Felipe Larraín assesses whether policies by certain Latin American populist governments could undermine present price stability and usher in a return of the high inflations of the 1980s.
One of the most striking aspects of Latin America over the past two decades is the reduction of inflation. In a region known for hyperinflation in the mid to late 1980s, inflation came down not only to single-digit rates but to less than 5% – on average – in 2006, its lowest rate in half a century.
Only two countries in the region have double-digit rates: Venezuela’s hovers around 20% while Argentina’s is closer to 10% (though price controls exist over some key goods and public utilities). Price controls, increased domestic liquidity and populist policies are elements tied to severe bursts of inflation in the region’s recent past, and have led some pundits to wonder whether high inflation – and even hyperinflation – may be on its way back to Latin America.
Hyperinflation is defined as an inflation rate of more than 50% per month, after the seminal contributions of Philip Cagan in the mid 1950s. If this rate does not seem spectacular, note that 50% per month leads to an annual inflation rate of almost 13,000%.
Currently only one country suffers from this precise malaise – Zimbabwe, where inflation is reaching the 5000% level. Thus, hyperinflation is not dead. It helps, then, to understand the conditions under which it happens.
Hyperinflation is a relatively recent 20th-century phenomenon. A high inflation rate can only happen under very special monetary circumstances that allow for spectacular increases in the money supply tied to the financing of large fiscal deficits. The spread of fiat money (that is, unbacked paper money) in the 20th century set the ground for the emergence of hyperinflations, and the more common occurrence of high inflations.
The hyperinflations that took place during the past century did not occur as isolated events, but rather came in bursts linked to global economic and political events. There are three distinct time periods when groups of countries succumbed to hyperinflation: the aftermaths of the two world wars, and the debt crisis of the 1980s.
The first two periods affected European and Asian nations such as Austria, Germany, Hungary, Russia, Greece and China. The crisis of the 1980s affected principally Latin American countries: Argentina, Bolivia, Brazil, Nicaragua and Peru. Poland and Yugoslavia also fell into this trap at this time.
Each high inflation and hyperinflation has unique characteristics that depend on the country in which it occurred, the time period, and the external circumstances. However, all share significant common elements.
Inflationary stresses
One traditional view links hyperinflation with war, civil war or revolution, which seems plausible since two of the three time periods where it occurred are related to war episodes. According to this view, the strain on the public budget brought about by the financing of a war effort leads to a major deficit that eventually becomes monetised.
A second view stresses weak governments which lack the ability to enforce tax collections and cannot implement necessary budgetary reforms. These governments are easily tempted to placate different groups of the population with transfers and subsidies in order to build up a political base. Under these situations they are likely to turn to inflationary financing.
A third argument relates to external shocks (such as the debt crisis) with budgetary implications. Under a fiat money regime, the value of the currency ultimately rests on the ability of the government to keep its current and future budgets under control. If economic agents feel that public finances may collapse, they may provoke a speculative attack on the currency.
Since the early 1990s, Latin America has experienced a huge decline in inflation. A transitory exception was Ecuador, which dollarised in 2000 at an over depreciated parity and had to endure corrective inflation. Increasingly, countries have appreciated the benefits of macroeconomic stability, have reined in fiscal deficits and have made progress toward more independent central banks. In this way, they have removed the fundamental underlying causes of high inflation. Thus, in 2006 the average inflation of the region was below 5% for the first time in several decades.
It is exceptional that all major countries in latin America have been able to bring inflation to within the 1% to 5% range. That is, with two notable exceptions. In Venezuela inflation is definitely not a priority; prices have been climbing at about 20% annually, and no credible stabilisation plan exists. Argentina’s inflation rate, on the other hand, is about 10%. Yet it is safe to assume that real inflation is above the official figure. This results from the introduction of price controls and export restrictions on various goods and services whose scarcity value is not reflected in their prices. Therefore, in Argentina the effective rate of inflation is several points above the official rate.
The rise of populism
Although the people of Argentina and Venezuela would certainly benefit from lower inflation, they are very far from the extreme price changes that Latin America saw in the recent past. The risk that one country in the region could develop hyperinflation is very slim.
If we go back to the historical causes of this malaise, none of the elements associated with it are present today in the region. There is no armed conflict, no distinctly weak governments, and no significant negative budgetary shocks.
The true risk of high inflation in Latin America lies in populism. It is no coincidence that Venezuela is the country with the highest rate of inflation in the region – though low by historical standards. Hugo Chávez, Venezuela’s president, is the face of Latin American populism, though of a different brand; a rare mix of socialism and populism for export which can be sustained without an explosion of inflation as long as oil-related fiscal revenues remain generous.
If that situation changes – and it will when the international cycle turns – the risk of high inflation is at the door. Hyperinflation is not dead, it is merely sleeping. Leaders such as Zimbabwe’s Robert Mugabe are capable of awakening the monster.
Felipe Larraín is professor of economics at the Pontificia Universidad Católica de Chile and is a consultant to the United Nations and the World Bank.
