Monetary-fiscal history of Latin America: lessons for Pakistan

Pakistan today suffers from significant macroeconomic instability, high inflation, a currency crisis and a risk of a sovereign bond default. However, the underlying issues which have caused its current crisis are not unique to the country.

A study of the fiscal and monetary policies of Latin America would show us that the underlying problem of Pakistan’s current economic crisis results from the inability, or unwillingness, of government to limit their spending to their own ability to raise tax revenues.

If we look at the history of Latin America, the region shows one dramatic case of a country that has not learned that lack of fiscal discipline leads to bad economic outcomes—namely, Venezuela—and three problematic cases: Argentina, Bolivia, and Brazil. The problems in each of these four countries reinforce the hypothesis that Pakistan’s underlying cause of their problems is also lack of fiscal discipline.

• The virulent economic crisis that has led to hyperinflation, economic misery, and political chaos in Venezuela started when the government did nothing to rein in spending in spite of a sharp fall in oil revenues.

• Argentina went through a recession that followed a run on its currency and a dramatic increase in country risk that led the country to ask for the International Monetary Fund (IMF) support, a very unpopular measure. The fiscal deficit in Argentina, which had been either negative or small until 2010, started to grow at that point. The principal condition of the IMF’s assistance was that Argentina rapidly reduce its deficit.

• Brazil, a country that was considered one of the giants of the emerging world a decade ago, is agonizing over a high deficit that has persisted for several years. The probability that the newly-elected government will succeed depends, to a large extent, on its ability to tame the fiscal deficit.

• Bolivia is less problematic than Argentina and Brazil. Nonetheless, the increase in external debt caused by increasing deficits since 2012, coupled with a loss of foreign reserves, is reminiscent of policy mistakes in the region that led to debt crisis and inflation.

This is not a statement regarding left versus right, more government or less government, or more or less redistributive policies. To be precise, the key variable in our main hypothesis is not the size of government. What matters is not how much the government spends; rather, what matters is the difference between how much the government spends compared to how much it raises in revenues.

Norway provides an example that clarifies this distinction: its government spends more than any Latin American government as a fraction of total output, but it raises even more revenues, to the point that it owns assets that are worth about three times the yearly GDP of the country. No fiscal clouds appear on Norway’s horizon.

A cross-country analysis makes clear that those countries with large and sustained deficits ended up having substantially more macroeconomic instability than the countries that did not. For instance, Chile and Argentina ran large deficits in the first half of the 1970s, compared, for example, to Paraguay and Peru, and therefore faced much more macroeconomic instability during that decade. Chile made structural changes to its fiscal policy following its debt crisis in the early 1980s, while Argentina did not.

Sure enough, while Chile managed to have very stable macroeconomic indicators, the 1980s brought a sequence of crises for Argentina. Eventually, in the 1990s, Argentina did make a structural change to its deficit and managed to stabilize the economy, albeit only for a decade. By 2001, after several years of recession, the government defaulted on its debt once again.

Paraguay and Peru, as mentioned above, had relatively conservative fiscal policies in the 1970s. As a consequence, macroeconomic instability was relatively low. For example, inflation in Paraguay was, on average, 11 percent per year, while in Peru it was 26 percent per year. While Paraguay maintained fiscal discipline, Peru started spending beyond its means during the 1980s, a process that led to hyperinflation.

Lessons from Mexico

Perhaps no other case presents a more strikingly similar case to Pakistan’s current economic woes than Mexico in the 1980s. In August 1982, Mexico defaulted on payments on its dollar-denominated foreign debt. Here the government deficits of Mexico played a central role in the balance of payments crisis and the debt crisis of 1982. This simple narrative leaves out other factors; however, that caused the crisis to escalate to devastating proportions for the Mexican economy.

Mexico was a perfect storm of lack of fiscal discipline combined with external shocks and a series of devaluations that sharply increased the value of dollar-denominated public and private debt compared to output. The devaluations of the peso that occurred in August 1982 and afterward were part of the debt crisis, which started in August, but the large devaluation in February 1982 was an attempt to avert a crisis.

The Mexican government resorted to increasing inflation and imposing multiple exchange rates, which led to large transfers to some economic agents at the expense of others and distorted incentives, thereby prolonging the crisis. During the 1980s, the inflation rate in Mexico increased from an average of 24 percent per year during 1979–81 to an average of 66 percent per year during 1982–85. (It was even higher in 1986 and 1987, before starting to fall rapidly in 1988.)

Way Forward

It must be noted that the greatest inflationary effect in countries in Latin America was found in economies which exhibited “fiscal dominance”, defined as a regime in which fiscal policy is profligate and the central bank is constrained only in a limited way from lending to the public sector.

The government must realize that austerity seems like the most desirable way to go about reducing the debt-to-GDP ratio. As mentioned earlier, a failure to reduce the debt-to-GDP ratio makes it harder for the State Bank to control inflation and increases the chance of fiscal dominance.

Copyright Business Recorder, 2023