Cambridge Review of International Affairs, Volume 15, Number 3, 2002

Argentina: The Case for a Permanent End to Fiscal Transfers

Jerome Booth The Ashmore Group, London
Abstract This article argues that (1) Argentinas current economic crisis is a re ection of a long-running chronic political situation;1 (2) that sustainable economic recovery will not be possible without addressing these political problems; (3) that the IMF is not the villain in the case and, given its understandable support for convertibility in 1991, did not err signi cantly in subsequent support; and, (4) that Argentinas experience is another nail in the cof n of the Washington Consensus as rigid dogma, but this is neither a great surprise nor should be seen as a negative development as far as policy prescription is concerned. The article rst elaborates structural rigidities in Argentina. It then discusses convertibility, arguing it was not a panacea but provided a missed opportunity to implement long-term structural reforms. The central issue of scal irresponsibility is then discussed and constitutional reform to stop transfers to the provinces permanently is proposed. The role of the bond market is then discussed, including a discussion of the nature of nancial contagion. The IMFs role is then brie y covered and largely defended, and nally the nature of the Washington Consensus and Argentinas impact on it is brie y examined.

Argentina, until the recent devaluation, could be characterised as having a closed economy with a xed overvalued exchange rate, an inability to export, and structural rigidities, particularly in the labour market. The debt-to-GDP ratio has grown signi cantlya growth that was unsustainablebut has been less worrying, being a closed economy, than the debt-to-export ratio. Argentinas economic history has been one of relative economic decline over the better part of a century, arguably accelerated by Peronism and its impact on reducing inward investment and competitiveness. The country has been plagued not only by the scourges of Latin American politicsauthoritarianism and populism but also by poor economic management and periodic bouts of high in ation and hyperin ation. The much maligned convertibility policy is the result, not the cause, of economic distress. In 1989, owing to economic chaos, President Alfonsn left the presidency early to make way for then President-elect Carlos Menem. After trying two other Economy Ministers, the new Menem administration experienced an even more virulent in ation and Menem fell back on a more radical option. He called on Domingo Cavallo to become the Economy Minister and in 1991 Cavallo introduced convertibility and a 1; 1 peg between the US
1 The term political is used throughout the article to describe political will rather than party politics, speci cally the lack of political will to back scal and other economic reforms.

ISSN 0955-7571 print/ISSN 1474-449 X online/02/03048315 2002 Centre of International Studies DOI: 10.1080/095575702200001101 5

484 Jerome Booth dollar and the Argentine peso. This led to stability, an investment-led boom and strong economic growth. Concurrently there were many market-led reforms including a major privatisation programme, though one driven primarily by the desire for revenue than to establish greater competitiveness. However, the historical pattern remained: Argentina had been and continued to be unable to live within its means. Debt service on the existing stock of debt called for larger primary surpluses to stabilise it. Signi cant scal surpluses were the requirement to turn the situation round. After initial recovery at the start of the convertibility period, the country managed successfully (if narrowly) to weather the subsequent Mexican Tequila Crisis of 199495. The relief, when it came in 1995, was fortuitous. After the tightening in 1994, US interest rates fell, exports to Brazil increased, and the country managed to access capital markets much sooner than previously anticipated. The banks survived intact, though in retrospect it is clear that they were only weeks away from crisis. Rather than heed the near escape as a warning, however, the next few critical years were squandered as an opportunity to generate long-needed scal surpluses. Indeed, the debt burden rose and the government took advantage of every opportunity to issue yet more debt in order to nance itself. Consequently, it barely met IMF scal targets, and never tried to exceed them.2 The IMF in turn concentrated perhaps less on scal targets than (with the bene t of hindsight) it should have done. Though having survived the Russian devaluation, recession then set in as the dollar strengthened, reducing Argentine competitiveness and, in January 1999, Brazil, a large importer of Argentine goods, devalued. Yet despite all this, Argentinas problems could still be characterised as primarily political in nature, not economic. The economic problems were for a long time chronic rather than critical, with recovery possible until the last few months. The precariousness of the situation was visible for many observers for not months but years before the house of cards collapsed, and many shrewd emerging market bond investors were avoiding core positions in Argentina for two years prior to default. Convertibility as a Missed Opportunity not a Panacea Although convertibility stabilised markets for 10 years, the reforms that accompanied it did not suf ciently address structural problems to avoid future crisis. Though economists have spent vast amounts of time in academic discussions regarding exchange rates, the policy decision of which exchange rate system to use is one that has to be taken in the practical wider context at the time, not in the abstract. An exchange rate is a means to achieve economic objectives rather than a goal in itself. That said, an encompassing policy objective of any exchange rate system is arguably to reduce uncertainty about what the rate will be in the future, where the future need not mean just the immediate future and where different time preferences may possibly lead to different prescriptions. With reduced uncertainty, other prices can adjust (though necessary adjustments of large magnitude may raise uncertainty as to the systems viability) and transaction costs can be minimised. Such reduced uncertainty
2 M. Mussa, Argentina and the Fund: From Triumph to Tragedy, Institute for International Economics, 2002, p. 11, found at www.iie.com/papers/mussa03021.htm

The Case for a Permanent End to Fiscal Transfers 485 would typically require a low probability assigned to a maxi-devaluation and also a signi cant uniformity of beliefs by economic actors as to the time vector of future exchange rates.3 This objective can be met by completely different systems in different contexts. A xed exchange rate may on the face of it appear to achieve this best, but not if there is suf cient speculation as to the peg holding. The introduction of the peso/dollar peg and of convertibility was arguably the best way of reducing uncertainty in 1991, but part of the reason for this was that convertibility tied Argentinas policy-makers hands. In the context of previous policy excesses it ensured that monetary and scal policy were emasculated. This was perceived as the means to force greater scal prudence without requiring prior wider political appetite for it. In short, exchange rate systems do not solve scal imbalances, instead they can put off the day of reckoning. They can help give political impetus to enact reforms. But they are not a substitute for structural reform and the transient opportunity given by the window of stability may be used productively or wasted. The convertibility system could never be a substitute for structural reform. Further, convertibility was not ideal for Argentina as a permanent feature (and neither is dollarisation). It suited small and powerful interest groups, and was an initially highly successful response to the crisis in 199091, but made the country vulnerable to both exchange and trade shocks. The broader context was that dollar parity did not re ect a trade-weighted basket of the currencies of Argentinas main trading partners (Brazil and the European Union), and Argentina was not and is not on a convergence path with the United States. In the last four years the discipline of the currency board, which procyclically shrinks the money supply as reserves dwindle, constrained domestic demand at exactly the time stimulus was needed. Consequent low growth led to low tax revenues, hence more dif culty in meeting scal targets and the need for greater scal austerity, which, in turn, again hampered growth. With a large external debt, low growth also worsened the debt ratios and their projections, damaging international con dence. The way out of such a trap is not easy. There was no simple magic to enable Argentina to escape quickly: hence the de nition of the problem as chronic. Abandoning the currency board or defaulting on the external debt was recognised as catastrophic.

The Fiscal Problem In that the opportunity for reform given by convertibility was wasted, especially in the boom years following the Mexican devaluation, what reforms were missing? The perennial and current problems are largely linked to scal irresponsibility and in particular to the relationship between the federal government and the provinces, which have been signi cant both for contributing to scal imbalance and sustaining collective political irresponsibility. Other reforms were lacking or awed, and four, inter alia, come to mind. Firstly, the judicial system was not reformed, and the lack of perceived impartiality of the Supreme Court
Although impacted by sentiment and nancing costs, liquidity and technical factors, this time vector of preferences is to some extent re ected in the currency non-deliverable forward (NDF) market, and the uniformity of these preferences by the NDF options market.
3

486 Jerome Booth has been a major impediment to cleaning up corruption, which in turn has impeded other reforms. Secondly, Congressional reform for a Chamber of Deputies that only meets once a week and often fails to reach quorum, and thus hampers and fails to balance the Executive, has been lacking. Thirdly, labour market reform has been woefully insuf cient to address the chronic unemployment and underemployment of labour. Fourthly, the privatisation process was driven by the one-off scal motive, rather than to create a more competitive market. Inef cient natural monopolies were transferred to the private sector purely to raise revenue without increasing competition or ef ciency and furthermore did so in a way that led to greater corruption of public of cials. Nonetheless, it is in the area of scal transfers that the most substantial long-term bene t can be achieved from the current crisis. The federal constitution of the mid-19th century established that provincial tax revenues would be collected on their behalf by the federal government. The federal government is obliged to collect and transfer this revenue and may be taken to court by the provinces if transfers fall short, even should this be a re ection of weak federal tax collection.4 In theory, then, the provinces can force the federal government to raise taxes whilst they themselves need not raise any. The political consequences of such a mismatch between where tax is raised and where it is spent have been predictable: collective scal irresponsibility. At least in normal and good times, provinces need not collect their own revenues and can leave the politically damaging task of tax collection to the federal government. Those politicians in a position to spend money, solve local problems through expenditure, create local jobs (including many in the public sector) and represent provincial interests in lobbying for more federal resources in Buenos Aires have historically and unsurprisingly attracted more voter popularity than federal government politicians more associated in the public mind with tax collection. Indeed, whether voters have or have not thought through the consequences of associating expenditure pledges at election time to the consequent need for higher taxes, it has nevertheless been in their interest to vote for candidates offering more expenditure given the wider national tax base than local expenditure base. At least in this sense voters have been complicit. The clear policy solution is to have tax and expenditure at the same level: local taxes paying for services provided locally and federal taxes paying for those provided by the federal governmenti.e. to stop net transfers to the provinces. However, provincial politicians clearly bene t from the current arrangement and have, over time, come to dominate national politics.5 Presidential candidates are often from the provinces. Likewise, those in federal government who support provincial interests may also bene t politically as a result. In the case of a strong state with universalistic values and a clear national identity of joint interests, such political dominance of the centre by the periphery may be balanced by strong central leadership. For much of Argentinas history
4 The Argentine Constitutions mandate for the federal government to take care of provincial nances can be found in Part Two, Title One, Section One, Chapter IV, Article 75, paras (2) and (3). 5 Taking, for example, the last three elected presidents, Alfonsn was from Chascomus in Buenos Aires province and before becoming president his elected of ces and party loyalties were provincial, Menem was from La Rioja, and de la Rua was Mayor of Buenos Aires.

The Case for a Permanent End to Fiscal Transfers 487 this has to some extent been provided by Buenos Aires province, with a main dynamic of political tension being between Buenos Aires and the other provinces. As in Brazil, where centralised government is associated with authoritarianism, the decentralised government structure has been seen by some as a bulwark against tyranny.6 The military experience in Argentina was particularly unpleasant, and few, including the military themselves, want to see any return. However, Argentinas sense of national unity has perhaps been wanting. Similarly to other large federal structures, including the United States and Mexico, there have been signi cant and persistent differences in political values and cultural identi cations across states and provinces. Though perhaps a somewhat nebulous concept, the sense of unity and national identity is important for reaching consensus. It can be gauged by the degree to which national interest can be united and sustained with regard to issues with political facets. In the case of Argentina, this was achieved by the war in the South Atlantic, but then quickly evaporated. Tax collection is another test. For many years paying taxes has been a somewhat voluntary activity in Argentina, and though the situation improved over the last 10 years, scal revenues remain weak and evasion high.7 Another test for large countries is the extent to which presidential candidates are identi ed as national or regional gures. This certainly used to be a major feature of elections in Brazil, but presidential candidates in the last two elections have enjoyed widespread national, as opposed to marked regional, support.8 In contrast, Argentine presidential candidates are still associated largely with particular provinces.9 Moreover, the perception that the political class is corrupt, and thus that much expenditure is wasted, only increases the desire to maximise the local pay-off from the system, and further reduces a possible unifying force creating national, as opposed to provincial, identity. Corruption feeds on itself. It erodes national identity and increases anomie and disillusion. It reduces tax revenue, the ability to gain a consensus for radical structural change and it reduces trust in authority. Hence, the other reforms mentioned above: of the judiciary, Congress, labour market and privatisation, though important, are linked to the scal problem through the public culture of excess and corruption. The tendency towards economic determinism, which is so prominent internationally, belittles this realityeconomic determinism is now interpreted as a right-wing rather than a solely left-wing phenomenon. However, insofar as one can de ne underdevelopment as the absence of, and imperfection of, institutions, from the structure of the nance ministry down to cultural norms dominant in everyday individual economic transactions, so non-economic
6 After the long transition from military rule in Brazil, the 1988 Constitution reacted to the previous over-concentration of power by decentralising it to the extent that consolidated scal responsibility became problematic there also. 7 Estimates of tax evasion have typically been around 50% of the federal budget. See, for example, FIEL (Fundacion de Investigaciones Econo micas Latinoamericana) , La Economa Oculta, 2001, pp. 83158. 8 In both cases Cardoso (who won both elections) and Lula Ignacio da Silva of the Workers Party. 9 Including the current Peronist candidates Carlos Reutemann of Santa Fe, Jose Manuel de la Sota of Cordoba and Carlos Ruckauf of Buenos Aires.

488 Jerome Booth factors are arguably signi cantly more important in successful economic policy making in developing than industrialised countriesand economic determinism consequently less relevant. Speci cally, the tendency to see reforms piecemeal and to marginalise the provincial scal problem (in line with the size of public scal de cits) is misleading as an identi er of where policy change should be prioritised. The problem in ltrates the whole public culture and is not separate from other issues. One might of course criticise the focus that several analysts have on the scal issue, and to the extent that many of the problems of mismanagement of the economy are linked, such a criticism would have some validity. One could argue for a whole package of reforms, as the IMF continues to do, at least in public at the time of writing,10 but this has been the case in the past and it is unsurprising that the hardest and most long-term of problems then becomes least prioritised. Then again, it could be argued that other policy areas are more comprehensive. For instance, it could be argued that the one policy area that should be prioritised is the creation of a strong independent judiciary to stamp out public excess and corruption directly, following which many of the other problems may fall into place and be resolved. This view also has some validity; however, the justi cation of the choice of the provincial transfers as the focus for this article is that it both forces bene cial structural political change and can be formulated as a tangible objective. Some might (incorrectly) argue with indignity that Argentinas judiciary is already strong and independent. It is not the purpose here to ght that argument except to say that it is easy to visualise a potential judicial reform that lacks effectiveness in the absence of strong political support for it. The point is that to stop permanently all net transfers from the federal government to the provinces is in contrast a clear target, independently veri able, one that will force a change in the natural power base of national politicians and policy makers, and can be used to cut excess dramatically. The fact that it is a clear target means political consensus can be built to support it.

The Bond Markets Perspective11 The bond market is an ef cient processor of information on sovereign risk. It learns fast, adjusts quickly to new realities and is in many ways a much better measure of policy than either academic economists or G7 policy makers. However, it is also ckle and myopic, the latter in part due to accounting methodologies and how Anglo-Saxon capitalism is nanced, and this may lead to large swings in market perceptions, which are not entirely undesirable. This has been
10 On 1 April 2002 IMF First Deputy Managing Director Anne Krueger said any economic programme would have to include sustainable monetary and scal policies, a workable exchange rate regime, changes to bankruptcy laws, the reversal of the nations economic subversion law, a scal policy that includes some kind of hard budget restraint on the provinces and lifting existing banking restrictions (source: Reuters News Item). 11 This author was a Washington-based international civil servant in the early 1990s and subsequently a participant in the bond market, both in an investment bank (the sell side) and subsequently as an investor (on the buy side). As the perceptions of the bond market have been in uential and at times very different from those in Washington it is perhaps worth relating them, albeit from a personal perspective of crude characterisation.

The Case for a Permanent End to Fiscal Transfers 489 the case for Argentina. In the mid-1990s the country could do no wrong. Its economic teams were impressive, responsive and understood well the issues investors cared about most. This was in contrast to the unof cial body of opinion in Washington that viewed convertibility as an unorthodox and temporary stop-gap measure, and who helped catalyse, through of cial lending, more external nancing in part from fear of what might happen if they did not.12 The market simply ignored the chronic scal problem. With 8% growth the debt ratios were not expanding signi cantly even if its service costs were.13 Put simply, the market at the time assessed countries ability to service debt in a static way, counting income and expenditure on the balance of payments, and rather like Charles Dickenss Mr Micawber, when projected expenditure came within revenues the result was happiness, but if the reverse happened, misery ensued. This binary lack of sophistication of the market led to arbitrage opportunities for some, but one should not draw the conclusion from this that individual market participants were being irrational, or that the of cial sector was a better judge of the situation. Gauging the perception of the market in advance is most of the time more important to an investor than being right about fundamental risks. In the speci c case of Argentina, the discipline imposed by convertibility was seen as a knife-edge equilibrium. If one is walking along a mountain ridge with a 1,000 ft drop on either side ones situation is clearly in one sense precarious, but there is also a strong incentive not to stray from the path. The bene t of convertibility is similar. By tying its monetary hand and, in effect, its scal hand behind its back Argentina was forced to adjust. Moreover, at the time Argentinas problems were seen as resolvable through the application of greater political will. Compared with economic crises, political crises are more likely to be able to generate their own solutions before an extreme event occurs. The sense of crisis creates political consensus, even if only driven by the fear of being singled out and blamed for catastrophe. In Argentinas case this pattern was repeated many times under the Menem presidency, often taking the form of tension between Menem and Economy Minister Cavallo.14 The con dence that politicians would deliver reforms when pushed kept concerns about chronic economic problems at bay, and short-term balance of payments and political concerns dominated market perceptions. This started to change in late 2000 when after a perceived weak start to Fernando de la Ruas presidency, Vice-President Carlos Alvarez resigned, weakening the ruling coalition between the formers Radical Party and the latters FrePaSo Alliance. Market concerns over devaluation and default started to come to the fore. As a broad characterisation, it was roughly at this time that the market shifted from perceiving Argentinas scal problems as minor irritants, which could be resolved with time, to perceiving them as intractable problems. However, though
12 This re ects private opinion expressed to the author whilst he was a member of staff of the Inter Development Bank. 13 Growth in 1997 was 8.1% and public debt/GDP rising slowly around 40%, as shown in M. Mussa, Argentina and the Fund, www.iie.com/papers/mussa03021.htm, table 1, p. 8. 14 The market traded on this dynamic in the mid-1990s and the pattern is brie y described in R. Fraga, Menem y Cavallo una vez mas, Revista Noticias, 24 March 1996.

490 Jerome Booth arguably still a chronic rather than critical situation the myopic nature of the bond market meant that chronic problems become critical once noticed, both because that is how they are perceived and because that is how market participants believe others in the market will perceive them.15 The scal problem became critical because the market focused on it, but until this point the Argentine government did not focus on it as important. In other words, the government had previously been too responsive to investors concerns at the expense of other issues. This reactionary policy dynamic can be traced back through Argentine economic policy making. President Menem consistently appeared to concentrate on xing economic problems only when they became serious, after which complacency again set in. This combined with a natural tension between him and his Economy Minister Cavallo, who was not a Peronist Party member and was in part responsible for accusations of corruption against his own cabinet colleagues.16 Another contributory factor was a widespread ideological tendency to view free markets as a suf cient indicator of which policy areas to focus on.17 Unfortunately for the Argentine policy makers this myopic focus of the market ignores chronic structural problems until they result in crisis. The response at this stage was still considered to stick broadly with current policies. Failure led to the appointment of Ricardo Lopez-Murphy as Economy Minister who attempted to impose a sharp scal adjustment that was politically unacceptable, and then Cavallo was again appointed in March 2001. Having received the message that medium-term issues were important, Cavallo tried to address medium- as well as short-term issues. First, he adjusted the exchange mechanism to reduce vulnerability to terms-of-trade and dollar shocks.18 More importantly, having successfully completed a US$29.4 billion debt swap to reduce dependence on external capital markets for the next year, Cavallo picked a ght with provincial Governors over their scal pro igacy, trying to cut back scal transfers. This was the right ght and, arguably, the right time to pick it as his bargaining power was heightened by the sense of crisis. The market reacted badly to many of Cavallos policies, however, particularly his changing of the exchange regime,19 and the sense of crisis deepened, but this in turn enabled a more profound policy response. The federal government
15 Such sudden changes in market focus are common due to the myopic herding instincts of nancial market participants. Whereas anticipating a change in market perceptions can be highly pro table, holding a view which in the longer term may be fundamentally correct but is not taken up by the market can be costly. Hence market participants tend to act in the short term as if they share the same view, and a particular fundamental problem can quickly change status from irrelevant to critical as a paradigm shift of the collective market view takes place. 16 Cavallo was allegedly the source of accusations against business tycoon Alfredo Yabran that led to the resignation of two cabinet colleagues in 1997. 17 With Reagans and Thatchers legacy this was a global and not merely an Argentine phenomenon, underpinning much policy prescription to the developing world. 18 Argentine trade with the United States is signi cantly less than with either the European Union or Brazil. 19 Having started to focus on medium- and long-term issues the market was arguably uncharitable when Cavallo started to address overvaluation and scal transfers. In part this may have been due to a lack of a clear market consensus on appropriate policy responses to the problem, in part due to Cavallos erratic policy changes and at times inappropriate emotional behaviour.

The Case for a Permanent End to Fiscal Transfers 491 announced the zero-de cit programme whereby it would not spend more than it received in revenue, to a large extent month by month, and invited (i.e. pressured) the provinces to do the same. They agreed initiallya major political achievement. 20 The programme was simple and, as a result, binary, in the sense that either it would or would not work. Either way, policy drift was avoided. The programme also had the bene t of addressing both of the countrys medium-term problems: not just scal imbalance but also overvaluation. There are two policy responses to an overvalued exchange rate: change the price of one thingthe rate of exchangeor change the price of everything else. The impact of the programme was expected to lead to a 25% drop in money wages, with goods prices to follow.21 This was politically too much, however, and the programme failed, banks were closed, Cavallo and de la Rua resigned; Eduardo Duhalde emerged eventually and formalised the devaluation and default. The knife-edge failed, and this was seen as a failure of the Argentine political system. Politicians who in the past had been pushed into line in crisis, at the end seemed eager to jump into the abyss instead. Collective self-destruction resulted from the lack of any effective leadership as much as their own lack of vision. The cracked facade of national common purpose shattered, and also unleashed a groundswell of opposition to the entire political class. The Demise of Financial Contagion and the Consequences for Argentina The lack of nancial contagion from Argentina to other countries (bar Uruguay) poses minimal systemic risk to the international monetary system, in contrast to the Asian, Russian or LTCM crises. Hence the argument for bailing out Argentina is reduced. The context was that the mid-1990s was also a time of nancial contagion in bond markets, very different from the more institutional investor base and less volatile market that has developed since the Russian devaluation in 1998.22 For developing countries most trade and investment links are with industrialised countries, not with each other: NorthSouth not SouthSouth. Developing countries are also highly heterogeneous. As mentioned, one de nition of underdevelopment is poor institutional development, and institutions develop only slowly over time, their gaps and inef ciencies remaining highly country speci c. Hence, developing countries are often much more diverse economically than industrialised countries. So, a broadly diversi ed portfolio of developing country sovereign debt should pool and reduce non-correlated risks. Hence the claim that nancial contagion was collectively irrationaland is arguably the most irrational feature of any nancial market. It may be collectively stupid, but knowing that the behaviour exists, the intelligent act of an individual is to act likewise (and rst), in turn strengthening the pattern. The
20 At this time provincial Governors did not want to be singled out as responsible for failure. 21 Initially federal workers salaries were cut by 13%, but as scal revenues were falling a second cut was widely expected in nancial markets. 22 Emerging bond index volatility, as measured by annualised standard deviation of monthly returns of the JPMorgan EMBI Global Constrained Index over the three years to end 2001 was 9.08%, a little over half that of 16.94% of the S&P500, the reverse of the situation in the mid-1990s (source: JPMorgan Index, Bloomberg).

492 Jerome Booth additional germ of contagion in emerging markets had been excessive leverage by non-discriminating speculative investors. Although Brazil and Russia do not trade with each other, when Russia devalued and defaulted in 1998 the problem spread to Brazil and other countries. This contagion was largely driven by margin calls on leveraged investments: as the value of Russian debt fell, so other assets elsewhere were sold to generate cash to meet margin calls on the leverage. 23 The same pattern had previously been observed when Mexico devalued in late 1994, also generating widespread bond market contagion, though the impact on sovereign bond spreads was more limited in 1997 with the Asian crisis.24 The depth of losses in 1998 from the Russian crisis was suf cient to scare off these leveraged speculators. Many found more fashionable investments elsewhere, especially the Nasdaq, and emerging debt at last fell out of fashion. Hedge funds reduced activity in the market and many disappeared altogether. Institutional investors became a more signi cant proportion of the investor base. Volatility decreased substantially, just as it was rising in many other asset classes, and over the last three years has been substantially less than for any major equity market.25 The remaining investors were, and still are, largely unleveraged and more discriminating of country risks. Contagion risks reduced as a result. The rst major test was the Brazilian devaluation in January 1999. It was well anticipated by the market and, with the sole exception of Argentina (which suffered a major terms-of-trade shock to which it could not adjust given its xed exchange rate), the major emerging markets rallied after no more than two days of uncertainty.26 The Argentine crisis has also been well agged, but has been more severe. But even though the crisis in Argentina is dramatic, involving default and devaluation, recession and political crisis, there has been no nancial market contagion beyond its blameless neighbour, Uruguay.27 The silver lining of the collectively irrational nature of nancial contagion is that when it does not exist and is perceived not to exist it is unlikely to re-emerge. Those who try to push the market around by short selling will be more likely to get their ngers burnt. The market has matured. The general move to oating exchange rates has also helped, as it was typically through currency markets, speculating against xed rates, that macro hedge funds made their returns. However, the lack of contagion has also reduced the systemic risk that Argentina poses for the international nancial system, and hence reduced the chance of being bailed out.
23 Many investors in emerging debt in the mid-1990s bought bonds and borrowed to pay for the purchase from the selling bank, which kept the bonds as security on the loan. As the price fell, the deposit or margin call on the loan needed to be increased. 24 The main reason why the Asian crisis had less direct impact on the emerging bond market (though not on other asset classes) was that the stock of bonds was much lower in Asia than in Eastern Europe or Latin America. This re ected higher historical savings rates and greater prevalence of domestic bank and equity nancing. 25 For more on this please see footnote 22. 26 Brazil devalued and moved to a free oat on Wednesday 13 January and the market was rallying by market close on Friday 15 January (source: JPMorgan Index, Bloomberg). 27 Uruguay is a relatively small economy that is highly dependent on Argentine nancial deposits and tourism.

The Case for a Permanent End to Fiscal Transfers 493 In Defence of the IMF (but not the G7) What was the role of the IMF throughout? It is easy to criticise the IMF with hindsighta seemingly tireless activity. The IMF has many enemies, but it is unreasonable to expect perfect vision from the IMF or anyone else. What one can expectthat the IMF learns and adapts quickly from experienceis broadly delivered, certainly compared with any other international agency. Moreover, insofar as the IMFs reputation has been tarnished in recent years, this is almost entirely due to visible, excessive and politically motivated intervention by G7 shareholders, rather than staff de ciencies or the desirable function of the Fund. With regard to Argentina there are three broad categories of criticism that deserve attention. First is that insuf cient attention was paid to structural reforms to improve long-term scal balanceincluding the transfers to provinces. Second, the last two support packages should not have been extendedin January and September 2001. Third, the IMFs greater perceived politicisation reduced its credibility in markets and hence its ability to in uence market opinion in support of Argentine reform efforts; it undermined its own objectives. With regard to scal focus, it has to be taken into account that the IMF is not a development bank but a balance-of-payments reman. There is also a defence that there was limited opportunity to push scal reforms harder. Throughout the last 10 years the IMF-supported Argentine economic programmes have been largely designed in Argentina. Convertibility was certainly not an IMF design; indeed, it was considered to be rather unorthodox from the start, even if an initially effective one given its impressive results in stabilising in ation and boosting market con dence suf cient for an investment-led growth boom. Once convertibility had been supported initially, though, it was dif cult to stop supporting Argentina until its collapse. Arguably, deeper scal reform should have been emphasised more strongly in the boom years after 1995 but with a government uninterested at the time it was dif cult to exert pressure. One might also argue that structural reforms to improve long-term scal balance were not as important 10 years ago as they are now. There are parallel arguments elsewhere that as the world changes so do policy priorities with them. To some extent this explains the phenomenon that after a crisis when economists list their lessons learned many of the lessons look familiar; but arguably, the principal value in these papers is what is included, and the order in which they appear, as well as what is not included. For example, prior to the Asian crisis, it was believed that opening the capital account and regulating ones nancial sector were both desirable. The former was considered more important, though. After the Asian crisis we know that the latter has to occur before the former to avoid subsequent unpleasantness, and the reason why this ordering was different after the crisis is in large part because the world changed: not that economists were previously wrong, rather that they were previously analysing a different world. Over the last 10 years scal issues have clearly become much more prominent. As the market belatedly concentrated on scal issues in Argentina, so they became critical there. However, this is a poor excuse for earlier inaction. It has been abundantly clear since long before convertibility that serious attention needed to be paid to Argentinas scal mess. Brazil, coming out of military rule with a decentralised

494 Jerome Booth constitution that made consolidated scal management similarly dif cult to Argentinas, has spent years addressing its scal problems through constitutional reform with considerable success, and now has a stronger tax base as a result.28 It was also understood as a priority in Argentina, and measures were taken to increase tax revenues29 and eventhough only signi cantly effective temporarily and in times of crisisto reduce provincial expenditure. Concerning the IMFs two packages in 2001 there has already been much criticism. To support Argentina in the rst case (January) with a larger package, even though scal targets had been missed, was understandable and predictable. Argentina was in an existing programme and could still pull through, and to abandon the country at that point would have been irresponsible. With hindsight, it was only a mistake given what happened subsequently. At the time, there was a strong probability that the programme would enable Argentina to survive. The market clearly believed this and Argentina managed to issue a new bond. However, this was followed by very poor scal results in the rst three months, and de la Rua replaced Jose-Luis Machinea as Economy Minister with Ricardo Lopez-Murphy. As mentioned above, he proposed a more radical scal adjustment, which in the face of widespread opposition de la Rua refused to back, replacing him with Cavallo. The second package (approved in September) was less defendable by its likelihood of success, but still success was possible and the same defence of the IMFs actions apply. Cavallo had managed to regain some market con dence and extended external debt maturities through a $29.5 billion swap, and he had started to pick a ght with Governors over transfers arguably the right ght. The third criticism is not really directed at the IMF at all, but an observation of the consequences of actions taken by its major shareholders.30 Any institution owned wholly by governments is inevitably political, but in recent years the market perception of the impartiality and technically driven nature of Fund staff recommendations has been eroded. The rst major incident occurred when there was last-minute intervention in the design of the Russian IMF programmeit was toughened in a way that made the conditionality non-credible, weakening market con dence in the programme.31 The second was the perceived involvement of Washington of cials (albeit denied, but not credibly) in Ecuadors Brady bond default, at a time when the money to pay the coupon sat in the Central Bank waiting to be paid. Since their Cologne summit, the G7 and bond market appeared to be on a collision course. The positive-sum game of cooperation had given way in of cial circles to an excessive concern with moral hazard and the need for burden sharing, souring relations with the bond market and reducing trust in the impartiality of the IMF. This, in turn, contributed to the reduced
28 Brazils tax revenue in 2001 was at a record high, 8% above target (source: Agency EFE News Service), and the country is expected to meet its primary surplus target of 3.5% of GDP in 2002. 29 These included several efforts to improve tax administration and tax amnesties in the 1990s. 30 A cynic might argue tongue-in-cheek that the G7 does not make mistakes, of course, so one cannot call such observations criticisms. It is their sovereign right to behave as they see t. 31 The market perception at the time was that this had been done at the insistence of the US Treasury to fend of possible criticism from Congress.

The Case for a Permanent End to Fiscal Transfers 495 market credibility of IMF statements and actions and hence, to reduced IMF effectiveness. W(h)ither the Washington Consensus? The Washington Consensus, developed from a set of 10 policy reform areas where there appeared to be some consensus in Latin America, was articulated in a conference held in Washington in 1989 and then emerged as a book.32 It became a set of prescriptions, then became a dogma that was extremely effective. It focused policy makers across much of the globe and gave an ideological impetus to the spread of market economy. However, this was not without costs. The bene t of dogma is that it helps to focus policy on key areas and reduces time-wasting con ict over design, and is most appropriate for a focused institution like the IMF with a narrow mandate to help prevent, but above all manage, balance-of-payment s crises. For development banks, dogma is more of a mixed blessing. Its aws are, rst, that developing countries problems are heterogeneous and so should be the prescriptions to address them, and second, that ownership of policy is increasingly more signi cant to its effectiveness than its technical design. In short, as a sales technique, dogma is effective, but as a means to design policy it is often a hindrance. The Washington Consensus may now be dead, but how far as a result of recent events in Argentina? Arguably very little: it was dead already. Convertibility was certainly never part of the consensus. If anything killed it, it was the G7s own reaction to the Asian crisis, during which G7 countries started openly criticising the IMFs prescriptions to an extent that started impairing the Funds effectiveness. 33 To what extent are Argentinas problems speci c to Argentina and of limited general prescriptive use elsewhere? Insofar as Argentinas problems are long in gestation and home grown, they may argue for special case status and not be re ective on the case against the Washington Consensus. Then again, the case against is precisely that all countries are special cases, and that the ideology of homogeneity propounded by the Washington Consensus was always both a simplifying ction and, as it contributed to perceptions that fed nancial contagion, a decidedly unhelpful one. The Washington Consensus does have different meanings. As a body of acquired policy experience from which useful lessons can be drawn, it has some use. As dogma, its demise (i.e. that a policy maker does not use it as a blueprint) is to be welcomed. With its demise also goes the trap of circular logic denying the existence of aws in its logic. Speci cally, the circular logic oft employed by the Washington Consensus as dogma is that if a country does not get the results desired after completion of an economic programme, there can be only two
32 J. Williamson, ed., Latin American Adjustment: How Much has Happened?, Washington, DC, Institute for International Economics, 1990. See also F. Stewart, John Williamson and the Washington Consensus Revisited, in L. Emmerij, ed., Economic and Social Development into the XXI Century, Washington, DC, Inter-American Development Bank, 1997. 33 In particular, following Australian government objections to the IMFs programme in Indonesia, German politicians also started openly criticising the IMFs role in the Asian crisis. This led to dif culty is assembling a German bilateral component for the Russian IMF-led support package, in turn delaying and reducing the size of that package in 1998.

496 Jerome Booth possible reasons. Either the country did not carry through the conditions mandated or, alternatively, more medicine is required. Notice that incorrect prescription is not in the dogmas policy vocabulary. The case with Argentina (the dead patient in this example) is that large doses of medicine have been given over a considerable period: hence, one may conclude instead that loan conditions cannot have been adhered to. Thus, in turn, the of cial community has been supporting the country either in ignorance of its non-compliance or by way of throwing good money after bad. Therefore, there has to be a witch-hunt and the IMF criticised as a result. The alternative truth is that Argentinas problems were home grown and speci c to Argentina, and Washington can neither take a great deal of credit for earlier success nor current failure. Conversely, Argentinas policy makers have to take the lions share of the blame for what has happened, and the electorate much of the blame for voting for them. Argentinas experience is another nail in the cof n of the Washington Consensus as rigid dogma, but this is neither a great surprise nor should be seen as a negative development as far as policy prescription is concerned. Conclusion The bond market has belatedly focused on the political nature of Argentinas problems. The observation that the political elite did not deliver scally when pressed means that the promise of deep-seated structural reform to create long-term scal balances will be required before capital markets can be accessed. The market is often accused of having a short memory, but no rational investor will lend without trusting there will be full repayment. The timescale of Argentinas problems is very different from that in, for example, Russia. The market cannot trust Argentina not to have identical problems in another ve to ten years unless scal sustainability is in place and permanent. Just over 10 years ago, convertibility was implemented as a means to convince markets of future scal discipline by making the cost of failure high: by creating a knife-edge equilibrium. Fiscal and monetary policy discretion was largely taken out of the hands of Argentine policy makers and left to the automatic rule of convertibility and the mercy and trust of the international capital markets. Likewise, Brady bonds were made deliberately dif cult to restructure, as the only means to re-establish credibility and enable new issuance again. All these measures were taken in recognition of Argentinas history of irresponsibility. None have worked, and the inevitable price is now being paid. There is no quick x. It is now time for Argentina to re-examine profoundly its scal pro igacy and the legitimacy of its leaders, and this will require not only new elections but also constitutional amendment to halt transfers to the provinces permanently. There is also no clear case for a change in international nancial architecture from Argentinas recent experience. Such a change would be to alter incentives for the whole bond market not because new information has become available: the costs of default were understood by Argentina and bond holders many years ago. Argentina took its own decisions then and so did investors. It would be counter-productive to try and restructure the external debt before the political crisis is over, as markets will price in a high premium for default on the restructured bonds; better to wait even two years and then address the issue once comprehensive reform has taken place. At that point, Argentina should

The Case for a Permanent End to Fiscal Transfers 497 manage to access markets quickly againand will be rewarded for making the effort to pay until the end. Lack of willingness to pay, as in Ecuador, will always be penalised more by the bond market than lack of ability to pay, as in Argentina. A less than genuine bond restructuring too soon could jeopardise this. In summary, Argentinas current economic crisis is a re ection of a longrunning chronic political situation; speci cally, the lack of political will to control scal expenditure. The scal irresponsibility is structural in that provinces are not obliged to raise their own revenue to nance their expenditure, but rely on transfers from the federal government. Political power is largely in the hands of provincial politicians or national politicians with dominant provincial loyalties, and this political dominance is in part caused by the ability to spend at the provincial level without the political cost of imposing taxes. Sustainable economic recovery will not be possible without addressing the scal and political facets of this arrangement. Delaying deep reform to address the issue is no longer possible as there is no longer any source of nance available to the government until scal responsibility is clearly established. Net transfers from the federal government must stop, and must stop permanently.