A Letter to the Politicians of Argentina Regarding Inflation

A letter to the Politicians of Argentina regarding inflation

Introduction

We aim to provide an overview of the current situation regarding inflation in Argentina, and offer policy advice on how the current level of inflation can be reduced in the short term, and maintained over a longer time scale.

A brief outline of inflation

Inflation can be described as an increase in the overall level of prices in the economy (Mankiw et al. 2011). In order to explain this further the money supply can be looked at as part of a supply and demand analysis. As the government of a country increases its money supply, this in turn increases the amount of currency in the hands of the population. As the scarcity of a money goes down, its value tends to follow, meaning individuals are able to “buy less” with the same nominal amount of money.

For governments facing reduced tax revenues, high spending, and possibly borrowing difficulties due to a high risk of default; monetary injections can look appetising. From financing infrastructure projects to receiving “inflation tax”, printing money offers many “superficial advantages” to quote John M. Keynes (Mankiw et al. 2011). But on the other hand, there are many long-run issues with inflation. The main consensus, or “end-point” of these issues regarding inflation is that they discourage long-run capital investment; preventing economies from reaching their production potential in years to come.

Taking inflation-induced tax distortions as an example, by increasing the money supply year on year, invested money needs to grow by a rate above the level of inflation to be profitable. But by taxing the income gained from interest payments at a rate not adjusted for inflation, this severely reduces the after-tax real interest rate—the effect being individuals are discouraged from investing in this way. There may be a search for other financial products with higher interest rates to invest in, for example the move towards Collateralised Debt Obligations preceding the Financial Crisis of 2007-2009.

A more obvious effect of changing price levels is general confusion—as consumers observe the prices of goods rising, they make decisions on what to buy using the prices as a key indicator. So if these prices are changing quite often, it can become difficult to analyse which baskets of goods will maximise their utility. In turn these changing consumer decisions mean markets are less easily able to distribute resources as productively. This can have knock on effects for GDP figures, as the efficiency with which a country’s economy operates with can be reduced by this inflation-induced action.

A description of argentina’s situation with respect to inflation

Argentina has historically experienced several periods of hyperinflation (inflation which is above 50% per month), the most severe of which occurring in 1989, where annual inflation soared to 305,763%. This spike can be attributed to the increase in money supply, as illustrated in Figure 1. In this period of time, the Argentinian Government introduced a fiscal consolidation package called the “Plan Primavera” (Kiguel et al. 1992), which aimed to reduce the government’s budget deficit and stabilise exchange rates. However, this austerity plan, and the subsequent “February” and “Austral II” plans failed to lift the country out of ever-shortening inflation-stabilisation cycles. The uncertainty created led to fears that the government may default on its sovereign debts, and so the interest rates with which lenders offered the Argentinian government rose significantly. Here, the overall effect was that in order to pay for the ever-increasing debt (including the deficit left over from the Falklands War, for example) the Government was forced to print even more money, further reducing the value of the Peso.

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From the data in Figure 1, there is a very clear correlation between fluctuations in the supply of money, and the resulting rate of inflation. This pattern of high inflation and subsequent austerity measures can be observed in other Latin American nations, such as Brazil and Peru. In the 10 year period from December 1975 to December 1958, the exchange rate between the United States Dollar (USD) and the Brazilian Real (BRL) went from 9.070 BRL/USD to 10,490.000 BRL/USD, an increase of 115,000% (to 3 significant figures) (The Chinese University of Hong Kong 2000). Similarly yet even more severe, the rate between Argentinean Pesos and the USD in the same 10-year period rose by 780,000%. Hyperinflation is not just a problem for these two Latin American countries – many others such as Venezuela and Peru have experienced similar circumstances, due largely to their tendency to print money in order to service debts (Salemi 2008).

Policy Advice

In most cases, inflation occurs when governments prints too much money to balance its deficit. Nevertheless, in the case of Argentina, several other factors have contributed to Argentina’s deteriorating fiscal situation and should therefore be tackled.

Firstly, it has been suggested that the government controlled statistical institute, INDEC significantly underestimates Argentina’s inflation (see Figure 2); and government officials, including President Christina Fernández, refuse to admit the seriousness of Argentina’s inflation situation (Mallén 2013). In order to fight inflation, the Argentine authorities should face the status quo and proactively implement macroeconomic policies in order to combat inflation.