Just when Latin America seemed to have overcome its chronic boom-bust cycles,
the implosion on Wall Street raised new worries about instability.
This time it was supposed to be different.
Even as the world economy spiralled into a free fall, Latin America seemed
not only poised to break the boom-bust cycle of the previous three decades—but
to survive the debacle of 2008. With the economic expansion that started in
2003, the region looked stronger than it had ever been, thanks largely to the
structural reforms enacted as a result of previous crises. Most national
economies were more efficient and resilient. Fiscal accounts had been put on a
solid track. Debt ratios had started to decline, and debt composition moved away
from short duration and dollar denomination toward safer forms, such as
long-term domestic currency debt. Credit ratings improved, and a growing number
of countries achieved investment–grade status, becoming at the same time less
dependent on volatile capital inflows.
Decoupling was the fashionable concept in analysts’ minds, as the region
seemed unaffected by the first signs of trouble in the U.S. in 2007. With the
price of food, energy and minerals buoyed by soaring growth in India and China,
Latin America became the destination of choice for investments in these market
Alas, to apply the words of Brazilian samba composer Vinicius de Morais: “Tristeza
não tem fim, felicidade sim.” (Sadness has no end, but happiness certainly
does.) Just as Latin America was getting used to growth rates that topped 5
percent, the music stopped abruptly in the fourth quarter of 2008. The fabled
decoupling disappeared and the so-called commodity super-cycle shrunk
Can Latin America, and the world, recover momentum? The answer is yes—but
only by turning to the international financial institutions that have been
largely ignored in the run-up to the present crisis. A look at Latin America’s
own turbulent economic history over the past decades can help to explain why.
More Things Change, More They… Never Mind
In the mid 1970s, skyrocketing commodity prices made Latin America a
preferred destination for the ample international liquidity that Middle Eastern
petrodollars and lax U.S. monetary policy funneled toward financial
institutions. That ended, however, in 1982, with a debt crisis caused by a
sudden cutback in global liquidity, as the U.S. tried to contain rampant
inflation by slamming on the brakes of its monetary policy.
It took the better part of the 1980s—the so-called Lost Decade—to arrive
at a new policy consensus: fiscal policy needed to become more austere and
sustainable; financial systems needed to be liberalized and reformed; trade had
to be opened up; and state-owned enterprises needed to be privatized. This
agenda, together with the Brady Plan, was supposed to provide a way out of the
debt crisis and revive growth.
And so it did—for a while. The courageous market-oriented reforms enacted
in countries like Argentina, Mexico, Colombia, Peru, Uruguay, and Venezuela
fueled a boomlet in the early 1990s—only to collapse in late 1994 with the
Tequila Crisis. In hindsight, the growth seemed less a product of reform than of
the temporary upsurge in short-term capital inflows brought about by the easing
of Washington monetary policy during the 1990–92 U.S. recession. As soon as
the U.S. started to raise interest rates in 1994, international liquidity
tightened, and the region fell into currency and banking crises.
The boom-bust cycle continued through the early years of this century. A
wobbly recovery during 1996 and 1997 was followed by another commodity price
collapse in 1998. Between 1998 and 2002, which some refer to as the “lost
half-decade,” the region was beset by a sequence of crises brought on once
again by the drying-up of capital flows that occurred after the Russian 1998
Still, after 2003, there was reason to believe that this time it really would
be different. As the region started to run hefty current account surpluses,
fueled by demand from China and India, Latin American countries seemed finally
strong enough to finance their own market-led growth.
A small but significant number of countries used the terms-of-trade
improvement of 2004–2008 to reassert state-led approaches and nationalize
industries ranging from oil and gas to cement, steel, telecoms, pension funds,
and banks. But most of the region’s countries used the good times to deepen
their commitment to market-friendly approaches. Even as the U.S. economy got
into trouble in the summer of 2007, the region kept moving ahead confidently.
Then, in the summer of 2008, terms of trade collapsed. As the global economy
slowed down, the commodity price bubbles of 2007 burst. Oil, copper, soy beans,
iron ore, steel, and rice fell to 2004 levels. Countries such as Argentina,
Ecuador and Venezuela saw the yield on their bonds move above 20 percent,
indicating an imminent probability of default. The best Latin American
corporations from the best countries in the region lost access to international
finance. Floating currencies such as the Brazilian real, and the Chilean,
Colombian and Mexican pesos depreciated by over 40 percent. In early 2009, the
IMF lowered its projected growth for Latin America to 1.1 percent for 2009, down
from 4.6 percent in 2008.
With financial conditions deteriorating globally, especially after the
collapse of Lehman Brothers, the region was hit by a sudden and quite massive
reversal in capital inflows. Growth slowed drastically as the region suffered
simultaneous shocks to the terms of trade and to capital flows—a double blow
not seen since 1982. The party, it seems, is over. Or is it?
The Only Way To Save Capitalism Is Capitalism
For those who consider global capitalism an unruly beast, the current crisis
is additional proof that market-friendly policies lead to disaster. Yet the
alternatives have the distinction of being worse. Venezuelan President Hugo
Chávez likes to boast that his country is immune to the “capitalist crisis”
because it has embraced twenty-first century socialism. Nothing seems further
from the truth.
Rather than demonstrate the intellectual failure of Latin American
macroeconomic thinking, the crisis of 2008–2009 confirms the value of the
hard-earned lessons of the recent past. Countries that adopted strongly
counter-cyclical policies in boom times, as epitomized by Chile’s 7 percent of
GDP fiscal surplus in 2007, are now able to adopt expansionary fiscal and
monetary policies in order to cushion the fall.
In contrast, countries such as Venezuela that ran deficits in the boom years
by expanding government spending and cutting taxes are now forced to contract
even more, thus aggravating the crisis’ impact on their economies.
Countries with floating exchange rates, such as Brazil, Colombia, Chile,
Mexico, and Peru, are protected by the automatic depreciation of their
currencies, thus softening the impact on the cash flow and the profitability of
exporting and import-competing activities. In contrast, countries that peg to
the dollar, such as Argentina, Ecuador and Venezuela, are left in the
uncomfortable situation of being unable to change relative prices with the U.S.
at a time when they are massively losing competitiveness with their floating
Argentina, in particular, seems to be repeating the mistakes of 1999–2001,
when the depreciation of the Brazilian real coupled with U.S. dollar
appreciation left it with the wrong parity at the wrong time. The same can be
said in comparing Venezuela with Colombia. Whereas the Bolivarian revolution
pegs to the dollar, its neighbor and second-largest trading partner floats.
It may not be a coincidence that the two Latin American countries that have
led calls for the downfall of the Bretton Woods international financial
institutions (IFIs) —Venezuela and Argentina—are suffering more than their
market-friendly neighbors. In February 2009, Venezuela, with an international
price of oil of $40 per barrel, was running a fiscal deficit close to an
unheard-of 20 percent of GDP. Argentina is facing an appreciation of its
currency vis-à-vis its neighbors, a deterioration in its terms of trade, and
the worst crop in 40 years. For a government that has relied on extraordinary
taxes on its agricultural exports to balance its public accounts, and has prided
itself on its repeated defaults, Argentina now faces a fiscal hole and no access
The only hope for both countries is a quick recovery of the world economy.
But that, perhaps ironically, will require a stronger and more proactive role
for IFIs. This will not happen overnight. The IFI arsenal must be restored by a
recapitalization campaign, and multilaterals must learn to operate with the
speed and flexibility to compensate quickly for the dramatic breakdown in
private credit markets. In the case of some IFIs, this shift may mean revisiting
the business model to redesign—or in some cases, resurrect—some core
institutional capabilities. It seems likely that, as this crisis runs its
course, market-friendly Latin American nations will do much better than their
neopopulist and neoauthoritarian counterparts. They may well do better than East
Asia and especially Eastern Europe. The lesson, in fact, is one that has global
Remember When We Were Happy and Didn’t Know It?
The growth that Latin America experienced in the 2003–2007 period was not
unique to the region; it was worldwide. The period constitutes the fastest and
most broad-based global economic expansion in human history.
But they were also days of excess. United States macro policy was amazingly
lax. An unpopular war led to very large fiscal deficits. Monetary policy, buoyed
by confidence that inflation had remained under control, was also unusually
loose. As a consequence, the external U.S. deficit skyrocketed to over 8 percent
At the same time, China was pursuing an unsustainable growth strategy that
saw its exports expand by over 20 percent per year, while its consumption grew
at just over 7 percent. The gap was expressed in a growing current account
surplus that, in spite of the deteriorating terms of trade (associated with the
rising price of energy and minerals), went from about 1 percent of GDP in 2000
to an astounding 11 percent in 2008. This surplus led to an unprecedented
accumulation of international reserves, invested mainly in U.S. Treasuries. The
large savings in China and later in the Middle East amply financed the growing
U.S. deficit: instead of the U.S. facing increasing difficulties in covering its
financial needs, long-term interest rates declined to historically low levels.
The best explanation to date for what happened was bad lending. With large
amounts of cash on hand, financial institutions needed to find new ways of
lending the money out, or new people to lend it to. This involved taking on much
more risk than would have been prudent, at a time when the financial industry
had become concentrated in terms of players, and more leveraged and more
globally diversified in terms of assets. If problems arose, they would quickly
become systemically large and have global impact.
Enter the Super-Borrowers
When the fan belt of a car breaks, the engine overheats, seizes and stops.
But a new fan belt is not the solution at this point. If Wall Street is the
belt, Main Street is the engine. Since the engine has seized, even fully
capitalized banks will be wary of lending in a downturn, and firms and
households would be unwise to borrow, even if credit were available. Credit
crunches often lead to recessions, but the eventual recovery has never been lead
The investors’ flight to quality means that those issuing the safe assets
are left as the sole remaining super-borrowers. These super-borrowers—the U.S.
and Japan, mainly—are the only ones left to reestablish financial links and
rewire the system.
It’s ironic. Excesses in the U.S. financial system caused a crisis that
raised the attractiveness of the dollar and of U.S. Treasuries, increasing the
de facto financial power of the country that was probably most responsible for
the advent of the crisis. While Latin American governments lose access to
finance at the first sign of trouble, preventing them from playing a stabilizing
and constructive role during crises, the U.S. Treasury finds itself able to
borrow more money at better terms than ever before.
How Should This Super-Borrower Advantage Be Used?
Up to now, two methods have been employed: propping up aggregate demand
directly through fiscal reflation—the $780 billion of fiscal stimulus approved
in February 2009—and recapitalizing the banking system through the $700
billion Troubled Assets Recovery Program (TARP) and its likely additional
History will determine the wisdom of these decisions. The economics
profession in the U.S. has made an implicit commitment not to repeat the
mistakes of 1929. Fiscal and monetary policies are as expansionary as anybody
would have thought imaginable, so as to err on the other side of Hoover. But
what are the likely mistakes of 2009 that policymakers and economists during the
next crisis will be trying to avoid?
One possible candidate is the fact that the recapitalization and reflation is
planned mainly for the U.S. domestic economy, while the problem and the borrowed
resources are global. The current strategy constitutes an attempt to restart the
global economy through a widening of the U.S. external deficit. Clearly, this is
not the best way forward because it tries to solve one problem by aggravating
another. It may cushion the fall now, but it will slow down the recovery later.
If current trends continue, by 2011, the U.S. balance sheet will look pretty
weak, given all the additional debt. Tax rates will need to go up, as is
currently planned through the expiration of the Bush tax cuts. If by then the
recession is not over, investors will feel much less sanguine about U.S.
Treasuries and the super-borrower power may evaporate.
It seems reasonable to assume that if the crisis is global, the solution must
also have a global character, even if the world has just a few super-borrower
nations. A more sustainable alternative is to use the super-borrower capacity to
reflate the global economy and to re-establish financial links globally.
This would imply using the capacity to borrow to buy financial assets abroad,
thus allowing other countries to expand their spending and investment. Through
this approach, the balance sheet of the U.S. does not get worse: the additional
debt is balanced by additional claims on foreigners, and the interest-rate
differential will make the U.S. taxpayer better off. The additional foreign
spending would seep into the U.S. through higher American exports, thus
stimulating the economy in a more sustainable manner.
How To Get It Done
Global reflation can be accomplished in several ways. First, multilateral
development banks should be recapitalized by having countries subscribe to new
issues of callable capital (i.e., de facto guarantees). This will allow the IFIs
to raise funds in global capital markets, which they can then lend to the
credit-starved developing world. For Latin America, this would imply a
recapitalized World Bank and Inter-American Development Bank (IDB).
The goal is for these institutions to be able to lend enough money to
partially compensate for the lost access to private markets. Loans should be
disbursed quickly and conditional only on an assessment beforehand of the
soundness of the country’s macro stance. They should be made in an amount
sufficient to prevent the inefficient, procyclical contractionary fiscal
adjustment that is being caused by the lack of access to finance. For the world,
a program of about $700 billion—already a familiar number— would be more or
less of the right size.
Second, part of the capital raised could be channeled through institutions
such as the International Finance Corporation in order to purchase a diversified
portfolio of private emerging market assets. This would provide a support
mechanism for this asset class similar to the relief that the Fed is providing
to private American assets.
Third, the IMF should also be recapitalized, possibly through an issuance of
Special Drawing Rights (SDRs), in order to ensure that the organization has more
than enough funds to help reconnect countries to finance. But the issue is not
just to fund individual countries in trouble. The goal should be to convince
safe countries that are currently hoarding large amounts of international
reserves as self-insurance against future crises that they need not sit on so
much liquidity because they will have ample access to contingent IMF funds.
This will allow countries to adopt policies that are more supportive of a
global reflation effort. In some sense, it would just be a formalized and
multilateral version of the strategy that the Fed announced in November 2008,
whereby it granted swap lines in the amount of 30 billion dollars each to Korea,
Singapore, Mexico, and Brazil. To make sure that this facility is used from the
start, emerging market members of the G-20 and others with high credit ratings
should simultaneously ask for these new resources in order to dispel the stigma
that is usually attached to borrowing from the IMF.
A lot of effort has been invested in discussing issues such as global
imbalances and the voting rights at the international financial institutions,
but too little has been dedicated to thinking about what these institutions
should do in the context of the current global crisis. If capital markets are
impaired over a long period, global and regional international institutions need
to play a much bigger role in the recovery than is currently being envisioned.
If this strategy is successful, it will lead to a more balanced and sustainable
global recovery. It will also strengthen the case for market democracy in the
eyes of Latin American voters.
The current crisis may be the worst recession the United States has seen in
80 years, but most Latin Americans alive today have suffered equivalent
financial catastrophes. We have also survived it. We have learned the advantages
of open economies, sound fiscal policies, flexible exchange rates, and respect
for markets and property rights.
We have also seen the value of international financial institutions. These
institutions were principal actors during previous crises and helped to restore
liquidity and growth when that task was beyond the capacity of individual
countries. They used multilateral mechanisms to solve financial problems— and
invested political, financial and intellectual capital in creating the changes
that will go a long way toward helping many countries in the region weather the
Their experience in Latin America offers a template for a way forward for a
world in crisis. With a little tweaking of the model, recapitalized,
reformulated and stronger IFIs could play a vital role in global recovery.
1 Guillermo A. Calvo, Alejandro Izuierdo and Ernesto Talvi, “Phoenix
Miracles in Emerging Markets: Recovering Without Credit from Systemic Financial
Crises” (NBER Working Paper 12101, National Bureau of Economic Research,