The Public Policy

Peso Problemas

Latin America's mercantilist policies are causing dangerously high inflation.

By 2.17.08

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Inflation has become a serious problem in Latin America. Argentina's foreign reserves recently reached a historic high, thanks to the Central Bank purchasing massive numbers of dollars to keep the exchange rate "competitive." Inflation there is now reputed to be as high as 20 percent. The same phenomenon is taking place across the continent. In 2007, the Consumer Price Index increased in all but two Latin American economies, reaching a regional average of 8.43 percent -- up almost 2 percentage points over the previous year. Unfortunately pundits are not connecting the dots, and they continue to blame inflation on high oil and food prices.

Inflation is certainly not new to the region, but unlike the well-known episodes of the past, most Latin American governments now employ good fiscal discipline, maintaining low budget deficits and soaring tax revenues.

So where is the inflation coming from? Back in the 1980s and early 1990s, it was fueled by the severe fiscal imbalances of regional governments. As public spending grew exponentially and revenues stagnated or even declined, Latin American politicians turned to central banks to feed their binge. The result was catastrophic: hyperinflation devastated Argentina, Bolivia, Peru, and Nicaragua. National currencies collapsed and were replaced with short-lived new ones.

Today, the outlook is quite different. Latin American governments are enjoying a rare fiscal bonanza. Most countries have small budget deficits or even surpluses. External debt is generally under control, and foreign reserves are steadily increasing.

BUT THE EXPORT boom, and the flow of dollars that's fueling it -- along with a surge in foreign direct investment and remittances from nationals living abroad -- has had an unwelcome consequence, at least in the mercantilist view that still prevails in much of the region.

Every Latin American currency except the Argentinean peso appreciated against the dollar in 2007, in some cases by almost a quarter: the Uruguayan peso jumped by 23.5 percent, the Brazilian real by 23 percent, and the Colombian peso by 22.1 percent. The Peruvian sol, the Paraguayan guarani and the Chilean peso each also appreciated by more than 10 percent last year.

Currency appreciation has generated grievances from exporters who complain that their products are becoming less competitive in international markets. Latin American manufacturers are already facing strong competition from China, and many claim that their economies are suffering from "Dutch disease" -- that is, high commodity prices that hurt the manufacturing sector by raising the exchange rate, making exports more expensive.

This has led state monetary authorities to intervene heavily in currency markets in order to keep their exchange rates "competitive" -- that is, artificially low. The central banks of Argentina, Colombia, Peru, Bolivia, Costa Rica, and Guatemala, among others, have all purchased billions of dollars in an effort to prevent their national currencies from further appreciation. Central banks have pumped up their economies with extra money, which is in turn pushing up prices.

Monetary authorities from these countries argue that measures have been implemented to avoid a rise in inflation as a consequence of these interventions, such as sterilization (selling bonds to banks in order to soak up the excess liquidity) and increasing mandatory bank reserves. However, Latin America can only use these tools up to a point. As data shows, the more dollars continue to flow into Latin American economies, the more trouble central banks have sterilizing and controlling inflation.

Inflation can spell serious trouble for the region. In countries that have lost monetary discipline, the inflationary spree can easily get out of control, especially once higher prices are embedded into people's expectations. Even worse, governments in the region are punishing Latin American consumers in two ways: by eroding both the domestic purchasing power and the foreign exchange value of their currencies.

Latin American governments are following the mercantilist credo that holds exports as good and imports as bad. The resulting inflation is essentially a hidden and highly regressive tax that punishes those who have the least.

Of course, not every country in the region follows the same pattern. In Chile, the rise in inflation has more to do with an increase in public spending than the manipulation of exchange rates. But most Latin American governments are succumbing to the temptation to tamper with their currencies, and thus exacerbating inflation.

These governments should stop decreasing the foreign exchange value of their currencies and restore price stability by pursuing monetary stability. As local currencies appreciate, imports will increase the demand for dollars, putting downward pressure on foreign exchange rates. Governments can accelerate this process by unilaterally reducing their own trade barriers to foreign goods -- a win-win scenario.

Latin American governments must realize that free trade means much more than just exports. Consumers also benefit from imports. And even more importantly, the officials should remember what they learned about monetary mismanagement in the not-so distant past.

Juan Carlos Hidalgo is project coordinator for Latin America at the Cato Institute's Center for Global Liberty and Prosperity.

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