It is a commonplace by now that having achieved macroeconomic stability Latin America needs to implement structural reforms in order to boost its growth rate. Higher growth is necessary to raise per capita income levels (which in many LatAm countries have stagnated over the past couple of decades) and to address the significant levels of social inequality. If governments fail to make their societies more equal, the political sustainability of the current emerging (but in some countries fragile) consensus in favour of stability-oriented macroeconomic policies will be at risk. It is important to remember just how precarious this consensus continues to be in some parts of Latin America. Higher and more equitable growth is a social and a political necessity.
Latin America’s economic growth performance has been very disappointing. Per capita incomes in the larger economies have stagnated during the past couple of decades. Economists attribute this to macroeconomic instability, microeconomic distortions and insufficient investment amongst other things. A recent IMF analysis titled “Sustaining Latin America’s Resurgence” bears this out, showing that in 1990-2003 labour productivity has risen 3-6 times faster in industrial countries and East Asia (excl. China) than in Latin America. Latin America has lagged in terms of total factor productivity growth. But the most important factor behind low labour productivity growth has been a lower level of investment, including in physical infrastructure and education. The World Bank estimates that the region has spent a mere 2% of GDP on infrastructure, while 55% of surveyed businessmen identify infrastructure constraints as a serious problem. The World Bank also reckons that the LatAm region would need to double or even triple its capital stock in order to reach Emerging Asia growth levels.
Brazil’s federal investment budget has averaged way less than 1% of GDP over the past few years, barely enough to keep the public capital stock at current levels. The larger Latin America economies typically invest slightly less than 20% of GDP. Emerging Asia invests around 25-30% of GDP. China invests an incredible 40% of GDP. No wonder China grows 10% a year and Latin America grows 3-4% a year.
Economists have compiled a long laundry list of reforms deemed necessary to lift the region’s growth potential. On the macro front, countries are supposed to maintain low inflation, limit fiscal deficits and reduce the external and public debt burden. Latin America has made huge progress in this respect in recent years. On the micro front, governments are supposed to reform cumbersome judiciaries, restrictive labour regulation, protected economic sectors, oligopolistic financial systems, unpredictable regulatory frameworks, distortionary fiscal policies and onerous social security regimes. No doubt, microeconomic distortions weigh heavily on the region’s economic growth potential. For example, it takes more than 70 days to open a business in Latin America compared with 46 days in Asia and 32 days in Europe & Central Asia. Enforcing a contract takes 660 days in Latin America against 477 days in Asia (World Bank “Doing Business” survey).
So what should Latin American countries do? Implementing optimal growth-enhancing reforms requires governments to make two types of assessment. It requires the authorities to identify what Ricardo Hausmann of Harvard University has called the “binding constraint(s) on growth”, the constraints that generate the highest pay-off when relaxed. It also requires an assessment of the political costs the government will incur due to the reforms. Governments do not have unlimited political capital when it comes to implementing reforms and they therefore need to set priorities. The economic reform with the highest growth pay-off may be politically impossible to implement. The political and economic circumstances will differ from country to country and a “one size fits all” approach does not exist. The growth-maximising reform agenda will therefore vary across countries. It is difficult to generalize then, but there is a case to be made in favour of tackling low growth, at least initially, through politically less cumbersome fiscal instead of microeconomic reforms.
Microeconomic reforms (so-called “second-generation reforms”) are meant to lift economic growth by increasing the quantity and quality of human and physical capital and lift the efficiency with which labour and capital are employed. The problem with microeconomic reform has been that they are cumbersome and politically difficult to implement, especially in Latin America where congresses are often fragmented and presidents, reform-minded or not, have limited control over the legislative process. In a sense the increased level of macroeconomic stability is not helping either, as it reduces the urgency to pass reforms. Microeconomic reforms are therefore bound to advance only very gradually, if at all. Often there is also a considerable time lag between the time when a reform proposal gets underway and when its benefits in terms of higher growth start to materialize. Once a reform is passed, it needs to b implemented administratively and then economic agents need to familiarize themselves with the new rules and gain confidence in their proper working and application. Microeconomic reform is absolutely necessary, but politically and economically it may be not the best way to kick-start economic growth.
Perhaps the most direct and fastest way to lift the economic growth rate in a sustainable way is to lift the levels of investment through fiscal policy. Latin American governments have often a greater degree of control over fiscal policy than over microeconomic reforms, thanks to fiscal responsibility laws and other legal provisions. Of course, the degree of political control varies substantially across countries and improving the structure of government revenues and spending will in many cases require “extra-budgetary” reforms (e.g. social security). But in these cases and in cases where radical fiscal reform is even more difficult than microeconomic reform due to restrictive constitutional provisions, like Brazil, governments often do have some degree of (short-term) flexibility. As a way to kick-start higher economic growth therefore, it may make sense to tackle the low growth problem by way of boosting investment levels through fiscal policy rather than politically more difficult micro-economic reforms outside budget policy. Clearly fiscal policy changes will very often be gradual. But if the government manages to credibly commit itself to a multi-year adjustment, the impact will be significant. In practice, this may involve governments saving more and opening space for private sector investment through lower taxes or greater tax incentives for private sector investment. It may also involve a shift from current expenditure to public investment spending.
Higher levels of investment especially in infrastructure and education are essential to lift the region’s growth potential. Limiting current spending in a situation where many countries have massive needs in terms of social and health spending is difficult. But bloated government wage bills and in some cases over-generous pension systems benefiting the middle class to the detriment of poorer social groups offer space for a re-allocation within current spending. Governments will be forced to challenge politically powerful groups and expend valuable political capital. But the “Bolsa FamÃlia” programme in Brazil shows how a government can buy political support at relatively limited fiscal costs. There are no easy economic and politically low-risk solutions. But if successful, the investment-enhancing fiscal reforms will generate higher economic growth and allow the government to use higher revenues to compensate the political and social groups opposing microeconomic reforms. Looking at the region’s track record of fiscal and microeconomic policy reform, this is all a bit of a long shot. But many countries in the region have managed to achieve a fair degree of macroeconomic stability over the past decade – and there really is no alternative. Latin America needs to increase its rate of economic growth and it needs to reduce social inequality. Tackling the low-growth problem through more investment-oriented fiscal policy, if possible flanked by politically achievable microeconomic reforms, is the economically and politically most promising strategy to kick-start higher economic growth and avert the populist challenge facing Latin America.