The lessons to take from Javier Milei’s Argentina

President-elect Javier Milei
Javier Milei has a radical programme, including the dollarisation of the economy - Natacha Pisarenko/AP

It is not often that the world’s eyes are focused on Argentina – unless it is about football. But since maverick Javier Milei was elected President last month, many of the world’s economists are keeping a keen eye on what happens next.

Argentina is a large country, much blessed by nature. It should be extremely rich. Indeed, in 1914, its GDP per capita was in the top 10 in the world, whereas it now ranks 70th.

Some countries, such as Singapore, have transformed themselves from the Third World to the First. Argentina has done the opposite.

The distinguished economist Simon Kuznets once said: “There are four kinds of countries in the world: developed countries, developing countries, Japan and Argentina.”

Since gaining independence in 1816, Argentina has defaulted on its debt nine times, with the first occasion happening in 1827 and the most recent in 2020. It is currently on its 22nd International Monetary Fund programme.

What went wrong? Argentina is a textbook case of how natural endowments are secondary to the human and institutional characteristics of a country. Argentina is a naturally rich country made poor by bad government. And this bad government has continued under both democracy and dictatorship.

The country has been prone to military coups that have installed governments with dictatorial powers. But it has been a democracy since 1982 when the military government of General Galtieri collapsed after Argentina’s defeat by the UK in the Falklands War.

Mr Milei has a radical programme, including the abolition of the central bank and the dollarisation of the economy. This may sound bonkers but it isn’t. Argentina has had an endemic inflation problem. The rate is currently running at over 140pc.

The problem originates with the habit of its government being funded by money created by the central bank. Once the peso is replaced by the dollar then Argentina will not be able to create money out of nothing.

Financially, it will be part of the dollar zone and monetary policy will have been outsourced to the US Federal Reserve.

Let us be clear: this is not an ideal solution. After all, there can be definite advantages to having your own currency. Indeed, these were at the heart of the argument over the UK joining the euro.

With your own currency, you can set interest rates appropriate to your national circumstances, allow the currency to move up or down on the foreign exchanges when trading circumstances change and, in acute financial difficulties, the government can be provided with funds by the central bank – thereby obviating the need for it to default on its debts.

Over and above this, countries issuing their own currency can effectively fund some of their financial needs without paying interest since bank notes are interest-free.

But to gain from these advantages, governments must exercise self-discipline. This is precisely what Argentine governments have been appallingly bad at doing.

They have had a perennial tendency to spend money way in excess of their ability or willingness to raise revenues through taxation. They have plugged the gap with a combination of borrowing and money creation.

The borrowing has caused the debt ratio to soar, thereby discouraging anyone from lending any more to it, leading to periodic defaults. The money creation has caused inflation to take off. Hence Mr Milei’s idea of abolishing the peso and the central bank which issues it.

It will be no mean feat to pull this off. It requires the conversion of all peso-denominated assets and contracts into dollars.

Getting the conversion rate right is extremely tricky. The peso is probably over-valued by 40-50pc. If conversion were to take place at a much lower exchange rate, current holders of peso-denominated assets would be big losers.

If the conversion were done at the current official rate, then this would leave Argentina uncompetitive in world markets.

Nevertheless, a number of countries have achieved successful currency conversions, including Panama in 1904, Ecuador in 2000 and El Salvador in 2001.

Once a currency conversion has been achieved, this should deal with Argentina’s serious inflation problem. It may still have a bit of inflation, depending upon what happens to America’s headline rate, but this will be minor compared to the past.

And interest rates will be dollar rates and hence much lower than what has prevailed with pesos. This change should bring much-needed stability and end the waste of time and resources involved in people constantly trying to keep up in the inflation game.

Nevertheless, merely ending endemic inflation would not solve Argentina’s problems at a stroke. The basic problem is fiscal incontinence.

If nothing changes, the government will continue to spend excessively, funded by borrowing in dollars. This would be bound to end in financial crisis and default.

But Mr Milei realises this. He plans a huge fiscal tightening, with drastic cuts to public spending, including welfare. Yet this plan is bound to meet stiff resistance. There have been many false dawns along Argentina’s slide into its present state.

Indeed, Mr Milei’s programme is in many ways a more drastic version of the reforms that President Macri tried to carry out in 2015-19. Despite some initial success, that package foundered, largely because of intense domestic opposition to painful spending cuts.

Argentina’s problems were common among emerging market economies in the 1980s and early 1990s. However, most of these countries have since made dramatic improvements in their policy-making.

Fiscal policy was tightened, central banks were made independent with bans on financing government deficits, exchange rates were floated and domestic financial markets were deepened.

Argentina never managed this. In many ways, what Mr Milei is attempting is admirable. But you would have to know nothing of Argentina’s history, or be a born optimist, to be confident that he will pull it off.

Roger Bootle is senior independent adviser to Capital Economics 

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