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Argentina, the land of deja-vu all over again

This is a follow-up to a post from last October, in which I discussed how the massive devaluation of the Argentine peso in early 2002 has translated almost one-for-one into higher inflation, very much as monetary theory would predict. I also mentioned how the government has been trying in vain to "suppress" inflation by gaming the CPI (first chart above).

Five months later, the story is the same, only now things are starting to get worse. As the second chart shows, true inflation is now double the "official" rate shown in the first chart. Since the peso was first pegged at 1:1 to the dollar in 1993, the price of a dollar has gone up by a factor of 4.4, and the price level (as measured by the GDP deflator) has gone up by a factor of 4.2. Confidence in the economy and the government is declining; the government has tapped the central bank's reserves to make payments on its international debt; in order to arrest capital flight which was also draining the central bank's reserves, the government has imposed exchange controls and restrictions on imports (many of which are not being granted, thus threatening to shut down the economy); and predictably, the exchange controls and import restrictions have led to the emergence of a "black market" for dollars.

I have been following developments in Argentina closely for the past 40 years, and I have lost track of the number of times that the government has meddled with the economy in ways which inevitably lead to inflation, devaluation, and economic collapse. I've seen this movie so many times it's like watching a slow-motion train wreck. The gap between the black market and the official exchange rate (now 5.25 and 4.4, respectively) will widen, more capital will leave the country, new investments will slow to a crawl, the economy will slump, and the government will eventually engineer one more in a long line of major devaluations. This in turn will provoke an inflationary recession and impoverish the private sector (the purpose of devaluations for countries like Argentina is to transfer wealth from the private to the public sector). As the dust settles, capital will begin trickling back in, import and exchange controls will be lifted, and the economy will slowly get back on its feet, but only at great cost in lost output and lower living standards for nearly everyone. It's a tragedy that has played out dozens of times in the past 40-50 years, but politicians never seem to learn, always thinking that they can outsmart the market—and line their pockets in the process.

Argentina is living proof that capital only resides in countries where it is respected and allowed to move freely. If capital is not free to leave, exchange controls only create a huge incentive for resourceful citizens and companies to skirt the controls and move money offshore, while destroying confidence and investment in the process. Unless President Kirchner comes to her senses quickly, which I doubt, the economy is doomed to suffer yet another painful recession.

We'll be spending a few weeks in Argentina next month, so I'll have the "privilege," that only an economist can enjoy, of watching how declining demand for pesos leads to higher prices even as the economy declines. The last time I saw this happen, prices almost tripled in the space of three weeks; I hope it won't be so bad this time.

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