The Mercosur Problem

The Mercosur Problem: The Southern Cone’s Rise and Fall in the 1990s

In December of 2001, an interim Argentine government moved to suspend payments on $132 billion of debt, the largest default in history. In neighboring Brazil, President Fernando Cardoso's government found itself obligated to accept a $30 billion aid package from the International Monetary Fund less than two years later, as his country, the world"s ninth-largest economy, plunged into economic freefall and its previously stable currency, the real, hit new lows. Both nations are currently locked in one of Latin America's worst financial crises; as the Brazilian and Argentine middle classes quickly shrink and the price of goods becomes unmanageably high, investors and policy-makers have begun to ask a central question: What went wrong?

As late as 1994, Argentina was considered a rising star in Latin America. A Business Week article praised the conservative economic policies of then-president Carlos S. Menem and proudly announced that the Argentine economy was "going like gangbusters" (26). Argentina"s economy had grown significantly since 1989, attributed in part to the decline in US dollar interest rates (Chartered WestLB 9). Foreign capital poured into Latin American markets in search of higher yields, and the resultant bubble in emerging markets funds in the United States and Europe created a hospitable climate for investors in ventures previously considered to be risky. The "tequila hangover" (UBS 1) crisis caused by the devaluation of the Mexican peso on December 20, 1994 deflated this bubble by a significant proportion; foreign investors began to feel that Argentina's artificially high currency would stunt growth. Mexico's devaluation made the damaging effects of Argentina's real currency appreciation evident, but central bankers in Buenos Aires refused to devaluate despite speculation and a significant dropoff in export growth (UBS). Argentina also failed to make much progress in correcting the long-term problems that were evident in 1993: "High unemployment, income inequality, and a poor educational system" (Business Week 26) failed to disappear largely due to a constitutional constraint of public spending and a reduction in tax revenues (Sims). By the end of the 1995, Argentina's total foreign debt had risen to nearly $100 billion, while its real GDP growth went negative for the first year since 1989 (EIU).

The world financial crisis triggered in 1997 by a default in Russia and the subsequent collapse of American hedge fund Long-Term Capital Management created mass panic in South America. The failure of the Wall Street maxim "nuclear powers don't default" (which itself had replaced "sovereign nations don't default" after Mexico's 1982 debt cancellation) pushed investors into a "flight to capital," regardless of the particular merits or defects of a given investment. Joseph Stiglitz, the World Bank's chief economist at the time of the crisis, wrote an opinion piece in the New York Times complaining that "South American countries deserve better than to be tainted by someone else"s economic troubles." The World Bank's representative praised Latin America's willingness to follow the directives of the international credit system, and pointed to "single digit" inflation as proof of their triumphs. He goes on to state that economic "achievements" in Brazil and Argentina are "serving as models for the developing world." That the World Bank's economic team gave an evaluation that was diametrically opposed to the current view of Latin American economies—that their main problems are privatization, high taxes, and unreasonably high levels of foreign debt—creates doubt in the mind of the investor who might look towards any emerging market. Argentina recovered slightly from the 1997 crisis, but enthusiasm in Latin American markets remained depressed. Diversion of capital to Silicon Valley in the late 1990s caused further suffering to emerging markets, which by this point had been dubbed "submerging markets" (Luukko) by smug industry analysts. After the crash of the technology market in March of 2000 and the subsequent unraveling of the developing world's economy, the all-but-forgotten experiment on the Southern Ocean quietly melted down.

Argentina's economy, once a source of pride for Latin America-boosting money managers and international creditors, had sunk into deep recession. The government's unwillingness to remove the Argentine peso's peg to the US dollar was the main contributor to the problem; fear of hyperinflation and the economic problems of the 1980s led the Argentine governmnent to maintain an inflexible currency plan that failed to condition itself to temporary shocks such as the peso crisis (Pearlstein). Prices of goods and services in Argentina began to spiral out of control; as exports dropped and Argentine businesses failed, consumer spending fell 25% from 1998 to 2002 (EIU). This vicious circle of lowered consumer spending as a result of higher prices caused by lower consumption created an inescapable dilemma for Argentina's government: It could either float the peso, causing extra inflation and assuring flight from Argentine investments, or maintain the peg, exacerbating the cycle at work. The government decided to devaluate, causing massive losses to foreign investors and an immediate withdrawal of funds from the nation"s economy. Shortly afterwards, following the resignation of President Fernando de la Rúa and assumption of power by interim president Adolfo Rodríguez Sáa, Argentina defaulted on its colossal obligations, valued at $132 billion.

In nearby Brazil, a similar process was taking place. The "Plano Real" (Real Plan) implemented by then-finance minister Fernando Cardoso in 1994, which consisted in pegging a new Brazilian currency to the US dollar in order to combat inflation, was hailed as a success by both investors and international economists such as Stiglitz. The Real Plan successfully combated the menace of hyperinflation that plagued Latin America in the early 1990s, reducing inflation from 3,000 percent when it was enacted to single digits by the end of the decade (EIU). By 1999, however, the Plan was showing serious signs of weakness. Despite its success in reducing inflation, it had created similar, although less drastic, problems for the Brazilian economy as those seen in Argentina. The solution authorized by Cardoso, since elected president, was to float the real; the Brazilian government preferred to allow the market to set the price of the currency over using hard currency reserves to prop it up in the international market. As expected, the price of the real dropped significantly against the dollar, but Brazil"s economic troubles were still far from over. The damage done by years of weakened exports and higher prices, as well as mounting debt, has caused great consternation among those interested in the nation"s economy.

The central causes of the recent Southern Cone financial crisis seem simple enough when viewed from hindsight: Rigid, unresponsive currency policies and muddled economic management created a downward spiral of increasing stagnation that ended in economic collapse and investor flight. However, the implications of the perceived failure of free-market capitalism in Latin America are not so clear-cut, though some observers point to evidence of a new trend towards socialism in some of the region's largest economies. The election of self-proclaimed socialist leaders Ricardo Lagos in Chile, Luiz Inácio Lula da Silva in Brazil, and Hugo Chávez in Venezuela has reinitiated a debate on the relative merits of US-style capitalism in South America, and the ideological fight is sure to grow more intense as the economic situation deteriorates. As politicians look to cast blame on foreign speculators or their own opponents and international financial arbiters scramble to defend their failed policies, doubt of the fundamental tenets of third-world economic management are emerging among the economists who initially proposed the disastrous plans. Where slogans like "open markets, open minds" used to suffice, intellectuals and decision-makers are demanding concrete solutions to address their current crisis and avert future disasters.

The Southern Cone nations are the latest failures of the principles of "financial austerity," the philosophy of government non-intervention and conservative economics promoted by the World Bank and the IMF for developing nations. As was observed in 1999, "if that approach fails…the ideal of a unified global economy knit together by trade and investment is threatened" (Nasar). Indeed, Brazilian politicians have already provided resistance against the United States's vision of a hemispheric free trade zone, and the Argentine government has shown an unwillingness to work with international creditors. If the past is any indication, South America must surmount many more obstacles before it reaches the ideal of stability and prosperity.

Works Cited

Business Week. December 19, 1994.

Chartered WestLB Investment Review. February 1993.

Economist Intelligence Unit Country Data. "Argentina." Accessed: 11 November 2002

Economist Intelligence Unit Country Data. "Brazil." Accessed: 11 November 2002.

Luukko, Rudy and Yee, June. "Emerging markets sink holders Mutual Funds." The Toronto Star 5 August 1998: C4.

Nasar, Sylvia. "One Choice Made, More to Come: Why Brazil Did What It Did and What Options Are Left." The New York Times 16 January 1999: A1.

Pearlstein, Steven. "Argentina"s Financial Quandary Is No Surprise." The Washington Post 21 December 2001: A38.

Sims, Calvin. "Argentina Still Struggling To Escape a Devaluation." The New York Times 17 June 1995: A15.

Stiglitz, Joseph. "An Economic Taint South America Doesn"t Deserve." The New York Times 16 September 1998: A29.

United Bank of Switzerland UBS International Finance. "Is Latin America Still Emerging?" November, 1995.