With the market-oriented choice of economic strategy discredited by results under Belaúnde, Peruvians voted for the dynamic populist-reformist promise of García and responded enthusiastically to his sweeping changes. García's program worked wonders for two years, but then everything began to go wrong.

The main elements of the economic strategy proposed by the García government were full of promise. They recognized the prior neglect of the agricultural sector and called for redirecting public programs toward promotion of agricultural growth and reduction of rural poverty. Correspondingly, economic activity was to be decentralized to break down its high concentration in Lima, and within the cities resources were to be redirected away from the capital-intensive and import-intensive modern sector to the labor-intensive informal sector. A strategy of concertación (national understanding) with private business leaders on economic issues was to be used systematically to avoid disruptive conflict. Problems of external balance were to be answered both by restructuring production to lessen dependence on imports and by reorienting toward higher exports over the long-term.

These goals for structural change could have improved the efficiency of resource allocation while doing a great deal to lessen poverty. But the goals clearly required both time and the ability to restore expansion without worsening inflation and external deficits. The government initially emphasized such macroeconomic objectives as necessary conditions for the structural changes. The first step was to stop the built-in inflationary process, but to do it without adopting orthodox measures of monetary and fiscal restraint.

To stop inflation, the government opted for heterodox policies of control within an expansionary program. Prices and wages in the modern sector were to be fixed, after an initial one-shot increase in wage rates. The increase in wages was intended to raise living standards of workers and stimulate production by raising sales to consumers. To offset the effects of higher wages on costs of production, financial costs of the business sector were cut by intervention in order to reduce and control interest rates. After making one adjustment of the exchange rate to minimize negative effects on exports, the government stopped the process of continuing devaluation in order to help hold down inflation. Imports were rightly expected to go up as the economy revived; to help finance them, García made his controversial decision to stop paying external debt service beyond 10 percent of the value of exports. Unorthodox as they were, all the pieces seemed to fit. At least, they went together well at the start under conditions of widespread idle capacity, with an initially strong balance of payments position.

The macroeconomic measures worked wonders for production. GDP shot up 9.5 percent in 1986 and a further 7.7 percent in 1987. Manufacturing output and construction both increased by more than one-fourth in these two years. An even greater surprise was that agricultural production per capita went up, running counter to its long downward trend. And the rate of inflation came down from 163 percent in 1985 to 78 percent in 1986, although it edged back up to 86 percent in 1987. In response to stronger market conditions and perhaps also to growing confidence that Peru's economic problems were at last being attacked successfully, private fixed investment went up by 24 percent in 1986, and capital flight went down.

The government avoided any spending spree of its own: central government spending was actually reduced in real terms each year. But because the government also reduced indirect taxes in order to encourage higher private consumption and to reduce costs for private business, its originally small deficit grew each year. The economic deficit of the nonfinancial public sector as a whole (excluding interest payments) went up from 2.4 percent of GDP in 1985 to 6.5 percent by 1987.

Although the government reduced its total spending, it managed to support a new public works program to provide temporary employment and to direct more resources to rural producers as intended in its program for structural change. Three lines of policy helped especially to raise rural incomes. The first was to use generous guaranteed prices for key food products. The second was to provide greatly increased agricultural credit, financed essentially by credit from the Central Bank. The third was to exempt most of the non-guaranteed agricultural prices from controls, allowing their prices to rise sharply relative to those of industrial products from the modern sector. From July 1985 to December 1986, prices of goods and services not under control increased more than three times as much as those under control. Wholesale prices in manufacturing increased 26 percent, but those for agricultural products increased 142 percent.

Besides higher employment and living standards, the first two years of economic revival seemed to offer a break in the cycle of rising rural violence. The flow of displaced peasants from the Sierra eased, and a good many peasants began to return to the countryside. That reverse might be explained by García's initial efforts to reduce reliance on military force to combat the guerrillas and thereby to lessen the degree of two-way violence driving people out of their villages. But the trend may also have been a response to the reality of better economic conditions and earning possibilities in the agricultural sector.

The first two years of the García government gave new hope to the people of Peru, with rising employment, production, and wages suggesting a clear turn for the better after so many years of increasing difficulties. It was hence doubly tragic to see the whole process unravel so quickly, once things started going wrong again. The first sign of trouble came, as it often had, from the balance of payments. The economic boom naturally raised imports swiftly, by 76 percent between 1985 and 1987. But the real exchange rate was allowed to fall by 10 percent in 1986 and by a further 9 percent in 1987. The boom pulled potential export supply into the domestic market, and the fall in the real exchange rate reduced incentives to earn foreign exchange. Exports fell slightly in 1985 and remained below that level through 1987. The external current account went from a surplus of US$127 million in 1985 to deficits of nearly US$1.1 billion in 1986 and nearly US$1.5 billion in 1987.

The García government reacted to the growing external deficit in exactly the same way as had the governments of Velasco and of Belaúnde--by postponing corrective action while the problem continued to worsen. As ever, a major fear was that devaluation would worsen inflation. Inflationary pressures were, in fact, beginning to worsen behind the façade of control. To some degree, they were growing in response to the high rate of growth of demand and output, reducing margins of previously underutilized productive capacity. But the more explosive pressures were being built up by relying on price controls that required a dramatic expansion of credit to keep the system in place. Prices of public sector services--gasoline above all, oil products in general, electricity, telephones, and postal services--were frozen at levels that soon became almost ridiculous in real terms. The restrictions on prices charged by state firms drove them ever deeper into deficits that had to be financed by borrowing. The borrowing came from wherever it could, but principally from the Central Bank. At the same time, Central Bank credit rose steadily to keep financing agricultural expansion. Still another direction of Central Bank credit creation was the financing used to handle the government's new structure of multiple exchange rates. Differential rates were used to hold down the cost of foreign exchange for most imports, again with the dominant goal of holding down inflation, while higher prices of foreign exchange were paid to exporters to protect their incentives to export. The Central Bank thus paid more for the foreign exchange it bought than it received for the exchange it sold.

The term used for these leakages--for extensions of Central Bank credit that did not count in the government's budget deficit--is the "quasi-fiscal deficit." Its total increased from about 2 percent of GDP in 1985 to about 4 percent in 1987. Meanwhile, the government's tax revenue fell steadily in real terms, partly because of tax reductions implemented to hold down business costs and partly because of the effect of inflation in cutting down the real value of tax payments. Added together, the fiscal deficit plus the quasi-fiscal deficit increased from 5 percent of GDP in 1985 to 11 percent by 1987.

The two horsemen of this particular apocalypse--the external deficit and the swift rise of Central Bank credit--would have made 1988 a bad year no matter what else happened. But President García guaranteed financial disaster by his totally unexpected decision in July 1987 to nationalize the banks not already under government ownership. No one has yet been able to explain why he decided to do so. It would not seem to have been a move necessary for any component of his program, or needed for government control in a banking sector in which it already had a dominant position. In any case, the action underlined the unilateral character of economic policy action under Peru's presidential system and wrecked any possibilities of further cooperation with private sector leadership. Private investment began to fall, and the whole economy followed it down shortly thereafter.

The García government tried a series of major and minor new policy packages from early 1988 into 1990 to no avail. The new policies never succeeded in shutting off the rapid infusion of Central Bank credit that was feeding inflation, even when they did succeed in driving production down significantly in 1989. Manufacturing production fell 18 percent in that year, agricultural output 3 percent, and total GDP 11 percent. Simultaneously, inflation increased from a record 666 percent in 1988 to a new record of 3,399 percent for 1989. The one positive change was the external current-account deficit: the fall in domestic production and income was so steep that the current account went from a deep deficit to a substantial surplus. The internal cost was perhaps clearest in terms of real wages: the minimum wage in real terms for urban labor fell 61 percent between 1987 and 1989, and average real wages in manufacturing fell 59 percent.

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Source: U.S. Library of Congress