Tag Archives: R. Dornbusch



R. Dornbusch and S. Edwards (1989)

Summary etc.

In a Nutshell

Despite the politically heterogeneous aspects of populism in LA, the economic policy of populism shows very similar traits emphasizing growth and income over inflation and deficit finance. This means that not only do the policies ultimately fail, but they often hurt the very people they were designed to assist. Although there are initial successes, forex constraints eventually force realism onto policy makers and real wages cuts ending in instability and often coup, result.

The Populist Paradigm

  • Initial conditions – slow growth possibly after IMF stabilization (later populist episodes) which have reduced living standards. Serious inequality provides economic and political appeal for a radical programme
  • No constraints – existing reserves allow for a rejection of conservative paradigm and risks of inflation from deficit spending are downplayed as there is thought to be lots of idle capacity to take up new demand.
  • The policy prescription – reactivation of the economy and redistribution. Forex to be saved by restructuring of the economy.
  • Phase I – vindication. Growth, real wage increases, employment are high etc. Inflation controlled by ex rate controls etc. Imports increase and inventories run down
  • Phase II – bottlenecks from increased demand mean shortages. Budget deficit worsens considerably and inflation increases.
  • Phase III – pervasive shortages, inflation accelerates. Attempts at stabilization by depreciation sees real wage cuts and political instability. The government is lost.
  • Phase IV – Orthodox stabilization under a new government. IMF programme. Decline is persistent due to lost capacity, and capital flight.

Allende’s Chile

  • Elected 1970
  • Influence by ECLAC thinking – inequality a key problem and unemployment, and the past administration condemned as dependent and monopolistic. There had been stagnant growth and increasing inflation. There was a large trade surplus.
  • The Allende programme was aimed at:
    • Structural economic transformations including nationalization
    • Raising real wages
    • Reducing inflation
    • Increasing growth
    • Increasing consumption
    • Reducing dependency on the ROW
  • The increase in AD was to come from government spending, and accompanied by income redistribution and administrative controls on prices. Thus it was in the stucturalist tradition.
  • It was thought that there was a huge amount of idle capacity in the economy as the economy was slanted toward the upper tier of the income distribution which wanted high capital/labour ratio luxury goods. If demand could be stimulated at the lower end of the scale, lower ratio goods would be wanted and the idle capacity would take up the slack without a resulting upward pressure on prices. So if there was redistribution the result would be inflation free expansion of demand and output.
  • The substantial forex reserves would be relied upon to prevent production bottlenecks.
  • There was little attention put on the financial sector as it was assumed that the lower capital/labour ratio production would need less investment.
  • A trade policy to diversify exports was needed: they abandoned the crawling peg and fixed the ex-rate.
  • They failed to realise that this would only produce a short burst of economic activity.
  • The first year saw success. Demand increased as did output. GDP grew at 7.7% and wages increased 17%. Labour’s share of GDP increased to 62%, more than 10% than a year earlier. This paid off politically in municipal elections where the president’s party increased its support dramatically. However, the deficit had grown from 3% to 11% of GDP.
  • The orthodox budget equilibrium recommendations had to be ignored to achieve the political objectives of raising support (Lopez – economist in the administration).
  • By the end of 1971, forex reserves were halved, inflation pressure mounting, there were shortages and production responses became more sluggish.
  • In 1972 inflation reached triple figures and the deficit was at 13% GDP. Inflation led to people moving to the informal economy and thus the tax base was eroded – vicious circle. It was not politically expedient to deal with these problems by reducing gov expenditure or reducing wages.
  • They took radical steps to stop the problems without addressing the causes; action taken on ex-rate front, but not on wages. Rationing etc. was introduced.
  • 1973 saw a coup. Although the middle classes had be alienated, it should be noted that Allende’s party share of vote rose from 30% in 1970 to 44% in 1973 even with the inflation etc. The military, foreign companies and governments all had a part to play in his downfall, and once he was out the devastating wage cuts took over.

Garcia’s Peru

  • Came to power in 1985 with a message of growth and redistribution.
  • Peru had grown well in 50s and 60s but stagnated in the late 70s with growing inflation.
  • The 1980-85 period was extremely testing: terms of trade deteriorating, IR rates, credit rationing etc. The IMF programmes saw inflation increase and GDP decline.
  • Garcia introduce heterodox solution to utilize idle capacity, reverse high unemployment, and to tame high inflation.
  • In Peru 1% of the population was getting 50% of the income. There was a huge gap between actual and potential output. They were unimpressed with the IMF programmes. Heterodoxy promised an end to inflation without the attendant costs of unemployment.
  • The policies focussed on: raising AD through wage increases;  Re-establishment of ex-rate control and abandonment of devaluation policy; external account managed by ISI and debt service limitations. Garcia effectively suspended the external constraint by suspending debt servicing which allowed for a widening trade deficit.
  • Short term the policies were a big success – inflation declined, employment rose, real wages were 52% higher after one year, the economy grew by 9.5% in 1986 and 6.7% in 1987. Thus given enough forex, and a depressed economy, domestic demand stimulation can work through capacity utilization – Garcia was celebrated.
  • The turning point was the bank nationalization in 1987. The aim was to get hands on the banks to have some control over credit to business. They had run out of forex. In that year, growth was slowing, inflation was high and the external constraints were now biting so bottleneck appeared.
  • Inflation was out of control, a result of the ex-rate situation and the deficit – subsidies and the decline in the tax base exacerbating the problem. The declining forex reserves forced a more realistic exchange rate and this spurred on inflation. So all they had really done was delay the cost of deficit spending for a year or two.