Fiscal Panic in Argentina

Of all the countries around the world that have tried to embrace the European welfare state, Argentina is perhaps the most tragic example. From the 1920s through the 1950s the Argentine economy was one of the strongest in the world, and there were years when Argentina attracted more immigrants from Europe than the United States did. But what could have become a formidable economic powerhouse caved in to the ideas of the welfare state. As the economy began declining, social and economic stability evaporated and Argentina suffered decades of political turmoil.

The long-term suffering of the Argentine people, and of many other South American countries, is a stark warning to today’s Europeans: their continent could become the same tragedy in the 21st century that South America was in the last century. Unfortunately, the Europeans refuse to hear the warning bells from recent history, so we might just as well pile on yet another story, on top of the ones already published about the crumbling Argentine economy and what brought it down. This one is from Bloomberg.com:

Argentina reduced government subsidies on natural gas and water by an average 20 percent in a bid to narrow the largest fiscal deficit in more than a decade. The government could save as much as 13 billion pesos ($1.6 billion) and will use proceeds to cover utility company costs and finance social spending, Economy Minister Axel Kicillof and Planning Minister Julio De Vido said today at a press conference in Buenos Aires. The cuts won’t apply to industrial users.

And the reason for the big deficit?

President Cristina Fernandez de Kirchner has boosted social spending since taking office in 2007 and left utility rates largely unchanged amid average annual inflation of about 25 percent, straining the finances of power distribution companies and leading to periodic blackouts.

If you live in California (which, thank my tax God, I don’t) you recognize this behavior. Back in the ’90s the state of California wanted to compassionately make sure that everyone could always pay their utility bills. So they regulated the price that utility companies could sell power for to households, but imposed no price regulations on the market where utility companies buy power from power producers. As a fourth-grader could have figured out, if the regulated price in the retail end was too low, on average utility companies would be buying power at a market price that exceeded the retail price they could charge.

The result? Rolling black-outs, no investments to improve either power production or power delivery, and in the end mounting costs for everyone in the back end when the entire power infrastructure needed massive upgrades anyway. (It did not help that California at the time was falling for the global warming delusion and chasing low-cost, fossil-based fuel out of the state.)

Now, Argentina finds itself in the exact same situation. But even more importantly, the Argentine government’s focus on entitlement spending is a stark parallel to Europe. Utility price regulation, which varies from country to country in Europe, is just another form of welfare-state intervention into the private sector. When coupled with the general plethora of entitlement programs that normally comes with welfare states, the subsidy becomes just another entitlement.

As Argentina demonstrates, this has consequences when government runs into fiscal trouble. Just like every welfare state the Argentine version combines spending determined by political preferences with revenues determined by a private sector, i.e., struggling entrepreneurs and tax-burdened consumers. Entitlement spending has a strong tendency to outgrow its revenues – in fact, I am working on an article for an academic journal defining a law that shows that welfare-state entitlement programs inevitably outspend their revenue – but politicians favoring the welfare state never realize that this is actually happening. Inevitably, therefore, they run into deficit problems, but since the politicians do not see this coming they are caught by surprise and react with fiscal panic.

There are three ways that fiscally panicking politicians can respond:

1. Buy time. This means, borrowing as much as they can. When they cannot borrow any more money by flooding the world with their Treasury bonds, they print money and have the central bank buy the Treasury bonds instead. If this happens in an economy with a stable financial system and a limited system of cash entitlements, the money printing will not cause high inflation. If on the other hand cash entitlements are comparatively important for daily consumer spending, then printing money to fund them opens a dangerous transmission mechanism for the money supply to cause high inflation.

2. Raise taxes. No longer a viable option, other than marginally. There is a fair amount of research that shows that voters in both Europe and North America grew tired of constantly rising taxes already back in the 1970s. Since then, an increasing share of the growth in government spending has been deficit-funded. The same is true in Argentina.

3. Cut spending. Since most politicians in our modern welfare states want to preserve the welfare state one way or the other, they do not want to eliminate entitlement programs. But when tax revenues do not grow as fast as they would want it to they are forced to downsize the welfare state to fit within a tighter revenue framework. This means chipping away at entitlements that people have gotten used to and based on which they plan their family finances.

For common-sense minded economists and politicians this means a good opportunity to prudently reform away the welfare state. “Just cutting spending, damn it” is not the way forward, but a structurally sound phase-out model can do wonders.

Leftists, on the other hand, go even deeper into panic. Bloomberg.com again:

Argentina, which has subsidized utilities since 2003, wants to cut aid from about 5 percent of gross domestic product to 2 percent of GDP and make higher income earners pay more for their utilities, Cabinet Chief Jorge Capitanich said March 12. “In 2003 the need for subsidies was clear,” Kicillof said in reference to the period after the nation’s $95 billion default and economic crisis. “Argentina isn’t ending subsidies, just redistributing them.” For Argentine households, the increase in their gas bill may rise as much as 161 percent for the biggest consumers and 306 percent for water bills, according to a presentation distributed by the Planning Ministry.

“The Planning Ministry”… Why not just adopt the Soviet acronym GOSPLAN and get it over with? Humor aside, though, it is worth noting that the families who are now hit with enormous price increases still have to pay the same amount of taxes as before.

The way out, again, is not to restore the subsidies. The way out is to end the entitlement programs and return purchasing power to the private sector so that those who have grown dependent on government can actually support themselves. This, of course, won’t happen in Argentina. What will happen there instead is that consumers now will respond by cutting spending elsewhere, thus reducing economic activity in general. This has repercussions for the tax base, which again will take government by surprise. And the entire process is repeated, with the difference that it starts from an already lower level of economic activity.

Europe is not in as bad a shape as Argentina is. But if they continue down the current path of using spending cuts and tax increases to save the welfare state in tough times, they will perpetuate their own crisis – and thereby perpetuate the need for spending cuts and tax increases.

The end station? An economic wasteland where children grow up to be poorer than their parents. That is, in effect, where Argentina is today, and has been for a long time. Sweden has been there for a good two decades and other European countries are beginning to see that same economic wasteland on the horizon.