Brasilia - Presidents Mauricio Macri, from Argentina, and Michel Temer, from Brazil, during the signing ceremony of Actos, at Palacio do Planalto (Antonio Cruz / Agência Brasil). Some rights reserved.
Argentina has been experiencing high inflation for too long now. In the 1990s, the currency board experience taught policymakers that fixed exchange rates and monetary expansion do not get along. After a troubling regime change, inflation seemed to have called for an armistice, but it lasted only a couple of years - as can be seen in graph 1. Two-digit figures were back and Argentina’s inflation shot beyond 20%.
Graph 1 – Annual inflation
Source: End of inflation. Linear interpolation for 2015 and 2016. Data from WEO IMF; author’s elaboration.
As if inflation were not enough, since the 2008 financial crisis economic growth has been disappointing too, making it all the more difficult to deal with high inflation.
Graph 2 – Real GDP Growth (%)
Source: Data from WEO IMF; author’s elaboration.
Dismantling inflation requires displacing a very difficult hurdle: inertia. This is something that Brazilians know pretty well.
The Real Plan building blocks
After a sequence of failed stabilizing plans, Brazil mastered inflation by devising a scheme – the Real Plan - which rested on three main pillars: fixed exchange rates, fiscal austerity and monetary reform.
The reasoning behind the first pillar was that, following the opening of the Brazilian economy at the end of 1980s and the beginning of the 1990s, a fixed exchange rate would impose price discipline through increased competition. Besides, cheaper imports would also foster growth of those sectors of the economy that rely on imported capital goods. Since capital was let to flow freely, the role of monetary policy was to maintain the exchange rate. So, whenever capital threatened to leave, interest rates rose to contain the menace.
After the contagion of three crises in a row (Mexico in 1994-95, Asia in 1997, and Russia in 1998), Brazil took a turn towards a flexible exchange rate, and policymakers responsible for it attracted some criticism at the time. Some analysts think that they had stubbornly maintained a fixed exchange rate for too long, thus imposing some difficulties on debt dynamics when interest rates reached 40%. Others acknowledge that, at the time, no one knew what the consequences on inflation of letting the exchange rate depreciate would be, and that fear of the ghost of hyperinflation justified their actions. The debate is still going on today.
The second pillar consisted in stopping both the federal and the state governments from behaving as if they had no budget constraints, from printing money as the ultimate choice when out-of-budget expansionary policies exceeded public revenue, and from increasing debt. The initial idea was to cut expenses and raise taxes. However, since fiscal austerity in Brazil traditionally focuses on the latter, rather than the former, some cuts in public spending were made, but they only lasted for a short period of time due to the rigidity of the federal budget.
The third pillar was monetary reform. The diagnostic was that inflation inertia was caused by i) lagged price adjustments, and ii) indexation. If you add to this a pinch of fiscal folly, then you have the perfect receipt for hyperinflation. Previous plans had tried to tackle inflation inertia by freezing prices and waging a top-down battle to de-index the economy. The Real Plan took the opposite path: full indexation. How did this happen? By letting two currencies live side by side.
Economic theory states that an economy cannot have two currencies at the same time. One of them gets discarded. However, if the introduction is made in steps, it might actually work. The new currency, the Real Unit of Value (URV in the Portuguese acronym), was used for new contracts and people were free to either set prices in the new currency or in the old one. The new currency’s value was linked to the US dollar and updated daily. So, if you set you prices in URV, you did not have to worry about your prices becoming outdated. The incentives to do this applied to everybody and, eventually, the whole economy was using the URV. When this happened, the URV became the Real. This unorthodox approach broke the inertia.
The Real Plan included several other important items, such as the political strategies, the legal reforms, the financial reforms (for instance, stopping inefficient public banks from financing state governments), but the main macroeconomic pillars were the three aforementioned.
Fighting inflation with flexible, rather than fixed exchange rates
The main lesson to be learned from Brazil’s Real Plan experience is that policy makers should not fear telling people the truth. Instead of imposing a price-setting behaviour, the Plan was announced and explained exhaustively, so that agents could choose how they would proceed and, once incentives were put in place, people behaved accordingly. If people understand what is going on, not only does the likelihood of success increase, but they may even anticipate it, thus diminishing the Plan’s economic costs. So, regardless of what is to be done, people should understand it. Here is my proposal:
i) A floating exchange rate
Unlike the Real Plan, I would let the exchange rate float. At first it would probably shoot up, but if the other parts of the Plan were implemented, this would not be a problem for too long. In Brazil, we used the exchange rate as the nominal anchor. In Argentina, though, the current account deficit (and its forecast) does not allow this without too much suffering.
Graph 3 – Current Account (%GDP)
Source: Data from WEO IMF; author’s elaboration.
ii) Fiscal austerity
In an open economy with fixed exchange rates, fiscal austerity is recessive. But with a floating rate, this might not be the case. After the overshooting subsides, the new exchange rate level should stimulate net exports, on the basis of a tight fiscal policy. It is important, however, to use spending cuts rather than tax hikes. Moreover, the current foreseen trajectory for primary surplus would put gross debt on a dangerous path.
Graph 4 – Primary balance (%GDP)
Source: Data from WEO IMF; author’s elaboration
iii) The New Peso
The previous two pillars are more or less mainstream receipts. Changing a country’s currency is not. I believe Argentina should follow the same steps the Real Plan made - legislation change, policy announcement, the creation of an optimal index for current contracts, mandatory for the new ones -, which would tackle the relative price-setting problem: since firms adjust prices at different moments in time, they have incentives to increase their prices even during a recession if they feel that they are outdated. If everybody sets prices in an Argentine Unit of Value, relative prices will be updated.
Not only relative price-setting is tackled in this way, but also inflation inertia. If you remove the incentives for price changes, inflation’s spine breaks and traditional monetary policy should suffice to manage inflation from then on. After a period, the whole economy will function on the basis of this new unit of value. That is the time to introduce the New Peso. Confidence in the new currency will boost results.
By putting an end to inflation, investment may boom and long-run growth too. If Argentina learns from Brazilian mistakes, the country may experience a smooth transition from high to normal inflation, and avoid a currency crisis. Besides, it might put public finances back on a sustainable track, attracting foreign investment - an additional source of growth.