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What is the most important determinant for long-term macroeconomic performance in small and open economies such as most in Latin America and the Caribbean (LAC)? Is it macroeconomic policy, fiscal or monetary, which can have a pro-cyclical or counter-cyclical behavior? Or is it the international context, which can be favorable or unfavorable?
What the figures suggest, for the period 1980-2012, is that the most important determinant of the level of economic activity and inflation in LAC has been the international context. This contributes decisively to determine if the level of economic activity rises or falls and if inflation remains high or low.
As the external environment is essentially exogenous for LAC countries, their destinies have been tied (and probably will be in the future) to good or bad luck (internationally).
How does the world affect us?
Small and open economies, like most of LAC economies, are exposed to exogenous changes in international conditions. The basic transmission channels that connect these economies with the rest of the world are the level of global economic activity, which affects the price and volume of exports, and the inflow or outflow of financial capitals, which affects the cost and availability of domestic financing. Analytically, as in the majority of the economic literature, we are considering capital inflows to the region as exogenous events.
In LAC, over 50 percent of exports come from the primary sector of the economy. The supply of these products is fairly inelastic, at least in the short term, so that changes in the level of global economic activity affect mainly prices and not volumes.
When we are in a context of global economic growth, terms of trade rise, mainly through higher prices of our exports of raw materials. This rise of the price in raw materials has three major effects. First, it increases the value of exports, which activates the economy, generating more income for the country and a fall in the exchange rate. Then, it increases the government revenue, associated with higher profits in the mining industry. This allows a higher public expenditure, contributing to the reactivation of the economy. Finally, the rise in international prices also attracts foreign direct investment.
In the same way, a capital inflow to the region, usually because interest rates in the United States are low, has two effects. First, money goes into the financial system, expanding the lending capacity of banks, raising the number of bank credits, and reactivates the economy. Second, capital inflows make the exchange rate to fall, which has a powerful anti-inflationary effect in small open economies.
In short, good luck, which is a good international context characterized by higher export prices and a strong inflow of financial capital, contributes decisively in raising the level of economic activity and in lowering the inflation. And bad luck, a bad international context with lower export prices and capital outflows produce recession and inflation.
Let's see if these hypotheses have a correspondence with the macroeconomic figures. Consider the effect of good luck and bad luck in our region.
Latin America and the Caribbean 1980-2012: “good luck” and “bad luck” effect.
In the eighties, in general, LAC had bad luck. Terms of trade fell by about 20 percent and there was a net capital outflow from the region. High interest rates from the northern hemisphere also contributed to the debt crisis. As a result, GDP per capita declined in this decade and inflation reached hyperinflation levels. It was a “lost decade” for Latin America.
In the nineties, luck improved. Terms of trade stopped falling, the interest rate in the United States fell, and there was a significant inflow of capital to the region. GDP per capita had a significant recovery and inflation rapidly declined.
Finally, in the last 12 years we had very good luck. It was like winning the lottery twice in a row. Despite the international crisis of 2008-2009 and its aftermath, the international context for our region was extraordinarily good. Terms of trade rose by about 20 percent and never before in the history of the region we have had this level of capital inflow. The result is that in the last 12 years LAC had the highest per capita GDP recovery and the lowest inflation of past decades.
It seems that our macroeconomic destiny depends crucially on good or bad luck. So what is the importance of the local macroeconomic policy? Let’s not underestimate it.
When there is bad luck, namely when the external environment is very bad as in the eighties for LAC, there are countries like Colombia and Chile that do not suffer from great loses, if any, like the rest of the region, thanks to sound macroeconomic policies. Likewise, when luck is good, as in the last 10 years, some countries such as Peru grow much more than the rest and maintain low inflation rates due to, again, sound macroeconomic policies.
Yet our central conclusion remains. In LAC, if luck is bad, it is very difficult to grow and maintain low inflation. If luck is good, is easy to grow and keep inflation low.
1. Head of the Department of Economics at the Pontifical Catholic University of Peru (PUCP in Spanish). This article is based on the document from Waldo Mendoza (2012), Contexto internacional y desempeño macroeconómico en América Latina y el Perú: 1980-2012, Documento de Trabajo N° 351, Departamento de Economía de la PUCP, Lima.