South-Western College Publishing - Economics  
An Agenda for Awakening Argentina
Subject Economic Policy
Topic International Finance
Key Words Recession, Inflation, Exchange Rates, Economic Growth, Deregulation
News Story

Argentina's economy is in recession. Forecasters have estimated that Argentina's Gross Domestic Product (GDP) will decline by 3 percent in 1999. Because of Argentina's fixed-rate currency system, both monetary and fiscal policy have limited ability to help the economy recover. The architect of Argentina's recovery in the early 1990s, Domingo Cavallo, has offered a proposal to end the current recession. His plan calls for broad tax cuts, deregulation of key industries, and a number of policy changes designed to insulate the economy from future economic fluctuations.

In the early 1990s Argentina was experiencing both recession and inflation. Mr. Cavallo, then finance minister, instituted a fixed-rate currency system known as the Convertibility Plan. The Convertibility Plan makes the Argentine peso interchangeable with the U.S. dollar on a one-to-one basis. This plan restrained the growth of the money supply, reducing the inflation rate to near zero and producing economic growth that averaged 6.2 percent per year.

Although the Convertibility Plan was credited with reversing Argentina's fortunes in the beginning of the decade, it is now being blamed for limiting Argentina's ability to recover from its current economic difficulties. The fixed-rate system prevents Argentina from devaluing its currency and thereby boosting its exports. It also handcuffs monetary policy, restricting changes in the money supply and interest rate movements.

Mr. Cavallo, now a presidential candidate, has proposed a broad program for economic recovery through measures to make Argentina's economy more competitive. His plan calls for a simpler tax system with significant reductions in the value-added tax, a flat tax on income and cuts for key economic inputs such as labor and diesel fuel. Other parts of his program call for decentralized labor negotiations and a new round of deregulation, especially in the communications sector. Losses in revenue would be balanced by increased collections. To insulate the economy from future economic fluctuations, Mr. Cavallo has proposed flexible bank-reserve requirements that would free up more capital during periods of economic slowdown. He has also proposed the establishment of an "anticrisis fund" to balance the budget during periods of recession. Mr. Cavallo believes that his program would restore annual economic growth rates of 6 percent.

(Updated August 1, 1999)

Questions
1. Argentina's economy is in recession. The article states that the country's Convertibility Plan precludes a devaluation of the peso. How would devaluing a currency help an economy recover from a recession?
2. One of Mr. Cavallo's recommendations is for the monetary system to adopt a flexible bank-reserve requirement. What is a bank-reserve requirement? How would a flexible bank-reserve requirement work to establish economic stability?
3. If policy makers were to use fiscal policy to stabilize the economy, what typically would happen to the government deficit during a recession? Why does Mr. Cavallo think this can be prevented?
Source Craig Torres, "Argentina's Cavallo Urges Shocking Economy Awake," The Wall Street Journal, July 23, 1999.

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