Will Hambly

October 12, 2006

Professor McIntyre
Economics 495

The 2001 Crisis in Argentina: An IMF Sponsored Default?

After a decade plagued by hyperinflation and fiscal mismanagement, Argentina emerged

in 1990 as the developing world’s most promising success story. In a nation that has historically

been troubled by inflation, bank failure, and military coups, the early 1990s were exceptional

times for Argentina. Output grew robustly at a 6.1%1 annualized rate, inflation remained

contained, and foreign direct investment increased as the prospects for Argentina’s growth

brightened. Under the presidency of Carlos Saul Menem and the Economics Minister Domingo

Felipe Cavallo, several liberal economic policies were pursued, including a reduction of import

tariffs, the privatization of several state-run corporations, and an expansion of the tax base.

Argentina’s persistent inflation bias disappeared as the government abolished the central bank in

favor of a currency board, which eliminated the nation’s ability to print money and tied the peso

to the U.S. dollar. Argentina also emerged unscathed from both the Mexican and Asian crises

which rattled emerging markets across the globe. This period of reforms and dramatic success,

however, proved to be fleeting. In 2000, the Argentine economy sunk into a period of deep

recession, fiscal delinquency, mounting foreign debt, and social strife. Not only was the

government unable to rein in spending, but it was increasingly reliant upon financing the fiscal

deficit by issuing bonds at a spread of over forty percentage points higher than American

treasuries. The market proved correct in demanding such a hefty risk premium on Argentine

debt, as reckless government borrowing, a decline in export competitiveness, and a severe

1
“A Decline Without Parallel.” The Economist, 28 February 2002.
 Hambly 2

economic contraction brought the country to crisis. Ultimately, the Argentine crisis resulted in

the largest sovereign debt default, a radical abandonment of the currency board, and utter misery

for the Argentine people. This paper will examine both internal and external factors that

contributed to the crisis and provide several policy recommendations.

Economic reforms in the early 1990s were hugely successful, but several problems still

lurked in the Argentine economy. In an effort to prevent the chronic hyperinflation that had

plagued the country in the past, Argentine policymakers took a hard-line stance on inflation and

adopted the Convertibility Plan, which included several liberal economic reforms and established

a currency board. The Convertibility Law stipulated that each peso in circulation be backed by

exactly one U.S. dollar held by the central bank, preventing the government from financing the

fiscal deficit with newly printed pesos. This solution to resolving the central bank’s inflationary

tendency proved successful in containing prices, but deleterious to the economy’s flexibility and

the central bank’s ability to manage output shocks. The peg prevented the central bank from

implementing expansionary monetary policy as output contracted in 1999-2002. Additionally,

the peg prevented the central bank from printing additional pesos to avert bank failure when

depositors demanded the withdrawal of $15 billion from commercial banks. Not only did the

fixed exchange rate render monetary policy impotent in correcting short-run economic

fluctuations, but it manipulated the real exchange rate to an inappropriate level given Argentina’s

economic fragility.

During Argentina’s boom years, the government ran only modest budget deficits, and

even ran the occasional surplus. Government revenues, however, soon proved to be inadequate

to cover interest payments on outstanding debt. Public debt grew exponentially as public sector

expenditure increased and the government assumed payments for the transitioning social security

system. When the economy sank into a deep recession in 1999, fiscal authorities responded to
 Hambly 3

the mounting government debt by raising taxes and cutting government spending, an egregious

policy mistake during a recession. In hopes of cutting expenditure, the government attempted to

release labor from many of the state-owned enterprises, but this policy proved to be futile, as

unemployment led to massive social unrest. Adding to the country’s fiscal woes was that the

government lacked the infrastructure to collect a greater portion of GDP in tax revenues.2

Taxation as a percentage of GDP remained markedly lower than comparable countries.

Furthermore, Argentine fiscal problems were exacerbated by the structural relationship between

the central and provincial governments. The central government was responsible for collecting

tax revenues which were then distributed and spent by the provincial governments. This system

of fiscal management banished any incentive for provincial governments to rein in spending and

deficits resulted at both levels of government. The inefficiency of the Argentine tax system is

reflected by the government’s meager tax collections, amounting to only 21% of GDP compared

to Brazil’s 30% and many developed countries’ levels approaching 50%.3 The result of

Argentina’s fiscal problems was increasing debt, which in 2001 reached nearly 55% of GDP, a

dangerously high for a developing country with questionable revenue systems. Being a

developing country with mounting debt, rising interest rates, and persistent budget deficits made

Argentina extremely susceptible to economic crisis and sovereign debt default.

Furthermore, contributing to the fiscal deficit and lack of export competitiveness were

rigidities in the Argentine labor market. During the late 1990s, public sector employment

accounted for 12.5% of the labor force.4 Both the existence of these jobs and the level of wages

were guaranteed by strong organized labor unions and political cronyism. As the economy fell

into recession, unemployment rose as labor was released from the private sector, but federal jobs
2
“A Decline Without Parallel.” The Economist, 28 February 2002.
3
Tella, Rafael Di, “The 2001 Crisis in Argentina: An IMF-Sponsored Default?” Harvard Business School, 7 January
2004.
4
Krueger, Anne, “Crisis Prevention and Resolution: Lessons from Argentina.” International Monetary Fund, 17
July 2002.
 Hambly 4

were maintained with wages nearly 45% higher than the private sector. 5 Not only did the federal

payroll prove to be a burden on the economy, but wage rigidity prevented prices from falling,

maintaining the real exchange rate at high levels and reducing export competitiveness.

Adding to fiscal weakness, rigid prices, and a lack of monetary policy flexibility was a

weak banking system. In contrast to most economic crises, in which banking system weakness

precipitates economic crisis, Argentina’s experience was the opposite. The economic crisis and

the government’s fiscal stance brought about a weakness in the banking system which

exacerbated the contraction in output and created social unrest. As the government deficit

expanded and debt swelled, the central bank raided banking deposits by strong-arming pension

funds and local banks to buy risky government bonds at below market interest rates.6 If the

banking system were more independent, commercial banks would never have foolishly bought

government bonds and surrendered deposits. News of the government’s raid on banking deposits

prompted a bank run and the government responded with a freeze on withdrawals, violating

basic principles of private property and trust between citizens and government. The deposit

freeze and seizure of bank deposits disrupted the link between savings and investment, led to

rioting in the streets, and dispelled any remaining faith Argentines had in their government.

While many internal policy decisions made Argentina susceptible to economic crisis and

default, international events ultimately led to the catastrophe. For years, the currency board was

hugely successful in containing inflation, but the dollar peg imposed a great cost on the

economy. With the value of the peso pegged to exactly one dollar, exports suffered as the trade-

weighted value of the dollar rose over 30% from 1998 to 2002.7 Additionally, beginning in 1999,

the U.S. Federal Reserve began raising interest rates to cool the U.S. economy just as Argentina

plunged into recession. Because the Argentine central bank was effectively abolished by the
5
Krueger, Anne.
6
“A Decline Without Parallel.” The Economist, 28 February 2002.
7
Board of Governors of the Federal Reserve System, Trade Weighted Exchange Index: Broad.
 Hambly 5

Convertibility Plan, monetary policy was set by the American Fed through the peso peg. The

combination of rising interest rates and a nominal appreciation of the dollar muted Argentine

output growth and burdened exporters. Adding to the decline in competitiveness, was the

Brazilian devaluation of the real in 1999, which made Argentine goods more expensive relative

to Brazilian goods. Further contributing to a high real exchange rate were rigid wages supported

by strong organized labor interests. As the economy fell into recession prices remained high,

preventing the real exchange rate from falling and the country’s exports from becoming more

competitive.

Additionally, the International Monetary Fund is frequently blamed for the crisis in

Argentina, as illustrated in Nestor Kirchner’s comments to IMF managing director Horst Kohler,

“You are greatly responsible for what happened in Argentina.”8 In order to receive aid from the

IMF, Argentina was under pressure to meet fiscal goals to comply with austerity. To reduce the

government deficit, policy makers were forced to cut spending and increase taxes as economic

growth stagnated, exacerbating the recession. Additionally, IMF intervention introduced the idea

of moral hazard. If the Fund stood to remedy the situation, Argentine policymakers had little

incentive to manage the fiscal deficit. Swelling debt, fiscal imbalance, and ultimately the IMF’s

reluctance to continue lending gave Argentina no choice but to default.

During Argentina’s boom years and as the economic crisis developed, policymakers

could have taken several steps to restore the health of the economy and safeguard it for the

future. Instead, Argentine policymakers chose to ignore several problems in the economy. In

retrospect, viable policy recommendations include inflation targeting, fiscal planning, increasing

flexibility in labor markets, and imposing a debt ceiling.

8
Tella, Rafael Di, “The 2001 Crisis in Argentina: An IMF-Sponsored Default?” Harvard Business School, 7 January
2004.
 Hambly 6

While the currency board solved the problem of inflation, it came at an enormous cost.

Rather than addressing the inflation problem with an exchange rate peg, the central bank should

have established an inflation target, which would offer at least some policy flexibility in the

event of an economic crisis or shock to output. By targeting a rate of inflation, the peso would

be allowed to float on world markets and the central bank would be free to stabilize output. The

currency board simply tied Argentina’s economic fate too closely with external variables.

Additionally, prudent fiscal planning and higher tax revenues would have averted the

crisis. During the boom of the early 1990s, the government failed to cut spending and raise

taxes. Having a budget surplus could have reduced the risk premium demanded on Argentine

bonds and allowed the government to implement expansionary fiscal policy during the crisis.

With a fixed exchange rate, fiscal policy is the only tool available to policymakers, and when

creditors are no longer willing to lend, expansionary fiscal policy during a budget deficit

becomes unavailable as well. With respect to taxation, compared to its neighbors, Argentina

collected far less of its GDP in taxes. Improving basic accounting systems and discouraging the

underground economy would have increased government revenues. Finally, making provinces

fiscally accountable would have decreased budget deficits as individual regions were made

accountable for their own collection and spending, aligning incentives and reducing reckless

spending.

Furthermore, increasing labor market flexibility would have helped Argentina weather the

economic crisis. As the recession set in, government employees earned nearly 45% more in

wages that private sector employees and comprised 12.5% of the labor market.9 With strong

labor unions and the government’s reluctance to trim its payroll, prices in the economy were

reluctant to fall. Flexible prices would have enabled labor markets to clear and the economy to

9
Krueger, Anne.
 Hambly 7

adjust to output shocks. A falling price level would have also encouraged exports as

competitiveness increased.

Lastly, government debt accumulation should have been carefully monitored by an

independent board and a ceiling placed on government debt as a percentage of GDP. As

Argentina’s debt rose to astronomical levels in the 2000-2001 period, there was little hope of

repaying the principal plus interest, as debt levels were several times the government’s annual

tax revenues. Limiting government borrowing to what the government is able generate in

revenue during a given year would have avoided the debt crisis, default, and the government’s

seizure of bank deposits.

Implementing these policy recommendations is no simple task, given the country’s

inflationary tendencies, profligate spending, high tax evasion, and organized labor at the federal

level. If Argentina were to have enacted these measures gradually throughout the 1990s, when

output grew robustly, the debt crisis likely would have been averted and the external shocks to

output could have been reduced. Policymakers should have attempted to remedy Argentina’s

economic condition during the period of high output growth. The apparent Argentine miracle of

the early 1990s proved too good to be true as unfettered optimism led to irresponsibility and a

reversal of fortune.

Works Cited
 Hambly 8

“A Decline Without Parallel.” The Economist, 28 February 2002.

Board of Governors of the Federal Reserve System, Trade Weighted Exchange Index: Broad

Krueger, Anne. “Crisis Prevention and Resolution: Lessons from Argentina.” International

Monetary Fund, 17 July 2002.

Tella, Rafael Di. “The 2001 Crisis in Argentina: An IMF-Sponsored Default?” Harvard Business

School, 7 January 2004.

Graphs
 Hambly 9

Source: Board of Governors of the Federal Reserve System