MONETARY POLICY, FISCAL DOMINANCE, CONTRACTS, AND POPULISM.

• Author: Edwards, Sebastian

Most populist experiences in Latin America, including the best known ones--Peru (1985-90), Argentina (2003-17), and Venezuela (2002-present)--have been characterized by "fiscal dominance." (1) Monetary policy is dominated by fiscal policy, and the central bank finances (very) large increases in public expenditures. The central bank purchases national and subnational debt (municipalities and provinces) and provides loans to state-owned enterprises. In this way, it finances large transfers to the lower and middle classes, provides funds to huge public investment projects, and helps pay for the nationalization of large firms. Fiscal dominance has been behind the explosion of inflation in the vast majority of Latin American populist episodes. Peru under President Alan Garcia ended up with hyperinflation of 7,000 percent in 1990, and Venezuela is on its way to 1,000,000 percent. Argentina under the Kirchners avoided hyperinflation, but in 2016, the last full year of President Cristina Fernandez de Kirchner in office, the consumer price index increased at an annual rate of 41 percent.

There are instances, however, when fiscal dominance is not possible. The most obvious case is when a country does not have a currency of its own, either because it is dollarized--that is, it uses another nation's currency as a medium of exchange--or when it belongs to a monetary union. In those occasions, inflation is mostly kept in check. In Latin America, Ecuador provides an interesting case study of a populist regime--Rafael Correa, 2007-17--without fiscal dominance. In March 2000, in the aftermath of a major macroeconomic crisis that resulted in 100 percent inflation and debt default, Ecuador decided to eliminate its domestic currency, the sucre, and to adopt the U.S. dollar as its currency. During Correa's 10 years in office, Ecuador averaged 3.8 percent inflation, significantly below that of other populist experiments in the Latin American region. However, in order to finance his populist program, Correa ran a very expansive fiscal policy:

* Between 2008 and 2017, the structural fiscal balance in Ecuador averaged -5.4 percent of GDP.

* During Correa's last five years in office (2012-17), the deficit amounted to 8.7, 9.4, 7.8, 7.9, and 4.6 percent of GDP.

* Starting in 2009, debt dynamics moved into an unsustainable path. Gross government debt went from 23 percent of GDP in 2010 to a projected 54 percent of GDP in 2020. (2)

Other instances of countries that, in principle, cannot adopt a fiscal dominance regime include those that have a currency board system, where the central bank cannot issue high-powered money, unless it is (fully) backed by international reserves. However, the degree of precommitment of this type of system is lower than in nations without a currency of their own.

Countries that give up their currency and dollarize or join a monetary union, always have the option of reintroducing domestic money at some point in the future. This was, for example, the case of Liberia in the 1990s. Indeed, Ecuador's Rafael Correa insinuated that he would go in that direction when in 2016 he stated: "Very few countries in the world have committed a monetary suicide like Ecuador, adopting a foreign currency that behaves exactly in the opposite way we want it to." Noting that Ecuador could not devalue, he compared the situation with that of neighboring countries: "Colombia devalued, Peru devalued, but we could not respond to anything" (see Telesur 2016). (3)

More recently, there has been talk about the possibility that Italy would leave the eurozone and reintroduce the lira as legal tender, an option that was also discussed seriously in 2013-15 in Greece. It has been argued that by abandoning the monetary union, Italy (or any periphery country that follows this route) would gain two policy tools: monetary policy, and the possibility of devaluing the currency as a way to gaining international competitiveness. This notion is based on the idea that a very strong euro, driven by Germany's rapid productivity growth, exacerbated the eurozone's periphery problems immediately after the 2008-10 financial crisis.

However, reintroducing a domestic currency is not easy. Some of the important issues that have to be addressed include the rate of conversion between die international currency (euro) and the new national money (lira), mechanisms for establishing credibility for the new regime, the creation of a full-fledged central bank with the appropriate staff, and negotiating with international institutions such as the IMF. In addition, there are logistical problems, including printing notes for the new-old national currency. But perhaps the most important difficulty--and one that tends to be overlooked in discussions on this topic--has to do with converting contracts denominated in the international currency (euros) into contracts denominated in domestic currency (liras or drachmas).

There have been some cases of contract conversions in history, and none of them has been easy. For example, after the devaluation of 2002, Argentina had to convert most contracts, which were written in terms of U.S. dollars, into pesos. In this case, the transition was not from an international to a domestic currency, but from a currency board with a fixed exchange rate (one dollar = one peso) to an adjustable currency system. Pesification was done at arbitrary rates. Some contracts (bank deposits) were converted using a 1.4 pesos per dollar rate, while the rest were rewritten at the old one-to-one exchange rate. The result was a barrage of lawsuits and legal cases in domestic and international courts, and in arbitration tribunals. (4)

But perhaps the most interesting--and, surprisingly, least known--case of contract conversion happened in the United States between 1933 and 1935, when President Franklin D. Roosevelt decided to abandon the gold standard and devalue the U.S. dollar relative to gold. At the time, most contracts in the United States were written in "gold currency." That is, the debtor committed himself to paying a specified amount in "gold equivalent." This meant that if the official price of gold was increased, as happened in January 1934, the dollar value of the debt would rise proportionally. As a consequence, a large number of companies would go bankrupt, and the value of the public debt would increase drastically. In June 1933, Congress decided to deal with this issue by passing a Joint Resolution that abrogated the gold clause in contracts in a retroactive fashion. Not surprisingly, a large number of lawsuits followed. The Supreme Court heard the "gold cases" in early January 1935. (5)

In this article, I analyze the U.S. episode in the 1930s and compare it with die case of Argentina in the early 2000s. The discussion shows many similarities, as well as important differences between the two events. An important goal of this discussion is to provide some clues on the likely consequences of decisions to ditch a monetary regime that constrains discretionary monetary policy, replacing it by one that allows, at least in principle, for the emergence of some form of fiscal dominance.

The Devaluation of the U.S. Dollar and the Abrogation of the Gold Clauses

On April 19, 1933, President Franklin D. Roosevelt announced that the United States was abandoning the gold standard. From that point onward, paper dollars were not convertible into gold at the historical (almost 100 years old) rate of $20.67 per ounce. Gold could not be held by individuals, banks, or corporations, or shipped internationally, except to settle trade balances and under authorization by the Treasury. At that time no announcement was made regarding an official devaluation of the currency with respect to gold.

On May 12 of that year, Congress approved the Agricultural Adjustment Act (AAA). It included a provision known as the Thomas Amendment, which gave the president the authority to devalue the dollar by up to 50 percent with respect to gold. Roosevelt believed that by doing so commodity prices would increase rapidly. This idea had come to him through Cornell University Professor George F. Warren, who had developed a theory of a close and immediate correspondence between the price of gold and that of agricultural commodities. The theory was presented in a long book (coauthored with Frank A. Pearson), replete with tables and graphs, titled Prices (Warren and Pearson 1933). FDR was also influenced by the British experience after the devaluation of sterling in September 1931; in his view, by abandoning the gold standard, the United Kingdom had begun to recover. During May and June of that year Roosevelt pondered by how much the dollar should be devalued in order for the...