Inflation: the mystery of the yellow room

Robert Mundell

As everybody knows, Argentine lawyer and Cabinet Chief, Alberto Fernández, talks about economy, basing his ideas on scientific grounds. He says Argentina has no inflation (on some occasions specifying 'increasing') and, most surely, his statements are not based on indexes made by Argentine Internal Trade Secretary, Guillermo Moreno (a man he does not like because he serves Argentine Planning Minister Julio De Vido), rather on determinations of the most ancient academic orthodoxy. There cannot be inflation when fiscal surplus and exchange rate are fixed. Almost from a handbook.

However, the truth is that Argentina has inflation, not in tune with regional neighbours (except for Venezuela) and the globe, running the risk of developing till turning economy unstable.

So, what's going on?, since other eminent economists are also wondering about the useless phenomenon of fixed exchange rate and fiscal surplus. Yet, they admit increasing inflation as opposed to Cabinet Chief.

It's obvious that a fixed exchange rate, as it happened in the 90's (Robert Mundell's Nobel), is useful as nominal anchoring, thus curbing inflation. This is a fact. As long as, other policies, like fiscal and salary ones, are in keeping with the goal. With exchange rate and prospects, we must admit that people have not favoured an outburst during these years because parity settles above ARG$3 and all believe it will continue at that level. For a long time, everyone agreed that peso was going to appreciate, rather than to depreciate.

However, current foreign exchange regime (leaks may start here) holds capital control, particularly those regulating it. We should not forget that exporters have to sell foreign currencies (offer of this currency increases) and that there are some obstacles blocking purchase of all dollars private sector desires (which would reduce demand in dollars). Outcome: surplus offer in dollars, which is the same as surplus offer in pesos, since Argentine Central Bank (BCRA, in its Spanish acronym) intervenes to hold nominal anchor. In other words, BCRA buys all dollars left over in market, but which are left as a consequence of its rules. As domestic market does not want little bills not paying interests (pesos), instruments doing so are issued (BCRA's Bills of Exchange and Securities, LEBAC and NOBAC), thus increasing the entity's liabilities. Such absorption with debt of BCRA happens when inflation has also done its job: causing peso demand to increase (for only one reason: more pesos are needed to make more transactions since prices rise).

And why do prices rise? Cabinet Chief and some orthodox may wonder. Simple: those receiving pesos do not want them, while some others do ask paid little bills. Of course that another portion of market uses surplus pesos to buy goods, for example (we should not forget that they cannot buy all the dollars they desire and, in some cases, it's useless to make a deposit, since, if interest rates received for their pesos do not exceed Moreno's inflation, why make a deposit? Result: they buy goods which they bet will be more expensive tomorrow). So, monetary/foreign exchange policy works today on inflation with these diversions.

And, doesn't fiscal surplus prevent inflation? The thing is that maybe surplus is no longer as important as spending increase with respect to income. And, as pro-consumption components (pensions, salaries, subsidies) increase within spending, added demand is boosted (as well as policy of negative real interest rates) to levels exceeding potential product growth. We do not need to be experts or officials to notice that this process generates inflationary pressures, to be afterwards validated by the monetary policy.

With this description (and the already-known reality that inflation does not stem from a single cause), we discover what Fernández grumbles about: foreign price hike, expansive fiscal policy, granting salary policy and monetary validation are twisting elements for an economy which, although it invests, it does so below what power product needs to grow at the same rates as added demand. A sufficient explanation, from high school; it will be useful for some orthodox as well as for Cabinet Chief, who will have to realize (since he will continue in office in a new Cristina Kirchner's administration) that if, for example, salary guidelines burst out of this plan during the rest of the year or in the first six months of 2008, his scientific discussion will have no place due to inflationary knockout.