Cavallo explained how to get out of crisis


The former Minister of Economy affirmed that Argentina needs to reform its monetary policy and affirmed that there is a solution for stagflation

The Economist Domingo Cavallo keeps its diagnosis on the situation in Argentina updated and also proposes measures for the country to overcome the crisis and avoid a possible “inflationary explosion

In an article he announced on his blog but was published in its entirety on the CEMA University website, the former minister affirms that Argentina suffers “stagflation“and draw an explanation of the problems that this implies.

“Implement a monetary reform that sanitizes the currency and recreates the public credit It will be the first great challenge that the government “that wants to solve the problem will face, according to Cavallo.

According to the former official, those are conditions that “the compulsive pesification of 2002 and the economic policies of the governments of Néstor and Cristina Kirchner were in charge of destroying

In fact, Cavallo points out that the solution to the problem of stagflation was discovered thanks to an “anti-Keynesian conceptual framework”.

Dollar: no restrictions

On the dollar, Cavallo proposes “a single and exchange-free market, without any restrictions on the purchase and sale of foreign currency

“Legalizing the partial or total dollarization of the economies is essential in the countries that during the hyperinflation had a strong informal dollarization because the financial indexation failed to avoid this phenomenon,” he adds.

Recognized by the 1 to 1 policy, Cavallo proposes an unrestricted dollar.

Less taxes and more debt

In a segment of his extensive writing Domingo Cavallo proposes to eliminate distorting taxes “that discourage investment and increase production costs”.

“Withholdings on exports, the tax on financial transactions that cannot be deducted from VAT and Profits, the high taxes on wages, the tax on gross income in the intermediate stages of production reintroduced by the provinces, are the mechanisms Prosecutors today discourage productive investment and destroy entrepreneurship, “explains the former minister.

And he adds that “the fiscal deficit that will result from the elimination of these distorting taxes should not be financed with monetary issuance (that is, with collection of the inflationary tax) but with long-term debt and at real interest rates that do not exceed the growth of the economy ”

Taxes: Cavallo proposes to reduce the tax pressure and sustain the State based on debt.

Taxes: Cavallo proposes to reduce the tax pressure and sustain the State based on debt.

Furthermore, near the end of his text, Cavallo issues a disturbing warning: “As long as the government does not bring about a great change in the economic organization of Argentina and continues with the policies that with few variations have been applied from 2002 onwards, it is probable that, in not long time, people start to fear a inflationary explosion

Following is the original full text by Domingo Cavallo.

To get out of the Stagflation you need public credit and sound currency

Stagflation, a phenomenon that was only known in the world in the 1970s, was solved in the United States by Paul Volcker and Ronald Reagan without theorizing, but with a lot of pragmatism. The inspiring intellectuals of Volcker and Reagan were not Keynesians but monetarists, with Milton Friedman at the helm, and supply-side growth theorists led by Robert Mundell.

From the great recession of 2008 onward, the problem in the advanced world has been the risk of the recession turning into deflation and leading to a major economic depression. It was precisely for such circumstances that Keynes developed his theory. For this reason, Paul Krugman and many macroeconomists return to discussing monetary and fiscal policies within the conceptual framework proposed by Keynes in his General Theory.

But our problem is different. We are experiencing stagflation, that is, recession with inflation, a problem that already hit our economy between 1975 and 1988 and that ended in the hyperinflation of 1989-1990. For that reason, if we want to get out of stagflation, we have to go back to the conceptual scheme developed by the monetarists and the theoreticians of the economy on the supply side. We should imitate the combination of restrictive monetary policy and expansive fiscal policy, based on the reduction of tax pressure, promoted by Volcker from the Federal Reserve in 1980 and Ronald Reagan from the United States Government in 1981.

But to do so, it is necessary to have public credit and healthy currency, economic institutions that the compulsive pesification of 2002 and the economic policies of the governments of Néstor and Cristina Kirchner were in charge of destroying. Mauricio Macri’s government managed to recreate public credit, but still at interest rates higher than the potential growth of the economy. In addition, during its first two years, it used this precarious public credit to finance a fiscal deficit that remained high, not due to the reduction of distorting taxes, but because it continued to maintain very high public spending. In the end, public credit was lost again and now Argentina is in virtual default of all its debt.

Therefore, implementing a monetary reform that sanitizes the currency and recreates public credit will be the first great challenge that the government will face if it decides to bring the country out of stagflation, be it the current one or the one that succeeds it.

Only by demonstrating that it knows how to defeat stagflation will that government succeed in consolidating sufficient political support and winning the popular support necessary to find solutions to the many structural economic and social problems that plague our society and have been exacerbated by the coronavirus pandemic.

In May 2014 Editorial Sudamericana published the book titled “Camino a la Estabilidad” that I wrote precisely to propose a monetary reform based on the rich historical experience of our country in terms of inflation and stabilization plans. But also in the experience of other countries in which, like ours, their citizens resorted to dollarization, even when it was not legal, as a way to protect their liquid savings from inflation. The proposal of that book is fully valid today.

Brief history of monetary policy and its relationship with fiscal policy

Until the Keynesian revolution, only attention was paid to monetary policy: basically the monetary management of the Bank of England. Monetary policy had, in the first place, the mission of providing a nominal anchor for the price level, that is, ensuring that there was neither inflation nor deflation.

Although the British pound was glued to gold, the Bank of England managed the interest rate to expand bank credit when there was a tendency to deflation and to contract it when there was a tendency to inflation. There had been periods of fiscal deficit and issuance of public debt, basically in the war years. The purchases and sales of public debt by the Bank of England (called open market operations) were the mechanism to manage the interest rate that influenced bank credit.

In the 1930s, Keynes argued that, in the case of deflation, monetary policy, however expansive, failed to solve the problem, because the liquidity trap occurred. Banks accumulated liquidity and did not expand bank credit. For this reason, he insisted on the importance of revaluing fiscal policy.

When the phenomenon of persistent inflation began to appear in advanced countries in the 1970s, monetarists emphasized the determining role of monetary policy and began to question whether the growth of the economy was driven by aggregate demand. The theory of growth on the supply side was revitalized, more linked to the classical and Austrian school traditions.

It was this anti-Keynesian conceptual framework that allowed us to discover the solution to the problem of stagflation.

The contractive monetary policy implemented by Paul Volcker from 1980 was combined with a special type of fiscal policy decided by Ronald Reagan. Expansive fiscal policy was based on a fiscal deficit that did not originate in the increase in public spending but in the reduction of taxes. The United States (and later most of the European countries) managed to reduce, until practically eliminating, inflation and the economy not only reactivated, but also had many years of sustained growth.

Argentina suffers from stagflation

Without public credit, there can be no healthy currency, unless the government generates very strong fiscal surpluses. As soon as the government begins to generate fiscal deficits, the monetary issue becomes a fiscal tool, more precisely a tax tool: it is the mechanism to collect the inflation tax. And the inflation tax has at least the same contracting effect as any other tax. There is evidence that it has even more contractionary effects, because it adds uncertainty and creates many opportunities for corruption.

When the currency tends to be the basis of the inflation tax, people try to get rid of the pesos as quickly as possible, precisely so as not to pay the inflation tax. It is detached from the pesos transforming them into goods or foreign currencies. That is, the demand for currency in real terms decreases. The currency is no longer credible. To finance the same percentage of the GDP of the fiscal deficit, more and more emission and inflation are needed because the base of the inflationary tax falls.

The fiscal policy that is needed so that, together with a restrictive monetary policy, the country can be removed from stagflation, is one in which the fiscal deficit does not originate in the increase in public spending but in the reduction of taxes that discourage investment and increase production costs.

Withholdings on exports, the tax on financial transactions that cannot be deducted from VAT and Profits, high taxes on wages, the tax on gross income in the intermediate stages of production reintroduced by the provinces, are the fiscal mechanisms that today discourage productive investment and destroy entrepreneurship.

To be successful in the fight against stagflation, the fiscal deficit that will result from the elimination of these distorting taxes must not be financed with monetary issuance (that is, with the collection of the inflationary tax) but with long-term debt and real interest rates that do not exceed the growth of the economy. Unfortunately, today this type of fiscal policy cannot be applied in our country because our economy does not have public credit.

How do you recreate public credit and a healthy currency?

The recreation of public credit and a healthy currency requires a monetary reform, just as when hyperinflation must be removed. The only advantage of starting with stagflation and not hyperinflation is that monetary reform does not need to start with the establishment of a fixed exchange rate.

The monetary reform needed to recreate public credit and clean up the currency has three ingredients:

– A single and exchange-free market, without any restrictions on the purchase and sale of foreign currency;

– The competition of the local currency with foreign currencies, at least with the Dollar, in all types of financial and commercial transactions. In other words, authorize all currencies to be legal tender (at least the Peso and the Dollar). This regime is called full convertibility or free choice of currency;

– Monetary policy should aim to stabilize the exchange rate, gradually lowering nominal interest rates and without intending to control the real exchange rate. The monetary system that results from this reform is not unprecedented, much less esoteric. It exists since 1991 in Peru and works very well. With slight variations, it also exists in Uruguay, Bolivia and Paraguay. Get the advantages of fully dollarized countries, such as Ecuador, Panama and El Salvador, without subjecting their relative price structure to extreme inflexibility against external shocks in the terms of trade.

Why is it necessary to legalize dollarization?

Legalizing the partial or total dollarization of economies is essential in countries that had strong informal dollarization during hyperinflation because financial indexing failed to avoid this phenomenon. If this is not done, stabilization has a strong recessive cost that more often than not leads to interrupting the restrictive monetary policy.

In countries that, like Brazil, suffered hyperinflation without informal dollarization, prefer not to authorize the use of the dollar in financial intermediation. But if they want to keep inflation low, they must permanently apply very high real interest rates. This accentuates the recessive cost of stabilization and limits the possibilities for sustained growth of the economy.

Countries that leave full freedom to choose the currency for their citizens can prevent real interest rates from being too high.

Monetary reform and the chances of success of the government that decides to carry it out

When a government, the current one or the one that succeeds it, decides to immediately eliminate any vestige of repressed inflation and applies a stabilization policy that begins with a monetary reform, it is very possible that it will increase its political power and have popular support to implement good solutions to other inherited economic problems.

The final results will depend on how it uses its political power and popular support to advance with reforms capable of reintegrating Argentina into the world, reducing public spending, eliminating distorting taxes, recovering internal and external public credit, obtaining efficient investments, increasing productivity and create high quality jobs.

If the stabilization plan with initial monetary reform succeeds in reducing inflation, but the government does not take advantage of strengthened political power and popular support to carry out the other indispensable structural reforms, the initially favorable results can quickly evaporate and something happen. similar to what happened at the end of the Austral Plan.

If, on the other hand, the initial success of the stabilization plan with monetary reform that reinforces political power and increases popular support, is used to carry out those reforms, it will have a lasting success.

The more flexible but equally stable nature of the new monetary system compared to the convertible regime with a fixed exchange rate (or its equivalent, full dollarization), together with the efforts made to avoid the mistakes of the 1990s (which I detailed both in “Stagflation” and in my new book when describing the history of inflation in Argentina), it will allow initial successes to be obtained as those achieved in that decade, without risking a deflationary crisis such as that of the period 1999-2002.

As long as the government does not produce a great change in the economic organization of Argentina and continues with the policies that have been applied with few variations from 2002 onwards, it is probable that, in not much more time, people will begin to fear an inflationary explosion..

With such results, the government will lose a lot of power and hyperinflation will not be off the horizon. Of course, in these scenarios, the government will not be able to solve any of the many problems that plague our society.

Something similar will happen if, even announcing a major turnaround in economic organization, you decide not to carry out a monetary reform that breaks inflationary inertia and applies a stabilization monetarist policy based on very high real interest rates. He will be reissuing the results of the stabilization policy of the military government in the period 1977-1980. It will lose political power and the possibility of solving most of the problems inherited from previous efforts.

It is true that history does not repeat itself, but it would be foolish that when thinking about the future we do not pay attention to how much our history has to help us find the right directions and avoid the mistakes that caused past frustrations.

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