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Latin America in the Trap

"A system change is necessary in which all the sacred cows of the dominant international economy must beslaughtered..Interest has to be fixed politically, not by the market..The unsystematic wild fluctuations of exchange rates unjustified by the data destroy the foundations for profits from the exchange of goods..The helplessness of the IMF and the G7 is nowhere clearer than in the development of the exchange rates of Latin American countries against thedollar
Latin America in the Trap

By Heiner Flassbeck

[This article originally published in: Blatter, October 18, 2002 is translated from the German on the World Wide Web,  http://www.linksnet.de/drucksicht.php?id=748.]

The economic drama in Latin America continues. After the Argentine collapse, Brazil, Uruguay and a series of other countries face great dangers...

... For Argentina, a decline of growth of 15% is expected, inflation rises to 50% and the situation of people deteriorates from day to day. The Brazilian economy stagnates at best. Nearly all other states struggle with recessive developments. Unemployment rises generally and the impoverishment of increasing parts of the population cannot be averted. Even worse, there is no hope that the situation in the region can change for the better in the foreseeable time.

Given this situation, the inactivity of the international community can only be termed scandalous. Brazil was granted a new generous IMF-standby credit while negotiations on Argentina's relief were stopped. A radical solution is not heard. The helplessness of the IMF and the G7 toward the situation is nowhere clearer than in the development of the exchange rates of Latin American countries toward the US dollar. After the Brazilian crisis of 1999, a decontrol of the Brazilian real was seen as the most important method for improving the situation of the country. The real which the Brazilian central bank before the crisis stabilized against the dollar at 1.8 (real/US dollar) sank within a short time to 2.4. In the meantime, it has fallen to 3.0. The devaluation of the real has also forced a massive devaluation of the Argentine peso that quickly fell under 2:1 (peso/US dollar) after almost ten years of a 1:1 bond to the US dollar. The real is traded at 3.6. The other currencies of the continent, insofar as they are independent currencies and not complete dollarization, were also devalued since the beginning of the year.

No country can live in the long run when important trading partners try to constantly increase their competitiveness through devaluations. However since nearly everyone does this, a devaluation race takes place that no one can win at the end. All Latin America's countries can only systematically improve their position against the US (and the rest of the world as far as they also do not devalue against the US). The unsystematic wild fluctuations of exchange rates unjustified by fundamental data completely destroy the foundations for profits from the exchange of goods in the relations of countries. The international community including the IMF and the World Trade Organization (WTO) with free and efficient trade on its banners is silent.

The senseless and dangerous race could be stopped by multilateral action stabilizing exchange rates. Insight and/or political will is obviously lacking. The abstinence of the western world in the international monetary order is disastrous for the internal economic conditions of the involved countries. Negative interest makes a greater difference on state budgets and private investors than the currency losses. These negative effects counter the positive effects of a devaluation of the currencies of most countries against the US dollar, Yen and Euro in the countries most intensely affected by the crisis.

For lack of alternatives in fixing economic interests, nearly all Latin American countries prescribe a regime that gives a remarkable priority to the "markets" in setting the interest level. These countries cannot be compared to the minor European countries before the monetary union or catch-up countries in the 50s and 60s.

Latin American countries are not members of a monetary system. Systems like Bretton Woods or the Euro Monetary Order (EWS) are made possible on one side through currency conditions (including devaluations) ordered by a key currency country. On the other side, interests are set largely by the key central bank, not by the markets. Latin American countries depend on themselves and therefore are largely handed over to the "forces" of the capital market and its assessment of the "country's risk". Countries that urgently need low declining interests receive high rising interests from the market and are destroyed.

Slaughtering Sacred Cows

A system change is necessary here in which all the sacred cows of the dominant "international economy" must be slaughtered. Given the multitude of taboos that would be broken in passing over to another system, international politicians for years not surprisingly preferred prescribing placebos (like the "new financial architecture) than even to dare thinking in this direction. The basic principle is simple and practiced day after day in the western world: interest, the most important reality of an economy investing in the future, has to be fixed politically, not by the market.

No great western industrial country of the rank of the G3 (US, Europe and Japan) leaves its interest to the market. The markets would dictate to the US central bank that interests have to rise in a serious recession since the risk of loss from investing in a recession increases. However interests intensify the recession. If the state attempts to tackle this with increasing state deficits, the risk of investors rises again. Consequently the "risk premium" "demanded" by these investors also climbs.

In such a case, the US would have no chance of overcoming a recession under its own steam. In the US (as in Europe and Japan), fettering the market by law is considered for quickly ending this disempowerment of the state and democratic society by the "market". No state intervention can oppose the power of the markets in a developing country according to the supreme doctrine of the democratic states.

The dominant doctrine of the economy that transfers uncritically and unpolitically points of view from the micro-economy to the conditions of states produces confusion. If the debtor's risk of failure rises, lenders demand a higher interest to cover part of their higher risk. "Risk premium" sounds rational and gives the creditor a good feeling. If an individual debtor can no longer pay the interest including the risk premium because his business cannot earn the effective interest, he must leave the market and creditors and write off the failure... As every bank knows, its demand for a very high interest increases the likelihood of a total failure of the credit. For this reason, the possibility of covering the risk of failure by a premium is very limited. Therefore the bank looks at the investor and debtor before awarding credit to make a judgment on his credit worthiness and/or immediately order the cession of less risky "securities".

Unproductive Collapse

Firstly, when the "markets" demand payment of a high-risk premium by a country, the land can not pursue a rational economic policy any more and must fall sooner or later. Thus the risk premium should remain trifling. No creditor looks at a sovereign state and demands securities since states do not disappear from the map. States can also pay high-risk premiums from their substance much longer than an individual business without being inflicted with the free market sanction of bankruptcy. Lastly, the economic and political conditions are far more complex than in a business so one cannot systematically expect a realistic assessment from individual banks and investment funds.

The risk premium must disappear at the end for a state to get back on its feet again and regain its capacity for action - which all creditors want. Businesses could simply disappear. The possible actions beyond changing interests are much less than those of businesses. Lowering costs, the tried and tested method of all business adjustment simply does not exist in the aggregate economy since the expenditures of one are always the revenues of the others. If the expenses of businesses altogether fall, the profits also fall. Businesses as a whole can never improve their cost situation. If no action possibilities exist, the sanction of the "markets" in the form of high interests is lacking from the start. In any case, the patient is killed and the awarded credit is pointless.

The necessary disappearance of the risk premium can never be arranged by the market, only by the state (in this case, by states or the international community of states). Since this is urgent, the community of states can and must be engaged before the collapse to avoid the unproductive detour around a collapse of market financing. In the example of Argentina and Latin America, the short-term real interest is presently (August 2002) at 30% (with a short-term nominal interest of over 50%). In Brazil, the same interest fluctuates at 10%, in Mexico three percent and in Chile only one percent. In the US, it is even negative. There are simply no measures besides a massive devaluation with which Argentina could counter the restrictive effect of extremely high interest. Still if all countries devalue, Argentina is simply lost and Brazil hardly has a chance. Consequently the international community must intervene sooner or later to liberate Argentina and Brazil from the vicious circle of devaluation and extreme interests. The later the intervention, the higher will be the costs on all sides.

All countries of the world seeking free trade and free capital transfer with each other need a global monetary order. This order must make possible a stable exchange rate and a level of interests that is not greater than the real growth possibilities. Anything less is ineffective as the Latin American crisis shows. Whoever does not work for such an order but urges countries to open their borders for goods and capital does not understand what he is saying or is an irresponsible cynic who inflicts long-term damage for everyone for his own short-term advantage.

The crisis in Latin America is a crisis of the dominant economy. A chance will only open up when aggregate economic thinking is again successfully anchored in the minds of advising economists and the ideological blockade on the theme market and the state is dismantled.

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