Mario I. Blejer and Adrienne Cheasty
Between July 1985 and March 1986, when hyperinflation was an imminent threat, Argentina, Brazil, and Israel each introduced comprehensive “heterodox” stabilization programs, with the primary aim of a quick and drastic reduction in inflation. The programs were called “heterodox” because they included a number of incomes policies such as wage and price freezes, as well as exchange rate pegging and de-indexation measures, in addition to, in most cases, orthodox fiscal and monetary policies. This combination of policy elements led to major reductions in the rate of inflation and in the trends of other macroeconomic variables, rather than producing the gradual adjustment associated with traditional stabilization packages. This article delineates the economic reasoning underlying those heterodox programs and discusses the role of price controls and de-indexation measures. In addition, the article stresses the characteristics of orthodox fiscal policy that were particularly significant to the heterodox program countries.
The “heterodox” policies were introduced because, besides recognizing that demand pressures on domestic prices are a crucial determinant of inflation, the designers of the “shock” programs also considered inflation to be strongly influenced by inertial forces. That is, given a history of high inflation and failed stabilization efforts, the public would continue to set prices and to bargain for wages as if inflation were going to continue at the high levels of the past, even if demand-management policies were consistent with a lower rate of price increase; and their expectations would be self-fulfilling. The heterodox elements of the shock programs were an attempt to break inertial expectations. A price freeze, for example, was intended to demonstrate immediately that the program had put an end to inflation; the de-indexation of wages would halt the wage-price spiral; and pegging the exchange rate would eliminate price pressures in the traded goods sector. The overall stabilization package would thus become more credible, and hence, more likely to be sustainable over a period long enough for demand-management policies to work.
Obviously, inertial expectations cannot be self-fulfilling and generate inflation unless monetary policy is accommodating. The designers of the shock programs believed that monetary policy was largely driven by the fiscal deficit, which had been substantially financed by money creation—the inflation tax—in each of the program countries. Inflation, while it financed the deficit, had gradually increased the cost of holding non-interest-bearing assets such as money. As money holdings shrank, the financing power of the inflation tax shrank correspondingly. Hence, governments who wished to maintain a given deficit in real terms, regardless of the inflation rate, had to print more and more money as the inflation rate rose, in order to generate the amount of inflation tax necessary to finance the desired deficit.
Given that people’s desire to hold money drops as inflation rises, it was believed possible that, if inflation were rapidly lowered (through a price freeze, for example), money demand would rise, i.e., the base for the inflation tax would expand, and so the same deficit would be financeable at a lower inflation rate.
Thus, the heterodox and orthodox policies each had two facets. The heterodox policies were intended (1) to create credibility for the stabilization program and (2) to raise demand for money rapidly in order to support an acceptably high level of aggregate demand at a low inflation rate. The price-fixing policies were mainly intended to be transitional—to interrupt price-setting in goods and factor markets, rather than to replace the market mechanism permanently. The orthodox, or demand-restricting, policies were intended (1) to reduce the fiscal deficit to a level where its monetary financing was consistent with equilibrium in the money market and (2) to signal, through large immediate (in some cases one-time or temporary) adjustments in fiscal variables, or through announcements of future radical fiscal changes, the government’s commitment to sustainable levels of demand.
Besides the expectation-adjusting mechanisms and demand-management policies, the heterodox programs in most cases included preparatory reforms. The most important of these were equilibrating adjustments in key relative prices (for example goods, wages, the exchange rate) prior to the program, in order to avoid perpetuating excess demand or supply in markets which happened to be in disequilibrium at the time of the freeze.
The heterodox policies were intended to affect expectations and to foster credibility in the programs as a whole, but they were often not without real costs. These costs arise because, when prices are frozen in disequili-brated markets, scarcities and rationing, or, in some cases, oversupply, quickly emerge, usually accompanied by political dissatisfaction and a loss of credibility of the controls. As soon as scarcities suggest that the controls may not be sustainable, people will accelerate their purchases, to take advantage of what they perceive to be temporarily low prices; this will exacerbate inflationary pressures and make the expectation of inflation and rupture of the price controls self-fulfilling. In addition, disequilibrium price controls tend to create and perpetuate distortions which may stunt output and hinder economic growth.
Even if controls are imposed in equilibrated markets, they may be associated with output losses arising from the large discontinuities, the administrative complications, and the uncertainties that wage and price freezes create in the economy. Output losses from these sources could be even larger than the output losses expected in gradual programs without incomes policies.
The types of costs that arise from price controls may well have direct budgetary implications. The administrative (and in some cases political) costs to government of controlling prices directly may be significant. Moreover, if prices start from a disequilibrium position, either the government or the private sector will have to bear the cost of the discrepancy between quantities supplied and demanded. When the government bears the cost, for example, through increasing producer subsidies, the operation has a direct fiscal burden. Subsidies are particularly likely to be burdensome if public sector tariffs are fixed at a disequilibrium level. Worse, the price freeze may lead to gradual substitution out of relatively expensive unsubsidized goods and into subsidized government services, making total expenditure on subsidies grow larger than planned at the beginning of the program. And, of course, any subsidy or administrative cost, unless it is offset by expenditure-tightening elsewhere, represents an expansionary fiscal policy which increases both demand pressures and expected inflation.
It should be noted that, no matter how carefully prices are set to equate supplies and demands at the beginning of a program, only rarely will that market equilibrium remain the same when the program goes into effect. Cuts in the government deficit, changes in the exchange and interest rate, and in the labor and financial markets, are all likely to change the amounts of goods, services, and factors demanded and supplied, and hence the prices that equilibrate their markets.
When the economy is at full employment, controls may be more costly and less effective in stemming inflation than in conditions of excess capacity. At full employment, supply constraints become apparent almost straight away and, thus, pressure from increased subsidies has to be completely repressed through the price freeze at a high and increasing cost, rather than partly serving to encourage production. Therefore, relatively slack conditions (as existed in both of the seemingly well-managed price freezes in Argentina and Israel), make price freezes less likely to be broken and less costly to administer.
On the other hand, policymakers may be reluctant to implement policies that create a situation of excess supply, as this may retard the reactivation of the economy and hamper prospects for long-term growth. For instance, the maintenance of a very high interest rate immediately after the introduction of a shock program might encourage the running down of inventories and, thus, alleviate supply constraints. High interest rates, however, could depress investment, and might even reduce total output.
Role of deindexation
The shock programs attached great importance to the removal of formal indexation, which was considered one of the main culprits in prolonging inflation after the underlying causes of price pressure were removed. Indexation mechanisms usually have two components: (1) a mechanical link between past inflation and present price increases; and (2) an expectational component. Indexation schemes protect people against large fluctuations in their permanent income, and so lead them to expect to be able to maintain a stable consumption pattern over time. These expectations fuel aggregate demand. Therefore, for a de-indexation scheme to be fully successful, it would have, on the one hand, to create an abrupt discontinuity between past and present price increases and, on the other, to generate changes in expected permanent income significant enough to make individuals alter their consumption patterns.
In both the labor and capital markets, the amount of de-indexation which actually took place during the shock programs was minimal, despite the prominence accorded to it. Although wages were frozen in all three countries, the public was, in general, given to understand that the freeze was a short-term measure and that former levels of real wages could be restored, if not by legislation, then through the bargaining process. In fact, in some cases, there was a refinement in the protection with which the indexation mechanisms offset the cost of inflation on incomes. Thus, the so-called “deindexation schemes” did not result in any long-run change in the expectations of wage-earners about the level of their permanent income which might have changed their consumption and savings patterns, nor did they bring about any long-term structural change in the system and in the mechanics of wage formation.
Analogously, there was very little de-indexation of financial assets. In Argentina, there were no formal de-indexation announcements concerning financial assets (allthough the application of a conversion scale for financial contracts was regarded as a de-indexation measure). In Israel, the indexation of long-term financial assets was not disrupted. The only substantive change was the prohibition of foreign-exchange-linked deposits with maturities of less than one year. Likewise, in Brazil, the only de-indexation that was enforced was on financial instruments of less than one year’s maturity. While a year’s standstill was imposed on the indexation of longer-term assets, this pause would have been costless to asset holders (unless they tried prematurely to liquidate their assets) because long-term assets could be indexed to a new government bond which, by design, would be fully adjusted for inflation. The permanent income of asset-holders, like wage-earners, was also protected so that they had no incentive to reduce their demand.
As in the case of wages, the most important program element in the treatment of financial assets was the breaking of the link between past inflation and present asset returns. In Argentina and Brazil this was done through a conversion table applied to financial contracts, which attempted to eliminate that part of the contract that had insulated creditors from expected high levels of inflation which, because of the price freeze, would not be realized. Use of the conversion tables prevented potentially large transfers of real income from debtors to creditors, thus avoiding dissatisfaction which could have undermined the price freeze in the same way that fulfilling past wage contracts at the expense of profits could have. But, again as in the case of wages, the disruption was a purely temporary though politically important phenomenon, and the crucial characteristic of an indexation scheme, i.e., the ability to index wealth to inflation, remained essentially unperturbed.
In theory, the price freeze itself would have accomplished the same end as the de-indexation schemes. If the freeze had suceeded in abruptly cutting inflation, from then on the relevant inflation rate to be taken into account in the indexation mechanisms would have been correspondingly less important. This is, in fact, what happened. The price freeze dampened the inflationary spiral. However, if inflation were to have increased again for any exogenous reason (as in fact happened), there was no reason why the same inflation growth as before should not have occured, given that the indexation mechanisms, although slightly changed in some cases, essentially remained in place.
In summary, wage and asset-return freezes and conversion tables cannot be seen as true de-indexation schemes. They did not create any lasting structural change in the ability of the shock-program economies to prevent the re-emergence of inflation. In that respect, the importance accorded them by the designers of the shock programs (relative to fiscal and monetary policy) may be considered to have been overstated. On the other hand, they did play a role in cutting inertia, by making the disruptions that had been imposed on wage and price trends acceptable.
In the shock programs, by far the greater part of adjustment in demand was attempted through fiscal policy. Performance under the programs highlighted the fact that there are interrelationships between fiscal policy and high inflation. It became clear that fiscal policy to bring down high inflation could be very different from fiscal policy in economies with a stable price level. For instance: (1) the size of the fiscal deficit might itself depend on the inflation rate; (2) different fiscal policies could affect inflation in different ways, so that success in reducing inflation through cutting the deficit might depend on the specific type of policy used to reduce excess government absorption; (3) different fiscal policies could have different effects on aggregate demand and on output, so that, to be optimal, a fiscal package should attain the necessary reduction in absorption while minimizing output losses; and (4) the composition of economic activity, and specifically the financial system, is usually changed by inflation, and hence tax bases too may be affected by inflation.
Effects of inflation on the budget. The fiscal deficit may boost inflation if it is financed by printing money. Conversely, accelerating inflation may limit the power of the government to finance its expenditures by conventional means. Tax revenues may fall in real terms as inflation rises. If this is the case, then a successful reduction in inflation could permit a higher level of public spending to be sustained (financed by a recovery in tax revenues), even if all fiscal policies were to remain unchanged. In the long run, an inflation-free economy may grow much faster than an economy where prices continue to rise.
Prediction of a high-inflation country’s low-inflation budget is complicated by the fact that almost every element of the budget is affected by inflation, but with different elasticities. On the expenditure side, for example, the inclusion of nominal government interest payments in the deficit (particularly when unindexed) magnifies the percentage increase in interest payments relative to increases in other expenditure and in revenue as the inflation rate rises. On the revenue side, the real value of tax collections falls when inflation is high (the Tanzi effect), mainly because of the lag between when the tax is due and its date of collection. The tendency of inflation to push nominal incomes into the higher tax brackets of progressive tax schedules would offset some of the decline. However, this effect is weakened in countries with high inflation, since they quickly develop indexed tax systems which are neutral to inflation.
In general, if government expenditures increase more rapidly than government revenue when inflation accelerates, then the real deficit will rise with inflation—which is one reason why inflation-prone countries quickly tend to find themselves in a high-inflation trap. On the other hand, a drastic reduction in inflation will have the added benefit of bringing with it a more than proportionate improvement in the fiscal balance. In the initial phases of the heterodox programs, the “passive” reductions in the deficit as inflation fell were very striking, with, for example, a drop in the Brazilian public sector borrowing requirement from 27 percent of GDP in 1985 to an estimated 10 percent in 1986. Paradoxically, the better an economy has adapted to high inflation by raising the nominal income elasticity of government revenue, the smaller the gain to the fiscal balance from cutting inflation. When the adaptation has taken place, for example through the introduction of costly accelerated collection procedures, reductions in inflation may even widen the deficit, as the administrative system becomes inappropriately complex for an economy in which prices are stable.
Tax rate increases versus cuts in government activity. As the countries undertaking the heterodox programs tended to be highly indexed, policymakers were concerned lest inflation be boosted by deficit cuts with price effects, such as tax or tariff increases or the reduction of subsidies. On the other hand, cuts in government activity, which would not have direct price effects, could create political difficulties by placing the full burden of adjustment on a few people (civil servants and government suppliers).
In the event, the major deficit-reducing instruments used in the shock programs were rate increases and subsidy cuts, on the argument that the importance of fiscal contraction in bringing down prices, through whatever method, outweighed any negative impact the rate increases might have on the price level. Furthermore, it was claimed that rate increases at the outset of a program could actually lessen inflationary expectations since they would clearly reduce the government’s need for future price adjustments. However, policymakers were careful to coordinate the timing of the rate increases with the attempted removal of indexation systems. This synchronization prevented the rate increases from being incorporated into index-driven inflationary spirals. It also avoided the political difficulties associated with abandoning indexation systems, and the “insurance” they provided, at a time when high inflation continued. Price movements observed after the start of the fiscal measures in the heterodox programs did not seem to reflect the rate increases to any significant extent, suggesting that inflation could be reduced even with instruments which increased individual prices.
Minimizing output losses—fiscal policy implications. One of the most consuming concerns in the shock programs was the desire to avoid recession during the period of adjustment. If inflation were truly inertial, it could be reduced through changes in inflationary expectations, without permanent reductions in the government deficit. Policymakers perceived, on the other hand, that temporary deficit cuts could play an important role in affecting expectations, as they would lend credibility to the government’s adjustment efforts. The improvement in private sector expectations was thought likely to lead to a surge in activity which would offset the decline in government absorption. Temporary fiscal measures were an important innovation compared to past orthodox stabilization programs. The public accepted one-time taxes, without reducing their consumption (or rejecting the program), that were far higher than they would have accepted had the measures been permanent.
The very sizeable inflow of up-front revenue from, for example, short-term forced saving schemes, reduced the deficit very quickly, adding credibility to the government’s program, and giving it a breathing space to introduce slower-acting, longer-run measures, including structural reforms to increase growth. The long-run success or failure of the shock programs depended significantly on whether or not policymakers used their breathing space to implement a fiscal policy which was sustainable in the longer term.
It was further argued that, when trying to minimize output losses and to concentrate on temporary measures, price-realigning fiscal policies were again superior to cuts in government activity, as they had a smaller multiplier effect on aggregate demand and, besides, would probably be more easily reversible. On the other hand, the potential damage to incentives and long-term growth from burdensome and distorting tax increases had also to be taken into account.
Effects on the financial system. Many high-inflation countries’ tax systems rely heavily on financial transactions as a tax base, partly because the financial sector tends to grow as a share of GDP as the country uses more sophisticated financial transactions to adapt to inflation, and partly because, as the inflation tax base shrinks, the logical alternative tax bases are the substitutes for money which have become attractive as inflation hedges. Conversely, when inflation drops, the financial sector tends to shrink, as the demand for money substitutes tends to fall drastically and the volume of financial transactions diminishes. Revenue losses from lower tax yields on financial incomes and on financial transactions can be quite sizeable, particularly where banks are permitted to offset losses against tax obligations.
In most of the shock program countries, the financial sector fell into difficulties as inflation dropped. Publicly-owned banks tended to be worse off than their private sector counterparts, as they were less free to make cuts in staff, and usually held their portfolios in longer-term and less tradeable assets. Neither the effects of lower inflation on the tax base nor, therefore, the tax losses that arose from the difficulties of the banking system, were fully anticipated by policymakers as unwanted side effects of a successful reduction in inflation.
Shock programs have heightened our awareness that the manipulation of expectations may significantly affect the outcome of an adjustment program. But expectation-changing policies can never substitute for the fundamental adjustment needed and achieved by an appropriate fiscal and monetary stance. Heterodox policies are not costless, and they may be successful only when combined with traditional demand-management policies. The implementation of these traditional policies—and in particular fiscal policy—however, is not as straightforward in the presence of expectation-changing policies as it is in stable economies; and the success of the policies, when they are called upon to ward off the threat of hyperinflation, is more difficult to ensure than when inflation is not an important determinant of the behavior of fiscal variables.