Why Latin American nations fail

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from Matias Vernengo and Esteban Pérez Caldentey
and WEA Commentaries

[Editor’s note: Here the authors summarise the main themes of their recently published book, Why Latin American Nations Fail(Matias Vernengo and Esteban Pérez Caldentey, 2017, University of California Press)]

Institutions are central to explaining the way in which, nations grow and develop. Traditionally the study of institutional economics focused on a very broad range of interests and made contributions in several different areas, including the structure of power relations, the beliefs systems, and also social norms of conduct. Contrarily the New Institutionalist turn in mainstream economics places the weight of its explanation on property rights.

Within the logical construct of neoclassical economic theory, the contribution of the New Institutional Economics is a necessity, basically because exchange and production in a market economy requires the prior definition of property rights (endowments and their distribution are part of the data jointly with technology and preferences that are needed to establish a market equilibrium). Because neoclassical theory is a-historical, the same framework derived from a priori reasoning must have universal validity and be applicable to any particular historical episode underscoring, in this way, the invariance of human behavior in space and over time. This dictates the New Institutionalist Economics´ approach to history which materializes in providing examples of hand-picked empirical evidence across different centuries, regions and countries and interpreting these as coherent with the deductive universal framework of neoclassical theory. 

Acemoglu and Robinson’s influential book Why Nations Fail (2012) constitutes one of the most comprehensive and illustrative examples of this line of thought. Its authors argue that the economic failure or success of countries depends on whether these have inclusive or extractive political institutions. Inclusive political institutions are those that distribute power broadly, constrain arbitrary exercise, and make it harder to usurp power or set the basis for rent-seeking behavior. Inclusive political institutions require well defined and secure property rights. Extractive institutions have the opposite characteristics.

Why Latin American Nations Fail is in part a response to this New Institutionalist turn in mainstream economics focusing on the case of Latin America.

Since the 1980´s up to the present day, for over three decades, Latin America as a whole has registered mediocre growth trend levels. The average rate of per capita GDP growth for the period 1980-2014 is 2%. This performance responds not only to the medium and long-run effects of successive crisis episodes within the region starting with the Mexican Tequila in late 1994 and culminating with the Argentinean default in early 2002, which many times were the product of unsustainable balance of payments difficulties, but also to expansions that, by comparison with other developing economies, are short-lived and less intense.

The most recent period of expansion (2003-2008) did not change the growth trend, in spite of improved international conditions including higher commodity prices and external demand and low international interest rates. Currently the region faces more stringent external conditions.

There has been a slowdown in external demand of developed economies and also of China, which had become a major trade partner for some of the economies in the region, coupled with a significant decline in commodity prices. These have affected those economies whose production structure and exports are resource based. Moreover, the decline in commodity prices has important balance sheet effects, as the liabilities of commodity producers and companies tend to increase while the value of assets tends to decline. As leverage rises and becomes one of the main sources of finance and profits, balance sheets become more fragile. Public and private debt associated with lower commodity prices may become an important issue in the near economic future for Latin America and an important obstacle to growth, in particular for countries with limited access to international capital markets and with a negative current account position.

Further, the fact that commodities have taken on the characteristics of financial assets and the fact that growth strategies are based on a financial asset increases the possibility of instability and uncertainty in the commodities market, a side effect of the process of financialization which was at the center of the Global Financial Crisis. For its part a strategy based on private debt, as is the case of some countries in Central American case, can rapidly lead to deleveraging and credit contraction. In addition, relying on remittances (i.e., the export of labor) can over time become an obstacle to growth. After all, exchanging a productive factor (labor) for a flow of income can eventually become extremely costly.

In spite of significant progress in some social areas, poverty remains a persistent phenomenon in Latin America. More importantly high inequality has become one of the trademarks of the region. In terms of the personal distribution of income Latin America and the Caribbean is the most unequal region in the world. Moreover, the commodity boom tilted the functional distribution of income away from wages and towards profits that in general have not been reinvested in productive uses. Finally, the spread of democracy in the region is being challenged by the failure of the government to respond to rising social demands and the impending corruption in some countries.

In Why Latin American Nations Fail we start from the premise that institutions are an essential component of Latin America’s development problem. But we think that the New Institutionalist view and the focus on property rights is part of the lack of success of mainstream policies that have dominated development economics in theory and practice in the past decades.

Given their importance, we believe institutions deserve a broad, critical and multidisciplinary approach beyond the property rights approach, which could then provide a basis for alternative policy recommendations. This is what we try to show in the book and in its different sections and chapters. The book is divided into two sections. The first highlights several key problems associated with New Institutionalist arguments and, in particular, with the way it is applied to view and understand Latin American development.

The New Institutionalist approach provides a limited view of comparative historical analysis failing to read and understand history on its own terms. An illustrative example is Acemoglu and Robinson´s characterization of the Spanish and English colonizations as being extractive and inclusive respectively when in fact the historical record shows that both types of colonizations were at times extractive and inclusive. The more recent historical experience of Japan in the post-WWII era, South Korea and some other Asian nations such as Singapore shows that economic success was not based on inclusive institutions.

Also, the New Institutionalist view overplays the role of the market and downplays the role of the state in the process of economic development. Several institutions of the developmental state that promoted industrialization, including the bureaucracies that managed macroeconomic and commercial and industrial policies, development banks, publicly funded or directly public universities and research institutes were central in many experiences of development, and were also part of the Latin American experience until the debt crisis of the early 1980s. The reversal of many of these policies after the crisis, and the predominance of the Washington Consensus, have not led to vigorous growth as New Institutionalist views would have indicated.

Moreover, the institutions emphasized by the New Institutionalism are uniquely concentrated on the supply side of the economy, and the generation of incentives for productive investment (to buy machines and equipment). However in practice the institutions that allow for the expansion of demand, including those that allow for higher wages to expand consumption and to avoid the external constraints, are and have been central to growth and development.

The second section provides critical assessments of this development strategy, identifies the future challenges, and presents alternative policy proposals to the ones that are currently being followed and implemented.

The two sections provide important policy recommendations that can be summarized in five points. First, development policy must focus on improving the character and quality of national institutions. Second the most important condition to promote development is a strong, but flexible and dynamic, government involvement across a wide variety of areas including investment, industrial policies and innovation, education and other social policies, besides the areas that traditionally fall under the scope of public policies. Third, states and governments rather than limiting their functions to that of mere ´referees´, regulators or market plumbers, must assume the role of architects and market makers in the design and establishment of institutions. Fourth institutions, must allow the expansion of demand to promote growth and development. Financial markets permit the growth of domestic economies according to their potential. Demand oriented policies means placing the focus on income and not substitution effects. Finally, government involvement is not tantamount to centralized government. Development institutions and demand oriented policies cannot work properly without bureaucratic autonomy.

From: pp.10-11 of WEA Commentaries 7(5), October 2017
http://www.worldeconomicsassociation.org/files/Issue7-5.pdf