Romesh Vaitilingam interviews Domingo Cavallo for Vox

September 2009

Transcription of an VoxEU audio interview [http://www.voxeu.org/index.php?q=node/4202]

Romesh Vaitilingam: Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview is with Domingo Cavallo, former Minister of Economy and Minister of Foreign Affairs in Argentina.

Domingo and I met at the Global Economic Symposium in Germany in mid-September of 2009, where he was speaking at a session on exit strategies from the financial crisis and outlining a plan for dealing with the potential threat of inflation as we emerge from the crisis.

Domingo Cavallo: Many people, and particularly me, we are worried about the risk of having inflation after this recession, because many countries, particularly the United States, in order to fight the risk of depression, have implemented very expansionary monetary and fiscal policies.

And therefore, public debts, in the United States and elsewhere, will be increasing very rapidly. And there is a risk that some countries, particularly the United States, try to inflate away its debt.

Of course, for the time being, if you listen to the governors of the central banks, they say, "No, we will retrieve our excessively expansionary policies by selling the assets that we had purchased, and there will be no excessive monetary expansion at the time of the recovery of the economy." But, at the same time, you can read the opinions by very prominent economists, like Ken Rogoff, for example, or Paul Krugman, and in a way, they advocate inflation as a way to reduce the burden of the debt.

This is something that, in Latin America, we have a lot of experience with, because normally in Latin America, after a huge increase in public debts, governments have generated inflation in order to produce negative interest rates and to wipe out the debts.

I am not predicting that the United States will do that, but there is a risk that there are pressures for them to inflate away their debt. That will be a problem for the world as a whole because it could generate a worldwide inflation.

A colleague of mine and I, we have made a proposal of trying to preserve the value of reserves of emerging economies. The Chinese, who own more than 700 millions of reserves in US dollars, particularly medium and long-term fixed-interest-rate bonds, issued by the US Treasury, are concerned about the risk of a devaluation or a depreciation of the dollar that will reduce the value of their reserves.

Our proposal is very simple. The US and China, for example, should negotiate bilaterally a swap between the medium and long-term dollar-denominated bonds issued by the US for TIPS, Treasury Inflation Protected Security. The same maturity, equivalent interest rates. Let's say if the expected inflation is 2% and nominal rates are 4%, the TIPS should be negotiated at two percent in real terms.

In that way, the US would be having its public debt mainly in TIPS rather than in fixed-income securities. So in that way, there will be no incentive for them to inflate away their debt, and the Chinese will be protected against the risk of inflation.

This sort of bilateral negotiation between the Chinese and the US could make room for the US, also, to convince the Chinese to let their currency to become a convertible currency, and also to float, not to be pegged to the dollar, which is considered to be one of the sources of the global imbalances.

And I think this methodology could be applied through bilateral negotiations with other countries that are concerned with the value of their foreign reserves. If the use of Treasury Inflation Protected Securities were generalized, not only in the US but in most countries that have huge public debts, I think that the risk of an inflationary acceleration after the recovery will be significantly diminished.

And there will be also lower risks that, let's say, because China decides to shift away from the dollar, there will be a huge depreciation of the dollar that would also endanger the global economy.

So I think this is a practical proposal. It's an element or an ingredient of a global solution, a part of the exit strategy from the crisis, and particularly from the very expansionary monetary and fiscal policies that had to be implemented in order to prevent the recession to become a depression.

Romesh: Domingo, what's your sense of how workable this solution is in terms of the international economic negotiations? You've had a lot of experience with that in your career. Do you think it could work?

Domingo: I think, probably not. If everybody engages in a sort of multilateral negotiations, that would be very complex. But what I suggest is to start with the bilateral negotiations between the US and China. If the US and China agree on such a swap, then it will be very easy for other countries that could be interested in using the same methodology to protect their foreign reserves to engage in similar negotiations with the US.

And once the US has negotiated with China, using also the negotiation for trying to convince China to move towards convertibility of the yuan, and also allow the yuan to float, which is something that the US tries to get from conversations with China, I think that it will be much easier for the rest of the world to in singular negotiation.

It might be eventually, there could be a sort of multilateral agreement on trying to reduce the uncertainty on inflation and on nominal interest rates, medium and long-term nominal interest rates in different countries, by relying in Treasury Inflation Protected Securities, issued not only by the US but maybe by European countries, by Japan, whoever needs to convince the markets that they are not going to inflate away their public debts.

Romesh: How serious do you think the threat of inflation is? Much of the talk since the crisis broke and in the process discussion afterwards, has been about the threat of deflation. And people saying that is a far, far worse threat because we don't really know how to deal with that. But we have experience of dealing with high inflation, because we've done it in the '70s and '80s, and in your country, a little later than that.

Domingo: Yes, but you know because you try to prevent deflation, which is really a very difficult problem to tackle. You expand monetary policy and also fiscal policy in a very aggressive way. While you have still a significant output gap, the risk of inflation is quite low. All you get, if you're successful, is to prevent deflation. And you move to ours that says normal 1% or 2% percent annual inflation, which is considered stability or price stability.

But the question is that once the output gap tends to disappear, it may very well happen that that excessive liquidity that was put into circulation starts to generate inflation. And, of course, the central banks could adopt decisions through open market operations, particularly selling the assets that they purchased at the time of expanding monetary policy, to retrieve, to contract monetary expansion.

But at this very moment, when there is the risk of the revival of the recession as a consequence of monetary contraction. So, it may very well happen central banks or governors of central banks say, "No, let's keep expansionary monetary policies for longer period of time."

At that very moment, for sure there will be increased uncertainty on future inflation. And that may be reflected in immediate long-term interest rate. If the countries that have significant amount of foreign resource denominated in dollars get scared about this risk of inflation, they may very well try to convert their resource from dollars into euros, or into yens, or into any other, or into commodities.

In that case, there could be a sharp depreciation of the dollar, and of course, that could fill up the process of inflation. So if, for example, Europe tries to prevent the extreme appreciation of the euro that could be deflationary in Europe, the only alternative for the European Central Bank would be also to expand the circulation of euros.

But that will, by itself, add to inflationary pressures. So I think there is a risk of inflation. Not immediate, I mean in the very short run, but immediately after the recovery becomes a reality and the output gap declines rapidly.

Romesh: Can you give us a sense of the human impact of high inflation and how hard the job is to reduce it, and what it does to your society?

Domingo: When you face the risk of deflation like the world's facing right now, everybody thinks that inflation is a good thing because they compare it with deflation and they say, inflation is better than deflation.

But once inflation becomes a problem into an economy, it creates many, many other problems. Because it affects the cost of living and reduces real wages, particularly for those workers and retirees that cannot protect their real wages or salaries or pensions by requesting increases in nominal terms. And the fashioning of the economy becomes distorted by the changes in relative prices which cannot be easily predicted by economic agents.

So inflation affects also the allocation of resources in the economy and affects productivity. So it has many, many negative side effects. And inflation develops a sort of inertia that makes it very difficult to be reduced once it has begun, let's say 5%, 6%, 7% annual inflation.

One has to remember what happened in the '70s in the world, and particularly in the United States. You know in order to fight inflation when inflation was about 10% per annum in the United States, Paul Volker had to implement very restrictive monetary policies. And interest rates went up to 20% and generated a very severe recession in '81, '82.

It is true that right now the risk of deflation and everybody is worried for preventing deflation. But we should be careful not to generate inflation in the future, because once inflation is embedded into an economy, it becomes a very serious problem, very difficult to tackle.

It used to be, the generalized opinion was that if you control money supply and you implement a restrictive enough monetary policy, you'll reduce inflation. It's true. But, meanwhile you will generate recessionary effects into the economy, and it is very difficult, from the political point of view, to stand and accept that recession in order to cure inflation.

It is better to prevent inflation from becoming a widespread problem into a national economy and, even more than that, in the global economy. If inflation becomes a problem in the global economy, we will have another big, big problem ahead.

Romesh: Domingo Cavallo, thank you very much.

Domingo: You're very welcome.