Summary

Rapidly rising inflation has stolen the headlines in Argentina. President Nestor Kirchner's considered approach to dealing with inflation has been to fan populist flames and threaten companies that raise prices with higher taxes. Unfortunately for Argentina, since the government is politically unwilling to carry out necessary economic reforms following the 2001 collapse, counterproductive state intervention is likely to remain the primary means of managing the economy, which can only mean that trouble lies ahead.

Analysis

In the last two years, economic growth in Argentina has been above 8 percent, with 9 percent year-on-year growth in the first five months of 2005. Industrial production has risen 14 percent to 16 percent in the last two years, exports are strong, and the country managed to pull itself out of the largest debt default in history when it completed a debt swap with creditors in June. The economic picture seems rosy, but below the surface it is quickly darkening.

Inflation is on the rise, reaching 9 percent in the 12 months through June 2005 compared to 4.9 percent during the 12 months to June 2004, and likely to top 10 percent for the year. In recent days, President Nestor Kirchner has been demonizing supermarket chains and other industries for raising prices and threatening to raise taxes if they do. Earlier in the year, Kirchner called for Argentines to boycott foreign energy companies who raised gasoline prices. Kirchner is playing Russian roulette with the Argentine economy. If he keeps it up, one day soon he will find the chamber with the bullet.

There are multiple reasons for the inflation, including relentlessly growing consumer demand, a string of successes by labor unions in getting wages raised by between 10 percent and 50 percent, rapidly increasing government spending as 2006 elections approach, and industrial production capacity stretched to its limits. The Argentine central bank also is buying up dollars in an effort to keep the peso competitive to fuel exports, which is increasing the money supply significantly and thereby further contributing to inflation.

Inflation is a natural consequence of factors such as these, but flawed economic policy tends to compound inflationary pressures. In Argentina, the population -- and therefore the government -- is hypersensitive to price increases, given the memory of the brutal hyperinflation of the 1980s. This tends to lead to overreactions to inflation, which are hazardous to Argentina's economic health.

In order to slay the hyperinflation demon of the 1980s, the 1990s government of then-President Carlos Menem established a one-to-one exchange rate peg with the dollar as well as a currency board that was legally required to ensure that there was a dollar backing every peso in the country. The change was an extreme step, as it took monetary policy out of the hands of the government by law, and it was a wild success, as Argentina became one of the world's great economic success stories in the 1990s.

That was until the binge on foreign borrowing -- a result of the sudden convenience of borrowing in dollars as a means of easing foreign transactions -- threatened to crash the country's finances. With its hands completely tied, Buenos Aires was unable to make policy adjustments to deal with the growing foreign debt burden, and the result was a $104 billion debt default. The country's collective fears of a return to hyperinflation were such that even when it was clear to the rest of the world the currency board had become the albatross of the Argentine economy, Buenos Aires refused to even consider loosening the vice-grip on its monetary policy.

Inflation has now returned, and the reaction of Kirchner's government has been equally extreme. With a population still recovering from the shock of its collapse into poverty in 2001 and demanding economic stability, Kirchner has decided the best way to fix the economy's very real problems is through a populist lambasting of producers involving threats of higher taxes.

Kirchner is essentially forcing Argentina's domestic and foreign producers to pay for his and his predecessors' economic sins. Since coming to office, Kirchner has done little to undertake the economic reforms necessary to help the Argentine economy avoid the kind of tragedy it suffered in 2001. The biggest needs are legal and regulatory reform, tax reform and access to credit. Little or no progress has been made in these and other vital areas, and this could largely be because of Kirchner's complicated political position.

Kirchner won the Argentine presidency with less than 25 percent of the vote when Menem pulled out of the 2002 election at the last moment, robbing Kirchner of a mandate. To make matters worse, the new president was left with a very unstable country in which socioeconomic dissatisfaction was running high and the economy was a mess. A populist approach -- sacrificing economic needs for political security -- was the best political strategy for Kirchner under these circumstances, and with congressional and presidential elections approaching in 2006, he will continue this strategy as he seeks his elusive mandate.

The problem, much like with the currency board, is that he has used this strategy for too long, and the energy crisis looming on the horizon is a perfect example of this. Buenos Aires put a ceiling on natural gas prices in 2002 to help Argentina's struggling consumers with their energy bills. This may have helped consumers, but it also served to discourage investment as producers' revenues took a beating. With the economy returning to strong growth, the cap is no longer needed, but it is still in place. The result has been a huge leap in domestic gas demand that has completely stretched the aging natural gas infrastructure.

As this example illustrates, Kirchner's populist political tactics punish producers in the interest of winning votes. Furthermore, his rhetoric, which is driven by his fear of popular accusations holding him responsible for the return of inflation, is creating strong disincentives for investment -- both foreign and domestic -- when Argentina needs it most to make continuing growth possible.

None of Kirchner's tactics will address the economy's problems, which, as the rising inflation rate indicates, are multiplying. Left unchecked, this kind of economic intervention will come back to bite both consumers and Kirchner when producers find themselves unable to meet demand, and the developing problems in the gas sector are the first sign of this.

Kirchner's approach could serve him in the short run, as popularity ratings above 70 percent indicate. However, there is little in his past to indicate that he would change his management of the economy even after his expected re-election in 2006. In other words, unless Kirchner's management of the economy changes, 2005 will likely be remembered as the peak of Argentina's recovery, that was followed by a return visit to the abyss