By President Javier Gerardo Milei
1. Introduction
Since mid-April, when the access to the foreign exchange market was restored, the monetary debate in Argentina has focused on two issues: the appropriate value of the US dollar and the extent of its pass-through to domestic prices in the event of an exchange rate increase. Although most analysts have greatly missed their forecasts, except for a handful of them and the economic team, what is surprising is their persistent reliance on recurring analytical misconceptions that have led them to be on a negative streak—even before the change in administration. Endogamous behavior is understandable, especially when those who make mistakes are not held accountable, while others are. This is the case where the logic of the Oracle of Delphi prevails (advice is given but no decisions are made).
In summary, I would like to point out that while the widespread claim about the US dollar exchange rate pass-through to prices might have some “empirical support”, it is false and evidences a deep lack of understanding in monetary theory.
2. Origin and Nature of Money
To grasp the nature of money, we must first internalize what an economy would be like without money, i.e., a barter economy. In a pure exchange economy, individuals meet their needs by transacting with their peers, exchanging goods they are willing to offer for goods provided by others. The equation, at first glance, is simple. However, in practice, a barter economy presents two different problems.
On the one hand, we have the issue of the double coincidence of wants, which means that for a transaction to occur two individuals must have mutually compatible needs, each must possess something the other desires at the same time. On the other hand, there is the issue of indivisibility. Even if the problem of double coincidence of wants is solved, ensuring that the goods involved can be divided as needed for the transaction to occur remains a challenge. For instance, imagine a scenario in which I might crave some bread, and a baker might want to hear one of my economic talks. Even in this case, the time and knowledge I am willing to exchange for a kilogram of bread would not help the baker to make a decision.
Faced with this adversity, the baker neither cried nor waited for someone else to solve his problem. He noticed that certain goods were traded more frequently than others, thereby discovering indirect bartering. This alludes to a good that is not purchased for consumption but for trading purposes. Ultimately, in his search for a solution, he discovered commodity money. The incipient forms of money were cattle, linen, salt, tobacco, coffee, and, more recently, cigarettes in prisons.
These goods meet the two basic conditions necessary for money to be valued as such: serving as a unit of account and as a general medium of exchange. However, they fail to serve as a store of value. Essentially, these perishable goods had a negative interest rate when stored because their value decreased over time. And thus, humans have transitioned to metallic money. However, this solution brought some drawbacks: It was both difficult and risky to carry large amounts of precious metals. It goes without saying that faced with this difficulty, people developed certificates of deposit to move around without the burden of excessive weight. And, as usually happens, cheaters found their way. This happened when deposit houses began issuing certificates in their favor without any backing. In response to the resulting disorder, the State stepped in. But instead of focusing on restoring the order, the State decided that it could not tolerate any competition in scamming people (through taxes). Hence, it took control of money issuance, made its currency the only legal tender, and turned what was already unfair into a robbery. The rest is well-documented by history.
3. The Monetary Nature of Inflation
In light of my previous statement, it should be clear that money is merely an indirect exchange good that only serves for the purpose of conducting both current transactions (like buying and selling) and/or future ones (saving for later use). Therefore, understanding this concept reveals that money demand stems from the total demand for goods and services in the economy. To make it clearer, money demand is a mirror demand.
In this context, the demand for money would be determined by the intertemporal consumption vector, and its functional relationship would be given by the parameters governing the consumption vector. Under these circumstances, money demand, just as consumption, would be determined by the intertemporal price vector. In terms of general equilibrium, many economists make a mistake by formulating that money demand depends only on income (derived from the sale of leisure in the labor market and participation in company profits), and the interest rate (which is implicit in the intertemporal price vector; in other words, the price difference between goods now and in the future). Finally, to figure out the equilibrium price vector, three factors that Robert Lucas Jr. called “deep parameters” are needed: (i) preferences; (ii) technology; and (iii) endowments. In turn, if there were money, the monetary base would also have to be added. We should also think about how property rights should be set up, but that is a different topic. To keep things straightforward, let me just assume that we are talking about an economy where people own private property.
Note that if money demand is determined by consumption trends—which ultimately depend on prices, and prices are set by the deep parameters—then, under normal conditions, real money demand would be a solid function that balances with real money supply in equilibrium (money = monetary base, divided by price levels). Thus, we reached the conclusion that inflation is always, and always will be, a monetary phenomenon caused by an excess of money supply. This occurs when the supply increases and/or the demand falls. This results in a loss of money’s purchasing power, which means all prices expressed in monetary units rise.
4. Hume-Cantillon Effect: Empirical Mirage of the Pass-Through Fallacy
Although the outcome is conclusive and essential for the design of a serious monetary policy aimed at ending inflation, its implementation takes time and patience. Specifically, monetary policy does not have an instant effect, it actually operates with delay. In Argentina’s case, the lag ranges from 18 to 24 months. Hence, even if the banknote printing machine were stopped on day one, the purgatory of inflation would last, at least, a year and a half. Therefore, given that the first stage of the BCRA’s balance sheet cleanup called for a six-month period to stop the banknote printing machine, it is expected that inflation will be just a bad memory for Argentinians by mid-2026.
At the same time, the purgatory of inflation may require longer time and/or higher inflation rates if there is money overhang in the economy. This type of phenomena typically occurs in price controls and capital controls. In the first case, the symptom is a shortage of supply. In the second scenario, the main indicators are the exchange rate gap between the FX formal and informal markets, and a loss of BCRA reserves. Moreover, capital controls generate an artificial increase in money demand which implies an increase in the tax base of the inflationary tax, thus exacerbating State fraud.
Besides, the Hume-Cantillon effect takes place over time, following the initial injection of money. Originally, this effect shows how income distribution changes as money flows into an economy. Thus, politicians, the first recipients of money, benefit the most from conducting transactions using today’s money and yesterday’s prices. This has a negative impact on subsequent recipients of money over time. The other side of this is that not all prices rise simultaneously; some increase first and others follow later.
In this context, and surprisingly for those who strongly believe in pass-through effects, the most widely recognized model for open economies with money is that of Rüdiger Dornbusch, also known as the overshooting model. There, he claims that an excess supply of money leads to a jump in the exchange rate that is more than proportional to the rate of devaluation implied by the rate of monetary expansion consistent with the purchasing power parity (PPP).
Thus, once the adjustment in the goods market occurs and surpluses for export increase, the exchange rate falls to the PPP level. It is striking to listen to some economists repeating these notions as if they were part of the Psittaciformes superfamily, seemingly unaware that the Hume-Cantillon effect lies behind them. This effect takes place because the goods market adjusts slowly, while the financial market does so instantly. Thus, in the presence of excess supply of money, people rush to the financial market to seek foreign currency. However, it takes time for the country to generate more foreign currency. This causes the exchange rate to jump much more than proportionately until the markets start to balance out. In other terms, it makes no sense to discuss pass-through effects, as the price level will inevitably converge towards the PPP. Following the same logic, when there is an excess supply in the money market and people start demanding more foreign exchange currency, the US dollar—which is a financial asset—rises first, followed by the prices of tradable goods, wholesale prices, retail prices, and finally, wages. This is the reason why devaluation is so unpopular. In conclusion, the causal relationship still flows from money to prices, and this narrative can also provide the empirical evidence on which the pass-through idea is based. However, when economists discuss pass-through, they actually rely on a poor economic theory because they assume that the causal relationship between exchange rates and price levels is based on an objective idea of value. Therefore, much to their dismay, they are mistaken, since this way of thinking about economic analysis was surpassed in 1871 with the work of Carl Menger, who developed the subjective theory of value concurrently with William Stanley Jevons and Léon Walras.
The reason might be that, deep down, they have moved away from classical economic thinking. The basis of their error dates back to 1936, when John Maynard Keynes dismantled the entire Wicksellian analytical framework (which caused professionals to discuss nonsense until 1972), choosing to ad-hoc revert to the objective theory of value.
If neither the Hume-Cantillon argument nor the one based on the theory of value is appealing, let’s consider a general equilibrium approach. If we develop the complete microfoundations of a general equilibrium model, the excess demand functions for each of the “n” goods in the economy depend on the “n” prices in the economy. In turn, adding the money market as described in the first section of the post implies the existence of an “n+1” system of homogeneous equations of zero degree (that is, they depend on relative prices). Moreover, according to Walras’s law, if “n” markets are in equilibrium, then the remaining market will be in equilibrium too. Therefore, considering money as the unit of account, it will be possible to determine “n” relative prices, which, since they are expressed in terms of money, they are monetary prices. This system can be described as having the following exogenous variables: preferences, technology, endowments, and money supply. It is important to note that the pass-through concept poses a serious issue: the price of foreign currency is endogenous in the general equilibrium system; contrarywise, for many local economists the price is exogenous, which determines the rest of the prices. Taking for granted that they are using general equilibrium models, as they claim, then there is no pass-through because the foreign currency price is both an endogenous and an exogenous variable at the same time. The reasoning exhibits a logical inconsistency. End of the story.
5. Final Thoughts: Menger is Watching
The preceding sections presented a set of aspects related to monetary theory that are crucial for accurately analyzing and understanding the policy implemented by the BCRA. Firstly, we have explained the money demand base as a derived demand from the goods market. Based on these findings, we have demonstrated the monetary nature of inflation. Furthermore, we have refuted the theoretical validity of pass-through, while clarifying that its empirical strength is merely a statistical mirage—one that is resolved within the framework of the monetary theory of inflation when the Hume-Cantillon effect is incorporated into the analysis.
Finally, in light of the subjective value theory, it is appropriate to offer an additional reflection based on Menger’s theory of imputation. In this theory, unlike the objective value, where costs determine prices, the imputation principle indicates that it is prices that determine costs for they are given by preferences, scarcity (technology and endowments), place, and time.
Drawing upon the ideas outlined above, let’s assume we have two goods, A and B. Now, for some reason, there is an increase in the demand for good A at the expense of good B. Accordingly, the relative price of A to B must rise; in other words, the price of A will increase and the price of B will fall. Thus, spending on good A will increase and consequently spending on B will decrease, which will push the price of B down. Now, if the BCRA believes that the price of B should not fall—which would lead to a decrease in activity levels—it will issue money so that the price of B does not drop, although this will cause the price of A to rise more than proportionally until it reaches the relative price of the new equilibrium. Therefore, for inflation to occur, the BCRA should validate rising prices.
In other words, without monetary validation, the price level remains unchanged, and it all comes down to relative prices. Moreover, let’s suppose that, due to the price increase of A, the sellers of good B want to raise the price. I tell you that just around the corner, Menger is waiting to warn them that, by the theory of imputation, they will not be able to sell their products and will end up with their warehouses full of merchandise, reducing asset turnover and destroying returns. Sooner or later, they will learn the lesson, unless they are masochistic. Now refer to good A as the US dollar and good B as the rest of the goods. The story tells itself: without monetary validation, relative price changes do not lead to inflation.
Finally, why do people still believe that the rise in the US dollar increases prices? Essentially, because they have been right for 90 years —except during the Convertibility Plan period—whenever the US dollar rose, prices followed. To make matters worse, during the Convertibility Plan, where the exchange rate was fixed, there was no inflation. Therefore, someone without training in monetary economics may fall victim to the illusion of spurious correlation—just as they might come to believe that a picture of many people wearing swimsuits brings summer, rather than the other way around. However, you would think that someone who spent, at least, four or five years studying economics, has one or more graduate degrees—including doctoral and postdoctoral degrees,—and many years of professional experience would not make such amateur mistakes that can be easily fixed by including the variation of money demand in the analysis. Now, finally, Argentina’s politicians are addicted to fiscal deficit. This pattern helps to explain the series of defaults, tax increases, and, particularly, monetary issuance, which triggered an inflationary disaster. As a result, Argentina has changed its legal tender five times and removed thirteen zeros from its currency over the years. For the good of Argentinians, I hope they take this lesson to heart.
May God bless the Argentine people.
And may the Forces of Heaven be with us.
EGAP
