Government policy has greatly influenced the development, or lack of development, of Uruguay's economy during the twentieth century. The government first became an important regulator of economic activity when it arranged for a portion of livestock export earnings to be transferred to the urban working class. As its interventionist role expanded during the early 1900s, the central government became the administrator of an elaborate social welfare system that was generous by Latin American standards. After the Great Depression, the government enacted tariff policies to promote domestic manufacturing and adopted the strategy known as import-substitution industrialization. The state also became an important participant in the economy. In a pattern repeated elsewhere in Latin America, the central government nationalized or established several of the largest service and manufacturing companies in the country. It became the single largest employer and producer in the nation.

The level of government involvement in the economy took on increasing significance after Uruguay entered a period of economic stagnation. When export earnings leveled off in the 1950s, the state's two roles in the economy became difficult to sustain yet vital to the population. Growing numbers of unemployed persons and retirees depended on the social welfare system, even as government revenues used to support that system declined. In addition, the overall economic slowdown made publicsector employment extremely attractive. Public employment, which was controlled by political parties rather than market forces, increased at 2.6 percent per year during 1955-61, while privatesector employment grew at only 0.9 percent. Government consumption expenditures for salaries and services remained high, but public investment was scaled back, penalizing future productivity. Despite this shift in the spending pattern, the state's income did not keep pace with its expenditures. By the 1960s, a public-sector deficit had developed, requiring borrowing from abroad and helping to fuel inflation.

The public-sector deficit was the hallmark of Uruguay's stagnated economy in the 1960s. Thereafter, efforts to reduce the deficit were a central feature of structural reforms. However, the web of government commitments within the economy--involving both administrative and productive activity--made this a difficult task. The military government (1973-85) partially succeeded at the larger task of reorienting the economy toward world markets but made only modest headway against the publicsector deficit. During the second half of the 1980s, the deficit was at first reduced but then increased again in the last two years of the Sanguinetti administration.

Fiscal Policy

The civilian government that entered office in 1985 faced a severe fiscal problem: the chronic public-sector deficit. It also faced a broader difficulty: an economy in deep recession. The deficit was believed to be perpetuating inflation. Inflation, in turn, prevented the economy from reaching a stable position conducive to renewed growth. Thus, the priorities of the Sanguinetti administration's economic plan--devised in cooperation with the International Monetary Fund ( IMF)--were to reduce the deficit, bring down inflation, and improve the balance of payments.

These multiyear fiscal measures were considered essential for renewed growth, but the serious consequences of the recession called for immediate action to spur economic activity. Between 1981 and 1984, the recession had taken its toll on all sectors of the economy. GDP had declined by almost 17 percent; agricultural production by 12 percent; manufacturing by 21 percent; construction by 48 percent; and capital formation (investment) by 56 percent. Workers were especially hard-hit by the decline. Between November 1982 and March 1985, real salaries fell by 19 percent. In real terms, workers only earned half of what they had earned in 1968, and unemployment had increased to 13 percent. Unable to ignore these signs of distress, the Sanguinetti administration also adopted an economic growth policy.

Initially, the stabilization effort took precedence over efforts to boost economic activity. The idea was to break the inflationary momentum of the economy first and restore growth second. In fiscal terms, the goal was to reduce the public-sector deficit from 10 percent of GDP in mid-1985 to 5 percent of GDP by 1986. The scope of government involvement in the Uruguayan economy meant that the public-sector deficit had to be attacked on three fronts: the central government, by reducing expenditures and increasing revenues; the Central Bank of Uruguay, which accounted for about half of the deficit; and the state enterprises, many of which had run small deficits through most of the 1980s.

The results of the stabilization effort were ambiguous. On the one hand, the Sanguinetti government easily reached its fiscal targets. During its first two years in office, the government enacted tax increases that raised real government revenues by 58 percent. Meanwhile, real expenditures increased by only 43 percent. As a result, the public-sector deficit declined to about 3 percent of GDP, better than the government had planned. Simultaneously, however, inflation--the underlying target of the government's fiscal policy--hardly slowed at all. Inflation went from an annual rate of 72 percent in 1985 to 57 percent in 1987, but it increased to 85 percent in 1989. The persistence of inflation in the face of fiscal restraint did not reflect a failure of the Sanguinetti government's fiscal policy; rather, inflation persisted because of the government's monetary and exchange-rate policies, the instruments it used to promote economic growth. Fiscal policy was also inadequate because the government expanded the money supply to pay for the fiscal deficit (8.5 percent by the end of 1989).

Monetary and Exchange-Rate Policy

The Sanguinetti administration turned to Uruguay's formerly strong export sector in devising its strategy for renewed economic growth. Through a combination of exchange-rate policy, liberal credit to exporters, and cultivation of new markets, the government hoped to revitalize the traditional export sector (primarily beef and wool) and promote the manufacture of nontraditional exports such as apparel.

The most important policy tool was the exchange rate. Initially, the government planned to allow the peso to float freely, in keeping with its philosophy of minimal market intervention. In practice, however, the monetary authorities carried out a "dirty float," repeatedly entering the currency market to lower the exchange rate of the peso. Devaluation translated into increased competitiveness. For a small country like Uruguay, facing given world (United States dollar) prices for goods, a devaluation of the peso (more pesos per dollar) meant that an exporter would receive more pesos for a given quantity of goods. This effectively raised the profitability of exports (leaving aside other effects) and encouraged the growth of the sector.

Exports and GDP both increased after 1985, partly as a result of the more competitive exchange rate. But the policy also had inflationary effects that counteracted the government's restrained fiscal policy. The government's intervention in the currency market consisted of buying foreign exchange and selling pesos. This raised the supply of pesos and lowered their price relative to other currencies (the exchange rate). But the intervention also increased the foreign-exchange component of the money supply, thus fueling inflation. The government attempted to compensate for this increase in the monetary base by decreasing other components of the money supply, a policy known as sterilization. However, an increasing share of Uruguayan bank deposits were denominated in United States dollars rather than pesos. Thus, the efforts to restrict the peso monetary base had little effect on the overall money supply, which continued to increase. As a result, the government could not fine-tune its export-promotion strategy to eliminate inflationary effects. Inflation persisted despite the decline of the public-sector deficit. In short, the government's notable accomplishments on the fiscal side were largely negated on the monetary side.

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Source: U.S. Library of Congress