August 8, 2001
Why Argentina's fleeting economic miracle didn't last
Fred McMahon's article in the National Post
here is the complete unedited text that Mr. McMahon emailed to witiger 08 Aug 2001 - some of the following text was edited out of the shorter Post article
By Fred McMahon

Perhaps nothing in modern history has absorbed as much creative effort as finding ways to derail an economy. Argentina, the current crisis poster-nation, has been at the forefront of this important work.

Surprisingly, Argentina’s crisis has a lot in common with Canada’s long economic decline. Still, it’s something like comparing lingering disease with getting smacked on the freeway by a cement truck, as happened to Argentina. The end result is the same but the freeway experience is rather more abrupt.

A decade back, hyperinflation flattened the Argentine economy. Now the solution to Argentina's inflation problem - a peg with the US dollar – threatens an equally deep crisis.

So much potential wasted! A century ago, Argentina was one of seven richest nations on earth, right up there with wealthy European nations and the emerging new world powerhouses, Canada, the United States and Australia. The poor and huddled masses of Europe found Argentina every bit as an attractive destination as Canada, the United States and Australia - even more so, depending on the year and whose statistics you trust.

I won't bore you with Argentina's century of lost opportunity, other than mention that it was marred by the Maude Barlow brand of nationalist populism (except with a military face) and the sort of policies Barlow’s Council of Canadians wants for Canada - state economic planning, protectionism, managed trade, cultural insularity, anti-Yankeeism, entrenched union power, and inflationary monetary policy. The results were disastrous.

By 1989, inflation had hit 3,080 per cent. To turn the nation around, Argentina's then (and now) finance minister, Domingo Cavallo, pegged the Argentine peso to the US dollar. Inflation was wiped out over night. Huge swaths of the economy were privatized. The economy was opened up to the outside world. Economic growth replaced monetary panic. Investment soared. Argentina appeared ready to fulfill its promise of a century earlier. But it didn't happen.

You can pour over Argentine macro statistics, as I have, and fail to find the cause of Argentina's downfall. Government spending and taxation are restrained. The budget is out of balance, but that's mainly because the nation's economic growth has faltered. Why?

A currency peg brings great advantages. Many sophisticated economists believe North American nations should join together in a common currency area. One of the advantages of a common currency area is that it forces nations to develop good economic policies.

And there's the rub. Argentina has huge policy problems, especially at the micro level. That’s led to trouble with costs and productivity. The peg worked at first because, when it was set, it was calibrated to match Argentine wages to the productivity of its workers. Argentine wages were competitive, and so were its products. This produced Argentina’s fleeting economic miracle.

But, over the last 10 years, Argentine productivity has continuously fallen behind US productivity. With US workers steadily becoming more productive than Argentine workers, Argentina could remain competitive only if wages fell relative to US wages. This can happen in three ways. Currency devaluation can lower relative wages. Inflation, which inevitably leads to currency devaluation, can also reduce real wages. But, the currency peg closed off these routes.

The best option is a flexible labour market, in which wages can adjust to changing conditions. This would bring out the great benefits of a common currency. Specifically, for Argentina to remain competitive under a currency peg, actual wages in Argentina would have to fall relative to wages in the United States. Militant unions and other economic rigidities closed that route.

Slowly, the nation priced itself out of the international market. Exports fell. Imports grew. Economic growth tanked. Unemployment soared. Companies just couldn’t afford to hire workers at, by international standards, inflated wages.

By the late 1990s, a recession – now celebrating its third birthday – began throttling the economy. Weak growth devastated government finances. Government debt ballooned to US$128 billion. International lenders began to wonder whether either private-sector or government borrowers would be able to make good on their debts. Argentina faced a new crisis.

But, why the low productivity growth? Any number of bad policies play a role.

The economy is highly politicized and corruption is rampant. Connections can provide greater rewards than competitiveness or productivity gains. As in Atlantic Canada, another highly politicized economy, businesses may spend more time polishing their connections than improving their efficiency.

Government remains a patronage job engine for the politically connected. The proportion of government spending devoted to wages and salaries, depending on the year, can be 50 to 100 per cent higher than in Canada or the United States. The politically-connected get jobs. Key government duties, like education and infrastructure, get neglected.

Union power is even more damaging. Permanent employees, in both the private and public sectors, typically must be union members. Incredibly, unions run Argentina’s main health care system. For permanent employees, unions receive a cheque both for dues and for health care, though how much money actually goes to health care is difficult to fathom given the opaqueness of union finances.

All in all, every dollar in salary must be topped off by another 50 to 80 cents to unions, government and various social plans. Small and medium size businesses simply can't afford these payoffs.  So the underground economy booms. Something like a third of Argentina's economy, and a half of its workers, are in the underground economy.

This deprives Argentina of the creativity and drive of some its most innovative and industrious entrepreneurs and workers, who are shackled by life in the underground economy. They can't join the export market. They suffer any number of legal limitations, not to mention their vulnerability to corrupt officials.

Such inefficiencies severely limited Argentina's productivity growth while union power makes wage adjustment impossible.

To deal with the crisis, Argentina – with a little prodding from your friendly neighborhood international agencies – has one foot on the road to disaster and one foot on the road to economic salvation. To the good is an austerity program, meant to cut away waste and patronage.

The government is also raising taxes and increasing enforcement. That’s bad news. The taxman will run more and more Argentine firms out of the legal economy and into the underground economy. There, the newly empowered tax police will hound them out of the black market and into bankruptcy. When the Irish faced their economic crisis in the late 1980s, one marked by a soaring debt, they cut taxes and hacked government spending so brutally that Margaret Thatcher and Ronald Regan looked like bleeding heart creampuffs in comparison. Stimulus from deep tax cuts boosted economic growth. Government revenues rose. Ireland’s economic miracle had begun. The IMF has cut off this growth path for Argentina by insisting on more taxes.

Unions, too, have been busy helping out the crisis. And I do mean helping out the crisis, not helping Argentina out of the crisis. Unions called a national strike and largely shut Argentina down earlier last month [July] to protest government cutbacks of $1.4 billion.

So what’s the Canadian connection? Bad policy in Canada – high taxes, politicized spending, militant unions, particularly in the public sector – have left Canada with one of the worst, perhaps the worst, productivity record among developed nations.

We face the same productivity problem as Argentina, though because of a different mix of bad policies. But, while the peg has forced Argentina to confront the consequences, we’ve been able to disguise them through continued devaluation. As our relative productivity falls, so too does our currency and our relative standard of living. It’s the only way we can keep competitive.

We’ve chosen the milk-run to disaster. The culminative damage is devastating, but the economy plummets in slow motion. Perhaps, that’s the reason for Canada’s complacency. Ottawa has refused to take any serious action to address our slowly failing economy. In some ways, Argentina’s crisis gives it an edge over Canada. It may force policy makers to act sensibly.

Things change quickly. Fifteen years ago, when Ireland faced its devastating crisis, Canada's per capita GDP was two and half times that of Ireland. Ireland reformed. Now, Ireland’s per capita GDP is 20 per cent greater than Canada’s. Today, as Argentina faces its devastating crisis, it’s interesting to note that Canada’s GDP is two and a half times that of Argentina.

Perhaps a hundred years from now, if Argentina does get its economic house in order, some irritating columnist may write with amazement about how Canada had been a wealthy nation, once even wealthier than Argentina, but let it all slip away.