earlyretirement
Moderator
Some wonder whether U.S. deficits could similarly fuel inflation; it all depends on the Fed
By Greg Ip
Nov. 22, 2023 at 6:53 ET
Argentina’s president-elect has promised to end inflation by replacing the peso with the dollar and abolishing the central bank. PHOTO: ERICA CANEPA/BLOOMBERG NEWS
Argentina is the bedtime horror story that other economies use to scare each other. Long after other emerging markets had internalized fiscal and monetary rectitude, Argentina has continued to lurch from default to hyperinflation and back.
So other countries may be tempted to conclude there is nothing to learn from the economic catastrophe that swept the radical populist Javier Milei to victory in this past weekend’s presidential election.
That might be just a bit too flip. Argentina’s problems are rooted in a combination of government borrowing, lax monetary policy and inflation, all of which other countries, including the U.S., have experienced to some degree in recent years.
What sets Argentina apart isn’t so much economic as political: its central bank is completely subordinated to the treasury, a combination economists call “fiscal dominance.”
As yet, this looks like a mostly Argentine problem. In fact, one positive takeaway of the recent surge of inflation is that central banks almost everywhere were allowed to combat it, with growing evidence of success. And yet in an era of structurally higher debts and populist politics, it would be foolish to dismiss the risk altogether.
Argentina’s budget deficit, which JPMorgan projects at around 5% of GDP this year, is actually smaller as a share of GDP than the U.S.’s. The problem is that years of economic mismanagement have left it with no access to the capital markets. Therefore the central bank finances the deficit by purchasing government debt in the open market and lending directly to the treasury.
This de facto money printing equaled about 5% of GDP in the first nine months of the year, according to JPMorgan. Moreover, the central bank loses money on this because it earns less interest on its loans to the government than it pays on the bonds it issues. Adding these losses, Argentina’s public deficit will balloon to about 14% of GDP this year, according to JPMorgan.
Iván Werning, an Argentine-born economist at the Massachusetts Institute of Technology, said the math is simple: to print enough money to finance a deficit of 5% of GDP requires expanding the monetary base (such as currency) by a like amount, which of course devalues the money the public already holds, yielding an inflation “tax.” Argentina’s inflation hit 142% in October.
Milei has promised to end inflation by replacing the peso with the dollar and abolishing the central bank. Dollarization makes it impossible to finance deficits by printing money. Other countries that have dollarized including Ecuador and El Salvador have ended inflation.
But there are problems with Milei’s plans. First, Congress, which opposition parties control, may not agree. Second, it is unclear where Argentina will get the dollars to replace its pesos with no access to private foreign capital and a current-account deficit (which entails a net drain of foreign currency to pay for imports and interest on external debt).
Finally, dollarization wouldn’t eliminate the underlying problem of government deficits. “The root of the problem is fiscal. If you don’t fix that, in the long run it is game over again,” Werning said. Milei has promised to take a chain saw to public spending, but much of it consists of subsidies and pensions that are politically difficult to cut.
A dollarized Argentina that didn’t reduce its deficits would eventually default. From 1991 to 2002, Argentina had a currency board, a form of dollarization, under which pesos and dollars were convertible one for one and circulated side by side. The government and private sector borrowed heavily in dollars, but mounting trade and budget deficits undermined confidence in their ability to repay. Eventually the peg broke and Argentina’s economy collapsed.
Populist outsider Javier Milei pulled off a massive upset Sunday with a resounding win in Argentina’s presidential election. PHOTO: LUIS ROBAYO/AGENCE FRANCE-PRESSE/GETTY IMAGES
Many emerging markets used to share Argentina’s history of reckless borrowing, hyperinflation and crises. Most left that behind in the last few decades by empowering independent central banks to target low inflation. The price surge that followed the pandemic and Russia’s invasion of Ukraine threatened to undo that progress. Yet central banks in emerging markets have aggressively raised interest rates and guided inflation back down.
The U.S. is the antithesis of Argentina: It has an independent central bank, little exposure to currency fluctuations and unparalleled access to capital markets. True, in 2020-21 Congress issued trillions of dollars of debt, some of which the Fed purchased under its quantitative easing program to ease borrowing conditions.
By early 2021, the broad money supply had soared 25% from a year earlier, in retrospect a tipoff that demand was growing too fast for supply to keep up. Prices soared. Still, if this was fiscal dominance, it was short lived. The stimulus ended, the Fed raised interest rates, the money supply is now contracting and inflation is closing in on the Fed’s 2% target.
Argentina Is a Textbook Case of ‘Fiscal Dominance’
Some wonder whether U.S. deficits could similarly fuel inflation. It all depends on the Federal Reserve.
www.wsj.com
