Letter from Uruguay Jude Wanniski January 5, 1982

MONTEVIDEO— Uruguay first caught my attention in 1976 while I was rummaging through a Price Waterhouse booklet of global tax tables. I was startled to find that it had no personal income tax of any kind, which qualifies it as the largest economy in the hemisphere, second only to Saudi Arabia's in the world, without such a tax. It was a recent event, though, 1975 being the first year it was not levied. Gift and estate tax had been abolished concurrently by the military government that had assumed power in April 1973. It had been wisely noted that the taxes were costing more to administer than they were yielding in revenues. All I could do from afar was note the experiment with fascination and keep an eye out for the occasional news dispatch from Uruguay. These almost always mentioned only the political environment, the continued absence of democratic elections. So it was with unusual eagerness that I accepted an invitation by the Banco Central del Uruguay and Citibank to participate in their economic conference of December 16-19 here in the capital city. I would finally get a close-up look at a country that has gone "cold turkey" on personal income taxes. I was not disappointed.

The country is about the size of Kansas, 72,000 square miles, with gently rolling hills and no serious prominences. It sits astride Argentina's shoulder, facing the Atlantic across the widest river in the world, the Rio de la Plata, which hits the beaches sweet or salty depending on the winds. There are 3 million Uruguayans, about 1.3 million in Montevideo, almost all of Southern European extraction; there is no "native" population. The people seem uniformly middle-class and tranquil, with a pace and morality that seem reminiscent of the 1950s in America. There is no crime to speak of and visitors are told they can walk anywhere in the city in the middle of the night without worry. Seventy percent of Uruguayans own their own homes. Universal free education extends to junior college. There is a symphony orchestra, opulent shopping plazas, exquisite restaurants (including the only five-star restaurant in South America, so they say). The climate is superb, on the order of the Carolinas, and it is now mid-summer. There is no mineral wealth or petroleum yet discovered and the forests are the sparsest on the continent. The land is rich, though, and the exports of wool, meat, grain and leather goods are abundant.

So what's the story?

It seems that at the start of the 20th century Uruguay gradually developed into a model democracy and welfare state, under the influence of its national hero, Jose Batlle y Ordonez. While president, he saw to the nationalization of power, railways, waterworks, petroleum, alcohol, cement, chemicals, banks, insurance, hotels, casinos, theatres, fishing and broadcasting. Women got the vote and divorce was legalized on demand. He or his successors (he died in 1929) introduced paid holidays, the minimum wage, social security and unemployment benefits, socialized medicine and education. Everything seemed to go well enough until the 1950s. Just at the time when the rest of the world went into economic boom, Uruguay stopped in its tracks. By 1965, Richard West, a British journalist, described conditions:

From the start of the Sixties, Uruguay has been on the point of utter bankruptcy and its people have been preserved from hunger only by great helpings of US money and aid ... Sloth and corruption have set in ... In Uruguay today, a work force of a million has to support 400,000 pensioners, many of whom retired as early as 40. A married woman teacher can retire on full pension at 30, many people draw two or three pensions from different funds. Both Batlle's Colorado (or Red) Party and the opposing Blanco (or White) Party hold the right to appoint political friends to jobs in the civil service. Each party is split into three factions each of which wants its share of favouritism, with the result that the civil service is swollen to 250,000 . . . Overstaffing is rife in the state-owned airlines, oil refineries, breweries, meat-packing plants and power corporations . . . The nostalgia and complacency of the Uruguayans have brought them almost to ruin. By 1965, they were in debt to the tune of three years' exports. There were more beggars on the streets than in backward countries like Paraguay and Bolivia. Yet every attempt to trim pensions, cut surplus staff, or chop the spare fat from social benefits resulted in a round of strikes and demonstrations.

By the spring of 1973 it would get much worse. The statistics for the 20-year period 1955-74 look bad enough: Gross domestic product grew by a mere 0.3 percent annually, which translates into a per capita decline when the 1.2 percent annual population growth is taken into account. The nation's capital stock was visibly eroding: Uruguayans remember the darkness of the cities at night; public power authorities didn't have the resources to replace worn-out equipment. Per capita fixed investment also declined in the two decades. The country was eating its seed corn, and the political parties vied with each other in producing destructive policy prescriptions. A general policy of "import substitution" coupled with capital controls was designed to keep wealth from flowing abroad. This meant a tariff wall so high that the country was effectively sealed off from the rest of the world. Ad valorem rates in excess of 500 percent were routine and imported autos were prohibited altogether. Among others, GM, Ford, Fiat and VW maintained factories where imported "kits" were assembled. They churned out obsolete models (1951 Fiats, 1966 Ford Falcons, the early Beetle) and sold them at exorbitant prices. Although imports now come in, Montevideo still looks as if it has been overwhelmed by an antique auto convention.

The country now seems so peaceful that it is difficult to imagine the early Seventies, when the Tupamaros emerged. These were the urban guerrillas whose reign of terror brought on the military takeover. These were the sons of upper- and middle-class families who had been pampered up the welfare-state ladder, educated, ready to challenge life, but with no place to go. Using the language of the revolutionary left, they rebelled against the stagnant, frustrating society their elders had arranged for them. At the outset, of course, the ever-tolerant, sophisticated urban elites professed sympathy for the Tupamaros. But it was this Establishment that Uruguay's youth was rebelling against. Before it was all over, the Tupamaros were averaging one murder, kidnapping or assassination daily, or so the locals recall. The fathers of the sons, the failed elite, simply invited the military to take control and restore order.

At the time, Uruguayans and others were astonished at how quickly the military regime ended the terrorism with the jailing of a few thousand activists (hundreds of whom are still imprisoned). But in retrospect, it seems reasonable to suggest that the movement's whole energy was directed at smashing the inertia of the Twiddledee-Twiddledum liberal-conservative Establishment, much as a spoiled youngster will goad his permissive parents into at last exercising authority out of sheer exasperation.

The fact that all this occurred in a model democracy is instructive. I asked a young Uruguayan professional, who had been in his twenties during the time of the Tupamaros, if either the Blanco Party (of the rural debtors) or the Colorado Party (of the urban creditors) had ever put forward a platform to open up the economy, as the military had. He grimaced instantly and exploded into several staccato "no, no, nos," as if the question itself was outlandish. It was a classic zero-sum game, with "liberals" and "conservatives" taking turns at the political wheel to feather their own nests. In the name of providing jobs for the poor, the Colorados arranged the import substitution plan, which of course simply protected the commercial elites — business and organized labor — behind a tariff wall. The farmers and ranchers were taxed heavily to pay for the social handouts, but in turn rewarded themselves periodically with peso devaluations at the expense of their metropolitan creditors. Professionals and industrialists arranged elaborate bureaucratic licensing procedures, which also worked to close off entry to the marketplace just as it provided bureaucrats with opportunities for bribery.

It all seemed very familiar and in fact is roughly the zero-sum routine that has occupied Washington for the last 15 years and more. I recall Jack Kemp sizing up the situation in 1977: "Half the Congress is trying to redistribute income from the rich to the poor and the other half is trying to redistribute from the poor to the rich. Nobody's thinking about economic growth."

In Uruguay, why was it that the authoritarian military regime that cracked down so harshly on political freedoms would simultaneously revive economic freedoms? Of the several answers I got to this question, the one that made the most sense was this: Unlike the Argentine military cadre that derives from elite families, the Uruguayan military traditionally draws heavily from rural, peasant backgrounds. Supposedly the Blanco Party, dominated by wealthy landlords, believed it would have the advantage of perpetuating its privileges under military rule. But the regime turned a deaf ear to both urban and rural elites, turning instead to technocrats to root out the corruption and get the economy moving.

This was not an unusual pattern in the Seventies. In 1975, economic misery finally drove the placid Indians to civil disorders and Prime Minister Indira Gandhi suspended civil liberties and ordered a political crackdown. Almost immediately, a supply-side tax reform was announced by edict and an economic expansion began. Uruguay's two neighbors in the Southern Cone, Chile and Argentina, both followed this pattern in recent years, democratic institutions suspended in favor of military rule and the military restoring economic freedoms that had been bartered away in the elitist zero-sum games. The problem all round is an insufficiency of democracy; democratic institutions are of little value if captured by elites who can muscle off the agenda any options that don't serve coalition politics. Had the initiative and referendum existed in Uruguay in the Sixties, would the Tupamaros been "necessary" to shock the system in the Seventies? Howard Jarvis shocked the California elite with Proposition 13 in 1978 and Ronald Reagan shocked the Establishment in 1980 by winning the open GOP primaries as the "populist conservative." The elite favorite, George Bush, gathered momentum only in the Iowa caucuses, which by their nature are elitist. All of which suggests that the greatest support around the world for free enterprise and open economies is at the grass roots, ready to be tapped by expanding democratic forms.

The three technocrats responsible for opening up Uruguay's economy are Alejandro Vegh Villegas, finance minister from 1974 to 1976, an engineer with economic training at Harvard, Valentin Arismendi, the current finance minister, and Jose Gil Diaz, chairman of the Uruguay central bank and former deputy finance minister. Both Arismendi and Gil Diaz studied economics and administration at the University of Uruguay. Their primary external consultant is Columbia University's Robert Mundell, who in fact organized the Banco Central-Citibank conference that brought me to Montevideo. Mundell now lives halftime in Uruguay wjiere he is also establishing a PhD. program at the university.

Here, we can say, is the truer test of supply-side economics, where both the finance minister and the central banker are practitioners. John Abbott, who heads Citibank's operations in Uruguay and considers himself a Mundellian, remarks that the Uruguayan experience is especially impressive in that its growth began coincident with the oil shock and economic decline in the rest of the world, and that Uruguay has not a drop of oil.

According to Citibank, between 1974 and 1980 Uruguay's GDP has grown at an annual average of 4.6 percent, industrial output at 5.2 percent, and fixed investment at 18 percent. Exports, which had stagnated at $200 million in the decade prior to 1974 are now up to $1.3 billion. International reserves, nonexistent a decade ago, are now at $1.8 billion. The budget has been in rough balance in the last three years.

Abolition of the income and estate taxes was a vitally important step. They accompanied the ending of the strict controls on capital which saw the peso tumbling from 2.2 per dollar to 3.4 in a few days, then climbing back in a month's time to 2.4. "Taxwise," we might say, Uruguay is a very attractive place to live and die, drawing capital with a magnet instead of trying to retain it with a fence.

Shedding state corporations, denationalizing, reduced pressure on the budget on the outlay side. Revenues came in via a Value Added Tax that began in 1973 at 10 percent, climbed as high as 20 percent, and as of January 1 is down to 16 percent. The VAT more or less substituted for the income tax, sales tax and a variety of "sin taxes" and nuisance taxes. The corporate tax rate is 25 percent.

It was not until 1978, though, that even the generals found the courage to bring down the tariff walls. Until 1978, under the old import substitution program, there was only a trickle of consumer goods. "We had forgotten what convenience was, quality in products. We had price controls and of course queues to go along with the darkness in winters. You couldn't find books in English.'' In 1978. the first major reductions in tariff rates took place and with immediate "Laffer Curve" effects (as a Uruguayan in public finance advised me). The 500 percent ad valorem rates are this year down to the 60 percent range and are scheduled to fall to 35 percent, uniformly, on January 1, 1985. In the two years from 1978 to 1980, imports leaped to $1.7 billion from $700 million and government coffers swelled with the custom duties. One spectacular effect of the liberalization occurred in autos. Until 1979, the country was buying 15,000 of the assembled "kits" per year. With the ad valorem rate at 70 percent in 1981, Uruguay imported 15,000 cars and still bought 15,000 of the locally assembled cars, while these dropped in price to about $11,000 from $14,000 for a subcompact.

Another startling effect of the liberalization came in housing. Rent controls were abolished in 1979. prices of rental units climbed, a building boom began (also feeding on reduced tariffs on building materials), and prices stabilized and in 1981 began to fall, so many rental units are now available.

Not all policy is so enlightened, however. The government retains its monopoly over petroleum refining and marketing, which means refined product can't be imported. In addition, product is taxed at about $2 per gallon. The price, then, is about $4 per gallon, $1 of which gets lost in the inefficiencies of the antiquated teapot refinery. The military council that runs things here has decreed the monopoly a "strategic" necessity. If the refinery simply disappeared, though, the country would be much better off, economically and strategically. (In winter, people heat their homes a few minutes at a time or not at all, the cost is so exorbitant.)

Inflation seemed as persistent with these fiscal reforms as without them, running 50 percent to 60 percent annually for the last thirty years. With huge budget deficits or balanced budgets, no international reserves or plenty of them, the economy stagnant or vibrant, the inflation rate persisted. But it is now "under control," says Mundell, at 30 per cent and receding just as its big neighbor and major trading partner, Argentina, is convulsed with 130 percent inflation.

The Uruguayan peso is now firmly fixed to the U.S. dollar in an unusual way. There are now 11.5 pesos to the dollar, and that number increases precisely by 1.17 percent per month, according to a table announced several months in advance by the Banco Central. This amounts to a planned 16 percent inflation rate in addition to the U.S. dollar inflation, which is why Mundell considers 30 percent "under control." Gil Diaz, the head of the central bank, has stuck to the formula so faithfully, against enormous internal pressures to devalue, that the markets are coming to believe in the peso, which is to say in the monetary authority behind it.

Considering the fact that Uruguay lives next to the country with the highest inflation rate in the world, where devaluation is a way of life, this is a tribute. Through the 1970s and repeated years of 150 percent inflation rates, in which Argentina struggled with fiscal policy to solve the problem, it never seemed to give a thought to maintaining the peso's value as a unit of account. Monetary policy was exchange-rate policy and exchange rates were meant to serve the interests of the exporters. The inflation rate did fall after September 1979 through 1980 as the government began pre-announcing devaluations and keeping to the schedule. By one measure the inflation rate got below 50 percent in the last half of 1980.

In 1981, of course, all hell broke loose. There have been three major devaluations: 10 percent in January, 30 percent in April, 30 percent in June. There have been five presidents over the same period. The unemployment rate, a year ago at 1.8 percent, is now at 13 percent. The peso, a year ago valued at 2,000 to the dollar is now 10,000 to the dollar.

The problem, Mundell believes, was the mismanagement of the boom of 1980, unexpected because of the Soviet invasion of Afghanistan and the U.S. grain embargo. The wealth that flowed into the economy spread through all sectors, farmers and their agents buying and buying on credit, as if the boom would go on forever. The central bank took in dollars and handed out pesos, bank reserves climbing to $12 billion from $8 billion in a year. And when the bloom came off the boom, the cry went up that the peso was overvalued and the bank allowed the usual coalition of debtors to maneuver it into the trio of devaluations. The $12 billion in reserves — which a year ago could have bought up every peso in Argentina — is now almost gone. A new finance minister, Robert Alemann, 59, a William Simon type, has been installed by the generals to try again, with every sign that he will be boosting taxes and slashing spending to get the budget under control.

Uruguay lived through all this and of course participated in the boom, and is also feeling the recession. Uruguay's farmers also spread the wealth and bought on credit and spent most of 1981 trying to pressure the government into a devaluation, to match Argentina's. But the pressures were diluted, says Mundell. At least there are sufficient numbers of Uruguayans holding dollar debts, rather than peso debts, that Gil Diaz, backed by the president, Gen. Gregorio Alvarez, has been able to hold the line. Now the Uruguayans have had a chance to observe the destructiveness of the Argentina devaluations and are fortified in their support of Central Bank policy.

Uruguay feels the world recession as well as the collapse in Argentina, and unemployment has climbed to 7.5 percent as tourism and construction have nosedived. But there are no signs of despair or even uneasiness that I could see. The people would clearly like to get their democratic institutions back and the process is underway, with elections said to be coming by 1985. General Alvarez, the appointed president, is said to be interested in running and winning his seat by popular vote, and so has been acting like a democrat already. The question here, or in Argentina or Chile or anywhere that military regimes are trying to grope back to civilian rule, is whether the same old zero-sum struggles will revive, Blancos taxing Colorados and Colorados taxing Blancos, no one pointing the way toward economic growth.

My comments to the Citibank-Banco Central conference touched on this point obliquely. The perhaps 300 people there represented the public and private financial communities of the Southern Cone, and I suggested that they would have to struggle along as best they could for a while, without the help of the United States, but that it was not really their fault, entirely or even mostly, for the financial turbulence in their part of the world.

I remarked that before I left New York I'd read in the Times that our Treasury Undersecretary for Monetary Affairs, Beryl Sprinkel, had decided that Paul Volcker had done a "magnificent job, on average" in 1981. They were feeling "the average" in Uruguay, in Argentina, in Chile, in Paraguay, etc., the cumulative errors of Paul Volcker and the U.S. Federal Reserve. In the same way, I said, as if they were being forced to measure distances with a yardstick that our director of weights and measures was keeping magnificently at 36 inches, on average.

The Uruguayan peso is fixed to the dollar, as is the Chilean and, for a while, the Argentine. But the dollar is fixed to nothing and it hasn't been for a long while. So the peso floats with the dollar. The biggest economy in the world, the most secure, throughout history has provided and defended a currency, a unit of account that all others can key on. It is because the United States refuses this responsibility that the Blancos and Colorados find themselves at each other's throats, and the Southern Cone finds itself the end of Paul Volcker's whiplash. There is now no constant, reliable guide in the world of commerce and finance, no Polaris. The dollar, such as it is, is all we have, which means that they, like we, must await a gold standard world that only the United States can initiate. Absent a gold dollar, though, we are all Fed watchers, concerned with what Volcker eats for breakfast and how it might affect where the dollar floats today.

Perhaps it was my imagination, but I sensed the message was not only understood, but the group was way ahead of me, at least the Uruguayans. They know where they've been and they know where they are now, and relatively speaking they've come further in the last decade than anyone else in the hemisphere; in the world, only China has come from further back in the darkness. So they have an air about them, self confidence perhaps, an innocent kind of self-assurance. I caught myself thinking about a Ronald Reagan remark during the 1980 campaign, when he said he knew there were a lot of people in the country who didn't realize that certain things just couldn't be done, and he wanted those kind of people in his administration.

Uruguay at the moment has people like this, who don't even seem to realize how thoroughly they are defying convention. Their breathtaking supply-side fiscal and monetary reforms, though, are having such spectacular results that it almost seems criminal that the rest of the world knows so little about them. Imagine, government revenues have climbed from about $600 million in 1974 with progressive taxation to nearly $2 billion in 1981 without progressive taxation! The New Year reports of another military coup in Ghana in West Africa, along with the usual catalog of the economic miseries there, seems all the more poignant, given the vividness of the Uruguayan experience. Most of impoverished black Africa is perfectly suited to the Uruguayan model. Indeed, so is the United States, and perhaps we will see more of it in the rest of the bright new year.