Dollarization without Fiscal Prudence Is Not Possible. With Fiscal Prudence, It’s not Necessary. 

The runoff election on Sunday, November 19 in Argentina between the Peronista Sergio Massa and the libertarian Javier Milei offers contrasting proposals to address that nation’s economic crisis. In Argentina, inflation is north of 300 percent per year, the local currency is kept artificially overvalued, incomes are falling in real terms, the country is without reserves of hard currency, and GDP is shrinking. These are the result of 80 years of statist populism, with the current government, of which Massa is the finance minister, being just the most recent iteration. 

Emblematic of how the libertarian candidate hopes to restore prosperity is his proposal of freedom in currencies and closing the central bank. Truthful to his libertarian convictions, and consulting with capable experts, Milei wants to allow the exchange rate to reach a price at which it becomes indifferent to the money holders to keep their holdings in the Argentine peso or the American dollar. He plans to achieve that by liberalizing the foreign exchange trade to allow the real demand for hard currency to be reflected in the exchange rate. Whatever the exchange rate of equilibrium, once it is achieved, then, a Milei government would retire the peso from circulation and allow legal tender status to other currencies. Once the peso is retired from circulation, the central bank will be closed in order to prevent future inflationary financing. 

Massa does not want any of that. Massa accuses Milei’s plan of caving in to IMF demands of devaluation and elimination of unsustainable public subsidies. Recently, he has doubled down on populist measures, as if the government were able to fund those with anything other than inflation. 

The differences between the candidates, however, hide an aspect of the reality from which neither can escape. Taking all together, Argentinians, for a long while, have consumed more than what they produce, and the only way for that to last as long as it has lasted in Argentina is when such entitlements become institutionalized. Usually, those entitlements are established by creating “cost-of-living adjustment” (COLA) clauses protecting the purchasing power of civil servant wages, pensions, and certain recipients of subsidies. If we understand inflation as a tax, automatic COLA arrangements “exempt” privileged earners from said tax. Furthermore, they create what may be deemed as “inflationary inertia,” since inflationary financing triggers a readjustment of said obligations and a new round of increases in prices. 

By the budgetary process, the government creates “false rights” in Jacques Rueff’s terminology: It creates claims over existing goods that were not created as a recompense for engaging in the production of those goods. They will therefore only give access to existing goods by defrauding the legitimate rights of others, by “taxing” part of their wealth and making it available to the privileged recipients of government largesse.  Inflationary financing, however, has even worse consequences. It disorganizes the entire price system. Couple this with infringements on the property rights and freedom of contract necessary to keep the interventionist policies in place, and you understand the poor economic performance of the country. 

But let us go back to that inescapable reality just mentioned. Regardless of what Massa says, the acceleration of the inflationary process, and the resulting loss in purchasing power among the majority of the population, is a different way of forcing the country to live inside its means as the dollarization proposed by Milei would do. 

The difference is that under current interventionist policies, the government picks and chooses losers and winners in order to buy political support, while the libertarian candidate wishes to leave that to the market to decide. Massa may try to continue to plow the waves, but Argentina seems to be moving to dollarization given the total discrediting of the current government. The only question remaining is how to distribute the pain of forcing the country to live by its means without disrupting the price system even further.  

 
Because I believe in fiscal dominance, I do not think that any change in monetary policy that is not preceded by changes in fiscal policy will last. Dollarization without fiscal prudence is not possible; with fiscal prudence, it is not necessary. The key is to bring the real purchasing power of public servants, the eventual recipients of subsidies and transferences, and pensioners to a level sustainable with revenues. 

Incidentally, that is the grain of truth in the “campaign of fear” waged by Massa on Milei. The changes proposed by Milei, as much as term they will benefit the country as a whole in the long term, will create losers in the short term, people such as low-income families which are recipients of income transference and subsidies, and the largely middle-class civil service sector that has been insulated from the worst of decades of poor economic performance by privileges such as COLAs. 

 
It seems important to do a back-of-the-envelope estimate of the haircut anyone receiving any transference from any government in Argentina would be for the public deficit at all levels to be eliminated. A “good enough” operational assumption here is that the difference between the formal and informal exchange rates indicates the size of the adjustment, and that is possible to determine by the definition of the exchange rate of the dollarization. The answer: a “haircut” of about two-thirds, when measured in US dollars, to all, including those protected by COLA clauses. 

There is an interesting question regarding the philosophy of money here. Is the value of money created by the state “real” or just “nominal”? That is, does the state have any obligation to keep more or less constant the value of the currency or, as in the words of Paul Krugman, is that “not part of the deal”? 

 
Possibly, the dollarization (a change in the nominal value of the legal tender) would be a necessary step to make the “haircut” legal, but if the fiscal adjustment is to work, it is also essential that it be done in a way that will not be reversed by the courts. Such a “haircut,” some may argue, is just the acknowledgment of what the real values of all peso-denominated assets and claims are, since the current exchange rate has been kept artificially low. Still, it will have significant distributive effects, and that does not come without political consequences. 

Be that as it may, there are two ways to arrive at an exchange rate of indifference (between holding dollars or pesos): One is to allow the market to float and reach that price by itself. The other is to decree a devaluation and do it all at once. 

Allowing the market to find the exchange rate of indifference by itself may trigger a hyperinflationary process. As relative prices will change dramatically, coupled with the inflationary inertia, the government will be compelled to inject external money into the economy. 

The alternative is to do the dollarization all at once, say, during a banking holiday. A bonus of doing the devaluation all at once is to curb inflationary inertia. That is, the definition of a new nominal value for legal obligations in the country as a consequence of the dollarization needs to be accepted by the judiciary as binding to all contracts in the country. If that is not achieved, the fiscal gains of the haircut may be lost, and all the pain may end up being for nothing. 

This may lead us to conclude that if it is to bring relative prices in line with international prices and to allow the economy to start growing again, the sensible way of doing that is by reducing fiscal imbalances first by cutting expenses, and at the same time liberalizing restrictions to business that would bring foreign capital to Argentina (land, banks, mining) and THEN start liberalizing the foreign currency exchange later, as fiscal wiggle room is gained. 

The alternative, of course, is to accept that the hyperinflationary process is inevitable. Regardless of who wins the election, the run to USD may even accelerate between when the electoral result is announced and when the new government is inaugurated. 

Regardless of how it is done, wild swings in relative prices between tradable and non-tradable goods will result in reductions in the quantities consumed of tradables in internal markets. Perhaps some of the public expenses may be diverted to programs guaranteeing food security, access to public transportation, cooking gas, and the like, since this transition will be very difficult for low-income families. 

I have no doubt that sound money and free markets are a much better institutional arrangement for individual human flourishing, and in the case of Argentina, dollarization offers a path to that. Regardless of how big the net result may be, however, there are trade-offs and there will be many net losers, at least in the short term. Argentinean problems are first political, then fiscal, and then monetary, and they need to be solved in the same order. Otherwise, they will not be solved at all.

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