)4135 .JLUy 1'8g' INDEXATION AND STABILIZATION Theory and Experience Paul D. McNelis FILE COPY he modern proponents of indexation are Milton Friedman (1974) and Herbert Giersch (1974). They called for the wide- spread linking of wages and financial assets to the price level as an instrument for promoting macroeconomic stability and reducing inflation. Such thinking has historical roots going back to the first decades of the nineteenth century (Lowe 1822, Scrope 1822) and was developed by Jevons (1875) and Fisher (1922). Fisher acknowledged that the purpose of indexing is not directly related to reducing infla- tionary fluctuations, but rather to preventing them from inserting speculative elements into business decisions (Fisher 1922, p. 335). However, he saw that lower inflation would be an incidental result of a fully indexed system, because credit cycles would no longer be stimulated (Fisher 1922, p. 335). In the 1940s and early 1950s Finland and Israel adopted widespread wage and asset indexing, whereas in the Federal Republic of Germany the Currency Act of 1948 prohibited indexing. During this period, research concentrated on the potential of indexing policies for reduc- ing the distortions of inflation, as well as for reducing the will to fight inflation. What was new about Friedman and Giersch was not their support for using indexation in an inflationary environment, but their proposal to use it as an instrument to reduce inflation. Both Friedman and Giersch were thus arguing against a widespread prejudice that indexation may cause inflation to accelerate. Indexing is not an act of weakness or capitulation, they said; it can ensure that a monetary program of price stability will not be endangered by rising unemployment or by crises originating in overindebtedness (Giersch C) 1988 The International Bank for Reconstruction and Development/The World Bank 157 1974, p. 12). Denying that indexation necessarily condemns an econo- my to perpetual inflation, Friedman argued that indexation can reduce some of the hardships that follow from a cut in aggregate demand and will permit such a cut to be more effective in reducing inflation (Friedman 1974, p. 42). The essence of Friedman's and Giersch's argument is that indexing should be symmetric, whether inflation is falling or rising. During a monetary disinflation, full indexation will prevent real wages from rising and thus will reduce or eliminate the employment and output costs of reducing inflation. There will also be less incentive for policy- makers to inflate in the future, since full indexation would prevent real wages from falling and thus reduce or eliminate the output gains from monetary expansion. In pursuit of their claims, Giersch advocat- ed the repeal of the anti-indexing provisions of the Currency Act of 1948 in Germany, and Friedman put forward specific proposals for tax and asset indexing in the United States, in addition to encouraging wider use of wage escalator clauses in the lJnited States (see Giersch 1974, p. 14, and Friedman 1974, pp. 36-41). Since then, other authors have added considerably to the literature. Gray (1976) and Fischer (1977) generalized and qualified the work of Friedman and Giersch. Their models, which analyzed the effects of indexing under two types of shocks (one "monetary," the other "real") became the basis for later work. They found the Friedman- Giersch proposal of 100 percent full indexation to be "optimal" (in minimizing output variability) when the economy is subject to mone- tary or nominal disturbances-those that affect only the quantity of money and not relative prices or output in long-run equilibrium. However, if the economy is subject to "real" or "productivity" dis- turbances which would have long-run output and relative price ef- fects-then the optimal degree of indexation should be zero. In the typical case of an economy subject to both eypes of disturbances, the optimal degree of indexing should be positive but less than unity. Gray (1976) and Fischer (1977) neglected one important aspect of indexing policy, which Fischer (1988) later took up. This is the differ- ence between ex ante and ex post indexation. In the original formula- tion of Gray and Fischer, the optimal indexing arrangement is based on ex ante indexation, whereby wage changes are linked to expected inflation rates. In practice, however, the indexing system is ex post, whereby wages are linked to past inflation rates. Instead of speeding- up a disinflation, ex post indexation may have the opposite effect. It introduces inertia into the inflation process and may significantly in- crease the output and employment costs of reducing inflation. Fischer (1986) also raised questions about asset indexation, which links in- terest on government debt to current inflation rates. Although indexed debt may help reduce the inflationary tendencies of a government, by 158 Researcb Observer 3, no. 2 (July 1988) removing the incentive to erode the burden of debt obligations through inflation, it also reduces the costs of inflation to the public (Fischer 1986, p. 265). The Gray and Fischer recommendation for only partial indexation gave theoretical support for various attempts to unlink wages from prices at the time of the major oil shocks in the 1970s. Furthermore, the inertia built into the inflation process by ex post indexing was recognized in the design of the stabilization policies in Israel, Argen- tina, and Brazil in 1985 and 1986. All of them suspended wage index- ation and reduced the scope of asset indexing. One point missing from much of the theoretical analysis is the effect of indexing on income distribution. When there is an unexpect- ed surge of inflation, workers locked into longer-term fixed contracts lose relative to those on shorter-term contracts. In such circumstances, indexation may reduce the dispersion of wages across sectors and thus may help to reduce labor market tensions. Governments thus may face a tradeoff in the use of indexing. Although a high degree of indexing may increase output and price instability in the presence of real shocks, little or no indexing may increase labor market tensions and output losses through its effects on income distribution. If policymakers consider the instabilities resulting from the increased labor market tensions to be more costly than the increased instability due to higher indexing, there may be a case for indexation-even in the presence of real shocks. The question is whether the distribution of the costs and gains from real shocks can be less socially disruptive (and through this, less economically costly) in the presence of some indexation. The answer can be sought in some country case studies. Brazil and Israel both have long experience with indexing-more Long-Term than three decades in Israel and two decades in Brazil. A comparison Indexation is of interest because of the different ways in which indexing policies were introduced and have evolved in each country.' Figure 1 pictures the evolution of inflation in both of these countries during the past twenty-five years. Brazil In Brazil there is controversy over the contribution of indexing to the successes of the late 1960s and early 1970s, when annual growth of gross domestic product (GDP) reached 10 percent and inflation was reduced from triple digits to 30 percent. There is also controversy over the role indexation played in the return to rapid inflation in the late 1970s. Paul D. McNelis 159 Fishlow (1974) and Kafka (1974) have argued that the combination of wage indexing and an exchange rate policy of keeping pace with the difference between domestic and foreign inflation through frequent small devaluations was critical to the reduction of inflation in the mid-1960s. However, Simonsen (1983) Figure 1 emphasized one point that Fishlow and Percent Kafka neglected to mention: the wage- 400A indexing laws introduced in 1965 were 300- basically tools of incomes policy, since Israel\ wages were linked to the expected rate of 200- ,A'8 inflation, not the actual rate, plus an ele- ment for higher productivity. Both the 100- /Brazil .. expected rate of inflation and the produc- w ' . '-- c ,z tivity gain were decreed by the govern- 0- ment, with no room for bargaining or 1959 64 70 76 82 86 strikes, at rates that consistently underes- timated actual inflation and productivity gains (Simonsen 1983, p. 119). In reality, then, the Brazilian indexing was a disindexation, which aided the disinflation process during the period after the military takeover in 1964. As for the return of rapid inflation in the late 1970s, Simonsen sees wage indexing policy, which increased the frequency of indexation adjustments of wages to past prices, as a culprit. In 1979, just at the time of the second oil shock, the indexing law reduced the adjustment interval for wages from one year to six months, with no downward revision of the real wage base (Simonsen 1983, p. 122). Simonsen predicted that the new system of indexation would lead either to massive unemployment or to a leap in the inflation rate (Simonsen 1983, p. 122). As it turned out, there was a leap in inflation (the previous annual rate quickly doubled), as well as increased instability of output, as the Gray and Fischer frameworlc would predict. Inflation in Brazil has remained rapid, in spite of reductions in aggregate demand in the early and mid-1980s. In an econometric study, Lara-Resende and Lopes (1981) found that indexing largely explains the behavior of Brazilian inflation, while excess demand has had little effect. Lopes and Lara-Resende argued that this resistance of inflation to reductions in demand is evidence of inertial inflation. More recently, Arida and Lara-Resende (1985) recommended disindexation as a way to end the inertial inflation. They cited the strong adjustment effort made through austerity measures, leading to a $12.5 billion surplus on the current account for 1984 and only a small fiscal deficit, and concluded that the 230 percent inflation in 1984 must derive from the Brazilian ex post indexing system (Arida arid Lara-Resende 1985, p. 29), as the Fischer model would predict. 160 Research Observer 3, no. 2 (July 1988) Israel For Israel, both Karni (1979) and Fischer (1984) blame the indexing system for reducing the will to fight inflation (Karni 1979, p. 81, Fischer 1984, p. 37). Since indexing has removed many of the inflation-induced distortions, policymakers have tended to conclude that the unemployment needed for a successful disinflation could not be justified; memories of the 1965-67 recession (with double-digit unemployment and net emigration) left as deep an impression in Israel as a Great Depression did in the United States (Fischer 1984, p. 37). One of the major controversies about Israel's experience centers on the linkage of government development loans to the exchange rate of the U.S. dollar, after a 67 percent devaluation in 1961. There was an immediate public outcry after debtors found that their nominal debt to the government increased overnight by the same 67 percent (Bren- ner and Patinkin 1977, p. 402; Fischer 1984, p. 18). Thereafter, the government did not index its loans until 1979. However, between 1973 and 1977 inflation rose to high levels-so government receipts from loan repayments fell substantially in real terms (Liviatan and Piterman 1986). By the end of 1983, government debt to Israeli citi- zens had reached 115 percent of GNP, from about 50 percent in 1970. By this time, over 60 percent of the financial assets held in Israel were indexed either to the price level or to the exchange rate (Fischer 1984, p. 12). Disindexation, total or partial, has also been an issue in Israeli anti- inflation policy. As early as 1966, a Committee of Experts recommend- ed the use of modified price indexes for wages, indexes which would exclude taxes and the prices of imported goods (Brenner and Patinkin 1977, p. 399; Shiffer 1986, p. 21). These recommendations were not carried out until the mid-1970s. Another committee in 1975 recom- mended that wages be indexed at a rate of 70 percent to the consumer price index. This "70 percent rule" was presented as a practical ap- proximation to the optimal degree of indexation. At best, this rule could be right only on average; in most periods it would compensate too little for nominal shocks, at other times too much for real shocks. The 70 percent adjustment was increased to 80 percent at the end of 1979, and until 1985 contracts were reopened when real wages were eroded beyond prespecified thresholds (Fischer 1985, p. 68). Comparing the Cases Is there anything to be learned from comparing the experiences of Brazil and Israel, besides the correlation of high indexing with high inflation? Indexing spread in a different sequence in each country; in Brazil, bonds first, then wages; in Israel, wages first, then bonds Paul D. McNelis 161 (Kleiman 1977, p. 170). Although selective indexing may be tempting to policymakers, the Brazilian and Israeli experiences indicate that it may be impossible in practice. Another important difference between the two countries was the frequency of wage adjustment. Brazil did not change the adjustment interval for wages after the 1979 law, even vhen inflation rose above 200 percent a year. Israel, in contrast, shortened the interval from a semiannual or annual basis in the mid-1960s, to quarterly from 1980 to 1983 to monthly at the end of 1983. Brazil's approach (which caused a reduction in real wages between adjustments) may have been responsible for keeping inflation from accelerating toward 1,000 per- cent, as happened in Israel (Dornbusch 1985). In their recent stabilization programs, both Israel (in 1985) and Brazil (in 1986) imposed freezes on wages and prices. They thereby suspended indexing, but allowed it to resume after the "unfreezing." Both programs reduced the scale of indexing in order to make infla- tion more susceptible to cuts in demand. Israeli indexation was sus- pended for wages for three months, but was unaltered for a smaller range of financial assets (Helpman and Leiderman, forthcoming, p. 16). In the Brazilian Plan Cruzado of February 1986, wage indexing was reduced rather than suspended (no indexing adjustments took place as long as inflation remained below 20 percent), whereas the indexation of financial assets was terminated for one year, and a tablita was announced for converting old currency units into new ones for financial contracts falling due after the stabilization program (Helpman and Leiderman, forthcoming, p. 24). At the time of the stabilization programs, observers believed that Brazil began with the more favorable conditions for success, since excess demand had already been considerably reduced. However, by the first quarter of 1987 Brazilian inflation had erupted once more, reaching an annual rate of 500 percent. In Isirael, by contrast, inflation remained at an average of 3 percent a month in 1987, without any noticeable costs in lower output or increased unemployment. What went wrong in Brazil and right in Israel? There were two key flaws in the Brazilian plan, which the Israeli plan avoided: (a) the Brazilian authorities froze prices at their existing levels, rather than removing subsidies and realigning relative prices of certain goods and services (such as basic foodstuffs and transportation) before the freeze. Consequently, (b) the budget deficit turned out to be ten times larger than the one expected when the plan began (Helpman and Leiderman, forthcoming, p. 24). The Plan Cruzado was soon replaced by Plan Cruzado II to align prices, and later by another, popularly known as Plan Bresse:r after Finance Minister Luis Bresser Pereira. These plans have more modest targets for infla- tion, of 50-60 percent a year. 162 Research Observer 3, no. 2 (July 1988) The disappointing Brazilian experience indicates that indexing poli- cy is immaterial, if fundamental macroeconomic problems are not corrected. In Brazil, the newly installed civilian government of Jose Sarney, taking office after twenty-one years of military rule and the death of President-elect Tancredo Neves, did not make the expendi- ture cuts needed at the time of the stabilization plan, nor work out a consensus for distributing the costs of the disinflation plan. By avoid- ing the fiscal cuts, the government won short-term popularity but undermined its own stabilization effort. In Israel, by contrast, the stabilization plan was built upon a mac- roeconomic restraint and a consensus among the Histadrut (the lead- ership of the trade unions), the government, and employers. When the cuts began to be felt, there was sufficient confidence in a fair distribu- tion of the costs of disinflation to mitigate the ensuing labor market tensions and social unrest. In the past decade Chile has disindexed wages and various features Disindexation of its financial system. These policies formed part of an overall stabili- zation and liberalization plan, which involved decontrol of interest rates, reductions in tariffs, and removal of capital controls. Finland and Iceland, both countries with a long history of indexation, ended indexing: Figure 2 Finland at the time of a devaluation in Percent 1967, and Iceland in May 1983. 100- 75- Chile Chile In 1973 Chile imposed rules that per- 50 - mitted only partial indexation of wages 25 to past price changes. When collective bargaining was allowed in 1979 for some 0 . 10 percent of the labor force, full com- 1977 80 83 86 pensation was allowed for this group. Be- tween 1973 and 1979 inflation fell steadily. When the indexing rules were suspended in June 1982, inflation began to increase (see figure 2). The average real wage in Chile did not return to its 1971 lev- el until 1982 (Meller 1987, figure 3). The growth of real output, nonetheless, averaged about 7 percent a year during 1977-81, which prompted talk of a Chilean miracle (Edwards 1986, p. 536). Corbo (1982b) has developed a model for Chile based on mark-up pricing behavior and a distinction between tradable and nontradable goods. Like Lara-Resende and Lopes for Brazil, Corbo found excess demand variables to be insignificant during the period of official wage indexation. Cortazar (1983) found that wages were exogenously and Paul D. McNelis 163 exclusively determined by indexing policy until 1979. He saw some evidence for a structural shift after 1979; even so, indexing policy continued to be the major determinant of wages. What is significant about Chile's disindexation policy is not that it worked. The country's military government was not constrained by labor market tensions and social unrest, so the credibility of its pro- gram was never in doubt. The main question about the Chilean experience is whether such a program could have worked in other political conditions. Finland Indexing was introduced in Finland in 1944, as a result of the Moscow Armistice in which Finland ceded about 10 percent of its territory to the USSR. Indexed indemnity bonds were given to the displaced families. Afterward, indexing spread. By 1967, three-quart- ers of all outstanding bonds were indexed. Indexation was ended when the exchange rate was devalued in 1967. The authorities feared that the in- Figure 3 dexed system of wages and assets would Percent reduce the benefits of the devaluation and 100- lead to faster inflation (Braun 1976). The 75- Iceland government initially wanted only wages to be disindexed, since they were consid- 50- ered the main route through which infla- 25- tionary impulses from abroad would be /N "^ . transmitted. However, unions soon de- 0- z ~ ~ Finland manded the removal of other indexation -25 , . l . . . as well, to protect their share of national 1950 60 70 80 86 income (Linnamo 1976, p. 23). After Finlar[d abolished indexation, unemployment decreased from more than 4 percent to less than 2 percent between 1968 and 1970, while wage increases continued to fluctuate between 6 percent and 12 percent. As figure 3 shows, the pattern of inflation barely changed in response to the disindexation policy. Only after the oil shock of 1973 (lid inflation rise to levels close to 20 percent. In an econometric study of wage inflation in Finland, Paunio and Suvanto (1981) report one result that seems common to most research on indexed systems: during the period of inclexing, excess demand had little effect on wage changes (Paunio and Suvanto 1981, p. 179). After the abolition of indexing, however, excess demand did have significant effects. Their study thus supports the view that ex post indexation weakens the impact of excess demand on inflation-and thus intro- duces inertia into the inflation process, as Fischer's model predicts. 164 Research Observer 3, no. 2 (July 1988) Iceland Indexation of all wages and salaries had been the general rule in Iceland from 1939 until 1983, but indexed bonds were fully permitted only after 1979. In the early 1980s inflation accelerated above 80 percent, whereas real GNP declined by 2 percent in 1982 and 5.5 percent in 1983. Between February and May 1983 consumer prices rose at an annual rate of 132 percent (Sigurdsson 1985, p. 110). After a general election in May 1983, indexing was suspended-on the same day as a devaluation was announced. Wage indexing was prohibited for two years, though indexation in the financial system was kept in order to stimulate savings in the face of a serious external deficit. In the summer of 1984, the government gave commercial banks greater freedom to set interest rates (Sigurdsson 1985, p. 112). Following these actions, inflation fell from more than 80 percent in early 1982 to 10-15 percent in the autumn of 1984. Unemployment remained relatively low, and the external balance of payments im- proved (Sigurdsson 1985, p. 112). The combination of stabilization with rapid disindexation worked in Iceland, as it seems to be working in Israel, because the play was based on a strong political consensus. This moderated the distributional effects following both the disindex- ation and the correction of the underlying fiscal imbalances. Australia and Italy have had indexation under conditions of moder- Indexing ate inflation. under Moderate Australia Inflation The wage setting process consisted of 9 automatic quarterly adjustments to mini- Percent mum wages from 1921 to 1953 (including a downward adjustment during the De- 20 pression). Then indexation was abolished - by the Commonwealth Court of Concil- 10- iation and Arbitration. As figure 4 shows, this was at the end of the Korean War boom, in which inflation reached more 0 \Australia than 20 percent before falling below 5 -5 percent in less than three years. The 1950 60 70 80 86 abolition of indexing was designed as an anti-inflationary measure (Nieuwenhuysen and Sloan 1978, p. 21). In the mid-1970s, Australia again turned to indexation-though this time, in line with the Friedman-Giersch thinking, to moderate strong inflationary pressures coming from increased oil prices, a commodity Paul D. McNelis 165 boom, and expansionary fiscal and monetary policy. The argument for restoring indexation was that it would stop workers from asking for wage increases to make up for the highest foreseeable inflation (Nieuwenhuysen and Sloan 1978, p. 104). Full indexation was adopted between 1975 and 1977; then there was only partial adjustment of wages to prices from 1977 to 1983, which helped to reduce real wages and labor costs by slightly more than 2 percent (Dornbusch and Fischer 1984, p. 48). After 1983 infla- tion began a moderate rise. The Australian experience of indexation, disindexation, reintroduc- tion of indexation, and disindexation once again illustrates the trade- offs in the use of indexing policy. Indexing was reduced or abolished to improve price stability, but it was reintroduced in order to moder- ate demand for higher wages based on the worst possible price fore- casts by workers. Italy In Italy, as in much of Western Europe, the government has moved to dilute (and then abolish) wage indexation while increasing the degree of financial asset indexation (Emerson 1983, p. 162). One reason for this trend toward disindexation in Europe is the viability of the European Monetary System. If EMS members wish to sustain their regional monetary block, they must harmonize their different indexing practices and financial policies (Emerson 1983, p. 163). Indexing in Italy and other European countries is sometimes ad- vanced as a reason for the slower recove:ry in Europe than in the United States after 1983. Sachs (1983) found that wages in Italy and in other parts of Europe, unlike those in the United States, were not significantly affected by excess demand factrors (proxied by domestic unemployment rates). Indexation thus made real wages less flexible in Europe and contributed to the general economic sluggishness. In 1985 Italy abolished its system of wage indexing, the Scala Mobile, through a national referendum. One interesting aspect of this system (which at times had been used in Australia also) was that the degree of indexing varied according to wage levels. The system thus functioned as an instrument for progressive income redistribution, since those on lower wages received a greater degree of indexation than those on higher wages. The result of the referendum, in a period of relatively low inflation, showed that the electorate was willing to set aside indexing as a redistribution instrument in order to seek greater price stability. Figure 4 shows a steady fall in Italian inflation since indexing was reduced in 1982 and abolished in 1985. The corre- lation does not imply causality in any particular direction (or at all, for that matter). 166 Research Observer 3, no. 2 (July 1988) During the past dozen or more years, various attempts to dilute or Assesment abandon indexation as a way of reducing inflation have not always and Conclusion been successful. Some countries have shown a positive correlation between extensive indexation and instability in output and prices, but disindexation programs have often been neither credible nor effective because the fundamental macroeconomic problems (such as fiscal defi- cits) were not corrected. Where disindexation did work (as in Israel), it was based on a political consensus in which the distributional consequences of the whole stabilization package were explicitly recog- nized. Disindexation may have helped, but certainly did not guaran- tee, the success of the stabilization efforts. This article describes early models of indexing as well as more recent models that call Abstract for less indexing of wages to prices in order to improve price and output stability. Policymakers may face a tradeoff: although increasing indexation may lead to macro- economic instability, reducing indexation may lead to greater income inequality and labor market tension. The article then concentrates on recent experiences, first in countries that have long histories of indexing (Brazil and Israel), then in countries that have reduced indexing (Chile, Finland, and Iceland) or that have used indexing under moderate inflation (Australia and Italy). Where disindexation worked, the costs of stabilization (involving both disindexation and fiscal correction) were recognized, and political agreements permitted an acceptable distribution of these costs. Earlier versions of this paper were presented at the Central Bank of Ireland, the Notes Kellogg Institute of the University of Notre Dame, and the Getulio Vargas Foundation (Brazil). D. Bigman, V. Corbo, P. deGrauwe, M. Moore, J. Niehans, and D. Seidman made valuable comments on these earlier versions. 1. It should be noted, however, that the wage-bargaining structure in Israel is quite different from the one in Brazil. 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