Today We Learn About: Economic Turmoil in Central America

Three decades ago Latin America sat at the peak of what turned out to be a rollercoaster ride that devastated over half of a hemisphere. In the 1970s Latin America was deep into the Import Substitution Industrialization model and widespread political revolutions. The following will argue that in the short time after the fall of substitution, Latin America went through drastic changes that would have negative consequences for both human and economic development.

The first topic that will be addressed is the level of external debt carried by all Latin American states; including how it accumulated and the troubles the debt caused. The next section will look into various methods governments used to stabilize the repercussions of excessive external debt.  Following will examine the influence of international investment on development and subsequently the financial deregulation across the board.  Lastly, it will be shown that the adoption of free trade had a negative effect on the socio-economic status of Latin America.

Import Substitution Industrialization was the dominant economic model for the mid section of the twentieth century and it represented a way for nations to focus inward to create a backlash toward the nations and banks that forced export specialization.  The prominent problem with such a plan was the massive amount of debt that individuals and governments had to bear in order to afford the capitol to industrialize.  When nations wanted to industrialize they had to acquire machinery so that they could produce goods.  The high initial start up cost was financed largely through loans from banks in the United States.  Afterward, the markets within Latin American were not developed enough to consumer the amount of goods needed to pay off the external debt. The initial debt was accelerated to extraordinarily high levels from governments that believed in high spending; money they did not have, through borrowing from banks in the United States that had negative prime interest rates.

The Federal Reserve Bank changed its focus to controlling inflation in 1979 by increasing the federal fund and essentially all interest rates, including those to prime borrowers such as Latin American governments.  By increasing the interest rate, the FED essentially made it more costly to take out new loans and increased the minimum required interest payments on outstanding loans.  In order to service their debt Latin America had to pay more than they could afford; to pay the new interest, new loans were taken out which could not be paid.  There was a circle of debt that could not be hemmed.

While the debt accumulation was in high speed, external shocks exacerbated the situation.  The market for Latin American goods in the United States shrank with the increased interest rates while markets for domestic goods in Latin America shrank as globalization reduced imports and raised unemployment.  As unemployment increased the ability to service debt decreased.  Another shock that increased debt was when OPEC required oil to be sold in dollars which then had to be deposited in US banks.  Therefore even more assets left Latin America and there income was decreasing.  In order to service the debt, nations started to increase their money supply.  The increase in local currency without an economic upturn fostered devaluation of most Latin American currency and increased inflation.

Once it was apparent that the level of debt was unsustainable there was a mass exodus from Latin America.  Locals with money deposited it in other countries and investors pulled as many of their assets out as fast as possible.  In the end banks were left out to die.  The largest banks in the country were overly exposed, having extraordinary loans that had a large chance of defaulting. But banks had the upper hand even after the defaults.  The US government was able to bail out banks in the 70s and 80s just as it could in 2008.  Since the US has a floating exchange rate and there will always be a demand for dollars (oil is sold in dollars), the government was able to print bail out money without any noticeable decrease in the value of the dollar.  The climax of the debt crisis occurred when Mexico announced that it was unable to maintain its debt and would stop all payments.  External shocks combined with unstable economic policies for a crisis that is still the major issue in Latin America thirty years later.

The first in a series of financial stabilization measures that were taken after the onset of the crisis was the theory that Latin America had an excessively high absorption rate.  The countries were thought to be consuming too many of their own resources instead of exporting.  In hindsight it is apparent that this was not the case yet at the time the International Monetary Fund wanted Latin America to consume less in order to use that money to service foreign debt.  That obviously self-serving policy disregarded the deeper issues of political and economic structures to give banks and investors immediate satisfaction.

After focusing on absorption began and Latin American nations all signed their letter of intent that promised to do whatever they were told (supposedly for macroeconomic gain) banks revived interaction with indebted nations.  Banks adopted new policies when interaction with Latin America such as provisioning, when payments are set aside toward profit before dividend payments as insurance incase of default.  More importantly banks created secondary markets for debt by selling loans as assets and cutting their exposure in with people who found it profitable to share the risk.   Secondary markets also produced debt for equity swaps that allowed US firms to invest in a Latin American country without having to relocate or invest directly and debt for nature swaps reduced US firms costs in obtaining raw materials.

The IMF enforced a monetarist theory of inflation control that focused on macroeconomic issues by cutting spending and tightening money supply and trade policies.  Results were massive set backs in human development and gained the criticism of those in favor of the structuralist macroeconomic theory.  Structuralist thought is that inflation and devaluation is caused by bottlenecks from oligopolies interacting with the labour market and external shocks that cause shortages.  The cause of inflation and devaluation most likely lies in a number of areas spanning both forms of thought.  However the stabilization measures focused solely on the monetary side of the problem.  While this was what banks wanted, it did not cure Latin America’s deeper structural issues that caused the debt crisis in the first place.

In order to pull out of crisis Latin America had to increase capitol inflows in both the short and long term.  In the short term there needs to be assistance from other nations to stabilize the accumulation of debt and in the long run there needs to be private investment that encourages raising the output of workers per wage through investment in human capitol. Investments are made almost entirely by banks, large companies and foreign governments in four major forms; loans, bonds, Federal Direct Investment, and Equity.  One outlying source of investment is from remittance money sent to respective home countries by Latin American ex-patriots.

Capitol mobility is maintained by either higher interest rates for bonds and loans or an increase in profitability for equity investment from Multinational corporations.  Higher interest rates are detrimental on local economies because it is more costly to borrow and there is a large probability that one could wind up in a debt cycle.  An increase in interest rates also put strain on governments that hold external debt, which may cause them to appreciate the value of their currency and hurt exports.

The structural conditions needed to attract MNCs are known to be less than optimal for the well being of the working class.  Multinational Corporations tend to form within a country with little ties to the local economy.  Week linkage means that the presence of a large company may have some small positive effects on individuals but not on the overall health of the economy.  MNCs are also known to not follow environmental policies and do not re invest in local development, they try to keep the working class from increasing their mobility.  If such a thing happens the MNC will most likely leave.

International capitol inflow is necessary to increase the ability of Latin America to service its debt but all roads to investment have drawbacks that must be considered.  Investments from bonds and loans must be accompanied by increased interest rates.  Federal Direct Investment requires nations to adopt policies that may end up benefiting the lending nation more than the borrowing.  Multinational Corporations invest toward their own well being and may or may not benefit the host nation.  In order for Latin America to stabilize its debt and start servicing it without too many negative repercussions there needs to be financing from private and public sources in a structure that is easy to monitor and reliably maintain.

In order for Latin America to gain capitol inflows the banks, firms and governments wanted something in return.  Latin America had to make their nations appear stable enough for investment as well liberalize their economies and accept the free flow of goods across boarders.  Trade liberalization had to be accompanied by fiscal reform and exchange rate management.  The governments that signed their letters of intent to the IMF represented those who banks viewed as politically stable and were on the road to recovery.

The next step toward liberalization was to ensure that the value of goods and equity was stable enough for banks to give loans with low enough interest rates.  Local currencies were seeing a decline in stability as many large Latin American firms began to list on international stock markets rather than relying on unstable exchange rates.  By pegging the value of local currencies to the dollar many nations were able to put a leash on the volatility in exchange rates.  Pegging currencies is when the total value of all nations’ money is fixed to the value of the number of dollars that the government holds.

Pegging increased stability and the appeal of foreign entities to invest.

The fiscal reform needed for capitol to flow is ensuring that internal consumption by both private and public sources is not so high as the surplus for export disappears and with it income needed to service debt.  Consuming fewer imports while dedicating more resources to imports assists in balancing debt and reaching an external equilibrium. Powerful western nations and banks that controlled the rules of international trade dictated unilateral changes.  Financial deregulation was just one part of an entire structural reform that changed the inward looking ISI model to an export focused development model.

Free capitol movement among nations is thought to foster gains to global welfare by allowing efficient firms to outperform lesser firms and increase global production.  However this theory leaves out exactly who will be the producers and benefitors of increased production.  In the modern world, the ability to gain market share lies in the level of technology that the local manufactures have.  If it is inferior then they will not be able to compete with other nations.  Such was the case for Latin America; the western centre of trade controlled both the intellectual property for technology and the production of the machines needed for manufacturing.  As Latin America opened up to Multinational Corporations to bring assets in as technology, the cost of labour decreased in many nations as the competition for investment drove the labour market to compete for lowest wage.

Along with free trade policy went a reduction in tariffs that was aimed to increase the total goods that was exchanged internationally.  There was an increase in flow and velocity of imports and exports, yet the composition of the export market did not expand to any substantial degree.  Latin America still focuses its export sector on primary goods, with some exceptions in Brazil manufacturing.  While Latin America pursued free trade it cold not get rid of protection all together.  Integration into the global economy was assisted through agreements between nations to ensure markets for goods.  One such agreement is between the US, Canada and Mexico and is called the North American Free Trade Agreement.  Among other things NAFTA allows for easier traveling and reduced costs to ship across boarders.

Many trade agreements exist between Latin America and the rest of the world as well as integration agreements within Latin America.  Subregional trade movements have made it possible for Latin America to unite with common goals of market access and reduced negative externalities.  The alliances have also shaped divisions in social agendas among nations.  Free trade in Latin America has the possibility to increase trade as well as divert trade away from other global players; the repercussions have been both positive and negative for different countries.  The success of free trade to increase capitol investment and bring economies out of debt crisis varies between nations and is on a case-by-case basis.  While Brazil has had relative success and is close to being a developed nation and Chile is seeing a massive rise in the middle class, nations like Argentina and Mexico have suffered from market volatility that collapsed their economies.

In the past thirty years Latin America went through drastic and fluctuating changes that reached deep into the fabric of society.  Latin America was required to abandon close to fifty years of ideology and restructure to neo liberal policies in order to make the rest of the world feel confident enough to resume loaning money.  The results have been somewhat positive in some nations but overall the policies have missed target.  Instead of focusing on the underlying cultural and political problems that increased the debt the IMF focused on the money supply and inflation so countries could service their debt.  Western banks did not mobilize Latin America to rise out of debt, only continue it.  In order for Latin America to stabilize their economies they need to have changes in society that promote increase in labour capitol and value added products, diversifying exports and branching into new markets.  Such a holistic and eclectic approach will not corner a government into committing to ideology that could hold development at bay.

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