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Inflation Stabilization with Incomes Policy Support: a Review of the Experience in Argentina, Brazil and Israel

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Inflation Stabilization with Incomes Policy Support: a Review of the Experience in Argentina, Brazil and Israel NBER WORKING PAPER SERIES INFLATION STABILIZATION WITH INCOMES POLICY SUPPORT: A REVIEW OF THE EXPERIENCE IN ARGENTINA, BRAZIL AND ISRAEL Rudiger Dornbusch Mario Henrique Simonsen Working Paper No. 2153 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 February 1987 Paper prepared for the the Group of Thirty, New York, October 2-3, 1986. We are indebted to Stanley Fischer for helpful discussions and suggestions. The research reported here is part of the NBER's research program in International Studies. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research. NBER Working Paper #2153 February 1987 Inflation Stabilization with Incomes Policy Support: A Review of the Experience in Argentina, Brazil and Israel ABSTRACT In 1985—86 Argentina, Brazil and Israel initiated programs of stabilization after episodes of high and sharply accelerating inflation. Among the key features of each stabilization program were the use of wage— price controls, a fixed exchange rate and fiscal correction as well as a significant expansion in the nominal quantity of money. The combination of fiscal correction and incomes policy has come to be known as "heterodox" stabilization policy, thus opposing it to the conventional IMF programs which emphasize tight monetary and fiscal policies as the exclusive instrument of stabilization. The stabilization programs in Argentina and Israel have now been in force for over a year and the more recent one in Brazil for half a year. There is accordingly enough evidence to make a first judgment on the success and the limitations of these new schemes. At the same time it is worthwhile spelling out some of the special features of stabilization and the resulting intellectual case for heterodox programs. The paper focusses on the conceptual issues related to the use of incomes policy in the context of stabilization when inertia is a central feature. The analysis includes the relation betweeen deficits and inflation, inertial inflation and the basics of monetary reform. We also review the actual stabilization experience in Argentina, Brazil and Israel. The paper concludes with a discussion of the political dimension of stabilization, showing the extraordinary political popularity of the new programs. Rudiger Dornbusch Mario Henrique Simonsen Massachusetts Institute of EPGE Fundacao Getulio Vargas Technologyand National Bureau of Praia de Botafogo 190 Economic Research Rio de Janeiro,R.J. 22.252 E52—357 MIT Cambridge,Ma. 02139 (21) 551—2849 (617) 661—7882 1 2 In 1985—86 Argentina, Brazil and Israel initiated programs of stabilization after episodes of high and sharply accelerating inflation. Amongthekey features of each stabilization program were the use of wage— price controls, a fixed exchange rate and fiscal correction as well as a significant expansion in the nominal quantity of money. The combination of fiscal correction and incomes policy has come to be known as "heterodox" stabilization policy, thus opposing it to the conventional IMFprograms which emphasize tight monetary and fiscal policies as the exclusive instrument of stabilization. The stabilization programs in Argentina and Israel have now been in force for over a year and the more recent one in Brazil for half a year. There is accordingly enough evidence to make a first judgment on the success and the limitations of these new schemes. At the same time it is worthwhile spelling out some of the special features of stabilization and the resulting intellectual case for heterodox programs. We leave little doubt that the concept of these new programs is entirely correct——a longstanding disdain for controls by the economics profession notwithstanding. But we also emphasize that the temptation to forget about fundamentals is extraordinarily large and ultimately fatal to stabilization. A main point of our paper is to isolate the precise role these programs can expect to play. Our point is that they provide an immensely valuable breathing spell in which price stability without deep recession, and as a result very strong political support for theprogram and the 3 policy maker, yield a platform from which to make the inevitable adjustments in the budget which are the ultimate pillars of stabilization. We note that mistaking the breathing spell for success, and failure to use the political support at its height for the difficult task of fiscal correction, will mean that soon the program must slip. And when it does slip it does so irrecoverably. The focus then is on how these programs, unlike traditional programs, do provide an immediate, temporary and very favorable opportunity for basic policy reform. Even if they do not provide a magic relief from the necessity of fiscal correction they surely represent a significant opportunity to try and achieve policy reform where before, in innumerable cases, that proved impossible or was overly delayed because of the perception of immense political costs associated with the large unemnployinent and slow disinflation. Table 1 gives an idea of the possible and impossible approaches to inflation stabilization. The table highlights two dimensions of policy: whether or not the program includes fiscal correction or austerity and whether the program has an incomes policy (wage, price and exchange rate freezing together with remonetization to be explained below). The standard program in the lower leftband box is the IMF approach which consists of fiscal austerity but does not make incomes policy a key instrument. It is true that the IMF favors wage restraint, but price controls are not typically, or ever, an item on the conditionality list. The alternative is shown in the upper lefthand box where the heterodox programs are located. They combine an incomes policy with fiscal -austerity. 4 Table1 Orthodox, Reterodox and "Nodox" Stabilization FISCAL AUSTERITY Yes No Yes Austral/Cruzado Poets INCOMES POLICY No IMF Magicians The remaining two boxes are essential to understand what the temptations are in the course of stabilization and where they lead. The most common is to attempt stabilization by controls only, without paying attention to the sine qua non of fiscal correction. This box is crowded with many thousand years of failed experiments from Emperor Diocletean to the modern day experiments of the Peronists in 1973—4, of Richard Nixon, or of Israel in early 1985. Inevitably these programs come to an end after a more or less brief period of effectiveness. They fail when shortages become a sufficient political headache. There may be an additional phase in which magicians get a shot, without controls and without austerity, but that is typically the final phase before the patient, often too late, is rushed to the IMF. 1 'This is not the place to offer an elaborate explanation or defense of IMF programs, but it certainly must be observed that countries do not go to the IMF for inflation treatment, but tatber to gain access to balance of payments financing. The fact that money and inflation are so central to 11ff programs stems from the close association between public sector dissaving, financing and the external dissaving. But the link is not completely tight so that it is possible for a country to satisfy the external targets and yet fail on the domestic targets. This fact has led many oberserves to argue that the IMF should exclusively to external targets. An entirely different criticism 5 An important point in Table 1 concerns monetary policy. The heterodox program includes significant monetization as part of stabilization, but recognizes the need for fiscal austerity. By contrast the orthodox IMF program emphasizes monetary and fiscal restraint. There is another dimension along which programs might be distinguished in four—way classification. Programs might be orthodox or heterodox and they can involve gradualism or shock treatment. In this distinction the present programs are classified as "beterodox shocks". An example of a heterodox-gradualist program would be the Brazilian Campos— Bulboes stabilization of the 1960s. An orthodox—gradualist program might be the case of Chile. It is more difficult to remember an orthodox—shock example, perhaps because of a lack of survivors to recount the episode. The paper is organized as follows: In the first three sections we review conceptual issues related to the use of incomes policy in the context of stabilization when inertia is a central feature. The discussion includes the relation betweeen deficits and inflation, inertial inflation and the basics of monetary reform. In the following three sections we review the actual stabilization experience in Argentina, Brazil and Israel. The paper concludes with a discussion of the political dimension focusses on an unwillingness of the IMF to require coordinated programs of wage, price, and exchange rate programs. The IMF certainly insists on exchange rate programs and even wage programs, as in Brazil's case in the early 1980s. The point of this paper is that there should also be a price freeze. Failure to include the price freeze means that the program lacks coherence and can only succeed by making unemployment high enough to be the coordinating device that a freeze would otherwise provide. 6 of stabilization, showing the extraordinary political popularity of the new programs. 1. INCOMES POLICY AND STABILIZATION In this section we review the analytical case for wage—price— exchange rate controls as an essential complement to the fiscal stabilization that, as already noted, is the sine qua non of successful anti—inflation policy. That aggregate demand discipline is a necessary condition for sustained price stability has long been known by economists and by well advised policy makers. Yet it may not be sufficient to stop inflation, or at least it may fail to work under conditions of tolerable unemployment. This is demonstrated by the failure of a number of 11ff-supported programs that ignored the problem posed by inflationary inertia.
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