Advanced Macroeconomics Essay. Why did Latin America experience such high inflation in the 1980s?

Prolonged bouts of inflation were prominent across the Latin American region during the 1980s. As measured by the consumer price index, inflation averaged 126% during the period 1981-1988, and 277.6% in 1988 for the region (Vito, p.642). This essay will discuss why the Latin American region experienced such high inflation. Focus will be directed towards the relevant economic theory and the specific explanatory external and domestic factors. Essentially, inflation is due to nominal money growth (Blanchard, p.457). It can not occur without it. Empirical data illustrates that in the long run high inflation is highly correlated with correspondingly high nominal money growth (Fischer, p.845) and is in line with Friedman's famous quote "inflation is always and everywhere a monetary phenomenon (Fischer, p.848). But this is a partial answer. In turn, nominal money growth is high because the budget deficit is also high. This much is common to the majority of high- and hyper-inflation's. Thus there is both a fiscal and a monetary element. What initiated the fiscal deterioration in Latin America? The answer lies both in external and domestic factors. External Factors: Two prominent external factors were the changes in international capital market real interest rates and in the terms of trade between the 1970s and 1980s. Prior to the 1980s, the said rate was negative and historically low, with foreign credit plentiful and thus encouraged countries within the region to heavily borrow in foreign capital markets and build up external debt. This figure stood at 305% of the region's exports in 1988 (Vito, p.642). The cost of servicing this debt dramatically increased and became problematic after the real rate of interest turned positive and exceeded that of the rate of economic growth within this region. Consequently a debt crisis hit in 1982 with high growing fiscal deficits (Vito, p.642). Terms of trade deteriorated in the 1980s. In the 1970s they had improved by 55% while during the period 1981 to 1989 they declined by 26% (Vito, p.642). Public sectors were unable to secure the same level of rents through exports (either directly through publicly owned resources or taxes levied on foreign trade). Moreover, public sectors were insufficient to 'finance its own domestic and foreign commitments' (Vito, p.643) which had dramatically expanded during the period of low international real rate of interest and by the

need to service the external debt burden accrued during this period. This had a negative impact on the fiscal accounts of Latin American countries (Vito, p.642). Domestic Factors: Domestic factors also played a part in the region's fiscal deterioration. Policy makers tend to discount the future and narrow their focus on the short run. As such, the temptation to ignore the potentiality of a future reversal in the terms of trade and a rise in the international interest rate was too great in light of the present inexpensive foreign credit available for plentiful exploitation and of which could ease political and social pressures through increased government expenditure. This is especially true when it's taken into account that those policy makers would most likely not be those subjected to dealing with the potentially negative consequences of their actions and given they believed that a proportion of public spending would accrue future returns that cover the costs (Vito, p.643). The problem can be further compounded by policy decisions regarding public expenditure. In order to attempt to decrease inflation, governments can restrict state-controlled enterprises from rising their prices. However, to cover the increased inflation-affected costs and lower revenues, the government needs to provide subsidies to those firms, thus further increasing the budget deficit. This was the case for Bolivia where the government attempted to maintain low prices for public services, only leading to large deficits for state-run firms (Blanchard, p.460). Additional factors: The budget crisis was exacerbated or partially caused by additional factors that are not uniform across the Latin America region. For example: significant economic or social 'upheaval' is a common factor and Nicaragua stands as an example which experienced a civil war that resulted in the destruction of bureaucratic structures and thus the state's ability to collect taxes severely deteriorated. Contraction in world trade during the early 1980s caused the prices of Latin Americas largest export, primary resources, to fall. The Bolivian case of inflation was in large part caused by a sharp and significant decline in the price of tin, a raw material that was its principle export good and a core source of revenue. The reduction in the export value of tin and reduction in national income led to a reduction in tax revenue and thus a large budget deficit (Blanchard, p.460). Servicing the Deficit: When faced with a high fiscal deficit, there are two primary methods of correction. Public and private borrowing is an option, although one which countries become increasingly unable to execute as the deficit grows larger and there is a loss of creditworthiness; and which the country can exhaust, as lenders become increasingly worried that the government will be unable to service the debt, fear default and thus demand a premium to account for the added risk or cease lending all together (Blanchard, p.457).

Given that the government faces a rising cost of servicing debt and little foreign capital inflow, once foreign reserves are depleted, it will be difficult to finance government expenditure without turning to the second option: money creation. For example, the net private foreign lending to the Bolivian government fell from 3.5% of GDP in 1980 to -1.0% in 1983. As such the government had no other choice but to resort to internal financing to cover their budget deficit (Sachs, p.460). The government creates money by a process called debt monetization whereby they issue bonds and ask the central bank to purchase them, the government then utilizes the money created by and extended to them by the central bank to service its deficit. This is enabled through the revenue that is obtained by the money creation: called seignorage. Seignorage is equal to the product of nominal money growth and real money balances (Blanchard, p.464). While debt monetization provides a short-term solution to servicing the deficit, financing the large budget deficit through seignorage is problematic in that it is characterized by increasing inflation (Blanchard, p.471). Initially, with low levels of money growth, an increase in money growth will increase seignorage. Seignorage increases with money growth; and decreases with expected inflation, which reduces the demand for real money balances. Thus, while money growth is exceeding expected inflation, seignorage increases and the government can effectively finance the deficit.

But this is unsustainable and there is a limit to the maximum seignorage that can be raised. Over time, expectations will catch up and expected inflation will rise in response to the increased money growth. As a result, people will reduce their real money balances. This is because currency will lose its real value and be more costly to hold, thus increasing the opportunity cost of holding money. Consequently, this results in decreasing seignorage and the further requirement of higher nominal money growth to keep seignorage levels up and 'finance the same real deficit', and thus further increases inflation. As the real money balance becomes progressively smaller, the required rate of nominal money growth will become progressively larger, and thus the rate of inflation required to generate a given amount of seignorage will also increase, resulting in an inflationary spiral, i.e. hyperinflation (Blanchard, p.471). A tipping point will be reached where money demand declines too rapidly for additional seignorage to be generated. Thus there is rate of money growth which maximizes seignorage (and which varies depending on the economy). Beyond that point, further increases in nominal money growth will decrease seignorage. This is illustrated by the seignorage laffer curve below1, where point A is the rate of money growth that maximizes seignorage.

1 The seignorage laffer curve follows that of most taxes. Inflation is similar to a tax, and is effectively a tax on money balances. Seignorage is effectively the tax revenues accrued while money growth is the tax rate.

An additional compounding problem of inflation is that high inflation can cause the budget deficit to actually increase. This is in part due to tax collection lags and is known as the Tanzi-Olivera effect. What occurs is that the real value of taxes deteriorate with inflation considering taxes are collected based on past nominal income, which is worth comparatively less in the future (Blanchard, p.467). After increasing inflation caused the tax system of Bolivia to collapse, government revenues fell from 9% of GNP in 1981 to approximately 1.3% in 1985 (Sachs, p.280). Argentina also experienced a marked drop in tax revenues as it experienced difficulty in controlling its public finances during the 1980s, falling from approximately 20% of GDP at the beginning of the decade, to about 12-13% at the end (Beckerman, p.664) In conclusion, high inflation in Latin America during the 1980s was the result of a deterioration in fiscal balances. Explanatory causes behind large fiscal deficits lay both with external factors (a downturn in the terms of trade and an increase in the international capital market interest rate) and domestic factors (excessive government spending in light of inexpensive foreign credit and poor policy decisions). In addition, specific country-level problems were of partial cause, which included political instability, civil war, and the fall in price of core export commodities.

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Sachs, Jeffrey (1997), The Bolivian Hyperinflation and Stabilization, The American Economic Review, Vol. 77, No. 2, pp. 279-283. Accessed at: http://www.earthinstitute.columbia.edu/sitefiles/file/about/director/documents/AER0587_000.pdf. Vito, T. (1992), Fiscal Policy and Economic Reconstruction in Latin America, World Develoment, Vol. 20, No. 5, pp. 641-657. Accessed at: http://www.sciencedirect.com/science/article/pii/0305750X9290143J.