Chile's Unidad de Fomento
Traveling to different countries can be eye-opening. One of the things that struck me in all three Latin American countries I visited was the deeply ingrained fear of a return to hyperinflation. The ravages of annual inflation rates of 1000% or more were keenly felt by the population, and the poor were hard hit. While this has not turned them into raving monetarists or Chicago-style free marketeers, they are willing to through some short-term hardship as long as it prevents a return to hyperinflation.
In Santiago I was talking to some people about Chilean government bonds and how they're inflation-protected. That is, the yield you get on a Chilean bond is a real yield, corrected for inflation, rather than a nominal yield like most bonds. Chile isn't the only country in the world issuing inflation-protected bonds, but it was one of the first ones to do so. By now, many governments issue inflation-protected bonds. There are the index-linked gilts in the UK, TIPS in the US, OATi's in France and various other flavors in Sweden and (I think) Australia. Issuance is fairly limited as demand has been surprisingly low for them. You'd think that a risk-free return over inflation would snapped up by institutional and retail investors alike, but in practice the uptake has been limited. Apparently the Treasury in the US is looking at increasing issuance of TIPS. (TIPS stands for Treasury Inflation Protected Securities; the story on the grapevine was that Robert Rubin, then Treasury Secretary, had a fit when he heard people were calling them that. "The US Treasury does not give TIPS!" he is said to have exclaimed.)
Chilean inflation-protected bonds however are not denominated in peso, but in a unit of account called the Unidad de Fomento, or UF. The UF's exchange rate to the peso is calculated on a daily basis relative to the peso, which is the currency in Chile. This exchange rate is based on inflation in the last two months, so that the real purchasing power of one UF remains the same, but it fluctuates in value relative to the peso.
What's remarkable is how widespread the use of the UF is. The UF is used not just for government bonds, but also for rents, house prices, long-term contracts, wages, services and big-ticket items. Its use is deeply engrained in the Chilean economy. Its value is calculated on a daily basis and is widely disseminated. All banks and newspapers carry the conversion rate of the UF to the peso. The value of the UF expressed in pesos depends on the inflation rate of the preceding two inflation data points, so you can project forward the value of the UF until the next inflation data point becomes available. That's why the conversion rate can be calculated for some days into the future.
A large part of Chilean contracts and some goods are denominated in UF rather than pesos. This has the effect of indexing that part of the economy to inflation, moving it out of nominal (inflationary) peso space into real (inflation-protected) UF space. But for all this, the UF is just a conversion factor to pesos. All payments are still made in pesos as there are no UF notes or coins. Whenever a payment is due that was agreed upon in UF, the current conversion rate is applied and the payment is transacted in peso. This means that the functions of money are split into a currency (peso) and a unit of account (UF).
The Chilean Central Bank has published a series of papers on indexation and its effects. The two key documents to read are the introduction and Robert Shiller's look at the UF. They key argument against the widespread use of indexation is that it creates persistence of inflation because it is of necessity tied to lagged inflation information rather real-time inflation data. While an indexed unit of account will create inflation protection in high-inflation environments and can be useful in the transition to a low-inflation regime, it is actually harmful in trying to get inflation into the low single digits. Many of the papers refer to exactly this problem and try to quantify the impact. On the other hand, Robert Shiller is a long-time fan of indexation and argues that the problems of inflation inertia can be overcome.
Shiller argues that all countries should create a unit similar to the UF, and accompany that with another unit indexed to wages. I refer you to his paper linked above for the details. In fact, Shiller goes so far as to argue that a complete monetization of the indexed units of account would be feasible, de facto creating inflation-protected currencies. But what good would it do if all prices were denominated in an inflation-protected unit? Would it not simply reintroduce inflation by another means? Shiller argues that since the monetized units of account would at their base still be convertible to the nominal currency, any inflationary effects would correct themselves in an inflation-protected currency. The least sticky prices would rise in UF and therefore in peso too, be picked up by the inflation rate, which leads to an adjustment of the UF/peso rate which then in turn leads to a downward readjustment of the UF price, pushing the inflation back into the peso and peso only. I'm not sure this would actually work, because if all the UF to peso conversions happen transparently, people will stop thinking in terms of nominal pesos. This in turn will allow inflationary expectations to creep into UF prices.
As a behavioral finance guru, Shiller writes a lot about the illusion of money (again I refer to his article for more detail). The illusion of money is that people feel better off if they have more in nominal terms even if there is no improvement in real terms. The canonical example is that people feel better off if their wages increase only at the rate of inflation. The real purchasing power remains the same, but the nominal amount is higher. This also introduces an aymmetry into the flexibility of any real wage adjustments, as people are extremely unwilling to see their nominal wages reduced. There's a floor at zero, while the upside is unbounded.
We're all accustomed to living in a nominal world although we really should be thinking in real terms. This applies even to people who you might expect to know better such as CEOs and CFOs, who you might assume ought to have some training in these matters. But company balance sheets live in nominal space, their P&L's are nominal, their share prices are nominal and their dividends are nominal. We've seen part of the repercussion of this nominal thinking in recent times as nominal GDP growth in the US had fallen to its lowest level since 1962. As a rough approximation, you might expect a company's top line to grow roughly in line with GDP; as the economy expands, so does the potential for revenue. But companies had gotten used to high nominal growth rates in the economy, and the recession of 2001 coupled low GDP growth with low inflation, resulting in low nominal GDP growth of just 1% or so. This crimped the expectations that companies had for their top line as they saw nominal sales growth decline to unprecedented levels (not many of them were CEOs and CFOs in 1962). An even worse situation exists in Japan, were nominal GDP growth has been negative for the better part of five years now.
Changing the mindset from nominal to real is hard to do and seems to come unnaturally. But in Chile at least part of the economy has been indexed, and people can and do deal effectively with an inflation-protected unit of account, even if it is not fully monetized. Ironically, the Chilean authorities are trying to reduce the reliance on indexation because it hampers efforts to reduce inflation even further. A partial nominalization is underway, as the Chilean Central bank explains on page 29. The UF is not being abolished, but the setting of monetary policy is now based on nominal peso interest rates rather than real UF interest rates. The central bank has also started to issue short-dated debt in peso rather than UF. As long as there is an agreed-upon calculation of the UF the people can continue to use it. So at the moment there is no real danger that the UF will be abolished altogether.
The US Treasury already calculates a daily CPI series based on interpolated data, much like the Chilean UF. In principle it could be used to create an American version of the UF to base transactions on. A more interesting variant would be for a private provider to issue an inflation-protected currency that would maintain its purchasing power relative to the CPI basket of goods. Modern methods of payment (credit and debit cards) make the use of such alternatives technically feasible. But this still would not solve a more fundamental problem with the current monetary system: if the central bank gets policy wrong, the economy will suffer. The central bank has the potential to screw things up in a massive way, and an indexed unit of account like the UF won't help either. There is no price discovery mechanism for money and we have to hope central bankers get it right.
But even if we were to move to a world of real prices by monetizing an inflation-indexed unit of account like the UF in Chile, then that still would not mean an end to price fluctuations. The laws of supply and demand still apply, and if there's a dramatic increase in the demand for milk, then milk prices will rise, UF or no. Only those who buy the exact basket of goods used in the CPI calculation will be fully protected against inflation. And even that protection is imperfect as the inflation data is lagged.
An inflation-indexed unit of account like the UF can be useful as the Chilean experience shows. The current efforts to nominalize the economy are limited in scope and the UF will continue to be used for the foreseeable future. There's also the fundamental question whether it matters if the central bank can get inflation down to 3% from 5% if a large part of the economy is inflation-indexed anyway. The Chilean Central Bank does seem to think it matters.
Chile has become an interesting economic laboratory over the last 20 years, with fully funded pensions and innovations like the UF. Its economy has done reasonably well with far better macroeconomic stability than the rest of Latin America. Thus far the experiments seem to be working. But more importantly, they provide crucial empirical data for economists to ponder.
Now if only I could get a Pisco Sour here...
Chile and Argentina
There seems to be a war on, but it's largely passed me by. I simply haven't had time to read blogs, watch much news or even read newspapers, so I only have the most cursory knowledge of what is going on with the war, other than that it's not over yet. The reason for all of this is a lot of travel, with my days being crammed with meetings from breakfast till dinner, and even on the weekends my time has been seriously limited. Hence the limited blogging. I should be back in Amsterdam in a week's time, after which normal blogging is likely to resume.
Meanwhile, a canceled meeting has left me with some time to catch up on my work email (866 unread messages), and now I even have a bit of time to write this, sitting in the lobby of my hotel in Buenos Aires. I'll be flying to Sao Paulo later today, so that's where I'll be posting this from if all goes well. My two experiences with Latin America thus far have been fascinating in their contrast. The sheer difference between the drive into town from the airport into Santiago de Chile and Buenos Aires is remarkable. In Santiago, there's a crowded road that passes scrapheaps (sometimes with people living in them) and shiny new office buildings, leading onto jammed winding highway that goes over hills into Santiago. Coming out of Buenos Aires Ezeiza airport the contrast couldn't be bigger: a gleaming six-lane highway, that could have been lifted straight out of Germany. It spills out onto the wide and spacious avenues of Buenos Aires, including the 9. de Julio, the widest avenue in the world (or so the Argentinians claim). Santiago is a town that started small and has been growing into a big town, with all the concomitant problems. They're currently building a highway under the river that flows through town in an effort to fix the traffic problems at least partially. Buenos Aires has the feel of an imperial city, planned to be big, and planned to impress. The rich 19th century architecture fits in perfectly with the idea of wide avenues and luscious parks.
Looks deceive in this case. Santiago is the more dynamic city in the country with an economy that actually works, whereas Buenos Aires is suffused with a wistful yearning for past glory and still hurting from the wounds of the devaluation that was forced on the Argentine economy. After a very promising start in the 1990s with macroeconomic reforms, the government never quite got its act together on the fiscal side as especially the provinces continued to be profligate in their spending. The peg which had kept the peso at 1:1 convertibility with the US dollar had to be let go, and it's amazing that it survived for as long as it had. The peso was horrendously overvalued at $1, and the economy was simply not producing enough economic added value to justify that exchange rate. Meanwhile, the inflexible labor markets and somnolent corporate management never made the adjustments necessary to maintain competitiveness in the face of the strong peso. Put simply, the price level in Argentina was too high, and deflation was the alternative to devaluation. But cutting wages was politically impossible, so in the end it was the devaluation which achieved essentially the same effect, reducing Argentina's labor costs dramatically. It also resulted in a massive impoverishment of the country as suddenly the value of all peso assets was reduced to a quarter of what it had been previously. Then again, the underlying value of assets in Argentina should not have been as high as it had been in dollar terms anyway. The ridiculous price levels still have their repercussions today, although at 3 pesos to the dollar it's becoming affordable for foreigners with hard currency. But restaurant and hotel prices were pre-devaluation on a par with London or Tokyo, and that was completely unreasonable.
It shows the danger of relying on a pegged currency to conjure up macroeconomic stability. It can work, but it requires a flexible and open economy to survive. The exchange rate is the external price of the currency, and as a price it is subject to supply and demand pressures. Changing prices convey economic information, and if you take away the flexibility to convey economic information through the exchange rate, it will find other avenues to assert itself. The underlying economic information is still there and fixing the exchange rate does not make it go away. A currency peg can work if the economy is flexible enough to respond to economic information in other ways, for instance by lowering the domestic price level. But that is painful to the people, who don't like seeing their wages cut and their house prices drop. A weaker currency does the same thing, but it feels very different. Hong Kong, which has its currency pegged to the US dollar too, is experiencing deflation and as a result the price level in Hong Kong is declining. But Hong Kong is able to respond more flexible than Argentina ever could.
It is sad to see how a once-great country and economy has fallen so far. At the beginning of the 20th century, Argentina was one of the ten richest nations in the world, and the lavish architecture from those days still reminds the current generation of the former glory. As one Argentinian told me, "all the nice things you see were built by our grandfathers, and we have been destroying them ever since." A sense of despairing, fatalistic hopelessness lurks in the background here, but there is also a worrying sense of entitlement, the sense that Argentina deserves better. It would certainly deserve better, but it won't get there without doing something to get it. Magic solutions are not going to fall out of the sky. Coming to terms with former glory is a hard thing to do, and current-day Argentina still hasn't entirely vanquished the ghosts of its own past.
Chile is doing much better. It's not as flamboyant as Argentina, the people are more conservative and scared as hell about the instability in Argentina and Brazil. The Chilean economy has been plodding along without major mishaps for a long time now, and is slowly moving away from its dependence on copper. It's attracting investment from Australia and Asia as a manufacturing base for shipping exports into the Americas. It has reasonably well-developed capital markets and a fully funded pension system (which will be the topic of a future blog entry). There's also an inflation-protected accounting unit, called the UF. Chilean bonds are quoted in UF, and other prices, such as rents, are also expressed in UF, making it almost a parallel currency (more on this later). One question that many Chileans had as the war was starting was about the relationship with the US. The Chilean president had spoken out against the allied military action in Iraq, and Chileans wondered how that would impact US relations. The people I spoke to were unhappy with their government's stance, but then again, these people were not a representative cross-section of the population. Being there on business, I generally avoided commenting too much on the war other than in generic terms, but some of my interlocutors did express their distaste for France, which I found interesting.
Argentina is the flamboyant and overconfident member of the Latin American family. Its little brother Chile is far less conspicuous, but has plodded along calmly without pretension to build a surprisingly solid economy. The price level in Chile is far more appropriate to an economy that's still not quite fully developed, certainly compared to prices in Argentina. The wines in both Chile and Argentina are pretty good, although I still have to give the edge to the Chileans. A big discovery was also the national drink in Chile, Pisco Sour. It's somewhat like alcoholic lemonade, although that description does not do it justice. I wish they would export it, as I never had the time to buy Pisco Sour while in Chile. As it was, I almost missed my flight to Buenos Aires.
It is time to leave for my final meeting in Argentina; more blogging perhaps over the course of the weekend, which I'll spending in Rio (without too many meetings I hope).