adjustment and development in latin america: the failure of peruvian heterodoxy, 1985–90

World Development, Vol. 19, No. 5, pp. 411-434, 1991. 0305-750X/91 $3.00 + 0.00 Printed in Great Britain. © 1991 Pergamon Press plc

Adjustment and Development in Latin America: The Failure of Peruvian Heterodoxy, 1985-90

EVA A. PAUS* Mount Holyoke College, South Hadley, Massachusetts

Summary. I This article analyzes the failure of the Peruvian stabilization and development program, 1985-90. It critically assesses major contributions during the 1980s to a theory of heterodox stabilization strategies for Latin American countries, and articulates a more comprehensive approach to the conceptualization and study of heterodox programs. This approach revolves around three key elcments: the need to break inflationary inertia, the necessity of reconciling short- and long-term policies, and the importance of evaluating ex ante the plan's political-economic feasibility. Serious misconceptualizations with respect to all three elements are found to explain the disastrous outcome of Peru's heterodox program. Lessons for future heterodox programs are diseusscd.

1. I N T R O D U C T I O N

In mid-1985, the newly elected Peruvian g o v e r n m e n t a t t rac ted widespread a t ten t ion with its s tabi l izat ion and deve l opm en t proposals , which seemed to hold out the promise of a viable a l te rna t ive to In te rna t iona l Mone ta ry Fund ( IMF)- type ad jus tmen t p rograms on the one hand and bloody revolu t ionary war on the other . Af te r impressive initial results, however , the promises were not , and indeed could not be, kept. This paper analyzes the reasons beh ind this failure.

Since the early 1980s most Latin Amer i can countr ies have exper ienced the deepes t economic recession in the last 50 years. Sharply reduced inflows of private in te rna t ional bank lending and large debt paymen t obl igat ions have resul ted m con t inuous foreign debt reschedulmg, a persistent net ou t - t ransfer of funds to the rest of the workt, and s tagnant economic growth. Dur ing this debt -cure-s tagnat ion crisis two approaches have emerged , each offering different policies to ove rcome the economic pr()blems. On the one hand . there has been a concer ted push, especially by in te rna t ional organizat ions , for o r thodox economic measures . Tha t means a r e t r e n c h m e n t of the g o v e r m n e n t ' s active role m the accumulation process, and grea ter price flexibility in key marke t s with the goal of increasing efficiency and establ ishing the basis for renewed economic growth. A l though or thodox policy r ecommenda - t ions were certainly not new, they owed their renewed p rominence to the l imitat ions of pre-

viously pursued deve lopmen t s trategies and to the more powerful posi t ion that the 1MF and the World Bank had acquired as the debt crisis cont inued , l On the o the r hand , a n u m b e r of Latin Amer i can gove rmnen t s have resisted o r thodox shor t - t e rm and/or long- term policy r ecommenda t ions to different degrees and adopted a l te rnat ive , so-called he te rodox , programs. He te rodox economic measures were first adopted by Argen t ina in June 1985, by Peru in Augus t 1985, and by Brazil in February 1986.

In A r g e n t i n a and Brazil, he te rodox policies were conceived as shor t - t e rm programs a imed at control l ing inflation. The he te rodox program in Peru, in contras t , c la imed to go beyond stabilization and combine shor t - t e rm policies with a new long- term deve lopmen t strategy that would en- compass redis t r ibut ion and res t ructur ing. In spite of the different goals, all three plans - - af ter apparen t initial success have failed to achieve thei r goals.

! will argue here that the main reasons for

*1 would like to thank John Sheahan, Maria Amparo Cruz Saco, Jens Christianscn, and the anonymous referees of this journal for constructive comments on an earlier draft. My thanks also go to the members of the ('entro de Inw,stigaciOn of the Univcrsidad del Pacffico in Lima l\)r their hospitality and helpfulness during my research stays in Peru, especially to Eduardo Mor6n for providing a copy of the ( 'oyuntura data base. I am also indebted to Trish Walsh for help in the elaboration of the tables, and to Mount Holyoke College for partial funding of the research.

411

412 WORLD DEVELOPMENT

the failure of the Peruvian heterodox program (PHP) lie in serious shortcomings in its conceptualization. The results of these mistakes were aggravated further by uncoordinated policy im- plementation. Based on a review and critical assessment of the main theoretical e lements in the li terature on heterodox stabilization programs in the 198(1s, I propose an expanded approach which incorporates the explicit recognition of structural long-term causes of inflation and of the poli t ical-economic context in which heterodox stabilization programs are pursued. The approach is primarily structuralist in orienta- tion, al though it also borrows from radical poli t ical-economic theory. It serves as the organizing f ramework for the subsequent analysis of the failure of the Peruvian heterodox program.

The conceptual f ramework is discussed m Section 2. After a brief out lme of the Peruvian program in Section 3, its failure is analyzed in detail in Section 4. The analysis is organized around the three key issues highlighted in Section 2: the need to break the inflatiomlry inertia, the necessity of combining short- and king-term policies, and the importance of anticipating the poli t ical-economic feasibility of the program. The final section summarizes the main argument and draws out lessons for future heterodox programs.

2. I I E T E R O D O X S T A B I L I Z A T I O N P R O G R A M S : A C R I T I C A L R E V I E W A N D

E X T E N S I O N

The monetarist-structuralist debate about the sources of inflation in Latin Amer ica had its heyday during the 1950s and 1960s. Today, some economists proclaim the controversy resolved in favor of a monetaris t consensus, others claim that the fired verdict has not yet been reached, and again others advocate the appropriateness of a modified structuralist f ramework. 2 The focus here rests on inertial inflation, which was the key e lement in inflation analyses in the 1980s by neostructuralist and some orthodox economists alike, and which provided the impetus for heterodox stabilization programs.

It has always been an accepted truism that persistent price rises have to go hand in hand with increases in the money supply beyond the growth of real output, if the income velocity of moncy is fairly stable. The nontrivial and con- troversial issue, however , is the question of causality. Does an increase in the money supply cause inflation viii demand expansion, or does it only validate and accolnmodate inflation that

originated elsewhere? At the risk of oversimplifi- cation, we can say that or thodox theory affirmed the former, and structuralist theory the latter. According to the structuralist view, inflation in Latin America is the inevitable byprodnct of growth because of the economies ' inflcxiblc structures of production. Foxley (1987, p. 244) smnmarized the main structural roots of inflation as resource immobility, market segmentat ion. and disequilibrium between sectoral clcmands and supplies, with the main bott lenecks arising from insufficient supply of food products, scarcity of foreign exchange, and rigidity m the tax structure.

Analyses of L a t e An le r i can mf la t ion in the 1980s reveal an emerging consensus that inerthll inflation is a critical e lement in an understanding of inflation and in the conceptualization of stabilization policies. Thc argument was that, due to widespread indexation and/or ovcrhipping sal i i ry contracts for example, iner t ia l in f la t ion unleashcs and feeds an inflationary dynan/ic of its own. cvcn though it is o r ig ina l l y set ii1 nl~,)tion by persistent disequilibria in the econonlv, lit contrast to the or thodox view, the structuralist theory of inflation has always made a distinction between root causes of inflation on the onc hand and propagatmg naechanisms on the other.+ In the debt-cum-mflat ion context of the 1980s, these inflat ion-promoting mechanisms became the primary focus in neostructuralist infhltion analyses, but their importance was now recognized and highlighted by some orthodox economists as well. a The name changed to mertial inflation, and the analysis became more rigorous and intricate, but, now as then, it concentrated on inflationary forces basically outside the reahn of the interplay of supply and demand.

Once inertial inflation exists, an orthodox stabilization program with ahsorption-rcducing measures will take a hmg time to bring inflation down to a low level." To be sure, it will eventually succeed in lowcrmg mflation, but the social costs incurred in the process, m tcrms of unemployment , lost output, and more widespread poverty, arc very high. If a government is at tempting to consolidate a young fledgling democracy, as was the case m a number of Latin American countries in the 19£1}s, these costs might be deemed too high.

t t e te rodox stabilization programs provided an attractive alternative. They were aimed at breaking the mertial inflationary momentum through {ill incomes policy, the frcczc of kcy economic prices, without provokmg a deep recession. ~' An lnconles policy will, however , not bear the desired fruits unless, concomitantly, other economic polit ics are adopted to correct tl~e under

FAILURE OF PERUVIAN HETERODOXY 413

lying fundamentals that cause inflation. Price controls are to wipe out people 's collective "inflation memory . " But they are also supposed to provide the requisite breathing space for the government to implement policies that will reduce, if not eliminate, the key forces which cause inflation and provide the breeding ground for renewed income struggles and inertial inflation.

For the or thodox economists favoring a heterodox stabilization program, the fiscal deficit is the fundamental root cause that has to be attacked. 7 Neostructuralist economists advocat- ing such a program also explicitly recognized the importance of controlling fiscal deficits in the short run. In contrast to the traditional or thodox demands for fiscal restraint, both or thodox and neostructuralist advocates of a heterodox program highlighted the importance of using the operational rather than the nominal fiscal deficit as a guide for deficit reduction. The operational budget subsumes the noninterest deficit and real interest payments. They also agreed that in the deficit-inflation linkage causality runs in both directions, s

By focusing on inertial inflation and short-term policy formulations, the neostructuralist inflation analyses of the 1980s overcame one of the weaknesses of the previous structuralist theory of inflation, which emphasized the structural root causes of inflation and focused on long-term remedies without concerning itself much with short- term inflation control. Ironically and unfor- tunately, however, the shift toward short-term inflation control led to policy formulations which neglected the long-term structural roots of inflation. To be sure, the 1980s witnessed a growing body of literature dedicated to the formulation of a neostructuralist development strategy (e.g., Bitar, 1988; Fffench-Davis, 1988; Rosales, 1988). These proposals reflect a constructive modifica- tion of previously held tenets, with a general emphasis on selective rather than universal policy application in different areas. They include a more critical appreciation of the state in the development process; a reaffirmation of the importance of import substitution, but with more emphasis on selectivity and efficiency; an acceptance of the importance of nontraditional export promotion, but on a selective basis; and a more explicit concern with income redistribution. There seems to have been little overlap, however, between the neostructuralist outlines of a new development strategy on the one hand and the neostructuralist formulations of heterodox stabilization programs on the other. The former did not concern themselves with specific short- term policy formulations, regarding inflation control or any other issue, since these presum-

ably have to be elaborated on an individual country level. The latter failed to incorporate long-term strategies that would include an attack on the structural roots of inflation.

If we give credence to the existence of structural causes of inflation, a presumption from which I start, then the mandate to complement an incomes policy with an attack on the root causes of inflation has to incorporate policies that aim at the reduction of the structural roots of inflation as well. The fiscal deficit is one of these causes, but it is not the only one, and, depending on the country case, not necessarily the most important one. Unless policies are adopted that begin to address the foreign exchange constraint and the low supply elasticity of the agricultural food-producing sector, to name but two, those roots of inflation will resurface with renewed strength and will possibly ignite a new wave of inertial inflation. Inflation stabilization and development become synonymous to a certain degree, since there is substantial overlap between the structural changes required for growth and more self-sustained development and those needed to eliminate the sources of inflation. It is this fundamental insight of the old structuralist theory of inflation that has to be revived and incorporated into a new conceptualization of heterodox stabilization programs that correctly and importantly highlights the need to break inflationary inertia. In other words, the sharp distinction between short-term and long-term problems and policy programs has to be replaced by an articulated strategy that links the two and focuses on the policy implications of a smooth transition from the short to the long run.

There is a general consensus among the advocates of a heterodox stabilization program that the program's success also depends on the prevention of large relative price distortions during the price freeze and on the adoption of consistent and credible macroeconomic policies. These conditions clearly carry over to a new heterodox stabilization program, where short- term adjustment policies are embedded in the larger context of a policy framework aimed at structural change. When the price freeze is imposed, relative prices have to be more or less aligned, and they must not change too much for the duration of the freeze. Otherwise, inflation will reemerge once the temporary freeze is suspended. By the same token, an incomes policy that changes the distribution of income significantly will reignite a subsequent inflationary struggle over shares, unless it is supported by a national consensus.

But what do we mean by "'credibility" of macroeconomic policies? What are the forces


that determine it'? Policy consistency is clearly important in determining credibility, but the demand for consistency addresses primarily the technical side of the issue and neglects the political aspects. With respect to the latter, it is important to highlight the class character of policy programs and choices, an element that is present, although often dormant, in structuralist writings, but at the forefront in radical political- economic theory. The choice of any particular adjustment or development strategy is not just an economic-technical issue, but also a political- economic one. Strategies differ in terms of the class alliances necessary to support their imple- mentation as well as in terms of the groups that stand to lose or gain from them, especially in the short run. Policy programs will be credible, if it can reasonably be assumed that the different groups of economic actors behave in accordance with the design of the program. For example, if capital accumulation by the priwtte sector plays a key role in the program, then it is important that policies inspire the necessary confidence in capitalists to invest. Or if real wage increases are to be restricted to prevent an overvaluat ion of the real exchange rate, then a way has to be found to convince workers to behave accordingly. Bul whether economic actors will behavc according to policy makers" expectations depends on whether they participated m the fommlation of the pmgnml in the first place, whether they expect to bcncfit from it, and whether they arc sufficiently organized to opposc it if they consider the program detr imental to their interests. This docs not imply that policy programs arc a zero-sum game, but they do provide differential bcnefils to different groups, in relative and possibly absolute terms, Thus, for a n lacro-ccononl ic policy program to be credible there has to be a shared consensus among the different groups in civil society about the inrplied distribution of benefits or, in the absence of such a consensus, ~t government has to be able to enforce it.

In summary, three key elcnlents have to bc integrated into the conceptualization of a heterodox program. The first one is the importance of inflationary inertia and the need to break it with a wcll-devised incomes policy. The second one is the recognition of the structural roots of inflation, which requires the adoption of consistent n3acroeconomic policies that are informed by the need for structural changes to address the long-term causes of inflation. The third element is the feasibility of implement ing such macroeconomic policies, which presupposes an understanding of the likely acceptance of the implied relative distribution of benefits by the various organized groups in civil society.

3. O U T L I N E O F T H E P E R U V I A N t t E T E R O D O X P R O G R A M (PHP)

When Alan Garc/a P6rez, the successful candidate of the A P R A party (Popular Revolut ionary Alliance of America) assumed the presidency of Peru on July 28, 1985, the economic situation was alarming: stagflation with no indication that the situation would improve. Unuti l ized industrial capacity was estimated at 5<~6(}%: the annual- ized rate of inflation was projected at 25(>300% : international rescrvcs were declining: total external debt was 92% of GDP: 58% of total liquidity was m foreign currency: the open unemployment rate was 11.8%; and growth projections for G D P for 1985 were negative (Carbonctto, de Cabellos. Dancourt , et al., 19~7, p. 50).

According to orthodox economic theory, as exemplif ied by the analysis underlying the IMF stabilization programs, a balance-of-payments problem and rising inflation are the result of excess internal demand. '~ Such a diagnosis leads to the well-known policy prescriptions of a real devaluation of tire exchan,,e rate coupled with dccrcased absorption, primarily through a rcduc- tion of the fiscal deficit and of rcal wages. While these recommendat ions arc aimed at sol~ing the short-term economic problems, thc hmgcr-tcrm problems require a different set of solutions. The key obstacles to long-tern1 growth and devclop- ment arc identified as inefficient production behind protective tariff wttlls, inward-looking growth dec to an antiexport bias ill trade ~tlld exchange rate policies, insufficient domcstic sav- ings, and inappropriately high capilal-mtcnsily ol produclion as a result of ~,overnmcnt-induccd factor pricc distortions. The proposed remedies consist of outward-or icntcd policies, the libera lizalion of product and factor markets, and the roll-back of govelll l l lcnl inte.-vcntion in the c c o n o n l v . 10

The A P R A economic team rcjeclcd the orthodox theoretical f ramework as well as the ensuhlg short- and hmg-tcrm policies as inappropriate in tile Peruvian c o n t e x t , n o t l e a s t in l h c w a k e o f a

failed libcralization cfforl under the B¢latmdc government during the first half of the 1Og{In. e\s in the or thodox analysis, the starting point of the alternative l+~ctcroclox analysis \ \as that the ect~ nomic problems of Peru in the mid-lCJ<S0s wcrc the result of cyclical as \\,ell as structttral internal and international factors. The contrast, however, arose in the identification of the reasons behind stagflation and of the nature of the hmg-teFm structural problenls, lt

The heterodox ccomlonlists" allah,sis ot t)Cltl'>, economic problems, particularly the brag-term OlleS, WaS c lcarh i n f l u e n c e d b y s t r t lc t t l r~ t l i s l


economic theory. The policy prescriptions, however , especially the more concrete ones concerning the short- term measures to be adopted by the Garcia government , were more idiosyncratic and specific to Peru's heterodox advisors. The key elements of the analysis underlying the PHP with the ensuing policy recommendat ions are discussed below. They are summarized in Table 1.

In the face of an economy with high unemployment and high levels of unutilized capacity in many sectors, the argument that inflation re- sulted from excess demand did not make sense. The heterodox economists argued that the fiscal deficit was not only not inflationary, but actually recessionary, since the deficit adjusted for external debt service payments showed a surplus (Carbonet to , de Cabellos, Dancourt , et al., 1987, p. 50). Instead, they attributed inflation to increasing costs resulting from devaluations,

rising interest rates, and modern sector price formation in response to declining demand. While a number of nonheterodox Peruvian authors embraced the rising cost explanation of inflation as an alternative to the excess demand hypothesis, the structural component (administered pricing) was the new element in the heterodox analysis. 12 The key assumption was that prices were not determined competi t ively in all markets. Rather , they were determined by supply and demand only in some markets, while in other markets they were primarily supplier- determined, in the form of government- controlled prices and of mark-up pricin~ (administered pricing) in the modern sector. 13 The primary emphasis in the explanation of rising inflation rested on the modern sector. With a downturn in demand, principally due to declining real wages, production declined, and unit costs increased. Firms were thus assumed to operate

Table 1. Schematic presentation of analysis underlying the Peruvian heterodox program

Problem Causes Policies

Short-term problems: Inflation

Recession

Long-term structural problems: Foreign exchange 1 ) constraint (dependence)

2)

Heterogeneity among economic sectors

Excessive centralization of economic activity in Lima

1) Increasing unit costs due to: 1) - - devaluations - - r i s i n g interest rates - -modern sector price

formation with declining demand

2) Inertial inflation 2)

Insufficient demand

Foreign debt payments

Structural causes: rigidity of export and import structures

Historical-structural

Historical-structural

Cost-reducing measures (lowering of interest rates and taxes) and increase in demand

Selective control of key prices: - - exchange rate - - government-controlled prices - -modern sector prices

Reactivation through: - -h igher real wages --special income and

employment-generating programs

- - "'dedollarization'"

1) Debt-service payments limited to 10% of export earnings

2) Change panern of consumption and production

1)

2)

Transfer of resources to rural Andcan and urban informal sectors

Incentives for investment outside of Lima Zoning of ncw regions with larger regional autonomy in dccision-making process


on the downward-sloping part of the marginal cost curve (Carbonetto, de Cabellos, Dancourt, etal . , 1987, p. 59). j4 In addition, unit costs for all firms went up because of devaluations and rising interest costs, t5 While rising unit costs were viewed as the source of the inflation problem, expectations and inertial inflation were consi- dered to be important in propagating inflation.

The policy recommendations based on this analysis focused on a reactivation of demand via real wage increases and special income and employment-generating programs, and a decline in the inflation rate through a selective freeze of key economic prices (the exchange rate, and government-controlled and modern sector prices) coupled with cost-containing measures (reduction of the interest rate and selected taxes). 1~ In view of the recessionary state of the economy and price formation in the modern sector, an expansion of demand was not con- sidered inflationary. It would, however, provide the necessary impetus for renewed growth and investment.

The foreign exchange constraint, it was argued, had two main sources: the excessive burden of the foreign debt service and the inflexibility of the export and import structures. A devaluation would not solve the balance-of- payments problem because of the structural nature of the latter. Traditional exports, whose short-run supply elasticity is very low, constitute around 80% of Peruvian exports, which leaves only 20% of exports that can respond to the improved export profitability following a devaluation. On the import side, roughly 85"/i, is accounted for by capital goods, intermediate inputs and food, all of which exhibit low import price elasticities. Many of these imports are complementary to domestic output rather than substitutive, given the weak development of domestic productive capacity in intermediate and capital goods production and the low short-run supply elasticity of domestic food production. 17

In order to avoid a balance-of-payments squeeze in the reactivation and stabilization program, debt service on public foreign debt was to be limited to 10% of export earnings, thus freeing scarce foreign exchange to support renewed economic growth. In addition, multiple exchange rates would be used to provide dif- ferentiated incentives for exports and imports according to established priorities. The structural nature of the foreign exchange constraint was to be reduced, if not eliminated, through a change in the prevailing patterns of consumption and production so as to lower the import intensity of economic growth and increase the use of domestic resources in production and consumption.

Restructuring was to be induced primarily through a change in relative prices. The necessary policies were, however, never spelled out in any detail, not least due to the fact that restructuring was on the agenda only for the medium r n n .

The economic team of the Garcia government identified heterogeneity among the different economic sectors and excessive centralization of economic activity in Lima, the capital, as the other key main long-term structural problems of the Peruvian economy. Is The heterogeneity among the different sectors of the economy was analyzed principally in terms of the large variances in labor productivity and capital intensity. The modern urban sector (mainly manufacturing) and the modern rural sector (mainly cash- crop production of cotton and sugar) exhibited substantially higher capital-labor ratios and labor productivities than the informal urban sector and the Andean rural sector. L,~ The technological gap between the modern sectors and the informal urban and Andean rural sectors, as well as the absence of well-established linkages between them, prevented the dynamic growth impetus which results from a more homogeneous and integrated national economy. Furthermore, industrial growth had led to excessive output diversification with insufficient linkages rather than to the development of potentially competitive integrated production chains. Thus, the industrial sector had remained highly dependent on imports without having developed the capacity to generate the foreign exchange to pay for them. The overwhelming concentration of economic activities in Lima was seen as another important manifestation of the lack of economic integration of the country. >

Decentralization was to be promoted through government incentives for investments outside of Lima as well as the zoning of new regions to allow greater regional autonomy in decision making. To decrease heterogeneity among the economic sectors, resources were to be trans- ferred from the capital-richer to the capital- poorer sectors, from the modern rural and urban sectors to the informal urban and Andean rural sectors. Such a redistribution was projected to lead to higher economic growth rates than those that would prevail with the continuation of the traditional pattern of accumulation. ~'~ While it was understood that greater sectoral homo- geneity could only be achieved in the medium to long run, policies to initiate the process were to be an integral part of the short-run program. Prices of the service sector would be exempted from the price freeze; the government wouM guarantee profitable prices for agricultural pro-


ducers, and special income and credit programs would be provided for the informal and disad- vantaged agricultural sectors.

4. A CRITICAL EVALUATION OF THE PHP

(a) A brief summary of the economy's performance under the PHP

The short-term Emergency Plan (Plan de Emergencia), which lasted from August 1985 until December 1986, brought forth very impressive results. The combination of selective price controls and demand reactivation led to a rapid increase in GDP and a substantial decline in the inflation rate. 22 After an initial decline in economic output during the last two quarters of 1985, GDP surged in 1986. 23 Total GDP grew by 9.5%, agriculture by 3.8%, manufacturing by 15.9%, construction by 24.1%, and trade by 13.9%. The driving force behind this growth was the 13.3% increase in consumption expenditures (see Table 2), which account for about three- quarters of GDP. Demand for consumer goods rose as a result of growing incomes and the "'dedollarization'" of the economy. 24 Inflation (measured as changes in the consumer price index) declined significantly from 158.3% in 1985 to 62.9% in 1986 (see Table 3). At the same time, however, a number of problems were looming underneath the surface, threatening to under- mine in the coming years the very achievements of 1986: a decline in international reserves, an increasing overvaluation of the real exchange rate, and a growing fiscal deficit. 25

The increase in aggregate demand had reduced excess capacity in key sectors of the economy harboring the danger of subsequent demand inflation. Furthermore, the indiscriminate reactivation across productive sectors led to a consider- able increase in imports. The government had decided to solve the conflict between service payments on external debt and increased imports for growth partly by limiting the former to 10% of export earnings. 2~' Given the very public announcements of debt payment restrictions and the open repudiations of the IMF, it is not surprising that international creditors did not react kindly, z7 While international private banks had stopped lending altogether in 1984, official agencies, governments, and international organizations now reduced their lending considerably. 2s Nevertheless, with the reduction in debt service, albeit not below 10%, the net transfer of resources abroad declined substan-

tially (see Table 4). 29 Even so, international reserves declined by $516.6 million in 1986, primarily due to the rapid deterioration in the balance of trade. The change from a trade surplus of $1,172 million in 1985 to a deficit of $16 million in 1986 was caused by a decline in exports of 15% and an increase in imports of 44% .3o The rise in imports was the result of rising demand coupled with an increasingly overvalued real exchange rate. With July 1985 as the base, the multilateral real exchange rate index had reached 80.03 for exports and 69.54 for priority imports by December 1986 (see Table 5).

The deterioration in the balance-of-payments deficit was not the only constraint looming on the horizon. The government deficit also grew in the course of 1986 (see Table 6). The central government deficit increased from 2% of GDP in 1985 to 3.5% of GDP in 1986. Given the lid on public sector prices, the deficit of the nonfinancial public sector grew even more, from 2.4% in 1985 to 4.9% in 1986.

During 1987, the Peruvian economy kept growing at 7.8%, but the latent problems underlying the 1986 success became increasingly real. Demand increases led to bottlenecks in key economic sectors, the consumer price index rose by 114.5%, the real exchange-rate continued to appreciate, the growing balance-of-payments deficit left international reserves at only $59.9 million in December 1987, and the fiscal deficit went up to 5.6% of GDP for the central government and 6.5% for the nonfinancial public sector. 31

Thus, by the beginning of 1988, severe re- trenchment and adjustment had become inevitable. The administration was intent on avoiding a large once and for all adjustment of key prices (exchange rate, public sector prices, etc.) in order to prevent the inevitable large negative social impact. Instead, it adopted a gradualist approach with four major policy packages in March, June, September, and November. The typical components of the adjustment programs were devaluations, increases in controlled and public sector prices and interest rates, and wage increases that were lagging behind the rate of inflation. The absence of a coherent approach, the lack of policy coordination, and the succes- sive partial adjustments, however, foiled the attempt to alleviate the impact of adjustment. 32 By the end of 1988, GDP had declined by 8.8%, and inflation had reached 1,722%. In 1989, the situation deteriorated even further. Economic output declined by an estimated 10% and the consumer price index rose by nearly 3,000% (CEPAL, 1989, pp. 18, 20). 33 The only positive element was a substantial increase in interna-

Tab

le

2.

Rea

l G

DP

hv

e.

rt)e

ndilu

re

tyl?

e (a

nnua

l gm

m'th

ra

tes)

Ex

pcn

dil

ure

ty

pe

1980

19

81

1982

19

83

1984

19

85

1986

19

87

1988

Fin

al

con

sum

pti

on

P

riv

ate

con

sum

pti

on

G

ov

crn

mcn

t co

nsum

ptio

n

Gro

ss

cap

ital

Io

rmat

ion

G

ross

fix

ed c

apit

al f

orm

atio

n

Ch

ang

e m

in

ven

tory

Ex

po

rls

Imp

ort

s

Gro

ss

do

mes

tic

pro

du

cl

7.1

l 4.

36

2.53

8.

80

0.98

2.

31

13.3

1 8.

29

- 10

.49

4.96

5.

34

0.88

8.

81

1.93

2.

l 1

14

.94

9.33

11

.76

22.3

3 -

1.58

13

.30

8.77

4.

57

3.53

3.

40

1.21

-

1.22

36.2

0 2t

).51

-7

.18

37

,88

-9.8

9

-10

.34

33

.94

23.8

2 -7

.01

21

.88

16.1

2 2.

02

-29.

113

6.17

10

.56

19.8

1 14

.79

13.1

9 34

8.37

46

.56

31.4

3 97

.22

-64

4.4

1

- 18

3.05

21

4.33

1

33

.1t2

29

.84

-9.1

7

-2.9

4

6.12

-1

0.3

4

9.12

4.

40

-1t1

.16

3.

84

-8.1

11

3tl.

25

15.9

2 2.

21

29.~

4 -1

8.1

8

-8.6

6

2tl.

37

14.4

5 -1

3.11

2

4.48

4.

42

0.25

12

.34

4.77

2.

36

9.53

7.

77

-8.8

1

©

v"

<

©

'7

Sou

rce:

C

asas

an

d

Bel

tram

19

89J.


Table 3. Percentage changes in price indices

1985 1986 1987 1988

Consumer price index 158.3 62.9 114.51 1,722.32

Producer price index Total 50.96* 79.39 1,877.07

Material origin 41.17" 76.61 1,855.51 Imported origin 34.88* 52.92 1,991.81 Agriculture 141.66" 81.00 962.63 Fishing 115.15" 65.56 945.85 Manufacturing 26.44* 66.97 2,4(14.93

Source: CP! from Data Bank, Coyuntura, CIUP (Centro de Investigaci6n de la Universidad del Pacffico, Lima): PPI calculated from INE (1989a), p. 149, and (1988), p. 108. *August 1985-December 1986.

tional reserves resulting from the drastic reduction in imports due to the severe recession.

(b) Analysis of the failure of the PHP

The brief, yet telling, description of the performance of the Peruvian economy under PHP has made it amply clear that the Peruvian heterodox program has failed abysmally. In the following analysis, I will argue that this failure was primarily due to severe shortcomings in the conceptualization of the PHP by Peru's heterodox economists. The analysis is organized around the three key issues identified in the earlier theoretical discussion of heterodox stabilization programs: the need to break the inertial inflationary momentum, the necessity of embed- ding a short-term policy program in the context of a longer-term strategy that addresses the structural roots of inflation, and the importance of the feasibility of the program in terms of the likely acceptance by different organized groups in civil society of the implied relative distribution of benefits. The analysis will selectively incorporate economic policies and their results, but it will not provide a detailed chronological account of the unfolding of events.

(i) lnertial inJlation

In contrast to the heterodox stabilization programs in Argentina and Brazil, the PHP focused on selective price controls. One of the conditions for a selective incomes policy to eradicate inflationary inertia is stability in the ratio of controlled and uncontrolled prices. In the Peruvian case, the relative prices changed dramatically. Between August 1985 and December

1986 (the duration of the Emergency Plan) the overall consumer price index increased by 83.4%. On a more disaggregated level, however, price increases differed considerably. Subdivid- ing the different products that enter into the calculation of the consumer price index into those whose prices were determined by supply and demand (flexible prices) and those whose prices were fixed or controlled by the government (administered prices) we find that during the 17 months span, flexible prices increased by 133.9%, but administered prices by only 38.40/0. 34 Thus, the relative price ratio between administered and flexible prices, equal to one in July 1985, had deteriorated to 0.61 by December 1986. The differential price developments in the fix- and flex-price markets are also reflected in the behavior of the wholesale price indices (see Table 3). During the Emergency Plan period, wholesale prices in manufacturing (most of which were frozen) increased by only 26.44%, in contrast to 141.66% for agriculture (where most prices were flexible).

One of the implications of the drastic changes in relative prices was a substantial redistribution of income. The Gini coefficient declined from 0.50 in 1985 to 0.43 in 1986 (INP, 1988a, p. 33). The winners were workers and employees with rising real incomes (see Table 7) and an increasing share in national income (see Table 8) as well as independent workers in the agricultural and informal urban sectors. The latter's share in national income increased from 23.6% in 1985 to 25.7% in 1986. The losers, in relative not absolute terms, were the capitalists, as evidenced by the declining share of profits and net interests in national income.

The failure to eliminate fundamental root causes of inflation, discussed below, contributed

Tab

le

4.

Bal

ance

of

paym

ents

(m

illi

ons

of

US

$)

1975

19

77

1980

19

81

1982

19

83

1984

19

85

1986

19

87

1988

Cu

rren

t A

cco

un

t B

alan

ce

Tra

de

bal

ance

E

xp

ort

s f.

o.b

. Im

po

rts

f.o

.b.

Fin

anci

al

serv

ices

P

ub

lic

Pri

vat

e N

on

fin

anci

al s

erv

ices

T

ran

sfer

p

aym

ents

l.o

ng

-ler

m c

apit

al

Pu

bli

c P

riv

ate

Bas

ic

bal

ance

S

ho

rt-t

erm

ca

pit

al

+

erro

rs

and

o

mis

sio

m

Bal

ance

o

f p

aym

ents

Ad

den

da:

N

cl

inle

rnat

ion

al

rese

rves

N

et

reso

urc

e tr

ansf

er

(1)

Lo

ng

-ter

m c

apil

al +

fi

nan

cial

ser

vic

es

(2)

(l)

+

sho

rt-t

erm

ca

pit

al

+

erro

rs

and

o

mis

sio

ns

-15

3

783

-10

2

1,72

9 1,

6119

-8

71

22

1 12

5 1,

079

1,49

5 -1

,12

8

- 1,

097

-42

2

826

-55

3

-42

9

293

1,01

17

1,17

2 16

-4

63

-5

6

1,33

0 1,

726

3,91

6 3,

249

3,29

3 3.

015

3.14

7 2,

978

2,53

1 2,

6{/5

2,

694

-2,4

27

-2

,14

8

-3,0

90

3,

802

-3,7

22

-2

,72

2

2,14

0 1.

8(}6

2,

596

-3,{

)68

2,

75{}

-28

4

-43

9

-90

9

- 1,

019

- 1,

033

- 1,

130

- 1,

165

- 1,

011

821

-76

9

776

-26

2

-43

7

-45

6

548

636

-80

6

7(17

-6

05

54

1 59

4 -

177

-47

2

-56

3

-48

5

-49

4

-35

9

-30

4

-21

6

-22

8

- 18

2 -2

31

26

-1

66

-3

18

31

4 -2

53

-2

21

17

0 34

3 39

5 -4

53

77

10

4 14

7 16

1 16

7 21

9 15

8 13

4 15

11

132

157

1,13

5 72

8 46

3 56

5 1,

194

1,38

4 1,

189

691

630

793

814

793

659

371

305

989

1,43

1 1,

392

814

606

664

718

342

69

92

260

2115

-4

7

-20

3

- 12

3 24

12

9 96

-40

0

-55

36

1 -1

,16

4

-41

5

513

968

816

449

702

314

- 17

7 -2

94

36

1 66

11

539

553

721

536

-68

-

1114

11

4

577

349

722

504

124

-40

24

7 28

(1

-51

7

-80

6

-428

;

115.

8 1

,10

11

.9

1,27

6.2

771.

4 89

6.2

855.

9 1.

1{/2

.9

1,38

2.6

866

59.9

-3

47

*

851

289

-44

6

-45

4

161

254

24

-32

0

191

24

38

674

- 5

- 85

20

6 70

~}

- 29

9 -

697

-. 8

56

259

81/

76

©

F"

~J

<

r'-

©

r~

Z

Sou

rce:

D

ala

Ban

k,

Co

yu

ntu

ra

Eco

nd

mic

a,

CIU

P

(bas

ed

on

B

CR

, M

emor

ias)

. D

ec

em

be

r 19

88,

FAILURE OF PERUVIAN HETERODOXY

Table 5. Average nominal and parity exchange rates

421

Av. Nom. Parity exchange rates: Ex. Rate* bilateralt multilateral$

Multilateral real exchange rate indices: priority average

Exports Imports Imports

1985 March 7.88 6.41 NA June 10.79 8.83 NA September 14.011 11.10 NA December 14.117 I 1.96 NA

1986 March 14.19 16.96 15.06 June 14.19 18.77 16.45 September 14.97 21.00 17.82 December 16.13 23.57 20.10

1987 March l 7.24 27.55 22.86 June 19.10 32.16 26.47 September 21.1/9 38.97 32.12 December 33.42 48.47 38.09

1988 March 44.53 74.21 58.83 June 66.7/) 102.02 82.19 September 247.10 342.75 285.43 December 627.29 845.89 680.62

1989 January 966.89 1,238.57 1,015.64 February 1,123.31) 1,757.92 1,449.08 March 1,253.21 2,486.12 2,1)63.88

99.26 99.11 99.1 l 94.85 95.26 95.26 97.66 97.97 97.97

1113.97 1113.65 1113.65 103.42 1[12.18 1112.18

87.52 84.09 86.98 94.87 92.81 93.54 86.87 84.98 85.65 83.16 78.44 84.78 8(1.03 69.54 80.43

76.46 56.10 71.25 76.62 64.68 74.83 75.01 59.86 69.27 711.16 49.58 61.04 94.19 41.82 911.38

86.46 41.75 74.78 82.25 27.118 69.1t9

105.20 27.29 57.07 8/t.03 73.76 93.119 79.91t 73.46 104.41

83.08 64.44 107.311 711.02 62.72 85.97 59.75 58.14 62.40

Source: Multilateral real exchange rate indices from BCR (1989, p. 55). All other pp. 218-219, and (1988), p. 176. *Average nominal exchange rate for commodities. tWith respect to US$; base: July 1985. SWith respect to seven major trading partners: base: July 1985.

data from INE (1989a),

significantly to the resurgence of inflation af ter the incomes policy was a b a n d o n e d in January 1987. But the substant ia l changes in relat ive prices and in the dis t r ibut ion of income by themselves gua ran t eed that inert ial inflat ion was only suppressed temporar i ly . It would, and did, resurface with new force as soon as the lid on prices was lifted.

(ii) Structural roots of inflation~Structural problems of development

Redis t r ibu t ion , the reduct ion of he te rogene i ty among the four economic sectors, was the only long- term policy goal tha t was an integral par t of the PHP from the beginning. The various policies adopted benef i ted agricultural p roducers and those in the informal sectors in numerous ways. Th ree policy ini t iat ives deserve par t icular a t ten- tion. First, with the except ion of a l imited

n u m b e r of food staples for which consumer prices were cont ro l led , the prices of agricultural products and of the informal sector con t inued to be freely de t e rmined by supply and d e m a n d dur ing the Emergency Plan period. Second, a public works p rogram, P A I T (P rograma de Apoyo al Ingreso Tempora l - - T e m p o r a r y Income Suppor t Program) prov ided e m p l o y m e n t for up to th ree mon ths at the m i n i m u m wage for projects in poore r u rban and rural areas. Be tween Oc tobe r 1985 and D e c e m b e r 1987~, slightly over one-ha l f million people found temporary e m p l o y m e n t th rough PAIT. 35 Third , a n u m b e r of policies were adop ted to s t imulate agricultural product ion . F R A S A (Fondo de React ivac ion Agropecua r i a y Seguridad Al imen- tar ia - - Fund for Agricul tura l Reac t iva t ion and Food Security) covered the dif ference be tween the newly es tabl ished gua ran t eed p roducer prices and the lower consumer prices for 12 key

422 W O R L D D E V E L ( ) P M E N T

Table 6. Selected indicators ~)1 fiscal develolmU'nt

1985 1986 1987 I988

(Millions el 1979 lntis)

Central governmenl revenue Total current goverllmelll revenue 4(~(1 398

rax revenue 442 385 Income t'Jxes 57 87 Property taxcs 10 18 hnport taxes t.~2 77 Production and consumption taxes 255 187

Central government expenditure Total expenditure 702 f~74

Current cxpcnditurc 444 422 Payroll 122 130 lntercst 129 77 I)cfense 107 ¢)5

Capital expenditure 68 94 I)cbt amortization 19(I 158

Econonlic and linanci:il deficits As a

( 'e l l i ra I governnlcll[ Economic deficit* 2.114 Financial dcficil 7.42

Non financial public scctorl Economic deficit 2.37 Financial deficit 9.21

295 3(~5 297 357

58 7S 12 20 h3 47

155 185

599 578 41(1 4O7 134 12S

97 75 87 41

102 130

perccntaoe el ( ; I )P

3.54 5.57 2.51 7.55 >;.23 5.41)

4.94 h.>O NA IOAi7 U.H2 NA

Source: INE (1989bl, pp. 538-54,~. ~Excludes debt amorlizalion. tlncludes ecntrfil govcrninent, decenlralizcd public instilulions, local govcrnnlcnis, public charitabk' sociclics, social securily institute, and nonfinancial imblic enterprises.

products. Agricultural inputs could be imported at preferential exchange rates. The agricultural sector en joyed preferent ial interest rates on loans, including zero interest rates for peasant communi t ies in the Andean Trapezoid, which comprises the poorest areas in the Andean high- lands. The subsidies implicit in fill of the support policies for the agricultural sector were very substantial .3,

In view of the high un- and underemployment rates in Peru, the PAIT was an important social program. The importance of the policies specifi- cally directed at the agricultural sector cannot be rated high enough in a country where the food- producing agricultural sector has long been the neglected, if not ignored, stepchild. Neverthe- less, in the conceptual izat ion of tile redistr ibution program, a number of germane issues were neglected or not very well defined. First, the absence of control of agricultural and in fo rma l sector prices dur ing the En lerge i lcy Plan led to the undesi rab le change ill re lat ive prices dis-

cussed above, which tmt le rnmled the a t tempt to eliminate inertial inflation. Second, the role of the urban informal sector m a more integrated econonly was never spelled out in any detail. While public works programs are important employnlent-crcat ing programs, they cannot bc but temporary , and by themselves they do nothing to structurally change the infl~rmal scctor. Third, and maybe most importantly, it was never explicitly specified who was to pay for tile t ransfer of resources and how. Resources clearly had to come from the nlodern private sector. But since that was the sector which was to bc enticed to invest and to carry out tile restructuring process, it was not to be antagonized through higher taxes. The result of this nondcfini t ion of t ransfer mechanisnls was that tile cost of the policies was absorbed by thc government and a growing fiscal deficit.

A t the beg inn ing of the ( ia rc ia i \c lmin is t ra l ion , when the eCOl lOl l ly was i l l recession, the Peruv ian he te rodox economists maintainecl thai

F A I L U R E OF P E R U V I A N H E T E R O D O X Y

Table 7. Indices oJ" real labor renumeration (1979=1001

423

Legal Renumera t ion Renumera t ion in min imum in general private sector*

income government sector Wages Salaries

1985 68.6 58.9

February 66.8* 62.0 87.9 65.4 May 58.9* 59.1 81.5 61/.2 August 77.6 57.1/ 82.7 59.1 November 70.8 55.9 89.5 69.1

1986 71.1 61.3

February 81.5 59.2 98.4 71.3 April 74.4 54.1 101.9 76.4 August 63.9 60.8 105.0 86.6 December 70.5 68.3 108.9 89.7

1987 75.2 69.4

February 62.6 61t.7 1118.8 84.3 April 78.2 69.4 111.1 85.4 August 83.0 70.7 106.0 93.5 December 811.4 94.2 108.6 82.4

1988 66.7 59.5

February 63.7 74.6 104.9 85.4 April 71t.5 72.11 95.2 74.2 August 64.1 59.4 86.2t 66.1 t December 48.3 28.2 41.7t 42.8t

1989

January 42.2 26.2 36.3t 40.5t February 37.2 21.4 31.6t 38.3t March 37.0 21.1 27.5t 36.2t

Source: INE (1989), pp. 164-168, and (1988), pp. 1211-124. *Metropolitan Lima. tEs t imated .

Table 8. Percentage distribution ~[" national income

1984 1985 1986 1987 1988

Wages and salaries 36.5 34.8 35.7 34.7 34.9 Wages 18.3 16.7 17.6 17.3 18.8 Salaries 18.2 18.1 18.1 17.4 16.1

Income of independents 24.6 23.6 25.7 24.5 21.6 Rent 2.5 2.9 2.tl 1.6 2.1 Profits 33.5 36.4 35.4 38. l 40.7 Net Interest 2.9 2.3 1.2 1.1 11.7

Total national income 10(1.{111 1110.01l 11111.011 11111.0t) 1011.011

Source: Data Bank, Coyuntura . CIUP (based on BCR, Memorias).


the fiscal deficit was not a source of inflation. That conviction, however, became dogmatic and inflexible, as it was not recognized quickly enough that the fiscal deficit can very well exert inflationary pressures under different economic circumstances, i.e., when the foreign exchange constraint starts to become binding. The dismissal of the potential inflationary threat from a growing deficit was a key mistake in the conceptualization of the PHP. First it led to a deliberate increase in the fiscal deficit, and later to procras- tination in attacking it. 3"7

Real government expenditures actually declined in 1986 and 1987, by 4 and 11% respectively (see Table 6). But real government revenue fell even more, 13.5% in 1986 and 25.8% in 1987. The decline in indirect taxes, which was primarily the result of anti-inflation policies, was not accompanied by a commen- surate increase in direct taxes. Furthermore, the attempt to slow down the increase in the inflation rate by holding back increases in government- determined prices (the infamous embalse) led to a growing deficit of the public nonfinancial sector. The index of the real price of gasoline, for example, whose development is representative of government-set prices in general, fell from 1.0 in August-October 1985 to 0.56 in December 1986, (I.40 in December 1987, and 0.36 in October 19881 ~ The increase in the public sector deficit had an expansionary effect on the monetary base. Central Bank credit extended to the public sector accounted for 45% of the increase in the Central Bank's assets in 1986 and for 51.7% in 1987. Thus, ironically, the effort to control inflation through the embalse of government-set prices and tax exemptions fueled the fires of inflation through monetary emission financing part of the public sector deficit.

To be fair, it has to be pointed out that Garcia's economic advisors did attempt to improve the fiscal deficit in 1987. This attempt, however, did not express itself in general tax increases, but rather in a mandatory purchase of public investment bonds for a select number of corporations, a measure which subsequently was declared unconstitutional. >

While explicitly recognizing the importance of the foreign exchange constraint, the economists behind the PttP clearly underestimated the speed with which it was going to become binding. More importantly, they failed to incorporate a restructuring of the production and trade patterns from the beginning. The 1986-9(/ Development Plan which hfid out the restructuring pattern was actually not finished until the end of 1986. The sequencing of policy priorities for the quinquen- nium, as summarized in that plan, was 1986 - -

year of reactivation, 1987 year of investment, 1988 - - year of exports, and 1989-9(1 - - years of productive restructuring (INP, n.d., p. 91)) o

With the import-intensity of production un- changed, the exchange rate increasingly overvalued, and large foreign lending unavailable, an increase in demand of the magnitude experi- enced in 1986 and 1987 had to lead to a rapid depletion of international reserves. A more cautious increase in domestic demand during those two years would have postponed the foreign exchange crunch. But slower growth would not have avoided the external constraint, unless, simultaneously, export diversification and import restructuring had been promoted aggressively.

During the Emergency Plan period some attempts were made to limit imports by shifting tariff positions to the list of restricted imports and through hidden devaluations, where tariff positions were shifted from the base exchange rate (MUC) to the higher financial exchange ratc. Nevertheless, imports could have been restrained further, if nonfood imports of consumer goods had been prohibited. They amounted to $378 million in 1986 and $4(15 million in 1987.

More importantly, however, the PtlP neglected to promote diversification. A number of studies have shown that the significant growth of Peruvian nontraditional exports in the second half of the 19711s had a large vent-fi)r-surplus component (e.g., Paus, 1985; Schydlowsky, Hunt and Mezzera, 1983). Thus, for nontraditional exports to grow and become competitive on the international market in the context of a growing domestic economy, policy makers would have had to make an explicit and long-term commit- ment to the promotion of nontraditional exports. One of the key elements in such an institutionalized support structure is a real effective exchange rate that provides at least equal incentive to produce for the domestic and the international markets. From the end of 1987 until the middle of 1988, Peruvian authorities made a deliberate attempt to improve the real exchange rate for exporters. It was, however, not enough for the real exchange rate to even reach the level of July 1985 (see Table 5). Furthermore, by aggrawtting the exchange rate differential between exports and imports, the loss that had to bc absorbed by the Central Bank increased with a resulting expansionary impact on the monetary base. 41 The losses of the Central Bank due to the multiple exchange rate policy amounted to 0.8% of GDP in 1985, 1.4% m 1986, 2.8% in 1987, and (}.8'~/,, in 1988 (Dornbusch and Edwards, 1989. p. 43).


(iii) Consistent and credible macroeconomic policies

The discussion above has shown the inconsis- tency of the policies adopted by the Garcfa economic team. The selective price controls were inconsistent with breaking inflationary inertia given the drastic change in relative prices. The rapid increase in demand coupled with an initial neglect of the fiscal deficit and the postponement of restructuring to a second phase of the program led to growing macroeconomic disequilibria.

Economic policy makers were not oblivious to the unfolding economic problems. In May 1987, Garcia's top economic policy advisors proposed an anti-inflationary shock, which in many ways looked like the measures adopted in August 1985. 42 The key difference, however, was the emphasis on strict foreign exchange control, promotion of nontraditional exports, and investment in high-priority sectors. It is doubtful that the revised model could have been rerun in mid- 1987 in view of the absence of excess capacity in key sectors and the scarcity of foreign exchange. But even supposing that those constraints were not yet binding, there were two elements in the proposal that raised serious doubts about its effectiveness beyond the short run. On the one hand, there was no mention at all of the need for an increased tax base. On the other hand, to keep price increases down, the middle classes were to see their income restricted through wage increases below the rate of inflation and the capitalist class through a limitation of the profit margin.

Both these elements are important in the discussion of the political feasibility of the PHP. While it is true that Peru's heterodox economists dismissed the importance of a growing fiscal deficit on economic grounds, it is also true that they were fearful of financing it through increased taxes on political grounds. It is important not to neglect this latter aspect in an analysis of the failure of the PHP because it highlights the political-economic roots of the fiscal deficit.

APRA's political platform exhibited an anti- imperialist, nationalist, and semi-corporatist ideology (e.g., Garcia, 1987). In the Garcia program, everybody was to win, or at least nobody was to lose. Garcia saw himself primarily as the advocate of the rural and urban marginal- ized and excluded. Their position, in accordance with the redistribution policies adopted, was to be improved. Organized labor in the modern and government sector was viewed as the privileged labor aristocracy. But while it became the most neglected sector in the Garcia political equation, it was favored in economic terms, since real wage

increases were to stimulate a reactivation of the economy. Private capitalists were wooed by the administration, since they were to carry out the restructuring program. The economic role of the government was explicitly limited to influencing private sector allocative decisions by providing differential incentives through tax, subsidy, and selective price control policies. 43 Investment decisions left to the private sector are by definition voluntary. Whether private capitalists will invest or not (in the high-priority sectors or in general) depends on expected absolute and relative pro- fitabilities. Thus, the policies of the Garcia government were greatly influenced by the desire to leave the profitability of private investment intact. The concern with private sector profitability led to a reduction of selective taxes during the Emergency Plan period and an unwillingness to increase taxes subsequently. The result was a growing fiscal deficit. The unconstitutional mandatory purchase of government bonds mentioned above suggests some awareness on the part of policy makers of the inherent dilemma in tapping private sector surplus without antagonizing capitalists.

I am not arguing against the possibility of achieving redistribution in a growing economy through differential, yet positive, gains for different groups and sectors. But for such a redistribution to materialize, there has to be a consensus about its desirability. Financing it through a government deficit is no more than a temporary option. In the early days of the Garcia administration, Schydlowsky (1986, p. 238) predicted that if the APRA policies fail, "it will be because the various competing economic groups cannot coalesce sufficiently around a coherent consen- sual policy that will promote everyone's interest to some extent and no one's interest to another's detriment."

It was one of the great failures of the Garcia government not to attempt the establishment of such a consensus. It is the absence of such a consensus, among other factors, that raises serious doubts about the possibility that the May 1987 proposal mentioned above could have been implemented successfully. Garcia neglected to define a national project that would have identified more clearly the relative winners and losers, that would have engaged the population or key parts of civil society and given them a way of participating in decision-making processes through institutionalized channels, that would have established legitimacy and support for sensitive decisions. As it was, Garcfa's reunions with peasant groups and communities (Rimana- cuy) and his eloquent speeches from the balcony of the presidential palace amounted to no more

426 WORLD I)EVELOPMENT

than one-s ided dialogues. The Garc ia govern- men t bypassed business organiza t ions like C O N F I E P ( C o n f e d e r a c i d n de I n s t i t u c i o n e s E m p r c s a r i a l e s del Peri l - - C o n f e d e r a t i o n of Ent rep reneu r i a l Ins t i tu t ions of Peru) and opted instead for concertaci6n with the heads of the large economic power groups to entice thenr to embark on new inves tmen t projects in high- priori ty areas. 44

Official rhe tor ic at the tinre clearly d e m o n - s t ra ted the bel ief in the success of com'erlaci6n. Yet it also showed concern over tile pr ivatc sector ' s potent ia l response. On numerous occa- sions, Garc ia implorcd the pr ivate sector to invest , to " m a k e a bet on Peru ' s future . "'as It is impossible to de t e rmine the extent to which inves tmen t was actually unde r t aken in the high- priori ty sectors, since inves tment data are un- avai lable on a d isaggregated sectorial level• It is, however , und i spu tab le tha t the priwltc sector as a whole did invest and that capital flight decl ined t e m p o r a r i l y f ' In 1986, pr ivate net fixed capital fo rmat ion (in cons tan t 1979 antis) grew by 23.5% and capital flight decl ined by a round $40(I million. In 1987, however , priwtte inves tmcnt growth slowed to 8.8%, and capital flight increased again. 47 Thc response el + thc pr ivate sector m 1987 seems to have bcen due to the real izat ion that the limits of expans ion were being reached and to uncer ta in ty about the policies the g o v e r n m e n t would adopt in responsc.

While the economic expans ion reached its limits by the second half of 1987, the political tu rn ing point came slightly earl ier with Garc ia ' s proposal in July to nat ional ize the bank ing and insurance companies . This frontal at tack on pr ivate proper ty relat ions encoun t e r ed s t rong oppos i t ion , not only froth the business conm m n- ity but also f rom parts of Garc /a ' s own party. The mcasnrc e m b o d i e d a fundan len ta l t u r n a r o u n d in the admin i s t r a t ion ' s rehttiotls with thc privatc" sector. It is unclear what mot iwt ted Garc /a to a rmounce the na t iona l iza t ion projcct dur ing his annua l address to the nat ion on ,luly 28, 1987. as Ostens ibly , thc measure was a imed at providing more democra t i c access to credit on a regional basis as well as for the small- iuld nledium-scale borrowers . Nat ional iza t ion ix, however , not a sufficient condi t ion for the democra t i za t ion of credi t access, as ev idenced by the exper ience of most of the bank ing system, which was already under public control . Fu r t he r m or e , wi thout the g o v e r n m e n t opt ing for a larger role in the accumula t ion process, it ix unclear why, within the confines of the g o v e r n m e n t ' s own thinking, the potent ia l benef i ts of file nat ional iza t ion would outweigh the aggressively negat ive re-

action by the whole pr ivate sector that had to be expcctcd. tu

In the end, af ter a seemingly endless saga, thc naf iomdizat ion measure failed. 5° Never theless , it did have fateful consequences . The process of concerlaci~Jn had come to an abrup t and irrexer- sable halt , the in ternal divisions within A P R A became more acute, and polar izat ion ill the political sphere al lowed for an organized

• SI r eemergencc of the right wing.- The nat ional iza t ion a t t empt highlights ano thc r

e l ement tha t con t r ibu ted to the failure of tile PHP: the somet imes haphaza rd and uncoordinated na ture of decision making in the Garcia gove rnmen t . O t h e r examples include tile fie- quen t and ad hoc changes ill exchange rates and the ineffect iveness of FIE (Fondo Nacional de hwers iones y E m p l e o + Nat ional Inves tment and E m p l o y m e n t Fund) , which never got off the ground for what seem to bc primari ly political reasons, s3 In the mid-1987 paper men t ioned above which con ta ined the ant i - inf lat ion program that was never in lp lemented , (}arc/a 's economic advisors are very explicit in their cxprcss ion of anger and f rus t ra t ion over the prevai l ing chaotic pol icy-fornm[at ion inechanisnls .

5. ( ' ( ) N ( ' I J J S I O N

In view of the s lagnat ion of thc Pcrt, vian ccononly for nearly two decades and the ad- winces of the guerilht group Sendero I,umim)so with its Maois t - indigenis t ideology, the pressures on the ( ;a rc ia he te rodox program to succeed were htrger than under any prcvious g o v c r m n c n t m recent times. >3 The faihu-c of the P t lP is therc forc part icularly grave.

I have argued that this failurc is primari ly the result of severe shor tcomings m the conccptn- alization of the P l fP by Peru 's he te rodox economists . Selectivc price control was incon sistent with breaking in f la t ionary inert ia in the absence of s table rclativc priccs. ;Fhe dismissal of a potent ia l mfht t ionary threat from a growing fiscal deficit ignored thc facl that a public scctor deficit becomes inflat ionary whcn internal and external bo t t lenecks bccomc binding. The rapid increase in den land and the failure to address res t ructur ing in the short run led to dcnmnd-13ull inflation and a rapid deple t ion of in te rna t iona l reserves. The combined effect of all of thcse forces wits an increase ill inf la t ionary expectations. Whi lc redis t r ibut ion was an in lpor tant part of the P I tP from the beginning, thc g o v c r n m c n t was unab le to specify the mechanisnls by which resonrccs were to be t ransfcr rcd . The cnvis ioncd pivotal role of the pr ivate sector in the accunlula-


tion process thwarted any policies that would have imposed the cost of redistribution on that very sector. Thus, the fiscal deficit was not simply the result of an economic-technical error on the part of the Garcia government , but also a reflection of the impossibility of increasing taxes for poli t ical-economic reasons.

In addition to the theoretical-conceptual mistakes, uncoordinated and at times chaotic decision making contr ibuted to the failure of the PHP as well. The latter points to the problem of the discrepancy between the conceptualization of a heterodox program by economic advisors and the actual implementat ion of policies which is shaped and constrained by institutional and political struggles. While this paper did not explore this issue in any detail, o ther authors have highlighted the limitations that the weak capacity of the Peruvian state imposes on efficient and consistent formulation and enforcement of key policies. 54

It is quite surprising that the planners of the PHP seem to have ignored some of the lessons of the recent economic history of their own country. Excessive growth (excessive only in view of the constraints), neglect of the foreign sector constraint, and the inability to tap priwtte sector surplus were key factors in the failure of the Velasco economic policies in the first half of the 1970s. 55 The failure of the PHP does not warrant the conclusion that a well-conceived and well- implemented heterodox program cannot work. In formulating such a program, however, the key lessons of the Garcia experiment must be heeded.

First, a selective incomes policy cannot be combined with redistribution via uncontrolled prices. In o ther words, a selective incomes policy will not work unless relative prices remain fairly stable, assuming that they were properly aligned before the imposition of the price freeze. Second, demand increases have to be more strictly controlled so that policies addressing key long- term bott lenecks are given the requisite time to bear fruit. Third, payments on the foreign debt have to be limited to manageable amounts, if they are not to choke off renewed growth. Fourth, restructuring of the foreign sector cannot be postponed, but has to be incorporated into a heterodox program from the beginning. To promote export diversification while the exchange rate is temporari ly fixed is difficult, but not impossible. As long as the overvaluat ion of the exchange rate is not too large, an increase in export subsidies (e.g., C E R T E X in Peru) can compensate for the anti-export bias. Proper sources of finance for these subsidies have to be found, of course, which brings me to the last

main point. Redistr ibution, like restructuring, has to be an integral part from the beginning. From an economic point of view, redistribution is necessary to alleviate the agricultural supply constraint and to increase economic integration among sectors and thus growth in the medium run. In political terms, redistribution is needed to counteract growing political instability. A pre- condition for successful redistribution is the ability to establish a national consensus on the mechanisms and financing of redistribution. With today's polarization of Peruvian society, meeting this condition would pose the greatest challenge for any government adopting a heterodox program.

6. E P I L O G U E

The legacy of the Garcia government has been the most severe economic and social crisis in recent Peruvian history. Since this article was written, Peruvians have elected a new president, Alber to Fujimori , who took office on July 28, 1990. In contrast to his predecessor, Fujimori adopted a stringent or thodox stabilization program aimed at eliminating hyperinflation. While it is impossible to predict the success or failure of this program six weeks after its implementat ion, the following discussion provides a preliminary assessment of the contingencies shaping the outcome.

In July 1990, the Peruvian economy was in its third year of decline, tax revenues as a percentage of GNP were around 4°/,,, real public sector prices had declined dramatically, the real exchange rate was highly overvalued, net international reserves were negative, foreign debt had reached close to $20 billion, and the official increase in the consumer price index was 63.2% for the month, bringing the inflation rate for the first seven months of 1990 to 854%. In addition, less than 20% of the economically active population were adequately employed, real remunerations were less than 50% of their July 1985 level, and one-third of the Peruvian population (seven million out of 21 million) lived in extreme poverty.

During the election campaign, Mario Vargas Llosa, the F R E D E M O candidate, had advocated very forcefully the necessity of an or thodox adjustment shock followed by market liberalizing measures to deal with the ills of the Peruvian economy. 5~ Although the program of Alber to Fujimori , candidate of the movement Cambio 90 (Change 90), was fairly general and vague, his promise of an alternative to Vargas Llosa's shock


program contributed significantly to his election victory. 57 Once elected president, however, Fujimori endorsed a package of stringent stabilization measures, not least on the advice of the IMF and the World Bank. 5~ The principal, if not exclusive, focus of the shock program was the elimination of hyperinflation. Elaboration of a medium-term economic program and of an immediate social program to address the pressing issue of poverty was relegated to a lower level of importance and thus basically left unspecified for the time being.

To increase government revenue the rates of public services were increased, the gasoline price was raised by 3,100% (from I./21,000 to I./ 675,000 per gallon), and a temporary tax of 10% was imposed on exports. On the expenditure side, the CERTEX was reduced to a uniform 10% and most subsidies were removed, including interest rate subsidies. The official exchange rate (MUC) was eliminated, with the exchange rate left to be determined by the market. The liberalization of the exchange rate was designed to have two beneficial effects: the elimination of the exchange rate subsidy that the Central Bank had been paying throughout the Garcia government, and the reduction of the foreign exchange gap. In addition, all nontariff barriers on imports were removed. To mitigate the adjustment cost every worker was paid a one-time bonus equivalent to his or her July salary, and a social emergency program with a $600 million budget was announced.

As a result of these stabilization measures, announced on August 8th, economic activity declined drastically, the official consumer price index increased by 397% in August, and real remunerations fell by more than half. Since the end of August prices have started to fall, however, and, given current data, inflation in the month of September will not surpass the one- digit level. In addition, the fiscal budget and the balance of trade are expected to show a surplus in September.

In spite of these promising results for Septem- ber, it is far from certain that the anti-inflation shock will render the intended long-term results. Even if the government budget continues to be balanced or in surplus, inflationary pressures can still arise from increases in wages and in the exchange rate. Workers' demands for nominal wage increases to compensate for the loss in purchasing power during August have only started to surface more forcefully now, and it is impossible to predict how successful these demands will be. The fact that the government does not seem to have a clear idea, at least not a publicly articulated one, of where it wants real

wages to settle only adds to the uncertainty over renewed inflation.

The exchange rate is probably an even stronger potential source of inflation. Before the shock, the MUC exchange rate v&-(i-vis the US dollar was I./44,000, and the black market rate was around I./120,000 (average figures for July). After the shock, the exchange rate increased, but by far less than expected. Presently, it is hovering around I./420,000, which is still far below the parity rate calculated at between I./600,(100 and I./900,000. The main reasons the exchange rate has remained overvalued in real terms are a decline in demand due to the depressed state of the economy, i.e., lower import demand, and the additional supply of dollars from people whom the liquidity squeeze has forced to acquire intis m the foreign exchange market. Although the overvalued exchange rate has a stabilizing impact on the rate of inflation, it works at the same time as a deterrent to exports. With the elimination of export financing credits at preferential rates (FENT), the de facto removal of CERTEX (the 10% CERTEX rate counteracted by the 10% tax on exports), and an overvalued exchange rate, many exporters, especially of nontraditional commodities, have reduced their exports or ceased exporting altogether.

When economic activity picks up again, the demand for imports and thus for foreign currency will increase. That will most likely lead to an increase in the exchange rate and a higher rate of inflation. It is unclear, however, which sector will provide the impetus for renewed growth. With government spending controlled, the outlook for private investment grim due to high levels of unutilized capacity, and consumer spending down because of the recession and the decline in real wages, the export sector is the most likely and hopeful candidate for stimulating the economy. But exports will not take off unless the real exchange rate improves, which, as pointed out above, would have inflationary consequences. The inflationary impact of a depreciation would be mitigated though, if tariff rates on imports were reduced concomitantly.

The government is clearly in a bind. If it wants to reactivate the economy it has to favor policies that directly or indirectly lead to a depreciation of the exchange rate and thus higher inflation. If it wants to persist in keeping inflation down, it must be cautious with respect to immediate reactivation. If it lowers import tariffs too rapidly, especially in the presence of an overvalued exchange rate, import competition might drive many Peruvian producers out of business. For the moment, the Fujimori government continues to be primarily concerned with keeping


inflation under control , t reading very carefully on the path of tariff reduction and reactivation. It has proposed a lowering and harmonizat ion of tariff rates on imports to three rates (50, 25, and 10%) until the end of 1990, to be followed by a further reduction in 1991. The Central Bank has also slowly increased liquidity by intervening in the foreign exchange market . During the first two weeks of September 1990, it purchased dollars in the free market at a rate of about $14 million a day. Thus, it has been accumulating reserves to accommodate future import needs and to pay its arrears on the foreign debt payments to multilateral international organizations. But unless Peruvians become reasonably optimistic about the success of the government program, it is quite possible that, as liquidity keeps increasing, they will get rid of intis and hoard dollars, just like before the shock program.

The fact that the government has not spelled out a coherent medium-term plan for renewed and sustained growth is clearly detr imental to the fostering of incipient optimism and credibility. The duration of the present depression is another critical e lement . The popular backlash against the costs of the stabilization program has been surprisingly mild so far, in spite of the fact that the Fuj imori government reneged on its promise of an alternative to the or thodox stabilization shock and in spite of the severity of the shock. The mild reaction may partly be explained by a widespread sent iment that some adjustment had to happen, albeit probably not of the magnitude

that has actually occurred, and that the government deserves a chance to prove itself. If inflation resuffaces, however , or if reactivation is postponed too long, then a much more explosive reaction is quite likely. In that case, the possibility of a civilian-military government or of an outright military coup becomes a very real one.

During the election campaign, Fuj imori in- sisted that a social pact was critical for over- coming the country 's economic problems. The formation of a cabinet that includes members of all major political parties (with the exception of A P R A ) is clearly one step in that direction, although that was at least partly motivated by the minority position that Cambio 90 representatives hold in the legislature. Otherwise, however , concertaci6n has been nonexistent, with the possible exception of some dialogue with private sector industrialists. The drastic decline in real wages has muted the option of an ar rangement with the unions. The slow start and, so far, very limited scope of the social emergency program, which has consisted mainly of food donations from abroad distributed by church-based organizations, has done little to address the immediate poverty problem, let alone foster support for the government . In view of the magnitude of the economic and social problems that Peru is facing, it is difficult to see how the absence of a social pact can be compatible with successful stabilization and renewed growth in a democrat ic context. It still might not be too late to establish such a pact, but t ime is running short.

NOTES

1. For an excellent discussion of the reasons behind the disillusionment with particular development strategies, that at certain times in the past had been viewed as the unquestionable credo of success, see Fishlow (1986).

2. One of the presently foremost textbooks in the field of economic development, Gillis et al. (1987), ignores the debate completely and presents only the monetarist theory of inflation. In another development textbook, Loehr and Powelson (1981, p. 332), it is argued that "'the structuralist-monetarist controversy was never resolved; it simply vanished from the literature." For a critically supportive position of the structuralist theory of inflation see, for example, Lustig (1988). For recent reviews of the monetarist-structuralist debate on inflation see, for example, Bitar (1988), Foxley (1987), Lustig (1988), Velasco (1988), and the chapter on "Inflation, External Deficits, and 1MF Stabilization Programs," in Sheahan (1987, pp. 99-129).

3. For an excellent review of this issue, see Schuldt (1988).

4. For a good discussion of inertial inflation by neostructuralists see, for example, Arida and Lara- Resende (1985) and Ocampo (1987), and for a discussion by orthodox economists that recognize the importance of inertial inflation see, for example, Dornbusch and Simonsen (1987).

5. Because of indexation the relevant rate of inflation in the wage-adjustment (catch-up) process is the higher past rate rather than the lower expected future rate. Since higher wages translate into higher costs which in turn mean higher prices, inflation reduction will proceed very slowly in response to a tightening of aggregate demand.

6. Several economists, e.g., Dornbusch and Simon- sen (1987), articulate the need for an incomes policy to fight inertial inflation in the context of a game theoretic

430 W O R L D D E V E I , O P M E N T

approach. Assuming that all economic actors would prefer a reduction in the inflation rate once it has reached a high level, that goal will not be reached unless everybody stops raising prices at the same time. The problem is, however, that individuals are not willing to take the first step and stop increasing their prices for fear that they will lose out if others do not follow suit. Noncooperat ion among economic actors will therefore prevent inflation reduction, and coopera- tion has to be enforced through a government- imposed incomes policy.

7. Dornbusch and Simonsen (19871 explicitly define a heterodox stabilization program as "'the combination of fiscal correction and incomes policy," (p. 1), where incomes policy means "wage, price, and exchange rate freeze togcthcr with remonetization'" (p. 2). Note that in contrast to the traditional stabilization program which advocates restrictive fiscal and monetary policies, the heterodox stabilization program as defined above favors an expansionary monetary policy. The rationale is that with a reduction in mllation the demaml for real money balances will increase, which will lead to an increase in the interest rate and thus recession, unless the money supply is allowed to expand.

8. Inflation can lead to a deterioration in government finances in two ways. First, rising inflatkm lowers the real value of taxes (the Olivcira-Tanzi effect) becausc of the lags involved in tax collection. Second, higher inflation leads to higher nominal interest rates. which in turn raise nominal interest payments on government debt and thus government expenditures. The rationale for focusing on the operational budget is the assumpt ion that the increase in interest payments is exactly offset by a decline in the real value of public debt. Assuming that the public wants to maintain the real value of its holdings of D)vcrnmcnt bonds, higher interest payments will not lead to more consumption.

9. While the diagnosis and policy recommendat ions result from the theoretical or thodox economic franre- work, their application to the Peru-specific context can be found, for example, in various World Bank country reports of the time.

1(1. For a more elaborate discussion see, for example, World Bank (1987, pp. 1 11).

I1. The following summary is based on Carbonet to, dc Cabellos, Dancour t et al. (1987); Carbonet to, Carazo de Cabellos and Ferrari (19871: INP (1988a, 1988b. 1986, and n.d.): and Chavez (1989 and 1986).

12. According to Wcbb (1987) and Parot and Rodriguez (1988), the key factors behind inflation during the Belafinde govcrmnent (19811-85) were ongoing devaluations and increases in government- controlled prices. The latter based their analysis on an econometric analysis investigating the determinants of quarterly inflation rates during 198(I-84. Webb tries to link inflation indirectly to the fiscal deficit by arguing that government-control led prices were raised in order to reduce the deficit.

13. More precisely, Carbonet to , dc Cabcllos, Dan- court et al. (1987, pp. 64-71) distinguished four types of markets: (a) markets where administered pricing dominates, i.e., prices are determined by costs and mark-up (the modern sector, accounting for 30-35% of economic output); (b) markets where prices arc determined by the interplay of supply and demand (services and nontraded agricultural goods, 25-3(1'7o): (c) mar~ kets where prices arc determined by international prices (agricultural traded goods and traditional ex ports, 15-20%); and (d) markets wherc priccs are controlled by the government (gasoline, electricity, etc., 20-25%).

14. Chavcz (1986) criticizes the notion of firms operating on the downward-sloping part of the marginal cost curve. Instead, he claims that the MC curve is horizontal, but that in reaction to an inward shift of the demand curve, it shifts upward as firms increase the mark-up. Thus he arrives at thc same result, nanrelv an increase in prices when demand declines.

15. According to one study "'an analysis of thc cost structure of 411 modern corporations showed that hi 40 percent of the cases fixed unit costs doublcd in the last six years [late 197(1s early 1980s], and m 60 percent of the cases they more than tripled" (Carbonelto, de Cabellos, Dancourt et al. , 1987, footnote 14, p. 42).

16. The increased production costs resulting from higher wages were thought to be counteracted by reduced interest costs and tax obligations. It was conceded that profit margins in the modern sector might fall, but assumed that total profits would increase with a renewed rise in production.

17. The implications of a small domcstic capital goods scctnr for economic growth and the balance of pay ments have been discussed and modeled by a numhcr of economists. See, for example, J imenez (19871 and ( ' asar and Ros (1983).

I8. The rigid structure oi Peruvian exports and imports, the inability of the industrial sector to generate a net foreign exchange balance, and the disarticula- tion of the ccnnomy arc all long-term structural problems that o ther authors and I have analyzed to varying degrees. See, for example, Thorp (1987a), Paus (1985), and MeClintock and Lowenthal (1983).

19. In 1981, the capital-labor ratio was $13,000 in the modern urban sector, $450 in the informal urban sector, $4,000 in the modern rural sector, and $22(t in the Andean rural sector. The figures for average labor productivity were $4,32(I, $816, $1,800, and $600, respectively. Cited in Schuldt (1987, p. 319).

20. Lima accounts for 28% of the Peruvian population, 69% of industrial GDP, 98% of private invest- merit, 83% of bank deposits, 87% of fiscal revenue, etc. (INP, ll.d., p. 311.

21. For details see Schnldt (1987, p. 319).

F A I L U R E OF P E R U V I A N H E T E R O D O X Y 431

22. The exchange rate was devalued by 12% in August 1985 and frozen until the end of 1986. Prices of the modern industrial sector were frozen at the same time. Interest rates were lowered successively from 110 to 75 to 45%, and a number of indirect taxes were reduced. D e m a n d was reactivated through real wage increases and a number of government-f inanced programs directed at the agricultural and informal sectors.

23. The initial decline in output is probably due to a lag between the adoption of policies and the response of economic actors as well as to the drawing down of inventories in response to rising demand.

24. The Garcia government had suspended the re- demption of bank certificates in foreign currency (CBMEs - - Certificados Bancarios de Moneda Extranjera) , but for their conversion into intis it offered an exchange rate ("Financial Market 1'" rate) above the base exchange rate (MUC rate - - Mercado Unico de Cambios).

25. For a description of the key policies adopted during the Emergency Plan period and a critical evaluation of their long-term potential for success see Thorp (1987b and 1987c) and Schuldt (1986).

26. To save additional foreign exchange the government suspended the repatriation of foreign exchange by foreign companies for 24 months in August 1986.

27. In addition, at the end of October 1985, Peruvian loans were declared value-impaired by US banking regulators.

28. Credit flows from official agencies and governments were $189 million in 1985, $128 million in 1986, and $97 million in 1987. The respective figures for credits from international organizations are $214 million, $85 million, and zero. Trade credits had declined to zero as well in 1987. The figures are from the Data Bank, Coyuntura Econ6mica, C1UP (Centro de Inves- tigaci6n de la Universidad del Pacifico), Lima.

29. Foreign debt service declined from $789 million in 1985 to $636 million in 1986. The latter corresponds to 18.9% of exports of goods and nonfinancial services. C E P A L (1989, p. 26) est imates that the debt service ratio would have been 33%, if all interest due bad been paid. That corresponds to $475 million more than was actually paid.

products 93.1%. In a survey conducted in November 1987, producers in 17 out of the 24 industrial branches named the lack of raw materials as the primary problem negatively affecting production, and in four branches they identified it as the second largest problem. INP (1988a, Section III, Table 5, p. 43).

32. For a detailed discussion of the economic events of 1988 see, for example, Cficeres (1989). As examples for the lack of policy coherence, C~iceres (1989, p. 168) notes that the economics ministry changed hands four times in the course of the year, and that for the September policy package the government consulted with six different groups of economic advisors.

33. The inflation rate corresponds to the variation between November 1988 and November 1989.

34.~ The figures were calculated on the basis of data provided by INE (Instituto Nacional de Estadistica).

35. For a detailed discussion of the PAIT see, for example, Vigier (1986). From October 1985 until December 1986, 250,707 workers were employed through PAIT (59.4% of them in Lima) at a cost of 819.7 million intis. In 1987, 280,749 workers were contracted (36.9% in Lima) for a total of 1,040 million intis (Casas and Beltram, 1989, Table 5a).

36. For a more detailed discussion see Escobal (1987). He calculated that the subsidy due to the difference between guaranteed producer prices and lower consumer prices for the principal agricultural products amounted to 0.33% of G D P in 1986 and 0.32% of G D P in 1987 (p. 36). The combined subsidies resulting from negative real interest rates and preferential interest rates for agriculture were 0.82% of G D P in 1986 and 1.55% in 1987 (p. 39). The subsidy due to the preferential exchange rate for agricultural imports varied between 0.2 and 0.4% of G D P in 1986 (depending on which exchange rate is chosen for the compari- son) and between 0.6 and 0.8% of G D P in 1987 (p. 41).

37. Carbonet to, de Cabellos, Dancourt , et al. (1987, p. 82) state: "'It is necessary to spend, even at the cost of a fiscal deficit, because, if this deficit transfers public resources to increased consumption of the poorest they demand more goods and this will bring about a reduction in unit costs. Thus the deficit is not inflationary, on the contrary!" Quoted in Dornbusch and Edwards (1989, p. 41).

30. The decrease in exports was caused by a decline in traditional as well as nontraditional exports. The latter declined in response to an increasingly overvalued exchange rate and the reactivation of the domestic market. Traditional exports fell due to lower quantities as well as prices. The decline of world market prices accounted for 74% of the reduction in traditional exports in 1986.

31. In July 1987, capacity utilization in the paper industry reached 99.6%, in the chemical industries 97.6%, in cement production 93.3%, and in basic metal

38. Coyuntura Econ6mica, CIUP, November 1988, mimeo.

39. Banks, financial and insurance companies as well as companies in the beverage and tobacco industries were to buy public investment bonds equivalent to 3(1% of their 1986 gross profits. Textile companies , those producing canned fish, and trading companies were to buy bonds worth 20% of their 1986 profits. The measure for the specified industries was to hold for all those companies that in 1986 had more than 200 units of taxable income.


40. Furthermore, the original models by Carbonetto and Dancourt were short-term one-sector models. See Carbonetto, de Cabellos, Dancourt, et al. (1987, Appendices 1 and 2).

41. During the second half of 1987, the exchange rate subsidy accounted for 13.2% of thc 62% increase in the monetary base (Le6n Astete and Paredes Lanatta, 1988, p. 217).

42. The document was submitted to Garcia on May 24, 1987 by Carbonetto, Ferrari, Schydlowsky, Tanta- lean, Gutierrez, Vigier and others. Excerpts are reprinted in The Peru Report (1988).

43. In Carbonetto, de Cabellos, Dancourt et al. (1987, p. 63) the door is left open for more active state intervention in the restructuring process: "In specific cases the State itself has to assume the role of investors." This statement is, however, neither elaborated further nor, to the best of my knowledge, reiterated in any other document.

44. For a more detailed discussion see Durant 11988 and 1987) and Ballon Echegarray (1987).

story is not told, however, there is no basis toe prefering one explanation over anot.her. The cxphma- tions range from a conflict between Garcia and Alva Castro to attempts to move the gnvermnent to the Iclt. Some point to Garcia's obsession with tile power ~l finance capital, nationally and internationally, while others believe it was simply a whimsical and irrational movc. Another hypothesis is that Garcfi~ was disen- chanted with the investment bchavior of the priw~tc sector, indicated by a study by Thorne (1987). In contrast to the methodology used by tile Instituto Nacional dc Estadistica and thc Banco ('entral de Rcscrva, Thorne based his calculations of private investment on the bahmcc sheets and financial state ments of a sample of 62 companies registcrcd with thc IJma Stock Exchange (46 ill industry, inehMing the largest companies, and 16 in mining, including medium-sized companies and the Southern Peru ('op- per Corporation). Thorne calculated that in 1986 net invcstmcnt declined hy 41 or 26.3% depending on thc price deflator used. While the study has been width,. criticized as biased and tmreprcscntatix, e, lhe rcsulls do indicate that not all companies, and especially not all large corporations, stepped up investment in 1986.

45. Early in his administration for example, Garcia told a group of entrepreneurs: "'I have an industrialist friend to whom I said the other day: look why don't you bet on the country and invest the third part of what you have abroad. You'll still have the other two parts. 1 am sure you have three or four million dollars. Invest one million; take a bet on Peru, where the three million came from: do this rawer to the history of Peru" (Proceso Eeon6rnico, 1985, p. 23).

46. The investment coefficient for the private sector (measured by gross fixed capital formation) increased from 12% in 1985 to 13.8% in 1986 to 14.5% in 1987. Nevertheless, investment did not grow as much as during the previous expansionary period, 1979-81, when the private investment coefficient increased from 15.8% m 1979 to 20.4% in 1981.

47. Fhe figures for net private investment tire calculated on the basis of information provided by Dircc- cidn General de Cuentas Nacionales of the lnstituto Nacional de Estadistica. Capital flight (using the World Bank method of calculation) was $407 million in 1985, $68.9 million in 1986, and $378.9 million in 1987. Using the Morgan method, the respective figures are $467 in 1985. $17.3 million in 1986, and $336,2 million in 1987 (Punto de Equilibrio, 1990, Table 1).

In view of the large supply of cocaine dollars, the above estimates of capital flight have to be taken with the necessary gram of stilt. Estimates of the area under coca cultivation vary bctween 120,0110 and 280,000 hectares, and the amount of "'coca-moncy" that stays in the country is estimated at between $800 million and $1,2110 million, i.e., between 30 and 45"/,, of Peru's legal exports in 1988 (Aetualidad Econ~hnica, 1988).

48. A variety of political explanations are bcmg offered by different observers. As long as the inside

49. Nevertheless, Garc/a seemed to have been stir- prised by the strong reaction of the private sector ( The Peru Report, 1987).

50. For a summary of thc seemingly endless saga ol the nationalization process see Latin American Weekh' Reporl (1988 and 19891.

51. The intercmtionally renowned novelist Mario Var- gas Llosa was an outspoken critic of the nationalization measure, which soon becanle but one element i l l a

broader antistatist crusade. In 1989, the center-right political coalition F REDEMO (Frente Democratico - - Democratic Front). which is fully supported by the business community, elected Vargas I,Iosa as its presidential candidate for the elections in 1990. F REDEMO is made up of Libertad (Freedom, Vargas Llosa's movement), AP (Acci6n Popular - - Popular Alliance, the party of ex-president Belatinde), and Pt'(" (Partido Peruano Cristiano - - Peruvian Christian Party).

52. FIE was a fund for decentralized private investment, which was to be highly subsidized by the government. It was highly acclaimed as a significant element in the decentralization and restructuring effort. The only disbursement R)r FIE ever made by thc Treasury was 50 million mtis in February 1988 (Inter- view with Edgardo Gomez. Treasurer, COFIDE, July 3, 1989). The explanations w~ry as to why FIE did not materialize. Some argue that FIE did not succeed because of the personal antagonism between Garcia and Alva Castro. FIE was the latter's project, and so Garcia did not want to finance it. Others assert that the necessary funds were missing, or that, with the changed political climate after the banking nationalization, it became irrelevant. Another explanation is that Peru- vian entrepreneurs wanted to irlahllaH1 control over


their companies, and opening them up through stock sales via FIE was not very attractive.

53. For a detailed analysis of the origins and nature of Sendero Luminoso see, for example, McClintock (1989).

54. See, for example, Thorp (1987b), chapter 10 in Thorp and Whitehead (1987, pp. 318-354), and Wise (1989). Wise (p. 165) argues: "'It is impossible to speak even minimally of a unified and autonomous state apparatus in Peru, capable of formulating and imple- menting collective policies generated from within the state. Rather, autpnomy exists in the negative sense of loosely linked administrative structures constantly stampeded by particularistic interest groups, both

public and private, and which frequently operate at cross purposes."

55. For a detailed analysis of the failure of the Velasco program see, for example, McClintock and Lowenthal (1983).

56. For more information on FREDEMO see note 51.

57. For more details on the campaign programs of the two candidates see for example Paginalibre (1990).

58. Some of Fujimori's key economic advisors re- signed in protest over the adoption of an orthodox stabilization shock program, e.g., Santiago Roca, Adolfo Figueroa, and Daniel Schydlowsky.

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