Significant pressure for currency causes depreciation and inflation spiral despite taxation

Dornbusch and Edwards (1991) identify the following four phases of populism. Phase 1. Policies very similar to those espoused by MMT are first put in place. Government expenditures increase rapidly, and massive income transfers are implemented. Public‐​sector wages and minimum wages are raised, and large public‐​sector investment projects enacted. These policies are financed by a combination of easy money that flows from the central bank, and foreign resources that come from the country’s international reserves. During this early phase growth and wages increase, and the populist views appear to be vindicated. The populist leader repeatedly makes the point that orthodox economics and its supporters are wrong. Phase 2. The consequences of the overly expansive heterodox policies begin to show up, and bottlenecks and imbalances emerge. Foreign exchange becomes scarce and there is significant pressure for the currency to depreciate rapidly. Exchange controls are introduced — France under Mitterrand, in 1984, is a good example of this development from outside of Latin America. In some cases, traditional exports are taxed. In spite of these measures, prices continue to rise. The populist response is to decree generalized price controls. Unions ask for higher salaries, and indexation practices are adopted. The central bank continues to lend vast amounts to the public sector, helping maintain the experiment. The economy enters into an inflationary spiral. A black market for necessities, and a parallel market for foreign exchange, usually appears. Phase 3. There is a deepening of imbalances and inflation accelerates, generally moving to the three‐ or four‐​digit terrain. “Fiscal dominance” becomes more acute, as the central bank continues to finance the government. The frequency of price adjustments, through indexation, increases — first to quarterly and then to monthly intervals. Pervasive indexation tends to worsen the fiscal accounts through the so‐​called Olivera‐​Tanzi effect. Government expenditures increase according to the indexation formula, while tax revenues are collected based on lagged income figures. Consumers ditch domestic money, and foreign exchange becomes the medium of exchange. However, since the government requires that taxes be paid in domestic currency, the local monies (pesos, soles, escudos, bolívares, and córdobas) do not disappear completely. Demand for domestic money, however, falls very rapidly, with velocity of circulation increasing significantly. The disparity between inflation (very high) and exchange rates (depreciating more slowly) intensifies the extent of real exchange rate overvaluation.17 Phase 4. The populist regime is finally replaced. The new post‐​populism government faces a very fragile economy and frequently a mess. Inflation is usually (very) high, international reserves are non‐​existent, exports are at an all‐​time low, the government debt is in default, and the real economy is replete with distortions. When the new government comes into power, real incomes and wages are often below what they were at the beginning of the experiment.