[A-List] The question of sovereignty

[Sabri Oncu <soncu@xxxxxxxxxxx>]

A full translation of this article appeared in the Turkish daily Radikal
(hardly radical) newspaper. Dani Rodrik is a Turkish economist and this may
have played some role in that but I think there are other reasons for this
full translation. How are our Argentinean friends doing in regards to this?

Best,
Sabri

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REFORM IN ARGENTINA, TAKE TWO.
Trade Rout
by Dani Rodrik

Post date 01.03.02 | Issue date 01.14.02 | The New Republic


Argentina's default on its $132 billion public debt on December 23 hardly
came as a surprise to its foreign creditors, who had anticipated it for many
months. It had been clear to most outside observers that the country's
currency-board regime, which locks in the Argentinean peso's value
one-to-one with the U.S. dollar, had held the peso at an unsustainable level
vis-à-vis other currencies. It was also evident that Argentina's political
system would be unlikely to deliver the belt-tightening needed to service
foreign creditors ahead of domestic payments on wages, pensions, and other
obligations. So, when President Fernando de la Rúa and Economy Minister
Domingo Cavallo resigned and the inevitable happened shortly thereafter, few
other markets around the world moved.

As is usual after a debacle of such a magnitude, fingers have been pointed
at enough culprits to explain the Argentinean crash many times over: The
Argentine "political class" was too shortsighted to reach a compromise on
fiscal policy. The currency-board system was too rigid to allow Argentine
exporters to regain their competitiveness following Brazil's devaluation of
its currency in early 1999. Labor unions were too unresponsive to demands
for reform. Cavallo pushed too many gimmicks to resuscitate the economy and
lower the cost of servicing the debt. Foreign creditors were too fickle and
should not have reversed course so dramatically after their rush into
Argentina in the early 1990s. The International Monetary Fund (IMF) should
have pulled the plug much sooner. The IMF should not have pulled the plug.
But the tragedy of Argentina goes much deeper than any of these
explanations. The collapse offers a humbling lesson about the limits of
economic globalization in an age of national sovereignty.

Even though many in Washington would rather forget it, Argentina's policies
during the '90s were in fact exemplary by the standards that neoliberal
economists have advocated around the world. The country undertook more trade
liberalization, tax reform, privatization, and financial reform than
virtually any other country in Latin America. And no country tried harder to
endear itself to international capital markets. The overvaluation of the
peso was a nagging concern to be sure, because of the loss of Argentinean
competitiveness. But economists have long taught that devaluation of the
national currency--the common remedy to overvaluation--is of little use in a
country that is financially integrated with the rest of the world, which
Argentina surely was. (When banks' balance sheets are dominated by dollar
liabilities, devaluation wreaks havoc with the financial system.) The
Argentinean experiment may have had elements of a gamble, but it was also
solidly grounded in the theories expounded by American economists, the U.S.
Treasury, and multilateral agencies such as the World Bank and the IMF. When
Argentina's economy took off in the early '90s after decades of stagnation,
the economists' reaction was not that this was puzzling; it was that reform
pays off.

The Argentinean strategy was based on a simple idea: Reduction of sovereign
risk is the quickest and surest way to reach the income levels of the rich
countries. "Sovereign risk" refers to the likelihood that a government will
be unwilling to service its foreign obligations even when it has the
capacity to do so. In domestic finance, the distinction between
willingness-to-pay and ability-to-pay is much less important because courts
and regulators can sanction recalcitrant debtors. But countries cannot be
sanctioned in quite the same way because they are sovereign--hence the term.

Sovereign risk matters because it is an important obstacle to economic
convergence among nations. If investors had no fear that their lending would
be expropriated, capital would move in abundance from the rich countries
where it is plentiful and yields are low to the poor countries where it is
scarce and yields are high. In the process, incomes would equalize across
borders. But in reality, capital often moves in the reverse direction--think
of the bank accounts in Miami and Zurich maintained by wealthy individuals
from developing nations. Yields may not be higher, but money invested in the
United States or Switzerland is at least safe from expropriation.

Viewed from this perspective, the challenge of economic development is
reduced to three simple propositions. Economic growth requires foreign
capital. Foreign capital requires removing sovereign risk. And removing
sovereign risk requires a commitment not to play games with other people's
money. All this made for a coherent theory, even if it did not correspond to
the actual development experience of any successful country larger than a
city-state. Getting rid of sovereign risk, it would turn out, requires a lot
more than commitment to sound money.

The overarching goal of Argentinean economic policy during the 1990s was to
deliver this commitment, and even more importantly, to convince financial
markets that the commitment was real and binding. The straitjacket of the
currency-board regime was the linchpin of this strategy: By linking the
value of the peso one-for-one to the U.S. dollar in 1991, and by putting
monetary policy on automatic pilot, the regime sought to counteract the
effects of more than a century of financial mismanagement. Privatization,
liberalization, and deregulation further underscored the government's
commitment to a new set of rules. Like Ulysses pinning himself to the mast
of his ship to avoid the call of the Sirens, Argentine policymakers gave up
on their policy tools lest they (or their successors) be tempted to use them
to repeat the errors of the past. Their hope was that they would be rewarded
with a sharp reduction in "Argentina risk," leading to large amounts of
capital inflows and rapid economic growth.

For a while, it looked as though the strategy might work. In the first half
of the '90s capital inflows did increase substantially and the economy
expanded at unprecedented rates. But then Argentina was hit with a series of
external shocks--the Mexican peso crisis of 1994 and 1995; the Asian crisis
in 1997 and 1998; and, most damagingly, the Brazilian devaluation of January
1999, which left Argentina's economy looking hopelessly uncompetitive
relative to its regional rival. Economic growth turned negative in 1999, and
foreign investors began to worry about the repayment of the huge liabilities
incurred during the course of the decade. By the second quarter of 2001
Argentina's country risk was rising relative to that of other "emerging
markets." This despite of the return to the helm of Cavallo, the architect
of the currency-board regime, in March 2001.

Cavallo, with his strong credibility in financial markets, at first looked
like he might be exactly what Argentina needed. But his efforts to engineer
economic growth through an unconventional mixture of tax and trade policies,
and a bungled attempt to alter the currency-board regime by giving the euro
a role parallel to that of the dollar, were not well received by markets and
cost him dearly. By the end of the summer the financial confidence game was
in full play. Markets demanded a huge interest premium for fear that
Argentina might default on its debt. But with interest rates so high,
default was virtually assured. The possibility that Argentina could default
was enough, ultimately, to ensure that it would.

That financial markets make only fair-weather friends is hardly news. That
they turned so rapidly against Argentina requires more explanation. This,
after all, was a government that had focused its priorities on attaining
investment-grade rating in credit markets--and on little else. The political
leadership's commitment to service the external debt was not in doubt.
Indeed, Cavallo and de la Rúa were willing to abrogate their contracts with
virtually all domestic constituencies--public employees, pensioners,
provincial governments, bank depositors--so as to not skip one cent of their
obligations to foreign creditors. Yet in the end, investors still wound up
thinking that Argentina was a worse credit risk than Nigeria.

What sealed Argentina's fate in the eyes of financial markets as 2001 came
to a close was not what Cavallo and de la Rúa were doing, but what the
Argentine people were willing to accept. Cavallo knew he had to regain
market confidence in order to bring down the crushing interest burden on
Argentinean debt. When his initial attempts to revive the economy produced
meager results, he was forced to resort to austerity policies and sharp
fiscal cutbacks in an economy where one worker out of five was already out
of a job. He launched a "zero-deficit" plan, and enforced it with cuts in
government salaries and pensions of up to 13 percent. But markets grew
increasingly skeptical that the Argentine congress, provinces, and common
people would tolerate such Hooverite policies, long discredited in advanced
industrial countries. And in the end the markets were proven correct. After
a couple of days of mass protests and riots just before Christmas, Cavallo
and de la Rúa had to resign in rapid succession.

In his ode to globalization, The Lexus and the Olive Tree, Tom Friedman
famously declared that the "electronic herd"--the mass of lenders and
speculators who can move billions of dollars around the globe in an
instant--reduces domestic politics to a choice between Pepsi and Coke, with
all other flavors banished. Having donned the Golden Straitjacket so
enthusiastically, the Argentina of the 1990s looked like the perfect
illustration of Friedman's point. The economic policies of de la Rúa and
those of the Perónists who preceded him were virtually indistinguishable.
But Argentina's real lesson proved to be a different one: Democratic
politics casts a long shadow on international capital flows, even when
political leaders are oblivious to it. When the demands of foreign creditors
collide with the needs of domestic constituencies, the former eventually
yield to the latter. Sovereign risk lurks in the background as long as
national polities exist as independent entities.

What one does with this lesson is less clear. Many will draw the conclusion
that Argentina took a wrong turn not because it went too far in its search
for the Holy Grail of globalization, but because it didn't go far enough.
The solution from this perspective is to improve on the Argentina model by
chipping away at national sovereignty and by further reducing the
responsiveness of economic management to domestic political forces. What
national governments need are stronger commitment mechanisms--a straitjacket
made of platinum, if gold proves too malleable. This is the neoliberal
vision that inspires some economists and political leaders to seek full
dollarization of their economies or to look at the prospective Free Trade
Area of the Americas (FTAA) as solutions to the governance problems of the
region. If you were to accuse adherents of this view of wanting to turn
their countries into replicas of Puerto Rico--wards of the United States, in
effect--they would not be offended.

But there is an alternative vision. It is to accept that separating politics
from economics is neither easy nor even desirable. Proponents of this view,
including myself, would not be embarrassed to claim primacy for democratic
politics over the electronic herd, no matter what the implication for
sovereign risk. They would concede that economic mismanagement by sovereign
governments has been very costly for the developing world, but would argue
that the appropriate response to mismanagement is not a lack of management,
but better management. This vision has no easy answers or short cuts to
offer to Argentine policymakers. It would be nice if improved governance
could be acquired simply via the discipline imposed by financial markets and
trade agreements. And economic development would be a lot easier if all that
were required was throwing a big welcome party for foreign capital. But the
historical record shows that the solution to underdevelopment lies not with
the adoption of foreign institutional blueprints or the undermining of
national autonomy. It lies with enhanced state capacity to undertake
institutional innovation based on domestic needs and local knowledge.

The tasks before Argentina's policymakers are colossal: to increase the
economy's competitiveness through a devaluation of the currency without
setting off an inflationary spiral; to reconstruct the financial system so
that it serves the needs of the real economy; to diversify the economy and
wean it from excessive reliance on agricultural products; and to address the
pervasive economic insecurity that afflicts the middle class through new
mechanisms of social insurance. Now that Argentina has cleared the deck by
defaulting on its debt, the country has to get on with the hard work of
rebuilding credibility for its political system--this time not for the sake
of financial markets, but for the sake of ordinary Argentines.

As governments ponder these alternatives, they would do well to consider the
following astonishing fact: Despite the tremendous wave of neoliberal reform
that swept over the continent during the last two decades, only three
economies in Latin America managed in the '90s to outdo the performance they
had experienced under the inward-looking, populist policies of the past.
Chile remains a success, in part because it has taken a cooler attitude
toward capital inflows than the others. Uruguay looks shaky and is hardly an
inspiring example in any case because its growth rate has been anemic. And
Argentina now lies in ruins. Its collapse reminds developing nations in
Latin America and elsewhere that they cannot postpone much longer the stark
choice they face. Either they will sacrifice sovereignty in a big way, or
they will reassert it vigorously.


Dani Rodrik is professor of international political economy at the John F.
Kennedy School of Government at Harvard University.