Stein’s Law and the Coming Crisis in Argentinean Wine

Stein’s Law, named for famed economist Herbert Stein, holds that if something cannot go on forever it will stop.  Unsustainable trends ultimately yield to the inevitable in one way or another.

Stein’s Law seems to be simply stating the obvious, but you would be surprised how many people find a way to ignore the obvious when it is in their interest to do so.  As Upton Sinclair wrote, “It is difficult to get a man to understand something if his salary depends on his not understanding it.”

Argentina’s Inflation Problem

And so we consider the case of the Argentinean wine industry. It’s not just the wine sector, of course, it’s the whole Argentinean economy, but wine is especially affected.  Something’s going to happen according to Stein’s Law, because it can’t go on forever as it has up to now, but it is hard to know exactly what.

The problem begins with Argentina’s high inflation rate. The official statistic puts the annual increase in consumer prices at around 10%, but this number is viewed with disbelief by the international economic community. The Economist magazine quit publishing the official figure in 2012, saying “Don’t lie to me, Argentina” to the officials there. The most commonly cited estimate of the actual inflation rate is 25% per year.

Inflation is a sensitive political issue in Argentina as it is in every country that has ever experienced a hyperinflation crisis (think Germany, for example). Some in Argentina go to great lengths to deny the obvious reality of inflation.

The story (which may be true) is told about a McDonalds restaurant in Buenos Aires that displayed all the usual products on its big backlit menu board except the signature Big Mac. Where’s the Big Mac? Oh, we have that price hidden around the corner so that no one will see it — especially the people from The Economist magazine who use it to estimate the purchasing power of the peso in their Burgernomics index!

Inflationary Squeeze

As a recent article on The Drinks Business website suggests, high inflation is putting the squeeze on Argentina’s wine producers. (The squeeze is made worse,  I understand, by government policies that restrict imports of products used in wine production as part of a general policy to control foreign exchange reserves). Production costs (grapes, labor, etc.) may have doubled over the past four years, putting a squeeze on margins.

It is difficult to pass these peso costs along to consumers in the U.S., Canada, the U.K. and Brazil, the main export markets. Consumers are price sensitive and while the average export price of  varietal Cabernet and Merlot wines have risen by 7.2% and 24.8% respectively in the past year, this provides only limited relief from rising costs since Malbec takes the lion’s share of the export market and its dollar export price has risen by just 1% in the last year and by an average of only 2.8% per year since 2009.

Purchasing Power Inaction

The textbook remedy to this situation is for the foreign exchange value of the peso to fall to achieve what economists call Purchasing Power Parity. In a system of market determined exchange rates, according to the PPP theory, a 25% fall in the domestic purchasing power of the peso due to inflation should result in a 25% decrease in its foreign exchange value.

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And indeed the peso has depreciated, but not by nearly enough to overcome the inflation difference between Argentina and the four main export markets. The peso has fallen in value by about 20% in the last two years, if we look at the official exchange rate, so each dollar of export earnings brings in more pesos,  but inflation-driven peso costs have increased by much more.  That puts a real squeeze on margins. This can’t go on forever — something has to give.

[I'm told that the black market exchange rate is 8 pesos per U.S. dollar, far below the official rate of about 5 per dollar. Such a big differential is often an indicator of crisis to come.]

Something’s Gotta Give

What happens when a country gets itself caught in a squeeze like this? Well, the conventional wisdom is there needs to be a sharp currency devaluation followed by monetary tightening to control inflation. This is a painful process and Argentina has been through it before. What if the government ignores the conventional wisdom? Internal adjustment must eventually take place to restore competitiveness if external adjustment through the exchange rate is ruled out.

A recent Wall Street Journal article about real estate prices in Buenos Aires shows one pattern of adjustment. The dollar prices of luxury apartments have tumbled as owners seek to cash out of their real estate investments and buy into the more credible U.S. currency.  The WSJ reports that

In May last year, Argentine President Christina Kirchner strictly limited access to U.S. dollars and other foreign currencies in a bid to stem capital flight. With the Argentine peso facing about 25% annual inflation (government figures, widely discredited, set the rate much lower), and an unofficial exchange rate that has effectively devalued the peso sharply, demand is high for dollars.

These days, the main feature that foreign buyers say they look for in a Buenos Aires property has nothing to do with closet space or a wide terrace. It is a seller with a bank account outside Argentina to which they can legally wire funds. This is a way to get around having to convert any dollars wired into Argentina into pesos at the official rate, after which it is nearly impossible to convert back into dollars at the official rate.

Something will have to give in the wine industry, too, if the exchange rate doesn’t adjust and the currency controls continue. In the meantime, I think every effort is being made to control costs and to keep margins out of the red. But, as Herb Stein might say, this can’t go on forever so somehow it will stop.

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Herbert Stein may be best known today as father of Ben Stein, the actor, law professor, and columnist, but he was ever so much more famous in his day as a chairman of the president’s council of economic advisers

Little known fact: the Pabst beer company held an economics competition in 1944 (the year of the Bretton Woods conference)  for the best plan to sustain high employment in the post-war era. Herb Stein’s plan was named the winner from among the more than 36,000 entries. He was 28 years old and the prize was $25,000 — the equivalent of $330,000 today.

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6 responses

  1. I enjoyed your piece on Argentina in part because of so many questions it raised.
    You said. “wine is especially affected” without demonstrating why. Inflation doesn’t usually hit a single industry especially hard. It’s traditional for any business affected by anything to claim that they’re especially hard done by and it’s “unfair”.
    And inflation isn’t all bad. Anyone who owes money loves inflation because t hey can pay the loan back with cheaper money. Banks hate inflation because it means they can’t rent money for as much in real terms as they can when inflation is low. The rich despise inflation because it means they’re not so rich in buying power as they used to be.
    Is 25% a year outrageous inflation? In Canada’s larger cities house prices in the late 70s went up far faster than that before Stein’s Law made them drop like a rock but no one confused that with Germany’s hyperinflation in the early 1920s. At 25% inflation companies often pay very high dividends. People buy the stocks; bank the dividends and when inflation gets under control have a lot more buying power.
    And finally, I’m sure Stein’s Law, like the law of diminishing utility, has exceptions. You’ve given me a lot to think about.

  2. Yes, I too would have liked you to correlate your thesis of inflation with wine and import/export issues.

    Are you implying that with the stronger dollar (esp after a massive devaluation), that ARG wine will be even cheaper than it is now?

    Or perhaps it may not be cost effective for them to export it since the costs may be more than what they can recoup? Then there will be an internal glut on their domestic market.

    And is the ARG central bank giving out free money much like the US Fed in order to stimulate their economy?

    I would enjoy a follow up to this article.

    Dileep

  3. A very informative and troubling article for those of us who care about Argentine wine–for all kinds of reasons. Certainly part of Argentina’s success over the past decade has been the extremely competitive price/quality ratio of their wines, a ratio that was the product of fundamental upgrades to the industry that produced high quality in the 1990s when the peso was strong and the ability to offer those quality wines at relatively low international prices when the peso significantly weakened after the 2001-02 crisis. It would appear that the industry’s price/quality ratio is now seriously threatened. One question: While the effect of inflation and currency control appears to be clearly shown for Cabernet Sauvignon and Merlot, how has Malbec been able to escape so far?

  4. Thanks to everyone for the comments.

    I would say that the wine market is especially affected by the economic crisis in Argentina because it uses imported inputs that are subject to the currency control bottlenecks, pays most of its costs in pesos but receives most of its earnings in dollars, which must be converted at the disadvantageous official exchange rate. The dollar export price is fairly rigid because of market conditions in the importing countries, which make cost pass-through difficult.

    The dominance of Malbec in the exports is based on consumer preferences in the export markets. Difficult recent harvest have made problems worse, although things look better on this front for 2013 I am told.

    Argentinean producers have been through economic crises before and are very resourceful. Margins have been trimmed and may be negative for some producers. The switch to bulk shipping, which is happening just about everywhere, is perhaps even more important for larger Argentinean producers because it allows them to shift some of the costs out of the peso. Is a shake-out possible if things continue as they are? Yes.

    Thanks again for comments.

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