September 2001
Argentina's Lesson
by Fred McMahon
Perhaps nothing in modern history has absorbed as much creative effort as finding ways to derail an economy. Argentina, the current crisis poster-nation, has been at the forefront of this important work.
Surprisingly, Argentina's crisis has a lot in common with Canada's long economic decline. Still, it's something like comparing lingering disease with getting smacked on the freeway by a cement truck, as happened to Argentina. The end result is the same, but the freeway experience is rather more abrupt.
A decade back, hyperinflation flattened the Argentine economy. Now the solution to Argentina's inflation problem—a peg with the US dollar—threatens an equally deep crisis.
So much potential wasted! A century ago, Argentina was one of the richest nations on earth, right up there with wealthy European nations and the emerging new world powerhouses, Canada, the United States and Australia. The poor and huddled masses of Europe found Argentina every bit as attractive a destination as Canada, the United States and Australia—even more so, depending on the year and whose statistics you trust.
I won't bore you with Argentina's century of lost opportunity, other than to mention that it was marred by nationalist populism, state economic planning, protectionism, managed trade, cultural insularity, anti-Yankeeism, entrenched union power, and inflationary monetary policy. The results were disastrous.
By 1989, inflation had hit 3,080 percent. To turn the nation around, Argentina's then (and now) finance minister, Domingo Cavallo, pegged the Argentine peso to the US dollar. Inflation was wiped out over night. Huge swaths of the economy were privatized. The economy was opened up to the outside world. Economic growth replaced monetary panic. Investment soared. Argentina appeared ready to fulfill its promise of a century earlier. But it didn't happen.
You can pour over Argentine macro statistics, as I have, and fail to find the cause of Argentina's downfall. Government spending and taxation are restrained. The budget is out of balance, but that's mainly because the nation's economic growth has faltered. Why?
A currency peg brings great advantages. Many sophisticated economists believe North American nations should join together in a common currency area. The Fraser Institute's Herb Grubel has been the leading pioneer in this. One of the advantages of a common currency area is that it forces nations to develop good economic policies.
And there's the rub. Argentina has huge policy problems, especially at the micro level. That's led to trouble with costs and productivity. The peg worked at first because, when it was set, it was calibrated to match Argentine wages to the productivity of its workers. Argentine wages were competitive, and so were its products. This produced Argentina's fleeting economic miracle.
But, over the last 10 years, Argentine productivity has continuously fallen behind US productivity. With US workers steadily becoming more productive than Argentine workers, Argentina could remain competitive only if wages fell relative to US wages. This can happen in three ways. Currency devaluation can lower relative wages. Inflation, which inevitably leads to currency devaluation, can also reduce real wages. But the currency peg closed off these routes.
The best option, one that brings out the great benefits of a common currency, is a flexible labour market in which wages can adjust to changing conditions. Specifically, for Argentina to have remained competitive under a currency peg, actual wages in Argentina would have to have fallen relative to wages in the United States. Militant unions and other economic rigidities closed that route.
Slowly, the nation priced itself out of the international market. Exports fell. Imports grew. Economic growth tanked. Unemployment soared. Companies just couldn't afford to hire workers at, by international standards, inflated wages. By the late 1990s, a recession—now celebrating its third birthday—began throttling the economy. Weak growth devastated government finances. Government debt ballooned to US$128 billion. International lenders began to wonder whether either private-sector or government borrowers would be able to make good on their debts. Argentina faced a new crisis.
But why has Argentina's productivity growth been low? Any number of bad policies have played a role. The economy is highly politicized and corruption is rampant. Connections can provide greater rewards than competitiveness or productivity gains. The proportion of government spending devoted to wages and salaries, depending on the year, can be 50 to 100 percent higher than in Canada or the United States. The politically connected get jobs. Key government duties, like education and infrastructure, get neglected.
Union power is even more damaging. Permanent employees, in both the private and public sectors, typically must be union members. Incredibly, unions run Argentina's main health care system. For permanent employees, unions receive a cheque both for dues and for health care, though how much money actually goes to health care is difficult to fathom given the opaqueness of union finances. All in all, every dollar in salary must be topped off by another 50 to 80 cents to unions, government, and various social plans. Small- and medium-sized businesses simply can't afford these payoffs, so the underground economy booms. Nearly a third of Argentina's economy, and a half of its workers, are in the underground economy. Argentina is deprived of the creativity and drive of some of its most innovative and industrious entrepreneurs and workers who are shackled by life in the underground economy. They can't join the export market. They suffer any number of legal limitations, not to mention their vulnerability to corrupt officials. Such inefficiencies severely limit Argentina's productivity growth while union power makes wage adjustment impossible.
To deal with the crisis, Argentina—with a little prodding from friendly neighbourhood international agencies—has one foot on the road to disaster and one foot on the road to economic salvation. On the positive side is an austerity program that is meant to cut away waste and patronage.
But the government is also raising taxes and increasing tax enforcement. That's bad news. The tax man will run more and more Argentine firms out of the legal economy and into the underground economy. There, the newly-empowered tax police will hound them out of the black market and into bankruptcy. When the Irish faced their economic crisis in the late 1980s, one marked by a soaring debt, they cut taxes and government spending so brutally that Margaret Thatcher and Ronald Regan looked like creampuffs in comparison. Stimulus from deep tax cuts boosted economic growth. Government revenues rose. Ireland's economic miracle had begun. The IMF has cut off this growth path for Argentina by insisting on more taxation. Unions, too, have fueled the crisis by calling national strikes during the summer and temporarily shutting Argentina down to protest government cutbacks of $1.4 billion.
What's the Canadian connection? Bad policy in Canada—high taxes, politicized spending, militant unions (particularly in the public sector)—have left Canada with one of the worst—perhaps the worst—productivity record among developed nations.
We face the same productivity problem as Argentina, though because of a different mix of bad policies. But, while the peg has forced Argentina to confront the consequences, we've been able to disguise them through continued devaluation of our dollar. As our relative productivity falls, so too does our currency and our relative standard of living. It's the only way we can keep competitive.
Canada has chosen the milk-run to disaster. The cumulative damage is devastating, but the economy is plummeting in slow motion. Perhaps that's the reason for Canada's complacency. Ottawa has refused to take any serious action to address our slowly failing economy. In some ways, Argentina's crisis gives it an edge over Canada. The crisis may force policy makers in that nation to act sensibly.
Things change quickly. Fifteen years ago, when Ireland faced its devastating crisis, Canada's per capita GDP was two and half times Ireland's. Ireland reformed. Now Ireland's per capita GDP is 20 percent greater than Canada's. Today, as Argentina faces its devastating crisis, it's interesting to note that Canada's GDP is two and a half times Argentina's. Perhaps a hundred years from now, if Argentina does get its economic house in order, some columnist may write with amazement about how Canada had been a wealthy nation, once even wealthier than Argentina, but let it all slip away.
Fred McMahon (fredm@fraserinstitute.ca.) manages the Economic Freedom of the World report at The Fraser Institute. He has just returned from Argentina where he was advising on an economic growth plan for its central region.
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