INFLATION AND STABILIZATION IN LATIN AMERICA

Leonardo Vera
JANUARY 2003

Latin American Centre Topics in Latin American Economics University of Oxford

Directed by Rodrigo Cubero-Brealey

WHY LATIN AMERICAN INFLATIONARY EXPERIENCES HAVE CAUGHT WORLD ATTENTION?

Latin American countries have been plagued with inflation over several decades without parallelism
There have been several episodes of extreme inflation with. Bolivian Inflation, for instance, between May and August of 1985 reached an annualized rate of 60,000 percent, the seventh worst case of hyperinflation in history. During the second half of the 20th century the region presented many interesting events of low and high inflation, hyperinflation as well as stabilization experiences. A rich debate focusing not only on the theoretical causes of inflation but on its appropriate solutions emerged

SOME PRELIMARY REMARKS

Inflation is the change in purchasing power of a unit of domestic currency during a period of time. More money is needed than before to achieve the same amount of purchasing power The rate of Inflation is calculated as the rate of change of the consumer price index (CPI)

The Consumer Price Index is calculated from a market basket of consumer goods and services
Occasionally it gets out of control: After World War I, for instance, in Germany money as so little value that a weeks wages had to be transported in a wheelbarrow. In Mxico, in periods of high inflation people bought new cars a put them on blocks because they retained their value reasonable well.

THE COSTS OF INFLATION

The economy start to emphasize finance at the expense of production (hedging, hoarding and speculation displace real production) Informational costs: inflation may distort information used to make comparisons between goods, generating problems of allocation and diminishing welfare. Re-distributional Costs: Income generated by long-term nominal contracts shrinks in real terms. Typical redistribution from lenders to borrowers. Capital flight may rise as people loose confidence in the local currency causing balance of payments problems Inflation may undermine institutions and conventions (past practices) such as rules of thumbs and contracts Menu Costs in the sense that firms have to spend time and money posting new prices in catalogues, and on ticketed merchandise

INFLATION, HIGH INFLATION AND HYPERINFLATION

Latin American countries have registered all types of inflations
In general low inflation countries have average inflation rates below 10 percent. These rates do not raise major costs to the economy. It is the typical range found in developed economies. You may play a fine tuning game. As inflation rises, volatility in the inflation rises as well and people start to develop protective behaviour. That kind of inflation becomes chronic but does not turn easily into hyperinflation. In extreme cases hyperinflation develops. In this case the increase in prices is always greater than increase the money supply People do not want to hold domestic currency Long-term contracts disappear of the economy

FAMOUS INFLATIONARY EPISODES

During the Roman Empire: Emperor Gordian in the third century reduced the silver content of the coins (silver denarius). Edict of Diocletian (301 A.D.) Spain in the sixteenth century, following the discovery of precious metals in America

US War of Independence, 1779-1780. Inflation reached 1,000%.

French Revolution. Introduction of the assignats (paper currency). Inflation reached 3,000% in 1795 US Civil War. Inflation reached 40% per month in the confederacy

THE THREE HYPERINFLATIONARY PHASES IN THE TWENTIETH CENTURY

The aftermath of World War I Between 1921 and 1924 hyperinflation developed in: Austria, Germany, Hungary Poland and the Soviet Union In the wake of WW II Hungary China and Taiwan Greece In the 1980s after the Debt Crisis Argentina, Bolivia, Brazil, Nicaragua, Per, Poland and Yugoslavia

German Hyperinflation: 192123

figure 2. Selected Latin American Countries: Inflation Performance

(Annual percent change in consumer price index) 600 500 400 300 200 100 Latin America 3500

485 percent

3000 2500 2000 1500 1000

Argentina

3,080 percent

500
1984 Bolivia 11,750 percent 1987 1990 1993 1996 1999 2002 0 1981 3500 3000 2500 2000 1500 1000 500 1984 1987 1990 1993 1996 1999 2002 0 1981 50 45 40 35 30 25 20 15 10 5 0 1981 1984 1987 1990 1993 1996 1999 2002 Brazil 2,948 1984 1987 1990 1993 1996 1999 2002

Selected Latin American countries

0 1981 14000 12000 10000 8000 6000 4000 2000 0 1981

Recent Inflation Performance

50 Chile 45 40 35 31 percent 30 25 20 15 10 5 0 1981 1984 1987

Colombia 32 percent

1990

1993

1996

1999

2002

1984

1987

1990

1993

1996

1999

2002

140
120 100 80 60 40 20

Mexico

132 percent

8000 7000 6000 5000

4000 3000 2000 1000 0 1981

Peru

7,486

0 1981

1984

1987

1990

1993

1996

1999

2002

1984

1987

1990

1993

1996

1999

2002

Source: IMF,

World Economic Outlook.

COMMON ELEMENTS OF THE INFLATIONARY EXPERIENCES IN LATIN AMERICA

High Budget Deficits

Rapid Increases in the Money Supply

Exchange rate Depreciation or Strong Devaluations

Based on the inflationary experiences in the southern cone, a strong debate started in the 1950s between two school of thought, the so-called monetarists and the structuralists. The debate was enriched over the years by the New Monetarists (Rational Expectations School) and the Inertialists (or New Structuralists). The debate have focused on the theoretical causes of inflation and its appropriate solution

INFLATION () AND MONEY GROWTH IN LATIN AMERICA

MAIN TENETS OF MONETARISM

Inflation: Too much money chasing too few goods Most Known Exponents: Bresciani-Turroni, Phillip Cagan, Milton Friedman, Tom Sargent, and the IMF Interpretation Budget Deficit
(weak governments, populism, expansionary keynesian policies, subsides, industrialization policies)

Expectations of Fiscal Disarray

Loss of International Reserves (if a fixed ER regime operates) or Exchange Rate Adjustment (in a flexible ER
system)

Increase in the Money Supply

(by printing money)

Inflation
(as a result of the excess of money)

Capital Flight, Currency Substitution, and Severe External Problems

MORE ON BUDGET DEFICITS AND

Government Budget Constraint
DEF = G T = MB + B 1. Deficit financed by bonds, no effect on MB and Ms 2. Deficit not financed by bonds, MB and Ms

Financing persistent budget deficit by money creation leads to sustained 1. Deficit financed by Ms leads to AD shifts out 2. If deficit persists, Ms continually and get P continually, i.e., as Conclusion: Deficit , only if it is 1. Persistent 2. Financed by money creation rather than by bonds

MAIN TENETS OF STRUCTURALISM

Inflation: The structure of LDCs give rise to imbalances and rigidities accommodated by passive money

Most Known Exponents: Osvaldo Sunkel, Julio Olivera, Dudley Seers, Lance Taylor, Edmar Bacha.
Interpretation External Sector Vulnerability: Fall in the
Terms of Trade, The Need of Key Imports, Increase in the Debt Service, Sudden Stops of Capital Flows

Monetary Policy Accommodates

Increase in the Budget Deficit

ER Depreciation or Devaluation
Price and Wage Increases

Increases the Debt Service in Domestic Currency Economic Contraction

Reduction in Tax Collection

POLICY RECOMMENDATIONS
Monetarists (a) Fiscal Adjustment (b) Limits to Money Creation (c) Liberalization or a freeing of markets from Government Intervention

Structuralists
(a) Government Investment in Key Sectors (b) Industrial Policy (c) Income Policies

INERTIA
During the 1980s and 1990s New Structuralists have emphasized the role of Inertia in the propagation and chronic behaviour of Inflation In LA countries sometimes contracts are written to include an adjustment for inflation (indexation) Formal indexation is usually backward looking. Wages, prices and contracts are adjusted for past inflation Also the shortening of the interval for adjustment of wages, prices, public sector prices and the exchange rate appears as inflation increases.

Inertialists claim that these two factors (indexation and the shortening of the intervals of price adjustments) will not allow drastic fiscal adjustment or fixed exchange rates to stop inflation rapidly. There is some inertia and the costs in terms of output can be severe.

FOUR RECENT EPISODES OF STABILISATION IN LA: Bolivia (1984-1985)

FACTS
Between 1971-1978 (during Hugo Banzer regime) Bolivia experienced favourable terms of trade and heavy borrowing (procyclical financial markets) By the late 1970s and early 1980s falling commodity prices (TIN) and tight international credit put an end to easy economic times By 1982 inflation was running at almost 300 % per year. Siles-Suazo, the head of a leftist coalition was put under pressure by strikes and lockouts and demands were attended increasing the fiscal deficit and money creation Bolivia faced a combination of debt overhang, huge fiscal problems, dolarization and social conflicts.

THE STABILISATION APPROACH

In 1985 the elected government of Victor Paz Estensoro implemented a stabilization plan (in September inflation had reached 56% per month)

The government declared a moratorium of Debt Service (accepted by the IFI)

The exchange rate was fixed The government implemented a deep fiscal reform (sharp increase in public sector prices, reduction of subsidies to the mining industry and public sector wage freeze) By 1986 inflation reached 66% (from 8.178% in 1985

FOUR RECENT EPISODES OF STABILISATION IN LA: Mxico (1987-1989)

FACTS
Mexico suffer chronic and moderate inflation since the 1970s Severe external crisis in 1982, debt overhang and exchange rate adjustment Rounds of new devaluations and fiscal austerity programmes in 1986 and 1987 accelerated inflation Failure of Orthodox Programmes led Miguel de la Madrid to look for alternatives with less output and employments costs

THE STABILISATION APPROACH

In 1987 the government announces the Economic Solidarity Pact, which was followed by the Pact for Economic Stability in 1989.

Strong adjustment of the peso followed by smalls and decreasing over time adjustments in the exchange rate
Guidelines for wage and price adjustments (voluntary agreements monitored by the three parties: business, labour and the government) Tariff reduction and trade liberalization Inflation diminished slowly and the costs in terms of output were low

FOUR RECENT EPISODES OF STABILISATION IN LA: Argentina (1990-1991)

FACTS
In June 1985 the annualised inflation rate reached almost 6,000 %.
Austral plan I and II; which consisted of wage-price controls and fixed ER were relatively successful in the short-run. When the price freeze was lifted, prices took off. At the time of presidential elections in 1989, the government of Alfonsin was weak, isolated and unable to collect taxes. In May interest rates hit 150% per month. Rumours spread the government had run out of paper and ink to print money. The situation led Alfonsin to step down early after the elections.

THE STABILISATION APPROACH

In 1991, after huge chaos, the convertibility plan was launched by the government and approved by the congress. Convertibility of the peso at 1-to-1 rate with the US dollar and obligations of the monetary authority to maintain full backing of the monetary base in foreign reserves were mandatory. The law also banned any kind of automatic price adjustment linked to domestic prices and contracts in foreign currency were allowed. The programme was complemented with a massive privatisation of public utilities (which solved partially the fiscal problem). The government implemented deep trade and financial liberalization. Successful results at curbing inflation.

FOUR RECENT EPISODES OF STABILISATION IN LA: Brazil (1984-1985)

FACTS
Until the mid 1980s inflation in Brazil was relatively stable because of dissemination of backward looking indexation. The relatively stability collapsed n 1986 with the Cruzado Plan. Inflation subsequently presented a upward trend. About 11 economic plans followed after the Cruzado plan with no success at curbing inflation. Fears emerged in terms of the survival of the fragile new democratic system.

THE STABILISATION APPROACH

Advocated by then finance minister Fernando Henrique Cardoso, the Real Plan was launch in June 1994. It had three phases.
Phase one of the plan was an attempt to secure fiscal stability through tax increases, expenditure cuts and the reduction of compulsory transfers to local administrations. Phase two, contemplated the creation of the Unit of Real Value (URV), a stable unit of account whose nominal value increase daily according to the rate of inflation (of cruzeiros reais).

Phase Three, was the transformation of URV into At the end of June 1994 inflation was running at the astonishing rate of 7,000% the Real . In took place in June after relative prices were aligned. per year. Severe problems in the fiscal front and the external sector. Inflation declined drastically

FOUR CASES OF STABILISATION IN LA

Evolution of the Rate of Inflation Before and After Stabilization Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Bolivia 24 25 296 329 2177 8170 66 11 Mexico Argentina Brazil

28 59 102 66 64 106 159 52 20 30 19 12 8

385 82 175 388 4924 1833 84 18 7 4 1,6 0,1

211 228 58 366 993 1765 2360 421 989 2086 2312 75 11 8