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ByNicolas Magud

Negative shocks are amplified more than positive ones; also, negative shocks depict rapid contraction while the recovery is more protracted.

The Argentine government finally found out that the international crisis will affect the country—the more so due to its poorly managed macroeconomy (although they will not recognize the latter). Good for them—better late than never.

In response to the expected increase in unemployment, worsening of the current account (to get even worse and affect the exchange rate), and thus fiscal stance (debt default possible?), the government apparently intends to increase public expenditure, unemployment subsidies, and protection (subsidies?, tax deductions?, closing the economy?) for inefficient sectors to smooth the volatility. In one way or another it implies a deterioration of the fiscal and the current account balances. And both could fall sharply…

Of course, I believe the argument would go, this is what developed countries (as well as Chile and Brazil among others) are doing to ameliorate the slump. However, in the above mentioned paper I show not only the asymmetric nature of business cycles, but also that counter-cyclical fiscal policy is only effective provided the level of debt to GDP is sufficiently low. Translating that from the model to every day economics it basically means that, all else equal, you can engineer standard Keynesian fiscal policy provided you can finance it.

Moreover, the transmission channel includes the fact that an increase in government expenditures increases the risk premium (think on the effects of Argentina’s country risk!). In turn, this generates a contractionary effect on output. Thus, unless the government has plenty of room to finance an increase in aggregate demand without affecting the interest rate much, that will be able to offset the mentioned contractionary effect, on the contrary, increasing government expenditures will end up being contractionary in terms of output.

To have a simple picture, compare the ability of the U.S. (or Chile and Brazil) to issue debt in order to finance government expenditures with that of Argentina. Consider not only the country risk differential, but the reputation of honoring debts, responsible intertemporal macroeconomics (U.S.) instead of pro-cyclical fiscal policy (Argentina), already high interest rates, higher unemployment, lower productivity, high default probabilities, a political administration highly dependent on unions, expectations of a depreciated exchange rate (the more so if the increase in government expenditures appreciates the real exchange rate), credibility of institutions(!), and the list, unfortunately, can grow longer and longer.

Notice also that Argentina has been manipulating the statistics and using creative accounting to show a supposedly strong fiscal surplus (the flow, not its sustainability though), financing increased expenditures based on temporary revenues that are now, as I posted on many times in this blog, decreasing: commodities’ prices have been (and will probably continue) contracting, as well as the VAT as the economy self-corrects the government’s pro-cyclicality. The economy is not only expected to suffer from lower international prices, but quantities produced and exported are also likely to keep on falling. I wouldn’t be surprised if this exerts pressures on the exchange rate with inflationary implications despite the expected lower domestic and foreign demand.

Now the administration wants to increase expenditures much more but, where will the financing come from? And, at what price? International financial markets are virtually closed and tax revenues will tend to contract. The nationalization of private retirement funds (AFJP), the government claims, will not be used to finance its expenditures. Will that still be the case? I do hope so.

Even if AFJP’s funds are used directly or indirectly (through financial intermediation, fiduciary funds, etc.), given all of the above, more likely the expansionary fiscal policy will end up being contractionary in terms of output. This will exacerbate the crises, especially given the “initial conditions” on which (and when) the policy is put to work. This just adds to worsen the overall situation, not only the real side of the economy, but could potentially be expanded to the monetary side—hopefully the increase in expenditures will not be monetized, because if it is, bye-bye…

Let me clarify that I do not necessarily mean that counter-cyclical fiscal policy is a bad thing; it depends. But in the case of Argentina, where the ‘good times’ had been wasted, it does not make much sense now. The more so since the government has been praising its policy of de-indebtedness since 2003, while the debt has actually increased. It can even be considered unfair for those (countries) that did behave “properly” and saved in good times for the bad times. But I guess the (sophisticated) market, unlike Argentina’s government, will internalize this.

To sum up, Argentina’s government put the country into an unsustainable path during the Kirchners’ administration. Now, the day of reckoning is approaching. The government, again, does not quite understand the sources of the problem and the way to address it. Furthermore, the economic crises-mode that the government put the country in can be compounded by the political crises that seems to be already in motion—which looks likely to worsen during the election year (2009).

The saddest part of this is the long terms effects. Poverty, if appropriately measured reached levels similar to the 2001-2002 collapse. Education and health did not improve in these years with all the supposed abundance. Thus, the correction that the economy will need to go through will only re-enforce this, worsening the country’s income distribution. But let’s be clear: it is not the market’s fault; it is solely the effects of the Kirchners’ administration that is forcing the market to internalize this mismanagement. Of course, we will see how this story ends as more information is made available—hopefully non-massaged data, though.

[1] “On Asymmetric Business Cycles and the Effectiveness of Counter-Cyclical Fiscal Policy,” Journal of Macroeconomics, Volume 30, Issue 3, September 2008, 885-908 and reproduced here with the author’s permission.