By Ricardo Hausmann
Latin America can take a punch. Its endurance of a whole series of rather large shocks in the last two years is a tribute to the region's extensive structural reforms. The consequences a decade ago would likely have been much worse. However, this resilience also reflects Latin America's greater experience at enduring financial crises: as I like to say, we are two crises ahead of East Asia. This issue of DRCLAS NEWS focuses on the economy in Latin America: its reforms, its strengths, its problems and its future.
In this issue, economists and non-economists examine a wide range of subjects. Dani Rodrick opens this issue with an analysis of the impact of wage and prices in Latin America. Jeffry Frieden examines the general issue of currency reform, while Juan Carlos Moreno Brid takes a close look at dollarization in Mexico and Eli Cohen looks at the same issue in Argentina. Florencio Lopéz de Silanes examines privatization in Mexico. Betty Ann Donnelly looks at the role the church has played in encouraging debt relief, while Esther Whitfied and Jacqueline Loss takes a thought-provoking look at the links between business and culture. Jeffrey Sachs and John Gallup write about the intriguing relationship between geography and economy. Javier Corrales writes about Venezuela, while Simón Romero focuses on Brazil.
Felipe Larraín recounts the history of the Harvard Institute for Economic Development's Central American Project. The role of other Harvard projects in finding practical solutions for Latin American economies such as INCAE, Harvard's Central American Business Institute and Zamorano, its agricultural school, are also featured.
We at the Inter American Development Bank (IDB) have looked at many of the issues raised in these articles, some of which focus on the stages of development in each country, including demographic transitions, urbanization, the development of new markets, and the accumulation of physical and human capital, and found they are key determinants in the individual progress of each country.
Many of these articles not only focus on the situations in individual countries, but on the relationship of each country to the global economic situation. It is that area that has the most question marks, as I would like to explain here to provide a bit of context for this provocative issue of DRCLAS NEWS. Our countries have done much to correct what for a long time was wrong with domestic policy, and the recent shocks that Latin America has suffered do indeed appear temporary. If now we can fix what is wrong with arrangements between national economies, the world can be made a safer and more prosperous place for everybody.
Conventional wisdom about capital markets and capital flows has changed in an important way: capital flows and asset prices are too volatile and too closely correlated across countries to be the consequence of righteous, selective indignation toward policy missteps in this or that country.
Withdrawal of capital flows from Latin America is not primarily against something that is wrong with Latin America. Sifting yet again through the data on Latin America will therefore not yield the answer, because the phenomenon is not, or not only, a Latin American phenomenon. Look at trends in bond prices in Bulgaria and Brazil, for example, or in Mexico and Morocco, and you might conclude that the correlation of capital flows to different countries is based as much on the alphabet as it is to geography or policy.
The theories that explore how to fix global capital markets fall into two groups: what I call theories of too much, and theories of too little.
Theories of too much assert that various distortions cause private returns to exceed social returns, leading to flows of capital larger than they should be. However, to me the mystery is not why there is so much capital flowing around the world, but why there is so little. One of the puzzles of international finance is that most domestic investment is financed domestically. What, then, is wrong with this so-called globalizing world that is keeping capital flows so small?
The fear that sovereign nations can disavow contracts with impunity is one risk factor. The specter of liquidity crisis, another major factor, signifies that international capital flows will be small and very unstable with investors always looking over their shoulders for the first signs of a bank run. Such crises are avoidable if there is a lender of last resort such as the International Monetary Fund (IMF).
The combination of global capital flows and weak national currencies appears to be a dangerous mix. Latin American currencies are considered weak because Latin Americans prefer to hold their assets in other currencies, long-term markets in these currencies are thin to nonexistent, and when we borrow abroad we do so in foreign currency. This naturally generates financial fragility, because Latin American countries are also net importers of capital.
Floating regimes paradoxically tend to generate procyclical rather than countercyclical results, according to recent IDB studies. Countries with floating currencies tend to import Federal Reserve decisions, for example, through movements in interest rates. Indeed these influences are even greater than those observed in countries with fixed exchange rates. So there is actually less monetary autonomy rather than more.
We thus find ourselves in an intolerable situation: fixed exchange rates do not work because they do not stay fixed, yet floating exchange rates do not work either. Not only do they fail to deliver the benefits that theory advertises, but they produce shrunken financial systems and a high real cost of capital as well. Both types of regime seem prone to financial vulnerability-the former by producing crises when a fixed rate becomes unfixed, the latter through the resulting feebleness of the financial system.
It is against this background that DRCLAS NEWS takes a wide-ranging and multidisciplinary look at the Latin American economy, which can only be understood in terms of both its particular history and its relationship to a globalized world.