 13 percent. Markets grewincreasingly sceptical that the Argentine congress, provinces, andcommon people would tolerate such Hooverite policies, longdiscredited in advanced industrial countries: No matter how adamantCavallo himself was to avoid default, domestic politics wouldeventually undo his efforts. And in the end, the markets were provencorrect. After a couple of days of mass protests and riots just beforeChristmas, Cavallo and de la Ra had to resign in rapid succession.

An Alternative Vision

In his ode to globalisation The Lexus and the Olive Tree, TomFriedman famously declared that the electronic herd the mass oflenders and speculators who can move billions of dollars around theglobe at an instant reduces domestic politics to a choice betweenPepsi and Coke, with all other avours banished. Having donned theGolden Straitjacket so enthusiastically, the Argentina of the 1990slooked like the perfect illustration of Friedmans point. Theeconomic policies of de la Ra and the Peronists that preceded werevirtually indistinguishable. But Argentinas real lesson proved to be a different one: that democratic politics casts a long shadow oninternational capital ows, even when political leaders are obliviousto it. When the demands of foreign creditors collide with the needsof domestic constituencies, the former eventually yield to the latter.Sovereign risk lurks in the background as long as national politiesexist as independent entities.

What one does with this lesson is less clear. Many will draw theconclusion that Argentina took a wrong turn not because it went toofar in its search for the holy grail of globalisation, but because it didso imperfectly and inadequately. The solution from this perspective isto improve on the Argentina model by chipping away at nationalsovereignty and by further reducing the responsiveness of economicmanagement to domestic political forces. What national govern-ments need are stronger commitment mechanisms a straitjacketmade of platinum, if gold proves too malleable. This is the neo-liberal vision that inspires some economists and political leaders toseek full dollarisation of their economies or to look at the prospectiveFree Trade Area of Americas (FTAA) as solutions to the governanceproblems of the region. If you were to accuse adherents of this view



2 See Dani Rodrik, After Neoliberalism, What?, Remarks delivered at aconference on Alternatives to Neoliberalism, Washington D.C., May 23, 2002.

of wanting to turn their countries into replicas of Puerto Rico wards of the United States in effect they would not be offended.

But there is an alternative vision. It is to accept that separatingpolitics from economics is neither easy nor even desirable.Proponents of this view, including myself, would not be embarrassedto claim primacy for democratic politics over the electronic herd, nomatter what the implication for sovereign risk. They would concedethat economic mismanagement by sovereign governments has beenvery costly for the developing world, but would argue that theappropriate response to mismanagement is not lack of management,but better management. This vision has no easy answers or shortcutsto offer to Argentine policymakers. It would be nice if improvedgovernance could be acquired simply via the discipline imposed bynancial markets and trade agreements. And economic developmentwould be a lot easier if all that is required is throwing a big welcomeparty for foreign capital. But the historical record shows that thesolution to underdevelopment lies not with the adoption of foreigninstitutional blueprints or the undermining of national autonomy. Itlies with enhanced state capacity to undertake institutionalinnovation based on domestic needs and local knowledge.2

The tasks before Argentinas policymakers are colossal: toincrease the economys competitiveness through a devaluation of thecurrency without setting off an inationary spiral; to reconstruct thenancial system so that it serves the needs of the real economy; todiversify the economy and wean it from excessive reliance onagricultural products; to address the pervasive economic insecuritythat afflicts the middle class through new mechanisms of socialinsurance. Now that Argentina has cleared the deck by defaulting onits debt, the country has to get on with the hard work of rebuildingcredibility for its political system this time not for the sake ofnancial markets, but for the sake of ordinary Argentines.

As governments ponder these alternatives, they would do well toconsider the following astonishing fact: Despite the tremendous waveof neo-liberal reform that swept over the continent during the lasttwo decades, only three economies in Latin America managed in the1990s to outdo the performance they had experienced under the




21Dani Rodrik

inward-looking, populist policies of the past. Chile remains a success,in part because it has taken a cooler attitude towards capital inowsthan the others. Uruguay looks shaky and is hardly an inspiringexample in any case because its growth rate has been anaemic. AndArgentina now lies in ruins. Its collapse reminds developing nationsin Latin America and elsewhere that they cannot postpone muchlonger the stark choice they face. Either they will sacricesovereignty in a big way, or they will reassert it vigorously.



3The Mistaken Assumptions of the IMFJos Antonio Ocampo

Argentinas adoption of a convertibility regime in the early 1990swas a legitimate attempt to restore a viable monetary andnancial system in a country that had lost condence in itsauthorities ability to manage the currency. Among all the availableoptions, however, the system that was chosen was the one thatrestricted the economic authorities manoeuvring room the most. Atthe time, this option was seen as the best mechanism for buildingcredibility in a country in which economic agents had lost faith in thesuccessive Administrations ability to manage the economy properly.Nonetheless, it was obviously not the only option available and, infact, none of the other Latin American countries that had beenafflicted by hyperination in the 1980s or early 1990s (Bolivia, Brazil,Nicaragua and Peru) chose a similar system.

The new scheme worked well for a time. It was effective inbringing about a rapid recovery in the early 1990s, a fairly swiftremonetisation of the economy, the reconstruction of the nancialsystem and the reappearance of corporate and personal credit. Theconvertibility system did, however, have two other very closelyrelated effects: a strong dependency on highly volatile externalnancial ows and, given the absence of any scope for exibility ineconomic policy, a sharp business cycle. The countrys heavydependence on external nancing was, in turn, reected in a strongtendency to run a trade decit, together with a clearly overvaluedcurrency. Advocates of the system tended to underestimate these

22



1 See ECLAC (2000), vol. III, chapter 1 (see gure 1.1 in particular).2 This also is a reection of the difficult learning processes involved in theformation of macroeconomic expectations that are characteristic of far-reachingstructural changes such as those experienced during these years. See the excellentessay by Heymann (2000) based on reections regarding Argentinas situation.3 See Altimir and Beccaria (1998) and Damill, Frenkel and Maurizio (2002).

23Jos Antonio Ocampo

effects, and actually saw them as positive outcomes of a properlyfunctioning market in which abundant capital ows were beinggenerated by a highly credible economic policy.

When compared with other Latin American countries, Argentinaexperienced a peculiar combination of macroeconomic stability andinstability during the 1990s: signicant price stability coupled withlarge instability in economic growth rates.1 Given the sharpness ofthe business cycle, it is difficult to determine what effect convertibil-ity had on long-term growth, since any estimation of the potentialGDP growth rate is strongly inuenced by the time periods chosenfor its calculation. This explains, in turn, why it was so difficult foreconomic agents to determine what level of income was sustainable.2On the other hand, restructuring the countrys labour markets waspainful. In large measure, this was a result of the currencys over-valuation, since the low rate of job creation in tradable sectorsbecame a structural trait of the convertibility regime. High openunemployment in a country that had traditionally had low un-employment levels, even during the lost decade of the 1980s wasits main corollary. This process was also accompanied by adversepressure on poverty and income distribution.3

Signicant trouble built up since the mid-1990s. Indeed,Argentinas economy was the one that was most heavily exposed tocontagion from the crisis that broke out in Mexico in late 1994. As weall know, the convertibility scheme managed to survive the Tequilaeffect and generated high growth rates once again in 1996, 1997 andthe rst half of 1998, largely as a result of the sustained expansion oftrade with Brazil. However, with the radical change in capital ows to emerging countries that came in the wake of the Asian crisis of1997-98, the Brazilian devaluation in early 1999 and the steadyappreciation of the dollar from 1998 to 2001, the overvaluation of theArgentine peso led to an outright structural crisis. As the convertibil-ity schemes exit costs were explicitly high (which was, in the eyes ofits advocates, its main virtue), the authorities clung to the system,



which, nonetheless, soon collapsed. The breakdown of the scheme,like its gold-standard predecessors, was chaotic and was heralded by arun on deposits in the nancial system and a loss of reserves.

The withdrawal of deposits, the loss of reserves and the collapse ofeconomic activity all occurred abruptly and simultaneously in 2001,that is to say, while the convertibility regime was still in full sway. Justas occurred during the gold standards collapse in the 1930s, theauthorities rst tried to make the system more exible (viacompetitiveness plans and public debt swaps) in an effort to stave offits downfall. When this effort failed, they restricted depositwithdrawals, declared a public debt moratorium and introducedexchange controls. These measures, in themselves, signalled areluctant abandonment of convertibility. Eventually, with thedevaluation of January 2002, the regime was discarded outright. Thesevere deterioration in the nancial systems liquidity disrupted thepayment chain and fuelled a strong demand for the central bank toact as a lender of last resort.

Thus, the credibility that had been built up on the basis of theconvertibility regime was more than offset by the recessionary effectsthat the system generated during crisis periods. In the end, the lack ofcondence in the sustainability of public and private debt servicingwon out, thus overpowering the system. What is more, because theexit costs were avowedly high, private agents mistrust in theeconomic authorities ability to maintain the rules of the game gaverise, at a critical juncture in this chain of events, to an explicit call fora run on deposits and thus, inevitably, to a chaotic denouement at theend of 2001.

Alternative explanations for the collapse will, of course, continue tobe offered. One of them is that there was not enough price or wageexibility. Actually, there was a moderate degree of exibility. However,it should be recalled that, during the era of the gold standard, it becameclear that exibility is not a panacea. In fact, exibility actually tends toexacerbate crises because nominal debt balances are not exible and theactual burden they represent therefore increases rapidly in the presenceof deation. In other words, deation is equivalent to a steep rise in realinterest rates; for this reason, it has adverse effects on economic activityand banks portfolios. This was also a point made by John MaynardKeynes when arguing against the orthodox formulas for dealing withcrises that prevailed up to the 1930s.

The Mistaken Assumptions of the IMF24




Another explanation is that scal austerity was lacking. This ispartially true especially in the second half of the 1990s but it isalso true that the scal crisis of the late 1990s was, in large measure,endogenous. The contraction of production activity as transmittedthrough the downturn in tax receipts, rising country risk spreads and,hence, the higher cost of public sector borrowing set in motion avicious circle in which primary spending cuts were invariablyinsufficient to offset the upward trend in the budget scal decit.What is more, the authorities were faced with the paradox that,insofar as the convertibility regime was characterised by an endemictendency to run a trade decit and by dependence on externalnancing, the scal decit was, in a sense, functional. It made itpossible to maintain aggregate demand and economic growth whileat the same time providing a portion of the necessary externalnancing that the economy needed in order to grow during boomperiods.

Wrong Assumptions

In 2001 the International Monetary Fund handled the Argentinecrisis in a radically different way than it had dealt with other episodessince the Mexican crisis and, in fact, than it had managed the crisis inArgentina itself up to December 2000, when international nancialinstitutions had provided it with its armour-plating. The rstassumption underlying the new approach adopted in 2001 was that,in order to avoid the much-touted problems of moral hazard,market discipline ought to be reected both in losses for investorsthat have assumed excessive risk and in a severe adjustment for thecountry whose policymakers have erred. The second assumption wasthat the contagion of other economies in the region could beavoided or, in other words, that the explosion could be contained.

The rst assumption was based on the mistaken idea that theinternational community could nd a way to wash its hands of theevents in Argentina. No one doubts today, either in Argentina orelsewhere, that errors were made in managing the countrysconvertibility regime. But it is also clear that the internationalnancial community played a role in creating the conditions thatultimately led to the collapse of the countrys monetary and nancial



system. Favourable expectations spurred what proved to be anavalanche of private capital, and its subsequent ight was one of thefactors that triggered the crisis. This herd behaviour during bothphases of the business cycle is nothing new; rather it is an intrinsicfeature of private capital movements. International nancialauthorities were not mere bystanders either. While recognising thatthe ultimate responsibility for the economic policies that wereimplemented rests with the national government, and despite thereservations that the IMF may have had and may have voiced ondifferent occasions, the fact remains that the Fund backedArgentinas economic programmes throughout the decade that theconvertibility regime was in place. In fact, at the annual IMF meetingin 1998, the Funds Managing Director heralded Argentinaseconomic policy as the best in the world. The private andmultilateral sectors of the international community had a hand increating the crisis, and they must have a hand in its solution.

The second assumption was just as mistaken as the rst. The delayin the support of IMF for Argentina no doubt exacerbated nancialmarkets hypersensitivity towards Latin America. Foreign directinvestors perception of risk in the region was heightened, sinceArgentina was one of the favourite destinations of such investmentsduring the 1990s. There are, of course, exceptions; some countrieshave managed to access nancial markets at reasonable spreads, buteven they have had to deal with investor caution, and none hasexperienced rapid growth. Through the capital account, as well asthrough trade, tourism, the reduction in remittances from migrantsliving in Argentina and the losses sustained by Latin American rmsthat have invested in that country, the Argentine crisis has beentransmitted to other countries of the region.4 The idea that it waspossible to isolate the crisis and prevent contagion thus tumbled likea house of cards. In an economic climate marked by the perception ofsevere uncertainty in Latin America and, it should be added, highlyunstable nancial markets in the industrialised countries themselves,the Funds belated response to the situation in Brazil and Uruguayalso yielded diminished returns.


4 For a detailed analysis of the Argentine crisis regional effects, see ECLAC(2002), and the chapter by Ffrench-Davis and Studart in this volume.




Lessons

The lessons to be learned from this experience are well known. Theeffects of volatility in nancial markets are devastating. One of theirinherent features is the alternation of periods of under andoverestimation of risk, i.e. of periods of irrational exuberance (theterm coined by the Chairman of the Federal Reserve, AlanGreenspan) and irrational panic. Just such irrational panic hasbeen seen in the cases of Brazil and Uruguay in 2002. Levels ofindebtedness which, shortly before, had been regarded as manage-able were suddenly reinterpreted as being unsustainable. Thisturnaround is particularly serious because as demonstrated bymodels of multiple equilibria and self-fullling prophecies and, forthat matter, as recently observed by the international nancierGeorge Soros in relation to Brazil the market sometimes has a wayof imposing its own expectations on reality, even when they areirrational. It should perhaps be added that, above and beyond anyerrors that may have been made by economic policymakers or anymistaken decisions made by individual investors, such self-fulllingprophecies have certainly been a factor in the Argentine crisis.

Given these circumstances, prompt action by the IMF is requiredto correct what are essentially market failures. Such action is alsocritical in order to prevent contagion, since the formation ofexpectations about the situation in a country cannot be divorced fromthe regional context. These observations therefore point to some-thing much more profound: an international nancial system thatgenerates this type of hypersensitivity and, hence, this high afrequency of nancial crises, is awed and must be reformed.

The management of the Argentine crisis has two additionallessons to teach us that should be borne in mind as we move forward.The rst is that, in the presence of great uncertainty and lack ofcondence, if the parties involved i.e. national authorities and theIMF are to advance in the right direction, they will have to take ahighly pragmatic approach and be willing to learn as they go along.This is the only way that the economic authorities can, slowly butsurely, gain credibility. In Argentina, the restrictions that have beenplaced on nancial transactions cannot be entirely dismantled untilcondence in the new monetary and exchange rate regime has beenbuilt up. Production activity has to be returned to some degree ofnormalcy in order for tax revenues to recover so that a lasting scal



balance can be achieved. Trying to bring about a scal adjustment bymaking even greater cuts in expenditure does not lead to scalequilibrium but rather to deeper recession and scal imbalances, asbecame clear in 2001. Refraining from intervening in the foreignexchange market when inationary expectations are based largely onthe exchange rate would simply open the door to hyperination andthen dollarisation. It is important to recognise that no one knowsexactly how events are going to unfold in the near future, nor has analternative route been plotted out in detail. This is why, once theultimate objectives have been clearly dened, pragmatism is the onlypossible avenue. Under present conditions, to demand a comprehen-sive blueprint is simply not realistic.

This points up to the nal lesson. Precisely because there is somuch uncertainty and because events are unfolding in a very dynamicway, the conditions for the commencement of formal negotiationsbetween the Fund and Argentina have been subject to signicantchanges through 2002. This has sparked a lack of condence on bothsides. The Government of Argentina has said, with some justi-cation, that each time it has met the stated requirements, newdemands have been made. For its part, the International MonetaryFund has had misgivings as to whether those requirements havegenuinely been fullled, and this has often been because of decisions,whether actual or potential, made by the legislature or the courtsrather than by the government as such or by the central bank, whichare the parties directly engaged in negotiations with the Fund. Apartfrom this, excessive public pronouncements by IMF authorities haveheightened the two parties mutual distrust. Under these conditions,in addition to the pragmatism mentioned earlier, the requirementsfor the commencement of negotiations should be clearly established,a high degree of condentiality must be maintained in thosenegotiations, and whatever public statements are made by the Fundmust be carefully considered (and even avoided).

Current Conditions and Outlook

The effects of the explicit abandonment of convertibility in 2002 didnot bear out the more pessimistic projections that had been made. Inparticular, despite great uncertainty and the absence of externalbacking, neither the exchange rate nor ination went through the





roof. A prudent wage policy has no doubt contributed to this result.The demand for money has been stronger than initially anticipated,even in relation to the more optimistic expectations. The scalsituation has changed for the better, although this improvement isbased on factors that would be difficult to maintain over the longterm (a wage freeze, a moratorium on the external debt, and exporttaxes).

The severe deterioration in production activity experienced in2001, which was only exacerbated in December of that year by theparalysation of the payments system, bottomed out in the earlymonths of 2002 and activity has normalised somewhat since thesecond quarter. The trade surplus has remained high, largely becauseof slack demand for imports. Exports have been hurt by the paralysisof credit and the contraction of intra-Mercosur trade, but some signsof a reactivation are beginning to appear. It is true, however, that itwas not until mid-2002 that the countrys favourable trade balancebegan to be reected in a stabilisation of international reserves, whichindicates that signicant capital outows continued throughout therst semester.

On the negative side, the combination of the higher un-employment levels associated with the slump in production activityand the decline in real wages was reected in a steep increase inpoverty and indigence. Nevertheless, since the collapse of productionactivity and the breakdown of the convertibility system both occurredin 2001, it is difficult to lay the blame for those events on the way thecrisis has been managed in 2002. The main problem in the latter casehas been that, even though steps have been taken to alleviate the mostextreme situations by setting up a programme to provide subsidies forheads of household, the efforts to reverse these trends have notsucceeded.

The recovery of production activity has been hindered bypolicymakers indecisiveness regarding the distribution of the costsand benets of the devaluation. This has given rise to varyingsolutions and to conicts between the government and the centralbank which have delayed the normalisation of the payments systemand of credit for working capital. Court decisions protecting therights of bank depositors and the protraction of the process ofreaching an agreement with the Fund have also been part of theproblem. The scal costs of resolving the nancial crisis thereforeremain uncertain, and it is possible that the prolongation of the crisis



may dim the countrys future nancial development prospects. Onthe positive side, it may be said that bankruptcies have fallen and thatrms have learned fast how to operate without credit.

There is still a long way to go. There is some degree of consensusas to the main things that need to be achieved, but there remains agreat deal of uncertainty as to how to go about it. First, and foremost,it is necessary to restore the condence in private contracts.5 Thenormalisation of the payments and credit systems is an element inthis process. This is certainly an area in which innovative solutionsshould be devised. Unlike earlier crises, the cost of restructuring theeconomy cannot be absorbed entirely by the State. Instead, it willhave to be shared with debtor rms, depositors, banks and taxpayers.Explicit, active external support that will help build up the newregimes credibility must also be forthcoming.

There is also a clear consensus as to the need to put publicnances in order. This includes low budget decits, an enduringscal covenant between the central government and the provinces, abetter tax system and, above all, an improved tax administrationcapacity. There is also clarity as to the need for a exible monetarypolicy that can ensure low ination and an orderly oating exchangerate regime.

The renegotiation of the external debt is another piece ofunnished business, but in some ways it is a less urgent task, since noarrangement could conceivably attract signicant amounts ofadditional capital in the near future. Consequently, reaching a debtagreement has only short-term costs, since its benets will only berealised in the long run. The countrys dependence on multilateralnancing will therefore be very marked in the immediate future. Thetask of remedying the debt problem may, however, be an appropriateeld in which to explore innovative mechanisms for speeding thetransition to the normalisation of private external nancing. Onepossibility in this regard might be a scheme for the provision ofmultilateral guarantees for additional nancing (i.e. bailing inoperations with the support of guarantee schemes) in exchange forthe normalisation of the servicing of their nancial claims. Reducingprotectionism in developed countries for temperate zone agriculturalproducts in which Argentina has a strong comparative advantagecould also be part of the solution.


5 See the chapter by Jos Mara Fanelli in this volume.


From: The Crisis That Was Not Prevented: Argentina, the IMF, and Globalisation,FONDAD, January 2003, www.fond

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