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A history of excess, crises, and stagnation

Poor fiscal policy is at the root of Latin America’s decades of economic instability and slow growth, but it’s not the only factor

October 15, 2020


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Article Highlights

  • Comprehensive review of Latin American history draws lessons for breaking persistent low growth
  • Same theoretical framework is applied to 11 of the region’s largest economies
  • Analysis pinpoints frequent crises due to poor fiscal discipline, plus internal and external forces, at heart of stagnation
A history of excess, crises, and stagnation

The first years of the new century augured well for Latin America. After decades of stagnation, it appeared that economies of the region’s largest nations might have turned a corner, with growth rates above those of previous years and higher than some advanced economies’.

But it wasn’t long before old patterns reasserted themselves, deepened no doubt by the Great Recession. In the 2010s, per capita economic growth slowed to just 0.5 percent per year, according to the International Monetary Fund. Then came the pandemic; fragile economies crumbled.

Against this backdrop, Minneapolis Fed economists Timothy Kehoe and Juan Pablo Nicolini, with colleagues Thomas Sargent of New York University and Carlos Esquivel of Rutgers University, have published two staff reports on Latin America's economic history, analyzing decades of data and drawing policy lessons that might help break the region’s persistent low growth.

Two staff reports on Latin America’s economic history analyze decades of data and draw policy lessons that might help break the region’s persistent low growth.

The first, by Kehoe, Nicolini, and Sargent, describes Latin America’s long history of economic stagnation, documents repeated economic crises coinciding with that stagnation, and develops a unified theoretical framework for analyzing the region’s economies.

The second, authored by Kehoe, Nicolini, and Esquivel, reviews 11 national case studies in which they and other scholars have applied the common framework to the 10 largest economies of South America plus Mexico, highlighting similarities and variation, and outlining strategies for academics and policymakers.

Both papers will be chapters in Kehoe and Nicolini’s forthcoming book, A Monetary and Fiscal History of Latin America, 1960-2017. (The title is a nod to Milton Friedman and Anna Schwartz’s classic A Monetary History of the United States, 1867-1960.) Also in the book are the 11 nation-by-nation studies. (The countries are Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela.) The book is the culmination of a massive project, begun in 2010 and involving 46 economists, sponsored by the Becker Friedman Institute for Economics at the University of Chicago.

Stagnation has resulted from continuous macroeconomic instability which, in turn, is caused by lack of fiscal discipline.

At its heart is recognition that a region of profoundly rich potential has failed time and again to fulfill its promise. For decades, Latin American economies have stagnated, seemingly locked in a Sisyphean series of revival and collapse. This pattern of failure is a prevailing cultural sentiment in Latin America, say Kehoe, Nicolini, and Sargent, citing work by Uruguayan writer Eduardo Galeano and Peruvian novelist Mario Vargas Llosa.

In these papers, the economists are more optimistic. They don’t promise a path of sustainable growth, but they offer analyses and lessons that might motivate others in the quest for better policies to “help break the vicious cycle of crisis and stagnation.”

Diagnosis and treatment

“A reasonable conjecture is that the prevalence of crises is at the root of a sizable fraction of the stagnation of Latin America.”

Their diagnosis of Latin America’s ills is deceptively simple. Stagnation has resulted from continuous macroeconomic instability which, in turn, is caused by lack of fiscal discipline—governments spending beyond their means. A typical scenario starts with increased government spending in response to social pressures, but without an adequate increase in revenues. Initially, the deficit is financed by printing more money and by borrowing, mostly from abroad. But when foreign lenders balk at further lending, inflation soars, and crisis unfolds. “A reasonable conjecture,” write the economists, “is that the prevalence of crises is at the root of a sizable fraction of the stagnation of Latin America.”

The harsh diagnosis carries a clear, if stern, lesson. To prosper, nations must exercise fiscal discipline.

The harsh diagnosis carries a clear, if stern, lesson. To prosper, nations must exercise fiscal discipline. And to underline its efficacy, the authors observe that seven of the 11 countries appear to have learned this lesson. In recent years, they’ve spent less than they’ve raised and enjoyed stable economic growth. The other four—Argentina, Bolivia, Brazil, and Venezuela—have not and have done poorly. Venezuela, in particular, has suffered dramatically from not cutting expenditures when oil revenues fell.

Historical overview

The “Framework” staff report begins with an overview of the region’s slow growth. With three charts parsing per capita GDP growth relative to the United States’ from the Great Depression to 1973, from 1973 to 2000, and then from 2000-2016, they demonstrate that Latin American economies modestly converged toward the United States’ in the first era, failed to sustain this in the middle period, and then resumed slow convergence in the 21st century.

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In another chart, the economists juxtapose this growth pattern against national inflation rates from 1961 to 2017. The result is stunning. In the middle period of economic stagnation (1973-2000), inflation rates soared in all 11 countries. Prior to that, and afterward, inflation moderated, and economic growth was reasonably good. (See figure.) The coinciding patterns suggest a relationship between instability and underperformance. Correlation isn’t causation, but it could be.

A common template

To better understand the relationship, the economists develop a framework capable of exploring mechanisms linking economic instability to slow growth. Their model blends theories and empirical findings from a vast economic literature, but conceptually it’s straightforward, focusing on just two basic elements: the government’s budget and the nation’s demand for money.

Governments raise revenues from taxes, loans, and money. If expenditures exceed revenues, the government must finance the deficit by increasing debt, money supply, or both.

By demand for money, the economists refer to “real” money—absent considerations of inflation—and they’re describing the relationship between the quantity of real money, on one hand, and price levels, short-term nominal interest rates, and real income, on the other. The bottom line: Increasing the money supply generates inflation.

In brief, the framework establishes a careful mathematical relationship between national fiscal and monetary policy: the government’s income and expenses, and its money supply. All of its elements are interdependent. If expenses rise, that has implications for inflation. If interest rates change, that affects foreign debt. And in Latin America, this delicate dance of economic elements has often tumbled into crisis.

The economists note that this framework, initially developed by Sargent for understanding the U.S economy in the early 1980s, lacks phenomena common in Latin America, such as balance-of-payments crises, debt denomination, and reputational concerns vis-à-vis foreign creditors. The framework helps explain macro instability, the economists say, but bad fiscal policy isn’t the only culprit.


In the second staff report, Esquivel, Kehoe, and Nicolini review the key messages gleaned from applying the analytical framework across all 11 nations. Their conclusion: The hypothesis that lack of fiscal discipline has been “the driving force behind [Latin American] macroeconomic instability” is correct.

While bad fiscal policy was a key factor, other forces played a powerful role. The list is long.

The economists devote much of the paper to close examination of Mexico and its 1980s depression. The focus is valuable, the economists say, because patterns seen in Mexico “were repeated over time and across countries.” Among other lessons, Mexico’s crisis again illustrates that while bad fiscal policy was a key factor, other forces played a powerful role.

The list is long: falling oil prices, rising international interest rates, and repeated currency devaluations that increased the value of foreign debt and resulted in default. Add to the list: a domestic banking crisis that the government “solved” through multiple exchange rates that reduced the value of U.S.-dollar-denominated bank accounts—in short, a bank bailout at the expense of middle-class Mexican depositors.

Review of the other 10 nations uncovers still other factors, include banking crises associated with explicit or implicit bailout guarantees, denominating sovereign debt in U.S. dollars, unbudgeted transfers to politically favored groups at the expense of taxpayers, and interference by external actors like international banks and foreign bank regulators. Each of these has interacted with ongoing fiscal deficits and amplified economic instability.

They also examine price stabilization policies and commodity price fluctuation. The first is often blamed for economic stability; the second credited for prosperity. Their review of the data suggests that price stabilization has often boosted economic output and employment, and that rising commodity prices are no guarantee of economic growth.

Beyond Latin America

And, finally, they draw lessons from their review of Latin America’s recent economic history that are applicable throughout the world. “The conceptual framework,” they observe, “is [not] exclusive to the region. Rather, it identifies policies that make countries more prone to macroeconomic instability.”

What are the preferred policies?

  • Solid fiscal policy—don’t spend more than raised through taxation.
  • Gradual financial liberalization—don’t quickly abolish existing controls on domestic and foreign credit markets.
  • Low exposure of government debt to real exchange-rate movements—don’t denominate sovereign bonds in foreign currencies.
  • Careful monitoring and control of spending by independent government institutions—don’t make off-budget transfers to favored groups.

These two papers, and the book in which they appear, are the culmination of years of work by dozens of economists. A short summary cannot begin to do justice to the breadth of detail and depth of analysis in this work. But one thing is certain: Its methods, findings, and conclusions have importance far beyond Latin America and these six decades. Without fiscal prudence and sound economic policy, sustained macroeconomic growth is unattainable.

Douglas Clement
Managing Editor

Douglas Clement is a managing editor at the Minneapolis Fed, where he writes about research conducted by economists and other scholars associated with the Minneapolis Fed and interviews prominent economists.