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POLICY MATTERS 18

Special Issue

Macroeconomic Policies, Livelihoodsand Sustainability

ALEJANDRO NADALCo-cair, TEMTI

Guest Editor


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POLICY MATTERS 18

MaizeCredit: Archive,Prensa Indgena


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TABLE OF CONTENTS

FOREWORD....................................................................................6Aroha Mead, Chair, CEESP

OVERVIEW: MACROECONOMIC..............................................10POLICIES FOR SUSTAINABILITY

Alejandro Nadal, Co-Chair, TEMTI

ARGENTINA: MACROECONOMICS,RE-PRIMARIZATION AND THE ENVIRONMENT...................48

Alan Cibils, Universidad de Buenos Aires, Argentina

THE FINANCIAL AND FISCAL ROOTS OFDEFORESTATION IN THE AMAZON.........................................72Sergio Schlesinger, FASE, Brazil

COSTA RICA: PAYMENT FOR ENVIRONMENTALSERVICES AND FISCAL POLICY.................................................90Carlos Murillo, Universidad de Costa Rica, San Jos

MONETARY POLICIES AND ENVIRONMENTALDEGRADATION IN ECUADOR.................................................106Pablo Samaniego, Consultant, Quito, Ecuador

MEXICO: THE NEOLIBERAL MACROECONOMICPOLICY PACKAGE AND THE ENVIRONMENT......................130Marcos Chvez, Consultant, Mexico City

GLOBALIZATION, MACROECONOMICSAND THE ECOLOGICAL CRISIS................................................148

Aseem Shrivastava, Economist, New Delhi, India

MACROECONOMIC POLICIES, DEMOCRACYAND SUSTAINABILITY IN INDIA.............................................174

Ashish Kothari, Kalpavriksh, Pune, India

AROUND THE WORLD.............................................................222

CEESP STEERING COMMITTEE................................................224


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MACROECONOMIC POLICIES, LIVELIHOODS AND SUSTAINABILITY

18, September 2011

FOREWORDBy AROhA TE PAREAkE MEADChAIR CEESP

Amazon RainforestCredit: Pahpaha,Creative Commons


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Foreword by Aroha Mead

FOREWORD This special issue of Policy Matters 18 innovatesat several levels. It is the rst time we are devot-ing an entire issue of our agship Policy Matters

journal to the analysis of economic policies and their

impact on sustainability. It is also the rst time a CEESPpublication explores the highly technical topics of mac-roeconomic policies in their relation to sustainability. Inthese two respects, the special issue of Policy Matters is awelcome addition to our interdisciplinary work on theeconomic, social and cultural factors that shape our rela-tion with biodiversity and the natural resource base.

The Commission on Environmental, Economic and SocialPolicies (CEESP) is inaugurating a new period of productive

work organized around the full range of economic poli-cies in order to study their implications for environmentalstewardship and for social responsibility. This work is beingundertaken by the CEESP Theme on the Environment,Macroeconomics, Trade and Investment (TEMTI).In previous years, the working group that pre-existedTEMTI carried out important analyses on the eects oftrade and investment policies, now this analysis has beenexpanded to the gamut of economic policies to includemacroeconomics and, as a result, sector level policies.

The studies contained in this special issue of Policy Mat-ters are an important contribution as they inaugurate akey avenue for policy-oriented research.

Everyone knows that macroeconomic policies play adecisive role in our daily lives. But too many people seethem as belonging to a mysterious and complex eldthat complicates or even forbids our having access tothe way in which priorities are decided upon. In fact,the whole eld of macroeconomics is usually seen as adiscipline that only experts in central banks or the trea-sury department (or professors in academia) are able tounderstand. In many ways, this explains why the mostimportant decisions in economic policy are left to theexperts, while the rest of the population passively acqui-esces and submits to these policy priorities. Even parlia-ments and congresses frequently are unable to monitorand inuence these policy decisions.


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The crucial point is that the priorities that are chosenwithin the framework of macroeconomic policies aectin a decisive manner the allocation of resources for so-cial and environmental sustainability. These policies af-

fect interest rates, taxation and income distribution, ex-change rates, subsidies and the conditions for access tocredit in the banking system. By aecting the produc-tion strategies of every agent in the economy, whether agiant corporation or a small-scale agricultural producer,these policies also shape resource management practicesand therefore, the relation to the environment and thenatural resource base. The studies that are published inthis special issue show that in many instances, macro-economic policies can spell the dierence between life

and death for peoples livelihoods.

In addition, macroeconomic policies inuence the al-location of resources for environmental stewardship andsustainability at the economy-wide level. This is evidentif we consider that priorities in scal policy determinethe rate and direction of public expenditures. For ex-ample, the public monies that are allocated to health,education, housing, sanitation services and natural pro-tected areas, just to mention a few examples, can be sig-

nicantly reduced when the ministry of nance decidesthat scal spending needs to be curtailed. Thus, in therealm of scal policy the linkages between macroeco-nomics and sustainability are easy to see.

Yet, in spite of these self-evident facts, very few policy-oriented studies have been carried out on the direct andindirect impacts that macroeconomic policies have onsustainability. TEMTI is making here a very importantcase for redeploying part of our energy and resources tothe analysis of this critical problem area. One could saythat its underlying message was that it is high time torecover this ground for policy making and really put-ting it at the service of social and environmental sustain-ability.

The world is immersed in a dangerous economic andnancial crisis that will have multiple ramications in


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Foreword by Aroha Mead

our societies. This global economic and nancial crisisis essentially a macroeconomic event of the rst order ofmagnitude. It is not the result of an external shock (i.e.,an oil embargo or a war) but rather the consequence of

endogenous forces inside the most advanced capitalisteconomies of the world. It is the consequence of a failedeconomic model that will not put us in a trajectory ofsustainable development. Unfortunately, the policy re-sponse to the crisis is now based on the premises of thatsame failed model. As a result, the crisis will be deep-er and last longer, aecting the jobs and livelihoods ofmillions of people in the world. Yet, for all the evidentimportance of this, the preparations for next years UNConference on Sustainable Development (Rio+20) are

not even considering a meaningful discussion on mac-roeconomic policies and their relation to long term sus-tainability. Through the work in TEMTI we hope tosend a clear message to the UNCSD that the macro-economic policies of the failed model that gave us theglobal crisis are incompatible with an agenda for long-term sustainability.

I wish to acknowledge and thank all the contributorsto this edition of Policy Matters, and particularly to the

Editor, Dr Alejandro Nadal, Co-Chair of TEMTI. Wewelcome your feedback on the ideas and analysis ex-pressed in PM18.

Aroha Te Pareake MeadChair, IUCN CEESP

Wellington NZ, 19 September 2011


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OVERVIEW:MACROECONOMIC POLICIESFOR SUSTAINABILITYALEJANDRO NADAL

Arid LandCredit: Hannes Grobe,Wikimedia Commons


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INTRODUCTION

T

he world is caught in thedeepest nancial and eco-nomic crisis since the Great

Depression. The extraordinary expan-sion of the nancial sector over thepast three decades has given wayto a crippled nancial system, withwealth destruction going into thetrillions. Astronomical nancial rescuepackages (bailouts) will leave an uglyscar that will mark scal policies wellinto the next decade. The fate of theonce powerful US dollar is even at

stake as a result of this gigantic crisis.And the frenzy of deregulated mar-kets, so characteristic of neoliberalismand globalization, has put millions ofpeople worldwide in poverty.

At the same time, the world is trappedin a vicious environmental predicament.

We are not only threatened by stag-nation, deation, unemployment

and poverty. Our world is also men-aced by climate change, deforesta-tion, soil erosion, polluted aquifers,over-exploited sheries and a man-made event of mass extinction. Theseverity of this environmental crisisis a threat to the survival of human-kind.

These two crises are intimately re-

lated to each other. Both point to aseries of critical aws in economicthought and policy-making. Theeconomic crisis is not the result ofwhat could be called a rare prob-ability event (a perfect storm) butrather the unavoidable outcome of aneconomic paradigm that dominated

policy-making since the early eight-ies. The policy package behind thiswas able to sustain growth onlythrough the formation of a series of

bubbles in dierent classes of assets.In this process, nancial marketstook control over manufacturingcorporations, and they sacricedlong term investments for shortterm protability. Not only werewages put under pressure, but underthe logic of nance, the environ-ment simply became another asset.It is clear that if we want to advance

towards long term environmentalsustainability we need to change thisstate of aairs.

That this model was also unable topromote growth with rational environ-mental stewardship is an understate-ment. To put it another way, thesame macroeconomic policies thatgenerated the worst crisis since the

1930s aect the rate at which we cuttrees, catch living marine resources,emit greenhouse gasses, depleteaquifers or exploit open pit mines.The reason is that activities related tothese phenomena are conditioned byinterest rates and ination, exchangerates, credits, securities performance,subsidies, taxes, depletion allow-ances, etc. It is no coincidence that

some of the speculative bubbles thatmark the latest crises were based oncommodities that are, by denition,close to the natural resource base (forexample, grains and foodstus).

There is no doubt that inter-capital-ist competition is the determinant

Overview: Macroeconomic Policies for Sustainability

OVERVIEW:

MACRO

ECONOMICPOLICIES

F

ORSUSTAINABILITY


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force behind the exploitation of thenatural resource base. But the eco-nomic forces behind environmentalexploitation (and the current nancial

crisis) are shaped by macroeconomicpolicies. The corollary of this is thatmacroeconomic policies will be acritical frame of reference as we moveaway from a wasteful economy andshift course towards sustainability.These policies will have to be rede-ned in order to direct investmentows towards renewable energysources, energy ecient manufac-

turing, retrotting of infrastructure,sustainable agriculture, etc. Macro-economic policies can be a potentdriving force behind our eorts toconsolidate good environmentalstewardship, or they can be a mightyobstacle in our eort to shift to a sus-tainable economy.

Macroeconomic policies are based on

relations between economy-widevariables. They are powerful enginesthat can be used for stability or change.They include monetary and scalpolicies. They also cover nancial,banking and capital account regula-tions, as well as the determination ofsome key economy-wide prices (pricesfor energy inputs, basic food com-modities and wages). Finally, becausemacroeconomic policies cover balanceof payments management, they arekey determinants of the worlds tradeand investment regime, as well as to

A macroeconomic policy package is made of a set of paramount policy objectives that are pursuedin a coherent manner by a group of economy-wide policy instruments. Thus, macroeconomicpolicy instruments do not act in isolation (although issues of inconsistency frequently arise). Thepolicy objectives are dened in accordance to a particular view of how prices and distributioninteract with output determination, employment and ination.

the international nancial architecture.Because they aect the way in whicheconomies relate to environmentalchange, its time to redirect mac-

roeconomic policies and to harnesstheir potential for sustainability.

Macroeconomic policies aect the rateof economic activity and, therefore,the usage rates of our natural resourcebase. Through their impacts oneconomy-wide prices, macroeco-nomic policies also condition outputcomposition and technology choice,

inuencing production and marketingstrategies of every economic agent,from the largest and most powerfulindustrial corporations, to the smallestagricultural units. They also aectasset composition of any investmentportfolio, bringing about importantchanges in the way in which nancialinstruments interact with productiveactivities in the real sectors of the econ-

omy. In view of the relation betweennancial variables and commoditiesprices in the worlds mercantile ex-changes and futures markets, this is avery important dimension that needsto be taken into account. It may

just be the tip of the iceberg whenit comes to the relations between thenancial sector and the environment.

When framed in these terms, the rela-tion between macroeconomic policiesand sustainability becomes self-evident.However, this has not been recognized by

John Maynard Keynes(1946), founder ofmodern macroeconomics.


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either the academic and policy-makingcommunities. This is a very seriousomission and may very well be themost dangerous blunder in interna-

tional policy making. This projectis a contribution towards lling thisgap with rigorous analysis. This reportconcentrates on how the macroeco-nomic policy package works and triesto identify its impacts on the envi-ronment. Readers should be awareof the fact that lengthy sections ofthis report (as well as the countrylevel studies) are devoted to a de-

tailed discussion of macroeconomicpolicies. This should not be inter-preted as the result of an academicbias for economic discussion and/ordisregard for the other theme in thetitle of this project. On the contrary,the project concentrates on macro-economic policies precisely becausethey carry deep implications for theenvironments health and resilience.

Conservationists and communitiesmust learn to deal with these themeswhich were until recently the privi-leged hunting grounds of simple-minded economists interested inhow economic aggregates interactwith each other. The stakes are in-deed very high and it is unwise toleave this realm of economic policyfor the exclusive manipulation of adiscipline that still counts environ-mental destruction as growth. Wehope that this report will help estab-lish the foundations for closer coop-eration between communities, theconstituency of the various IUCNcommissions and the world of policymakers.

One nal clarication is important.Many years have gone by since HermanDaly (1991) called for the develop-ment of an environmental macro-

economics. Since then very littleprogress has been made in this eld.Although many publications do ad-dress this problem, their approachhas systematically avoided dealingexplicitly with macroeconomicpolicy. Thus, a substantial amountof work on environmental steward-ship and conservation has ignoredthe importance of monetary and -

nancial relations, or of scal policyobjectives, or the distributional andemployment problems and their rolein shaping the economic forces thatso deeply aect the real sectors ofthe economy. In a way, Dalys call isresponsible for this lack of progress.His appeal was essentially concernedwith the problem of scale and thereality of nite resources. For him,

the market took care of the ecientallocation of resources, but was in-capable of dealing with the problemof scale. This is inaccurate: one keyresult of general equilibrium theory(by far the most rened and sophis-ticated theory of interdependentmarkets) is that there is no proof thatmarkets allocate resources eciently.Thus, Dalys reference was basedon an erroneous assessment of howmarkets operate and on the healthof received economic theory. On theother hand, the problem of scale, whichDaly described as the most importantof our time, is something that can-not be addressed without taking intoconsideration the macroeconomic



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policy framework that shapes theeconomic forces. It could be argued,for instance, that the importance of thenancial sector, for example, is at least

as important as the issue of nite re-sources. However, macroeconomicpolicy has remained outside of theradar screen, even for the followersof Herman Daly.

Perhaps the disarray in which macro-economic theory nds itself discour-aged Daly and his followers in en-gaging a meaningful dialogue with

the community of theoretical mac-roeconomists. The fact remains thatvery little work has been published onmacroeconomic policy and the en-vironment. In fact, what has beenpublished (see for example the workof Heyes (2000), Lawn (2003), Tham-papillai (1995) and Munasinghe (2002)continues to be based on standardtextbook IS-LM models and sim-

ply ignores the evolution of mac-roeconomic theory during the pastve decades. This ignores the debatesamongst academics and policymak-ers concerning the eectiveness ofmonetary and scal policies, or therole that each one of these shouldhave in a world of interdependentopen economies. What little workhas been published on macroeconomicpolicies and the environment pays noattention to the discussion concerningdisequilibrium, the nature of nan-cial crises and the role of regulatoryagencies. In fact, these analyses pay no

Perhaps the disarray in which macroeconomic theory nds itself discouraged Daly and his followersin engaging a meaningful dialogue with the community of theoretical macroeconomists. The factremains that very.

heed to the admonition of Friedman(1968) concerning the limited roleof monetary policy, a view that hascaused great damage and should have

been totally discredited by now. Ig-noring the evolution of macroeco-nomics also leads to overlooking thecontributions of post-keynesians tothe debates about demand manage-ment and unemployment in todaysworld. There is no doubt that thechasm that separates macroeconomicsfrom environmental concerns con-tinues to be a deep one.

Part of our analysis in this specialissue is the result of the project onThe Macroeconomic Connection:Monetary and Fiscal Policies forSustainability in Latin America. Thelast two essays, by Aseem Shrivas-tava and Ashish Kothari, focus on asimilar analysis for the case of Indiaand they highlight the similarities

that exist in the relation betweenmacroeconomic policies and sus-tainability even across continents.The project on Latin America wascarried out with the nancial sup-port of the 3IC Fund of the Inter-national Union for the Conservationof Nature. The project covered casestudies in ve Latin American coun-tries. This project examines the im-pacts of macroeconomic policies onthe environment. It focuses on veLatin American countries: Argen-tina, Brazil, Costa Rica, Ecuador andMexico. The main objectives of the


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project are the following. First, toidentify and analyze the eects ofmacroeconomic policies on variousenvironmental dimensions such as

biodiversity, forests, aquifers, soils,genetic resources, atmospheric pol-lution, solid waste and toxic wastemanagement, etc. The scope of thisproject covers monetary, scal,credit, exchange rate policies, as wellas current account liberalization andnancial deregulation. A secondobjective is to examine how mac-roeconomic policies constrain or

strengthen environmental policies.This will be done in relation to policiesthat relate to the dierent environ-mental dimensions mentioned in theprevious point (particularly importantwill be the analysis of eects on poli-cies related to natural protected areasand biosphere reserves). The thirdobjective is to contribute to strategyformulation and to identify viable

policy options.The individual consultants respon-sible for the Latin American country

level studies are Alan Cibils (Argen-tina), Sergio Schlesinger (Brazil),Carlos Murillo (Costa Rica), PabloSamaniego (Ecuador) and Marcos

Chvez (Brazil). The project was de-signed by Alejandro Nadal, Co-chairof TEMTI, who also monitored thestudy and prepared this synthesis re-port. In this introduction, the rst,second and third sections containan overview of the Latin Americaneconomy as it evolved in the pastsixty years. The fourth and fth sec-tions focus on how the neoliberal

open economy model works and onthe expansion of the nancial sector.The sixth section presents a synthesisand a re-interpretation of the countrylevel studies.

SECTION ITHE LATIN AMERICANEXPERIENCEDuring the 1980s, most of Latin

America underwent a radical trans-formation in its policies for economicdevelopment. Until then the majorityof Latin American economies had


Credit:Miguel B. Sanchez

Wikimedia Commons


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followed a development strategybased on import substitution. Butin the context of the nancial andeconomic crisis detonated by the

violent rise in interest rates and thecollapse in oil prices in 1981-1982,this strategy was abandoned. By themid-nineties, most economies in theregion were implementing an openeconomy model, complete with -nancial liberalization and a macroeco-nomic policy posture aimed at reduc-ing State intervention in economiclife. With variations in timing and

in the use of policy instruments,Latin America adopted the so-calledneo-liberal economic strategy.

At the country level, the new macroeco-nomic model had two critical objectives:growth and equilibrium. The growthcomponent was important because in1990 the region was emerging from adecade of practically zero growth. After

the performance of the period 1945-1978,with average annual growth rates of6.5%, this was a dismal accomplishmentand people referred to the eighties asthe lost decade. This stagnation had ex-acerbated unemployment, inequality

There were dierences in timing. Some countries started introducing neo-liberal reforms aspart of the stabilization packages negotiated with the IMF, while others took those steps as part ofstructural reforms. The history of the Chilean economy is dierent and worth considering. Afterthe coup in 1973, a radical model of an open economy was imposed by the military dictatorship.The tenets of that model were shaped by the doctrine of the New classical macroeconomics school

(created under Milton Friedmans theoretical work). This model combined a very radical approachtowards trade liberalization with an uncompromising view on nancial deregulation. But theChilean economy continued to rely on exports of primary goods to survive. By the end of theeighties, the Chilean economy was showing the signs of a looming crisis. A typical current accountcrisis was detonated in the early eighties and the military authorities were forced to introduceimportant changes in the policy package. These included controls over capital ows. Ironically,because of the measures introduced by the military dictatorship, especially capital controls and othermeasures (a return to higher import taris), Chile was spared some of the worse consequences ofthe nancial crises that aected Latin America in the nineties. Still, Chile continues to rely heavilyon exports of raw materials (copper, agricultural products, forest and wood products, sheries).

and poverty in most countries. Thepromise of economic growth sug-gested the possibility of permanent,good quality jobs. This would abate

poverty and inequality.

On the other hand, the equilibriumcomponent had three dimensions.The rst two were related to domesticeconomic aggregates. The general pricelevel had to be stabilized, while scal ac-counts had to be balanced. The thirddimension was related to each countrysexternal accounts. The current account

crises of the recent past had to becontrolled if the region was to attainadequate sustained growth rates.

Twenty years later the promises ofthe neoliberal policy package remainessentially unfullled. Growth ratesin Latin America were lower for theperiod 1980-2008 than in the years1945-1978. On the other hand, equi-

librium in domestic macroeconomicvariables was not easily established,and the region remained prone tocurrent account crises. In addition,the region was aected by a newtype of crisis, as the reversal of capital


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ows hit several countries causingsevere damages and bringing aboutnegative growth rates. These crisesleft a heavy legacy of public debt in

several countries as bailouts of banks andlarge corporations were implemented.

The region is also perceived as be-ing generously endowed in natural re-sources. Although it only has 8% of theworldspopulation, it possesses 23% ofthe worlds potentially arable land, 10%of cultivated land, 17% of pastures, 22%of forests (and 52% of tropical forests) and

31% of permanently usable water (Chi-chilnisky and Gallopin, 2001). Althoughthe region is associated with severe at-mospheric pollution in its large cities(Sao Paulo, Mexico City or Santiago, forexample), its environment is also con-sidered to embrace pristine regionsand ecosystems. Eight of the eighteencountries classied as mega-diverse byUNEP are in the Latin American region

(Bolivia, Brazil, CostaRica, Colombia,Ecuador, Mexico, Peru and Venezuela).Together, these countries have a veryhigh percentage of the worlds speciesof reptiles, amphibians, mammals, birdsand vascular plants. Endemism is veryhigh and several of the most importantbiodiversity hotspots are found in the re-gion, including the Amazon tropical rainforest, the Tropical Andes and the Meso-american corridor. Most of these ecosys-tems are threatened and in some cases,severely aected by human activities.

Latin America is also marked by somecommon patterns in its developmentstrategies. During the period follow-ing World War II most of the regions

economies embarked inan industrializa-tion process based on an import substitu-tion strategy. The strategy was accom-panied by strong leadership from State

agencies. This scheme met with somesuccess, until the seventies, when inter-nal and external tensions slowed downgrowth rates. The debt crisis that ex-ploded in the early eighties (due tohigh interest rates and falling com-modity prices) spelled the demise ofthe import substitution strategy, andin some cases, of the aspiration to in-dustrialization. This led to signicant

changes in the development strategiesof the most important Latin Ameri-can countries.

Eventually, the old inward lookingmodel of import substitution gave way tothe establishment of an open economymodel along the lines of the Wash-ington Consensus. The economicperformance of the Latin American

economies under this new strategicapproach presents a rather mixed pic-ture, but in general, average growthrates were slower than in the post-war

years. In addition, the old contradic-tions and tensions that marked theLatin American economies did notcease to exist (in fact, new problemsappeared). Finally, during the nineties,several nancial crises struck in most ofthe region and this also caused im-portant changes to be introduced inthe policy outlook of countries likeArgentina, Brazil and Ecuador.

Eorts to carry out the economicintegration of the Latin Americaneconomies have come and gone.



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Probably the most important oneswere the Latin American Free TradeAssociation (ALALC) and at the re-gional level, the Andean Pact and the

Central American Free Trade Region.These eorts were not successfuland when the time came to open theeconomies to international trade andnancial ows, most countries wenttheir own way. Mexico took the lead,becoming a member of GATT in 1987and then signing the North AmericanFree Trade Agreement (NAFTA),which sealed the subordination of its

economy to the U.S. Most of the coun-tries in South America took dierentpaths, each trying to gain from itsindividual advantages in its articulationwith the world economy.

Throughout these dierent phases ofeconomic activity, the environmentalintegrity in the region has been en-dangered. The degree of deterioration

justies posing the question concerningthe eects of this process on the regionsfuture prospects for development. It hasbeen continuously aected by the expan-sion of the agricultural frontier, defores-tation, urban development, irresponsibleactivities by extractive industries (by bothprivate and public enterprises), as wellas various forms of pollution sources.Although most countries in the regionestablished ministries for the environ-ment, the fact remains that none of thecountries in the region has been able toestablish a policy framework that dulyintegrates environmental stewardshipwith economic development.

One word of caution is required atthis stage. To speak of the LatinAmerican economy is a risky ven-ture. After all, this is a set of highly

heterogeneous economies in a vastcontinent. It includes very smallcountries in Central America (andnow the Caribbean), as well as thelarge economies of Brazil, Mexicoand Argentina. The dierences be-tween the countries in the regionhave intensied in the past fteen

years. Today, discrepancies in eco-nomic policy (almost at all levels)

are quite visible. Clearly, the ag-gregation of the LAC countries inone unit really lacks analytical value(Urquidi 2005).

SECTION IIIMPORT SUBSTITUTION ASA DEVELOPMENT STRATEGYAfter World War II, most of thecountries in the region embarked in

industrialization strategies based on aset of policies to substitute imports.The new Latin American perspectivewas inspired by the work of a groupof economists at ECLAC who main-tained that development and growthwould not come simply from capitalaccumulation and comparative advan-tages. The new perspective had ana-lyzed trends of in international termsof trade and concluded that they weremoving against traditional primaryproduct exports. Thus, domestic pro-duction would have to substitute fornon-essential imports through a set ofprotectionist policies. This called for a

In some cases, especially in the smallest countries, the development strategy relied on the oldmodel based on exports of primary products.


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stronger role for the public sector. Theconsequence here was that develop-ment would be more the eect ofpolicy, than of market forces.

This import-substitution industrializa-tion (ISI) strategy met with mixedsuccess in the various economies andlasted for over forty years in somecases. However, the ISI strategy didnot proceed according to a well de-ned plan or program for industrialinvestments, internal competitivestructures, technological development

or export promotion schemes. Thisled to several important problems,starting with high costs and poor resultsin the trade balance.

In general, the ISI pattern of growthwas accompanied by good GDP growthrates in the period 1950-1973. Sus-tained growth rates of the order of 6%were not rare in the region. But in 1973

international oil markets were severelydisturbed by the oil embargo imposedin the aftermath of the Yom Kippurwar, and things started to change. The

rate of growth of per capita income is agood indicator of the evolution of theregions most important economies.For a sample of twelve Latin Americancountries, annual growth rates in theperiod 1950-1973 averaged 2.12%.During the period 1973-2000, thisaverage rate dropped to 0.79%. Thedisparities between these countries canbe readily seen in Table V.1.

During a twenty year period, be-tween 1950 and 1970, the ISI strat-egy successfully brought about theexpansion of the manufacturing sec-tor and of employment. Between1960 and 1965, the manufacturingsector in the region grew at a yearlyrate of 7%, with Argentina, Braziland Mexico leading the way. In most

Table V.1


According to Fajnzylber (1983: 246) the industrial sector of the Latin American region expandedat an average annual rate of 6.5%.


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cases, the industrialization process tookplace without a denite plan or in-vestment policy. This is why man-ufacturing industries in all types of

branches were developed almost atthe same time. The central idea be-hind this strategy was that indus-trialization would provide the neededdynamic impulses for economicgrowth and development.

The ISI strategy ignored several im-portant aspects of economic change.First, it neglected the assimilation of

technological capabilities. The crucialdierence with the protectionist poli-cies of Japan and South East Asiancountries that were also rapidly in-dustrializing is that in Latin Americatechnological development was nevera part of the equation. Investing inR&D lagged behind in all countriesin the region. The acquisition of disem-bodied technology was done through

contracts involving licensing agree-ments on patents and trademarks, andthese contracts frequently containedrestrictive clauses on exports. Em-bodied technology was obtainedthrough imports of capital goods andintermediate inputs. As an incentivefor investment by the private sector,taris for capital goods were verylow. A short term perspective waspromoted, with almost no attentionfor the heavy industries that neededa longer time horizon to mature.

Second, protectionism in the LatinAmerican experience was uncondi-tional. This has been aptly described as

frivolous protectionism by Fajn-zylber (1983). The very high taristhat provided a closed market re-gime generated perverse incentives

that rewarded ineciencies. In ad-dition, tari schedules had no timelimitations and no performance re-quirements. This provides a verystrong contrast with Japan, Koreaand Taiwan, where protectionismand nance were subject to technol-ogy, employment and technologyperformance requirements (Amsden1989). All of this led to high prices

and lack of competitiveness in theinternational market, which in turnaggravated the deterioration of thetrade balance.

These two features reveal that the ISIstrategy really took place without acoherent scheme of industrial policy.There were no priorities and no per-formance requirements, and nothing

to ensure that the acquisition of tech-nological capabilities could lead to fur-ther waves of innovation and ecien-cy gains. In a way, the ISI strategy wasnot what many of its critics say it was:an interventionist, State-dominatedprocess.

Third, the distortions of the industrial-ization process in Latin America inten-sied the vulnerability of the externalaccounts of the economies in theregion. In contrast with the role ofthe manufacturing sector in highly in-dustrialized countries, where it plays akey role in maintaining a surplus in thetrade balance, in Latin America it helps

For a rigorous and insightful analysis of the experience in South Korea, see Amsden (1989).


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explain the chronic external decit(and of the currency gap). In fact, thetrade decit of the industrial sector inmost countries in the region was of the

same order of magnitude as the tradesurplus for the rest of the economy. Be-tween 1955 and 1975 the trade decitthe industrial decit increased from 5to 28 billion dollars. Nevertheless, it isalso important to take into account thatduring the period 1955-1975, indus-trial exports were growing at a higherrate than imports.

Most of the decit in industrial goodsis due to the high imports of capitalgoods. This is an important featureof the entire process because capitalgoods are critical for the disseminationof productivity gains in all branches ofindustrial activity. The fact that the in-dustrialization process bypassed themmeant that it could not be the enginefor growth that most analysts had

hoped it would become.Fourth, the size of the domestic mar-ket was a serious problem. This isintimately related to the issue of pro-duction scales allowing for low costs.Because the domestic market for man-ufactured goods was relatively smalland limited to the urban centres, animportant question was if the manu-facturing sector could contribute toincrease the size of the internal marketpermanently (Urquidi 2005: 164). Thetruth of the matter is that although

real wages in the manufacturing sec-tor increased and were higher than inother sectors, the absolute size of thispurchasing power was not enough

to allow for investments in more e-cient scales of production. In addition,wages in the agricultural and servicessectors did not increase at a sucientlyrapid pace. This is related to the issueof the macroeconomic policy packagethat characterized those years. We re-turn to this point below.

Finally, the highly unequal income

distribution structures in most LatinAmerican countries also contributed tolimit the size of the domestic market.The Gini coecients for most of theLatin American countries remainedat high levels during the ISI strategy(Ibid.: 486). Most countries had Ginicoecients of the order of 0.500 inthe period 1960-1970. The exceptionswere Argentina, Costa Rica and Uru-

guay, where the Gini coecient was0.400. These high levels of inequalitydid not disappear during the next fewdecades. Once again, this is related tothe macroeconomic posture, a themeto which we now turn our attention.

Macroeconomic stability played animportant role during the heydayof the import substitution strategy.Exchange rate volatility was not acrucial problem, although somecountries did experience balance ofpayments diculties that required

The Gini coecient measures inequality in the distribution of income. It measures the surfacebetween the line of equal distribution (a 45 diagonal) and the curve of actual observed distribution.If the coecient is very small, it indicates that actual income distribution is closer to the line ofequal distribution. In the largest European countries, the Gini coecient is typically of the orderof 0.300.



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adjustments. On the other hand, s-cal policy allowed for the buildingof infrastructure and social expen-ditures at adequate levels. Finally,

monetary policy relied on bankingregulations that maintained creditows towards productive activities.This placid scenario was to changeabruptly during the seventies andwith the debt crisis in the eighties.

Much of the industrial structure inLatin America suered great losses asa result of the macroeconomic crises

that exploded in the eighties. LatinAmericas industrial performancehas declined since the 1980s, andthe region has been constantly losingground in industrial competitiveness(especially in manufactures) to EastAsia. Argentina, Brazil and Mexico,the most industrialized countries in theregion were unable to trigger enoughmomentum to transform its productive

structures and become truly industri-alized economies. In spite of its suc-cess in several manufacturing branches(automobiles, electronics and aircraft)and its diversied markets, Brazilsmanufactured exports per capita areUSD 382 (2004), still below Lat-in Americas average. The share ofmanufactures in Brazils GDP wasonly 10.7% in 2004. Mexico, for itspart, can boast an impressive share ofmanufactures in its exports of 84%,out of which more than 60% comesfrom medium and high-technologyintensive branches. However, thisoft-quoted gure can be misleadingbecause almost all of this comes fromits in bond (maquiladora) industrial

sector which has very little linkageswith the rest of the economy. Thisexplains why the locomotive of theexport sector can take o swiftly and

still leave the rest of the economy inthe tracks at the station. The engineis disconnected from the economyand this means that Mexico is, in fact,exporting cheap labour.

Towards the last years of the nineties,it was thought that Latin Americacould regain some of its competi-tiveness in manufactures. This is

important because it would signal astructural transformation that couldlead to greater eciency, less de-pendency on the natural resourcebase and better environmental stew-ardship. However, a succession ofsevere macroeconomic crises (Mex-ico 1995, Brazil 1997-98, Ecua-dor 1999 and Argentina 2001) hadvery negative consequences. The

share of manufactures in regionalGDP shrank from 17.2% to 16.6%,while manufacturing value addedin the region declined from USD316 to USD 285 billion between2000 and 2004. In the arena of in-ternational trade, Latin Americanexports of manufactures expandedby 5% yearly, well below the worldaverage of 8.8%. This explains whyLatin Americas share in global tradeof manufactures dropped from 4%to 3.5% during the years 2000-2004.Medium and high technology ex-ports also declined during that pe-riod. To summarize, manufacturesshare in total exports from the regiondropped from 49.2% to 48.2%, showing


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the signs of a trend to rely more onlow-value added and resource-inten-sive commodities as Latin Americanmoves towards reprimarization.

SECTION IIIMACROECONOMIC POLICIES,ISI AND THE ENVIRONMENT:THE LONG LOOKThe import substitution strategyimplemented after World War IIbrought about deep changes in thestructure of the Latin Americaneconomies. But it did not generate

permanent dynamic impulses andthus, the growth process associatedwith this strategy came to an end inthe 1980s. It also failed to provide thefoundations for sound environmen-tal stewardship and healthy naturalresource management practices.

Data on environmental deterioration inLatin America for the period 1950-1980

is in short supply. However, during thethree decades (1945-1975) that makeup the core years of the ISI strategy,Latin American economies did notgive adequate attention to environ-mental objectives. In retrospect, thismay appear understandable for atleast two reasons. One is the lack ofawareness that this was a crucial ele-ment of any development strategy.The second is that it can be arguedthat policy-makers and the powerelite were too preoccupied with theissues of scal accounts and the balanceof payments. Nevertheless, the truthis that during these decades the natu-ral resource base was heavily taxed andvery little in the form of investment

went into what we now call envi-ronmental expenditures. Natural re-source management practices, clean-ing-up, reforestation, good practices

for soil conservation, water manage-ment, urban planning and pollutionabatement, as well as other aspectsof environmental sustainability werealmost entirely neglected by govern-ments in the region during this period.In fact, in many instances, measuresthat implied heavy environmentaldegradation were adopted, leadingto soil erosion, deforestation, aquifer

depletion and pervasive pollution.Cumulative damages suered by theenvironment compromises the pros-pects for future development andsustainability.

The rate of genuine savings (dened asthe rate of savings after due accountis taken of the depletion of naturalresources and damages caused by

pollution, but adding investmentsin so-called human capital) was verylow in the region. This is a clearindicator that the natural resourcebase and the environment have beenundergoing a continuous processof degradation without any visibletrend to revert this process. This is areference from a World Bank studymentioned in Lopez (2003).

Lopez (2003) relies on an analyticalframework that concentrates onmarket failures and property rightsineciencies. For example, a capitalmarket failure would prevent thepopulation from investing in naturalcapital, or inadequate denition of



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property rights would cause distortionsthat inhibit investments in naturalassets. In addition, the lack of robustregulatory regimes allows for pol-

luting externalities to further degradethe environment (Ibid.). Imperfec-tions in the credit market imply thatonly the larger corporations (solelyconcerned with protability and ac-cumulation) have access to nancefor their investments. Due to creditmarket imperfections, there is noow of savings from the income-generating sectors to the household

sector to nance investments in humancapital and the environment. Typi-cally, the smaller agents are left outbecause they lack collateral or connec-tions to the world of formal nancialsystems.

But this was not the result of marketfailures, imperfections or negativeexternalities. It was the consequence

of macroeconomic policies that fa-voured growth through the accu-mulation of physical capital. Themost visible aspects of these macro-economic policies are in the eld ofcredit markets and monetary policy,as well as in scal policy (taxationand subsidies). In addition, a low wagerate has contributed to greater inequal-ity and the persistence of poverty.

At the macroeconomic level, twobig problems persisted. The rst wasthe scal decit which remained anintractable problem for most LatinAmerican countries. This was partlydue to the need to increase pub-lic investment in order to maintain

growth rates at their historic levels.The decit came along from this in-creased responsibility for the publicsector and the unwillingness to im-

plement a redistributive scal reformthat could have generated the re-quired resources without frighteningaway investors.

Fiscal policy in the region duringthe heyday of the ISI strategy optedfor low tax rates on capital gainsand prots. In addition, all types oftax credits and rebates were imple-

mented to foster private investment.Typically, scal revenues came froma regressive tax system and the prices ofgoods and services supplied by publicsector enterprises. In addition, subsidiesfor the accumulation of physical capitalwere generously granted wheneverpossible. These resources were insuf-cient to keep pace with the grow-ing demands of health, education,

housing, transportation, infrastruc-ture, and of course, environmentalstewardship. In many instances (ex-amples abound) public enterpriseswere hard pressed to maximize thesenon-tax scal revenues and theywere able to achieve this through ir-rational exploitation of the naturalresources at their disposal.

Monetary policy in Latin Americaduring the same period had theoverarching objective of full em-ployment. This did not mean thatprice and exchange rate stability wasnot considered important. In fact,manipulating exchange rates withinthe limits tolerated by the Bretton


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Woods arrangements was commonin order to redress trade balancesand to put a brake on inationarypressures. In fact, all along this pe-

riod there were moderate price hikes(things changed in the seventies withthe transmission eects of incre-ments in oil prices). For the ISI strat-egy, the accommodating monetarypolicy focused on its main objective:growth and employment genera-tion. For this, most countries in theregion did not rely on a free mar-ket for credit and instead established

strong regulatory regimes for creditallocation. However, these creditregulations lacked priorities anddid not incorporate industrial (andtechnology) policy criteria. In addi-tion, the vast majority of loans wentto consumption and some workingcapital in industry. Productive in-vestments in industry were the objectof self-nance by corporations (up to

60% of nancial requirements weresatised by the companies them-selves). One reason for this is thatthe time horizons contemplated inloans from commercial banks weresimply not long enough to allow forthese investments to ourish.

In addition to these problems, ascommented above, there was achronic decit in the trade balanceof most countries in the region. Inthe context of an ISI strategy thismay seem ironical, but the fact is thatimport substitution led to overvaluedexchange rates and this was a strongincentive for increased imports. Crawl-ing peg exchange rates implemented

in the sixties led to more inationarypressures (as imported goods becamemore expensive) rather to a correc-tion of the trade balance.

Inationary pressures have been ex-plained by both monetarist and struc-turalist perspectives (Cardoso andFishlow 1989). The monetarist viewinsists that ination came about basi-cally by large budget decits nancedby money creation: thus, ination isthe direct result from overspending bythe public sector. On the other hand,

structuralists maintain that budgetdecits are not at the heart of the mat-ter. The roots of ination are to befound in bottlenecks, supply short-ages and, in some cases, inconsistentclaims of dierent groups in societytrying to get a larger share of the pie(Ibid.: 19). The irony here is that thisled to stabilization policies in whichcontrols over the wage norm became

one of the central components. Thispattern of wage determination aggra-vated income mal-distribution andfurther constrained the size of thedomestic market.

In the end, the internal tensions, to-gether with the negative transforma-tions in the international economy(recession and ination in the USduring the seventies, the high interestrates implemented by Volckers Fedand the drop in commodity and oilprices) brought about the demise ofthe ISI.

The international debt crisis of the1980s was detonated in Latin America



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(starting with the Mexican default in1982). It led to the eective interrup-tion of the import substitution ap-proach to growth, industrialization

and development. After that decade,in which per capita growth stagnated(the lost decade), none of the LatinAmerican countries returned to theISI model. Instead a new approachwas undertaken, based on trade andnancial liberalization, following inthe nineties, the tenets of the Wash-ington Consensus.

SECTION IVNEOLIBERALISM IN LATINAMERICA: THE OPENECONOMY MODELBy the end of the 1980s most LatinAmerican countries were setting thefoundations for the adoption of adierent development strategy. Thenew approach was very dierentfrom the ISI strategy. It was based on

the idea that the development processhad to be left in the hands of marketsoperating with as little interventionas possible. Although the notion thatmarkets allocate resources ecientlylacked any scientic demonstration(Box 1), the ideological triumphof this belief had been consolidatedsince the 1970s, especially under thepolitical hubris of Mrs. Thatcher and

Ronald Reagan.During the 1980s, the main inter-national nancial organizations, theIMF and the World Bank, had usedthe international debt crisis and thestabilization plans to further pro-mote the policy agenda that became

known as the Washington Consensus(Williamson 1990). The ve crucialoperational components of the policypackage were the following:

a) the main objective of monetary policyis price stability.b) scal policy is to be based on the

principle of balanced budgets.c) the capital account is to be deregulated.d) international trade liberalization.e) State intervention in economic lifehas to be reduced to a minimum.

Ination had remained a negative

feature during the eighties, mostlyspurred by the abrupt adjustment inexchange rates. This adjustment wasindispensable as the crisis had beendetonated precisely by the collapseof the regions external accounts, butination needed to be controlled. Inorder to do this, domestic aggregatedemand was severely constrained.The policy instruments to do this

were rst, domestic credit becamescarce and very expensive (high in-terest rates played a double role andhelped attract foreign capital). Thesecond instrument was found in thecurtailment of public expenditures sothat scal policies acted as a pro-re-cession instrument. If in the past s-cal decits had been considered thesource of all evils (monetization, in-

debtedness and crowding out), in thenew scheme of things, scal policyhad to be subordinated to the man-tra of a balanced budget. Finally, realwages were systematically drivendownwards as their determinationwas usually carried out through theirbeing pegged to expected ination,


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Bo 1The Theoretical Underpinnins of the Open Economy Model

The structural components of the open economy model ap-plied in many Latin American countries bear a close resem-blance with the Mundell-Fleming model, the widely cited stan-dard for macroeconomic analysis of open economies (Fleming1962, Mundell 1963). That model was one of the principalaccomplishments that led to the award of the Nobel Prize ineconomics to Robert Mundell in 1999. The Mundell-Flemingmodel does not have strict microeconomic foundations, but itsanalytical structure is closely linked to the notions that marketsalways clear, and that trade liberalization is the best way to or-

ganize production and consumption. In fact, the close associa-tion between the Mundell-Fleming open economy model andgeneral equilibrium theory was acknowledged by its authors(Mundell 1968), and this close relationship has also been recog-nized in more recent work (Geanakoplos and Tsomocos 2001).From this perspective, its just another member of the family ofdynamic stochastic general equilibrium models.

This model is an extension of the IS-LM model which incor-porates an equilibrium curve for the balance of payments andcan also assimilate dierent assumptions concerning xed oroating exchange rates, as well as perfect mobility of capital.

With a exible exchange rate regime, there is no room for anindependent monetary policy. In the Mundell-Fleming modelthe adjustment of the money supply is automatic, and is tiedto the surplus or decit of the balance of payments (when themonetary approach to the balance of payments prevails). Asurplus in the balance of payments implies monetary expan-sion, while a decit involves an adjustment due to the contrac-tion of the monetary supply.

The critical detonator of the crisis in 1982 had been the unsustainable debt. Eorts to save the internationalnancial system and restructure the debt of the main debtor countries failed. But in 1988 the U.S. Treasurydeveloped a new plan to restructure debt and restore liquidity to the sovereign debt market. This planwas implemented with some success.


not to eective or real ination. Thisled to a loss of purchasing power andto a contraction of aggregate de-

mand. By the early nineties, ina-tion rates had gone down in most ofthe economies in the region.


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Initially, the new open economymodel that was established in mostof the Latin American region led tostrong positive expectations about

investment and growth. The gener-alized dominance of the Washing-ton Consensus ideology also pro-vided a sense of stability, as if a newprolonged era of policy making anddevelopment was being introduced.Growth rates improved in the earlynineties as inationary expectationsdiminished and foreign direct in-vestment started to recover.

However, very soon economic growthstarted to weaken and in 1994 a newcrisis exploded in the region. Thedetonator was a reversal of capitalows that were going into Mexico,and the shock wave aected all ofLatin America. This crisis was er-roneously interpreted as a foreignexchange crisis and described as a

nancial crisis.In fact, it demonstrated how the maincontradictions of the model would

inexorably lead to nancial crises.Very soon, other Latin Americaneconomies were suering simi-lar crises, with the same pattern of

causation links and the similar af-tershocks: Brazil (1997), Ecuador(1999), Argentina (2000) and othercountries suered deep contractionsand the destruction of capital as thecrises multiplied. The stabilizationprograms that were implementedled to painful adjustments, increasedpoverty and inequality and probablyhad deep environmental eects.

These crises typically unfolded throughseveral stages. First, nancial liberaliza-tion and other reforms attracted for-eign capitals, not only as FDI, but alsoas portfolio (short term) investments.At a certain stage, investors started todoubt the recipient countrys ability tomaintain exchange rate stability, whichis the centrepiece of the model, and

lead for the exit. And although therewas talk about the fact that perhapsthere were mistakes abd/or negligencein the way in which the model was

Credit:George ChernilevskyWikimedia Commons


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being implemented and/or handled,there is an alternative line of analysisthat points in a dierent direction.

In order to understand how macroeco-nomic policies aect the environmentand to follow the country level studies,it is essential to analyze how the openeconomy model functions. In the restof this section we examine its main fea-tures through what we call the internalcontradictions of the model. Internalcontradictions arise when structuralelements that are essential to a model

simultaneously act as obstacles for themodels performance. In other words,a model contains internal contradic-tions if components that are necessaryto its inner workings also hinder thefunctioning of the model. The result-ing tension leads to a distorted processin which the models policy mix can-not accomplish the goals that wereoriginally established.

The open economy model as dic-tated by the International MonetaryFund and the World Bank has sev-eral essential contradictions which

can be summarized as follows. Therst and most important contra-diction is related to the role of theexchange rate which is expected tooat freely, maintaining equilibri-um in the trade balance. The openeconomy model rests on the fun-damental premise that internationaltrade is so advantageous that any at-tempt at regulating and restricting it

does more harm than good. Thatswhy when there is a decit in thetrade balance it must not be correct-ed with restrictions on the ow ofgoods and services, but by adjustingrelative prices. Thus, within a ex-ible exchange rate framework, theadjustment through variations in theexchange rate should follow auto-matically.

The reference here is the Mundell-Fleming macroeconomic model. This model is an extension ofthe IS-LM model which incorporates an equilibrium curve for the balance of payments and can alsoassimilate dierent assumptions concerning xed or oating exchange rates, as well as perfect mobil-ity of capital. With a exible exchange rate regime, there is no room for an independent monetarypolicy. In the Mundell-Fleming model without sterilization the adjustment of the money supply isautomatic. It is also tied to the surplus or decit of the balance of payments (when the monetary ap -proach to the balance of payments prevails). A surplus in the balance of payments implies monetaryexpansion, while a decit involves an adjustment due to the contraction of the monetary supply.

The General Agreement on Taris and Trade (GATT) prevented signatory parties from sur -rendering to the temptation of routinely resorting to controls on trade ows in order to tackleexternal decits. GATT Article XII established the possibility of exceptionally resorting to mea-

sures such as quantitative restrictions and tari surcharges to reestablish equilibrium in the bal-ance of payments. It was thought that it was better to regulate exceptional measures and imposedisciplinary measures to avoid abuses, than to leave GATT members at total liberty in this matter.Interestingly, the North American Free Trade Agreement (NAFTA) cancelled the possibility ofresorting to exceptional measures. NAFTA Article 2104 establishes that fees, tari surcharges,import permits, or other similar measures cannot be exceptional measures, and, in eect, it cancelsthe possibility of applying any such measures. Under these conditions, if there is a decit in thebalance of trade, the adjustment must be made only and exclusively using the relative price system(i.e., the exchange rate). For a detailed account of these provisions in the context of the Mexican1994 crisis, see Nadal (1996).



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That ination must necessarily be re-duced to the level of a countrys mostimportant trade partners is anotherkey policy objective that prevails in

the open economy model. The ideahas led to a veritable obsession withreaching and maintaining one-digitination rates. In terms of growth, thecost of attaining this objective hasbeen signicant. One of the main pol-icy instruments on this front has beenthe use of the exchange rate as thenominal anchor of the relative pricesystem. But this approach to control-

ling inationary pressures entails asignicant rigidity in the exchangerate, contradicting the use of a uctu-ating exchange rate to adjust the tradebalance. In the end, the exchange rateends up being overvalued, further de-teriorating the trade balance.

There is another force that hampersthe ability of the exchange rate to act as

the key variable in the adjustment ofthe trade balance. The open economymodel incorporates perfect capitalmobility as one of its central com-ponents. Capital mobility is seen as auseful instrument to direct produc-tive investment to economies withinsucient domestic savings. Thedemand for assets denominated in thecurrency of the recipient countrynaturally leads to currency apprecia-tion, also contributing to further de-teriorate the trade balance.

In addition, because capital that owsinto a given economy is invested inassets denominated in the local cur-rency, pressure builds up to maintain

exchange rate stability. In general,in the world of deregulated capitalaccounts and interdependent nan-cial markets, countries make eorts

to guarantee exchange rate stability;this can be done through a literallyxed rate, or through a dirty oatof the exchange rate. Once foreigncapital is invested in a given coun-try, investors expect the exchangerate to remain stable; in the face ofdevaluation risks, a risk premium isrequested by investors.

If a country wants to remain attrac-tive to these capital ows, it musttry not to betray their condence bymaintaining exchange rate stabil-ity. When capital ows are reversed,the exchange rate is depreciated asinvestors ee assets denominated inthe local currency, and the inationrate increases rapidly. To preventthis, the central bank oers a higher

interest rate as an incentive to keepassets in the country. The eects onthe interest rates are examined in thenext section. The point here is thata devaluation of the exchange rate isdeemed unacceptable to economicauthorities and this further degradescompetitiveness. Typically, the ad-

justment is postponed; the adjust-ment is nally made when its toolate and it is implemented in a dis-orderly fashion, in an environmentcharacterized by chaos, volatility, andeconomic collapse.

Abrupt devaluation makes local as-sets cheaper for foreign investors,stimulating incoming capital ows.


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Once again, these capital ows areplaced in assets denominated in thelocal currency and tend to raise theexchange rate anew. This exchange

rate appreciation cancels the eectsof the initial devaluation and onceagain, contributes to deteriorate thecountrys trade balance. The externaldecit generates a greater need forexternal nance and the process becomesa vicious circle as capital ows seriouslyincrease external vulnerability.

Thus, these three elements (using the

exchange rate to stem ination, ex-change rate appreciation caused by in-coming capital ows and maintaininga low exchange rate convertibility risk)bring about an important contradictionin the model. A central feature of themodel is the adjustment in foreign ac-counts via changing relative prices, thatis, with a exible exchange rate regime,but other elements in the model im-

pose a high degree of rigidity on theexchange rate.

How is this contradiction resolved inpractice? The adjustment through ex-change rate movements is delayed asmuch as possible, with the resultingdeterioration of the countrys foreignaccounts. When the adjustment in the

Examples of the above contradiction, where exchange rate adjustment becomes necessary but dicult,

abound in recent nancial crises. The conict between the goal of using the exchange rate as an adjust-ment variable for any external disequilibrium and the need to keep the exchange rate stable in orderto benet short-term foreign investment was clearly manifested in Mexico in 1994. Throughout that

year, the overvaluation of the exchange rate had reached exaggerated levels and the deterioration offoreign accounts demanded an important adjustment in the exchange rate. However, even aftercapital ight had begun, the pressure exerted by foreign investors to keep the exchange rate stableprevailed. This pressure forced economic authorities to adopt the unusual measure of indexing govern-ment bonds held by several foreign pension funds and brokerage rms to the exchange rate.Eectively this meant that the risk of devaluation fell on the Mexican government. This case is an extremeexample of conicting goals for the same macroeconomic variable in the open economy model.

exchange rate is nally carried out, thistakes place under conditions of greatvolatility and unrest in the nancialmarkets. The adjustment and its eects

then become disproportionate. In ad-dition to the unrest in nancial mar-kets, the ination rate rapidly rises andpast achievements in this area are wipedout. Although the crisis is said to be anexchange rate crisis, it really is a structuralcrisis of the open economy model.

The second contradiction is related tothe interest rate. The open economy

model is based not only on trade liber-alization, but on nancial deregulationas well. The capital account is deregu-lated in order to attract and use foreignsavings to increase productive invest-ments and promote growth. Financialderegulation implies eliminating bar-riers to the free ow of capital, a pol-icy measure that has profound impli-cations for the role played by several

macroeconomic policy instruments.The exchange rate is no longer thekey variable that regulates contactbetween two relative price systems(domestic and foreign) in the goodsand services market; instead, as wehave seen, it becomes a variable thatis more closely linked to the needs ofthe short term capital ows.



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In the Mundell Fleming model a cur-rent account decit is nanced bycapital inows. Under fully exibleexchange rate regimes, this variable

adjusts so that the sum of the currentand the capital accounts is zero. Theadjustment process is automatic. Forexample, consider the case of an openeconomy with a xed supply of mon-ey, exible exchange rates and xedprices. In this economy a current ac-count decit causes capital inows,which lead to an increase in the sup-ply of real balances and a reduction in

interest rates. This reduction gener-ates capital outows, which provokea depreciation of the exchange rate,making the domestic productive sys-tem more competitive and leading toan expansion of demand for exports.Total output now expands until a newequilibrium is reached for the moneyand the goods markets, as well as forthe balance of payments.

But now consider the case of an econ-omy that is the recipient of incomingcapital ows for other reasons, per-haps because its domestic interest ratebecomes higher than the prevailinginternational rate. In the absence ofany intervention, the domestic moneysupply expands as demand for assetsdenominated in the domestic cur-rency increases. This leads to an ex-pansion of the money supply. At thisstage, the capital account displays asurplus, the exchange rate appreciatesand the domestic interest rate is forceddownwards. The drop in the domesticinterest rate gradually reduces the owof incoming capital and equilibrium is

restored in the balance of payments.The drop in the interest rate and theexchange rate appreciation may or maynot lead to a new equilibrium involv-

ing a greater level of output, dependingon the elasticity of imports and exportsvis--vis exchange rate variations, andof the investment schedule with respectto changes in the interest rate.

The expansion in the money supplyresulting from foreign capital inowscan be an important source of ina-tionary pressures, but it can be cur-

tailed by sterilizing the eects of theinux of capital. This can be donethrough open market operations inwhich the central bank sells bonds orsecurities and withdraws money fromcirculation in an amount equivalent tothe incoming capital ows. In doingthis, the central bank increases its do-mestic indebtedness. To put it in otherterms, sterilization takes place when the

central bank trades foreign exchangefor domestic currency but reversesthe expansion of the money supplythrough open market operations. Thispermits the economy to operate witha constant money supply and to keepination under control. The problem,however, is that although limiting theexpansion of the money supply maybe a worthwhile objective, the centralbanks intervention with sterilizationinterrupts the adjustment process. Theautomatic regulation outlined aboverelies critically on interest rate varia-tions as capital ows take place. But,by maintaining a constant money sup-ply, sterilization keeps the interest rateat an articial level that is higher than


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the international rate. Capital inowscontinue, reserves grow (but at anadditional cost), and domestic invest-ment continues to be confronted with

a high interest rate.

The contradiction is dened in termsof two processes in the model. Onone hand, the model requires the in-terest rate to fall in order to restoreequilibrium in the money market inthe face of incoming capital ows.On the other, a basic tenet of themodel is that because an expansion

of the money supply leads to increasedination, the money supply must re-main constant; this keeps the inter-est rate articially high. In practice, thecontradiction is resolved throughintervention with sterilization, a higherinterest rate and an overvalued currency.

The third contradiction is related tothe role of nancial liberalization. As

is well known, a country can accessforeign savings to nance its pur-chases of capital goods and interme-diate products, and thereby increaseproductive investment. But capitalows also allow a country to nancea decit in its trade balance. Fromthe point of view of the models ra-tionale, this is a desirable outcome,as imports of capital goods can beused to increase exports. However,if the trade decit is basically due In the case of Mexico, intervention with sterilization has been taking place since the crisis in 1994.This has allowed authorities to maintain an overvalued exchange rate, bringing ination undercontrol but further reducing competitiveness and deteriorating the trade balance. As internationalreserves have increased to historical levels, the central bank has continued to pursue a restric-tive monetary policy, maintaining interest rates at even higher levels. This limits the economyscapacity to attain adequate growth rates, while, at the same time, maintaining high rewards forforeign capital. The capital ows that result from this further contribute to the appreciation of theexchange rate and the deterioration of the countrys external accounts.

to imports of consumer goods, thetrade decit cannot be nanced bycapital inows for a long period oftime. Foreign capital ows may in-

crease the nal capacity to import ata faster pace than the build-up of theproductive capacity to export.

Incoming capital ows can arti-cially maintain a countrys capacityto import goods, without any clearrelationship to the countrys capac-ity to export (and to generate badlyneeded hard currency ows). From

this point of view, capital ows areanalogous to foreign aid, which canalso articially support a high levelof imports. Some economists havenoted that the use of capital inowsto maintain imports may have acontractionary eect on the domes-tic market and the level of aggregateactivity (Bhaduri, 1998, and Bhaduriand Skarstein, 1996).

These authors analyze the problemin a simplied manner, starting withthe basic formula of national ac-counts in an open economy:

I S = I sY = (M X) = A

where I is investment; S, savings;Y, income; s, the (constant) fractionof income assigned to savings; M,imports; X, exports, and A, foreign



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capital ow. According to this for-mula, the level of national income,determined by the size of the domes-tic market or aggregate demand is

derived from the following formula:

Y = (1/s)(I A)

This second equation indicates thatas capital inows take place (A in-creases), for any level of investment,national income is reduced by themultiplier eect. These imports maylead to a reduction in aggregate in-

come through a perverse eect ofthe well-known Kahn-Keynes mul-tiplier: the initial impulse towardscontraction is provided by the sub-stitution eect that replaces domesticproduction with imports in certainbranches of industry; the multiplierprocess leads to successive roundsof additional induced reductions inaggregate demand for domestic pro-

duction, in the familiar, converginggeometric series.

At the beginning of the process thesubstitution eect leads to a reduc-tion in prots, wages, and jobs as thesome branches aected by increasedimports are eliminated. But in succes-sive phases, this initial reduction of do-mestic production creates additionalcutbacks in aggregate demand. Theoverall, nal reduction in prots,wages, and jobs can be signicantlygreater than the original drop causedby the direct impact of imports. Thecontraction of demand and domestic

production in successive stages doesnot imply new or greater substitu-tion eects directly caused by tradeliberalization or by the capacity to

nance imports that capital owsbring about. That is, the inducedimpact does not come from the lackof competitiveness of local industry.Perfectly healthy domestic industriesare weakened and put out of actionby this indirect eect.

These perverse consequences are evenmore intense when capital inows

take place in the framework of rapidand indiscriminate trade liberalization,as was the case in Mexico in 1989-95. The contractionary eect is morepronounced when, as in Mexico at thattime, scal policy emphasizes generatinga primary surplus and when restric-tive monetary policy is attempting tocontrol ination. The primary sur-plus is determined by the dierence

between tax and non-tax scal rev-enues and expenditures excludinginterests and nancial charges. Thus, ameasure of the sustainable debt to GDPratio is given by a primary surplusthat is enough to cover interest pay-ments. Formally, in order to maintain aconstant (or declining) ratio of debt toGDP ratio, a government is supposed tocomply with the following condition:

pst =( rt - gt )dt-1

where ps = primary surplus, r = real in-terest rate, g = GDP real growth rateand d = ratio of public debt to GDP.

This is the expression widely used in models for optimal taxation and debt management. SeeCroce and Juan-Ramn (2003).


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In a recession, as g falls, sp must in-crease in order to meet the terms of thiscondition. Besides, the primary surpluswill have to increase even more if r is

raised (for example, to attract more for-eign capital or to control inationarypressures). But this view of the relationbetween scal and monetary policiesimplies the impossibility of resortingto countercyclical macroeconomicpolicies. In the midst of a recession,scal policy will adopt a posture thatwill aggravate the recession, seekingto increase sp. Typically, sp will be in-

creased through cuts in public spend-ing, something that aects investmentin social programs, as well as environ-mental programs. We return to thispoint below.

In this adverse environment, the com-bined eect of foreign capital owsand government policy amounts to averitable attack on domestic produc-

tive capacity. And this scenario be-comes still more complex because ofits interaction with the rst contra-diction: the overvaluation of the ex-change rate encourages an increase inimports, while the need to encourageand maintain foreign capital inowsrequires exchange rate stability andstrengthens trends leading to great-er overvaluation. Capital inows donot necessarily reect a healthy stateof the economy. In fact, they turnthe capacity to import into an exog-enous variable. The liberalization ofthe nancial sector and of the capitalaccount opens the possibility of in-creased private sector indebtedness. Asa result, a countrys capacity to import

becomes disconnected from its abilityto generate foreign currency throughexports. In this context, higher levelsof investment and capital ow make

aggregate demand and income grow.But this expansion in aggregate de-mand translates into greater imports,which have a contractionary eecton domestic production. As Bhaduripoints out (1989:155), this perverse ef-fect will appear even when a higherlevel of capital ow leads to greaterinvestment and exports, as long as themarginal propensity to import associat-

ed with capital ows is larger than thecorresponding marginal propensity toinvest and export.

Under a oating exchange rate re-gime, like the one implemented inMexico since 1995, the above con-clusions are not reversed; in fact, theymay even be strengthened. Despitethe trade imbalance, the exchange

rate appreciates as a result of capitalows; this normally means that thetrade decit becomes even worse.15Thus, as a result of capital inowsand increases in imports, domesticproduction and demand contract(Ibid.). In a framework of nancialand trade liberalization, capital owsthat can nance the capacity to im-port without generating foreigncurrency through exports may leadto a perverse process of cumulativecausation using the terminologyfrom Hirschmanns theory of devel-opment economics. The disequilib-ria in a countrys foreign accounts canbe nanced by capital inows, butthese resources only help deepen the



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external imbalance and, through theeects on aggregate domestic demand,contribute to further dismantling ofthe domestic productive apparatus.

This contradiction is resolved by main-taining nancial deregulation, and byhoping that it will somehow lead toenough investment to escape from theimport trap. The problem of articialpromotion of imports is convention-ally ignored; the free ow of capital issimply presented as the ideal mannerfor a country to access foreign savings,

increase productive investment andenter a path of sustained growth.

These three contradictions act not onlyas a powerful brake on the entire econ-omy, slowing down growth and jobcreation. They also entail the ingre-dients of instability, as the balance ofseveral critical macroeconomic accountsare driven farther away from equilib-

rium. In addition, all of these contra-dictions are aggravated by the factthat nancial markets are inherentlyunstable and that they are drivenby expectations in the context of un-certainty. The combination is trulyexplosive and leads to various mani-festations of nancial and economiccrises. In Latin America, the stabi-lization programs that followed in-volved draconian measures that cutpublic expenditures, restricted mon-etary policy and reduced real wagesin order to curtail eective demandand control inationary pressures.

The fourth contradiction of theopen economy model arises when

an economy attempts to increasedomestic savings in the hopes ofleading to higher rates of productiveinvestment through deregulation

of the bank and non-bank nancialsector. It is assumed that the deregu-lation of the nancial and bankingsectors can lead to an increase indomestic savings because economicagents have greater opportunities forprotable investments. In addition, itwas thought that domestic nancialderegulation provides more power-ful risk management instruments.

However, it is dicult to ascertainthat the rewards to nancial savingsgenerally bring about greater produc-tive investment. Because of deregu-lation, a growing part of domesticsavings can be directed instead to-wards nancial or speculative invest-ments such as the stock market, vari-ous nancial instruments, and evencurrency markets. Returns to specu-

lative investments in currency mar-kets, for instance, can be a powerfulattractor and shift resources awayfrom new productive investments.

The process of international nancialderegulation is usually implement-ed at the same time as an almostcomplete deregulation of the do-mestic banking sector. When thistakes place, domestic restrictionson cross-market access for nancialinstitutions are eliminated, blurringthe traditional distinctions betweenthe operations of banks, investmentrms, mutual and pension funds, in-surance companies, and stock exchangebrokerage rms. Also, quantitative


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controls on various forms of loanallocation schemes are scrapped, aswell as requirements for the provi-sion of credit to specic sectors such

as agriculture or housing. Perhapseven more important are the elimi-nation of preferential interest ratesfor favoured sectors and the slack-ening of cash reserve requirementsfor nancial institutions. In theory,competition among banks wouldlead to better service, greater optionsfor investors in terms of nancialproducts and credit operations, and,

above all, lower interest rates. Thesegoals were not attained. Domesticsavings did not increase signicantlyand the rate of investment remainedstagnant or declined.

Here the contradiction is expressedas follows: on the one hand, domesticsavings must be increased in order topromote productive investment, but

on the other hand, the deregulationof the nancial sector opens newpossibilities of speculative invest-ment for the domestic saver. Thesenew possibilities can be more attrac-tive than those oered by invest-ments in the real economy, and thusthe incentives for productive invest-ment are distorted. In addition, therate of return that comes from plac-ing funds in nancial instruments,within a framework of deregulatedcapital accounts and interdepen-dent nancial markets, connects re-sources from domestic savings withthe sphere of international nancialspeculation.

We must also consider that to the extentthat currencies from other econo-mies become more attractive assets,especially if we consider arbitraging

opportunities and the possibility ofmoving from one economic space toanother in response to disparities inexchange and interest rates, agentsmay prefer to speculate on the for-eign currency market. As volatil-ity and uncertainty intensify, agentsfeel increasing pressure to engage inthese operations. The need to seekprotection from foreign competi-

tion, which becomes more intenseas a result of simultaneous trade andnancial deregulation, com

policy matters 18 final final-1

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