The BCRA (Argentina’s Central Bank) is not the one that establishes the market interest rate to lower inflation but rather it is the market that, in fact, sets the interest rate for the BCRA.
At this stage of the game, any professional economist knows that the interest rate is not the cost of money. If so, it would be enough to print banknotes in industrial quantities until the interest rate is zero.
Only in the Kirchner period could be heard from a president of the BCRA, Marcó del Pont at the time, the barbarity that the Central Bank had to issue currency so that there was credit. So, for Marco del Pont, saving which is the counterface of credit, wasn’t generated in fact it was printed thus the saying of our ancestors which read: Saving is the basis of fortune, under the Kirchner presidency transformed into something like: the printing of currency is the basis of fortune.
I think that having surpassed such economic barbarities, today we face a dilemma with the interest rate. Since the beginning of Cambiemos administration, the BCRA has used the interest rate as an instrument to curb inflation. I understand the meaning of this action by the BCRA but, on the one hand, without an economic policy consisting of fiscal and monetary matters, it is difficult to control the inflation rate. On the other hand, here it seems to me that there is a severe confusion, it is not the BCRA that establishes the market interest rate to lower inflation, but rather it is the market that, in fact, fixes the interest rate to the BCRA. That’s why the use of the interest rate as a brake on inflation failed.
To demonstrate the above statement, first you have to understand what the interest rate is. The market interest rate has several components.
i = io + iinfl + icred + iinstitutional
The market interest rate i has 4 components. Namely:
Io: which is the original interest rate. That is, for someone to generate savings, which is to postpone current consumption for future consumption, he would ask for something in return. And that something in return is the original interest rate. Being, that for me is not indifferent to consume today than to consume within a year (if that were the case then I would be indifferent to time), not to consume now and consume within a year and lend to someone I will ask for something in return. And that something in return is the original interest rate. That’s why the interest rate can never be zero. If this were to be the case, it would mean that time does not matter for humans so it would be the same to consume now that within a year.
The second element that I am going to demand, so to postpone current consumption for future consumption, is iinfl that means asking that the rate paid to me covers me against the inflation, that I hope there will be, in the period that I have borrowed my savings. In other words, I do not want my savings to be liquefied in time. Here lays the first ingredient that shows the basic error of using the interest rate as a brake on inflation. It is not the BCRA that tells the market what the expected inflation has to be, is the opposite, the market who tells the BCRA what inflation rate it expects and, consequently, sets the interest rate to the market that compensates for the loss in the purchasing power of the currency. What does this mean? That if the BCRA establishes an interest rate below the expected inflation rate, by the economic agents, only the distracted will buy assets remunerated by interest rate and the rest will take refuge in other types of assets which they consider that can cover inflation.
If to this initial error of the BCRA, that some economists fiercely defended, but now retreat with caution and in silence by the evidence of the gross conceptual error committed, we add that the Central Bank err the inflation forecast for 2017 and for 2018, less can now be thought that the interest rate could become a useful tool to curb the interest rate. Nobody believes the BCRA inflation forecast.
Let’s look at the last two components that determine the market interest rate. First, icred that would be the credit risk that I assume when lending someone my savings. What credit repayment capacity does my creditor have? If the BCRA puts a very high-interest rate in real terms, what I have to ask myself is: who does the BCRA loan at that interest rate or at a higher interest rate so that it can repay my savings? In other words, if the real interest rate that the BCRA pays me for my savings exceeds the average profitability rate of the economic activity, the most probable thing is that when the time comes they will not return my savings. When the BCRA becomes a great savings vacuum at interest rates that are inconsistent with the real sector of the economy, we are surely heading into a solvency problem.
Finally, the last component is iinstitutional which is nothing more than the institutional risk that I assume of lending my savings in a country with a strong tendency to not pay its debts. Argentina has the sad story of carrying several defaults, having private deposits turn from foreign currencies to local currency, confiscate savings form the AFJP (a pension system) and confiscated assets with crazy taxes. The institutional risk goes hand in hand with the quality of its governors and the fiscal problems that the treasure has. The greater the fiscal deficit, the greater the risk of confiscation or default of the debt and the recovery of my savings. In short, the higher the institutional risk, the higher the interest rate that the market demands.
So these four components determine the interest rate, which made it an illusion to believe that the BCRA could fix the market interest rate. The system works just the other way around. What the BCRA can do is raise the interest rate to generate an arbitrage rate versus the dollar that ends abruptly when high-risk investors turn the position around. We have seen this many times in contemporary Argentine economic history.
Now, from what it was exposed above, it could be concluded that I think that the differences between the BCRA and the political wing of the government, I believe that the political wing of the government is right to force the interest rate. Grave mistake. For me neither of them is right.
The lowering of the interest rate does not necessarily translate into an increase in investment or exports due to a rise in the exchange rate.
For investments to take place, the government has to show stronger signs of progress in structural reforms and, above all, in the work culture. Nobody invests in a state that later comes and seizes through confiscatory taxes the fruit of the labor to be distributed among rioters who live off extortion, a game to which the political wing of the government tends to lend itself almost with passion.
Devaluations could somewhat improve primary exports, but in general, they act more as a barrier to imports.
Finally, the big question remains, whether the BCRA will be able to lower the interest rate without the holders of LEBACs (Letters of the Central Bank are short-term debt securities that are bided by the Central Bank of the Argentine Republic) abandoning their position in those letters and going to the dollar. Let me clarify, I am not forecasting an exchange rate run, but it is clear that this rate versus dollar game accumulated a stock of LEBACs of $ 1 trillion (the equivalent of a half budget for 2018) and lasted too long.
Personally, I would have preferred that instead of just announcing an increase in inflation, they would have announced a complete, consistent economic plan that would generate confidence in the population.
Regrettably, the Chief of Cabinet, the Finance Minister (inherent in economic, budgetary and tax policy, economic and fiscal relations with the Provinces and the Autonomous City of Buenos Aires), the Finance Minister (in charge of the National Public Sector, to preserve the public credit of the Nation, and to the financial relations with the Provinces and the Autonomous City of Buenos Aires) and the BCRA President only to announced that inflation this year will be 15% instead of 10%. A rude error of communication of economic policy that shows that the political wing of the government has little idea about how the economy works and the relationship between economy and institutions. Being straightforward, with that press conference they showed they do not have the slightest idea how to dominate the heavy and poisonous inheritance of the previous administration and that everything seems to last.
Roberto H. Cachanosky
Academic Council, Freedom and Progress
This article was originally written in spanish for: http://www.economiaparatodos.net