Enter the Monetary Wonderland

Part 1:
Deflationary Wonderland of Japan and Inflationary Wonderland of Argentina


Published: 21 August, 2018
Edited: 22 October, 2018
by Michio Suginoo

INTRODUCTION

Monetary conditions affect our psychology. A change in monetary conditions can transform our collective social behaviours, dictating our perceptions about political economy. This is a simple statement. But to capture what it means, it requires some explanations.

In my case, I learned this notion through my own real life experience in two extreme monetary realities—deflationary Japan (1998-2011) and inflationary Argentina (2011-2014). I witnessed that their opposite monetary conditions shaped very contrasting social, economic, and political behaviours between these two countries.

THRIFTY JAPAN & SPENDING SPREE ARGENTINA

In the late March in 2011, after having been stuck in Japan for 13 years, I moved to a country almost exactly on the opposite side of the globe, Argentina.

Besides many contrasting cultural and social differences between these two countries, the most notable difference from Japan that caught my attention was the spending behaviours (thus, economic behaviours) of the working middle-class in Buenos Aires.

Through my living experience during the particular 13 years in Japan, I had been sort of brain washed with a particular prevailing norm of the time among the local working middle-class: ‘tight spending to prepare for the future uncertainty.’  Both the corporate sector and the working class household maintained tight spending—investment and consumption respectively—to make their effort to increase their stock of money: the corporate sector increased saving; the working-class households explored a desirable allocation mix between financial assets and deposit (to be discussed later) out of their declining income. Overall, during this period, Japan’s private sector and households were going through a thrift mode, finding money stock valuable.

Now, standing at the opposite end of the globe from Japan, I observed the totally contrary behaviours in Argentina among the local working middle-class: ‘spend now and get rid of money ASAP!’ Some even went for an excess borrowing with credit cards in order to spend. In other words, they managed to spend even before they earned money. I felt the pace of their spending faster than the speed of light. As I had been so accustomed to the contrary custom in Japan at that time, they appeared nothing but a group of ‘spending cult.’

The spending behaviours between these two countries stood as opposite as their geographical positions on the globe: almost upside down. What was taken for granted as a prevailing norm in Japan would no longer be true in Argentina. I was quite perplexed. What economic rationality is dividing these people’s behaviours? Facing such a striking contrast in people’s economic behaviours, I needed to restore a sense of economic rationality. I felt as if I had travelled from one ‘Wonderland’ to another.

I decided to ask locals about their rationality in their spending behaviours. But, first, I needed to explain why I had such a question. To begin with, I started describing the contrary behaviours in Japan. Some locals responded to my story with a fascination: as if what was happening in Japan sounded to them like a fairy tale. Typically, those with this type of reaction tended to perceive Japanese as a highly disciplined society. (As an insider, I was not that convinced with this sort of response.) Some responded with a self-criticism, blaming their spending attitude on their social and cultural degradation and dismissed it irrational and reckless.

Are Japanese more disciplined than Argentineans? Are Argentineans irrational? Neither did convince me. I felt as if I was standing between two contrasting wonderlands.

As time went by, gradually I began to realise that it was the acts of given contrasting monetary conditions what divided their economic behaviours between these two countries during these particular periods. While Japanese spending behaviours were tranquilized by their given deflationary conditions, Argentinean spending behaviours were boosted by their given inflationary conditions.

Yes, it was neither that Japanese were highly disciplined, nor that Argentineans were irrational. And as I gained a better insight over the situations in both countries, I understood that the difference in behaviours had something to do with the difference in the purchasing power of money.

In a deflationary environment, prices would decline along the passage of time. In other words, time increases the purchasing power of money. The longer you hold a sum of money for, the more it gains its real value; although its nominal value remains the same. In other words, the same amount of money would buy more products/services in quantity in the future than it does today. In this setting, a better economic option is to obtain more products (or to spend less for a certain quantity of products) in the future with the same amount of money. Thus, it would be smarter to increase money stock as much as possible today. Although this is a little over-simplified perspective (to be discussed later), it would capture the rationality behind the weak spending behaviour among the working middle-class in Japan during that particular period.

On the contrary, under an inflationary environment, in which prices would increase along the passage of time, the contrary rationality should be justified. A certain amount of money can buy less and less as time impairs the purchasing power of money. It would be rational to spend money as soon as possible before its value declines. This would support the spending behaviour of those who went on a spending spree in Argentina

Having all said, actually, the realities in both cases were little more complicated than the simplified pictures that I just painted. We are going to dig into their complicated realities shortly.

Overall, these contrasting pictures capture how our collective economic behaviours and our psychologies are influenced or even dictated by monetary condition. Furthermore, as we discuss later, we will see that the influence of monetary conditions can go beyond our economic reality and penetrate into our social and political reality. A change in monetary conditions can alter our social, political and economic behaviours. And in return, a change in our collective behaviours can also transform our monetary reality. Yes, we live in ‘Monetary Wonderland,’ a manifestation of a series of ‘feed-in and feed-back’ interactive dynamics between our collective behaviours and monetary reality.

Ever since, my inquiry about these contrasting behaviours has preoccupied my perception in my daily life and it remains vivid even today. This set a momentum of my journey to explore our ‘Monetary Wonderland’ to understand interactions between monetary conditions and our collective social, economic, and political behaviours.

Now, I would like to dig little more into the stories of these two countries during these particular periods: 1998-2011 in Japan and 2011-2014 in Argentina.

DEFLATIONARY WONDERLAND OF JAPAN
(With an intense focus on the 1st Decade of the 21st Century)

My life in Japan from 1998 to 2011 covers the second decade of Japan’s notorious ‘Lost Decades,’ which is often characterised as a protracted deflationary economic stagnation.

In order to have an overview of the historical backdrop of inflation in the general price level of services and goods (call it ‘Consumer Price Inflation’ or ‘CPI inflation’), Chart 1 tracks Japan’s Consumer Price Inflation rate history for more than 5 decades from 1960 to 2016. The chart reveals that the particular 13 years period between 1998 and 2011 was infested by a deflationary pressure (negative interest rates). While Chart 1 traces inflation history in consumer prices, Chart 2 traces inflation history in asset prices: stock index and land price indices (all Japan average index at prices in 1980=1.00) as proxies.


Now, we will have a quick overview of Japan's inflation history in both consumer price (Chart 1) and asset prices (Chart 2) since the 60s:
  1. The 60’s: ‘Consumer price inflation’ rates range from 3.5% to 7.66% (Chart 1);
  2. The 70’s: a period of global supply-driven inflation: ‘Consumer price inflation’ was caused by the supply disruptions arising from two oil shocks during the 70s. Consumer price inflation rate rose up to 23.18%. On the other end, its low remained at near par with the preceding decade, 3.69%. (Chart 1)
  3. The 80s can be divided into two distinctive periods. The first half of the 80s: Post-‘oil shock’ global disinflation period: It was the period of normalisation in the post-‘oil shock’ period. Consumer Price Inflation came down below 1%. (Chart 1)
  4. The second half of the 80s: Domestic debt-driven asset inflation: As inflation of goods and services, consumer price inflation in our term, came down, an expectation for declining interest rates and a positive economic growth prospect arose. It encouraged lending and investment in the corporate sector. Inflation manifested itself only in ‘asset prices’ on one hand (Chart 2), inflation in the general price level of goods and services (consumer price inflation) remained low and did not even reach the bottoms of the 60s and the 70s (Chart 1). The annual average price of a stock index, Nikkei 225, nearly FIVE-folded between 1980 and its peak in 1989. Land price indices continued its rise over the turn of the 90s and peaked in 1991. Between 1980 and 1991, commercial land price index EIGHT-folded; residential land price index multiplied by 4.5 times; industrial land price index FOUR-folded. Overall, it was a period of debt-driven asset inflation (Chart 2). Toward the end of the decade, inflationary pressure finally penetrated into consumer prices. As a result, consumer price inflation picked up to 3.3 % (Chart 1).
  5. The 90s: Asset deflation during the 1st decade of the ‘Lost Decades.’ The bursting of the debt-driven asset bubble unfolded the decade of ‘asset deflation.’ Nevertheless, consumer price inflation remained registering positive records most of the time. By the end of the decade, the annual average of Nikkei 225 lost its value by about FOURTY % from its peak; commercial land price lost its value by nearly EIGHTY % from its peak. (Chart 2) The failure of a local securities trading house (Yamaichi Securities, Inc.) in 1997 caused a domestic financial crisis and marked a bifurcation point in which monetary reality shifted from ‘asset deflation’ into ‘consumer price deflation’ in the years to come (Chart 1). In-between these two monetary realities, the real disposable income growth became negative (to be discussed shortly).
  6. The 1st decade of the 21st century (The 2nd decade of the ‘Lost Decades’): unfolding of Consumer Price Deflation. The financial crisis that occurred in 1997 brought a new phase in the ‘Lost Decades,’ consumer price deflation. Consumer price inflation rates remained negative most of the years during the decade (Chart 1: with 2 exceptions 0.25% in 2006 and 1.38% in 2008).  
Now we return to our focus on the period of my life in Japan between 1998 and 2011. This period, covering the entire second decade of ‘Lost Decades (the 1st decade of the 21st century),’ was infested by consumer price deflation. This peculiar protracted deflationary monetary condition affected people’s collective psychology and collective behaviours. Repeatedly, among the working middle-class Japanese, ‘spend less and prepare for the future uncertainty’ was pretty much a prevailing norm; and among business, ‘cost-cutting and streamlining’ took a momentum. Of course, these behaviours were the product of the given unfolding monetary (deflationary) reality: therefore, temporal, but neither chronic nor cultural. Chart 3 in the next section tracks the historical evolution of spending behaviours among the worker's household. As a matter of fact, as the chart reveals, its preceding bubble era during the second half of the 80s had its own unique monetary condition. During the bubble period, the same working middle-class of Japan went on a spending spree (Chart 3). The same business community engaged over-investment with excess financing.

Japan’s bubble economy during the second half of the 80s and its ‘Lost Decades’ after 1991 had totally opposite monetary settings. As the monetary reality shift from asset inflation to asset deflation, then further to consumer price deflation, the psychology of the society also has transformed from one end to another. The same society between these two periods exhibited very contrasting collective behaviours.

DEFLATION'S TWO COUNTERACTING DYNAMICS:
its primary dynamic and secondary dynamic:

As mentioned earlier, deflation increases the purchasing power of money and the increasing purchasing power of money discourages spending and encourage saving. This simple cause and effect mechanism captures the primary dynamic of deflation. Nevertheless, if I say, deflation alone automatically discourages the aggregate consumption and induces the aggregate saving of the society, that would be a little over-simplification. It is because deflation can also exert its secondary dynamic which counteracts against the primary one.

What is the secondary dynamic of deflation? It is manifested through interest rates, the cost of finance and the rate of income from saving.

Deflation can also reduce interest rates: arguably down to the floor limit of zero. The resulting reduction in interest rates would translate into a lower financing cost as well as a lower saving income. When one’s own saving deposit earns a lower interest income, it would not promote saving. Savers can withdraw their deposits and hoard money at home; or alternatively invest them into some other assets that earn better returns. Second, a lower financing cost could encourage consumers (or investors) to borrow money to consume (or invest). That would encourage finance-fed consumption (investment). All these effects, theoretically, would counter-balance the primary dynamic of deflation, the effect of increasing purchasing power of money.

Thus, the overall consequence on saving behaviours and spending behaviours would be the result of the tag of war, or the net effect, of these two counterbalancing dynamics: the effect of increasing purchasing power of money against the effects of reduction in interest rates.


Chart 3 gives us a big picture of the working household’s consumption behaviour. In Chart 3, the consumption expenditure index of the worker’s households had kept rising since the turn of the 80s and throughout the bubble (asset inflation) period of the second half of the 80s. From around the end of the bubble, the index started consolidating its top during the 1st decade (1991-2000) of the ‘Lost Decades,’ the period of asset deflation. Then, in 1998 the index started falling. In retrospect, this decline of the consumption index was a precursor of the coming period of consumer price deflation in the second decade (2001-2010) of the ‘Lost Decades.’

As a matter of fact, a year earlier, the real disposable income growth turned negative. (to be explained shortly with Chart 5). Naturally, it reduced the source of cashflow for consumption. Thus, households were compelled to reduce consumption. The resulting reduction in consumption would translate into a lower level of consumer prices. Here, we can deduce a loop of reinforcing interaction between the monetary reality and the consumption behaviour.

This declining consumption trend reveals the fact that the deflation failed to exert the secondary dynamic, in which a lower interest rate promotes finance to restore consumption. Then, a question arises: why didn’t the secondary dynamic emerge to counterbalance the negative effect of deflation? We will return to this question shortly.

Now, we move on to the saving behaviour. The saving behaviour of Japan since 1999 is complicated because of two primary factors: first, a secular demographic trend of aging population; second, declining disposable income among households.

Japan has been experiencing its secular trend of demographic aging. Chart 4 traces the evolution of Japan’s demographic components—population below the age 15, between the ages 15 and 60, and above the age 60—between 2000 and 2015. Aging is visually obvious in this bar chart.

A prevailing speculation has that, as Japan’s population ages, the increasing retired population will primarily erode Japan’s saving rate in aggregate. An existing study on this topic, ‘Impact of aging population on household savings and portfolio choice in Japan,’ might have suggested a more granular picture of the actual saving behaviour of the population above 60. According to this study, while the population below 60 maintained their saving rate within a range, the population above-60 made a drastic wealth reallocation from deposit to other financial assets: most likely to explore a better risk-return profile to cope with a near zero deposit rate environment [i] (Iwaisako, Ono, Saito, & Tokuda, 2016). A more detailed analysis can be found in their paper.

Since my observation concerns the economic reality of the working population, we narrow down our focus on the working age group.

First, let’s have an overview of the real GDP growth history. To see the impact of the aging population, Chart 5 compares the real GDP growth and per-worker real GDP growth. When we see the real GDP growth rate per working population in the chart, its post-bubble data in 5 year average had remained significantly below the pre-bubble (1980-85) level of around 4%. It only rebounded up to 1% between 2001-2005. This reflects the state of economic stagnation under the unfolding deflationary pressure. The drop in following 5 year average was due to the global financial crisis, an external factor, revealing the vulnerability of Japan's domestic economy to the acute decline in the global economy.


Chart 4 & 5 provide us with a general backdrop of the post-bubble Japan—demographic aging and stagnated economy (reduced level of real GDP growth) respectively. Given this backdrop, let’s see the evolution of the income growth, both nominal and real, in Chart 6.

Chart 6 traces the historical monthly disposable income (annual average) of worker’s household, both in level and in growth rate (nominal and real), along the historical passage of inflation rate. A significant change took place in the disposable income growth after the bursting of the bubble. A visually salient feature in this chart is the high correlation between Consumer Price Inflation rate and the nominal income growth. They almost synchronised in time-series movement.


When we shift our focus to the real income growth—nominal income growth minus inflation rate—the year 1997 divides the real income growth history. It started frequently registering negative records after 1997. As a background, the new executive branch led by Ryutaro Hashimoto that came into the office in 1996 made their decision to raise tax. 1997 was the year when Yamaichi Securities Co, Ltd. filed bankruptcy. The failure of the securities trading firm, triggering a financial crisis, transformed the post-bubble reality from the asset deflation to the negative real income growth, thereafter in 2 years, finally to the realisation of full-fledged deflation (Consumer Price Inflation entered into the negative territory in 1999).

Here, we see the overall evolution of deflation in a nutshell: deflationary pressure originated from asset deflation at the burst of the preceding bubble and gradually penetrated to the real income growth (negative real income growth) to be transmitted into consumer price (deflation).
Here are two observations from Chart 6.
  • First, it is rather surprising that it took quite a long time, 6-7 years, for the deflationary pressure to penetrate into the real income growth from the asset deflation (the scale of 80% drop in commercial land prices) after the collapse of the bubble.
  • Second, it took only 2 years for the deflationary impact to be transmitted from the negative real income growth to consumer price deflation.

For the first observation, there were two Japan’s vernacular factors that accounted for this unexpected lag. One primary factor is that the government expanded its fiscal spending to create jobs. The other is Japan’s local custom of lay-off aversion, almost a tacit unwritten social contract between companies and workers. Of course, the unemployment rose after the bursting of the bubble. But it was contained below 5.36% (Chart 7). To the scale of 80% of collapse in the commercial land prices, 5.36% of unemployment would sound a miracle without these two magic tricks. As a result, the disposable income, although having stagnated after the burst of the bubble, did not fall until 1998.

These observations also partly explain the reason why the real GDP growth did not register an acute negative record in the post-bubble economy until 2008 (Chart 5). Nevertheless, this chart reveals that the real GDP growth was more affected by the Global Financial Crisis. When we compare the magnitudes of negative records of the post-bubble economy’s real GDP growth before and after the Global Financial Crisis, it becomes clear: before the crisis (Chart 5), we have 'minus 0.5%' in 1993, 'minus 1.1%' in 1998, and 'minus 0.3%' in 1990: and after the crisis 'minus 1.1%' in 2008 and 'minus 5.4' in 2009. This suggests that Japan’s economy is more vulnerable to a global economic crisis than to its domestic economic disaster.

In his speech in 2012, Shirakawa further examines other factors that affect deleveraging process. Interested readers are encouraged to read either the script posted in the Bank of Japan’s website here (Shirakawa, January 10, 2010) or my summary in the link here (Suginoo, 2017).

Overall, we saw that the real disposable income growth acted as a critical hinge in the progression of deflation. This might give us an insight that restoring real disposable income could be an important step, if not the only, toward the economic recovery out of the deflationary economic stagnation. Now, we move on to the saving behaviour of the working population.

Chart 8 witnesses that the saving rate of the worker’s household stagnated in a range between 9.6% and 12.8% during the 2nd decade (2001-2010) of the ‘Lost Decades.’ Nevertheless, it also confirms that the saving rate did not fall drastically during the same period.


Finally, putting together these observations—declining real disposable income growth, stagnated saving rate, and declining consumption expenditures—we can shape an overview of the backdrop of the prevailing norm, 'spend less and prepare for the future uncertainty,' during the 2nd decade of the ‘Lost Decades (2001-2010).’ The decline in disposable income placed a stringent constraint on both saving and consumption behaviours among the worker’s households during the period. Despite such difficulty, the worker’s households managed to maintain their effort within their capability to cut spending and allocate money into saving out of their declining disposable income. These deflationary hardships must have enhanaced the notion and ingrained the norm on the mind of the working population: although the level of their saving rate was not impressive compared with saving rates of some rapidly growing emerging economies. In a way, the psychology behind the norm was shaped as a flip side of the downward pressure on consumption due to the decline in the real disposable spending among the working class.

MAIN DRIVING FACTORS OF 'LOST DECADES'

Now, we return to our earlier question: why didn’t deflation exert its secondary dynamic, in which a lower nominal interest rates would systematically encourage finance and discourage saving to restore spending?”

Simply put, Japan’s ‘Lost Decades’ was a consequence of the preceding bubble economy that took place during the second half of the 80s. Since it is a product of its past, in order to understand the economic reality of Japan’s ‘Lost Decades,’ it would be imperative for us to understand the past, how the bubble economy had been shaped and had collapsed. This will be covered in Part 2 of this series. For the time being, we focus on the specific period 1998-2011, the 2nd decade of the 'Lost Decades.'

Two legacies

Cut the long story short, the preceding bubble, when it collapsed, left two economic legacies in a systemic scale: excess leverage (high indebtedness) in corporate sector and asset deflation.
These conditions gave rise to the ‘Lost Decades.’ With excess leverage (high indebtedness) in the corporate sector, corporate borrowers would not have an ability to borrow.

While the value of the assets was compressed on one side (asset deflation), on the other the amount of debt remained fixed (high indebtedness): the balance sheet of the corporate sector became distressed. As long as the balance sheet is distressed, even if the central bank reduces the interest rates drastically, business would have neither an ability nor willingness (a risk appetite) to take out new loans for investment.

Expansionary monetary policy faced a limit in its effectiveness in a deflationary environment. Among many reason, systemically distressed balance sheets blocks the transmission mechanism of monetary policy. Why?

A conventional monetary policy is a powerful tool to regulate the level of banks’ reserve accounts within the central bank, but cannot directly regulate the circulation of money in the economy even under a normal circumstance. In-between, private lending activity plays a significant role as the transmission mechanism of a conventional monetary policy. It is a cornerstone of the very architecture of the creation and the destruction of modern money (Minsky, 1985): when a lender lends money to a borrower, money is created; on the contrary, money is destroyed when the borrower repays money to the lender; if the borrower failes to repay the debt to the lender, money is evaporated. Without new loans issued, money cannot be created. Unless the system restores its net asset of the balance sheet—by either restoring the nominal value of its assets through asset reflation or reducing the nominal value of its debts through debt forgiveness—lending activities would not recover. As a result, accommodative monetary policy would fail to transmit its positive impact into the economy. Thus, the economy would remain stagnated. Richard Koo coined this type of prolonged stagnation as “Balance Sheet Recession.” (Koo, 2011)

In addition, with an uncertain income prospect emanating from the balance sheet recession, neither would households have an ability and a willingness to take out loans for their housing and consumption.

How to restore these two problems—the impaired balance sheet of corporations and the negative income prospect of households? One remedy is the government's fiscal spending. The government can borrow money (from the central bank) and spend to create demand and jobs in the economy. Yes, the remedy is in the territory of fiscal policy, but not in the territory of monetary policy. Japanese government did expand their fiscal spending. Nevertheless, against the severe asset deflation, it's scale was proved to be insufficient. In addition, Hashimoto administration that came into the office in 1996, by raising tax and withdrawing some fiscal spending, further muted the tone of the slow recovery.

These developments capture a big picture why the secondary dynamic of deflation—in which lower interest rates induce borrowings, thus, finance-fed demands—did not function. There were more factors that muted the secondary dynamic (to be covered in Part 2). All those factors interacted each other to reinforce the primary dynamic of deflation.

A big picture

Up to now, we had a brief overview of what’s behind the psychology—spend less and save for the future—among the working class in Japan during the specific period (1998-2011) of the deflationary wonderland of Japan. It was a flip side of the downward pressure on consumption due to a decline in the real disposable spending among the working class, rather than an increase in thier saving rate.

Overall, the deflationary wonderland of ‘Lost Decades’ was a by-product of the preceding bubble. And Japan’s story suggests that the monetary reality did swing from one extreme to another—from the debt-driven asset inflation to the deflationary ’Lost Decades’—to shape a pendulum like cycle. This cyclical dynamic will be discussed in Part 2 of this series, covering a longer extended period of Japan’s economic history.

Now, we move on to another monetary wonderland, Argentina.


INFLATIONARY MONETARY WONDERLAND
OF ARGENTINA

On the other side of this planet from Japan, in Argentina, monetary and economic conditions were opposite. Argentina suffered from a chronic inflation.

Inflation is not necessarily problematic as long as it is contained within an expected range. In a way, as long as consumers and business can anticipate the pace and the level of inflation to prepare for it, it would not cause much problem. As a matter of fact, in most of advanced economies, 2% is arguably deemed to be an ideal inflation rate. However, when inflation goes out of control and it becomes difficult for all the economic agents to anticipate its pace and level, it becomes problematic, since both consumers and business cannot prepare for it. Uncertainty in inflation, both its level and its pace, can cause devastation.


Spend faster than you earn

Inflation, when compared with deflation, would exert a totally contrasting effect on monetary reality: it impairs the purchasing power of money as time goes by. Highly uncertain inflation could discourage people from holding cash. When inflation goes out of expectation, people are compelled to exchange money for real goods and services as soon as practical before the same amount of money would lose its purchasing power. Then, the question is: how fast is ‘as soon as practical’?

Many of Argentina’s working middle-class spent money even before they got it: in other words, they took out credit to purchase products and services before they received salary. And sometime, they took out more than they would be able to pay back with the current salary level within a reasonable time frame. To me, a guy who had just arrived Argentina from a deflationary monetary wonderland (Japan), the pace of spending by Argentinean local working middle class appeared faster than the speed of light.

Is Argentinean’s credit behaviour reckless and irresponsible? A quick answer is ‘Not necessarily.’

Although their behaviours are opposite to the behaviours that I observed in the deflationary Japan, they are simply responding to the contrary monetary reality, a highly uncertain inflation condition, with a certain economic rationality for their survival. (That said, whether they can win the situation or not depends on other factors, especially responses from the other side of the equation, lenders: to be explained shortly.)
Here is a logic to support their behaviours with two assumptions: households debts are denominated in the local currency; the interest rates are adjusted with a substantial time lag against the pace of inflation.

As long as the debt is denominated in the local currency—a big assumption—the amount of the debt would not fluctuate due to the fluctuation in the currency exchange rate. On the other hand, inflation will increase the prices of products and services. And hopefully, it will also increase income sooner or later with some time lag. Under this setting, if you take out a loan to purchase a durable product, the value of the durable product would increase (put the accounting depreciation aside for the sake of argument), while the value of the loan remains unchanged. Since the collateral value is increasing against the fixed debt, to repay the old fixed debt would become much easier as time goes by. Simply put, inflation will reduce the real value of the existing debt along the passage of time. Even if the borrower were not to repay the debt, inflation automatically would reduce the real value of the debt: as if inflation is repaying some portion of the debt for you in real term [ii]. Further, the rising collateral value creates an excess room for extra financing, the borrower even might decide to take out additional loans. Thus, ‘borrow now and spend today’ is not necessarily an irrational behaviour under a highly uncertain inflationary environment.

Now, this scheme sounds extremely convenient for borrowers, as if they could have ‘free lunch.’
It only tells us a part of the entire story. Whether or not borrowers can win ‘free lunch’ out of the situation, totally depends on the other side of the equation.

Here, repeatedly, this scheme requires pre-conditions that the debt is denominated in the local currency and the interest rate adjustment substantially lags against the pace of inflation. When the debt is denominated in a foreign currency, the situation would be quite different (to be illustrated later). It would not be unrealistic to assume that ordinary public takes out loans in their local currency. The second condition is subject to questions.

On the other side of the equation, lenders most likely are more astute, strategic and tactical than borrowers. This might explain the reason why retail banks in Argentina were reluctant to issue long-term debts to households. Mortgage was almost non-existent, when I was there. So, for ordinary consumers, credit card was the most likely only available means of credit.  In order to catch up with the pace of inflation, they adjust the interest rates accordingly. But, this is not enough, since the fluctuation in inflation rate can go beyond their expectation. To protect themselves, credit card business would charge a substantial risk spread to cover unexpected fluctuations in inflation, besides the expected inflation cost. Nevertheless, this is easier said than done, because to capture inflation reality, both actual and forecast, is not an easy task in Argentina. To begin with, the government politically understated the actual inflation rates at that time (to be explained shortly). In addition, no one knew how badly the government was capable of accelerating inflation. Too much uncertainty would prevent all the parties from shaping a rational expectation and reliable forecast. Without a fail, financial institutions fall victim to highly uncertain inflation as well.

Overall, who falls into a loser and thrives as a winner would totally depend on the course of inflation. And no one would know that in advance. That said, a highly uncertain inflationary environment that the government creates certainly shapes people’s spending and borrowing behaviours: ‘get rid of money as soon as practical in exchange for real goods and services.’ And we cannot simply dismiss their behaviour as irrational or lack of discipline. These behaviours are the products of the government’s economic mismanagement. And the government economic failures are due to politics.


PRESERVATION OF WEALTH:
Get rid of money in exchange for real asset

In order to preserve wealth in a highly uncertain inflationary environment, people want to get rid of money, which loses its purchasing power, in exchange for real assets: precious metals, jewelries, real estates, and automobiles.

Wait a minute! Automobile? Is it a better alternative than cash to preserve wealth? It sounded absurd to me. Again, was I brainwashed by deflationary thinking?

Automobile has a substantial depreciation per annum, at least in accounting term. And they do not generate cashflow like real estates (rent). As time goes by, while cash can lose its purchasing power through inflation, automobiles can also lose their value through depreciation. Then, the question is which would be the better way to preserve wealth: holding automobiles or holding cash? In order to answer this question, we need to compare two rates: annual depreciation rate of automobile and the inflation rate. In order for automobiles to be a better alternative to cash for wealth preservation, the inflation rate has to be higher than the annual depreciation rate. Then, money would lose its value via inflation faster than automobiles loses its value via depreciation.

Nevertheless, there was a critical problem for me to make this comparison. Under then political regime, it was difficult to obtain reliable information about inflation. The executive branch in power was manipulating inflation statistics: the government official release of inflation statistics was always understated and did not capture the actual monetary reality of local’s daily life. As to be explained later, the executive power had a special reason to deny the inflation. Nevertheless, even if the government could distort the inflation data in their official statistics, they could not hide the inflationary reality in the daily life. Locals, experiencing the actual inflation through the daily price changes in all sorts of products and services, were aware that the government release was politically manipulated. When some economists in private sector released their own politically-neutral assessment of inflation to reflect the economic reality, the government did not hesitate to punish them by imposing them substantial financial penalties. Here is a link to an article that tells a story of an economist who was punished by the government for that matter (Economist, 2011). Those economists came up with their inflation rate estimate above 25% at that time. This contrasts the official inflation release at 9.4%, which was politically manipulated. (Economist, 2012)

For the purpose of our discussion, let’s say the depreciation was at 20%, an arbitrary but not-unrealistic hypothetical setting. Then, 25% inflation—a realistic minimum inflation rate consensus among those economists punished by the government—would exceed the depreciation rate of 20% by 5%. In other words, money loses its purchasing value faster than automobiles lose their value through depreciation by 5%. 5% differential in these rates would be big enough to explain the rationality for the local’s collective behaviour: ‘get rid of cash in exchange for automobiles.’ Their behaviour was merely a manifestation of their rational economic thinking in response to the particular monetary conditions given. The reason why it was opposite to the economic behaviours among the working middle-class in Japan was simply because Argentinean working middle class was experiencing contrasting monetary conditions.


USD denominated Sovereign Debt, Managed Currency, & Inflation:

Up to now, our focus was totally domestic. Now, let’s think more international. When Argentinean locals want to get rid of their own currency, it would be difficult to persuade foreigners to take their currency. Naturally, the highly uncertain inflation situation together with the government’s manipulation over inflation statistics could induce capital outflow and as a result would place a downward pressure on the currency.

Argentina has a particular context in terms of their own currency, Argentine Peso (ARS). The context is related with its sovereign bonds. The substantial portion (roughly between 60% to 70%) of Argentina’s sovereign bonds is denominated in foreign currencies (Chart 9), especially in USD. Simply put, when the debt is denominated in a foreign currency, the worst currency scenario in the context of the sovereign debt is an acute depreciation of its local currency against the particular foreign currency that denominates the bond.

The currency depreciation of ARS against USD would increase the value of USD denominated portion of Argentinean sovereign debt in terms of Argentine Peso, even if its value in USD remained the same. Given a substantial portion of Argentinean sovereign debts are denominated in USD, the local currency depreciation against USD would not be desirable from the sovereign bond perspective.

In a way, the USD denomination of Argentinean sovereign debts is a source of many of their social, economic and political problems. This simple but hard monetary constraint could compel the government to take any political measure to avoid the currency depreciation in order to prevent the debt value from increasing in its own local currency unit [iii].

Now, in the short run, politics starts overpowering economics. Nevertheless, as we will see, economics will fire back the politics in the long run.

Let’s look at the following four historical charts. Chart 10 traces the historical passage of the currency exchange rate of ARS/USD, or the price of USD in ARS—when the chart goes up, it reflects the depreciation of ARS against USD. Chart 11 tracks Argentina’s historical current account balance (% of GDP) since the 60s. Chart 12 tracks Argentina’s historical Fiscal Deficit: the positive graphs represent the size of ‘deficit,’ while the negative graphs represent the size of ‘surplus.’ Chart 13 traces the evolution of Argentina’s government debt in Mil USD.


A General Question: Is Fiscal Deficit an evil? It Depends.

Before proceeding our Argentina’s story, to avoid confusion I would like to make some general remarks regarding fiscal deficit. A fiscal deficit would not necessarily be bad, even if it is extended for a prolonged period of time (e.g. USA). In an extreme scenario, the sovereign state would be able to finance its fiscal deficit by monetising their debt. Here are two primary, if not all, conditions that would support fiscal expansion:

  1. As long as the sovereign state issues its own debt only denominated in its own local currency, it can print its own money and expand its fiscal deficit to create jobs. Since the state lends itself money, it can never default its own. On the contrary, if the sovereign state has a substantial portion of debt denominated in a foreign currency, an expectation for a prolonged fiscal deficit could cause a significant depreciation of its own currency. The resulting currency depreciation would increase the nominal value of its debt in terms of the local currency.
  2. As long as inflation is contained within a manageable range or below the level of the policy target, printing money (monetising fiscal expansion) would not cause devastating inflation right away. On the other hand, under a highly uncertain inflationary environment, printing money could add fuel in the fire of inflation and cause instability in the domestic economy. In addition, such an economic development would lead to a depreciation of its own currency, which would hurt the sovereign debt, if it is denominated in a foreign currency.
 
Unfortunately, Argentina’s case during this period breaches both of these primary conditions. So, we need to watch out its fiscal deficit. Now, we go back to Argentina’s story.


Argentina's Specific Case:

Even after a long period of chronic deficits in both its fiscal budget and its current account until the end of the 80s (Chart 11 & 12), Argentina kept borrowing with the help of IMF and conducted USD peg currency exchange regime—ARS 1 per USD 1—during the most part of the 90s (Chart 10). Given the twin deficits, the local currency, ARS, had been overvalued under the currency peg regime. Finally, the scheme proved to be unsustainable: in 2001-2002, Argentina announced default on its sovereign debt. As an immediate impact, the currency peg regime broke down and ARS was devalued to a level around ARS 3.1 per USD—in other words, the currency value shrank to one third in USD term (Chart 10).

The devaluation was obviously negative in terms of the USD denominated sovereign bonds on one hand, on the other it yielded some positive impacts. The new weaker exchange rates better reflected the actual macroeconomic reality of Argentina. Repeatedly, under the peg regime, the local currency had been overvalued. Now, the new devalued currency restored the price competitiveness of Argentinean products in the global market. Since 2002, a year after the default, Argentina had experienced an exceptional period of current account surplus for 8 consecutive years (Chart 11). In addition, Argentina restored fiscal balance for a short period of time (Chart 12).

After the breakdown of the currency peg regime, the new currency intervention regime that replaced the currency peg was classified as ‘crawl-like arrangement’ by IMF (International Monetary Fund, 2012, p. 5). Here is a description about the new regime from an IMF paper.

For classification as a crawl-like arrangement, the exchange rate must remain within a narrow margin of 2% relative to a statistically identified trend for six months or more (with the exception of a specified number of outliers), and the exchange rate arrangement cannot be considered as floating. Usually, a minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required. However, an arrangement is considered crawl-like with an annualized rate of change of at least 1%, provided the exchange rate appreciates or depreciates in a sufficiently monotonic and continuous manner. (International Monetary Fund, 2012, p. 61)

Under ‘crawl-like’ currency arrangement, in case of an abrupt massive capital outflow, it would still require a substantial amount of USD reserve for a successful intervention to maintain the exchange rate within the predetermined range. In a way, the limit of the intervention is constrained by the amount of USD reserve to fight against the market pressure. Once the central bank runs out of USD reserve, inevitably the intervention comes to an end.

During the exceptional period of current account surplus, then President, Nestor Kirchner, managed to consolidate a new political regime. The Nestor Kirchner administration managed to negotiate debt restructuring with creditors and pay down some portion of Argentina’s external debts in 2004-2005. The regime also managed to stabilise the exchange rate until 2008 under the ‘crawl-like’ currency regime. Nevertheless, this positive momentum gradually faded away. And, in 2010 onward, its current account returned to deficit (Chart 11). By 2009, a year before its return to current account deficit, the macroeconomic reality already exposed ARS to the market pressures. Despite the presence of the intervention, the currency started depreciating.


Bad Luck called Bad Mismanagement

In order to secure the continuity of his policy as the mastermind of the regime, after serving as the President from 2003 to 2007, he managed to place his wife, Christina Fernandez de Kirchner, as his proxy in the position of the President from 2008.

Then, a critical bad-luck struck Argentina’s political arena. The mastermind of the executive regime since 2003, Nestor Kirchner, passed away in 2010. In the absence of the mastermind, then President, Christina Fernandez de Kirchner, the widow of Nestor Kirchner, started improvising her policy actions. The regime went through a period of internal political struggle and started losing their prudence over the economic governance. The bad luck struck Argentina at the bad timing and called a series of bad mismanagement.

In response to the given weakening economic circumstances, the government became eager to stop capital outflow from the country in their attempt to contain the market pressure on the currency. A prudent way would be a ‘causal treatment’ to resolve the causes by restoring the budget and/or current account balances. Nevertheless, it would demand a time-consuming process which might not yield much meaningful result during the term of the current administration. The next administration might reap the harvest of the current administration’s painful effort. It would not sound appetizing to the current administration. The executive power needs to demonstrate a desirable impact within its term for political reason. One quick way might be a ‘symptomatic treatment’ to alleviate or paralyse the symptoms temporarily by authoritative coercion. But, a ‘symptomatic treatment’ would not be a great choice. First, because ‘symptomatic treatment’ does not aim at the causes, the government might only allow the causes to grow further. Second, because it will induce counter-productive responses, it might prove self-defeating.

In addition, even for the symptomatic measures, ‘capital control,’ there should have been a clear distinction between the short-term capital flow and the long-term capital flow, since these two capital flows exhibit different economic effect to Argentina. Argentina, as a highly indebted developing nation with twin deficits, would need long term foreign capitals to stimulate their domestic economic growth. While long-term capitals are good for the economic growth of Argentina, the short-term capital flow represents speculative fund activities, thus, is a source of volatilities and disturbances in the economy. The government should arrest the speculative fund activities, while promoting the long-term investment capital inflows.

Nevertheless, the administration did not hesitate to take a self-destructive measure. Without distinguishing these two capital flows, the government attacked both types of capital by conducting discretionary capital control. Once it took effect, foreign business operating in Argentina could not repatriate their profits to their home countries at their will. The capital control scared off new incoming long-term foreign direct investment. This was one of the first counter-productive consequence that the government voluntarily invited, worsening the growth prospect.
In order to alleviate the public criticism against the counterproductive measure, the government had already invented a scape goat, foreign capitals as a common enemy, by portraying them as a group of exploiters who steal wealth from Argentina. In its campaign against foreign capitals, it openly confiscated a substantial domestic asset held by a Spanish energy company, REPSOL: (The New York Times, 2012). Along this course, the government also had created a series of subsidies to feed the low income class. Import control was justified in the name of the protection of the domestic producers. This created a paradise for uncompetitive domestic producers with inefficient cost structure. Now, in the absence of efficient foreign competitors, they could raise prices and pass their cost to consumers. This definitely fortified the inflationary pressure. In addition, there were another winner, exporters. Naturally, the government was encouraging export to earn in USD. They must have been successful in preserving their wealth in USD, which would increase the value of their wealth against their own home currency, thanks to ARS depreciation against USD.

This paints a rough picture to illustrate how monetary conditions can reinforced a political momentum of ‘populism.’

As a natural consequence of their own cause, the administration brought back to Argentina its twin deficits—fiscal deficit and current account deficit. Furthermore, the government voluntarily killed new inflow of long-term foreign direct investment by their hostile capital control. Given the constraints, money has to come from printing. (Their measures only made it more difficult for them to borrow from foreign investors.) Money printing can only add fuel in the fire of inflation. The government, by its deed, fed one of its own worst enemy, a cause for the currency depreciation, inflation.

On the street, despite the official capital control in place, people exchanged their local currency, ARS, with USD in the black market in their pursuit to preserve their wealth. The government even monitored the black market’s exchange rate and released the unofficial (illegal) rate as ‘blue rate.’ In a way, the government officially acknowledged the unofficial currency exchange market openly. Quite paradoxical.

Under these conditions, the new currency regime, ‘crawl-like’ currency exchange arrangement, started demanding an enormous amount of USD to counter-act the market pressure to maintain the rate within the predetermined range. With their stock of USD limited, the failure of its intervention becomes a matter of time.

As the government was running out of the only fuel for the currency intervention, its USD reserve, the currency devaluation became imminent. Then, automatically, their existing sovereign debt will be inflated in ARS term. Although politics had overpowered economics, now the time for economics to firing back. The political manipulation of monetary affair was proven self-defeating.
In a way, this foreign currency denominated sovereign debt is a source of multiple economic and political problems in Argentina. Until the day Argentina can issue its sovereign debt only in its local currency, Argentina’s story will continue.

Overall, Argentina’s story above illustrates how different sets of monetary conditions can shape different sets of our social behaviour, from people’s collective economic behaviours to the government political behaviours.

SUMMARY

Overall, the influence of monetary conditions reaches beyond the territory of our monetary reality. On one hand a given set of monetary conditions can shape our particular collective behaviours, on the other our collective behaviours can also transform our monetary reality. In a way, we live in a ‘Monetary Wonderland’ that is a manifestation of a series of ‘feed-in and feed-back’ interactive dynamics between our collective behaviours and monetary reality.

Part 2 of this series will focus on the cyclical dynamics of monetary reality, demonstrating how monetary policy can transform a ‘Monetary Wonderland’ from one extreme to another.

NOTE

[i] A conventional wealth management principle would suggest that this behaviour of the ‘above-60’ cohort most likely reflected the behaviours of high wealth individuals. Otherwise, the cohort of this age group must have maintained a significantly large allocation to deposit (and bonds) to manage market risk. Possibly longevity risk might have compelled them to take more market risk to increase their wealth.
[ii] a caution here, it is strictly in real term, but not in nominal term, since the nominal value of the debt would remain the same unless the borrower pays back or the lender forgive it.
[iii] On the contrary, the current Mauricio Macri administration as of August 2018 seems to have abandoned its commitment in debt management.

REFERENCES

 
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