No Tears For Argentina----But A Swift Kick To The Greenspan Fed Is Warranted

Argentina has (apparently) defaulted again. This is the seventh time in its history, but no tears are warranted. For more than a half-century, its government has been a chronic fount of fiscal profligacy and statist economic schemes that have destroyed its once fabulous national wealth.

Perhaps now it will face that historic day of reckoning that has been for so long deferred. Hopefully, its long suffering citizens will finally come to realize that they have been governed by charlatans and crooks, and demand a clean break with the kind of destructive Peronist policies which have plagued the nation for most of the last 70 years. In this context, the short-run pain that the hedge fund "holdouts" are inflicting on the nation's 41 million citizens is regrettable, but in pursuing their contractual rights and speculative gain they are, in fact, doing the work of the economic gods.

Yet there is an important back story in this saga that should not go unremarked. Argentina's most recent plunge into national bankruptcy actually originated in the financial repression policies of the Greenspan Fed back in the 1990s. At that time, Argentina's government under Carlos Menem attempted to cure the nation's historic addiction to central bank money printing and periodic bouts of virulent hyper-inflation by enacting the so-called Convertibility Law.  This effectively put the Argentine central bank out of business and shackled its printing presses in favor of a de facto dollar standard. In effect, Argentina's peso money supply could not expand by even one dollar equivalent unless a new US dollar was added to its reserves.

Needless to say, switching to a dollar standard and what amounted to an old fashioned fixed exchange rate in the external financial markets swiftly quashed the peso hyper-inflation that had brought its economy to ruins in the 1980s. Indeed, in theory it established a sound monetary foundation that would allow the labor and enterprise of the Argentine people to once again earn a higher standard of living.

Unfortunately, there was a huge fiscal chink in Menem's armor. Once on the dollar standard, the days were numbered for the government's historic fiscal profligacy. Large government deficits financed in the local peso market would swiftly crowd-out private investment, send interest rates soaring and the domestic economy into a tailspin.

And that's as it should be. Under a system of honest money, there is no fiscal free lunch---no painless "monetization" of the public debt. Instead of being put off onto future generations, increases in the public debt dispense penalties and pain to current citizens and taxpayers, thereby providing the basis for politicians to exercise budgetary discipline and prioritize spending from the tax revenue actually available.

At the end of the day, Argentina's chance for fiscal salvation broke down not due to the Convertibility Law and its quest for honest money at home, but owing to the temptations provided by dishonest money up north in New York. Specifically, Argentina began to finance billions of its public debt in the Wall Street bond market under New York law. The latter feature was crucial because bond fund managers were attracted by the extra yield on Argentina bonds versus US treasuries, but wanted their rights protected under a legal regime that could not be manipulated or corrupted by a future government in Buenos Aires.

So far, so good. Unfortunately, there was a huge problem in the New York bond market----namely, Alan Greenspan and his merry band of money printers at the Fed. As shown below, the revolt of the bond vigilantes in 1994 sent 10-year treasury yields soaring to north of 8%. Owing to still large US budget deficits and the gathering collapse of the domestic savings rate, long-term interest rates in an honest market would have remained high---in the 7-9 percent range shown in the graph---- until the demand for borrowing and the supply of savings were rebalanced.


But the Greenspan Fed panicked and opened-up the monetary spigots, driving the yields down by 30 percent in short order. This tampering with honest price discovery in the bond market, in turn, caused bond prices to soar, thereby generating windfall gains for speculators and bond fund managers alike. In short order, the bond vigilantes learned that supply and demand were no longer relevant concepts in the fixed income markets.

Henceforth, the relevant consideration would be the actions and signals emanating from the monetary politburo in the Eccles Building. And even more to the point, the Fed would no longer allow the bond market to clear based on its own internals or allow rates to spike as they had done in 1994. Accordingly, the bond vigilantes became born again bulls, and the great bull market in US treasuries was off to the races.

The Argentina government went along for the ride. Public spending reached a historic high of 30% of GDP, deficits averaged about 5% of GDP and public debt grew by 15% per year during the mid-1990s. According to one authoritative analysis, on a purchasing power parity basis Argentina's public debt soared from 48% of GDP in 1992 to more than 90% by the end of the decade.

By the time of the default crisis in 2001, Argentina's public bonded debt totaled $96 billion, but $93 billion of that was in foreign currency--- mainly dollars. What had happened was that the Greenspan bull market in New York had permitted Argentina to escape the fiscal discipline implicit in its sound money Convertibility Law by selling debt in New York at deeply sub-economic yields.

Stated differently, under the Fed's financial repression policies the New York bond market had become a fountain of malinvestment. In an honest two-way market, the US treasury benchmark would have been in the high single digits and based on its pitiful fiscal history and current condition, the Argentina government would have faced a huge risk premium on top of the treasury rate.

But the Greenspan bull market negated both of these factors. This permitted  Argentina's government to avoid the double digit borrowing rates it would have otherwise faced in the external dollar markets, and the powerful incentive they would have provided to get its fiscal house in order.

At the end of the day, Greenspan's born-again bond bulls obviously did not force Argentina's government to bury itself in debt, nor to blow the fresh start that its sound money Convertibility Law had provided. The ultimate responsibility for the 2001 default, and the sorry history of attempted Peronist recovery and restructuring since then, lies with the governments in Buenos Aires, and the nation which keeps electing them.

Yet financial repression by the world major central banks is truly an evil economic force in the world economy. Argentina's fiscally incontinent governments are but a tiny exemplar of the manner in which trillions of unsustainable public and private debt have been incurred owing to the vast mis-pricing in fixed income markets that flows from monetary central planning.

The excellent attached essay provides additional background on the origins and technical dimensions of Argentina's current default.


By Nicolas Cachanosky at the Mises Daily

.....Following the 2001 default, Argentina offered a debt swap (a restructuring of debt) to its creditors in 2005. Many bondholders accepted the Argentine offer, but some of them did not. Those who did not accept the debt swap are called the “holdouts.” When Argentina started to pay the new bonds to those who entered the debt swap (the “holdins”), the holdouts took Argentina to court under New York law, the jurisdiction under which the Argentine debt has been issued. After the US Supreme Court refused to hear the Argentine case a few weeks ago, Judge Griesa’s ruling became final.

The ruling requires Argentina to pay 100 percent of its debt to the holdouts at the same time Argentina pays the restructured bonds to the “holdins.” Argentina is not allowed, under Griesa’s ruling, to pay some creditors but not others. The payment date was June 30. Because Argentina missed its payment, it is now under a 30-day grace period. If Argentina does not pay by the end of July it will, again, be formally in default.

This is a complex case that has produced different, if not opposite, interpretations by analysts and policy makers. Some of these interpretations, however, are not well-founded.

How Argentina Became a Bad Debtor

An understanding of the Argentine situation requires historical context.

At the beginning of the 1990s, Argentina implemented the Convertibility Law as a measure to restrain the central bank and put an end to the hyperinflation that took place in the late 1980s. This law set the exchange rate at one peso per US dollar and stated that the central bank could only issue pesos in fixed relation to the amount of US dollars that entered the country. The Convertibility Law was, then, more than just a fixed-exchange rate scheme. It was legislation that made the central bank a currency board where pesos were convertible to dollars at a “one to one” ratio. However, because the central bank had some flexibility to issue pesos with respect to the inflow of US dollars, it is better described as a “heterodox” rather than “orthodox,” currency board.

Still, under this scheme, Argentina could not monetize its deficit as it did in the 1980s under the government of Ricardo Alfonsín. It was the monetization of debt that produced the high inflation that ended in hyperinflation. Due to the Convertibility Law during the 1990s, Carlos Menem’s government could not finance the fiscal deficit with newly created money. So, rather than reduce the deficit, Menem changed the way it was financed from a money-issuance scheme to a foreign-debt scheme. The foreign debt was in US dollars and this allowed the central bank to issue the corresponding pesos.

The debt issued during the 1990s took place in an Argentina that had already defaulted on its debt six times since its independence from Spain in 1816 (arguably, one-third of Argentine history has taken place in a state of default), while Argentina also exhibited questionable institutional protection of contracts and property rights. With domestic savings destroyed after years of high inflation in the 1980s (and previous decades), Argentina had to turn to international funds to finance its deficit. And because of the lack of creditworthiness, Argentina had to “import” legal credibility by issuing its bonds under New York jurisdiction. Should there be a dispute with creditors, Argentina stated it would accept the ruling of New York courts.

Many opponents of the ruling today claim that Argentina’s creditors have conspired to take away Argentine sovereignty, but the responsibility lies with the Argentine government itself, which has established a long record of unreliability in paying its debts.

The Road to the Latest Default


These New York-issued bonds of the 1990s had two other important features besides being issued under New York legal jurisdiction. The incorporation of the paripassu clause and the absence of the collective action clause. The paripassu clause holds that Argentina agrees to treat all creditors on equal terms (especially regarding payments of coupons and capital). The collective action clause states that in the case of a debt restructuring, if a certain percentage of creditors accept the debt swap, then creditors who turn down the offer (the “holdouts”) automatically must accept the new bonds. However, when Argentina defaulted on its bonds at the end of 2001, it did so with bonds that included the paripassu clause but which did not require collective action by creditors.

Under the contract that Argentina itself offered to its creditors, which did not include the collective action clause, any creditor is entitled to receive 100 percent of the bonus even if 99.9 percent of the creditors decided to enter a debt swap. And this is precisely what happened with the 2001 default. When Argentina offered new bonds to its creditors following the default, the “holdouts” let Argentina know that under the contract of Argentine bonds, they still have the right to receive 100 percent of the bonds under “equality of conditions” (paripassu)with those who accepted the restructuring. That is, Argentina cannot pay the “holdins” without paying the “holdouts” according to the terms of the debt.

The governments of Nestor Kirchner and Cristina Kirchner, however, in another sign of their contempt for institutions, decided to ignore the holdouts to the point of erasing them as creditors in their official reports (one of the reasons for which the level of debt on GDP looks lower in official statistics than is truly the case).

It could be said that Judge Griesa had to do little more than read the contract that Argentina offered its creditors. In spite of this, much has been said in Argentina (and abroad) about how Judge Griesa’s ruling damages the legal security of sovereign bonds and debt restructuring.

The problem is not Judge Griesa’s ruling. The problem is that Argentina had decided to once again prefer deficits and unrestrained government spending to paying its obligations. Griesa’s ruling suggests that a default cannot be used as a political tool to ignore contracts at politician’s convenience. In fact, countries with emerging economies should thank Judge Griesa’s ruling since this allows them to borrow at lower rates given that many of these countries are either unable or unwilling to offer credible legal protection to their own creditors. A ruling favorable to Argentina’s government would have allowed a government to violate its own contracts, making it even harder for poor countries to access capital.

We can simplify the case to an analogy on a smaller scale. Try to explain to your bank that since it was you who squandered your earnings for more than a decade,you have the right to not pay the mortgage with which you purchased your home. When the bank takes you to court for not paying your mortgage, explain to the judge that you are a poor victim of evil money vultures and that you have the right to ignore creditors because you couldn’t be bothered with changing your unsustainable spending habits. When the judge rules against you, try to explain to the world in international newspapers how the decision of the judge is an injustice that endangers the international banking market (as the Argentine government has been doing recently). Try now  justify the position of the Argentine government.



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