Excellent analysis of Argentine crisis

[Steve Diamond <sdiamond@xxxxxxx>]

Note the argument that links Argentinian crisis to hollowing out of American
manufacturing.
-------------------------
International Perspective    - by Marshall Auerback

AMERICA'S 'STRONG DOLLAR' POLICY AND ARGENTINA'S DEFAULT: A ROOT CAUSE THAT
DARE NOT SPEAK ITS NAME
28 December 2001

www.prudentbear.com

Argentina has been a habitual problem throughout 2001, so it is perhaps
appropriate that the country's new government has ended the year by
announcing the largest sovereign debt default in history.  So much for
former Citibank Chairman Walter Wriston's belief that only companies go
bust, not countries.

Needless to say, the blame game has already started as to who or what caused
this fiasco with the usual suspects now being lined up in front of us: the
IMF, former Presidents  Menem and De La Rua, former Economics Minister
Domingo Cavallo, the currency peg system itself, Argentina's fiscally
irresponsible provincial governments, the list goes on.  Curiously, there
has been very little attempt to look at the problem from another
perspective, namely the consequences of Argentina being yet another in a
string of international casualties emanating from America's strong dollar
policy.  As was the case in emerging Asia, Argentina's decision to retain a
link with a manifestly overvalued currency must surely rank as one of the
leading root causes of the default. While this is not the sole cause of
Argentina's current woes, retaining the peso-dollar convertibility peg
ultimately did a huge amount to undercut the competitiveness of the country'
s external sector, consequently rendering its debt servicing requirements
untenable.

Even when it was becoming clear that Washington's economic policy makers
were adhering to a strong dollar policy solely as a means of appeasing the
increasingly large foreign constituency financing America's huge and growing
private sector financial deficit, the Treasury and the IMF continued to
insist that Argentina retain its convertibility system (with no
modifications) as a quid pro quo for receiving continued assistance.  This
left Argentina in an economic cul-de-sac, with virtually no policy options
left to alleviate the country's 4-year long recession.  They were forced to
operate under conditions that no American politician would dare advocate for
the US - cutting public expenditure in the midst of a fully blown recession,
raising interest rates - in short, the exact opposite of what American
policy makers have been doing since the US economy began to descend into
recession. Yet the multifold adverse effects from these policies have thus
far occasioned little analysis within the context of Argentina's current
plight.

It is one thing to say that the US should not allow its policy on the dollar
to be subject to an international veto (as Washington and others seem to be
urging on Tokyo in regard to the yen). It is quite another to ignore the
international implications of such a policy, whilst simultaneously seeking
to assert global dollar hegemony. It is also perverse to continue to
advocate a strong dollar policy independent of any considerations relating
to trade competitiveness in the US itself and the corresponding threat posed
by debt trap dynamics in the event of a substantial current account deficit.


Under Treasury Secretary Rubin and his two successors who have slavishly
continued his policy, short run speculative trend following capital inflows
which buoy domestic stock and bond markets and keep domestic interest rates
low have been deemed to be consistently more important even as the strong
dollar policy has wreaked havoc domestically in America's manufacturing
heartland and created huge external imbalances in the current account.  It
has also propelled asset markets ever higher with unstable fuel from inflows
of short term global speculative capital.  In the case of the US it is now
hurtling the world's largest net debtor nation toward a record current
account deficit as a share of GDP, whilst concomitantly drawing desperately
needed capital funding requirements away from the emerging world (thereby
helping to create the kind of underdeveloped gangster states that we now
recognize pose formidable risks to American domestic security).  Finally,
the strong dollar policy has helped to perpetuate a high tech bubble rife
with capital expenditure excesses, and a stock market and real estate
bubble, all of which are symptoms of a credit system run amok in the US
itself. Washington's attempts to deal with the aftermath of these excesses
has already begun to exert a powerful deflationary toll on the global
economy, thereby further exacerbating the problems of a country like
Argentina, as it seeks to export its way out of its current financing
crisis.


It didn't used to be like this. From the early 1970's onward, American
industrialists have been concerned about competitive inroads from lower wage
countries on a rapid path toward modernization.  In the 1980's the focus was
on Japan and its successful takeover of a long succession of consumer
durable goods markets (autos, TV's, etc.) and some high tech markets
(semiconductors) that were developed initially by US firms.  By the 1990's
and the early part of this century concerns have intensified that imports of
an ever widening range of goods from lower wage countries, particularly in
the Far East, have "hollowed out" America's industrial base, destroying the
country's export capability and rendering the United States hostage to the
fickle forces of speculative foreign capital inflows.

Prior to Robert Rubin, Secretaries of the Treasury in the United States
conducted economic policy partly with an eye toward preventing a loss of US
competitiveness.  Faced with calls for protectionism from firms and workers
whose industries and jobs were at risk, these former Treasury regimes were
biased toward a low dollar exchange rate which would enhance the position of
US industries in world trade without running the risk of trade wars posed by
protectionist solutions. This was the rationale behind the Louvre Accord,
for example. Most of these Treasury Secretaries remembered an earlier era
when the US ran current account surpluses and was the world's largest
creditor nation.  From this perspective, US current account deficits were a
source of weakness they wished to rectify.  It was only 8 years ago at 100
yen to the dollar that Mickey Cantor and Lloyd Bentsen were fighting to
improve US competitiveness in global tradeables markets with, among other
weapons, a threat of dollar devaluation.



The Rubin Treasury developed policies that marked a conspicuous break from
this trend in that it followed a very strong dollar policy, an orientation
that has been continued by his successors, even as the American current
account went into record deficit as a percentage of GDP earlier this year.
Secretaries Rubin, Summers and O'Neil have been quite consistent in their
respective focuses:   trade competitiveness is seldom cited as an issue;
instead, all have emphasized the support a strong dollar gives to domestic
capital markets (indeed, in the case of Mr. O'Neil, he went as far as to
dismiss the current account deficit as nothing more than an outdated
accounting anomaly).  We see the preference clearly expressed as early as
September, 1996 in an interview Mr. Rubin granted to the New York Times.



Mexico was still boiling when Rubin faced his second potential political
disaster, the fall of the dollar to below 80 yen.

For Rubin, this was more familiar territory: he had supervised the currency
traders at Goldman, and he knew both the fiscal and political risks.  "These
kinds of occurrences are not without consequences," Rubin said.

A declining dollar tends to drive investors out of American stocks, bonds
and Treasury debt, putting pressure on the federal government to raise
interest rates.  "It would take a while to show up, but I'm certain it would
have happened," he said.

Encouraging strength in a dollar that is too low is constructive in that it
reverses the flow of speculative short term capital in a fashion that
restores long run equilibrium to the exchange rate.  This is what
coordinated intervention is all about when it is on the "right side of the
fundamentals".  This may have been appropriate on the dollar's rise from its
1995 low at 79 yen.  However, once a currency has risen appreciably,
continuing to encourage trend following speculative short term capital
becomes questionable.  It eventually can become destabilizing, causing a
speculative overshoot in the direction of extreme overvaluation.  But the
persistence with which the strong dollar policy has been pursued suggests
that Rubin, Summers and O'Neil have all been oblivious to these dangers, or
simply chose to ignore them to great international cost.

For these gentlemen, a loss of competitiveness, a rising current account
deficit, and a growing net debtor position, all associated with a very
strong dollar, appear to always be outweighed by any potential risks from
destabilizing capital flows out of US stocks and bonds.  As we have noted
about Rubin in the past, this would appear to be symptomatic of the "US
short-termism" that one would expect from a trader from Wall Street, but not
from leading policy makers within the US government.   Yet somehow a policy
designed to deal with a short-term problem of the dollar bloc's external
competitiveness, gradually metamorphosed into something akin to holy writ,
as America's capital markets became increasingly captive to foreign capital
to sustain the unsustainable.  Certainly, this policy kept the US markets
buoyed for a much longer period of time, but at the cost of drawing away
badly needed capital for countries with large external financing
requirements, such as Argentina.

To give some indication of the scale of this capital misallocation, in the
mid-1990s, net private capital flows to the emerging world peaked at $225bn.
Western investors pushed money abroad in the search for yield; debt costs
dropped while equities soared. In 1994, publicly quoted emerging market
companies were relatively even more expensive, on a price to book basis,
than their developed country peers, according to Merrill Lynch estimates.
This hungry search for yield led Western portfolio managers into markets
where they had little understanding, and virtually ignored pre-existing
prudential requirements that they would have applied to companies in their
home markets.   Greedy foreign lenders lent to Asia's highly indebted firms,
for example, because they did not want to miss a party.  Based on their
Western prudential limits and guidelines, they should never have lent to
Korean firms who were leveraged 4 to 1, but they did.  When the environment
soured, they looked at these companies for the first time in terms of their
prudential limits and guidelines and decided that they wanted out.

(Parenthetically, it is worth noting that the behaviour of Western portfolio
managers during the 1990s was in marked contrast to earlier debt crises in
the emerging world.  When banks lent to Brazilian or Argentine firms in the
1970's, for example, these firms had conservative balance sheets.  When
balance of payment crises occurred, the banks were able to justify their
loans on the basis of corporate credit worthiness criteria even if country
credit worthiness criteria were not met, and they rolled over their loans.)

In any event, the bubble comprehensively burst during the emerging markets
financial crisis of 1997/98. Capital flows now stand at less than a quarter
of their peak, bond spreads have ballooned, and equities are now worth less
than half, on the same relative basis, than their US and European peers.
There has clearly been a huge cost both from the perspective of the US and
the emerging world: The outflow of short-term capital from the emerging
world into the US has created financial and economic crises in these
economies which further weaken global markets for US industries; the
resultant inflows into the US created huge capital expenditure excesses in
the American economy, which will likely take years to work through, as well
as exerting a powerful global deflationary undertow.

As far as the immediate effects of the strong dollar policy on Argentina, it
is clear that the late 1990s tech boom, combined with high US economic
growth, drained Buenos Aires of available capital. True, mere words cannot
in themselves engender a "strong dollar policy".  It is indicative of the
high confidence that the markets reposed in Messrs. Rubin and Summers (after
successfully turning up the dollar against the yen in 1995) that the two
were able to perpetuate the myth that American government officials by force
of words alone could maintain this policy objective for as long as they
wished, irrespective of fundamentals. Both were clearly loath to address the
growing problem of the current account deficit for fear of driving investors
out of American stocks, bonds and Treasury debt and destroying the illusion
of America's formidable new economy. Argentina became an indirect casualty
of this policy preference.

Alan Greenspan's incessant discussion of a high-tech led productivity
miracle also helped to foster the belief in a "new economy", supposedly
making the US a much more attractive repository for overseas' capital than
beat up emerging markets, rife with crony capitalists, or an economic bloc,
such as the European Union, with a brand new relatively untested currency
(as Washington policy makers implied on numerous occasions in regard to both
Asia and the EU). Collective cognitive dissonance on the part of global
investors also played a role, but this was undoubtedly encouraged by the
persistent cheerleading of Messrs. Rubin, Summers, O'Neil, and Greenspan.

Whatever the cause of the strong dollar policy, American policy makers have
been uniformly successful in sustaining it, even as the US external position
has become more unbalanced, thereby drawing away funds for the rest of the
world.  Simply put, the money Argentina needed to service its $95bn of
traded debt was misallocated to fibre optic cable networks that will never
be built, dotcoms that went spectacularly bust, or cell phone handsets and
personal computers now sitting in factories as unsold inventory.

Deflationary pressures intensified as consequence of the IMF's
conditionalities for further loans.  After years of throwing good money
after bad, the IMF has acquired religion all of a sudden by refusing to
extend any further credit to Argentina. But this comes at the worst possible
time and in a manner which simply makes a bad situation in Argentina much
worse.  The Fund is unwilling to disburse a tranche of its already approved
loan to Argentina in the absence of further fiscal tightening. Yet highly
restrictive fiscal policies have already done much to contribute to further
depressed aggregate demand, causing more deterioration in corporate cash
flows, thereby aggravating the domestic debt problem.  The country has been
in recession for the past 42 months, with the most recent GDP figures
indicating an annualized contraction of -4 per cent. The same mistakes
committed in Asia are being repeated again, doing little to enhance the IMF'
s long-term credibility.

 The Fund is no longer seen as a disinterested financial intermediary in
much of the emerging world, but as Uncle Sam's enforcer. But to attack the
IMF as the sole cause of Argentina's collapse misses the broader point.
Argentina is, above all else, a casualty of America's strong dollar policy.
Trade competitiveness has eroded as a consequence of retaining a peg to an
overvalued currency, whose external value the Argentines had no means of
controlling.  As the current account deteriorated ever greater offsetting
capital flows were required to support the peg.  At the same time, returns
to investments in tradeables fell.  After all, why would anyone build a
plant in such an economy when factor endowments and relative prices made it
more profitable to build it elsewhere?  The IMF's policy prescriptions
simply intensified a pre-existing deflationary dynamic, but were not the
proximate cause.


A major benefit of the gold standard was the fact that it was unencumbered
by nationality and therefore could not be operated in a capricious,
irresponsible manner; America's policy on the dollar policy clearly is.  If
a US dollar-based reserve currency system is to be upheld internationally in
a credible manner, its success must be predicated on America's financial and
monetary authorities conducting themselves in a manner which does not
engender further global instability.  We have long discussed America's
increasingly growing financial imbalances and its consequent vulnerability
to third world-style debt trap dynamics. The country's perpetuation of a
strong dollar policy has contributed to this vulnerability, as well as
having the consequence of hollowing out American domestic manufacturing
industries and leading to a corresponding dependence on finance capitalism
in which the country's manufacturing and industrial interests are generally
subservient to those of finance and banking. This is fine as far as it goes;
America's policy makers are perfectly entitled to make decisions they view
to be in the best interests of their country, however irresponsible others
may think these decisions are.  But if Washington is to insist that the
dollar continue to retain a major international role, surely it behooves
policy makers to incorporate into their deliberations the international
implications of their currency policy.

 When such policies themselves become a source of major global financial
instability, it ultimately undermines the greenback's international status,
thereby undercutting the strong dollar policy that has been the hallmark of
the last 3 Treasury Secretaries. Moreover, it is perverse to insist that
countries such as Argentina (which have no control over the dollar's fate)
are forced to retain a monetary system predicated on a link to this
overvalued currency as a quid pro quo for receiving further financial
support and assistance, only to be dropped like a hot potato when the
consequences of religiously adhering to this advice become too adverse.
Unfortunately, this is precisely what has happened over the past 5 years
during a time when Argentina's problems have continued to build.  Paul O'
Neil and his fellow policy makers in Washington may indeed wish to wash
themselves of the embarrassment now being caused by Argentina's default, but
they cannot evade their responsibility in helping to create the mess in the
first place.

--------------------------------------

Stephen F. Diamond
School of Law
Santa Clara University
sdiamond@xxxxxxx