Hyperinflation and Stabilization in Bolivia: The crisis of 1985

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Hyperinflation and Stabilization in Bolivia The
crisis of 1985

• Eduardo Yi
• International Macroeconomics
• April 12, 2007

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Bolivia
3
Bolivia
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Hyperinflation and Stabilization in Bolivia

• I. Hyperinflation
• II. Hyperinflation in Bolivia
• III. The Stabilization Program
• The New Economic Policy
• Reasons for success
• Costs of stabilization
• IV. Conclusion

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What is Hyperinflation?

• The classic definition of hyperinflation is
  price increases above 50 per month (Cagan,
  1956)

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Two Schools of Thought on Inflation Monetarism
vs. Structuralism

• Monetarism
• Inflation is bad
• Caused by excess demand due to budget deficits
  financed by printing money
  
• Govt must cut domestic credit creation
• Monetarists work with full employment models
• Monetarists are identified as conservatives

• Structuralism
• Tight monetary policy is bad
• Inflation is caused by structural imbalances and
  rigidities
  
• The costs of cutting inflation are high, govt
  must use income policies and price freezes
  
• Structuralists emphasize unemployment
• Structuralists are identified as progressive
  reformers

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Five Factors of Latin American Inflationary
Processes (Cardoso and Helwege, 2002)

• Seignorage
• Balance of payments crisis
• Dollarization
• Capacity constraints
• Indexation

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Seignorage

• The governments ability to buy goods and
  services by printing money
  
• When the government puts money into the economy
  without directly taxing production, the value of
  cash drops
  
• Inflation works like a tax on cash holdings
• Opportunity cost of holding currency increases

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Balance of Payments Crises

• A balance of payments crisis linked to a sudden
  fall in terms of trade or a halt of capital
  inflows generates an immediate jump in the
  inflation rate
• A shock to terms of trade (severe price drop of
  export commodity or rise of major import) creates
  shortages of foreign exchange
  
• Rise in international interest rates and
  withdrawal of foreign lending deprive government
  of foreign exchange
  
• Response has been to devalue

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Dollarization

• As value of domestic currency declines, people
  tend to substitute it for foreign money
  
• With high inflation, domestic money loses
  function as unit of measure and store of value
  
• With high inflation, local currency inevitably
  devalues
  
• Costs of dollarization
• Dollars could be better use by external sector to
  import actual goods
  
• If wealth is transferred out of the country,
  credit available to local investors declines

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Capacity Constraints and Supply Shocks

• Real wage increases raise demand, and firms often
  raise output, but if firms are protected, they
  pass on the higher wage bill to consumers
  
• Populist governments fail to recognize capacity
  constraints and over-stimulate the economy
  
• Bad harvests and earthquakes increase prices too
• If inflation is too much money chasing too few
  goods, shocks that increase demand or restrict
  supply create inflationary pressure

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Indexation

• Contracts are written to include indexation
• Minimum wage legislation includes indexation to
  past inflation
  
• Indexation makes inflation a self-perpetuating
  process
  
• Current supply shocks are transferred to future
  periods

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Bolivian Hyperinflation An Overview

• Worst case of hyperinflation in Latin American
  history and seventh worst in world history
  
• The only case of hyperinflation that did not come
  in the aftermath of a war or political
  revolution
  
• During period of hyperinflation prices rose by
  20,000
  
• During the worst surge of hyperinflation, prices
  rose by an annualized rate of 60,000
  

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Bolivian Hyperinflation An Overview

• High inflation in Bolivia lasted from the first
  quarter of 1982 to the fourth quarter of 1985
  
• According to Cagans definition, hyperinflation
  in Bolivia lasted from May 1985 to August 1985
  
• As with other cases of hyperinflation, the end
  came abruptly with a stabilization program in
  August 1985
  

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Bolivian Hyperinflation The Backdrop

• Bolivia was, and is, a very poor country
• Small industrial base (only 1.2 of GDP in 1985)
• Relied on two export commodities tin and natural
  gas
  
• High political instability
• Bolivia was not immune to the 1982 Debt Crisis

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Bolivian Hyperinflation The Backdrop

• Morales (1987) argues that Bolivias failure to
  tackle large illegal cocaine production hindered
  the flow of external resources to support
  stabilization

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The Five Factors of Inflation in the Bolivian Case

• Seignorage From 1965 to 1985 money grew by an
  average rate of 360.2 and inflation by 528.1.
  Phylaktis and Taylor (1993) argue that the
  policies of the government were tantamount to
  maximizing inflation tax revenue
• Balance of Payment Crisis There was a collapse
  of the price of tin in world markets, and
  multilateral organizations stopped lending to
  Bolivia
• Dollarization Most prices were set to dollars,
  although transactions were usually carried out in
  pesos. Workers and firms shifted their efforts
  from production to schemes to get dollars

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The Five Factors of Inflation in the Bolivian
Case (continued)

• Capacity Constrains Only 1.2 of GDP accounted
  for by industrial sector, and 2.5 of labor force
  employed in it. Large portion of GDP dependant on
  tin and gas exports
• Indexation In October 1982, wages were indexed
  to inflation for the first time in Bolivia with a
  trigger mechanism of readjustment whenever
  inflation reached 40

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Three Fundamental Aspects of Bolivian
Hyperinflation (Sachs,1986)

• Cutoff of international lending and the increase
  in international interest rates in early 1980s
  
• The recourse to seignorage jumped as the net
  international resource transfer turned negative
  
• Increasing inflation caused the tax system to
  collapse

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The Stabilization Program The New Economic
Policy

• An orthodox package based on the monetarist view
  of inflation
  
• It was not the first attempt at stabilization,
  previous attempts failed after severe public
  opposition
  
• It was the first stabilization attempt, however,
  by a newly elected government
  
• After experiencing hyperinflation, people were
  willing to try anything
  

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The Stabilization Program The New Economic
Policy

• Devaluation and managed floating exchange rate.
• Immediate reduction of fiscal deficit
• Proposed tax overhaul (enacted eight months
  later)
  
• IMF standby agreement and rescheduling of debt
• Adoption of new currency not an important factor
  in reducing inflation

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Managed Floating Exchange Rate A de facto
Devaluation

• Private agents buy and sell foreign exchange at
  whatever price they want
  
• Central Bank sells foreign exchange to the public
  in a daily open auction
  
• Central Bank buys foreign exchange at the average
  price from last auction
  
• Central Bank determines
• Base price for bids at each auction
• The amount of foreign exchange offered at each
  auction
  
• 93 de facto devaluation

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Reduction of Fiscal Deficits

• Raised prices of oil products provided by
  state-owned oil company YPFB
  
• Wage freeze for all public sector employees
• Reduction of public sector employment, mostly in
  state-owned mining company COMIBOL

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Tax Overhaul

• Harmonization of all import tariffs to 20
• Value Added Tax of 10
• New taxes on wealth
• Incidence of taxes were proportional to income,
  except for very low incomes

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The Standby Agreement with the IMF

• With stabilization, the government regained
  credibility and access to foreign sources of
  finance
  
• Loans were secured for US 1.2 billion
• Debt with Club of Paris rescheduled
• Agreement with IMF was signed on June 1986
• Subsequently, Bolivia was granted a Compensatory
  Finance Loan and a Structural Adjustment Loan

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Monthly Growth Rate of Money Base, March 1984
March 1987
Arrow indicates beginning of stabilization
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Monthly Changes of Average Price Levels, March
1984 March1987
Arrow indicates beginning of stabilization
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Month-to-month Average Changes of Foreign
Exchange Rate in Parallel Market
Arrow indicates beginning of stabilization
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Reasons for Success of NEP

• Sargent (1981) argues that a convincing regime
  change is the necessary and sufficient condition
  for rapid disinflation
  
• Morales (1987) posits that stabilization was
  effective because of super tight liquidity and
  lowered expectations
  
• Sachs (1986) argues that hyperinflation ended
  because the exchange rate was stabilized

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Convincing Regime Change

• In Sargents view, once it is clearly understood
  that the government will not rely on the central
  bank to print money, inflation recedes and the
  exchange rates stabilize

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Super Tight Liquidity

• Strong devaluation and price hikes produced
  contraction of real money supply and a liquidity
  crunch
  
• With liquidity shortage, expectations of
  inflation or further depreciation on the short
  run abated
  
• Lower (peso) liquidity and lower expectations had
  their most immediate impact on the parallel
  foreign exchange market
  

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Exchange Rate Stabilization

• In Sachss view, the end to hyperinflation
  preceded credibility of the government and the
  NEP
  
• Because prices in Bolivia were set in dollars, by
  stabilizing the exchange rate, domestic inflation
  could be made to revert immediately to the U.S.
  dollar inflation rate

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Costs of Stabilization

• Estimates of decreased GDP in 1986 range from
  2.9 to 3.5
  
• Investment in 1986 reached lowest level to that
  date
  
• Unemployment increased by 3 to 20,
  underemployment increased from 50 to 60

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Costs of Stabilization

• Real wages decreased dramatically right after
  stabilization, and remained stagnant after that
  
• Quality of services provided by public sector
  significantly deteriorated
  
• Many middle level civil servants quit the sector
• 25 of rural teachers abandoned their schools

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Conclusions

• High inflation in Bolivia lasted from Q1 1982 to
  Q4 1985
  
• Hyperinflation lasted from May 1985 to August
  1985
  
• Bolivia suffered a BOP crisis with the 1982 Debt
  Crisis and the fall of tin prices in the world
  market
  
• Bolivia experienced a lot of political turmoil

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Conclusions

• An orthodox stabilization package called the New
  Economic Policy was introduced and inflation
  ended abruptly
  
• Hyperinflation ended in spite of public not
  having regained confidence in government
  
• According to Sachs, this is because the economy
  was dollarized and the exchange rate was
  stabilized
  
• The short run effects of the stabilization
  program were recessionary, and where accompanied
  by a marked decline in the quality of public
  services, including education

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Thank You