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Second Quarter 2023, 
Vol. 105, No. 2
Posted 2023-04-10

External Shocks versus Domestic Policies in Emerging Markets


Debt crises in emerging markets have been linked to large fiscal deficits, high inflation rates, and large devaluations. This article studies a sovereign default model with domestic fiscal and monetary policies to understand Argentina's experience during the 2000s commodity boom (2005–2017), following the default of 2001. The model suggests that domestic policies played a critical role in Argentina's poor economic performance. Despite exceptionally favorable terms of trade, a rise in government spending led to higher taxation, inflation and currency depreciation, and lower output. Economic performance would have been worse had Argentina followed a strict, rather than accommodative, monetary policy without curbing its expansionary fiscal policy. Finally, limited access to international credit markets during this episode did not appear to play a significant role.

Emilio Espino is an associate professor of economics at Universidad Torcuato Di Tella. Julian Kozlowski is a senior economist, Fernando Martin is an assistant vice president and economist, and Juan M. Sánchez is a vice president and economist at the Federal Reserve Bank of St. Louis. The authors thank Rody Manuelli for valuable comments and Samuel Jordan-Wood, Marco Spinelli, and Olivia Wilkinson for research assistance.


Inflation, exchange rates, and fiscal deficits play key roles in sovereign debt crises. Revisiting the history of Latin America, Kehoe, Nicotine, and Sargent (2020) argue that "despite their different manifestations, all economic crises in Latin America have been the result of poorly designed or poorly implemented macro‐fiscal policies.'' On the other hand, there is a long tradition connecting domestic economic performance to external factors. For example, Drechsel and Tenreyro (2017), Fernández, Schmitt-Grohé, and Uribe (2017), and Fernández, González, and Rodríguez (2018) find a significant contribution of commodity price shocks to output fluctuations.

In this article, we contribute to the classic debate on whether external factors or domestic policies explain the poor economic performance of emerging countries. To this effect, we study the experience of Argentina  following the default of 2001, specifically between 2005 and 2017. Two driving forces, favorable terms of trade, and an increase in government expenditure go a long way in explaining the country's macroeconomic performance  during that period. Our exercise suggests that government expansion accounted for the rise in taxation, inflation, and currency depreciation and kept output growth low, countering the benign effects of favorable terms of trade. We also argue that following a strict monetary policy, though potentially successful in containing inflation and currency depreciation, would have been detrimental without addressing the rise in spending. Finally, we find that varying Argentina's access to international credit markets does not alter the story significantly.

Our analysis employs the framework developed by Espino, Kozlowski, Martin, and Sánchez (2022, hereafter EKMS). The economy is a version of a tradable-nontradable (TNT) small open economy (as in Uribe and Schmitt-Grohé, 2017, §8), extended to include production, money, and sovereign default. The government makes transfers and provides a public good, and it obtains resources from labor taxes, money creation, and external debt issued in foreign currency. Each period, the government may choose to repudiate the debt, at the cost of temporary exclusion from international credit markets and lower productivity. Importantly, the government lacks the ability to commit to future policies.

The experience of Argentina from 2005 to 2017 allows us to use the model to shed light on the debate of the role of external factors and government policy in explaining macroeconomic outcomes. During this period, Argentina experienced favorable terms of trade due to a global boom in commodity prices. At the same time, government spending grew considerably and taxation and inflation rose significantly. In our analysis, we take  the term-of-trade boom and the rise in government spending as given and let the model predict debt, taxes, inflation, currency depreciation, and output. We also conduct several counterfactuals to understand the role of exogenous and endogenous factors.

We obtain four main results. First, our model simulations imply that the rise in government spending, coupled with an accommodative monetary policy, was the main driver of higher taxation and inflation and lower output. In other words, domestic policy was to blame for Argentina's poor economic performance. Absent the expansion of government, the boom in commodity prices would have implied a rise in real output.

Second, the interaction of fiscal and monetary policies played an important role. If Argentina had followed a strict monetary policy by fixing the money growth rate, inflation would have been contained at the cost of even higher taxation. The result would have been lower output. One could further conjecture that an unwillingness to raise taxes to accommodate a strict monetary policy in this counterfactual scenario might eventually lead to debt crisis.

Third, the simulations and counterfactuals suggest that the boom in commodity prices might have facilitated the rise in government spending. In our benchmark scenario, inflation rises 10 percentage points between 2006 and 2012, which closely matches the experience for Argentina. In the absence of a commodity boom, the increase in inflation would have been 15 percentage points. Similarly, gross domestic product (GDP) expressed in US dollars would have decreased rather than increased and would have limited  Argentina's ability to borrow internationally when it reentered credit markets in full in 2016. 

Finally, we find that exclusion from international credit markets did not play a major role in explaining domestic policies or macroeconomic performance. We show this result by running a counterfactual in which the government gains full access to international debt markets in 2005 instead of 2016. Although the government would have used debt upon reentry (driving the debt-to-GDP ratio to be 10 percentage points larger by 2016), the evolution of the model's main variables is affected in only a minor way. However, we find that earlier debt accumulation would have lowered Argentina's capacity to handle the adverse shock to its terms of trade that occurred in 2013.

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