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Frenkel, Roberto. NEW PROSPECTS FOR LATIN AMERICAN DEVELOPMENT. CEDES, Buenos Aires, Argentina. 1994. p. 31. (economía : Nº101)

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Documento CEDES/101

Serie Economía

Roberto Frenkel

El autor agradece el apoyo brindado por el IDRC (Canadá), la SAREC (Suecia), el North-South Center (Universidad de Miami) y la Mellon Foundation (Estados Unidos).


Buenos Aires, 1994

New Prospects for Latin American Development

"[...synergy among political and economic reforms...] give our governments the political incentive and economic capacity to address more effectively the social needs our people face. President Clinton is endeavoring to address those needs in his powerful initiatives on health care, welfare reform and crime, to mention only a few. Leaders throughout the hemisphere are making similar efforts.

Addressing these social needs and providing greater social equity and more responsive, honest and effective government generates more popular support for democratic government, increasing social stability and broadening the base for economic growth. These in turn reassure investors and encourage flows of capital and technology and trade which produce growth.

Some have described this next phase as the "second generation" of reforms. The first generation of reforms aims at taking government out of the things that it didn't do well and probably shouldn't do at all and empowering markets to be the main decision-makers for the economy.

The second generation of reforms aims at giving government the capacity to do well what only governments can do and what markets cannot do or do only imperfectly. The idea here is shared growth to benefit all elements of society and to benefit future as well present generations."
Remarks to the Council of the Americas by Alexander F. Watson, Assistant Secretary of the State for Inter-American Affairs. May 2, 1994.

This paper asserts that the nineties have opened new room in Latin America for discussing and implementing development policies and that the multilateral institutions have a role to play in contributing to the analysis and promotion of these policies. The first message is that there has not yet been a serious discussion of the development strategies that Latin American countries should follow to replace the old post-war model. The second is that the new international financial context of the early nineties, assuming it is lasting, clears the way for that discussion and for the implementation of long-term development policies. The third is a manifestation of the hope that multilateral agencies will have the willingness to take advantage of present conditions and commit their intellectual resources to contribute to an open and uninhibited analysis of alternatives.

The first message may sound bizarre in light of the unprecedented intensive structural reforms of recent years. However, we shall argue that these reforms and policy regime changes implemented were not based on a deep appraisal of their potential as development tools: for both the countries and the multilateral agencies, the reform program was instead driven by a combination of urgency and the lack of well developed alternatives. A role should be left in its genealogy for ideology and political convenience, but we rather want here to stress the lack of solid development foundations than to criticize those other factors.

Evidence supporting the second message can be seen in many Latin American countries. The macroeconomic situation has improved in most cases, although there are some relevant exceptions. Inflation has fallen, and growth and investment have recovered. Foreign capital is flowing again to LA countries and this financing, in conjunction with the debt renegotiations under the Brady terms and the lower international interest rates, has relegated the external debt to a secondary concern. Although the horizon is not completely free of dark clouds, as we shall comment below, the Latin American situation does look better than before at the macroeconomic level.

The same cannot be said of other aspects of the current situation. The "lost decade" accentuated the traditional inequality in income distribution and had devastating effects on the already weakened social-service systems. Recent fiscal adjustments in some countries, although successful in their stabilization objectives, reduced even more the resources devoted to development and social policies. Aggregate growth rates disguise very asymmetric sectoral and regional performances, coupled in some cases with rising unemployment. Political symptoms of the worsening of the life conditions of the poor have been recently observed in some countries.

On the other hand, the governments of the region have generally gained political support from stability and reactivation But there is a parallel increasing public concern about the lack of a well defined development program, able to give continuity to recent macroeconomic trends and to generate improvements in employment and in the life conditions of the poor. Chile seems to be an exception regarding these apprehensions, but the portrait is nevertheless accurate in most cases. The change of focus and perception is not paradoxical, but rather a natural consequence of stability and recovery. Once the heroic stage of economic policy and the sense of urgency related to inflation, fiscal adjustment and debt are left behind, there is more freedom for public, academic, and political concerns about development issues and future prospects.

An analogous motivation has probably induced the recent changes of emphasis regarding Latin American policies expressed by the American administration and the multilateral agencies. The quotation at the beginning of the paper is intended to call attention to these changes, and may also be taken as an evidence supporting our second message. There is a manifest concern with poverty and a new emphasis on social policies, which should undoubtedly be considered positive. However, economic development issues are still not on the agenda and a sustainable improvement of the standards of living could hardly be the result of social policies added to an economic setting unable to foster development tendencies. Nevertheless, the mentioned changes in perception and concern may open the way for the subsequent introduction of developmental issues. This is the main justification for the third message of the paper.

The first two sections of this paper are retrospective, as we consider the intellectual and political origins of the so-called "market friendly approach" (MFA)2 and suggest why the context of the 1980s was not suitable for discussing and implementing new development policies. We argue that throughout its evolution the MFA carried an original sin. The pros and cons of the former Latin American development pattern were never evaluated in depth because the early eighties debt crisis and its lasting consequences were taken as a thorough proof of its complete inadequacy. The diagnosis was superficial and led to another mistaken judgment: while the economic performances of the 1980s were attributed to long term factors, the effects of international credit-rationing and the consequences of the shocks and external transfers on the macroeconomic dynamics, investment and savings were never fully acknowledged. Starting from these premises, the set of reforms and policy-regime changes that subsequently gave shape to the MFA were mostly conceived as inverted mirror images of the elements of the former model. We also present a stylized explanation of the eighties performance to show that the MFA diagnosis overlooked essential elements, and we suggest that in that context the debate on development policies was in fact not on the agenda. There was the compelling task of stopping at once the negative macroeconomic trends before thinking about a new development strategy.

The third section is devoted to the early nineties. We argue that the improvement in the regional macroeconomic performance is basically explained by the relaxation of the external constraint. The new conditions, if lasting, open the way for the discussion and implementation of new development policies and also for a new kind of dialogue with the multilateral institutions.

I. The debt crisis and its economic and intellectual consequences.

I.1. The multiple Latin American ways of starting the eighties.
With the benefit of retrospection it is possible to talk about the common model of development of the Latin American economies in the post-war period. But it is apparent that the countries reacted differently to the international financial conditions of abundant liquidity and low interest rates of the seventies and connected in different ways with the then booming international financial system. The following account shows the varying conditions across the countries of Latin America as they entered the bleak eighties.

Mexico and Venezuela were simultaneously blessed with high oil prices and easy cheap credit. While this was not new for Venezuela, it was for Mexico. Both countries "deepened" the old model accentuating the role of the state in investment and production and attempting to distribute part of the gains in massive social programs. Many of the projects initiated in this last wave of "late developmentalism" led to a significant waste of resources. Both countries overshot demand expansion and fiscal and current account deficits, generated inflationary trends and reduced competitiveness by appreciating the exchange rates. As a consequence, both suffered massive capital flights that represented a big proportion of the accumulated external public debt. In both cases the combination of the "Dutch disease", "late developmentalism" and populist temptations proved to be lethal when confronted with the rise in the international interest rates. In the Mexican case, this was in striking contrast to the previous thirty years of relatively high growth rates, low inflation and financial stability.

Brazil had been growing since the mid-sixties at very high rates combining import substitution and export promotion. It ranked comfortably as an emerging NIC in the early seventies. Confronted with the first oil shock, the country decided to push the industrialization process forward, reducing dependence on imported capital goods, industrial raw materials and energy (as the Japanese did in the past and still do in the present,) taking advantage of abundant international credit and the low interest rate. The strategy worked pretty well for six years, until 1979, when the second oil shock combined with the jump in international interest rates to make the external account unsustainable. Brazil's accumulation of external debt during the seventies was the only Latin American example of a conscious decision to finance higher total and public investment rates with external credit. The strategy's unsustainability was determined by simultaneous, unexpected (and unforeseeable) real and financial external shocks. A case in favor of the strategic decision of the early seventies can be made by mentioning that Brazil is the only big debtor that adjusted its external gap fully and permanently in the early eighties. The articulation of the country with the international financial system was planned and intermediated by the State. Unlike Argentina, Mexico and Venezuela, Brazil did not suffer from significant capital flight amounting to a major portion of the external debt.

The Argentine and Chilean histories are more complex. In the first half of the seventies both countries came to be ruled by democratic governments that intended to implement a revolutionary push towards development. Both experiences ended in deep economic crises that opened the way to military coups. Grouping together the Peronista and the Unidad Popular administrations is a bit forced, not only because of their ideological differences but also because of their different attitudes towards property rights and the relative role of private and public ownership. But the correspondence is closer regarding the envisaged pattern of development: both planned to overcome a situation of perceived stagnation and uneven income distribution by giving a new impulse to the old State-led ISI strategy of development. The similarities were still greater in the actual practice of economic policy and its consequences. Both regimes set in motion unsustainable populist expenditure and wage policies, lost control of the public finances, generated conditions of more or less repressed high inflation, and ended up with dramatic balance of payments crises. Although both the agendas and the electoral successes of these administrations reflected intellectual and popular dissatisfaction with the previous economic situation, it seems clear that the Argentine (1975) and Chilean (1973) economic crises should be attributed to political factors, inconsistent measures and social turmoil, rather than to the collapse of the previous development model.

The military regimes imposed by the coups attempted another economic revolution, completely in the opposite direction from the former. The crises were seen both in Argentina and Chile as symptoms of a long period of economic mismanagement. Moreover, the former pattern of development was considered inadequate in both cases not only because of its economic failure, but also because social unrest was diagnosed as being rooted in the associated socioeconomic structure3. A set of reforms was implemented aimed at substituting a new private-oriented, deregulated and more open economic regime for the old development model. The reforms implemented in Argentina and Chile during this period had much in common with the still unborn "Washington Consensus", although they were combined with a heavy repression of social and political expressions. The new regimes gave the countries rapid access to multilateral support and private credit. It was only then that the Argentine and Chilean economies were actually exposed to the international financial environment, because the countries had remained relatively isolated under the previous administrations. Once financial deregulation was in effect and exchange and capital-flow controls removed both economies became almost completely open on the financial side. Trade liberalization and financial deregulation-opening combined in both countries with the appreciation of the exchange rate (under stabilization programs inspired in the "monetary approach to the balance of payments"), followed by consumption and import booms, financial bubbles and soaring current account deficits financed by the abrupt accumulation of external debt. The increase in international interest rates found both countries with high external deficits and debts. In the Argentine case, as was already mentioned, the capital flight that took place in the last stage of the experience accounted for a significant proportion of the increased debt. It is worth remembering that the policies and the observed results were considered rigorously orthodox and praised by many international financial experts (including the Fund) even in the last stage, when the financing of external accounts was clearly unsustainable. As can be seen, the Southern Cone road to the debt crisis was completely different from the Brazilian and had few points in common with the Mexican experience. The Chilean and Argentine debt crises owed more to the policy experiments than to the strategy of development followed by the countries until the early seventies.

Colombia's entry to the eighties was different again. The salient stylized fact of the seventies is that the country did not significantly alter its relationship with the changing international financial system. It continued growing following essentially the same strategy of development, (a mixture of ISI and export incentives), preserving the external trade regime and the financial and exchange regulations intended to segment the domestic market from abroad. As a consequence, while gross external debt rose moderately throughout the decade, net debt remained practically constant and the debt/GDP ratio fell by about a half in the period. Colombia, for better or for worse, did not attempt to give a big push towards development nor to implement deep structural reforms. Among the countries examined, it represents the only clear example of continuity. If any case can be made for linking the Latin American debt crisis and the disastrous performance of the eighties to the perpetuation of the old development strategy and policy regime, Colombia should be the prominent example. But this is precisely the country that is an exception to the average Latin American performance. Although in the early eighties Colombia had to bear a (relatively) moderate impact from the international financial crisis, caused mainly by the generalization of credit rationing, it did not experience a full-scale debt crisis and continued growing during the rest of the decade, achieving the best performance in the region over the eighties as a whole.

Let us now draw some conclusions. The first is that the different ways in which the Latin American countries adapted to the former period of easy and cheap international financing ended up in negative results. Moreover, when the experiences are classified according to the degree to which economic policy adapted (in a broad sense) to the international setting (with Colombia at one extreme and Argentina and Chile at the other), the more adapted countries were the most severely affected by international volatility when it arose. A similar classification can be established according to a more specific criterion: the extent to which the mechanisms embodied in the different policy regimes to offset negative external shocks were market-based or not. This standard generates a classification of countries similar to the one above. The more market-based policy regimes suffered greater destabilization when the economies suffered external shocks. The market-type stabilizing mechanisms (i.e. the flexibility of prices and of the domestic rate of interest and the flexibility of portfolio and real resources allocation) did not work as they were supposed to, or gave rise to "perverse" mechanisms (e.g. the financial dynamics generated by the increase in domestic interest rates.) In stressing this conclusion we are not advocating isolation nor regulations under any and all circumstances, but, simply noting that the pendulum has swung too far in the opposite direction. The observation is especially relevant because some countries in the region have adapted to the nineties' international financial environment by replicating in many respects the most negative experiences of the seventies. We return to this point below.

The second conclusion is that the debt crisis and its lasting consequences can hardly be attributed exclusively nor primarily to the collapse of the post-war development model or, more precisely, to certain inherent features of that model. The lack of flexibility of the real sector, the rudimentary character of the financial sector and the fragility and rigidities of the fiscal sector were all typical features of Latin economies and played significant roles both in the genesis of the crisis and in the dynamics of the adjustment process. But, as argued above, the main prerequisites of the crisis emerged in a relatively short period as effects of the conjunction of the particular conditions in international financial markets and ad-hoc domestic policies. Taking the crisis and its lasting consequences as a demonstration of the endogenous collapse of the post-war development path is a non-sequitur.

This conclusion does not imply praise for the old Latin American development model as a whole nor advocation of a return to it. Many of the criticisms presented by neoclassical development economists were well founded4; some had already been pointed out by Latin American analysts5. Besides, the present domestic and international contexts differ significantly from the conditions prevailing in the fifties and sixties, making any return to recreate the old pattern impractical. But this is not the point. The point is that the debt crisis and the stagnation which followed were seen by too many observers as an overall test of the merits of the earlier model. At the extreme, the whole post-war development model and policy regime, together with each of their components, were blamed for the situation. The critique focused on such different items as development banks, exchange regimes, financial regulations, trade and industrial policies, public enterprises and so on. The next logical step -- the design of an alternative framework and a set of institutional and policy reforms -- was largely based on the assembling of inverted mirror images of the elements of the old framework. This procedure paid little attention to the development potential of the resulting combination nor to its internal consistency.

Neither of the two steps of the above logical sequence has rigorous foundations. On the first, a serious evaluation of the pros and cons of the former Latin American development path is still awaited. On the second, it is worth emphasizing that even if the negative assessment of Latin American post-war development were correct, this would not imply that doing the opposite would induce development. Knowing what not to do is not the same as knowing what to do. A consistent development strategy capable of substituting the old one should be designed and evaluated considering its own merits, founded on analysis, experience and a deep understanding of the countries' characteristics and potentials.

I.2. Missing issues and biased focus in the MFA.
We looked at the experiences of the seventies to understand the range of circumstances in which different LA countries entered the eighties. The moral of the story is that (almost) all roads led to the same place. Here we look at the eighties from the opposite viewpoint. Instead of stressing the country specificities underlying external debts and deficits, we focus on the common stylized facts regarding the macroeconomic dynamics and the consequent emergence of new constraints to growth.

During the eighties Latin America experienced the worst economic crisis of the post-war period, triggered by the abrupt deterioration of the foreign variables faced by the region. The magnitude of the negative external shocks was widened at the domestic level by the extreme weakness of the macroeconomic setting. In the period preceding the shock, as we noted above, the public sector was typically running huge deficits, the financial sector showed a marked fragility and there was a tendency toward unsustainable current account deficits. The anatomy of the crisis and its effects on growth can be succinctly described in terms of the fiscal and external gaps and in terms of the transmission mechanisms that tended to amplify the disequilibria represented by these gaps.6

Obviously, the first impact of the negative external shock was to open the external gap. The drop in the terms of trade together with the increase in interest rates induced a huge imbalance in the current account, with the exception of Colombia. The highly indebted countries, with the only important exception of Chile, were unable to finance the increased disequilibria because of the lack of access to voluntary sources of credit and the scarcity of funds provided by multilateral organizations. Consequently, the possibility of smoothing the adjustment by increasing indebtedness in the short run was precluded and the main objective of macropolicy became that of generating a trade surplus equal in magnitude to the deficit in the financial services account.

The consequences of the effort to generate a trade surplus at any cost were strongly distortive from the point of view of stability, especially because the exchange rate policy was oriented to increasing the real exchange rate via nominal devaluation. This led to an impressive acceleration of inflation and many countries (Peru, Bolivia, Brazil, Argentina) were put on the brink of or directly experienced hyperinflation.

The fact that in most Latin American countries the bulk of the foreign debt was held by the public sector meant that the external shock had a direct impact on the fiscal accounts. The increase in the international interest rate exogenously augmented public expenditures in a context in which the government was already facing severe problems in financing the existing public deficit. This implied that there was a simultaneous widening of the fiscal gap together with the opening of the external gap. This had two important consequences at the macroeconomic level. In the first place, given the shallowness of the domestic financial system and the difficulties in the access to external financing, most governments resorted to inflationary finance. This rendered monetary policy passive and greatly helped to validate the inflationary pressures stemming from nominal devaluation. In the second place, the attempts to reduce the deficit fell basically on public investment, whose reduction entails the least political conflict in the short run. The behaviour of public expenditures is one of the most important causes of the observed contraction in the investment rate. In addition to its direct effects on global investment, the fall in public investment induced a reduction in private investment because of the existence of a "crowding-in" effect that relates the two. On the other hand, the increase in the real exchange rate and the public sector imbalance, together with the acceleration of inflation and the existing indexation mechanisms, acted as transmission belts that spread the crisis into the weak existing financial sector. Many countries (e.g. Argentina, Chile, Brazil, Mexico, Uruguay) experienced a financial breakdown that made the financing of investment projects extremely difficult.

In this scenario of extreme macroeconomic uncertainty, there was a huge reduction in the private saving and investment rates and, related to the latter, a stagnation in the process of learning and innovation with the consequent deterioration in the international competitiveness of the economy. Foreign direct investment followed a trend similar to aggregate investment. Moreover, the process of growth was additionally hampered by the fact that this environment favored capital flight, used by economic agents as a defensive tool against inflation and financial instability.

By the end of the eighties it was clear that important structural changes were necessary if the growth process was to regain momentum in the region. In this context of extreme instability, however, it was very difficult to articulate stabilization efforts with policies oriented toward growth and structural change. Furthermore, the context of the debt crisis was not propitious for re-thinking the development strategy since economic policy was almost completely determined by the need to achieve a minimum level of stability. Growth and development issues lost ground both in theoretical thinking and on the economic policy agenda.

The crises of the early eighties were not temporary episodes but generated lasting consequences. They triggered macroeconomic dynamics that in many cases led to the amplification of the original disequilibria and caused a persistent worsening of economic performances. In these contexts, growth was constrained by many new obstacles.

With the aim of organizing our thinking about the constraints to growth posed by the eighties macroeconomic context, in a previous paper (J. M. Fanelli, R. Frenkel and G. Rozenwurcel (1990) we classified these obstacles in three categories. The first constraint is related to the global availability of resources. Sustained growth requires a sufficient amount of savings, which was impeded by the reversal of external transfers and the reduction in per capita productivity and income. We call this the Smithian constraint. The second constraint to investment stems from the deep breakdown of the domestic financial system, capital flight and credit rationing at the international level. It is necessary to ensure that the non-consumed part of income will be invested, because it is not warranted that savings will be automatically invested. Because this is the problem highlighted by the Keynesian tradition, we called this the Keynesian constraint. Third, there is the limitation to growth that results from the inefficiency in the allocation of a given amount of resources. If a low efficiency had been a feature of the old pattern of development, it surely worsened in the highly unstable and uncertain context of the eighties. We call this the neoclassical constraint.

We think that this classification helps to clarify the erroneous MFA diagnosis of economic performance during the eighties. It also sheds light on an important source of discrepancies and controversy between the MFA, on one side and, let us say, a Latin American perspective, on the other. Synthetically, while economic policy experience and the more careful analyses of most countries' experiences highlighted the relevance of all constraints, the MFA focused almost exclusively on the third. In putting the emphasis on the low efficiency of resource allocation, the MFA almost completely disregarded the first and second constraints to growth in its explanation of the actual performance of most countries as well as in the consequent policy advice.

Although this focus seems to be consistent with the MFA diagnosis of the debt crisis, overlooking its lasting domestic and international repercussions was not a logical implication of the diagnosis. The rationing of international credit, the need to effect heavy external transfers and the consequently unstable macroeconomic dynamics imposed new constraints to growth that should have deserved adequate consideration, independently of any diagnosis of the debt crisis' origins.

The mentioned difference was deeper than any specific disagreement about the promoted reforms, because it was a difference in focus and perceived priorities. This basic difference impeded the establishment of a common framework and a comfortable environment for discussing development policies in the eighties.

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