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Backgrounder #1432 on Latin America

April 19, 2001

Argentina's Economic Crisis: An "Absence of Capitalism"

By and

As U.S. Secretary of the Treasury Paul O'Neill explained to The Financial Times in February, the key factor underlying recent financial crises is not a failure of capitalism, but an "absence of capitalism." Argentina provides a cogent example; its lack of economic freedom--the necessary environment for capitalism to work effectively--resulted in continual economic decline and, ultimately, the financial crisis that erupted in November 2000.

Poor economic policies and political instability contributed to Argentina's decline from its noteworthy position as the world's 10th wealthiest nation in 1913 to the world's 36th wealthiest in 1998. Argentina is the only wealthy country to experience so great a reversal in recent history, despite the involvement of the International Monetary Fund (IMF). Indeed, the IMF's loans and guidance have aggravated, not alleviated, Argentina's problems. After more than nine bailouts and extensions of IMF loans since 1983, Argentina once again faces a financial crisis, with fewer
prospects for stimulating effective economic growth in the future.

Instead of supporting a continuation of Argentina's policies that feed the current 33-month-long recession, the Bush Administration should encourage Argentina to adopt policies that will increase economic freedom and lead to long-term growth and stability. Specific policies that the Administration should encourage Argentina to implement include:

  • Adopting the U.S. dollar as its official currency. Speculation about the sustainability of Argentina's currency board helped increase interest rate premiums on debt. The best way for Argentina to address the interest rate premium resulting from currency risk would be to adopt the U.S. dollar as its own currency. This would eliminate the risk stemming from the peso-dollar exchange rate and lead to lower interest rates on the country's debt, which is what happened in El Salvador and Panama after they adopted the dollar.

  • Reduce spending and taxes. To spur economic growth, Argentina needs to bolster productive behavior by lowering taxes to increase the incentive to work, save, and invest. To lower taxes without aggravating the fiscal deficit, it also needs to slash government expenditures. A plan introduced by the Minister of Economy includes a cut in expenditures; but instead of lowering taxes, it would shift the tax burden from businesses to international investors, imposing new costs without allowing the beneficial stimulus associated with an overall reduction in taxes. Restoring economic growth will require much deeper reductions in government expenditures and more extensive tax cuts.

  • Foster further deregulation. President Fernando de la Rúa succeeded in getting a labor reform bill passed by Argentina's Senate and lower house. Argentina should build on this progress by scaling back regulations governing, for example, the ability of employers to lay off employees. The government also needs to scale back the wages and numbers of public-sector employees. This is particularly true in the provinces, where many public-sector workers do not contribute to production and are a drain on public resources.

  • Encourage free trade. Argentina should expand its export markets and diversify its export base by signing agreements with other nations that are receptive to unrestricted trade. Considering the linking of the peso and the dollar, a free trade agreement between the United States and Argentina would be particularly beneficial by providing greater stability to Argentine exporters. Argentina will need to open its market in order to facilitate trade talks with the United States. If necessary, it should withdraw from the Mercosur trading bloc; if it wishes to remain a political ally of Mercosur as Chile has done, it could do so.

  • Strengthen the rule of law. The vulnerability of the judiciary to bribery and political
    influence has undermined public confidence to the extent that ordinary Argentines do not use the legal system and businesses restrain investments. The Argentine government must punish corruption more aggressively, insulate the judiciary from political pressure through whistle-blower protections, and increase standards for those employed in law enforcement.

Argentina should not look on these reforms as options. Unless the country resumes strong economic growth soon, it will likely default on its debt and see its access to international capital markets crippled.

Restoring economic stability and promoting growth for Argentina will benefit the United States as well as the Argentine people. To help avert another crisis in Argentina, the Bush Administration should encourage Argentina to end its cyclical dependence on IMF loans and make the reforms necessary to stimulate growth. Economic growth would enable the government to service its debt and--if expenditures are also cut--end its reliance on IMF loans.

It is just as imperative, however, that the role played by international financial institutions in the global economy be restricted. The Bush Administration should seek to implement the recommendations of the congressionally mandated International Financial Institutions Advisory Commission, chaired by Allan H. Meltzer of Carnegie Mellon University, in order to establish a solid framework for reforming the IMF and World Bank. The reforms should maximize the organizations' effectiveness, increase accountability for their lending decisions, and limit their harmful influence in the global market.

Future crises will be less likely in an environment that promotes the efficiencies and benefits of open markets. Unless the Administration addresses the "absence of capitalism" that afflicts economies around the world by taking this approach, economic crises will become more frequent and more severe.

Ana I. Eiras is an Economic Policy Analyst for Latin America and Brett D. Schaefer is Jay Kingham Fellow in International Regulatory Affairs in the Center for International Trade and Economics at The Heritage Foundation.

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