Saturday, 11 August 2007

About the unsustainability of economic imbalances

What a title!
All I mean is that if a country or a company in a market economy has an economic imbalance, sooner or later it will end. If it is recognized as unavoidable and well handled, a soft landing will be the result, and most probably, a positive result will come out. Otherwise, crisis ensues.
I will write a couple of things about a country that is basing it's whole economy in a huge devaluation. Since I want to avoid specifics, I'll only say that the name starts with A in almost every language and it has a great national football team.
A few years ago its currency was pegged to the dollar on a 1-1 basis; due to several reasons (government inefficiency, under-investment, high debt payments) the country was in recession with deflation and high unemployment. In the long term would have caused the prices to adjust to be market-efficient and market forces would have brought salaries down.
However, some illuminated minds thought that the process was too tough, so devaluation was the way to solve the problems, with the "better" minds of the government "gently" guiding the invisible hand.
So, in a few months, the Peso (let's say that's the name of the currency) was moved to a 3-1 rate against the dollar. Salaries were cut in real terms (even though they stayed the same in nominal terms), and of course, imports and exports immediately went up. Following the exact laws of economics, unemployment went down, since labour was cheap compared to industrial imported goods.
To fight inflation, exports were taxed, so the full impact of devaluation was not felt immediately (taxing exports makes them cheaper inside the country since those taxes don't have to be paid). Of course, to maintain the currency at such low levels money had to be printed to buy the currency brought in by the trade surplus.
Expensive foreign goods, industrial capacity at 100% usage and money being printed are to inflation what gin and vermouth are to a martini. Inflation became the norm, unions started asking for pay rises (creating inflation in non-tradable good as well as well), and some artificial measures where used to curb prices, such as maximum prices, unmovable rates for utilities, statistics make-up, etc. The obvious result: shortages.
One interesting fact is that non-unionized labour didn't get the same rises as other jobs. One of the groups that suffered this problem is IT staff, which produces one of the few easily tradable services. High demand and low prices don't match, so engineers (especially the best qualified) are getting jobs abroad and creating an even worse staff shortage.
What will happen in the future? My opinion (as always, personal, doesn't reflect the opinion of my employer, yaddy yaddy yadda) is that everything will crash. Inflation will raise (due to full industrial capacity, expensive imports, expensive investment due to expensive capital imports and expensive capital, high emission rate), unions will request higher raises adding pressure to prices. Of course, when the currency exchange reaches stable levels inflation will slow down; however, recession will come back since problems are structural, not conjectural. To avoid recession the currency could be further devalued, which is a short term solution, since inflation will go even higher after devaluation expectations become normal.
Oh, in case you haven't guessed, I am speaking about Argentina.

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