Rethinking Reforms: How LAC Might Counter a Potential Great Suppression

Economic Policy
Macroeconomics - Economic growth - Monetary Policy

As advanced countries come to terms with fiscal challenges and policy uncertainties, world growth is likely to be suppressed below potential for several years to come. The IMF’s January 2013 World Economic Outlook has the world growing at about 4.2% for the next five years (2013-17) against 4.8% during the Great Moderation (2003-07).1 Bumps on the road to strengthening the fiscal and banking union in Europe or heightened fiscal policy uncertainty in the US could put even that subdued growth rate at risk, and advanced economies have little fiscal and monetary policy space to respond. The world may then be at the doorstep of a Great Suppression.2

But Latin America and the Caribbean can escape this somber global outlook and boost growth by adopting appropriate structural reforms. That is the theme of the recently published 2013 Latin American and Caribbean Macroeconomic Report.3  Rethinking Reforms argues that if countries across the region embrace reforms that are tailor-made to their particular institutions and situation, but are implemented across the region then spillovers will give an additional considerable boost to growth.

LAC is likely to grow just 3.9% annually over the next five years, nearly one percentage point lower than the 4.8% registered before the 2008/9 Great Recession.4 Slower growth in world trade and a decline in commodity prices are expected to dampen consumption and investment in Latin America and the Caribbean (LAC). Moreover, fiscal space has shrunk in the last year, and the room for both fiscal and monetary policy is lower now than compared to the pre-crisis period, as spending has continued apace even as growth has risen to close to potential given the state of the world economy. There is a danger that the counter-cyclical policies used so successfully to counter the global recession will be seen as simply expansionary rather than truly cyclical. Figure 1 plots primary spending and the structural balance for the typical country in the region. It is not a question today of using fiscal and monetary policies to counter a negative shock and bring growth in the region up to its potential, the region needs to find measures to increase its growth potential.

Primary spending in Latin America

Even in those economies where there is room for counter-cyclical fiscal policy, governments may be advised to refrain. Fiscal space should be conserved to react to any negative shock to the baseline, as growth may be subdued for a while. Moreover, currencies have appreciated strongly. Appreciations have likely been fuelled by high commodity prices and strong capital inflows attracted by investment opportunities and partly induced by the expansionary monetary policies and Quantitative Easing (QE) policies of Central Banks in advanced economies. Whatever the causes, countries should consider the right policy mix to respond. The optimal is likely a tighter fiscal policy, which then allows for a looser monetary policy to lean against appreciation pressures, assuming that inflationary pressures can be kept under control.5

Additional measures are then needed to boost growth; it is time to reignite the region’s reform agenda. However, at the same time the region should learn the lessons from the reforms of the 1990’s. They had what might at best be described as “mixed success” in part due to reforms not being adequately tailored to countries’ institutions and political realities.6  This led to reforms that were not implemented fully or with inappropriate sequencing that even made countries more vulnerable to financial crises. Post the 1990’s there has been greater success in strengthening financial systems that has brought greater resilience; very few countries suffered a financial crisis in recent years despite the global financial meltdown. But reforms in other areas have lagged in the last decade. 

Moreover, the Latin America and Caribbean region has the economic resources to grow much faster, but there is a need to allocate those resources more effectively. In a detailed analysis building on the work done in IDB (2010), if the region could increase the efficiency of how it deploys its economic resources to the efficiency of that of the U.S. economy over a ten year period, then productivity would be 20% higher and growth would be increased by at least a full 1% per year over that decade for the typical country.

There are many areas in which countries could focus reforms to improve economic efficiency. A first step is a comprehensive country by country diagnostic to attempt to identify the areas with the greatest payoffs and what may be the most severe barriers to growth. Considering the region as a whole, tax reform and education are obvious candidate areas where reforms might enhance growth and development more widely.7  But in Rethinking Reforms the focus is on two other areas where the region has clearly lagged: labor market reforms, and investment in infrastructure.

In those countries where informality rates are high, labor markets are dysfunctional and resource allocation may be severely distorted. LAC is the world region with the highest rate of worker informality, with an estimated 56% of the employed working informally.8  Measures to combat informality and encourage companies to become formally registered could lead to the establishment of larger, more efficient firms, with lower employee turnover, better worker training, enhanced access to credit and a reduction in illegal practices. The resulting increases in productivity could have a large payoff in the form of greater economic growth.

Second, the LAC region puts just 2.5% of GDP into infrastructure investment. Estimates of the gap for the region call for at least double this amount: boosting infrastructure investment could have a significant growth impact. But higher investment requires both higher, long-term savings in domestic currency and a regulatory framework to attract the private sector. Current levels of savings in LAC are stuck at close to 18% of GDP while those in Emerging Asia are roughly double that figure. LAC has relied more on foreign savings. But the required current account deficit to finance the “savings gap” has been sustained by very few countries in the region for more than a few years. Countries should promote savings in domestic currency by pursuing pension, social security and tax reforms. At the same time countries should work on improving regulations and institutions to attract greater investments. Public-Private Partnerships (PPPs) may be one route forward but enhancements can be made whether the investments are public, private or a mixture of the two.

Latin American Economic Growth Expectations

The estimates stemming from a Global Vector Auto-Regression model based on data from 14 countries in LAC and the main world regions indicate that there are significant spillovers across the region.9 Given the nature of the trade links and other connections, a truly regional effort is required, and the spillovers from reforms in just the two largest economies (Brazil and Mexico) are relatively modest. But if a typical country could achieve an increase in annual growth of about 1.5% through its own reforms (one standard deviation of unexplained growth fluctuations in the G-VAR), then a concerted region-wide effort across all countries could bump that increase to 2.3%, lifting the projected growth in the region to more than 6%, somewhat higher than projected growth rates for the countries in South East Asia (Figure 2).10  Moreover, given the risks to the outlook for world growth, such a tailor-made reform agenda implemented across the region would be very valuable to counter the possibility of a global Great Suppression.

1. See IMF (2013).

2. The IMF has tended to define a global recession as less than 3% growth given population growth at about that level, but rather than a short sharp shock the idea of a Great Suppression is subdued growth for the medium term.

3. See IDB (2013a) available at,3169.html?pub_id=IDB-MG-145

4. Again see IMF (2013), these projections are also consistent with consensus forecasts.

5. In background work Mariscal, Powell and Tavella (forthcoming) find that LAC inflation targeting regimes have gained credibility in that inflation expectations are now more anchored than before although if inflation rates exceed upper target levels then they may become de-anchored.

6. See Lora (2000), (2001), (2012), Lora and Panizza (2002), and Lora, Panizza, and Quispe-Agnoli

7. On tax reform see IDB (2013b) and on education see Bassi et al. (2012) and Cabrol and Székely (2012).

8. See Levy and Shady (2013).

9. The model is based on that in Cesa-Bianchi et al (2012) and was employed in the 2012 Latin American and Caribbean Macroeconomic Report. One innovation here is an extension to include separately fourteen LAC countries.

10. The ASEAN-5 group is comprised of Indonesia, Malaysia, Philippines, Thailand, and Vietnam.
International Monetary Fund (2013) projects their growth at 5.5 percent for 2013 and 5.7 percent for 2014.


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Economist, Inter-American Development Bank, Washington, DC. Forthcoming


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