A Latin American Phenomenon?

Even a cursory examination of the evidence shows that inflation—that is to say, the serious kind of inflation that I am concerned with here—is in fact by no means limited in its incidence to Latin America; there are, for instance, striking examples in Asia. Moreover, in Latin America inflation is by no means a general problem. Of the 19 Latin American republics for which we have data, as many as 10 showed average annual increases of less than 5 per cent in the cost of living over the last 18 years or so. Among the others extremely high though fluctuating rates of inflation prevailed throughout the entire 18-year period in only 4 countries: Argentina, Brazil, Chile, and Uruguay. In some countries—such as Bolivia, Colombia, and Paraguay—high average rates of inflation for the period as a whole have resulted because rates of inflation have been particularly high during some years, while being relatively low in others. An interesting fact is that even in those countries in which a rather high rate of inflation has gone on practically without interruption for the last two decades, this inflation has nowhere degenerated into hyperinflation and the extreme economic distortions that usually accompany that phenomenon.

Causes and Control

The question of how to bring serious inflation under control is one that has plagued policymakers and economists for a long time.

The causal relationship between inflation and growth is a subject on which it may never be possible to reach agreement. In countries where there is both severe inflation and a lack of economic progress, is the inflation responsible for the lack of progress? Or is the inflation the result of the lack of progress? Or are both the inflation and the lack of progress a reflection of other deep-seated social and political phenomena? We need not, in my opinion, prolong this controversy, because there is apparently broad agreement today—as distinguished from the situation a decade or so ago—on the proposition that avoidance of inflation is favorable to economic development. At the same time, there is increased recognition that the transition from an inflationary to a noninflationary situation is an extraordinarily difficult process—in part, but only in part, because this process of transition is apt to be accompanied by a temporary interruption of economic growth.

The process of inflation is set in motion when economic and political groups in a community are unable to agree on the wage policies, tax policies, credit policies, etc., that together would ensure the distribution of the national product at approximately stable prices, and when instead an apparent solution of this problem of distribution is found by increases in the general price level. We as economists could perhaps feel reasonably relaxed about inflation from the point of view of welfare and development if in fact it did no more than produce a rise in the general price level. But instead of being limited to that, the inflationary process invariably produces sizable changes in relative prices, and it is the resulting distortions of the price structure that makes inflation harmful to economic development.

It is difficult to make any generalization about the manner in which inflation normally distorts the relative prices of many leading sectors of the economy. But there are three very important sets of prices which, in inflationary situations, almost invariably lag behind the general price level. These are (1) “political” prices, a category which includes public utility and public transportation rates, the prices charged by state industrial enterprises, and the prices that private producers are allowed to charge under governmental price controls designed to “protect” the consumer; (2) the rate of exchange, which determines the relative prices between foreign and domestic goods; and (3) the rate of interest. The effects of price distortions of this kind are readily observed in many countries suffering from inflation.

Effects of Price Distortions

(1) There are many striking instances in Latin America and elsewhere where rates charged for public utility and transportation have lagged behind other prices and in so doing have undermined the financing of important components of the economic infrastructure. Again, the efforts to hold down, by price controls or by special exchange rates, the prices of popular consumption goods with a heavy weight in the cost of living index have been responsible in several inflation-ridden countries for the sorry state of their agriculture.

(2) Overvalued exchange rates have hampered the development of badly needed new export industries. They have frequently caused a haphazard development of import-competing industries, because, for lack of the normal protection of a realistic rate of exchange, such industries have been bolstered by the application of import and exchange restrictions, which operate much less systematically. Overvalued exchange rates have led to the exhaustion of exchange reserves, and once having deprived countries of this cushion that can buy them the time required to perform needed economic adjustments, they then have precipitated periodic exchange crises with consequent uncertainties in the economy.

(3) Inadequate or, even worse, negative real rates of interest have discouraged savings in financial forms, and as such have impeded the development of financial intermediaries and capital markets, both of which can play an important economic role in bringing the flow of savings to those who can employ them in investment ventures. In addition, such unrealistic rates of interest are apt to have a negative effect on the level of savings as a whole.

Not Inevitable

While these distortions are not inevitable accompaniments of inflation, they do reflect very common tendencies in countries suffering from inflation, so much so that it would be hard to point to such countries where all these problems were not present to some degree. It is worthwhile, therefore, to stress two essential aspects of the fight against inflation: first, the desirability of going as far as possible toward adoption of true stabilization policies under which the transition from inflation to stability would be achieved; and second, the need of assuring that, insofar as this basic objective cannot be fully reached, the effects of continued inflation on development are minimized. There is, indeed, a close link between these two aspects. The longer inflation lasts, the more severe are the distortions it tends to produce. And, conversely, the elimination of existing distortions, and the measures taken to prevent new distortions from arising, may be essential preconditions for a successful attack on the imbalance between demand and supply.

Serious Inflation Often Stubborn

One of the clear facts of life in the postwar experience—and not only in Latin America—is that many stabilization plans undertaken have not, or not fully, succeeded. I do not believe that such failures of stabilization plans should be ascribed primarily to their technical deficiencies. I certainly would not want to suggest that all stabilization programs which the Fund has supported have been perfect, but I believe that their main thrust has been correctly placed. There has to be some effective restraint of aggregate demand by means of suitable monetary, fiscal, and incomes policies. Without such restraints, there is no hope that inflation may eventually yield to stability. But the willingness to start a stabilization plan is frequently not sustained in the face of the difficult problems which stabilization inevitably presents, and which inflation permits a country to dodge for the time being. Moreover, it may not always be possible to achieve full stabilization quickly. Severe distortions produced by past inflation pose special difficulties for the process of transition from an inflationary to a stable environment, and these difficulties often cannot be quickly eliminated. Thus, a long history of inflation compounds the problems faced in the transition so that concerted corrective efforts may well have to be applied over a relatively long period of time. Indeed, the difficulties of reaching an effective agreement on the distribution of the social product may not be subject to resolution until sufficient resources have been pried out of the uneconomic sectors. These difficulties have often been compounded by the fact that the inflationary period preceding the stabilization plan made very heavy drafts on the country’s international reserves and on the ability to borrow abroad, so that stabilization had to shoulder the added real cost of a necessary sharp improvement in the country’s balance of payments.

Where countries are not capable of setting a quick end to their inflationary processes, great stress must therefore be placed on the correction of the economic distortions caused by lagging “political” prices and overvalued exchange rates, and, to a lesser extent, by inadequate interest rates.

The problem of the underpricing of public utilities tends to present itself through the effects that these prices have on the profitability of public utilities and indirectly on the government budget. In part, the remedy of such situations involves higher rates for these public utilities. But often the distortions in this sphere of the economy have gone beyond price distortions and require a concentrated attack on the organization of the industries concerned, including complete modernization and a severe reduction in the work force. To perpetuate the uneconomic production of these industries, and to eliminate the resulting deficits by merely allowing very large increases in rates, only makes the solution of the problem of inflation that much more difficult, since it maintains the public utility sector (or elements within it) as an unduly large claimant on the resources of the economy.

With respect to the distortions between domestic and foreign prices, it has been a basic principle of the Fund from the very start of its activity that countries that were unable to contain inflation would be better off not to try to maintain a fixed rate of exchange. On these grounds the Fund in its early years was satisfied with the fact that a number of its members did not declare an initial parity. In the last ten years or so the Fund has pushed further along this same road and has suggested to countries that were not able to master the problem of inflation that they adopt a fluctuating rate of exchange and adjust that rate in consonance with internal inflationary developments. The Fund has refined this approach in recent years to make increasingly sure that failure to control inflation did not, through the maintenance of an overvalued rate, lead to distortions on the external side of the economy, and that fluctuating rates would reflect promptly the extent of internal inflation.

Nor should it be forgotten that effective measures are available to minimize the distorting effects of inflation on the attractiveness of savings in financial forms. Basically, the answer lies in very high nominal interest rates, which in some countries have been ensured by tying deposits and loans to the cost of living. Extremely high interest rates are by no means an attractive feature for any economy, and the same can be said about a persistently declining exchange rate. But if a country is unable to resolve the basic issues of distribution of the national product so as to prevent continuous inflation, it will usually be better off if it prevents at least some of the more glaring economic consequences of this inability than by pretending that the problem does not exist, and maintaining low interest rates and a pegged rate of exchange to further this pretence.

Recognition that full stabilization may not be possible in the short run is no reason for not adopting a domestic policy mix aiming at all times at the maximum stabilization obtainable in the given circumstances. But efforts at a gradual stabilization of the price level have a chance of success only if such price increases as continue to take place are not allowed to produce any major economic distortions. Only on this basis can there be any hope that the gradual attack on inflation will eventually yield to true stabilization—a stable price level, a fixed rate of exchange, and relative prices conducive to rapid economic development.

This article is adapted from observations made at a Panel Workshop on Latin America on this subject, at the Tenth World Conference of the Society for International Development, held in Washington, D.C., U.S.A., in March 1968.