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The US Is Entering a Debt Spiral

Argentina has accumulated seven months of over 100% of year on year consumer price inflation since February 2023. The official and parallel exchange rates between the Argentine Peso (ARS) and the US Dollar (USD) have doubled in half a year, while the spread between the official and parallel rates has held steadily at around 100%. The central bank of Argentina has been for most of its history the prime example of fiscal dominance and inflationary bias, despite sparse periods of de jure independence. The Argentine Peso is one of the most defective currencies in the world and it is being kept on life support at the expense of the stability necessary for a functional market process and everything that implies.

In this context, combined with a presidential election, the idea of retiring the Argentine Peso through the liquidation of the central bank has gained popularity. There are three relevant coalitions in the current political theater in Argentina. The incumbent coalition, Union for the Fatherland (UP), has Sergio Massa as the presidential candidate. Massa is a long time politician and lawyer who is the current Minister of Economy. They represent the continuity of the status quo, with minor adjustments if any. The coalition that represented the main opposition until recently, Together for Change (JxC), is running Patricia Bullrich for the presidency. Bullrich is a long time politician and political scientist who was the Minister of Security under the previous government. They represent the option of change within the establishment; the usual swing of the pendulum. The new coalition mainly consisting of outsiders, Liberty Advances (LLA), is led by Javier Milei as presidential candidate. Milei is an economist with sympathies for the Austrian school and has been a Member of Congress since 2021. They represent the push for a substantial overhaul.

Milei is having a surprisingly good electoral performance. Betting odds markets currently give him an over 70% probability of winning the election. Massa has an under 20% probability and Bullrich has an under 10% probability. In terms of relevance to monetary reform, Milei and Bullrich agree there should be a change to the monetary regime, making it likely to happen. Bullrich proposes going to a bi-monetary regime. Milei proposes what is known as a dollarization, but goes beyond past dollarizations in scope. Within Milei’s technical teams there are two camps that differ about how to get there. There are two dimensions to all proposals: changes to the legal tender rules and changes to the central bank.

The main exponent of Bullrich’s bi-monetary plan is Carlos Melconian, an economic consultant who would become Minister of Economy if Bullrich wins the election. Melconian has not given a detailed account of the plan but has, in diverse interviews, given clues to what it may entail. A cornerstone of the plan shared by the rival plans is fiscal equilibrium. This is rather sensible, since in the case of Argentina stopping the monetization of debt is a necessary condition to anchor inflation expectations. A problematic element of this step is that they intend to achieve a lower deficit through an increase of the revenue in real terms, rather than through extensive spending cuts. Taxation already represents over 30% of GDP, and the effective tax burden for the average company is 106% of profit, according to a report by the World Bank.

In regards to legal tender rules, this plan would have US Dollars and Argentine Pesos sharing legal tender status. Whether Theirs’ or Gresham’s law would apply depends on the exchange rate policy. In the early days of the campaign, Bullrich had said that they would eliminate exchange rate controls on day one. If this was the case, then Theirs’ law, by which good money drives out bad money, would apply. The problem with this, albeit transitory, is that it would cause a discrete and substantial jump downwards in the demand for Argentine Pesos, in a context where unanchored inflation expectations already exert such pressure.

The central bank has remunerated liabilities known as liquidity bills, in spanish letras de liquidez (LELIQs), which are effectively analogous to the Federal Reserve’s Interest on Reserve Balances program (IORB) by which they sterilize issued money. The interest rate currently paid on the LELIQs is over 200%. The LELIQs are held by banks, which in turn pay interest on deposits. The high interest is necessary to keep holders from fleeing to other assets. The size of the outstanding LELIQ mass is three times the monetary base. Along with the government’s fiscal deficit, the interest paid on the LELIQs is a cause for automatic monetary expansion.

If the exchange rate is allowed to float without disarming the LELIQs, or without increasing the exchange rate further, the lower expected future relative value of deposits would drive the holders to spend them or exchange them for other assets, thus driving the banks to liquidate the LELIQs to fulfill the withdrawal requests. This would imply the quadruplication of the base money in circulation in a high price inflation context.

Melconian has since retracted the proposal to float the exchange rate on day one, suggesting that it would be something achieved gradually. His transitory exchange rate policy proposal consists of an administered exchange rate for importers and exporters with a special focus on everything linked to food and basic necessities, as well as a floating exchange rate for everyone else, with an ultimate goal of convergence. In practical terms it is not very different from the status quo. Maintaining a spread between a floating and an administered exchange rate is rather expensive, especially in the context of bi-monetary regime. The spread is effectively a subsidy on imports and a tax on exports, but it is not self financing.

Melconian and Bullrich have not said what they will do about the LELIQs. For this plan to not be inflationary, the government’s budget surplus would have to be large enough to cover the flows from the LELIQs and the cost of maintaining the spread. This cost could represent over 10% of GDP, so it would require substantial spending cuts or substantial revenue increases. This does not seem sustainable. It appears that their intention might be to let the proverbial bomb explode at the beginning and stabilize afterwards. This is especially likely if we consider that part of their proposed monetary regime would take away the payment function from the peso by making debts in dollars only payable in dollars, whereas they are currently only payable in pesos at the official exchange rate. Under these conditions Theirs’ law would apply, they would not increase or would even decrease the interest rate, the sterilized monetary mass would circulate, there would be a jump in inflation, and everyone would switch to dollars.

The administered exchange rate would be a form of limited corporate welfare for importers during this period. The exporters would simply avoid it if they can switch their payments of inputs to dollars. The central bank would continue to operate and they would probably build a new peso from the ashes of the prior one by eliminating four zeros or so, as it happens after most hyperinflations. The central bank and the government would however have limited flexibility in conducting monetary and fiscal policy, as Theirs’ law would keep them in check as long as there continues to be a floating exchange rate and the dollar maintains its legal status.

The main exponent of Milei’s preferred plan is Emilio Ocampo, an academic, historian, and financier with Wall Street experience, who would be named president of the central bank if Milei wins the presidency. Ocampo wrote a book on the matter with Nicolas Cachanosky, who is an economist and professor at UT El Paso. Ocampo’s plan has both transitional and long term institutional aims. It seeks to avoid causing undue harm to those who hold pesos or claims denominated in pesos during the transition. It also seeks to usher in a monetary regime with free currency competition and a free and stable banking environment.

In the end state of this plan, the Argentine peso would no longer exist and the central bank would have been liquidated. Under this regime, everyone in Argentina would be free to denominate their contracts in any currency, commodity, or index they want. Banks would be able to freely issue banknotes and take deposits denominated in any currency, commodity, index they want. There would be no government controlled clearinghouse nor a singular lender of last resort. The banks would either be forced or encouraged to take their treasury balances offshore, such that they are beyond the reach and responsibility of Argentine jurisdiction. The authors of the plan expect that the absence of a safety net will lead the banks to follow better risk management practices, to form a private clearinghouse, and to seek emergency liquidity from larger international entities.

The operational plan for the transition is complex but consistent. The exchange rate and capital controls would not be removed but until after the sterilized monetary mass from LELIQs has been disarmed. In order to do that, the LELIQs would be repurchased by the central bank at present value in exchange for US Dollars at an exchange rate calculated from the bond markets which price the same bonds in Argentina in pesos and in New York in dollars. It has been speculated that this process might take around three months and it would take about $30 billion USD.

After the LELIQs have been dealt with, the capital controls would be removed, the exchange rate would be allowed to float, freedom of currency would come into effect, and the central bank would start to repurchase the monetary base. Any remaining deposits in pesos held by the banks at the central bank would be converted into dollars at the unified floating exchange rate. The banks would be instructed to convert the peso balances in their clients’ accounts into dollars. At that point there would be a flexible period for the physical currency to be deposited or exchanged for physical dollars at the banks. The main difficulty in that phase is that most dollars physically present in Argentina are high denomination and the largest denomination peso note is currently equivalent to $2 USD. The plan would be to import lower denomination bills and to allow private banknotes to satisfy some of that demand for physical currency, even if it is slower than digitalization.

Milei has rejected the idea of digitalization as a solution for that particular issue because he fears the government having higher tracking capabilities. Digitalization would put Milei in an awkward position because around half of the economic activity currently takes place outside the tax collector’s radar. Having the data for those transactions would place him in the dilemma of taxing the transactions and therefore disrupt the sector that could not survive being taxed, or not taxing the transactions, thus effectively bestowing a discriminatory privilege that is inconsistent with his equality under the law messaging.

Once two thirds of the physical pesos have returned to the possession of the central bank, a countdown for redeeming the remaining third would be triggered. The physical pesos would be redeemable for three months at that point. The monetary base is currently equivalent to around $10 billion USD. By the end, the central bank would have discharged all of its obligations, any remaining assets would be transferred to the government’s treasury, and it would cease to exist. Milei and Ocampo expect the entire process to take a maximum of 24 months.

There is a skeptic camp within the ranks of those who support Milei’s presidential campaign. The main exponent of this camp is Dr. Carlos A. Rodriguez, a Chicago economist, founder of UCEMA, and Secretary of Economic Policy during Menem’s government, who would be the president of Milei’s council of economic advisors if he wins the election. The main concern Rodriguez has regarding Ocampo’s plan has to do with securing the US Dollar liquidity necessary to execute the plan.

The central bank has around $10 billion USD in relatively liquid assets, and it has around an equivalent value of $30 billion USD in relatively illiquid assets. The relatively liquid assets include gold, foreign currency cash, and credit swaps. The relatively illiquid assets are mainly obligations owed by the Argentine government, most of which are in the form of bonds known as untransferable bills, in spanish letras intransferibles, which are subject to Argentine jurisdiction.

Ocampo’s plan is to convert all these obligations into bonds subject to New York jurisdiction like the ones which are currently traded in the markets. Those bonds would be transferred to a new monetary stabilization fund which would be subject to foreign jurisdiction. The bonds would serve as collateral for a line of credit that would provide the US Dollar liquidity necessary for the liquidation of the central bank.

The issue in dispute raised by Rodriguez is over the value of the bonds. The bonds which are currently tradable have a market price of around 25% of their face value. The obligations which would be converted into tradable bonds have a face value of around $120 billion USD. This represents around a third of Argentina’s total government debt. 25% of $120 billion is indeed $30 billion. Rodriguez believes however that the conversion of the government obligations held by the central bank into tradable bonds would negatively affect the market price of the tradable bonds. Rodriguez concludes therefore that the most viable path to disarming the sterilized monetary mass is by gradually lowering the interest rate of the LELIQs, around 10% per month.

The problem with this suggestion is that financial instruments have a high relative price elasticity, such that gradually lowering the interest rate would have a similar effect to lowering the interest rate in a large discrete jump, as Cavallo did in the 70s during the military regime. Thus, if the suggestion was adopted, the transition would be effectively the same as the one implied by Melconian’s plan. The end result would be different because instead of building a new peso as Melconian would do, Rodriguez would support Mieli’s plan to liquidate the central bank, which would be a lot cheaper after a hyperinflation, as the dollar value of the liabilities would go down with the peso’s value.

The objection that Rodriguez raises to Ocampo’s plan is not likely to be an issue. It is true that the conversion of the government obligations held by the central bank into tradable bonds applies a downward pressure on the market price of the tradable bonds, and that other things being equal the market price of the tradable bonds would go down. But other things would not be equal if the whole plan is executed. There are four elements that mitigate the issue with this downward pressure.

The first element is that these converted bonds would not circulate, they would remain in the balance of the monetary stabilization fund. The fund would pay the flows owed to the liquidity credit line with the flows from the bonds, rather than by selling the bonds. The second element is that there will probably be no need to use the totality of the liquidity credit line, as the LELIQs would not all be repurchased simultaneously but over the course of three months and the banks would not necessarily immediately redeem their resulting dollar claims but would rather keep them as deposits at the fund, because the liquidity credit line would provide credible redeemability.

The third element is that a substantial part of the risk that is keeping the market price low comes from the government’s portfolio currency mismatch, which would be eliminated by the process. The government currently has their income flows in pesos and the relevant owed flows are paid in dollars. This risk would cease to exist because most of the government’s inflows and outflows would be in dollars by the end of the process. The fourth element is that the other part of the default risk would be greatly mitigated by Milei’s parallel plan to reduce public spending by 15% of GDP.

Milei plans to achieve this spending cut by having all infrastructure projects be funded privately, eliminating subsidies, privatizing state-owned companies, streamlining bureaucracy, and not exercising discretionary items in the budget. He would not eliminate welfare programs and would honor pensions in order to avoid social havoc. This spending cut would be deep enough to even cut taxes and probably not suffer a reduction in tax revenue, as a result of laffer curve effects. The third and fourth elements would exert an upward pressure on the tradable bond market price, probably larger than the downward pressure from the mere conversion of government obligations held by the central bank into tradable bonds.

If we compare the alternatives, it is clear that the long term monetary regime achieved by either of the paths that could be followed by a Milei administration are superior to Bullrich’s bi-monetary regime and to Massa’s status quo, because it would provide relative monetary stability with a higher degree of credibility stemming from higher costs to reverse the reform. Comparing alternative transitions, it is clear that adopting the path suggested by Rodriguez to achieve Milei’s proposed monetary regime would be no worse than Melconian’s plan. Ocampo’s path is the most desirable, if achievable, because it would minimize economic disruptions and harm to the most vulnerable; it would effectively disarm a hyperinflation. It is reasonable to believe that Ocampo’s path is achievable. The worst case scenario would be to stay the course in the status quo with no clear stabilization plan on the other end.

References

Central Bank of the Republic of Argentina. 2023. “Estado Resumido de Activos y Pasivos.” Weekly Balances. https://www.bcra.gob.ar/PublicacionesEstadisticas/balances_semanales.asp.

Lott, Maxim, and John Stossel. 2023. “Argentina 2023.” Election Betting Odds by Maxim Lott and John Stossel. Accessed October 11, 2023. https://electionbettingodds.com/Argentina2023.html.

Madero Radio. 2023. Basics Dolarizacion en criollo con Emilio Ocampo. https://www.youtube.com/watch?v=OtOSUygFyrI.

Madero Radio. 2023. BASICS El Wingman de Ocampo en la Dolarizacion. https://www.youtube.com/watch?v=FSyE22vNKIU.

Madero Radio. 2023. Basics invitado Carlos Rodriguez. https://www.youtube.com/watch?v=f7KKqwr6a1k.

Neura Media. 2023. Carlos Melconian presenta su plan de economía con Alejandro Fantino. https://www.youtube.com/live/dBqmIiahNCg?si=nwi15p-yQHM6awdF.


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