Economics of Latin America Research Paper

1. Economic Structure

The countries of Latin America and the Caribbean (LAC), from the largest to the smallest, have all been shaped by their common experience of European imperialism. Starting with the revolution in Haiti in 1791, the independence movement gathered pace and by the end of the 1820s all mainland countries except Belize and the Guyanas had become separate states. Decolonization in the Caribbean was much more complicated and, indeed, has never been completed. Several countries remain overseas territories of either Holland/or the United Kingdom, others are an integral part of mainland France, while the United States retains responsibility for defense and foreign affairs in Puerto Rico and the US Virgin Islands.

All the available evidence suggests that at the time the United States secured its independence, the difference in living standards between North America and the rest of the hemisphere was modest (see Coatsworth and Taylor 1998, Chap. 1). During the nineteenth century the gap, as measured by Gross Domestic Product (GDP) per head, steadily widened and by the end of the century GDP per head in Latin America was only 12.5 percent of the comparable US figure (see Thorp 1998, p. 353). This differential did not increase in the twentieth century, but this is largely due to the rapid growth of Brazil—the largest country by far in LAC—from 1900 to 1980. If Brazil is excluded from the comparison, the gap has in fact widened over the last 100 years.

The LAC region has therefore lagged behind North America (the US and Canada) despite the fact that many countries have been independent for nearly 200 years. The region is (correctly) classified as ‘less developed’ by international agencies and a handful of countries (e.g., Haiti) are so poor that they are categorized as ‘least developed.’ Within each country poverty is widespread and the most recent estimates suggest that over one-third of households are poor; this amounts to some 200 million people (see CEPAL 1999, p. 36).

While poverty is generalized, there are also pockets of wealth for two separate reasons. First, a handful of countries in the Caribbean have enjoyed rapid economic growth and now have standards of living comparable to those in the less wealthy countries of the European Union. These include some (but not all) former British or Dutch colonies, such as the Bahamas and Aruba, the French Departements d’Outre Mer, and the territories linked to the United States. There are no rich Latin American states, but the regions around Sao Paulo in Brazil, Buenos Aires in Argentina, and Monterrey in Mexico have many of the characteristics of developed countries and a standard of living comparable to southern Italy or Portugal.

Second, income distribution is highly unequal in almost all LAC countries (the main exception is Cuba where socialist economics after 1958 narrowed wage differentials and eliminated private income from capital) and it is not uncommon for the top 10 percent to receive 40 to 50 percent of household income. This social group—nearly 20 million people in Brazil, for example—is almost a state within a state and is largely isolated from the rest of society through education, housing, transport, and international ties. The consumption pattern of this decile is similar to its counterpart in developed countries, while its propensity to save is much lower than the equivalent group in Asia. Thus, wealth—not just poverty—is an important component of the LAC region at the beginning of the twenty-first century.

Ideology has always played a central role in the LAC countries. Economists and policy-makers have by tradition identified explicitly with one or other school of economic thinking since the time of in- dependence. There have been intense debates over the economic model considered most appropriate for each country; new ideas have also spread quickly, helped by an absence of cultural and linguistic barriers. The adoption of an apparently successful new policy in one country is invariably followed by a similar experiment in other parts of the region. It has been relatively rare for intellectuals to argue in favor of the uniqueness of their country’s economy (as happens frequently in the United States and the United Kingdom). Part of the reason for this is the exposure (some would say vulnerability) of each country to similar external influences.

The role of ideas is illustrated by the enthusiasm with which LAC countries have adopted since the mid-1980s a new paradigm based on market-friendly policies and export-led growth. Based to some extent on a false reading of the Asian miracle, the new paradigm also owes a great deal to the experience of Chile, widely recognized as the star performer in the LAC region from 1985–2000. Indeed, Chile could be said to have initiated many of the reformist policies— in social security, health, education, and environmental management—that are now being adopted not only in the rest of LAC, but also in many European countries.

2. The Inward-Looking Model

The new paradigm has replaced the inward-looking model of development based on import-substituting industrialization (ISI), which became increasingly popular after the 1929 depression. The slump in commodity prices and the collapse in capital flows, after widespread bond defaults, hit LAC countries hard in the 1930s. The region’s integration into the world economy based on the export of primary products and the import of manufactures, although it had contributed to the rapid rise in living standards in a few countries (notably Argentina), was criticized for its vulnerability to external shocks and its failure to take account of protectionism in developed countries.

The ISI model was slow to reach maturity. The political elite remained close to the pressure groups associated with export-led growth and policy reform in the 1930s was piecemeal rather than wholesale. World War II gave a strong boost to the region’s incipient efforts at industrialization, spurred on by the absence of competing imports. In the late 1940s, and in some cases even later, tariffs and non-tariff barriers were set explicitly to favor the protection of industry. This process gathered pace and by the 1960s Latin American countries had some of the highest tariffs in the world coupled with a system of quotas and licenses that made the import of consumer goods almost impossible in the larger countries.

The shift to a fully-fledged model of import substitution after World War II owed much to the influence of the United Nations Economic Commission for Latin America and the Caribbean (usually known by its Spanish acronym, CEPAL) and especially its second Director (Raul Prebisch). No doubt influenced by his experience at the Central Bank of Argentina in the 1930s, Prebisch was persuaded that specialization in primary products did not reflect Latin America’s long-run dynamic comparative advantage. This idea, put forward by Prebisch for the first time in 1948, was also being developed independently by Hans Singer at the United Nations in New York and for that reason it has come to be known as the Prebisch-Singer Hypothesis (PSH).

The PSH claims—on both empirical and theoretical grounds—that there is a secular tendency for the price of primary product exports to fall in relation to the price of manufactured imports. Since LAC countries by tradition export primary products and import manufactures, this amounts to a claim that Latin America’s Net Barter Terms of Trade (NBTT) are set to deteriorate over the long-term. The policy implication, according to the PSH, is to shift resources out of primary product exports and into manufacturing for the home market, i.e., ISI. Over time, both Prebisch and Singer recognized the need to adopt additional measures that would promote the export of manufactured goods and this was the rationale behind the move towards regional integration in LAC countries in the 1960s and 1970s.

The empirical basis for the PSH was always stronger than the theoretical. Prebisch in particular was forced to switch between different—not always consistent— theoretical explanations for the hypothesis, including the claim that different ‘institutional arrangements’ made it possible for factors of production to reap the benefits of technical change in the ‘north’ (i.e., developed countries) while forcing the ‘south’ to transfer the benefits to the rest of the world through lower prices for exports.

The PSH spawned a huge debate inside and outside the region and produced a series of theoretical innovations. One of these was dependency theory, popularized by Fernando Henrique Cardoso in the 1960s nearly three decades before he became President of Brazil (see Cardoso and Faletto 1979). Dependency theory went beyond the PSH by claiming that Latin America’s links with the rest of the world had resulted in a distortion of development from which the region had derived only modest benefits. In its extreme form (the theory of unequal exchange), dependency theory provided a justification for almost any policy that promoted national autonomy through inward-looking development and discriminated against imports, multinational companies, and other forms of foreign investment.

The ISI model was not without its successes. The manufacturing sector grew rapidly and increased its share of GDP. Industrial activity became increasingly sophisticated, including capital goods production in the larger countries. Direct foreign investment by multinational companies was promoted by legislation offering tariff reductions on imported inputs and tax holidays on profits. Employment opportunities in the large industrial conurbations, where manufacturing was concentrated, encouraged rural–urban migration and by the end of the 1970s almost four out of five Latin Americans were living in cities.

However, the timing of the ISI model was most unfortunate. It reached its apogee just as the postwar secular boom in world trade was unfolding. With its anti-export bias and discrimination against imports, the model led to a rapid withdrawal of the LAC region from international trade. The share of world trade of the 20 Latin American republics, over 10 percent in 1950, had fallen to under five percent in 1980. The LAC region was in large part deprived of the stimulus from foreign trade: so important for the transformation of much of South-East Asia after 1960.

Withdrawal from world trade did not reduce the region’s vulnerability to external shocks, contrary to what had been claimed by the architects of the ISI model in CEPAL. ISI proved to be very import intensive, while the profitability of the traditional export sector was undermined by overvalued exchange rates, tariffs on inputs, and (in many cases) taxes on exports. Manufactured goods, profitable to produce behind a tariff wall, were too high cost for the world market. Thus, many of the region’s governments faced an uncomfortable balance of payments constraint that often required standby agreements with the International Monetary Fund (IMF).

The ISI model was also associated with high rates of inflation. Not all LAC countries suffered from high rates of inflation and some (smaller) countries used a nominal exchange rate anchor with great success to keep inflation at or below the US rate. However, all the larger countries (with the exception of Mexico) suffered from chronic inflation, which occasionally resulted in hyperinflation. This inflationary experience led to a heated debate between monetarists, associated with the IMF, and structuralists linked to CEPAL. The monetarists, with their emphasis on the budget deficit rather than structural weaknesses such as an alleged food supply bottleneck, had the better of the intellectual argument, but they were no more successful than their rivals in eliminating inflation.

The ideological conflict between monetarists and structuralists led to an abrupt change of policy in the 1970s in the southern cone (Argentina, Chile, Uruguay) after military coups in each country. The southern cone model was a conscious attempt to reverse the inward-looking policies in each country that had brought low growth, high inflation, and successive balance of payments crises. The most extreme version of this model was adopted in Chile under General Pinochet, where it was led by a group of technocrats dubbed the ‘Chicago Boys’ in honor of their association with the University of Chicago’s Department of Economics where Milton Friedman had kept the flame of monetarism burning during the long period of Keynesian dominance.

The southern cone model was radical and excited much attention. Tariffs were lowered sharply, state-owned enterprises were privatized, and market forces were given free reign. However, the model was undermined by the application of inconsistent policies at the macroeconomic level and the excessive speed with which financial liberalization was adopted. This led to financial crises in all three countries at the beginning of the 1980s and the (temporary) abandonment of the model.

The exhaustion of the ISI model was apparent to many as early as the late 1960s. However, the move towards syndicated lending and flexible interest rates in the international capital market, coupled with the 1973 4 and 1978 9 oil crises, gave Latin American governments and state-owned enterprises access to commercial bank loans in almost unlimited quantities. This loosened the balance of payments constraint, but at the expense of a rapid build up of external public debt. The result was the Latin American debt crisis, triggered in August 1982 by a threatened Mexican default.

3. The New Economic Model

It took nearly 10 years to work out a solution to the debt crisis, culminating in many cases in the replacement of commercial bank loans with Brady bonds (named after Nicholas Brady, the US Treasury Secretary at the time) offering longer maturities and lower interest rates. By that time the ISI model was completely discredited and Latin America had begun its transition to the new paradigm. Labeled variously neo-orthodoxy, neo-liberalism, or the New Economic Model (NEM), the new paradigm revolved around a series of policies that were favored by international financial institutions. For that reason, it was also known as the Washington Consensus.

3.1 Trade Liberalization

The first step towards the new paradigm was trade liberalization. Those—numerous—countries that were not yet members of the General Agreement on Tariffs and Trade (replaced in 1995 by the World Trade Organization, WTO) applied to join and tariff and non-tariff barriers were reduced unilaterally. For those countries doing so in the mid-1980s (e.g., Mexico), this was a bold step, as the balance of payments had once again become a major constraint on growth. The consequence was a sharp depreciation of the nominal exchange rate, leading in some cases to an increase in inflation.

Trade liberalization was eventually adopted all over the LAC region; in many cases (e.g., Argentina and Brazil) it coincided with the renewal of net capital inflows at the start of the 1990s. This eased the adjustment problem of unilateral trade liberalization, but made it more difficult to promote nontraditional exports. One result was a revival of interest in regional integration schemes. These had been launched in the region in the 1960s as part of the ISI model, but had collapsed with the debt crisis. The new schemes were less concerned with the promotion of industry and more concerned with providing a platform for reducing costs of production and thereby gaining access to the world market for a broad range of goods and services. It was therefore named ‘open regionalism’ by CEPAL in order to distinguish it from the ‘closed regionalism’ of the 1960s and 1970s.

Regional integration has been a mixed success. The efforts to revive previously moribund schemes—the Caribbean Community (CARICOM), the Central American Common Market (CACM), and the Andean Pact (now known as the Andean Community)—have been disappointing with many of the old problems surfacing again. The new schemes—the North American Free Trade Agreement (NAFTA) and the Mercado Comun del Sur (MERCOSUR)—have been much more promising. Mexico’s membership of NAFTA has given economic policy a credibility it lacked before and has contributed to a rapid increase in exports to the US and Canada. MERCOSUR, made up of Argentina, Brazil, Paraguay, and Uruguay together with Bolivia and Chile as associate members, has not only brought about a major increase in intraregional trade since its launch in 1991, but has also stimulated direct foreign investment and the overhaul of the region’s antiquated infrastructure.

3.2 Fiscal Reform And Financial Liberalization

The increase in imports made possible by trade liberalization and the renewal of capital inflows forced governments to address seriously the problem of inflation stabilization. At the center of these efforts has been the reform of fiscal policy, including an overhaul of the tax system, a revision of spending plans, and the privatization of state-owned assets. This process is far from complete in most countries, but budget deficits have been reduced and monetary policy has become more responsible. Argentina, under the Ley de Convertibilidad in 1991, established an extreme version of the new orthodoxy, which succeeded in bringing the rate of inflation below that in the United States.

The renewal of capital inflows to the LAC region since 1990 has been a mixed blessing. While it has allowed countries to raise their investment rates above what would have otherwise been possible, it has been subject to great volatility and generated considerable uncertainty. It has also led in many cases to an appreciation of the real effective exchange rate (i.e., the nominal rate adjusted for inflation), undermining the efforts to promote nontraditional exports. Some countries, notably Chile, have tried to reduce the inflow of short-term capital through the system of taxation, but none have resorted to capital or foreign exchange controls. It is fair to say that LAC countries are still searching for policies that will maximize the benefits of capital inflows while minimizing the costs. The other elements of the NEM have all involved microeconomic reforms: health, education, social security, and the labor market to name but a few. There has been a learning-by-doing process with Chile in many cases as the pioneer. The privatization of the pension system in Chile has been adapted, rather than copied, in many parts of the region while the reform of the health system in Colombia has been much admired.

The reform program in general has benefited from the priority given to it by international funding agencies: notably the Inter-American Development Bank and the World Bank. Inevitably, political constraints have slowed down or distorted the process of reform in some countries, but the overall picture is impressive with very few sacred cows left untouched.

4. The Performance Of The LAC Economies

It will be many years—perhaps decades—before the new paradigm can be judged satisfactorily. The rate of growth of GDP per head in the 1990s was certainly faster than in the ‘lost decade’ of the 1980s, but it has not yet returned to the rate achieved during the golden age of the ISI model in the 1950s and 1960s. A small number of countries appear to have achieved a structural break with their past, leading to a realistic prospect of sustainable long-run growth rates of GDP per head faster than those in the United States and other developed countries. Chile and Mexico are the most important cases, but some of the smaller countries—Costa Rica, for example—may also be included in this list.

The disappointing rate of growth of the LAC region in the first decade of the NEM is in part due to the sheer weight of Brazil. With over 30 percent of the population and over 35 percent of GDP, the performance of Brazil is crucial for any regional indicator. While Brazil has succeeded since the launch of the 1994 Plano Real in eliminating chronic inflation, it has been only partially able to implement other elements of the NEM. As a result, exports remain less than 10 percent of GDP and the country has yet to enjoy export-led growth. There is no doubting the commitment of successive administrations in Brazil to the need for reform, but the size of the country, the complexity of decision-making, and the depth of the inherited problems have made the application of the new model particularly difficult.

The new paradigm emphasizes the need for LAC countries to promote nontraditional exports. There has been some progress in this area. Mexico has rapidly expanded its exports of manufactures and oil now accounts for only a small proportion of the total. Chile has developed new markets for agro-industrial products and non-oil mineral exports are emerging in Argentina for the first time since the collapse of the Spanish empire. Even Cuba, a reluctant reformer denied access to the US market, has been able to diversify exports with tourism replacing sugar as the major source of foreign exchange. However, traditional primary products continue to account for almost half of all exports and a much higher proportion in the smaller countries. Prices remain volatile for these products and the reforms to world trade in agricultural products under the WTO have not been able to eliminate the many obstacles that exporters face.

Diversification of products has not been matched by diversification of markets. Despite the revival of regional integration, the United States is still the main market and absorbs almost 50 percent of all LAC exports (this proportion tends to fall as one goes south so that for MERCOSUR the European Union is the principal trade partner). The United States is also the leading source of direct foreign investment in most countries and provides much of the equity flows to the region. The bulk of new bond issues are placed in New York and the commercial bank links through financial centers in the US (now including Miami) are very strong. However, far from being resented, US economic influence is generally welcomed. This is partly because of the cultural changes associated with the NEM in the LAC region, but also because international economic relations have become more rulebased with arbitration (in the WTO, for example) occasionally favoring LAC countries. Furthermore, the proposal by President Bush in 1990 for a Free Trade Area of the Americas (FTAA) was taken up enthusiastically by the rest of the continent and negotiations involving all countries except Cuba were formally launched in 1998.

The NEM has yet to make much impact on equity in the LAC region. The proportion of households classified as poor has fallen in the 1990s, but it is still no lower than before the debt crisis. Income distribution remains stubbornly unequal; indeed, inequality has increased in many countries from 1990–2000 despite the fall in inflation (widely seen as a tax on the poor). This is partly due to the widening of wage differentials as firms compete for the skilled labor needed to meet the quality thresholds demanded by foreign buyers. It is also due to downsizing by companies in the private and public sector looking for cost reductions; this has swelled the numbers seeking work in the informal sector where wages and hours of work are flexible. The drop in household income has also forced many women and children to seek work, further adding to the supply of labor and putting downward pressure on unskilled or semi-skilled wage rates.

The launch of the NEM has coincided with a rise in concern for the impact of economic growth on the environment both inside and outside the region. Some of these concerns are focused on pollution in cities, where inadequate legislation and lax regulation have combined to produce environmental hazards and health problems. The northern border of Mexico, home to most of the country’s maquiladoras, is a good example of this problem and this was one of the main reasons for the introduction of a side agreement in NAFTA obliging Mexico to enforce its environmental laws. However, the LAC region is also home to some of the most sensitive rural environments, notably the Amazon basin, where damage can have spillover effects on the whole planet. International agencies now insist on Environmental Impact Assessments before approving loans in these areas, but the region is still far from achieving a pattern of growth that does not involve some deterioration of the environment.

None of the LAC countries, with the possible exception of a handful of small island states in the Caribbean, has yet fulfilled the potential that has been promised for so long. On the world stage, the LAC region occupies an intermediate position between developed countries and the poorest countries of Asia and Africa. Narrowing the gap with the rich countries has proved both difficult and frustrating. Neither orthodoxy nor heterodoxy has yielded the benefits claimed by their proponents. There have been some successes, but no major LAC country has been able to sustain a strong performance over a long enough period to break out of the straitjacket of underdevelopment. Now that equity and the environment are part of any definition of development, the task has become even harder since these are areas where LAC countries are seriously deficient. The sense of frustration will therefore remain and the current consensus on economic management is therefore likely to prove fragile.

That consensus owes much to the belief among Latin American elites that globalization will remain the dominant external influence on the region and that the task of policymakers is to help the private and public sectors adapt to the new reality. The economic theory underpinning globalization is generally accepted among the elites (President Chavez in Venezuela and Fidel Castro in Cuba are the main exceptions), leaving little or no room for a specifically Latin American theory of development. This is partly a reaction to the failures of inward-looking development, but is also a reflection of the influence of higher education institutions in North America and Europe where so many of the Latin American elites have been trained. Among mass organizations, however, including many trade unions, political parties, and churches, there is much greater willingness to think in terms of a specific Latin American reality that demands a different approach. Thus, the balance of power between mass and elite organizations—a critical part of any democracy—is likely to have a strong influence in the future on the extent to which LAC countries reassert the specificity of their region.

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