A new approach to public policy seems to be in vogue in Washington: when confronted by a problem with two possible causes, choose the proposed policy solution that promises to cost the least. We saw this principle in action when the Bush administration withdrew from the Kyoto treaty on global warming. Now it is being applied to international finance, with the US Treasury’s management of Argentina’s crisis a case in point.
The low-cost interpretation of international financial crises is that they result from what economists call “moral hazard” – investors’ appetite for risky ventures rises because they receive implicit guarantees that protect them from potential loss. Governments provide these “guarantees” when they bail out failing banks; central banks when they commit to peg an exchange rate; the international community when it provides financial rescue packages to countries in trouble. The solution, say advocates of this theory, requires countries to improve regulation and supervision of their financial systems and float their currencies, and for the international community to pull the plug on financial assistance.
Such theories, however, always seem to explain the last crisis but never successfully predict the next one. Latin America’s debt crisis in 1982 was blamed on large fiscal deficits and excessive public-sector borrowing, leading to an ambitious reform agenda to downsize government. When, despite sound public finances, the Mexican crisis erupted in 1994, the blame was shifted to low and declining domestic savings. Latin America was advised to focus, like East Asia’s economies, on boosting domestic savings through measures such as social security reform. In 1997, when crisis hit East Asia – countries with the highest savings rates in the world – the blame was shifted yet again, this time to bad banks and excessive short-term debt.
Argentina, however, seemed to do everything right when it embarked on a decade of structural reform. After stopping hyperinflation and ushering in price stability, it pared its public sector, privatizing steel, oil, banking, telecommunications, and airline companies, as well as water utilities, highways, postal services, and even the social security system. It adopted a sophisticated public-debt management strategy that lengthened the maturity of its liabilities and put in place the toughest banking standards in the developing world, allowing first-rate foreign banks to dominate its financial sector. Now, despite a three-year recession, it is attempting to lower a modest fiscal deficit to zero. So why is Argentina in such deep trouble?
The most plausible theory is based on self-fulfilling expectations. When markets fear that a country might not repay its debts, they demand higher interest rates, which in turn make countries less willing or able to repay, justifying the initial fear. In Argentina’s case, high interest rates made it difficult for the government to service its debt by stifling economic growth and depressing tax revenues while inflating borrowing costs to prohibitive levels. This made it riskier to invest in Argentine bonds, validating the high interest rates.
The main challenge for policymakers when crisis strikes is thus to manage market expectations. But in almost every successful case – for example, Mexico and Argentina in 1995, Korea in 1998, and Brazil in 1999 – what worked was a combination of domestic adjustment and international support. Domestic adjustment makes it clear that a positive outcome is feasible, while international support helps move the market toward that outcome. Sometimes international support must take the form of financial assistance; at other times a similar effect can be achieved through expressions of commitment.
From this point of view, the US Treasury’s behavior has been a major factor in Argentina’s current malaise. For months, it said nothing. Finally, as the crisis deepened, National Security Advisor Condoleeza Rice stepped in to praise Argentina’s efforts at domestic adjustment – traditionally Treasury’s job. When Treasury Secretary Paul O’Neill at long last did speak out, he flatly contradicted Rice, telling The Economist that Argentina’s crisis was caused by its lack of an export industry and unwillingness to do anything about it. He also dismissed concerns about international contagion, asking the journalist, “Do you think anybody will remember any of this 5 years from now?”
Markets understandably interpreted such statements as an invitation to pessimism. Could O’Neill really be so ignorant as to suggest that Latin America’s model reformer had done nothing over the last decade? Or was he suggesting that the US-inspired reform agenda that it had followed was wrong and that it should instead focus on Japanese-style industrial policy? The uproar caused by O’Neill’s reckless comments finally forced President Bush to order John Taylor – the Treasury’s second in charge – to visit Argentina on a fact-finding mission, but the facts could have been found much earlier had there been any concern.
Why has the US Treasury acted so myopically? The answer is simple: looking through the lens of moral hazard, officials see only reckless Wall Street investors in need of a stern lesson. Argentina became merely a vehicle for sending a message from Washington to New York. But if the alternative view is right, America’s Treasury irresponsibly fueled bearish market expectations by bad-mouthing serious reform efforts and by denying the financial assistance that could have prevented them from becoming self-fulfilling.
Emerging economies such as Argentina have conscientiously sought to embrace openness and globalization, despite the vagaries of international capital markets. O’Neill’s policies and statements may well discourage these long-term efforts, by needlessly aggravating the short-term pain such reforms inevitably entail.
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US President Donald Trump’s import tariffs have triggered a wave of retaliatory measures, setting off a trade war with key partners and raising fears of a global downturn. But while Trump’s protectionism and erratic policy shifts could have far-reaching implications, the greatest victim is likely to be the United States itself.
warns that the new administration’s protectionism resembles the strategy many developing countries once tried.
It took a pandemic and the threat of war to get Germany to dispense with the two taboos – against debt and monetary financing of budgets – that have strangled its governments for decades. Now, it must join the rest of Europe in offering a positive vision of self-sufficiency and an “anti-fascist economic policy.”
welcomes the apparent departure from two policy taboos that have strangled the country's investment.
The low-cost interpretation of international financial crises is that they result from what economists call “moral hazard” – investors’ appetite for risky ventures rises because they receive implicit guarantees that protect them from potential loss. Governments provide these “guarantees” when they bail out failing banks; central banks when they commit to peg an exchange rate; the international community when it provides financial rescue packages to countries in trouble. The solution, say advocates of this theory, requires countries to improve regulation and supervision of their financial systems and float their currencies, and for the international community to pull the plug on financial assistance.
Such theories, however, always seem to explain the last crisis but never successfully predict the next one. Latin America’s debt crisis in 1982 was blamed on large fiscal deficits and excessive public-sector borrowing, leading to an ambitious reform agenda to downsize government. When, despite sound public finances, the Mexican crisis erupted in 1994, the blame was shifted to low and declining domestic savings. Latin America was advised to focus, like East Asia’s economies, on boosting domestic savings through measures such as social security reform. In 1997, when crisis hit East Asia – countries with the highest savings rates in the world – the blame was shifted yet again, this time to bad banks and excessive short-term debt.
Argentina, however, seemed to do everything right when it embarked on a decade of structural reform. After stopping hyperinflation and ushering in price stability, it pared its public sector, privatizing steel, oil, banking, telecommunications, and airline companies, as well as water utilities, highways, postal services, and even the social security system. It adopted a sophisticated public-debt management strategy that lengthened the maturity of its liabilities and put in place the toughest banking standards in the developing world, allowing first-rate foreign banks to dominate its financial sector. Now, despite a three-year recession, it is attempting to lower a modest fiscal deficit to zero. So why is Argentina in such deep trouble?
The most plausible theory is based on self-fulfilling expectations. When markets fear that a country might not repay its debts, they demand higher interest rates, which in turn make countries less willing or able to repay, justifying the initial fear. In Argentina’s case, high interest rates made it difficult for the government to service its debt by stifling economic growth and depressing tax revenues while inflating borrowing costs to prohibitive levels. This made it riskier to invest in Argentine bonds, validating the high interest rates.
The main challenge for policymakers when crisis strikes is thus to manage market expectations. But in almost every successful case – for example, Mexico and Argentina in 1995, Korea in 1998, and Brazil in 1999 – what worked was a combination of domestic adjustment and international support. Domestic adjustment makes it clear that a positive outcome is feasible, while international support helps move the market toward that outcome. Sometimes international support must take the form of financial assistance; at other times a similar effect can be achieved through expressions of commitment.
From this point of view, the US Treasury’s behavior has been a major factor in Argentina’s current malaise. For months, it said nothing. Finally, as the crisis deepened, National Security Advisor Condoleeza Rice stepped in to praise Argentina’s efforts at domestic adjustment – traditionally Treasury’s job. When Treasury Secretary Paul O’Neill at long last did speak out, he flatly contradicted Rice, telling The Economist that Argentina’s crisis was caused by its lack of an export industry and unwillingness to do anything about it. He also dismissed concerns about international contagion, asking the journalist, “Do you think anybody will remember any of this 5 years from now?”
Markets understandably interpreted such statements as an invitation to pessimism. Could O’Neill really be so ignorant as to suggest that Latin America’s model reformer had done nothing over the last decade? Or was he suggesting that the US-inspired reform agenda that it had followed was wrong and that it should instead focus on Japanese-style industrial policy? The uproar caused by O’Neill’s reckless comments finally forced President Bush to order John Taylor – the Treasury’s second in charge – to visit Argentina on a fact-finding mission, but the facts could have been found much earlier had there been any concern.
Why has the US Treasury acted so myopically? The answer is simple: looking through the lens of moral hazard, officials see only reckless Wall Street investors in need of a stern lesson. Argentina became merely a vehicle for sending a message from Washington to New York. But if the alternative view is right, America’s Treasury irresponsibly fueled bearish market expectations by bad-mouthing serious reform efforts and by denying the financial assistance that could have prevented them from becoming self-fulfilling.
Emerging economies such as Argentina have conscientiously sought to embrace openness and globalization, despite the vagaries of international capital markets. O’Neill’s policies and statements may well discourage these long-term efforts, by needlessly aggravating the short-term pain such reforms inevitably entail.