Journal Issue


International Monetary Fund. External Relations Dept.
Published Date:
January 1994
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Chronic Inflation 20 Years Later: A Progress Report

Over 20 years ago, in his well-known study Chronic Inflation in Latin America (New York: Praeger, 1972), Felipe Pazos convincingly argued that the inflation strain that had afflicted several Latin American countries from 1949 to 1970 had been quite different from the hyperinflations that had ravaged Europe after the two world wars. While the hyperinflations had been characterized by short and explosive outbursts of extreme inflation, Latin American inflation, although higher than in industrial countries, had been relatively stable and, to a great extent, self-sustaining. During the 1970s, Israel had the dubious honor of joining the, hitherto Latin American-only, club of chronic-inflation countries. After several failed attempts, and with inflation running at an annual rate of close to 400 percent, the July 1985 Israeli stabilization plan achieved a quick and lasting reduction of inflation to levels around 20 percent a year.

The two books under review were inspired by Israel’s experience with chronic inflation and disinflation. Although quite different in spirit and approach, both books make for exciting reading. Bruno’s book is largely nontechnical, policy-oriented, and aimed at a broad audience. It also provides a rare, and quite fascinating, insider’s look at the trials and tribulations of policymaking. In contrast, Leiderman’s book is a collection of papers, grouped under five major topics, most of which were published in top academic journals over the last 10 years. A reading of these books suggests that, 20 years after Pazos’s pathbreaking contribution, many of the issues underlying the phenomenon of chronic inflation remain as topical and controversial as ever.

In the tradition of Pazos, the notion of inflation inertia is the leitmotif in Bruno’s book. Inflation inertia, in Bruno’s view, refers to the highly persistent nature of inflation due to backward-looking wage indexation, slowly adjusting inflationary expectations, and accommodating monetary and exchange rate policy. In the presence of inflation inertia, Bruno argues, price shocks can translate into permanent increases in inflation. The stepwise profile of inflation in Israel from 1973 to 1985 can thus be explained by a series of shocks (oil price increases, cuts in subsidies, and step devaluations), and the subsequent accommodation through the linkage of key nominal variables (the exchange rate, prices, wages, and money) to past inflation. Such a process of “shocks and accommodation” leaves the economy with no nominal anchors. Inflation thus acquires much of a life of its own, independent of the fiscal problems that originated it.

Michael Bruno

Crisis, Stabilization, and Economic Reform

Oxford University Press. New York, NY, USA, 1993, viii + 300 pp., $38

Leonardo Leiderman

Inflation and Disinflation

The Israeli Experiment

The University of Chicago Press, Chicago. IL, USA. 1993. ix + 333 pp., $45.

Bruno’s best efforts notwithstanding (Bruno, like Pazos, is at his best when discussing inflation inertia), it is hard to escape the feeling that inflation inertia remains one of those elusive, catchall concepts that often raise more questions than they answer. (The fact that common sense tells us that it is an important notion makes this state of affairs all the more distressing.) Leiderman, of course, does his best in reinforcing whatever qualms the reader may have had when he argues that the existence and relevance of inflation inertia remains an open empirical question. The mere finding, Leiderman claims, that inflation is persistent over time (which is Bruno’s empirical measure of inflation inertia for Israel) does not necessarily imply that the inflation rate is fundamentally sticky or predetermined (which is Leiderman’s definition of inflation inertia).

He illustrates this point by building a model in which inflation may be highly persistent over time even though, by construction, the inflation rate is not sticky. In Leiderman’s view, a proper test of the hypothesis of inflation inertia would require empirically testing a model that embodies it. Perhaps more disturbing are Leiderman’s findings that shocks in Israel have, by and large, not given rise to long-term inflation persistence, and that most fluctuations in inflation have been primarily transitory. Curiously enough, however, in the introductory chapter Leiderman seems to side with Bruno on the importance of inflation persistence in Israel, in spite of some of his own earlier findings.

The empirical relevance of inflation inertia is crucial for the discussion on the desirability of price and wage controls in a stabilization plan. (Neither author disputes the need for a fiscal adjustment to ensure a successful disinflation.) Bruno advocates a coordinated freeze of the exchange rate, prices, and wages (the heterodox approach) to break the self-momentum, or persistence, of inflation. In contrast, Leiderman takes a much more skeptical position on the usefulness of the heterodox approach. Bruno heralds Israel, as well as Mexico, as prime examples of the critical importance of the heterodox approach in chronic inflation countries. As evidence of the failure of the orthodox approach, Bruno cites the Chilean program of the late 1970s (the tablita), in which the exchange rate was eventually fixed at the same time that, by law, nominal wages were fully indexed to past inflation.

Although it is hard to disagree with Bruno on the Chilean case, his attempt to generalize about the orthodox approach based on Chile’s case is less convincing. Undoubtedly, formal backward-looking indexation will make the inflation rate sticky and might, therefore, call for the heterodox approach if, as argued by Leiderman, that is the only way (for political reasons) of cutting the link between nominal wages and past inflation. The mere fact, however, that inflation is persistent—due to, say, policy accommodation or an incredulous public—appears to provide a much weaker case for the heterodox approach.

In the April 1991 Convertibility plan in Argentina, for example, the exchange rate was fixed without controlling for any other nominal variable (a prime example of orthodoxy in a country with five decades of chronic inflation). The success of the plan would suggest that, as long as inflation persistence is not due to formal backward-looking wage indexation, a credible stabilization plan based on an active (i.e., non-accommodating) exchange rate policy may be enough to ensure a rapid fall in inflation. In such a case, the well-known costs of price and wage controls (on which both authors agree) might offset the benefits. The reader is also left wondering why, if in Bruno’s view the Uruguayan tablita—implemented with a balanced budget and with no major problems of formal indexation—was a policy mistake, fixing the exchange rate in the Convertibility plan was not. Clearly, from an ex-ante point of view (which is what matters for policy decisions), both plans looked quite similar in terms of their “orthodoxy.” If, as many would argue, the key difference between the two programs lies in the accompanying structural reforms, it would be an indication that such reforms, rather than the “heterodox” components, are critical to success.

A related issue, as Leiderman argues, is that the response of key macroeconomic variables to major stabilization plans in chronic-inflation countries has been very similar, regardless of whether the plans were orthodox or heterodox. Typically, there has been an initial expansion in economic activity in spite of an appreciating real exchange rate. The contractionary costs associated with disinflation have appeared only later in the programs. Hence, even if the heterodox approach were to alleviate some of these problems (say, the real appreciation), it does not seem to fundamentally alter the underlying response of the economy. Such findings, which suggest that other, more basic reasons lie behind this common pattern, thus call into question Bruno’s emphasis on heterodox components.

Leiderman argues that lack of credibility, generally expected in countries with a history of high inflation and countless failed attempts, may explain this post-stabilization business cycle. Bruno disagrees with this hypothesis (at least for the Israeli case) and suggests that the initial boom, which he attributes to an increase in perceived financial wealth, simply delayed a recession caused by the protracted structural crisis in Israel (which was reinforced by the Intifada and the real appreciation). Whatever merit Bruno’s position on Israel may have, however, it clearly cannot account for the similarity of experiences across countries.

In summary, these books provide a stimulating intellectual journey through the world of chronic inflation and stabilization. In addition to the issues discussed (which are the more controversial), the books cover many other related issues, ranging from Leiderman’s formal look at the interaction between budget deficits and inflation to Bruno’s discussion of stabilization in Eastern Europe. The arguments are well presented and clearly articulated. Even when readers disagree, they are forced to critically re-evaluate (and often revise) their own position, a valuable exercise in itself. Given that Bruno’s book is policy-oriented while Leiderman’s is academic, it is only natural that they differ markedly in style. Bruno writes with the vigor and enthusiasm of an insider, Leiderman takes a more detached view; Bruno takes a stand on almost every issue, Leiderman is more cautious; Bruno seeks to persuade, Leiderman seeks to question. Fortunately, there is no need to choose, and any serious (and not so serious) student of the subject should place both books alongside Pazos’s classic study.

Carlos A. Végh

Patrick Low

Trading Free

The GATT and US Trading Policy

The Twentieth Century Fund Press, New York, NY, USA, 1993, vii + 297 pp., $25.

Takatoshi Ito and Anne O. Kruagsr (editors)

Trade and Protectionism

The University of Chicago Press, Chicago, IL, USA, 1993, 458 pp., $68.

The public debate on trade policy reflects broad agreement among economists on the benefits of open world trade. This view is not based on naive assumptions about perfect markets; rather it recognizes the massive government failures arising from special interest politics and bureaucratically managed trade. Even those who have developed the new “strategic trade theory,” which establishes the case for intervention in the presence of monopolistic advantage in production, generally recognize that governments are very unlikely to improve matters by attempts to implement strategic trade policies. Moreover, the “new growth theory,” with its emphasis on market incentives for introducing new products, has generally reinforced the case for open trade policy. Unfortunately, agreement among economists on these matters does not extend to the general public.

Patrick Low describes the threats to the multilateral system from protectionist forces in the industrial countries, especially the United States. The author’s treatment of his complex material is precise and persuasive. At a time when many developing countries are moving toward more open trade and investment policies, or are showing serious interest in doing so, Low notes that the multilateral trading system is under severe strain. Not only have protectionist pressures grown in industrial countries, but the commitment of governments to a predictable, rules-based approach to trade policy has weakened.

Low argues that the growing emphasis on “fair” trade in the policy debate has allowed lawmakers to promote protectionist outcomes without taking responsibility for them—blaming foreign malfeasance deflects protectionist stigma. The decisionmaking process in the United States, built on competitive tension between the administrative and legislative branches of government, has muffled the articulation of the national interest in trade policy matters. Traditional US leadership in defending an open world trading system has diminished, and neither the European Union nor Japan has shown signs of taking up the slack. Low’s book was written at a time when repeated attempts to complete the Uruguay Round of multilateral trade negotiations were failing, which the author characterized as symptomatic of the malaise. Now that the Uruguay Round has been completed, it would be interesting to know whether the author would modify his thesis.

The authors of the 15 conference papers edited by Ito and Krueger present a variety of views, but all agree on the desirability of market-directed trade and emphasize the importance of the politics of trade policy. Many of the papers describe how aggressive US policies look from the perspective of Korea and Taiwan Province of China (where US threats have tended to result in acquiescence in opening of the domestic markets, but with considerable resentment). Gary Saxonhouse argues that the relatively low level of Japanese imports of consumer goods results from its economic structure rather than from cultural bias or conspiratorial behavior. An interesting chapter by Robert Baldwin and Douglas Nelson describes concisely the evolution of US and Taiwanese trade policy, both in general and in relation to each other. The theme of the autonomous state, which is losing its autonomy in both cases, plays a prominent role in their discussion. In both cases they argue that intellectual arguments were important influences on trade policy, during the periods in which state autonomy was relatively high. In another paper, Richard Snape comes out strongly in favor of multilateralism rather than the regional approach that is currently in favor in US policy circles.

How realistic are these arguments in favor of a completely open world trading system? Free trade economists may finally have to come to terms with the fact that we are not going to get all that we want. We should continue to be clear on the virtues of a fully open system, but we should also be clear on the priorities when compromises have to be made. The calculation of welfare losses may be a misleading guide to what matters most in trade policy. Trade is probably most important for its ability to weaken distributional coalitions, promote technical progress, and perhaps foster reasonably harmonious international relations, reducing the probability of war. Economists need to continue to pursue the topics treated in these two books in order to contribute to the evolution of a trading system that will retain the support of the diverse nations of the world and the people within those nations.

Christopher Clague

Professor of Economics

University of Maryland

Barry Bos worth

Saving and Investment in a Global Economy

The Brookings Institution, Washington, DC, USA, 1993, ix + 188 pp., $28.95.

This book is a valuable addition to the literature on international adjustment, combining as it does a survey of existing empirical results with a wealth of new information. Bosworth first elucidates and then examines the “conventional model” that links the domestic and international economies.

The model consists of three links: differences in desired levels of domestic saving and investment lead to changes in domestic interest rates (for example, if desired saving is lower than desired investment, interest rates rise); higher interest rates attract international capital while at the same time raising the value of the exchange rate; the appreciation in the exchange rate induces a deterioration in the trade balance, creating a rise in imports and a fall in exports—a necessary counterpart to the inflow of capital. How well does this model explain the trends in current account surpluses of the 1980s, a period that saw unexpectedly large current account divergences across the major industrial countries? The book focuses on answering this question.

Bosworth outlines these links in the introductory chapter and, anticipating his conclusion, adds that “the conventional model of international macroeconomics works surprisingly well in explaining macroeconomic developments over the 1980s.” The second chapter discusses the conventional model in more detail and is followed by three chapters that look at the empirical results for the crucial building blocks in the model—trends in saving and investment, determination of exchange rates, and the factors affecting exports and imports. In a particularly welcome departure from the approach of many US economists, the original work in the book (and there is quite a lot of it) focuses on behavior across a wide range of industrial countries, not simply the largest ones.

The importance of the book lies in these empirical chapters. All three provide a valuable guide to empirical work in the area and extensions to existing results. The analysis of saving and investment trends across countries is particularly informative and serves as a useful antidote to those who regard international imbalances purely as a function of disembodied external inefficiencies, such as (in the case of the United States) access to Japanese markets or the level of the exchange rate. The holistic approach of the book, showing how changes in underlying variables led to movements in the current account, is also very useful.

If there is a problem with the book, it is not in the nuts and bolts of the empirical chapters, but in Bosworth’s overall assessment of the conventional model. The model still leaves several anomalies unexplained. If international capital markets are highly integrated, why are movements in the private saving-investment balance largely offset by movements in the government saving-investment balance, rather than in the current account? Why are floating exchange rates so variable from day to day? These and other questions, although discussed in the text, might make one less sanguine than Bosworth about the overall health of the conventional model. In this sense, parts of the book add up to more than the whole.

Tamim Bayoumi

Lawrence E. Harrison

Who Prospers?

How Cultural Values Shape Economic and Political Success

Basic Books, New York, NY, USA, 1992, vii + 280 pp., $22 ($13 paper).

Economists endlessly debate why some nations—most recently the East Asian ones—do better than others. Is it good or bad government policy that determines success? Is it foreign aid or colonial exploitation? Lawrence Harrison, a former mission chief for the US Agency for International Development, offers a seductively simple alternative: culture is the decisive factor in economic success. Sounds intriguing—but the book is utterly unconvincing in its arguments.

The cultural theory of success is like a shiny used car—it looks good on the lot, but when you try to drive it, the wheels fall off. The theory has a problem: cultures are long-lasting, while economic success is sudden and short-lived. Explaining a few decades’ growth by a millennia-old culture is like attributing a hot summer day to global warming. Take Harrison’s discussion of Korea’s success, which he attributes to the Confucian ethic of hard work and high saving. But wait a moment—isn’t that the same Confucian ethic that in the early 1960s had given Korea a saving rate of 3 percent of GDP and left it one of the world’s poorest nations?

Harrison frankly acknowledges these difficulties—one of the charms of his book is that he evenhandedly presents evidence on both sides. His answer is that the negative aspects of Confucianism—authoritarianism and disgust at commerce—had dominated the scene for millennia but then that the “latent positive forces”—frugality and veneration for education—fostered the takeoff of Korea and other Asian “miracles.” Alas, such a theory is of little use for predicting who is going to succeed; how are we to know on what side of the bed Confucianism is going to wake up tomorrow morning?

Harrison’s other argument is that culture can change. Here he at times indulges in circular reasoning. The problem is that we have no objective measure of culture by which we can see it change. The book says that the Korean economy had rapid growth because the culture improved. And how do we know that the culture improved? Because the economy had rapid growth!

Harrison similarly bobs and weaves when attacking the “Iberian” heritage that allegedly suffocates Spain and Latin America. But did not Spain have rapid economic growth the last few decades? His explanation: they opened up to other Europeans and US citizens, through both foreign direct investment and “a surge of tourism”! He argues that it was helpful that the Spaniards “eliminated the visa requirement for Western Europeans and Americans.” According to Harrison, when East Asian nations do well, it is the “latent positive forces” in their own culture; when Spain does well, it is the influx of foreign culture.

Spanish-speaking cultures are not given a break in this book. Is Costa Rica a model of democracy? The book speculates that it was, because there were “large numbers of Basque and Catalan immigrants” in Costa Rica. To explain political strife in the rest of Latin America, the book makes the portentous claim that there is no word for “compromise” in Spanish (is there one in Basque?). Actually, the claim is wrong: the Spanish words acuerdo or consenso will do just fine.

The book’s description of some of the stultifying aspects of the culture of poor people, such as lack of planning for the future, is more convincing. But the book slights the possibility that it is reverse causation—poverty causing culture, not culture causing poverty. People close to subsistence find it difficult to save. Indeed, the book itself shows this and other adverse cultural traits to be universal among poor people, including poor people from the cultures that Harrison admires.

Harrison is right that blaming colonialism or dependencia for underdevelopment is not very persuasive. But neither is blaming culture. In one view, we have the poor who blame their poverty on others, and in the other, we have the prosperous who attribute success to their own virtue. Between these extreme views, maybe there is a lot to be said for the old-fashioned economist’s view that people are the same everywhere and will respond to the right economic opportunities and incentives.

William Easterly

Shingji Takaji (editor)

Japanese Capital Markets

Basil Blackwell, Cambridge, MA, USA, 1993, xi + 560 pp., $64.95.

Kenneth, J. Singleton (editor)

Japanese Monetary Policy

National Bureau of Economic Research Publication

University of Chicago Press, Chicago, IL, USA, 1993. xx + 204 pp., $35.

Juro Teranishi and Yukata Kosai (editors)

The Japanese Experience of Economic Reforms

Japan Center for Economic Research Publication

Macmillan Press Ltd., London, UK, 1993, xx + 560 pp., $69.95.

Japan’s phenomenal postwar growth performance and its emergence as an economic superpower in the early 1980s have aroused renewed interest in the Japanese economy and the characteristics of its policy framework. The contributors of these three volumes offer valuable insights into the strategic factors that have accounted for Japan’s economic success by examining three areas of its economy—the functioning of capital markets, the evolving monetary system, and the process of economic reforms during 1945-70. These volumes, particularly Teranishi and Kosai’s, are also relevant to the former centrally planned economies and developing countries. Takaji’s Japanese Capital Markets traces the evolution of Japanese capital and related markets since the gradual relaxation of controls in 1975. Not only has the size of Japanese capital markets increased—they now rank with those of the United States—but their structures have also changed substantially in recent years. This widening and deepening of capital markets has induced new research in such areas as the cost of capital (Jeffrey Frankel), corporate financing practices (James Hodder and Adrian Tschoegl), the pricing of Japanese stocks (Hideki Hanaeda; Shinji Takagi), and stock trading rules (Hideki Kanda). The authors of the 16 chapters in this volume explore these areas, covering institutional, analytical, and policy issues.

Japanese Monetary Policy discusses the evolution of monetary policy and its instruments, particularly since 1980. The book emphasizes a peculiar characteristic of Japanese monetary policy: the impact of monetary policy is transmitted to the real sector through changes in credit availability rather than through changes in the money supply. This unusual trait is the result of the reliance of the major commercial banks (city banks) on credit from the Bank of Japan—a reliance that enables the Bank of Japan to use administrative guidance and the discount rate as effective instruments of monetary policy. The research presented in this volume suggests that the institutional setting in which monetary policy was implemented during 1955-88 has substantially influenced real economic activity in Japan.

However, the volume does not adequately emphasize that this institutional setting, within which interest rates and the bond market are heavily regulated and the financial system is under the general control of the Ministry of Finance and the Bank of Japan, is the result of a deliberate government strategy to develop a bank-oriented financial system.

The last and perhaps most interesting volume, The Japanese Experience of Economic Reforms, provides a fresh investigation by Japanese experts into various aspects of economic reforms in postwar Japan. The book focuses on economic reforms, structural changes, and inflation control during 1945-50, although the long-term trends of deregulation and liberalization are also taken into account. It is important to note that the system that emerged after the reforms was by no means a pure market-based system; instead, it was characterized by a substantial degree of government intervention.

An important characteristic of Japanese reforms, according to Teranishi, has been the gradual and protracted nature of the processes of deregulation and liberalization. They have been designed to provide firms with non-neutral (discriminatory) incentives—through protection, subsidies, subsidized credit, and tax measures—to adopt, adapt, improve, and diffuse modern technology; attain international competitiveness; and promote a viable process of import substitution and export promotion. Thus, until at least 1973, government intervention (through various instruments) was critical to the unique, high annual growth rate—about 10 percent—Japan experienced during 1953-73.

Further, the growth- or production-oriented stabilization policy the government adopted during 1945-50, which was in direct opposition to the more orthodox policies recommended by the World Bank and the IMF, made it possible for Japan to attain macroeconomic stability along with substantial increases in industrial output. Such selective, purposive, discriminatory interventions, according to the neoclassical perspective and the emerging consensus on development theory, are dysfunctional; however, in the case of Japan, they have been not only functional but also very effective in accelerating the pace of development.

This volume, however, does not deal with several significant aspects of the Japanese institutional and policy framework. First, what measures were taken to make the state industrialization ideology acceptable to farmers, industrial labor, and private firms? Without such acceptance, state interventions would have been ineffective. Second, how did various coordination mechanisms evolve so as to create a highly competitive environment within a cooperative framework? In many developing countries, the stabilization and structural reforms quite often do not provide the expected results because of the lack of appropriate coordination mechanisms. Third, how did the highly competent and motivated Japanese bureaucracy evolve with such a high degree of integrity? Without its bureaucracy, Japan could not have formulated and implemented growth-inducing government interventions.

V.V. Bhatt

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