Gerber Ie7e PPT 15

International Economics
Seventh Edition
Chapter 15
Trade and Policy Reform
in Latin America
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning objectives (1 of 2)
15.1 Describe the strengths, weaknesses and
reasons for import substitution industrialization.
15.2 Explain the strategy and performance of

economic populism.
15.3 Give the main reasons for the debt crisis of

the 1980s and analyze its relationship to ISI.
Learning objectives (2 of 2)
15.4 Discuss the goals of economic policy
reforms that began in the later 1980s.
15.5 Explain why some Latin American leaders

have become impatient with economic policy
reforms.
What is Latin America?
• Latin America is one of the most diverse regions in the world.
– Traditional definitions focus on countries to the south of the United
States, or Spanish America and Brazil.
▪ The Caribbean is sometimes included, sometimes not;
▪ Small, non-Spanish and non-Portuguese speaking countries are
sometimes included, sometimes not.
– A combination of indigenous, African, European, and Asian heritages.
• Some common themes:

– Mostly Spanish and Portuguese colonies;
– Became independent in the 1820s (unlike Asian and African colonies);
– Many depend on commodity exports;
– Shared economic strategies during much of the 20th century.
Population, income, and economic
growth (1 of 3)
Region Population GDP GDP per
(Millions) (US$ capita
Billions) (US$ PPP)
Central American common market
Costa Rica, El Salvador, Guatemala, Honduras, 41.5 164.9 7,512

Nicaragua
Common market of the South (Mercosur)
Argentina, Bolivia, Brazil, Paraguay, Uruguay, Venezuela 297.5 3,333.8 16,742
Pacific alliance
Chile, Colombia, Mexico, Peru 222.3 2,137.3 16,079
Other countries
Dominican Republic 9.8 64.0 14,014
Ecuador 16.0 100.9 11,324
Panama 3.9 49.2 20,779
Total 591.0 5,850.1 15,680
growth (2 of 3)
• Countries vary in population, from less than 4 million
(Panama and Uruguay) to more than 200 million
(Brazil).
• Countries vary in income, from under $5,000 in

Honduras and Nicaragua (PPP, U.S. dollars) to over
$20,000 in Argentina, Chile, Uruguay, and Panama.
• Four countries are more than 70 percent of population

and almost 80 percent of GDP:
– Brazil, Mexico, Colombia, and Argentina.
growth (3 of 3)
• Latin America was one of the world’s fastest
growing regions from 1900 to 1960.
• Growth slowed in the 1970s and in the 1980s, the

Latin American debt crisis (1982-1989) led to the
Lost Decade.
▪ Debt crises plus recessions, banking crises, currency crises,
hyperinflation, and balance of payments crises.
• The 1980s and 1990s began a period of economic

reform which continues in various ways today.
Import substitution industrialization
(1 of 8)
• Import substitution industrialization (ISI) is an
economic strategy emphasizing industrial
development.
– The emphasis is on production of goods that
substitute for imports.
– ISI is a core policy of state-led development strategies
implemented throughout Latin America from the
1930s forward.
• ISI was dismantled during the reforms that

followed the debt crisis of the 1980s.
Import substitution industrialization:
Origins (2 of 8)
• Most countries of Latin America relied on
commodity exports in the late 19th and 20th
centuries.
▪ Coffee, silver, tin, copper, bananas, sugar, cotton, oil, wheat,
rubber, etc.
▪ World War I and the Great Depression interrupted trade
patterns; World War II temporarily increased demand for
their minerals and foodstuffs.
• After World War II, demand for many Latin

American commodities fell.
Origins (3 of 8)
• ISI assumes that commodity prices have an inevitable tendency to
decline relative to manufactured goods prices due to the falling
share of income spent on food and raw materials as income grows.
– Ignores the effect of rising manufacturing productivity on prices of
manufactured goods.
• If correct, the terms of trade (TOT) for Latin America will fall over
the long run.
– TOT = (export prices) ÷ (Import prices).
– Referred to as export pessimism.
• The theory implies that Latin America should move away from
commodity exports towards manufactured goods.
Origins (4 of 8)
• The creators of ISI were two economists, Raul Prebisch and
Hans Singer.
• Prebisch became the first director of the Economic

Commission on Latin America (ECLA or CEPAL in Spanish), the
first regional economic commission created by the United
Nations.
– Prebisch was very influential from this position in guiding
development strategies in Latin America and other parts of the world.
• Ironically, industrial development needed imports of

machinery;
– Most countries continued to rely on commodity exports in order to
earn the revenue to buy imports.
Strategy (5 of 8)
• ISI tried to conserve foreign exchange for purchase of
needed machinery and parts.
– Hence the goal was to produce goods that are imported and use
foreign exchange, but that can be made at home.
• Industrial efforts should begin simple and grow more

sophisticated over time:
– Begin with simple consumer goods: apparel, furniture, bottling
and canning, etc.
– Move on to more complex consumer goods (autos and
appliances) and some industrial goods (pumps, generators,
metals);
– Finally, move into complex industrial goods (chemicals,
electronic equipment, machine tools, etc.).
Tools (6 of 8)
• The tools for implementing ISI are the same as
those for industrial policies:
– Government subsidies, tax breaks, loans, etc.,
including nationalization in some cases.
– Trade protection;
– Monopolies;
– Exchange rate policies.
Criticisms (7 of 8)
• Governments misallocated resources;
– Undoubtedly the case, but at the same time, overall growth rates and
rates of industrialization were very good.
– Critics argue that governments were not adept at identifying market
failures where interventions might help, but responded to political
pressures from special interests.
• There was a persistent tendency towards over-valued exchange

rates.
– This was a deliberate policy in many cases to keep imported capital
goods cheaper in domestic currency terms and to conserve foreign
exchange;
– It also helped keep urban workers on the side of the government;
– But it hurt agriculture, exporters, and probably increased inequality
between urban and rural areas.
Criticisms (8 of 8)
• Protectionism generated several inefficiencies;
– Increased monopoly power in many protected
industries;
– Reduced innovation and hurt the development of
manufactured exports;
• ISI increased rent seeking:

– Favored industries could profit from government
supports and protection, so they put resources into
obtaining those benefits.
Case study: ISI in Mexico (1 of 3)
• The Mexican constitution of 1917 establishes the
responsibility of the government to promote economic
growth and to referee social conflicts.
– This gave the government an argument that it needed to be powerful
or else it would be dominated by special interests.
– Economic policy was to promote growth but also to increase the
government’s power.
• The government adopted many of the tools of ISI

without labeling it ISI.
– Numerous nationalizations of industries.
– Loans and loan guarantees;
– Access to foreign exchange on favorable terms;
– Trade protectionism.
• Economic growth was very good until the 1970s:
– 3.1 percent per year for real GDP per person, 1950-1973.
– U.S. grew 2.2 percent; largest Latin American countries
grew 2.5 percent.
– Manufacturing output rose significantly.
• Mexico’s ISI was successful partly due to its ability to

attain economies of scale.
– Brazil had similar benefits.
• But poverty and inequality were not reduced and

growth began to slow in the 1970s.
• Other problems:
– Focus on the internal market caused firms to locate in
or near Mexico City, turning it into one of the world’s
largest cities;
– The export sector remained weak and undeveloped;
▪ This was a very large problem when the debt crisis hit in the
1980s.
• The debt crisis of the 1980s was not due to ISI;
– External shocks, macroeconomic management were
larger factors.
Economic populism (1 of 2)
• Populism is a form of economic nationalism;
– Often used by governments in Latin America to garner support
from urban workers and domestic businesses and to isolate
rural elites and foreign interests.
– Frequently has a strong interest in income growth and
redistribution.
• With the slowdown in world economic growth that began

in the 1970s, a new form of populism emerged in Latin
America:
– Less concerned about macroeconomic imbalances;
– More aggressive in spending to promote growth and
redistribution.
Economic populism (2 of 2)
• The cycle of economic populism has four stages:
– Initial conditions of low growth or recession, cause a rejection of
traditional policies, calls for “reactivating, redistributing,
restructuring.”
– In the second stage, dramatic increases in government expenditures
lead to rapid growth and a vindication of the policies.
– In the third stage, bottlenecks appear, inflation begins to take off,
budget become unsustainable.
– Finally, growth collapses as capital leaves on fears of devaluation, real
wages fall, IMF intervention becomes necessary.
• In the end, real wages may be lower than at the start, growth is
negative, inflation is high, and trade deficits require adjustment.
Case study: Economic populism in
Peru, 1985-1990 (1 of 2)
• Peru suffered a serious recession in 1983, leading to deep
dissatisfaction. In 1985, newly elected President Alan García
promised to promote growth and redistribute income.
– In 1986 and 1987, economy responded favorably to his economic
stimulus;
– Inflation began to pick up in 1987 due to bottlenecks;
– Higher inflation led to real appreciation of the exchange rate and a
large and growing current account deficit.
• As problems developed, García nationalized financial services to

stop outflow of capital, increased subsidies to other businesses,
imposed price freezes.
– By 1988 a serious recession was underway, reached its deepest point
in 1990.
– Real wages were lower than when García took office.
Case study: Economic populism in
Peru, 1985-1990 (2 of 2)
GDP Real wage Deficit/GDP Inflation Current account
growth (% change) (%) (Millions US$)
1984 4.8 -8.0 6.7 110 -221
1985 2.3 -8.4 3.4 163 -137
1986 9.2 26.6 5.7 78 -1077
1987 8.5 6.1 7.9 86 -1481
1988 -8.3 -23.1 8.1 667 -1091
1989 -11.7 -46.7 8.5 3339 396
1990 -5.1 -14.4 5.9 7482 -766
The debt crisis of the 1980s:
Proximate causes (1 of 5)
• The Latin American debt crisis began in August,
1982, when Mexico announced it lacked the
foreign reserves it needed to pay the interest and
principle on its foreign debt.
• From Mexico it spread to other countries with

similar circumstances.
• Over the next 2 years, nearly all of Latin America

defaulted.
Net Interest
Gross External Debt Net External Debt as Payments as a
Country (Millions of US$) a Percentage of GDP Percentage of Exports
Argentina 43,634 75.3 62.8
Bolivia 3,328 141.9 38.5
Brazil 92,961 48.3 38.7
Chile 17,315 87.6 32.9
Colombia 10,306 25.1 18.8
Costa Rica 3,646 137.8 45.4
Mexico 86,081 63.8 32.1
Peru 10,712 52.4 20.1
Venezuela 32,158 38.8 9.6
• Several shocks hit Latin America in the early 1980s.
– Oil producers suffered a collapse in oil prices in 1981.
– Other factors were also important:
▪ All countries were hit by interest rate increases on variable rate loans;
▪ Much of the debt was denominated in dollars;
▪ The world’s industrial economies were in recession in 1981-1982.
• The shocks came after nearly a decade (1974-1982) of

increased international lending.
– Debt levels were relatively high in Latin America and other parts
of the world.
– This was the recycling of so-called “petro-dollars,” the abnormal
profits of oil exporters that were deposited in industrial country
banks.
Responses (4 of 5)
• Initial assumption was that the crisis was a liquidity
problem: with increased lending, growth would resume.
– In 1985, the U.S. proposes the Baker Plan to restore lending,
but no banks are interested.
• Severe current account deficits, partly due to interest

payments on debt, led to expenditure switching and
expenditure reducing policies.
– Deep recessions resulted.
– Governments made up loss revenue by printing money, which
increased inflation.
– Devaluations were often inadequate to compensate for high
inflation, so that real appreciation occurred and exacerbated the
current account deficits.
Responses (5 of 5)
• By the late 1980s, debt relief was considered.
– In 1989, the Brady Plan offered debt relief to countries that:
▪ Began to control inflation and reduce budget deficits;
▪ Made significant economic reforms, including dismantling government
controls and interventions.
– The plan gave some minor debt relief but was more effective as a “seal
of approval” by the international community.
▪ Debt relief was in the form of new loans, reduced interest rates on old
debt, some options to write-off old debt.
▪ International capital flows to Latin America began to return in 1989 and
thereafter.
• The biggest impact of the debt crisis was Latin America’s shift away
from state-led development and ISI to more open and market
oriented policies.
Neoliberal policy reforms (1 of 7)
• Neoliberalism is a set of policies that favor markets over
governments, oppose state-led development and ISI, and
disparage most government interventions into the
economy.
• In Latin America, there were three main elements:

– Stabilization policies to control inflation and budget deficits;
– Privatization of state owned enterprises;
– More open trade polices with less protection.
• These policies are also known as the Washington

Consensus on policy reform.
Neoliberal policy reforms:
Stabilization (2 of 7)
• Many countries experienced hyperinflation due to excess money creation.
– Inadequate tax revenues during the recessions, plus lack of government
borrowing ability, left money creation as a main way to finance government
expenditures.
• An orthodox model held that inflation could be stopped with cuts in

money creation and budget cuts.
– But this was difficult for political reasons: A fall in inflation would
disproportionately harm wage earners; budget cuts hurt social services and
supports.
• A heterodox model held that inflation was caused by inertia, not money
creation.
– Inflationary expectations will cause inflation even if no new money is added to
the system.
Inflation Average 1982–1987 Average 1987–1992 Highest 1982–1992
(% per year) (Year)
Argentina 316 447 4924 (1989)
Bolivia 776 16 8170 (1985)
Brazil 158 851 1862 (1989)
Chile 21 19 27 (1990)
Colombia 21 27 32 (1990)
Mexico 73 48 159 (1987)
Peru 103 733 7650 (1990)
Venezuela 10 40 81 (1989)
• One of the primary problems was an inconsistency
between inflation stabilization and exchange rate policies.
– Countries pegged their rates to the dollar (usually) and made
small, frequent devaluations to prevent real appreciation.
– The intention was to let the domestic currency become slightly
overvalued, foreign goods slightly cheaper, and to use that as a
brake on price increases.
– Often, the domestic currencies became strongly overvalued,
current account deficits ballooned, and a radical devaluation
was forced on the country.
• This inconsistency led to frequent shocks due to sudden

large devaluations.
Structural reform and trade (5 of 7)
• Structural reform policies focus on microeconomic reforms
that attempt to make economies operate more efficiently.
– Privatization, deregulation, trade reforms.
– Structural reforms are a key component of the Washington
Consensus.
• By the mid-1980s, several countries were shifting away

from ISI and towards more open markets.
– Many quotas were converted to tariffs;
– Tariffs were reduced;
– Trade agreements were signed with many other nations, inside
and outside Latin America.
Average tariff 1985 1992 2010
rates, in percent
Argentina 28 14 11
Brazil 80 23 13
Chile 36 11 5
Colombia 83 12 11
Mexico 34 14 7
Peru 64 18 5
Venezuela 30 17 13
• The goals of trade reforms:
– Reduce the anti-export bias.
▪ ISI favored import-substitute production; this made it more
profitable and drew labor and capital away from export
production.
– Raise productivity.
▪ Via the introduction of new products, new methods, and
competition.
– Make consumers better off by reducing the costs of
imported goods.
• Exports increased, particularly non-traditional exports,

and productivity increased in many countries.
Case study: regional trade blocs in
Latin America (1 of 2)
• Latin American economies have experienced two
waves of trade bloc creation.
– The first was in the 1960s and was in response to ISI:
Countries wanted to capture economies of scale.
– The second began in the 1990s and was in response to
the structural reforms and market opening.
• Many of the first round blocs were re-organized

during the second round.
Case study: regional trade blocs in
Latin America (2 of 2)
Year Members Goals
Andean Community of 1969 Bolivia, Colombia, Ecuador, Peru Customs
Nations union
Caribbean Community 1973 Antigua and Barbuda, the Bahamas, Barbados, Customs
(CARICOM) Belize, Dominica, Grenada, Guyana, Haiti, union
Jamaica, Montserrat, St. Kitts and Nevis, Saint
Lucia, St. Vincent and the Grenadines, Suriname,
Trinidad and Tobago
Central American Common 1961 Costa Rica, El Salvador, Guatemala, Honduras, Customs
Market (CACM) Nicaragua union
Dominican Republic-Central 2005 Costa Rica, Dominican Republic, El Salvador, FTA
America Free Trade Guatemala, Honduras, Nicaragua, United States
Agreement (DR-CAFTA)
Common Market of the 1991 Argentina, Bolivia, Brazil, Paraguay, Uruguay, Customs
South (MERCOSUR) Venezuela union
North American Free Trade 1994 Canada, Mexico, United States FTA
Area (NAFTA)
Pacific Alliance 2011 Chile, Colombia, Mexico, Peru FTA
The next generation of reforms (1 of
2)
• Satisfaction with the neoliberal reforms and the Washington
Consensus is very low.
– Inadequate economic growth rates, high levels of inequality,
vulnerability to economic shocks are still very real problems.
• Two trends have emerged:

– A shift back towards state-led development in countries such as Brazil,
Venezuela, Ecuador, Bolivia, Nicaragua.
– A continuation of neoliberal policies in Pacific Alliance countries.
• Some countries in both groups have begun to look at new

approaches.
– More focus on institutions;
– Greater attention to policies that are more inclusionary.
The next generation of reforms (2 of
2)
• Inclusionary policies include various institutional and social
elements:
– Formalization of land titles for squatters;
– Reducing the bureaucratic obstacles to formally registering
businesses;
– Reform of bankruptcy laws to encourage more risk taking;
– Breaking up of monopolies.
• One type of policy has shown significant impacts:

conditional cash transfers.
– Small monthly cash transfers to poor families that (1) send their
kids to school and (2) receive regular health check-ups and
vaccinations.
Case study: The Chilean model (1 of 2)
• Chile was a leader in economic reforms.
– The reforms, however, are identified in time with a brutal dictatorship
and were partially discredited because of that.
– The reforms failed initially, but later succeeded.
– Subsequent democratically elected governments kept many elements
but amended them with policies that were more inclusionary.
• Augusto Pinochet came to power in 1973 after a bloody coup

that overthrew democratically elected Salvador Allende.
– He eventually appointed Chilean economists who were trained at the
University of Chicago.
– They quickly ended ISI and privatized many parts of the economy.
Case study: The Chilean model (2 of 2)
• In 1982, the economy crashed. When grow resumed in 1984,
economic policy was much more pragmatic, less ideological.
• Governments after the restoration of democracy in 1990

continued to follow policies of open trade and private
markets, but they added policies focused on social justice.
– Expanded health care, retirement accounts for workers earning too
little to save, expanded educational access.
• They also invested heavily in infrastructure.
• In the end, poverty fell, income grew, and Chile became the
leader in Latin American economic prosperity.
The End

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International Economics

15.2 Explain the strategy and performance of

15.3 Give the main reasons for the debt crisis of

15.5 Explain why some Latin American leaders

• Some common themes:

Costa Rica, El Salvador, Guatemala, Honduras, 41.5 164.9 7,512

Argentina, Bolivia, Brazil, Paraguay, Uruguay, Venezuela 297.5 3,333.8 16,742

Chile, Colombia, Mexico, Peru 222.3 2,137.3 16,079

Dominican Republic 9.8 64.0 14,014

Ecuador 16.0 100.9 11,324

Panama 3.9 49.2 20,779

Total 591.0 5,850.1 15,680

• Countries vary in income, from under $5,000 in

• Four countries are more than 70 percent of population

• Growth slowed in the 1970s and in the 1980s, the

• The 1980s and 1990s began a period of economic

• ISI was dismantled during the reforms that

• After World War II, demand for many Latin

• Prebisch became the first director of the Economic

• Ironically, industrial development needed imports of

• Industrial efforts should begin simple and grow more

• There was a persistent tendency towards over-valued exchange

• ISI increased rent seeking:

• The government adopted many of the tools of ISI

• Mexico’s ISI was successful partly due to its ability to

• But poverty and inequality were not reduced and

• With the slowdown in world economic growth that began

• As problems developed, García nationalized financial services to

• From Mexico it spread to other countries with

• Over the next 2 years, nearly all of Latin America

• The shocks came after nearly a decade (1974-1982) of

• Severe current account deficits, partly due to interest

• In Latin America, there were three main elements:

• These policies are also known as the Washington

• An orthodox model held that inflation could be stopped with cuts in

• This inconsistency led to frequent shocks due to sudden

• By the mid-1980s, several countries were shifting away

• Exports increased, particularly non-traditional exports,

• Many of the first round blocs were re-organized

• Two trends have emerged:

• Some countries in both groups have begun to look at new

• One type of policy has shown significant impacts:

• Augusto Pinochet came to power in 1973 after a bloody coup

• Governments after the restoration of democracy in 1990

• They also invested heavily in infrastructure.

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