It’s hard to imagine how the Argentine economy could get much worse.


Economic woes have prompted street protests in the capital of Buenos Aires, five new presidents have been sworn in over the past month, the country is in default on $141 billion in debt and its currency was just devalued by 40%. All this comes after four years of a deep recession bordering on a depression.


The country is now in economic free-fall and international finance experts at Wharton and private firms see no quick way out. “Basically all economic activity has come to a stop,” said Wharton management professor Gerald McDermott in an interview from Argentina on January 9. “The place is bordering on a complete economic meltdown.”


Argentina’s current plight is all the more troubling because only a few years ago the country was hailed as a poster-child for free-market economic reform in developing nations.


Today’s crisis is rooted in dramatic moves Argentina took in the early 1990s to halt hyperinflation that had ravaged the country in the 1970s and 1980s, reaching a rate of nearly 5,000% in 1989, said finance professor Richard Marston, director of Wharton’s Weiss Center for International Financial Research. The country cut its budget deficit, sold off national assets to the private sector and created a currency board to halt the government’s ability to simply print money. To give the new currency, the peso, credibility it was pegged to the dollar at a 1:1 ratio.


Initially, it worked.


“Within a year inflation went down below 10% to U.S. levels. At the same time, interest rates come down. It was an absolute miracle,” said Marston. Economists, he added, worried all along that there would be fallout, but at the time the country needed a dramatic and easily understood policy in order to restore confidence quickly.


Finance professor Richard Herring, director of the Joseph H. Lauder Institute of Management and International Studies, believes that Argentina’s current problems lie in its decision to tie the peso to the dollar. The dollar, for reasons totally unrelated to Argentina, went on to appreciate substantially, making Argentina’s goods more expensive to produce and export. Meanwhile, Argentina’s largest trading partner, Brazil, devalued its currency in 1998 and 1999, thereby exacerbating Argentina’s competitiveness problem.


To get by, the government began to borrow from abroad to pay federal and provincial government obligations. At the same time, it failed to put through changes in its labor laws or other economic policies that would have made Argentine goods more competitive in world markets, Herring said. “That’s tough in a country like Argentina with a long tradition of militant unions. But if you can’t have internal flexibility you really can’t have a currency board. One thing or the other has to be flexible.”


Argentina could have relieved some of the pressure if it had pegged the peso to the euro as well as the dollar or other currencies. The country also let its budget deficits balloon beyond what was sustainable, Herring said. “In this they were, in an odd sort of way, aided by lateral and multilateral aid through the International Monetary Fund that let them sustain big current account deficits longer than they should have.”


In the current crisis, Argentina may roll back the economic reforms it did make, Herring added. “That’s the bad scenario and unfortunately you can’t rule it out.” The best scenario, he said, would be for Argentina to float its currency to a stable level and move forward with deep reforms, not only in the labor arena.


According to management professor Mauro Guillen, “the basic problem that has been facing this country for quite some time – and by some time I mean 30 or 40 years – is it has been unable to find a way of being competitive” in the global marketplace. Argentina tends to go through cycles of opening its economy, then closing it up again when domestic companies and workers feel threatened.


The country remains “a paradox,” he added. While it is “very richly endowed in terms of natural resources and a well-educated population,” its political problems are substantial. “There are certain interest groups in the country, parts of the working class and some parts of the business community, who prefer that the government protect them and they have been able to extract that [protection].”


One concern of the Argentine government and public, for example, is that inflation will return, noted McDermott. An even bigger concern is that the country’s banks will collapse and the country fall into a classic liquidity trap and deep depression. In early January, McDermott was at a posh beach town where even the wealthy were simply not paying for goods and services. “No one can pay their taxes, nobody can get money out of the bank,” he said. “There is literally no cash flow.”


The collapse of Argentina’s economy may be blamed, in part, on misplaced faith in the neoliberal model embraced by so many developing economies after the fall of the Soviet Union, McDermott added. “A lot of them bought into the neoliberal model which said to liberalize and privatize. But that’s not a substitute for good economic institutions.”


For example, McDermott said, the country sold interest in its banks to foreign companies thinking that these entities would automatically bring reforms. But the new owners did not invest much in small and medium-sized companies in ways that might have generated true economic growth.


The country’s current problems should not be blamed on the lack of labor flexibility alone, McDermott added. “You cannot maintain long-term competitiveness on labor rates. You need productivity and you need innovation.”


Argentina’s devaluation hit foreign investors hard, particularly the Spanish, leaving them on the hook for an estimated $6.2 billion. FleetBoston, thought to be the U.S. bank with the largest exposure, delayed its earnings announcement this month because of the crisis in Argentina. The Argentine government “is defaulting on the foreigner,” said Marston. “A lot of foreign companies are asking, ‘Why did we trust the Argentinians?’” An incident like this, he added, typically remains in investors’ memories for five to 10 years.


So far, Herring said, there has been little contagion from the Argentine crisis like that which spread through Asia following the collapse of the Thai baht in 1997. Gregg Wolper, senior analyst at Morning Star International Funds, said investors’ enthusiasm for emerging markets was already weak. “In general, investors have been getting more hesitant for several years now because of the repeated crisis in various countries. The Argentine crisis in itself really hasn’t had the effect of turning them away from emerging markets.”


A workout financed by international financial bodies does not look promising at the moment, though a technical team from the IMF arrived in Buenos Aires on Monday January 14. On January 11, the IMF sent Argentina a letter suggesting it develop a more “coherent” economic policy. The next day, the government said the IMF letter was itself incoherent as well as “offensive.”


“What we see is complete chaos,” said Jaymie Sullivan, senior editor of emerging markets research at Bank Credit Analyst Research Group in Montreal. “It seems that when Argentina has two choices it always takes the wrong one.” She predicted the Argentine government will concede to IMF demands to restructure its economy and that the global financial agency will ultimately deliver a stabilization package. “The rest of the world can’t really let this go on much longer,” she added. “It is complete hysteria in the market and for the citizens of Argentina.”


According to Herring, a U.S. bailout, which helped Mexico in its currency crisis, is unlikely, since Argentina is much farther away and less integrated into the U.S. economy. According to Guillen, he would not be surprised if yet another president takes office and social unrest continues to grow. “What I do hope is that there is not a return to semi-authoritarian rule.”


And according to McDermott, the military has been largely discredited in Argentina, but an authoritarian leader, in the style of Vladimir Putin, could emerge. Argentina’s middle class, the largest in Latin America, is now deeply involved in the crisis. The devaluation, he said, will wipe out its savings and could lead to massive mortgage defaults and bankruptcy. “Finally the middle class is waking up and taking to the streets. These are women with pots and pans, hundreds of thousands of them. They’re saying, ‘we don’t want any more of this; we’ve been snookered.’”


“It’s a big mess and the worst is still to come,” said Guillen. Government officials “waited for so long to relieve the pressure from the system. Now it has exploded.”