The Economist: Milei turned Argentina into a libertarian laboratory

But the biggest economic test is yet to come..

In the early hours of June 13, the Senate approved two bills aimed at boosting growth and increasing revenue, giving Milei his first legislative victory since taking power in December. Hours later, he traveled to the G7 in Italy, where he laughed with Prime Minister Giorgia Meloni, hugged Pope Francis and befriended Kristalina Georgieva, head of the IMF. “I always love our dates,” he told Georgieva. However, the relationship between Milei and the fund, which has a $44 billion loan program with Argentina, may soon become less friendly. Uncertainty about the president’s plans for the central bank is worrying investors and the IMF.

Milei’s early successes are impressive, considering the mess he inherited. For years, the central bank had been creating money to finance the fiscal deficit, fueling inflation. It also had no foreign reserves. Another default seemed almost inevitable.

In his inauguration speech, Milei warned Argentines about difficult times, declaring that “there is no money”. He immediately fired hundreds of bureaucrats, cut spending, and devalued the peso by more than 50% (which initially increased inflation). Meanwhile, public salaries and pensions were kept low, reducing their real value. As a result, Argentina ran fiscal surpluses for five months, something not seen since 2008. Inflation fell to 4.2% per month, the lowest since January 2022.

Some Argentines are angry about the resulting pain. On the night the Senate voted on the reforms, protesters threw Molotov cocktails and set a car on fire. Labor unions organized large marches. Yet despite the grinding recession, more than half of Argentines still approve of Milei. Jorge Juliano, a 72-year-old taxi driver in Buenos Aires, gives a simple reason: “With the others, we were living in Disneyland, a fantasy.”

Investors welcomed Milei’s recent progress. But enthusiasm is tempered by uncertainty over the president’s plans for the central bank and the peso, which again appears overvalued. The next months of government may be more difficult than the first.

One reason is political. Although Milei’s coalition only has 15% of the seats in the lower house, he took office with a robust personal mandate. This persuaded opposition lawmakers to negotiate. Milei’s main bill was approved with 400 fewer clauses than the original, but it is still a big victory for him. He declares a state of economic emergency for a year, during which he will have extraordinary powers over energy, economy and finance. It also paves the way for privatizing several state-owned companies and creates incentives for foreign investors. The package now returns to the lower house for final approval. He may choose to reinstate income taxes, which the government hopes to do but which the Senate has refused to do.

Opposition lawmakers may feel they have given Milei enough. “It’s going to get more and more complicated,” says Luis Juez, a senator who supported the reforms. The lower house is already reacting. It recently approved a pension formula that could cost almost 0.5% of GDP this year. Milei attacked those who voted in favor as “fiscal degenerates” and promised to veto it. But if it passes with a two-thirds majority in both houses – a distinct possibility – he won’t be able to change it.

The biggest challenges, however, are macroeconomic. Milei has prioritized fighting inflation, but Argentines are starting to worry about unemployment and will eventually cry out for growth. The recession has been deep. Construction activity in April was down 37% from a year earlier.

Complicating the recovery is the overvalued peso, which is making the country unjustifiably expensive in dollar terms. The official exchange rate is currently set by the government, which also imposes capital controls. Almost all of December’s devaluation has been eroded. This involved initially devaluing the peso by more than 50% and then 2% each month. But monthly inflation has been greater than the gradual adjustment of the exchange rate. The result is that the real effective exchange rate is rising.

The effects are obvious from the top of the Andes. On a single long weekend in April, some 40,000 Argentines crossed the mountains into Chile to buy everything from sneakers to car tires because, surreally, Chile had become cheaper than Argentina. Milei criticizes those who say the peso is overvalued as “intellectually dishonest.” But when an Argentine president says there will be no devaluation, taxi drivers know there is a good chance there will be, jokes Nicolás Gadano of Empiria Consulting in Buenos Aires.

An expensive peso drives away tourists, makes exports expensive and discourages investors. An overvalued currency often ends up devaluing. “If you see Argentina appreciating, that’s always a sign of worse things to come,” says Eduardo Levy Yeyati of Torcuato Di Tella University in Buenos Aires. The drop in exports makes it difficult for the central bank to accumulate dollars, which it needs to pay external debts and build its security reserves.

The government could allow the peso to float or accelerate the gradual 2% adjustment. But either option would likely increase inflation, putting Milei’s popularity at risk and undermining some of the benefits of devaluation. For now, Milei is able to maintain tight control over the exchange rate because of capital controls.

Monetary madness

What’s next? Milei has promised to eventually remove capital controls as part of his plan to restore investor confidence. He insists that inflation will soon be 2 percent a month, the same as the rate of devaluation. That, he says, would allow him to slowly ease restrictions and float the peso without its value plummeting.

This is optimistic. There is little, like increased productivity, to justify a stronger weight. Worse for Milei, preliminary data for June suggests that inflation is rising. Argentines are being hit with staggering energy bills as the government cuts subsidies that were keeping prices low. Real wages are also starting to recover as workers push for wage increases, potentially driving up other prices. Levy Yeyati predicts that monthly inflation will hover around 4-5% for a while. If this is correct, the risk of an abrupt currency correction will increase.

On top of all this, there is a thornier question: what to do about the central bank and the peso. Milei campaigned on a promise to blow up the former and scrap the latter, declaring that the local currency was “worthless.” These days, his team prefers to talk about currency competition, in which dollars and pesos would both be legal tender. But no one knows the details of the plan or the monetary program to stabilize the peso that would accompany it. “More work is needed on defining some of the key fundamentals,” the IMF concluded diplomatically on June 17.

Milei, although not his economic team, seems particularly enthusiastic about a scheme he calls “endogenous dollarization”. This would involve fixing the supply of pesos. When the economy grows and more money is needed, Milei hopes that Argentines will use their own dollar savings for transactions. “The weight will become like a museum piece,” he said in mid-May. He would then close the central bank.

The IMF appears concerned. If Argentines believe the peso will end up in a museum, its supply could exceed demand, fueling inflation. It is also unclear what would happen to the peso-denominated financial system. The IMF instead gets excited about currency competition. Peru has a system like this, with the sun and dollars being used. If Milei insists on his scheme, it will certainly be more difficult for his government to obtain new funds from the IMF.

Milei has done a remarkable job so far of shedding the fiscal baggage that has burdened Argentina. But if he gets the big macroeconomic issues wrong, that will count for little.

Via The Economist.