Observatorio Argentino 9: A tale of two depressions

  Argentina seems to be slipping into its third major economic contraction in less than two decades.  (Actually, this may be the fourth.)  Leticia Arroyo asks:  what happened the last two times?

You can blame Mexico (not Canada, sadly) for the 1994 contraction.  Investors dumped their Argentine holdings in response to the mess in Mexico and as a result Argentine interest rates spiked and economic activity fell.  Argentina pegged its peso to the dollar at the time.  The peg survived the contraction, but recovery was slow and halting.   

The 2001-02 collapse was a different animal. 

It is harder to assign blame than one might think.  Argentina's internal and external accounts didn't look that bad in 1999 or 2000 or 2001.  (They didn't look that good either, but nothing to justify the scale of the calamity that followed.)  Investors, foreign and domestic, started to worry about a devaluation, charging the Argentine government higher and higher interest rates every time it had to refinance.  Why did they start worrying?  I am honestly not sure.

That said, what was clear by 2001 was that the currency peg had become too restrictive, but the government had no clear plan to transition out of it.   Fully dollarize, in order to end speculation of a future devaluation?  Devalue early?  Devalue, then dollarize?  The government punted.  People became more and more convinced that there would be a devaluation.  Speculation became widespread, and I mean crazily widespread, unimaginably widespread:  nobody wanted to accept pesos that could lose two-thirds of their value at any moment, and nobody wanted to spend dollars that might jump by two-thirds in local terms at any moment.  Call it hedging, call it speculation, call it crazy, but do the math:  by the time December 2001 rolled around, huge chunks of the Argentine economy had been reduced to barter. 

This sort of thing seems like a real fear in several Eastern European countries right now. 

The question is whether they can imitate Argentina's rocket recovery by devaluing their currencies.  A devaluation will probably wreck their banks.  A devaluation will also make their exports more competitive.  So here are the questions for, I dunno, Edward Hugh:

1. Which is worse for the stability of the banking system:  deflation or devaluation?  Deflation will make domestic loans shakier, without a doubt, but it's a slow process.  Devaluation could, as it did in Argentina in 2002, wreck the banks all at once. 
2. Will devaluation work in 2009?  In 2002, Argentina managed to jump onto a commodity boom.  The world really wanted the agricultural products that the country had to sell.  In 2009, Eastern Europe is diving into a collapse of the demand for the manufactured goods that it makes.  How high is the elasticity of export demand right now?

Add to that the fact that most of Eastern Europe still isn't quite as bad off as Argentina was in 2001, and compound that with the risk that an Eastern European financial collapse could wreck banks across the planet (something that Argentina wasn't going to do in 2001, no matter how bad things got) and the lessons from the Southern Cone for Europe may in fact be quite limited. 

There is a second question:  what are the lessons for the southern cone of the recent economic history of the southern cone?  I'm less certain of the answer to that one.  Leticia?

Comments

[Leticia]

Technically you have three questions there. In reply to your second second question: sometimes I wonder (especially as an exercise to avoid writing my dissertation) what the elements of the perfect storm were in Argentina and what we can do to prevent future severe recessions. I think that the underlying problem in my dear country is the lack of longer-term growth/development strategy. The adopted policies generally address a current situation without taking into account the future (i.e. when the next government is in power).

The last two crises had an clear weak point in common: the currency board arrangement. The CBA that saved Argentina from hyperinflation became a de facto long(ish) term policy without a clear exit strategy. I am not sure I have the right answer but I think that if an economy is too reliant on capital inflows, a CBA is very restrictive. What to do when capital flows fly to quality and there is no monetary policy or lender of last resort to speak of?

Just my $0.02, we can keep on discussing this forever, right?