The Lion in Winter
Javier Milei has been booked and busy lately: he finally passed one law. He tweeted a bunch about transgender sports. He got himself a girlfriend. He put together a budget. He got a strange medal from the Bolsonaro family. But how is the country actually faring under his administration?
All roar, no bite
Back in May I wrote that Milei had been having trouble passing legislation, and he still does: the government has gotten roughly one piece of major lawmaking signed, a very heavily watered down version of the Bases Law - an economic reform bill. But politically, it hasn’t been great, with infighting at the top levels of the administration and in the party, Congress giving several rebukes to the administration’s agenda, and declining popularity. The exact contents of each dispute are rather uninteresting1, but Milei is clearly running out of political capital and isn’t capable of governing as he intends with 0 governors or mayors, only 30 of 257 deputies, and 7 of 72 Senators.
Additionally, Milei’s popularity (which held steady for most of the year) has eroded since May, and his approval rating is now in neutral or even negative territory. This follows a steady uptick of concern with unemployment over inflation, where the public has went from rating prices as their number one concern in December (over 70% of respondents, according to one poll) to focusing on unemployment and poverty (around 50% of the public) as of late. This development has generally tamped down public optimism over the economy and reduced satisfaction with Milei’s agenda.
But are Milei’s economic policies yielding results? Kind of. The real sector of the economy is still not picking up: GDP shrank 1.7% in the second quarter versus the first, and while indicators for July are positive, the scarce early news we have for August is worse. Particularly, the labor market remains completely deflated, and real wages (as per a viral chart2) have not recovered much from the initial inflationary shock - initially they fell around 20% between November of 2023 and March, and have only really recovered 5% or so over the last three months.
Inflation has also been another sore spot for Milei: after rapidly decreasing from 25.5% MoM in December to 4.2% in May (and core inflation falling from 28.3% motnhly to 3.7%), prices have just not really decelerated as of late. Monthly price growth is still at or above 4% monthly, and core inflation stopped falling at 3.7% a month (around 55% annual), and has increased for two months in a row (to 3.8% in July and 4.1% in August). While some of this acceleration is due to regulated price increases and seasonal factors, the truth is Milei’s anti inflation agenda has run head first into the brick wall of inertia.
One final sticking point are international reserves: since late July, the country’s net USD holdings3 have been stuck at around USD -4 billion for the better part of two months, despite a trade surplus of roughly USD 4 billion in the same period. A lot of this is due to large payments to creditors in July (around USD 4 billion to private creditors and another billion to the IMF and other multilateral lenders) and a significant chunk in August (around USD 1 Bn between the IMF and various small payments), but the country has received USD 550 M from the IADB. To meet its IMF reserves target for September, the central bank needs to come into 2 billion dollars (from -4.6 billion to -2.5 billion), which are only plausible through a series of foreign loans. The fourth quarter is… unknowable, with smaller interest payments but also with a target of gaining USD 1 billion in net reserves - and some private estimates consider the government might miss by as much as 10 billion dollars.
The rules of the non-game
So what has Milei been doing that he’s gotten more or less nowhere in the last four months? Well, for starters, the exchange rate has held steady, with a monthly crawling peg devaluation rate of 2% a month - considering that inflation has been at 4% monthly, that means the real exchange rate is going up, which has not helped on the reserve front. The question of a sudden devaluation is not really an if anymore, but a when, and all signs point to the first three months of 2025 (basically, to not have to deal with currency issues during the midterm election season). One surprisingly positive factor for Milei has been the Bank of Japan related currency issues happening in other countries, because capital controls have kept the peso somewhat stable and expectations have been of currency appreciation in Brazil and other major trading partners, thus softening the blow on the multilateral real exchange rate (which has increased 46% since December - while the global financial pseudo panic chipped away at 1% of the overvaluation, it’s expected to go up around 7% by the end of the year, and return at the extremely overvalued levels previous to Milei taking over).
The fiscal balance, meanwhile, has held strong, with an (unexpected) surplus in June and a slight financial deficit in July (caused by double the average interest payments as over the previous six months). The government has successfully fought back against bills to increase spending, but Milei has also taken another political blow by letting literally every single competing political movement score free points on defending pensioners and public education at his expense.
Underlying fiscal dynamics now that inflation is out of outrageous annualized territory are not very good: real revenue has faltered, since it was being held up by really good international trade related numbers (which, for obvious reasons, are not doing very well), while taxes tied to the domestic economy (VAT, income tax, social security revenue, excise taxes) have not really recovered. On the spending side, the government’s serial reluctance to raise utility bills has put a big damper on what is politically feasible to cut, and declining inflation paired with backwards-looking adjustments to pensions and welfare spending means that high inflation can’t take care of the deficit either.
The government’s recent budget proposal shows this, with a primary surplus of 1.5% of GDP in the first seven months of the year, and of just 0.2% in August through December. The budget also fails to clarify any major macroeconomic questions, because it has completely unrealistic inflation dynamics (a rapid decrease to 1.4% monthly in the final four months of the year, for instance), completely unrealistic GDP figures for 2025 (+5%?), and no adjustments to the exchange rate, yet massively improved import and export tax revenue. Policy wise, it just promises more of the same, without any detail as to which cuts
The one aspect of economic management where there has been significant movement is monetary policy, where the Central Bank has straightforwardly communicated its intentions via very convoluted charts.
The new monetary framework is quite simple: historically, the country has had a very high fiscal deficit, which was funded partially or totally and directly or indirectly via central bank currency creation. Starting in 2020, to ensure that the banks would actually go along with the government’s game, the central bank pressured them on two channels: first, via financial repression, where policymakers restrict all channels of investment except government bonds. Secondly, and to ensure some profitability, the central bank offered private banks interest-bearing liabilities to dump off their liquidity. To sum up a very complicated dynamic, the government had to print money so banks funded the government, then had to also print more money to pay for the interest payments necessary to keep the money they printed off the streets. This meant that higher interest rates eventually resulted in higher inflation (given the more future money printing), and created a very hard to sustain dynamic that could potentially be hyperinflationary under very specific conditions.
In the January through May phase, the Milei government was very clever about this and used financial repression to their advantage: they cut interest rates from 133% to 40% over six months, and because there was a financial surplus (that is, the government didn’t need to borrow any money), then banks didn’t want more central bank assets, so those lower interest rates sucked money out of the economy and thus reduced inflation. The Milei administration goal was to completely cancel out central bank liabilities, which were made up of those interest rate assets (called LELIQ), plus puts on Treasury assets, plus a few random things here and there. Fundamentally, the government saw that the public’s demand for money, of around 9.5% of GDP, was taken up mostly by government assets and not actual money (at around 3.5% in August). So the policy agenda shifted by cancelling out four “faucets”of money printing: to fund the government, to pay for the Ponzi scheme interest rates, weird stuff like Treasury puts, and buying US dollars from exporters4.
What you can take away from the overcomplicated charts of the Central Bank’s details of the future government agenda is that there is no real fundamental vision of what to do next, or at least not one that they’re telling us. The government says that the Jan-May period was of “housekeeping”: bringing up the exchange rate, loosening up price controls, increasing reserves, and cleaning up monetary and fiscal. That’s all fine and good. Now, the government says phase two was completely wiping out the government’s interest Ponzi scheme, and replacing it with a weird setup known as LeFi: the Central Bank sets the policy rate, but the Treasury pays the money out to banks (which is not included in the main interest account due to weird accounting issues), which puts a lot of pressure on the fiscal side of things. This means that bank demand for money is high if the fiscal deficit is low, but a higher deficit can completely tank the demand for money, thus raising inflation.
In the future, what the government intends to happen is quite simple: inflation goes down to 1% a month or less very fast (that is, annual single digits), reserves recover fast, the fiscal surplus remains at around 1.5% of GDP a year, and this increases confidence, so people pump their savings (of USD cash) back into the financial system. Fundamentally what the Central Bank wants to have is some system where the stock of pesos is fixed and the stock of US dollars is flexible and determines fluctuations in the stock of pesos. It’s not really clear whether the exchange rate would float, be pegged, or some strange thing in between - which is the biggest question everyone wants to know!
This is all, of course, completely nuts. Having the peso as the “strong currency” is a very weird decision because it harkens back to both the Great Depression and, more relevantly, the 1995-2001 Convertibility Crisis. To not get into the liquidity trap for the millionth time, the central bank tying itself to a thing it cannot control (gold or dollars) means that, if there’s a recession paired with some kind of financial panic, it is completely incapable of stimulating the economy. Added to the fact that bank demand for money is tied up to fiscal performance, and that demand for money has to be replicated with movements in the reserve stock, then you have an entire policy apparatus that is completely incapable of responding to the business cycle. Bad stuff.
Fundamentally, everyone wants to know the future exchange rate system, particularly because the exchange rate is the only natural anchor for a stabilization program (more on this later), and because it also implies changing a lot of things about the tight system of capital and import controls - which are both reducing the supply of industrial inputs and depressing investment (according to businesses, at least). Milei, to his credit, has been quite smart about this and has said that there’s three necessary conditions to exit the capital controls system (known as “the clamp” locally - like in that one scene of Casino): fiscal surplus, closing the monetary “faucets”, and inflation converging to the 2% monthly crawl. Of course, the latter is the most stubborn, and most economists would agree that without positive net reserves, eliminating currency controls (known as currency market unification) would also imply a big jump in the exchange rate. The market consensus here was that Milei is not playing coy about the exchange rate, but rather, he just doesn’t know what currency regime he’s going towards - not a very good sign, particularly when he’s had a year to come up with it.
Has Milei f****d it?
The Macri macroeconomic (Macrieconomic?) program of 2016-2018 was, of course, a failure (given that inflation is not 2% at the moment), and precisely why is a major question - my take was that inflation targeting was a poor fit for a pre-stabilization economy for various technical reasons, that completely and instantly eliminating capital controls exposed the economy to balance of payments issues (another stalking horse of my macroeconomic takes), and that monetary and fiscal policies were at odds with each other in what’s known as the Unpleasant Monetarist Arithmetic (hey!).
The Milei Agenda, I fear, has already failed to get off to the “failing for interesting technical reasons” way. I think the government has already missed their chance at actually stabilizing the economy. Fundamentally, as I outlined in May, the government pegged the exchange rate for an overly long period of time, which means that a second devaluation is inevitable. Now, I think they can save it by unveiling a clear, credible, and consistent monetary stabilization program at around the same time, as well as getting some money to sort out the “no reserves” thing. But the former is… a crapshoot considering how unclear the whole thing has been, and the latter is a fat chance (anyone remember the funds with 35 billion to instantly dollarize the economy?). The only shot is the IMF, who could be persuaded to pony up several billion if the government makes progress, but they’re going to demand a stabilization program of the normie kind, so we’re back to square one.
The problem is as follows: inflation is stalled at the 4% ish monthly range. Why? Well, first, you have to adjust a bunch of regulated prices, most notably utilities and public transportation. If you adjust them, inflation goes up (some quick math is that they go up around 5% a month, and since they make up 20% of the entire CPI, that means an additional 1% a month). Real wages recover at around 2% a month, which mostly reflects in services prices, which gives out another 0.7 points (taken from a very rough estimate of the CPI weight at 35%). Wholesale prices, which represent the cost of goods (mainly), grow at 2-3% a month, which let’s be generous and say is 0.8 (it includes electric services that are already covered, plus monthly variance). So if the government is right that underlying inflation can converge to 1.5% a month in September to December, readjusting relative prices implies 2.5 extra points - or 4% a month. So the government either gives up on relative prices or it pospones phase three of stabilization for a while.
But it can’t postpone stabilization because the exchange rate is a mess, and a 2% monthly crawl with 4% inflation means balance of payments issues. Can it give up on relative prices? No. Regulated price adjustments have mostly been done on privately owned services (telecommunications, healthcare, and fuels), while public transportation and utilities have lagged behind. Rent is a whole other thing so ignored. So adjusting prices also means adjusting public services, which serves the fiscal stability goal - and not adjusting, by default, means additional spending. It also can’t really do much on the wages end, because risking purchasing power decreases would piss people off royally, and next year is a midterm year where the president could double his share of Congress and have a genuine foothold on power. And nobody really cares about goods prices, but when the exchange rate shot up by 118% in December, wholesale prices increased 54% in one month. It could be possible to square the circle with some kind of price-wage agreement (the main reason those are used, besides “not stopping inflation, is to keep wages down) but that is obviously not going to pass muster with an ideologue like Milei.
I also think that, besides the immediate impact on wholesale prices, a currency devaluation at any point without a plan backing it would not help break inertia. Fundamentally, while “does a currency jump increase inflation” is a complicated question, there is some merit to the notion that at lower inflation rates (where inflation expectations are better anchored) there is little chance of a pass-through effect, and at higher rates there’s a fairly high chance. My intuition here is that, if the government accompanies the devaluation with a plan (and perhaps some money), which includes a detailed exchange rate policy, then expectations will be anchored and the program will succeed even if inflation doesn’t really go its way. If the government, instead, plans for a repeat of December 2023 where vagaries and fiscal hardheadedness carry the day, it will be sorely disappointed. People's expectations aren't suited for that kind of tune, I'd expect.
Conclusion
I think we’re screwed. Given the degree of ball knowing that Milei and his people have exhibited, I wouldn't hold my breath that they can manage the (to their credit, very hard) transition from hammering away at every source of money printing to chipping down inertia and expectaitons.
Well, except for the part that a congresswoman who believes in Flat Earth Theory and a guy who got plastic surgery to look like an elf (he's called The Elf) are blackmailing the President with (allegedly) videos taken by the flat earther while she was dating Milei, particularly of him having some sort of dollarization-related mental breakdown while completely naked.
The chart isn’t precisely accurate: using more recent government data, real wages for all workers were roughly 15% below November 2023 levels in June, and had fallen about 20% by March. There’s also seasonal issues I don’t want to get into in a lot of the data that probably skews December-to-March estimates on the lower end, plus very off the mark initial monthly inflation estimates. It is, however, correct to say that real wages have fallen a lot since Milei took over the government in early December of last year.
Net reserves are gross reserves (aka all USD denominated assets held by the central bank) minus debt owed to China, mandatory reserve deposits by banks on USD-denominated deposits, and a few assets tied up with international and insurance organizations. Per the IMF methodology it also subtracts fluctuations in the value of gold.
This one is a bit perverse because the government achieved it by just not buying USD anymore, hence the stalling net reserves, and also by spending a lot of money on the financial market to keep the financial exchange rates stable.