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Policy Roots of Country Income Inequality in Latin America: Analysis of structural reform following the 1980s Latin American debt crisis

Submitted by Sarah Lynch

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Master of Arts Degree in Sustainable International Development

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Table of contents

Abstract Executive Summary Acknowledgements Abbreviations Introduction Background and development context Methods Literature review Substantiative discussion Conclusion and implications References

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Abstract This paper address the question whether policy reforms made under structural adjustment programs following the 1980s financial debt crisis in Latin American are related to levels of country income inequality. It examines empirical evidence presented by similar studies, and compares these findings to an independent analysis of the relationship between policy measures and macroeconomic indicators of reform and measures of inequality. In particular, it uses panel regression analysis to examine policy reform in the areas of trade liberalization, fiscal discipline, and monetary stabilization, and the extent to which estimates are robust to different definitions of inequality. The results of this analysis do not find a consistent relationship between the policy reforms included in the study and country income inequality which are robust across different measures of inequality. They do not find sufficient evidence to suggest there is a relationship between trade liberalization or fiscal discipline and country income inequality, though they would suggest that reforms in the area of monetary stabilization are associated with higher inequality. This study suggests that further analysis of the joint effects of these policies is necessary to test the claim that short-term losses related to inequality which result from these policy reforms are outweighed by their long term, though many studies reviewed support the argument that reforms are generally regressive in nature.

Executive summary This study examines the relationship between structural reforms which occurred in Latin America following the 1980s financial crisis and the relationship these policies have with levels of inequality. This study presents the empirical evidence presented by similar studies and tests the hypotheses that structural adjustment policies intended to stimulate economic growth and reduce deficits have a positive relationship with levels of income inequality, using regression analysis of indicators of policy reform against measures of inequality. The selected policy measures and macroeconomic indicators have been categorized into three general areas of reform, including trade liberalization, fiscal discipline, and monetary stabilization. It hypothesizes that reforms in areas of trade liberalization and fiscal discipline are associated with higher inequality, and those in monetary stabilization are associated with lower inequality. To ensure results of the analysis did not hinge on the definition of inequality, I used three measures of inequality: the Gini Index, Theil Index, and EHII. The main findings of this analysis confirm some of the study's hypotheses, and challenge a number of others. They do not suggest there is a consistent relationship between trade liberalization and inequality which is robust across different measures of inequality. These results do not provide sufficient evidence to suggest there is a relationship between fiscal discipline and country income inequality, though they would suggest that reforms in the area of monetary stabilization are associated with higher inequality. This study examines the World Bank's claim that short-term losses related to inequality which result from these policy reforms are outweighed by their long term benefits by setting countries on the path to sustainable growth. The majority of evidence found by other studies challenge this claim, arguing that the benefits of these policies have been shared disproportionately by the wealthy, and that these policies themselves are not sufficient to reduce levels of inequality. The findings of this analysis may suggest there are unanticipated causal relationships to support either side, though it warrants further investigation into the joint effects of these policies.

Acknowledgments The author would like to thank Dr. Ricardo Godoy for his guidance, editorial and technical assistance with this study, and Marion Howard for her support throughout the program.

Abbreviations EHII Estimated Household Income Inequality FDI IMF M2 Foreign direct investment International Monetary Fund Money & quasi money

Introduction The 1980s and 1990s in Latin America witnessed a significant shift toward the development agenda outlined by the Washington Consensus, and serves as a primary example for the intensity and speed at which developing nations have switched from state planning to market-driven growth under the direction of multilateral agencies such as the World Bank and International Monetary Fund (IMF). The Latin American financial crisis known as the lost decade began in the late 1970s and early 1980s, which lead to the collapse of many economies under unmanageable foreign debt and macroeconomic instability. The perceived failures of state intervention and inappropriate domestic policy in the developing world invoked strong agreement among major international actors like the U.S. government to advocate a reform agenda calling countries to practice fiscal discipline and rely for the most part on market forces to guide the economy. The development model pushed forward by conditionalities for receiving foreign assistance and debt relief placed by the IMF and World Bank on trade, monetary, and fiscal reforms under structural adjustment programs lead to a shift in the orientation of many economies from protectionist, import substitution towards liberalized, export-dominant models. Strict austerity measures and shifts in tax bases were also implemented to slow rising deficits and remove state intervention in the market. The region's economic recovery from this crisis has fallen short of many expectations, and growing criticism of structural reform argue it has failed to bring Latin American countries out of debt without widening the gap between the rich and poor (Perkins, 2013). It has invoked a growing opposition to this agenda, particularly trade liberalization and reductions in public spending. Some nations including Chile and Costa Rica have rejected or repealed such policies, claiming they have caused a significant drop in growth and well-being. Though Latin American countries represent a diversity of economies and levels of development, the differences between their recoveries from a similar indebtedness suggests there is a relationship between the policies under which growth occurred and levels of poverty and inequality. It is essential to address inequality in the discussion of economic policy because this relationship is closely tied to growth and poverty. While some policies associated with reducing inequality are argued to inhibit economic growth, inequality itself is also believed to be detrimental to growth. Without considering the impacts of inequality, growth should raise living standards and reduce poverty. However, when growth is associated with rising inequality part of the gains from growth will be offset by the negative impact of rising inequality (Wodon, 2000). Higher levels of inequality may concentrate wealth in the highest percentile, which reduces the benefits of growth to the poor. This suggests that whatever growth policies may achieve, if they are associated with rising inequality, poverty might not be reduced by growth. Advocates of structural reform, such as the IMF and World Bank, have increasingly acknowledged that many of these policy measures have generated losses among the poor. They argue these policies will offset any short-term losses by setting countries on the path toward sustainable growth (SAPRIN, 2002). However, recent history has shown the losses have not been short-term, after years of adjustment there is little evidence that they reduce poverty or inequality, and the predicted
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macroeconomic benefits have not been achieved. To truly measure the effects of structural adjustment programs on levels of inequality, we would first have to create a model which would allow us to separate their effects from a variety of internal and external forces influencing inequity before and after these policies were implemented for each country. Though it is nearly impossible to deconstruct the effects of complex packages of reforms, we can examine these linkages by measuring the relationships between some of its components and outcomes such as country income inequality. This study explores how policy reforms associated with structural adjustment programs are related to levels of country income inequality in Latin America. The paper begins with a brief summary of the context in which these changes occurred, and an outline of the main areas of reform. It will then discuss the issue of inequality in Latin America and its implications for economic policy. The following section presents the methodology used for this study and limitations to this approach. It continues with a review of existing literature and arguments for key issues in this area of study. The main section will present the results of an empirical analysis on the association between structural adjustment reforms and levels of country income inequality. The paper concludes with a discussion of the main ideas emphasized by this analysis, and the implications these may have for future policymaking and development. The overall objective of this study is to offer some explanation as to the source of inequality, and how this issue may be addressed most constructively.

Background and development context The Latin American financial crisis known as the lost decade began in the late 1970s and early 1980s, leading to the collapse of many economies under unmanageable foreign debt. Aid, particularly from the IMF, was given on conditionality that structural adjustment programs be implemented. The majority of reforms entailed monetary, fiscal, and trade policies which promoted austerity measures and shifted many economies from import substitution towards export-oriented, liberalized trade. A major shift in structural policies in Latin America occurred between the mid-1980s and late 1990s, and the economic recovery from this crisis has not been uniform across countries. Differences in economic growth, poverty, and inequality have been influenced by many factors, though this paper focuses particularly on attributing these outcomes to different policy reforms. Though the debt crisis affected most of Latin America, LA should not be considered a single economic block, but a diverse set of countries with widely different sized economies, at various levels of social and economic development. Several factors were involved in the cause of the financial crisis and massive accumulation of debt. Leading up to this point most countries applied state-driven development strategies, characterized as the import-substitution industrialism model. This was heavily state controlled and included interventions for the protection of domestic markets. The 1970s were also a time of heavy borrowing by Latin American governments. Large amounts of foreign capital from an oil boom were given out as loans indiscriminately, regardless of their ability to be repaid. Early signs of trouble began with the first oil shock of 1973 and subsequent rising of inflation. The region also experienced a number of other
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shocks, including military overthrows of government, guerrilla activity, and industrial strikes (Saha, 2002). Multilateral aid agencies and organizations such as the IMF and World Bank offered aid on condition that structural reforms be implemented. They were first introduced in Argentina, Uruguay, and Chile in the mid-70s, which initially deepened the crisis in these countries, resulting in hyperinflation and economic stagnation (Lora, 2012). The US Federal Reserve launched an anti-inflation package in 1979 which drastically hiked up the US interest rate and triggered a debt crisis across the world. This hit Latin America especially hard because of its heavy borrowing at variable interest rates. These rates of these loans increased rapidly as well, contributing to the already large debt burden. This lead to a period of recession and socio-political conflict during the 1980s, resulting in rampant inflation, burgeoning debt service costs, rising unemployment and widespread social unrest (Saha, 2002 p.84). Reforms had been implemented in Bolivia, Costa Rica, Mexico, Peru, and Venezuela by the mid-1980s, and most countries had taken up World Bank and IMF structural adjustment programs by the 1990s. More favorable views of it emphasize its role in balancing budgets, reducing widespread hyperinflation, reducing the overvaluation and black market premiums on exchange rates, eliminating forms of price control (Perkins et al., 2013). However, this was often in the face of popular protest against liberalization reforms and the privatization of state-owned enterprises (Saha, 2002). The economic growth experienced since then has not met the expectations of the IMF and the World Bank. In the early 1990s, advocates of market-oriented reforms expected they would generate growth rates in Latin America and the Caribbean similar to those in emerging East Asian countries (Loayza, 2005). Critics argue that economic growth rates are neither higher nor more equitable under this set of policies, and the pressures on market deregulation and cuts to public spending have worsened poverty and inequality reference. Structural Reforms Structural adjustment programs began as individual country-by-country programs, but evolved into a comprehensive view of what successful development involved later known as the Washington Consensus. (Perkins et al., 2013. p.148). This created an agenda of reforms necessary to receive funding from multilateral agencies, primarily aimed to reduce or remove price distortions generated by government intervention in the economy. Structural adjustment programs are complicated packages of policy measures, each containing an average of 40 conditionalities. The IMF recommended an almost identical policy package to all Latin American Countries, focused on devaluation, reduction of fiscal deficits, decreases in real wages, relaxation of controls on trade and capital flows, and the elimination of subsidies and other government interferences (Pastor, 1987). This package of policies are criticized to be particularly problematic and inappropriate in the midst of a global economic slow-down, and argued to ignore the combination of policy failures in different countries leading to the crisis, and placed blame primarily on domestic mismanagement and concentrated on domestic adjustments (Pastor, 1987).

The majority of reforms focused on liberalization of domestic markets to encourage trade, liberalizing financial systems and labor markets, opening markets to international financial flows, and withdrawing state control from economic activities. The goals of this reorientation were improving efficiency, facilitating the working of markets and reducing the distorting effects of state intervention (Lora, 2012). These are categorized in a number of different ways in other studies, though this paper divides them into three general areas of reform: 1. Trade liberalization Opening trade has many potential benefits, and countries gain from exploiting their area of comparative advantage, leading to higher productivity and specialization. It also expands potential markets and facilitates the diffusion of technological innovation. By eliminating restrictions on imports and exports, lowering barriers to trade opens sectors to foreign competition and investment. This includes tariff and non-tariff barriers such as licensing, quotas, and anti-dumping laws. Between the mid-1980s and early 1990s, Latin America saw reductions of at least 15 points in average import tariff rates (from 41.2 percent in 1985 to 13.2 in 1991, and less than 10 percent in 2005 (Lora, 2012). Reforms to liberalize the financial sector posed fewer restrictions on banks, reduced fees on transactions. Most counties have maintained these incentives for foreign investment and free trade zone agreements. 2. Fiscal discipline Supported by loans, government spending expanded under import substitution. Structural reforms intend to rebalance budgets by curbing spending and increasing revenue. These include reductions in government subsidies, public services, and the privatization of public companies to the private sector. Tax reforms until the late 1990s were deep, shifting the tax base to raise revenue while attracting business development. Countries adopted value added consumption taxes to moderate the distorting effects of taxation on production and investment decisions, and extreme marginal rates on personal income were cut substantially (Lora, 2012. p. 10). 3. Monetary stabilization Policies in this include eliminating controls on interest and exchange rates, and rations on the use of foreign exchange or currency quotas for imports. State interventions to ration the use of foreign exchange usually create multiple foreign exchange markets. This may result in extreme differences between the free market and most regulated exchange rates, which would reflect deep monetary imbalances (Lora, 2012). Structural reforms intend to reorient economies and stimulate growth by eliminating inefficiency caused by government intervention, and opening markets to free trade, and the speed and extent to which Latin American countries reformed was remarkable. Several countries adopted more trade and financial liberalization policies and put through more privatizations and tax reforms within a short time (especially until the mid-1990s) than other transitioning economies of East Asia did in three decades (Rodrik, 1996). Should structural reforms produce economic growth as expected, it is assumed that gains from trade will benefit both consumers and producers, increasing net welfare. The speed and depth of reforms has varied not only across structural policy areas, but across countries
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(Lora, 2012). To compare differences in outcomes under structural adjustment programs, a system may be used to categorize countries by the extent to which reforms were made. This study has adopted the model used in a World Bank working paper studying the effects of structural adjustment programs (Kakwani, 1990), which provides a more accurate view of how involved countries were in lending programs. This classification of countries is presented in Table 1.

Table 1. Classification of lending and reform status for Latin American countries
Classification Definition [A] Countries that received structural adjustment loans: IAL (Intensely adjusting countries) Began lending in or before 1985, and Bolivia either received three or more loans, or had Brazil completed two adjustment programs. Chile Colombia Costa Rica Mexico Received less than three loans before 1985. Received loans from 1986-1988. [B] Countries that did not receive structural adjustment loans: NAL + (Non-adjusting countries) NAL (Non-adjusting countries) Experienced an increase in average annual Dominican Republic per capita GDP growth during 1980-1987. Paraguay Peru Experienced a decrease in average annual El Salvador per capita GDP growth during 1980-1987. Guatemala Nicaragua Venezuela Ecuador Panama Uruguay Argentina Honduras Countries

Pre-1986

Post-1985

Source: adapted from classification system by Kakwani (1990)

The first group which did not receive loans, NAL + may represent countries which did not need the assistance of the IMF or World Bank, or had at least avoided it during this time. The second group, NAL - may possibly be considered candidates for adjustment programs. Kakwani suggests that considering most countries began lending after an economic downturn, the NAL - countries are probably the closest one can get to a counterfactual (p.6). In contrast to the major policy changes brought on by structural adjustment programs, changes in terms of labor reforms have been few and of limited scope (Lora, 2012. p. 18). Many of the protections workers had were dismantled, and a greater labor-market flexibilization saw increasing unemployment, the greatest rates taking place in the lower-income population groups (SAPRIN, 2002. p. 50). Without social protection systems (such as restrictions on hiring, temporary contracts, and firing costs), workers faced disadvantages such as higher payroll taxes and minimum wages falling relative to productivity. While it may be expected that workers ultimately benefit from structural reforms because they
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encourage economic growth, these policies also influence the distribution of gains and losses from growth. Financial crisis and economic depression are undeniably bad, but it is possible that the benefits from improved economic performance realized by the general population are outweighed by the price they pay in terms of livelihoods, cost of living, and social services. Country income inequality The issue of social and economic inequality has arisen as a political topic in the U.S., particularly with protest movements in 2011, concerning the distribution of wealth in the top 1%, the power of private interest in government, and corruption in the financial sector. While the incomes for the vast majority of people have stagnated in a downturn of the global economy, the incomes of the wealthiest have grown substantially. According to Rosnick (2012), the increase in income at the 90th percentile in most countries is dwarfed by the increase in income at the 99 th percentile, 99.9th percentile, and even the 99.99th percentile. In fact, in some OECD countries the 90th percentile worker barely kept pace with the rate of productivity growth in the economy, meaning that they were not, on net, beneficiaries of any increase in inequality. (p. 2). This issue is not only crucial to address for the alleviation of poverty, but for economic development strategy as well, due to the relationship between growth and inequality. The challenge with addressing this issue is the potential impacts that inequality may have on future economic growth, though policies intended to stimulate growth may themselves be worsening levels of inequality. According to the induced-growth argument, higher initial country income inequality may result in lower subsequent growth. However, economic distortions hampering growth may result from redistributive policies necessary to reduce inequality and poverty. (Wodon, 2000. p. 41). This suggests that polices intended to stimulate economic growth may actually inhibit future growth if they result in rising inequality, as their effects run contradictory to one another. It may also suggest that applying a single set of policy measures across countries with differing levels of inequality may not be the most effective approach. Without considering the impacts of inequality, growth should raise living standards and reduce poverty. However, when growth is associated with rising inequality, part of the gains from growth will be offset by the negative impact of rising inequality. Higher levels of inequality may concentrate wealth in the highest percentile, which might reduce the benefits of growth to the poor. This issue is crucial in the analysis of the performance of Latin American countries amidst the financial crisis, as levels of inequality have changed over the years. The need to consider rapid policy changes is supported by evidence that most of the increase [in inequality] took place between 1986 and 1989 (Wodon, 2000. p. 4). Although Latin America is considered middle-income status, it has huge masses of people in severe poverty, and its societies are some of the most unequal in the world. They have some of the highest Gini indices, Brazil being the second highest in the world (after Sierra Leone) with an index of 60. Guatemala and Paraguay are also above 59, six more are above 50, and the remaining countries fall between 40 and 50 (Saha, 2002. p. 109). This is compared to the indices of Western European countries between mid-20s to low 30s. Even the US, which is the most unequal industrialized country has an index of 40.8, which is lower than the lowest in Latin America (Saha 109). Gini indices have risen substantially since the 1980s, in three of the largest Latin American countries; Brazil, Mexico, and Colombia. The Gini index of country income inequality rose as well in Chile and El Salvador (Saha 109).
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Examining these differences may shed light on the causes of inequality and the relationship they have to approaches taken to stimulate economic growth. It may also provide insight on the factors which help to reduce inequality. This is important to address because inequality may reduce the prospects of the poor of escaping poverty through growth because the higher the initial inequality, the lower the share of the poor in the benefits of growth (Wodon p41). In terms of policymaking, the alleviation of poverty may require that reducing inequality take priority over growth.

Methods This study combines several methods of research as well as independent work. These include reviewing literature from peer-reviewed studies, and official reports and statistics by international institutions. The information collected for this study is supplemented with previous coursework in the fields of economics, sustainable development, trade policy, and data analysis. This topic has been addressed in several other papers and empirical work throughout undergraduate and graduate courses, and the focus of my academic study has been crucial in developing a greater understanding of this subject. Considering the many external forces influencing a country's development, it is difficult to precisely measure the effects of structural adjustment programs using observational data. This includes estimating what effects may be attributed to them, or how changes in policy affect the outcomes. Because we cannot conduct randomized trials on these policies changes, there is no counterfactual or way to determine what would have happened in the absence of them. Using a categorization system such as the one shown in Table 1, may be one way to create an approximate control group (the NAL-) to compare outcomes across countries. The accuracy and availability of data present a number of difficulties in analytic work, and acquiring a continuous series of data with common methodologies for collection or calculation was a challenge. Because developing countries are more likely to be missing data, they may be underrepresented in such studies, which might bias results. This is true for the data used in this study, particularly with measures of inequality in Latin America. All observations in this study are measured at a country-level, which offers a degree of simplicity and allows for cross-country comparisons. However, the interpretation of this data should consider the method in which it is collected and the limitations of using national averages. Measures of country income inequality generally rely on data at the individual or household level, which contains well known biases of random and systematic measurement error. Household or individual income data may not accurately reflect levels of wellbeing due to fluctuations in paid work or employment in the informal sector. Underreporting tends to be more severe when poverty measures are based on income rather than consumption levels, though data on consumption is much less available in areas such as Latin America (Wodon, 2000). This problem of underreporting also applies to national economic data. Although it is relatively reliable in accuracy, it may be less precise in developing countries with greater participation in the informal economy. (Wodon, 2000).
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The choice of Latin American countries in this study was partly determined by the amount of data available, their involvement in the financial crisis, and the status of their economy. This sample includes Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Peru, Paraguay, El Salvador, Uruguay, and Venezuela. All of the information for this analysis is contained in a dataset which had been used in prior academic work. This data was gathered from multiple sources including the World Bank and IMF. It includes time series data from these 18 Latin American countries from 1960 to 2012. Definitions and summary statistics for the variables used in the analysis are provided in Table 2.
Table 2. Summary Statistics
Table 2. Definition and summary statistics of variables used in the regression of policy measures and macroeconomic indicators associated with three areas of structural reform on country income inequality in 18 Latin American countries, 1960-2012.
Variable Definition A. Dependent variables Gini index Annual country Gini coefficient in percentage points as calculated by WIDER (estimated using decile data and reported Gini, in household and individual income or consumption inequality). Theil's T statistic is computed as the product of states population share, quotient of state average income, and natural logarithm of quotient of state average income Estimated household income inequality (EHII) are estimates of gross household income inequality, computed from a regression relationship between the Deininger & Squire inequality measures and the UTIP-UNIDO pay inequality measures, controlling for the source characteristics in the D&S data and for the share of manufacturing in total employment (Deininger & Squire, 1996). B. Explanatory variables I. Trade liberalization Trade tax Total annual taxes on international trade (import duties, export duties, profits of export or import monopolies, exchange profits, exchange taxes), as percentage of GDP Sum of annual exports and imports of goods and services measured as a share of gross domestic product. Annual median ratio of export prices to import prices, calculated as the value of a country's exports relative to imports (exports / imports * 100). A measurement greater than 100% indicates an accumulation of capital, measurements less than 100% indicate net capital is leaving the country. 360 2.57 1.60 0.41 9.31 370 50.18 6.58 29.90 68.20 Obs Mean SD Min Max

Theil Index

439

0.05

0.03

0.01

0.26

EHII

439

41.76

5.90

26.14

62.32

Trade openness

906

52.30

30.10

9.06

198.77

Terms of trade

651

106.79

29.76

33.75

253.28

II. Fiscal discipline Subsidies (as % revenue) Sum of annual subsidies, grants, and other social benefits include all unrequited, nonrepayable transfers on current account to private and public enterprises; grants to foreign governments, international organizations, and other government units; and social security, social assistance benefits, and employer social benefits in cash and in kind. 456 4.22 5.96 -43.44 46.30

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Table 2: Continued
Debt service Total annual debt service (principal repayments + interest paid on long-term, short-term debt in currency, goods, or services + repayments to IMF), as percentage of exports of goods, services and primary income Annual net inflow of investment in an enterprise in economy foreign to investor, as percentage of GDP 661 25.18 16.72 0.14 156.86

Foreign direct investment (FDI)

709

2.09

2.42

-12.21

17.13

III. Monetary stabilization Money & quasi Annual average money and quasi money supply (currency outside banks + money (M2) non-government demand deposits + savings + non-government foreign currency deposits), traditional measure of financial depth Overvaluation Annual average percentage difference of deviation of actual real exchange rate (REER) from PPP. Used as a proxy for outward orientation Annual average percentage difference between the black market rate for foreign currency and the pegged official exchange rate Inflation as measured by the consumer price index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly. C. Control variables GDP Year Country Gross domestic product (current U.S. dollars, in billions) Year of survey (1960-2012) 929 52 18 7.06 1.99 2.30 2.50 642 122.14 219.60 43.52 5526.61

Black market premium Inflation

669

120.07

1951.11

-10.24

49990.00

762

75.87

562.63

-3.90

11749.60

Literature review The following section will discuss four main bodies of literature: measures of country income inequality, measures of policy reform, economic growth as a determinant of inequality, and policy measures as determinants of growth. This will present the findings and differing arguments made in relation to these areas. 1. Measures of country income inequality One main concern in empirical studies of country income inequality is the lack of consistency in which data is measured. Income inequality may be measured using data on gross or net income (before or after tax), consumption or expenditure, on either household or individual levels. Almost all studies do not measure inequality in a consistent way, mostly due to the limitations of data available. A study by Stephen Knowles (2005) proposes there are potentially serious problems with data quality (particularly in older studies), and that much of the empirical work on inequality should be interpreted with caution because of this inconsistency.
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Knowles finds the significant negative correlation often found between income inequality and growth across countries may not be robust when income inequality is measured in a consistent manner, though it finds evidence of this correlation in developing countries using consistent measures (p. 1). However, other studies including Borro (2000), claim the use of consistent measures does not affect results. Some studies attempt to avoid such problems with inconsistent measurement by transforming data. Studies by Perotti (1996), and Deininger and Squire (1998) find different results using transformations, though Knowles claims it is not an adequate fix to this problem (as cited in Knowles, 2005. p. 1). In addition, Knowles argues that the measurement of inequality may exaggerate the degree of income inequality relative to countries using different measures. He states that Latin American countries more frequently have data on gross income distribution for individuals, which is expected to produce a higher Gini coefficient than other measures (p. 4). Forbes (2000) points to attenuation bias as a source of measurement error. She notes that if more unequal countries underreport their inequality statistics, and also tend to grow more slowly, this could generate a negative bias in cross-country estimates of inequality on growth. Inequality measures may also be misleading whether they are reported using population-weighted figures or equal country weights. For example, the World Bank Technical Paper on Poverty and Policy in Latin America and the Caribbean by Wodon (2000), finds no clear pattern towards changes in inequality over time when using equal country weights. However, the outcome changes when using population-weighted measures, indicating that changes in inequality in LAC reflect in part the weight of Brazil and Mexico, where inequality increased between 1986 and 1989, and then receded only partially (p. 37). In addition, using country-level measures may hide important within-sector variations in inequality, as rates tend to be higher within urban than in rural areas in Latin America. National level estimates may be even higher if they take into account the inequality between urban and rural areas (Wodon, 2000). The use of different inequality measures is also challenged. One study by Rosnik and Baker (2012) argue against the OECD's recently published report on inequality over the last three decades. This analysis claims the OECD is missing most of the story because of the measurements of inequality used (ratio of annual wage of the 90th percentile to 10th percentile worker), and that most of the gains were much further up the income ladder (p. 1). This study finds that gains to the very high earners as opposed to the merely high earners form a substantial part of the growth in inequality. This study includes three measures of inequality; the Gini index, Theil index, and Estimated Household Income Inequality (EHII). These were chosen because each uses different methods of calculation, and often present differing pictures of inequality. This approach is taken in an effort to ensure the results of the analysis do not hinge on the definition of income inequality.

2. Measures of policy reform Empirical work studying the effects of structural adjustment programs often note the issue of finding an adequate series of policy variables. Specifically, this addresses the difference between variables which may be directly influenced by policy decisions (such as tariff rates, taxes, and bank reserve ratios), and
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those which measure economic outcomes of policy choices (such as the ratio of imports to exports, and rates of inflation). The latter are influenced by policy decisions and a variety of other internal and external phenomena including the business cycle, terms of trade or foreign interest rates. One study by Lora (2012), argues that this has prevented accurate measures of the magnitude of reforms, as well as the relative importance of the various areas of reform, and distinguishing between the effects on growth of the structural reforms themselves and those derived from macroeconomic stabilization (p. 26). This study uses a revised set of indexes to measure the effects of policies in five different areas. This study acknowledges the limitations with using variables which are indirectly determined by policy choices and external factors, and has included a set of both policy measures as well as macroeconomic indicators which structural reforms intend to influence. 3. Economic growth as a determinant of inequality Many studies have found a negative correlation between income inequality and GDP growth, though improvements in data allowing panel studies have produced results challenging this widely-held opinion. Perkins (2013) confirms that early studies found statistical evidence to support that high initial inequality, especially of landholdings, was associated with slower subsequent growth. But later studies, using larger data sets and different econometric techniques, either found no such effect or even an opposing one. Knowles (2005) finds no evidence of a significant relationship between income inequality and growth, though this study does find evidence for a significant negative relationship between inequality of expenditure and economic growth (p. 4). Forbes (2000) challenges the negative relationship when controlling for time-invariant country-specific effects, and finds that in the short and medium term, an increase in a country's level of income inequality has a significant positive relationship with economic growth, which is robust across samples, differences in variable definitions, and model specifications. Forbes also argues that this negative relationship depends on exogenous factors, such as levels of development and political systems. The study cites other models which find positive relationships (Grilles Saint-Paul & Thierry Verdier, 1993), (Benabou, 1996), and hypothesizes that more unequal societies may vote for higher expenditures on public services that promote growth, and that inequality increases during times of technological innovations, which concentrate wealth among high-ability workers. 4. Policy measures as determinants of economic growth The common thread of all the recommendations made by the Washington Consensus is that growth was inhibited by major distortions in the market, distortions for the most part introduced by inappropriate government policies (Perkins, 2013. p. 148). Removing these distortions was seen as the key to accelerating growth, and that government failure, rather than market failure, was considered the
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primary impediment to economic growth and development. A number of studies have examined the link between these policy reforms and economic growth. One of which, by Jeffrey Frankel and David Romer (1999), tests whether the same variable used in this study for trade openness (trade as a proportion of GDP) causes growth. They find that a 1 percentagepoint increase in the ratio of trade to a country's GDP increases income per capita by at least 0.5 percent. David Dollar (1992), constructed an indicator of trade policy orientation based on real exchange rate distortion and volatility, and found that during 1976-1985 developing countries that were most open to trade had an average annual growth rate of 2.9 percent per capita, compared to the most closed portion of the sample countries experienced negative growth of -1.3 percent. One of the most well-known studies by Jeffrey Sachs and Andrew Warner (1995), constructed a composite indicator of openness to trade which classified countries as either open or closed based a number of trade policy indicators. They found openness to have a substantial influence on growth, and that open countries (between 1970 and 1989) grew at least 2 percentage points faster on average than closed countries Francisco Rodrguez and Dani Rodrik (2000) challenge the validity, interpretation and robustness of these policy indicators used by Sachs and Warner, and claim that the evidence for the relationship between openness to trade and growth is inconclusive.

Substantive discussion Estimation strategy To estimate the association between income inequality and three areas of structural reform (Trade) liberalization, (Fiscal) discipline, and (Monetary) stabilization, I use the following model:

[1]

yct = + 1Tradect + 2Fiscalct + 2Monetaryct + 3Cct + ct

where y is a measure of country income inequality, (Trade), (Fiscal), and (Monetary) are vectors of policy measures and macroeconomic indicators as explanatory variables, C ct includes a vector of control variables, and ct is the regression residual. The subscripts c and t stand for country and time. The following section will describe the variables as they are categorized. A. Dependent variable (y) Inequality is measured in three ways, using the Gini Index, Theil Index, and Estimated Household Inequality Index (EHII). As discussed in the literature review, using different methods to calculate inequality will produce different results. In addition, the sample size for each measure differ widely in
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the countries and years represented, which might produce different estimates of the effects of policies on country income inequality. B. Explanatory variables (trade, fiscal, monetary) This study focuses on a set of variables for policy measures which may be deliberately controlled by the government, as well as variables for macroeconomic indicators which policy reforms attempt to change. These indicators cannot directly measure the reforms, but may suggest whether their intended effect is significantly related to inequality. These have been organized into the three general categories of reforms, related to trade liberalization, fiscal discipline, and monetary stabilization. I. Trade liberalization: One variable for policy measures includes tax on international trade as an indicator of trade liberalization. Variables also included a measure of the total value of traded goods relative to a country's GDP, which is commonly used as an indicator of openness. Terms of trade is another indicator of a country's capacity to trade. II. Fiscal discipline: Two variables for policy measures include the relative amount of a country's revenue spent on subsidies, and the relative amount a country pays to service external debt. Another variable is included to measures the amount of foreign direct investment received by a country, which may result from preferential corporate or income tax rates. III. Monetary stabilization: The variable for money and quasi money supply (M2) is a traditional measure of financial depth. Other variables include exchange rate overvaluation, which captures the impact of monetary and exchange rate policies that distort the allocation of resources between the exporting and domestic sectors (Loayza, 2005. p. 42). Another indicator is the rate of black market premium, or the excess which must be paid to purchase foreign exchange in illegal markets which indicates the use of fixed exchange rates. Inflation is another measure macroeconomic or price stability, which indicates the quality of fiscal and monetary policies. C. Control variables (c) Control variables include: (i) dummy variables for year and country to sweep away time and location invariant fixed effects, and (ii) baseline GDP since it is associated with country growth and country income inequality. Hypotheses My hypothesis is that structural reform programs, as a whole, are associated with higher inequality, though the three areas of reform are expected to be correlated differently in the following ways: H1. More liberalized trade will be associated with greater inequality, and reducing taxes on trade will be related with higher inequality. I also expect to find a positive coefficient for openness to trade. Because export-oriented economies are more vulnerable to declining terms of trade, I expect it to have
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a stronger negative association with inequality. H2. The vector of variables related to fiscal discipline will have the largest (positive) effect on inequality. Reducing subsidies will increase inequality, and an increase in public funding redirected toward debt service will also increase inequality. FDI is also expected to lead to a greater consolidation of wealth and increase inequality, though to a lesser extent than the other variables for this vector. H3. Monetary stabilization is the one area of reform expected to benefit the poor and decrease inequality. The lack of financial depth, indicated by lower money and quasi money supply (M2) increases the risk of financial crisis, and is expected to increase inequality. Higher overvaluation, black market premium, and inflation are all expected to be associated with price distortions that particularly hurt the poor and increase inequality. Results I begin by analyzing the association between each explanatory variable and each of the three measures of inequality, controlling for baseline GDP, time- and country-fixed effects. Table 3 contains the OLS regression results and Table 4 compares the results with the expectation from the hypotheses. I. Trade liberalization We find a positive relationship between tax on international trade and all three measures of inequality, though only the EHII is statistically significant at the 90% confidence interval. Contrary to the hypothesis, this suggests that a 1% increase in taxes relative to GDP is associated with a 0.018% increase in inequality. We also find a significant positive relationship between trade openness and inequality using the Gini index, as expected. This suggesting that a 1% increase in the ratio of imports and exports to GDP is associated with a 0.05% increase in inequality. The EHII produces a similar insignificant result, though the Theil index shows a negative, but insignificant relationship. The coefficient of terms of trade is both positive and insignificant using the Gini index and EHII, but the Theil index shows a significant negative relationship with inequality. As hypothesized, we find that a 1% increase in terms of trade is associated with a 0.217% decrease in inequality. This shows a much stronger relationship than the two insignificant results. As a whole, these results do not suggest there is a consistent relationship between trade liberalization and inequality which is robust across different measures of inequality, as we find only one significant coefficient for each variable and differing signs across insignificant coefficients. II. Fiscal discipline We do not find any evidence of the relationships between inequality and subsidies or foreign direct investment from these results. However, we find negative coefficients of debt service with all three measures of inequality, two of which are significant. This suggests that 1% increase in the amount a country spends on debt service relative to its income is associated with a 0.02% or 0.15% decrease in inequality (using the Gini and Theil index, respectively), which runs counter to H2. Overall, these results do not provide sufficient evidence to suggest there is a relationship between fiscal discipline and
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country income inequality. III. Monetary stabilization We find one highly significant negative relationship between M2 and inequality using the Theil index, which is much stronger than the insignificant positive and negative relationships found with the other inequality measures. This supports the hypothesis that greater financial depth is good for the poor, and that a 1% increase in money supply is associated with a 0.163% decrease in inequality. The relationship between overvaluation and inequality was expected to be positive, though we find a highly significant negative association using the Theil index (the others show both insignificant negative and positive relationships). This result suggests that a 1% increase in overvaluation, indicating lesser outwardorientation, is associated with 0.192% decrease in inequality. Similarly, we find a significant negative relationship between black market premium and inequality using the Gini and Theil indexes, the EHII is also negative but insignificant. This challenges the hypothesis that dismantling controls on exchange rates would benefit the poor, and suggests that a 1% increase in black market premium is associated with a 0.01% or 0.04% decrease in inequality. Lastly, we find two highly significant negative coefficients of inflation using the Gini index and EHII, the Theil index is also negative but insignificant. These both suggest a 1% increase in inflation is associated with a 0.01% decrease in inequality, though this was hypothesized to disproportionately hurt the poor. As a whole, these results would suggest that reforms in the area of monetary stabilization are associated with higher inequality.

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Table 3. Main Regression Results


Table 3. Policy measures and macroeconomic indicators associated with structural reform as determinants of inequality OLS Regression results of policy measures and macroeconomic indicators in three areas of reform on three measures of income inequality in 18 Latin American countries, 1960-2012
Explanatory variable [1] I. Trade liberalization Trade tax Trade openness Terms of trade N R2
178 0.68 361 0.61 0.005 (0.02) 0.050** (0.02) 0.006 (0.04) 268 0.61 258 0.72 422 0.59 0.014 (0.05) -0.057 (0.10) -0.217** (0.11) 397 0.59 238 0.88 420 0.67 0.018* (0.01) 0.045 (0.03) 0.015 (0.03) 394 0.68

Gini index [2] [3] [4] [5]

Theil index [6] [7] [8] [9] [10]

EHII [11] [12]

II. Fiscal discipline Subsidies Debt service FDI N R


2

0.010 (0.01) -0.020* (0.01) 0.008 (0.01) 172 0.73 291 0.61 309 0.67

-0.031 (0.03) -0.153*** (0.04) 0.016 (0.02) 186 0.57 421 0.60 313 0.70

0.011 (0.01) -0.011 (0.01) 0.001 (0.00) 178 0.55 407 0.68 319 0.68

III. Monetary stabilization M2 Overvaluation Black market premium Inflation N R2


368 0.59 270 0.58 196 0.65 0.018 (0.01) -0.004 (0.02) -0.010** (0.00) -0.013*** (0.00) 287 0.60 437 0.55 398 0.54 303 0.54 -0.163*** (0.06) -0.192*** (0.07) -0.042*** (0.02) -0.015 (0.02) 339 0.58 435 0.67 387 0.66 304 0.72 -0.001 (0.01) 0.007 (0.01) -0.001 (0.00) -0.014*** (0.00) 356 0.56

Notes: Observations measured annually from 1960 to 2012 for 18 Latin American countries. All values are in natural logarithms. All estimates control for baseline GDP and time- and country-fixed effects. Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1

Summary A number of the study's expectations were challenged by these findings. The hypothesis that trade liberalization is associated with higher inequality is supported by the coefficient of openness, though this is contradicted by the finding that lowering barriers to trade such as taxes is related to lower inequality. It is also surprising that debt service, which was expected to hurt the poor in particular by redirecting public funding from social services, is inequality-reducing. Many of the hypotheses about monetary stabilization were also contradicted by these results, which showed that indicators of price distortions and intervention in the money market are associated with lower levels of inequality.
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One possible explanation for these discrepancies may be that the policy reforms were not implemented or possible to implement in a uniform manner. Latin American governments were criticized for their maintenance of overvalued currency and reluctance to switch to floating exchange rates, though addressing problems such as hyperinflation took much more of a concerted effort. Overall, we find very few results are significant and robust across different measures of country income inequality. In addition, the model's simplicity and extremely limited sample size for all of these estimates suggests these results should be interpreted with caution. Table 4: Summary of Empirical Results and Expectation from Hypotheses
Table 4. Summary of Empirical Results and Expectations from Hypotheses
Hypotheses H1: Trade liberalization a. b. c. Trade tax Trade openness Terms of trade (-) higher taxes, lower inequality (+) greater openness, higher inequality (-) increasing terms of trade, lower inequality (+)* column 9 is significant (+)** column 2 is significant (-)** column 7 is significant Sign of expected association with inequality Estimated coefficient from Table 3

H2. Fiscal discipline a. b. c. Subsidies Debt service FDI (-) higher subsidies, lower inequality (+) higher debt service, higher inequality (+) greater FDI, higher inequality (0) none are significant (-)*,*** columns 2, 6 are significant (0) none are significant

H3. Monetary stabilization a. b. c. d. M2 Overvaluation Black market premium Inflation (-) greater money supply, lower inequality (+) greater overvaluation, higher inequality (+) higher premium, higher inequality (+) higher inflation, higher inequality (-)*** column 5 is significant (-)*** column 6 is significant (-)**,*** columns 3, 7 are significant (-)***,*** columns 4, 12 are significant

Source: See Table 3 for regression results. *,**,*** denote statistical significance at 90, 95, 99% confidence intervals

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Conclusion and implications It is troubling that Latin America has not experienced as strong an economic recovery as anticipated, though what seems more unfortunate is that it spent more over the last 20 years servicing external debts than it has on basic education, health, and social services, combating poverty, and building infrastructure (Saha, 2002). These are all essential elements which make achieving sustainable development possible. Foreign debt also provides international financial institutions a certain degree of political leverage, and countries may be pressured to adopt policies which may not serve the best interests of its people. In general, the packages of reforms have appeared to focus primarily on domestic policies which may have played relatively smaller roles in the cause of the financial crisis, and have ignored the global nature of the crisis and external factors contributing to the excessive debt and financial shocks. Rather than address policy inadequacies in international flows of capital, they have become increasingly unregulated. Financial-sector liberalization is argued to have contributed more to economic crises and increased vulnerability to external shocks through irresponsible bank lending, volatility of foreign and domestic capital, bailouts of the private system with public funds, and worsening debt (SAPRIN, 2002). As indicated in the literature reviewed on this subject, there still remains an uncertainty as to the nature of the relationship between economic policy and inequality. While there may be some growing acknowledgement of the issue of inequality on the part of the World Bank and IMF, there appears to be very little progress made in the way of the policy framework advocated to address it. Saha (2002) cites some recent changes in position on the need for integration between economic and social dimensions of development. As early as 1991, the World Bank's World Development Report indicated that a shift was needed from the earlier neoliberal approach to a more socially sensitive approach, in which the state was to play a greater role (p. 86). The 1996 Conference on Development, co-sponsored by the World Bank, IMF, and Inter-American Development Bank, noted the urgent need for a second generation of reforms which supported institution building and a stronger proactive role for the state in managing development (Saha, 2002. p. 87). However, it is my belief that these acknowledgements may be of little consequence due to the fact that the basic policy framework advocated by the World Bank has not changed. Though they recognize the relationship structural reforms have with rising inequality, the World Bank continues to argue that the macroeconomic gains from the implementation of adjustment policies offset any short-term losses among certain population groups and sectors by setting countries on the path toward sustainable growth. (SAPRIN, 2002. p. 185). This statement implies that inequality is result of these policies, though it is regarded as a short-term problem which will inevitably be self-corrected. The World Bank reports that over the short-term, fiscal retrenchment is alleged to have hurt the poor via cutbacks in public expenditure programs largely devoted to them, but this negative effect is seen to be more than counterbalanced by the positive impact on reduction of inflation (Wodon, 2002. p. 21). They also suggest that the cutbacks in public sector employment also appear to have negatively affected the poor in the short-run, but over the medium- and longer-term, the net effects on the poor are seen to depend on the rate and composition of overall economic expansion, employment creation in the private sector, and the adequacy of safety nets and educational programs for cushioning the
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transition to a new productive structure (Wodon, 2002. p. 21). The evidence supporting this claim is not widely confirmed in the literature reviewed, particularly in the case of Latin America. One study by the Structural Adjustment Participatory Review International Network (SAPRI, 2002) finds radically different results, claiming that the overall impact of adjustment policies include increased current-account and trade deficits and debt, disappointing levels of economic growth, efficiency and competitiveness, misallocation of financial and other productive resources, the disarticulation of national economies, destruction of national productive capacity, extensive environmental damage, greater intensity and pervasiveness of poverty and inequality, higher concentrations of wealth, and far fewer opportunities for the poor (p. 185). However, the results of this analysis suggest the association between these policy reforms and inequality may support some claims on either side of this issue. There may be a great deal of unobserved causal relationships influencing these outcomes, and that further study into the joint effects of these indicators is recommended. The issue of inequality should continue to be studied at greater length within the greater context of policy as it is inexorably linked to the goals of economic growth and the reduction of poverty. Addressing the issue of inequality constructively may not be possible without first gaining a better understanding of the relationship between inequality and the strategies currently being used to promote economic growth.

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References Barro, R. J. (2000). Inequality and growth in a panel of countries. Journal of Economic Growth, 5(1): 5-32. Bird, G. (2001). IMF Programs: Do They Work? Can They be Made to Work Better? World Development, 29(11): 1849-1865. Deininger, K., & Squire, L. (1996). A New Data Set Measuring Income Inequality. The World Bank Economic Review, 10(3): 565-91. Dollar, D. (2000). What Explains the Success or Failure of Structural Adjustment Programmes? The Economic Journal, 110(466): 894-917. Dollar, D. (1992). Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidence from 95 LDCs, 1976-1985. Economic Development and Cultural Change, 40(3): 523-544. Dreher, Axel (2006). Does Globalization Affect Growth? Evidence from a new Index of Globalization. Applied Economics, 38(10): 1091-1110. Easterly, W. (2005). What did structural adjustment adjust?: The association of policies and growth with repeated IMF and World Bank adjustment loans. Journal of Development Economics. Fan, S., & Rao, N. (2003). Public spending in developing countries: trends, determination, and impact. International Food Policy Research Institute . Forbes, Kristin J. 2000. A reassessment of the relationship between inequality and growth. American Economic Review, 90(4): 869-887. Frankel, J., & Romer, D. (1999). Does Trade Cause Growth? American Economic Review, 89(3): 379399. Kakwani, N., & Makonnen, E., & Gaag, J. (1990). Structural Adjustment and Living Conditions in Developing Countries. (Policy, Research, and External Affairs Working Papers). World Bank. Knowles, S. 2005. Inequality and economic growth: The empirical relationship reconsidered in the light of comparable data. J Development Studies, 41:1: 135-159. Loayza, N., & Fajnzylber, P., & Calderon, C. (2005). Economic Growth in Latin America and the
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Caribbean: Stylized Facts, Explanations, and Forecasts. Washington D.C., World Bank Publications. Lora, E. (2012). Structural Reforms in Latin America: What Has Been Reformed and How to Measure It. (IDB Working Paper). Inter-American Development Bank. Noorbakhsh, F. (1999). Standards of living, human development indices and structural adjustments in developing countries: an empirical investigation. Journal of International Development Pastor, M. (1989). Latin America, The Debt Crisis, and The International Monetary Fund. Latin American perspectives, 16:1: 79-110. Perkins, D., Radelet, S., Lindauer, D., & Block, S. (2013). Economics of Development. New York, W.W. Norton & Company. Plaza, O., & Stromquist, N. P. (2006). Consequences of Structural Adjustment on Economic and Social Domains: Two Decades in the Life of Peru. Annals of the American Academy of Political and Social Science. Roberts, K. M. (2012). The Politics of Inequality and Redistribution in Latin America's PostAdjustment Era. (Working Papers: UNU-WIDER Research Paper #8). World Institute for Development Economic Research (UNU-WIDER). Rodriguez, F., Rodrik, D. (2001). Trade Policy and Economic Growth: A Skeptic's Guide to the CrossNational Evidence. NBER Macroeconomics Annual 2000: 261-338. Rosnick, D., & Baker, D. (2012). Missing the Story: The OECD's Analysis of Inequality . Washington, D.C., Center for Economic and Policy Research. Saha, S. K., & Parker, D. (2002). Globalisation and Sustainable Development in Latin America: Perspectives on the New Economic Order . Cheltenham, UK, Edward Elgar Publishing Ltd. SAPRIN. (2002). The Policy Roots of Economic Crisis and Poverty: A Multi-Country Participatory Assessment of Structural Adjustment. Washington, DC: Structural Adjustment Participatory Review International Network. Wodon, Q., & Ayres, R. L. (2000). Poverty and policy in Latin America and the Caribbean . Washington, DC: World Bank.

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Data Sources Inter-American Development Bank, Latin American and Caribbean Macro Watch Database (http://www.iadb.org/Research/LatinMacroWatch/lmw.cfm). UNU-WIDER World Income Inequality Database, UTIP-UNIDO Dataset, Estimated Household Income Inequality Dataset, IMF World Economic Outlook Database, and World Development Indicators Database (http://utip.gov.utexas.edu/data.html). World Bank, Economic Policy & External Debt Databank (data.worldbank.org). World Bank, The Lost Decades: Developing Countries' Stagnation in Spite of Policy Reform 19801998 Dataset (http://go.worldbank.org/4D1S9KQUP0).

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