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- grams 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 (1988) - 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 success. Orthodoxy 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 inﬂation. 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 objectives: - 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 living. 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 regimes. Heterodoxy 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. Example 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 GDP). 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- anism. 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 up. 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. ın 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 months. - 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 20%. 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 burden. - 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 zero. 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- dox). Reduced inﬂation from almost 160% in Dec 1987 to 8.6%. 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- cree. The Pacto came to an end in 1995, in the aftermath of the 1994-1995 Mexican Debt Crisis.
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