Download Latin America`s Debt crisis

MACROECONOMIC POLICY,
INFLATION AND STABILIZATION
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Why was Latin America so inflation prone?
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What caused inflationary pressures in the region?
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Why was inflation so intractable?
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What mechanisms were used to bring inflation under
control in the region? 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?
WHAT CAUSES INFLATION?
Two Schools of Though: Monetarists VS Structuralists.
1. Monetarists:
theory of money”
Too much money chasing too few goods. “Quantity
The equation of exchange with multiplied terms on both sides:
Where
 M is the total amount of money in circulation on average in an economy
during the period, say a year.
 V is the velocity of money, that is, how often each unit of money is spent
during the year. This reflects availability of financial institutions,
economic variables, and choices made as to how fast people turn over
their money.
 P•Q is the money value of expenditures
 P is the price level for the economy during the year.
 Q is an index of the real value of expenditures
 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. According to monetarists inflation occurs because
monetary authorities increase the growth rate of money supply despite
of the rising in prices.
 Monetarist
explanations for such excess in Latin
America include:
a. Irresponsible deficit financing,
b. Erosion of the tax base,
c. Mismanagement of the debt crisis.
A.
DEFICIT FINANCING
G-T > 0 Government budget deficit; G-T = 0 Govt’ budget balanced;
G – T < 0 budget surplus
If
If
government spends more than it collects, then it must finance its
deficit thru either (i) printing money (seignorage); (ii) issuing domestic
debt or (iii) borrowing from abroad.
LATAM
governments were precluded from borrowing abroad due to
the recent debt crisis and from issuing domestic debt because of the
underdeveloped domestic financial markets. They financed their deficits
by increasing the money supply (printing money) this spurted inflation.
Interest rates sky rocked causing a large contraction of investment and
consequently a halt on economic growth. High inflation with recession
(Stagflation)
Whereas
deficit spending in most industrial countries is
countercyclical, in Latin America it has largely been procyclical. That is,
instead of spending to stimulate the economy during a recession, Latin
American governments tend to contract during recession. This is tied to
access to funds. As recession erodes the government’s ability to raise
money in international markets, it must reign in spending. Unfortunately,
such procyclical policies, by their very nature, exacerbate
macroeconomic volatility.
o
B. TAXATION
The level of taxation in Latin America is very low
compared to other regions. This exacerbates the
necessity of monetize the deficit
C. Effects of the Debt Crisis
 No
access to international financial markets
for new loans and the necessity of service the
debt pushed governments to print more
money. Devaluations increased the value of
external debt in terms of domestic currency
2. STRUCTURALISTS: CAUSES OF INFLATION ARE DUE
TO THE INCOMPLETENESS OF MARKETS IN DEVELOPING
COUNTRIES.
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Structuralist or heterodox explanations focus on the structure of the
underdeveloped economy as the propagating mechanism for inflation.
Economies in Latin America can best be understood as incomplete markets
that do not automatically tend toward full employment equilibrium.
Bottlenecks in both the agricultural and the industrial sectors create price
pressures. If input markets cannot quickly adjust to price signals to meet
supply requirements, inflation will result.
External price shocks from the international economy can also introduce or
exacerbate instability in the domestic market.
Cost-push elements represented by internal and external shocks interact
with the structure of industry and labor organization to fuel an inflationary
struggle.
Inflation then reflects the distributive conflict between capital and labor.
If all agents assume inflation, each side wants to build predicted price
increases into its share of the pie.
INDEXATION, INFLATIONARY
EXPECTATIONS, AND VELOCITY
o
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Measures introduced to minimize the costs of inflation:
wages were indexed to indicators that accommodate
periodically to inflation. Indexing made easier to live
with inflation.
Inflationary expectations
 Velocity of money changed in response to economic
agents learning to live with inflation.
 V= GDP/M. If V is increasing or equivalently M is
decreasing without changing GDP.
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TIMING AND ADJUSTMENT
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Three policy choices that are often considered desirable
are: (1) Fixed exchange rates (less uncertainty), (2) Free
movement of capital, (3). Independent monetary policy.
The macroeconomic policy trilemma is that only two
of these three objectives can be attained simultaneously.
The trilemma provides a convenient way to categorize the
choices that different countries make. The United States
runs an independent monetary policy (the Taylor rule),
allows free capital mobility, and has a flexible exchange
rate.
Facing this “trilemma,” monetarists largely counseled
abandoning domestic monetary policy and linking to a
“hard” international currency; structuralists suggested
exchange controls to preserve domestic autonomy.
HETERODOX APPROACHES TO INFLATION STABILIZATION IN THE 1980S: BRAZIL
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The Cruzado plan in January 1986 (President Jose Sarney)
A general price freeze and a partial freeze on wages following an 8-percent
readjustment was implemented.
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If the consumer price index increased more than 20 percent, wage increases would
be permitted.
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Indexation of contracts with less than one year’s duration was prohibited.
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A new currency was created called the cruzado, set equal to 1,000 cruzeiros.
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The exchange rate was fixed at 13.84 cruzados to the dollar.
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In less than four months inflation fell from 459.1 % in January to 4.5% in April.
Brazilian’s consumer demand surged and credibility on the government commitment
to combat inflation eroded.
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A year and a half after the introduction of the plan, inflation topped 1,000 percent.
Brazil continued its heterodox experiment with the Bresser plan included another
revaluation of the currency, lopping off three zeros once again and calling it the novo
cruzado.
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THE REAL PLAN (FERNANDO HENRIQUE
CARDOSO)
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The real plan was a pragmatic mix of orthodox and heterodox
elements.
Eliminate the inertial elements of inflation to break out of a cycle of
indexed price increases that adjusted for past inflation by identifying
disequilibria, eliminating price distortions, and introducing emergency
fiscal adjustments.
All wages, prices, and taxes, and the exchange rate, were
redenominated in a new accounting unit called the urv, or the real
unit of value, roughly set at par to the U.S. dollar.
Indexation to other rates was prohibited, and the money supply was
tightened, indicating a monetarist bent.
A new currency, the real, was introduced; it was tied initially one to
one to the urv accounting unit.
The policy changes implemented in association with the Real plan
were credible to the public.
The gradual, preannounced nature of each step served to calm
expectations.
After more than two decades of unsuccessfully battling inflation, the
public was simply ready to bite the bullet. Expectations of inflation
were changed.
LESSONS:
 (1)
Heterodox policy alone is not enough. Simply focusing on
expectations and taming the inertial component does not eliminate
the imbalances creating the expectations. Fiscal and monetary
fundamentals also need to be adjusted. Without reshaping the
fundamentals, it is not possible to generate confidence that the
imbalance in the domestic economy has been corrected.
 (2)
A pure orthodox approach was not dramatic enough to generate
confidence and support. Simply restraining the money supply had
perverse effects. When the money supply was cut and interest rates
rose as a result, economic agents perceived this as a rise in the
nominal interest rate. Without a change in expectations of inflation,
without a clear sense of a change in the rules of the game, inertial
aspects of inflation will plague the orthodox strategy.
THE CASE OF ARGENTINA: FROM THE AUSTRAL PLAN TO THE
CONVERTIBILITY PLAN
The Austral plan (Raul Alfonsin)
A
heterodox plan, froze wages and prices (including the exchange
rate), and introduced a new currency with a promise not to print
money.
Fiscal adjustment was the third element of the plan.
Initially the plan succeeded as inflation decreased from 350 percent
in the first half of 1985 to 20 percent in the second.
The Austral plan collapsed because its credibility was undermined.
The exchange rate became overvalued and external accounts
deteriorated.
The convertibility plan (an orthodox plan, President
Menem)
The
convertibility plan locked the Argentine peso to the U.S. dollar.
Through a currency board independent of the Treasury, by law the
money supply could be increased only if the U.S. dollars held in reserve
were to rise.
Liberalization of the economy promoted exports and the inflow of
foreign investment to increase the stock of dollars in Argentina.
THE CONVERTIBILITY PLAN (CONT’)
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Fiscal adjustment was dramatic (but incomplete).
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The government embarked on a large-scale privatization program,
putting fifty one firms on the auction block between 1989 and 1992
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Tax reform increased revenues to balance government books.
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Inflation tumbled in Argentina from the peak of more than 3,000
percent to an astoundingly low rate of 0.1 percent in 1996.
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Domestic and international capital believed in the long-run
commitment of the plan. International capital flowed to Argentina.
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Social costs were high reflecting a 17-percent unemployment rate.
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When its trading partner, Brazil, let the real float in 1999, fragilities in
the Argentine model were exacerbated.
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At the same time the strengthening dollar compounded the
overvaluation of the peso.
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External accounts deteriorated, unemployment remained stuck at
socially unacceptable levels in the range of 18 percent, and fiscal
deficits were not brought under control.
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In January 2002, and Argentina tumbled into economic chaos.