9913 Puzzle of Latin Am.Ec.Dev. 1/23/03 2:27 PM Page 113 Price Stabilization A Critical Ingredient for Sustained Growth CHAPTER FIVE The debt crisis contributed to the lost decade of development in Latin America. (Courtesy of Amanda McKown.) 113 9913 Puzzle of Latin Am.Ec.Dev. 1/23/03 2:27 PM Page 114 114 CHAPTER FIVE Inflation plagued Latin American economies from the 1980s through the first part of the 1990s. Imagine the difficulty—as was experienced in Argentina, Brazil, Nicaragua, and Peru—of living with inflation rates exceeding 2,000 percent per year! These were not isolated exceptions; as we can see in table 5.1, only Costa Rica, Panama, and Bolivia had rates under 20 percent in 1990, and as we will see, Bolivia paid a huge social price to tame inflation in the mid eighties. Inflation exacts a high cost. Real wages—earnings after the inflationary bite— fall, thus reducing purchasing power. Inflation hits the poor particularly hard; the wealthy can insulate themselves through financial mechanisms indexed to the infla- tion rate. Macroeconomic instability creates uncertainty and undermines the invest- ment climate. Inflation compromises the business environment, making long-run decision making impossible. It erodes tax earnings and reduces the ability of the government to provide public services. It promotes consumption today, reduces savings, and creates environmental pressure. Inflation hurts nearly all economic actors. Despite these costs, excessive inflation persisted in Latin America for nearly fifteen years. Our discussion in this chapter revolves around several questions: • Why was Latin America so inflation prone? • What caused inflationary pressures in the region? • Why was inflation so intractable? • What mechanisms were used to bring inflation under control in the region? Table 5.1. Inflation of Latin American Countries, 1990 Country Hyper (>2000%) High (>30%) Medium (>20%) Low (< 20%) Nicaragua 7,485.0 Peru 7,481.5 Brazil 2,937.0 Argentina 2,313.7 Uruguay 112.5 Guyana 63.6 Ecuador 48.5 Guatemala 41.2 Venezuela 40.6 Paraguay 38.2 Colombia 29.1 Mexico 26.6 Chile 26.0 El Salvador 24.0 Honduras 23.3 Suriname 21.7 Costa Rica 19.0 Bolivia 17.1 Panama 0.8 Source: IADB, Economic and Social Progress in Latin America (Washington, D.C.: Johns Hopkins University Press, various years); and IMF, World Economic Outlook 1997 (Washington, DC: IMF, 1997), 148. 9913 Puzzle of Latin Am.Ec.Dev. 1/23/03 2:27 PM Page 115 PRICE STABILIZATION 115 • What worked? • Is inflation in Latin America now gone for good? Will the collapse of the exchange rate-based stabilization plans in Argentina and Brazil result in renewed inflation in the region? Latin America has been a virtual laboratory for macroeconomic experiments in the 1980s. This chapter will address these issues of macroeconomic stabilization, underscoring the causes and costs of inflation and highlighting the measures used to address it. It will look at the range of policies introduced to provide some insight on the difficult problem of maintaining stable prices while an economy is going through the complex and sometimes tumultuous process of economic growth. Theories of Inflation: Monetarists versus Structuralists Policies to attack inflation rest on an understanding of inflation’s causes. Two broad schools of thought address the problem: the monetarists and the structural- ists. For monetarists, or orthodox theorists, the cause of inflation is rather simple: too much money chasing too few goods. Monetarists such as Milton Friedman and the Chicago School look to the equation of exchange as a key to the cause of infla- tion. With M representing the quantity of money, V equal to the velocity or the number of times per year a unit of currency is used to purchase final goods and services, P as the price level, and Q standing for national output or gross domestic product (GDP) in real terms, monetarists argue that M × V= P× Q If the rate of growth of output and velocity are assumed to be constant in the short run, prices are determined by the quantity of money in circulation. A rising level of money in circulation causes price acceleration. Although in the short run resource price shocks or shortages may accelerate prices temporarily, monetarists perceive that inflation over time is caused by excess liquidity in the system. Under- standing persistent inflation for the monetarist involves highlighting why monetary authorities would continue to make policy errors by increasing the money supply in the face of rising prices. Monetarist explanations for such excess in Latin America include irresponsible deficit financing, erosion of the tax base, and mismanagement of the debt crisis. Let’s consider these in turn. Deficit Financing If a government is spending more than it is taking in, the deficit must be financed. This can be done in three ways: print money, issue domestic debt, or borrow from for- eign sources. As John Maynard Keynes pointed out in 1923, a government can live for a long time by printing money.1 A government’s ability to buy goods and services 9913 Puzzle of Latin Am.Ec.Dev. 1/23/03 2:27 PM Page 116 116 CHAPTER FIVE by printing money is called seignorage. Indeed, if the economy is growing at a strong pace, the quantity of goods and services available increases and the price effect may be moderate. However, once growth slows down, there is too much money chasing too few goods. Deficits in Latin America imply different dynamics than in the United States. The U.S. dollar is the world’s most important reserve currency. If the Federal Reserve issues more dollars—and if the world continues its appetite for dollars as a safe investment—investors throughout the world absorb the dollars and reinvest in America’s sophisticated capital markets. If the Bank of Mexico emits pesos, a strong international demand is far less likely. The value of the peso erodes, confidence van- ishes, and a crisis erupts. There may come a time when the demand for dollars weakens sufficiently to present binding constraints. For now it is enough to appreciate that tough budget problems in Latin America resolved by printing money are more likely to result in inflation and balance of payments crises. The alternative to printing money is issuing debt to finance government spending. Governments are often precluded from issuing domestic debt—the equivalent of a U.S. Treasury bond—by underdeveloped local capital markets. If the public cannot be induced to hold bonds, a government must borrow externally or print money. When the debt crisis hit in the early 1980s in Latin America, the external borrowing option dried up and the simplest response to deficits was to monetize them. We can observe the pattern of macroeconomic instability in Latin America up to the 1990s in tables 5.2, 5.3, and 5.4. In table 5.2, we note the trend of strong and per- sistent deficits throughout the region from 1982 to 1990. Only two countries—Chile Table 5.2. Overall Surplus or Deficit in Latin American Countries, 1982–1990 (as a percentage of GDP) Country 1982 1983 1984 1985 1986 1987 1988 1989 1990 Argentina –3.7 –10.1 –5.7 –2.9 –3.2 –4.4 –3.8 –2.6 –1.7 Bolivia –13.7 –17.0 –18.3 –9.3 –1.7 –3.7 –5.0 –2.0 –1.3 Brazil –3.1 –4.3 –5.0 –11.1 –14.0 –12.6 –16.3 –17.5 –6.2 Chile –2.6 –3.7 –3.0 –1.9 –0.5 2.3 3.6 5.0 1.4 Colombia –2.0 –1.0 –4.3 –2.7 –1.3 –0.5 –1.4 –1.7 –0.1 Costa Rica –3.2 –3.4 –3.1 –2.0 –3.3 –2.0 –2.5 –4.1 –4.4 Ecuador –4.4 –3.0 –0.6 1.9 –2.2 –6.2 –2.0 0.4 3.5 El Salvador –5.9 –4.1 –3.2 –2.0 –3.6 –0.9 –3.0 –3.7 –1.5 Guatemala –4.7 –3.6 –3.7 –1.8 –1.5 –1.3 –1.7 –2.9 –1.8 Guyana –34.3 –40.1 –44.5 –56.1 –58.8 –42.4 –31.6 –6.6 –22.9 Honduras –9.7 –9.0 –9.8 –7.2 –6.0 –5.8 –4.1 –6.0 –4.1 Mexico –11.9 –8.2 –7.2 –7.6 –13.1 –14.2 –9.7 –5.0 –2.8 Nicaragua –13.3 –30.0 –22.5 –21.3 –14.5 –16.0 –25.1 –3.5 –18.7 Panama –11.4 –6.2 –7.4 –3.4 –4.5 –4.2 –5.2 –6.9 6.8 Paraguay –1.5 –4.7 –3.5 –2.3 0.0 0.4 0.6 2.4 3.2 Peru –3.1 –7.3 –4.4 –3.0 –4.3 –6.9 –3.9 –6.3 –3.5 Suriname –1.7 –17.6 –18.4 –21.4 –26.0 –24.8 –21.3 –14.0 –6.3 Uruguay —. –4.2 –5.8 –3.1 –1.3 –1.3 –2.0 –3.4 –0.1 Venezuela –2.1 –0.6 2.8 2.0 –0.4 –1.6 –7.4 –1.0 –2.1 Source: IADB, Economic and Social Progress in Latin America (Washington, D.C.: Johns Hopkins University Press, various years). 9913 Puzzle of Latin Am.Ec.Dev. 1/23/03 2:27 PM Page 117 PRICE STABILIZATION 117 Table 5.3. Average Annual Rates of Growth of Money Supply in Latin America, 1982–1990 Country 1982 1983 1984 1985 1986 1987 1988 1989 1990 Argentina 154.2 362.0 582.3 584.3 89.7 113.5 351.4 4,168.2 1,023.2 Bolivia 228.8 207.0 1,798.3 5,784.6 86.1 36.6 35.3 2.4 39.5 Brazil 68.5 102.7 204.1 334.3 330.1 215.4 426.9 1,337.0 2,333.6 Chile 2.8 15.6 22.8 24.2 43.3 21.0 46.5 17.2 23.3 Colombia 25.4 23.4 24.1 10.7 —.