ECON The Economy of Latin America Orthodox and Heterodox by marcjackson


									ECON 4311: The Economy of Latin America

        Orthodox and Heterodox
         Stabilization Programs
After the 1982 Debt Crisis, the Latin American countries
realized that something had to be done in order to bring
the economies back to normal.

Several stabilization programs were undertaken, with sev-
eral objectives: reduction of inflation, correction of bal-
ance of payments disequilibria, output reactivation, and
so on.

In this class we will focus on a special kind of stabilization
programs undertaken in the 1980s in Latin America: the
so-called heterodox stabilization programs.
The difference between Orthodox and Heterodox Pro-

   Stabilization programs in Latin America can be (roughly)
   categorized into orthodox or heterodox.

   Stabilization programs are closely associated with their
   explanations of inflation.

   Orthodoxy : derived from the monetarist interpretation
   of inflation.
Examples of orthodox programs in Latin America:

 - Chile (1956-58, 1973-78)

 - Argentina (1959-62, 1976-1978)

 - Brazil (1964-73, 1982-1983)

 - Bolivia (1956, 1985), Peru (1959, 1975-1978), Venezuela

 - Mexico (1983).

None of them obtained success without a high social cost.
Heterodoxy : based on interpretations of structuralism
and inflation inertia.

Examples: the Austral Plan in Argentina, the Cruzado
Plan in Brazil, the Inti Plan in Peru.

In Mexico: the Pacto Plan was a combination of orthodox
austerity followed by heterodox incomes policy. It was a

  In Latin America, if one talks about orthodox stabilization
  programs, the first idea associated to it is the IMF.

  Although the IMF was created to aid in the management
  of a stable international exchange rate system, its main
  activity since the 1970s has been to manage foreign ex-
  change crises of Third World countries.

  Since Mexico’s default in the 1982, the IMF became the
  major organizer of debt agreements. The banks insisted
  on linking their rescheduling agreements to the fund’s
  seal of approval for a debtor’s economic policies.
The IMF’s prescription for balance of payment problems
and inflation invariably involves a sharp recession: only by
slowing down spending it will be possible to bring prices
and trade balance back in line.

For many, the cure seems as sensible as bleeding a fever-
ish patient. The poor suffer a lot.

Monetarism supplies the rationale for orthodox programs:
budget deficits and consequently fast money growth cause
Main Ingredients of an Orthodox Stabilization Program

(1) Cuts in budget deficit:

     - The first target is often the government payroll (since
       in most Latin American countries the government is
       one of the main employers).

     - Second instrument: privatizations of publicly owned
       firms (airlines, telephone, electricity, etc).

(2) Devaluations: Improve current account by raising the cost
    of imports and making exports more attractive.
(3) Freeing prices:

     - Price freezes usually hurt producers by limiting the
       amount they can receive for their output and thus
       creating urban food shortages.

     - Price controls increase fiscal deficits (either prices of
       public services or by tax collection).

(4) Liberalization of imports and exchange controls.

(5) Higher interest rates.
(6) Real wages must fall:

     - Lower real wages increase the competitiveness of ex-
       ports and encourages firms to hire more labor.

     - High real wages in the formal sector may reduce the
       number of good jobs, and hence might push workers
       into the informal sector.
Most orthodox programs are aimed at one of several core

 - Smaller role of the government in the economy.

 - Stable prices through slower monetary growth.

 - Greater competitiveness and efficiency by bringing prices
   into line with costs.

 - Balance of payments stabilization through promotion
   of exports and foreign investment.
The Political Implications of Orthodox Stabilization

   Orthodox stabilization programs are unpopular because,
   at least in the short run, they lower the standards of

   As a consequence, governments are reluctant to apply
   them, since they might erode their popularity.

   Thus, there is a debate about the fact that orthodox
   programs can only be implemented under authoritarian

  Programs based on a combination of income policies, fis-
  cal correction and monetary reform.

  They recognize that aggregate demand discipline is not
  enough. They propose government intervention to stabi-
  lize the economy.

  Wage and price controls (and freezes) to stop inertia in in-
  flation by making consensus. Analogy to football games.

  They also urge a big reduction in fiscal deficits.
Heterodoxy calls (in contrast with the IMF) for monetary
expansion to avoid increasing real interest rates.

Monetary reforms (or the introduction of a new currency)
has also been associated with heterodox programs. In
1985 Argentina introduced the austral, and Peru the inti.
In 1986, Brazil introduced the cruzado. Rationale:

 - Ease bookkeeping by eliminating zeros (convenient when
   things are traded in the millions).

 - Fight inflationary expectations by introducing a new
   currency as a symbol for policy change.

 - Avoid wealth transfers.

   Suppose you owe 1000 cruzeiros in period t, and promise
   to pay 10% interest in t + 1, plus principal. Imagine the
   expected inflation is 8% ⇒ real interest rate around 2%.

   Imagine govt introduces a new currency, the cruzado at a
   exchange rate of 1000 cruzeiros per cruzado. This means
   that in t + 1 you would owe 1.1 cruzados.

   Suppose that with this cruzado plan, the government is
   successful in lowering inflation, and it turns out to be
   zero. Then, the borrower ends up paying a 10% real in-
   terest rate (instead of an expected 2%) ⇒ wealth trans-
   ferred from borrower to lender.
Imagine now that the government introduces a tablita,
i.e. a schedule of exchange rates of old currency for new
currency. For example: in t, 1000 cruzeiros for 1 cruzado,
in t + 1, 1078 cruzeiros for 1 cruzado.

Then, in t + 1 the borrower owes 1100/1078 = 1.02
cruzados. The interest rate is 2%, as originally planned.

The tablita provides an instrument to align the real value
of payments with the expectations implicit at the time
the contracts were signed.
Wage contracts pose a problem in designing a freeze.
Workers will ask for a compensation for expected infla-
tion, but this would create inflation inertia.

On the other hand, there might be workers that just
received their compensation and might find themselves
with a higher real wage. Not “fair”.

Heterodox programs ended with rapid acceleration of in-
flation in Brazil, Argentina, Peru, and many others.
The Austral Plan (Argentina)

   Initiated in June 1985. It had three fundamental points:

  (1) Prices, wages and exchange rate management: As a way
      to break inflationary expectations, a price freeze was
      decreed in June 1985. Public wages were frozen and
      the (nominal) exchange rate was fixed.

  (2) Fiscal adjustment: By late 1984, Argentina’s fiscal fi-
      nances were out of hand (deficit was almost 15% of

      Designers of Austral Plan tackled this by imposing
      higher prices for public services, higher import tariffs
      and forced savings schemes for workers.
    These policies reduced deficit to 2-3% of GDP by
    late 1985, but this success was short-lived, with deficit
    around 7% of GDP by late 1986.

    Why? Since public services prices were fixed, they
    declined in real terms, increasing the deficit of state-
    owned firms.

(3) Monetary reform: The peso was replaced by a new cur-
    rency, the austral. Contracts initially signed in pesos
    were converted into australes using the desagio mech-

    Monetary policy: wanted to remonetize the economy
    by increasing domestic credit.
Initially, the Austral Plan was a success: inflation dropped
from 350% in the first half of 1985 to almost 20% in the
second half.

Euphoria predominated, and early success was declared.
Interest groups started asking the authorities to relax
their fiscal stance.

Given that inflation was still present, and since the nom-
inal exchange rate was fixed, the real exchange rate be-
came overvalued, and the external accounts started show-
ing deficits.
Also, public services prices started to lag in real terms.

In April 1986, the main anchors (nominal exchange rate,
public sector wages and public services prices) were given

A crawling peg was introduced, and wages and prices were
increased. By that time, euphoria had vanished, and the
program had lost credibility.
By late 1986, fiscal deficit was around 7% of GDP, and
inflation was soaring.

By 1989, per capita output was lower than it had been
15 years ago.

In 1988, as inflation was accelerating, the Alfons´ admin-
istration took the first steps towards trade liberalization
(more on this later).
The Cruzado Plan (Brazil)

   Policymakers believed that past inflationary shocks were
   being perpetuated in a vicious circle by indexation, and
   that the freezing of prices, exchange rate and wages
   would break this vicious circle.

   In February 1986, President Jose Sarney unveiled a bold
   stabilization plan.

   As in Argentina, the main belief of the program was that
   indexation was the root of all inflationary problems.
Main Elements

 - A monetary reform replaced the cruzeiro with the cruzado,
   which was fixed to the dollar.

 - A tablita was devised to eliminate the expected inflation
   in contracts.

 - Sharp initial monetization of the economy to avoid ex-
   ceptionally high interest rates.

 - General price freeze at the February 28 levels.
- Wages were transformed from cruzeiros to cruzados at
  a level corresponding to real wages from the previous six

- Indexation clauses were eliminated from every contract
  of less than one year.

- An automatic mechanism for wage adjustment was to be
  put into effect every time accumulated inflation exceeded
The program did not consider any explicit fiscal or mon-
etary targets.

External conditions favored the program in three aspects:

 - World interest rates declined, reducing the debt service

 - World oil prices fell.

 - The drop of the value of the dollar reduced the cost
   of the dollar-denominated debt and imports.
Inflation dropped, but this was short-lived. Between Febru-
ary and June, the accumulated inflation rate was almost

Industrial production increased by 12% in the first half of
the year, relative to the same period in the previous year.

However, mostly as the result of lack of fiscal control and
credit control, inflation rebounded to 44%.
Policymakers avoided to make adjustments until after the
November election.

The structure of the CPI was changed 5 times to conceal
price increases in the year before Nov 1986.

Credibility on the program dwindled.

In September 1986, the fixed nominal exchange rate pol-
icy was abandoned.
The Pacto Plan (Mexico)

   Probably the most successful of the heterodox programs
   in Latin America (although it was not completely hetero-

   Reduced inflation from almost 160% in Dec 1987 to

   In Dec 1987, the Pacto de Solidaridad Social was signed
   by the Mexican government, the largest labor union, and
   representatives of the private sector.
Differences with previous programs:

 - The cornerstone was a major fiscal reform that turned
   a primary fiscal deficit of 12% of GDP in 1982 into a
   surplus of 6% of GDP in 1987.

 - The nominal exchange was not fixed rigidly: the gov-
   ernment conducted a large initial devaluation and then
   continuous sliding adjustments.

 - It was part of a broader program to modernize, dereg-
   ulate and open the economy.

 - The income policies were the result of a concerted so-
   cial agreement, whereas in Argentina and Brazil, price
   and wages freezes where imposed by government de-
The Pacto came to an end in 1995, in the aftermath of
the 1994-1995 Mexican Debt Crisis.

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