Tuesday, January 11, 2005

Argentina's Recovery as Market Failure

International macroeconomists don’t think about market failure enough, and that is why I found this book particularly refreshing.

Tirole looks at international capital markets through the lens of corporate finance, and concludes that most of the problems of international finance are the result of market failure. Market failures, in turn, happen because some players in the game do not fully internalize the overall costs of their actions. Thus, for example, there is moral hazard involved when a government has an incentive to promise a certain thing in order to secure international financing, but then renege afterward.

I wonder if Argentina’s economic success might be a symptom of an externality. Argentina has broken its promises to pay and there needs to be a mechanism of punishment to discourage such behavior. If this mechanism is effective, sovereign borrowing in general will become cheaper because there will be less risk of default. However, while it is in the interest of all lenders (and foreign investors in general) to punish Argentina, an individual lender could make a killing. Those few foreigners who bought real-estate following the crisis know about this.

This brings up the issue of pledgeable capital. One of the main problems of sovereign borrowers, according to Tirole, is that they lack the ability to pledge assets against their borrowing because foreign investors can’t come in and take over, say, Buenos Aires, in the event of default. In the absence of pledgeable capital, sovereign borrowers must undergo costly exercises to increase confidence, like accumulating foreign reserves. Granted, accumulating reserves isn’t so expensive these days.

But then again, I keep having to remind myself that Argentina is a net lender to the rest of the world, and not a net borrower. Indeed foreign investors are not financing Argentina’s growth, but rather the other way around. Argentina’s economic success is mostly a function of its current account surplus, and its current account surplus is a function of loose US monetary policy (weak dollar, low interest rates), the recovery in Brazil, and high commodity prices. Things would look considerably different if Argentina needed to access foreign savings right now, and world interest rates were higher.

You can read a favorable review of Tirole’s book here and a less favorable one here.


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