metadata: authors: 0: author: De La Torre,Augusto
1: author: Ize,Alain
count: Latin America
docna: 0: docna: Latin America’s Growth: Looking through the
            Demand Glass
docty: Policy Research Working Paper
theme: Analysis of economic growth,Improving labor markets,Export development and competitiveness
majtheme: Economic management,Trade and integration,Social protection and risk management
abstracts: cdata!: This paper revisits the historical roots
            of Latin America&#x2019;s disappointing growth using a
            novel macro and trade-based growth decomposition and a
            simple model of industrialization in a commodities-exporting
            country with a large informal sector. The approach suggests
            the need to better qualify two opposite narratives: that the
            post-1982 (&#x201c;neoliberal&#x201d;) reforms have
            failed, and it is time to look back to the import
            substitution industrialization era for policy inspiration;
            and that the post-1982 reforms went in the right direction
            but must be completed to unleash significant productivity
            gains. Both can be misleading because they downplay the role
            of demand. The apparent &#x201c;miracle&#x201d; of
            import substitution industrialization does not provide a
            realistic point of comparison because it reflected an
            unsustainable, demand-induced boost in productivity. And the
            gains expected from Washington Consensus-style reforms alone
            can be overstated because they are derived from overly
            restrictive assumptions on demand. By allowing demand to
            play a more central role, the paper finds a close and
            revealing relationship between the growth patterns followed
            by Latin American countries, the quality of their
            macroeconomic policies, the nature of their trade, and the
            segmentation of their labor markets. Going forward, the
            policy agenda calls for an outwardly oriented growth
            strategy, supported by a more proactive role for the state
            that promotes not only efficiency in supply, but also the
            appeal to demand.
display_title: Latin America’s Growth: Looking
            through the Demand Glass
listing_relative_url: /research/2022/11/33933584/latin-america’s-growth-looking-through-demand-glass
topicv3: Macroeconomic Vulnerability and Debt
            m1326057 1104,Private Sector Development m1326060 1921,Economic Growth m1326241 471,Trade m1326924 698
publishtoextweb_dt: 2022-11-08T00:00:00Z
dois: 10.1596/1813-9450-10227
origu: Off of Sr VP Dev Econ/Chief Econ (DECVP)
author_keys: 0: author_key: 143858
1: author_key: 929614
model_extractions: Policy Research Working Paper 10227 Latin America’s Growth Looking through the Demand Glass _Augusto de la Torre Alain Ize_ Latin America and the Caribbean Region Office of the Chief Economist November 2022
Policy Research Working Paper 10227

# **Abstract**

This paper revisits the historical roots of Latin America’s disappointing growth using a novel macro and trade-based growth decomposition and a simple model of industrialization in a commodities-exporting country with a large informal sector. The approach suggests the need to better qualify two opposite narratives: that the post-1982 (“neoliberal”) reforms have failed, and it is time to look back to the import substitution industrialization era for policy inspiration; and that the post-1982 reforms went in the right direction but must be completed to unleash significant productivity gains. Both can be misleading because they downplay the role of demand. The apparent “miracle” of import substitution industrialization does not provide a realistic point of comparison because it reflected an unsustainable, demand-induced boost in productivity. And the gains expected from Washington Consensus-style reforms alone can be overstated because they are derived from overly restrictive assumptions on demand. By allowing demand to play a more central role, the paper finds a close and revealing relationship between the growth patterns followed by Latin American countries, the quality of their macroeconomic policies, the nature of their trade, and the segmentation of their labor markets. Going forward, the policy agenda calls for an outwardly oriented growth strategy, supported by a more proactive role for the state that promotes not only efficiency in supply, but also the appeal to demand.

This paper is a product of the Office of the Chief Economist, Latin America and the Caribbean Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at adelatorre@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Latin America’s Growth: Looking through the Demand Glass**

Augusto de la Torre and Alain Ize<sup>⊗</sup>

**JEL classification codes:** 040, 054, F10.

**Keywords:** growth, convergence, Latin America, export-led growth, import substituting industrialization, commodity dependence, natural resource curse, export diversification.

> ⊗ Augusto de la Torre (adelatorre@worldbank.org and <u>apd2151@columbia.edu) is adjunct professor at Columbia</u> University’s School of International and Public Affairs (SIPA), Director of the Economics Research Center (CIEE) at the Universidad de las Américas (UDLA) in Quito, Ecuador, and consultant to the World Bank. Alain Ize (ai2372@columbia.edu) is adjunct professor at SIPA. This paper, which builds on De la Torre and Ize (2019, 2020a, and 2020b), was prepared for a book project sponsored by the UNDP and the Yale Center for the Study of Globalization. The authors gratefully acknowledge comments from Bernardo Acosta, Alejandro Castañeda, Santiago Levy, William Maloney, Samuel Pienknagura, Jorge Thompson Araujo, Andrés Velasco, and participants in seminars at El Colegio de Mexico and Tulane University.
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allocation and use of such factors, aggravated by the migration of resources towards lowproductivity informal activities. At the policy level, it favors “horizontal” (sector-neutral) reforms aimed at improving the enabling environment in all relevant dimensions (contract rights, information, taxation, regulation, etc.) and boosting the resource allocation function of markets, particularly labor markets. Thus, the culprit behind the unexploited productivity potential in the LA region is an incomplete or insufficiently implemented set of supply-side policy reforms that failed to fully unleash the power of markets and awaken private investment optimism.

The ISI narrative, on the other hand, contrasts the higher growth and faster productivity gains obtained (most visibly in Brazil and Mexico) under the ISI era with the region’s dispiriting growth performance under the post-1982, Washington Consensus-style macro stabilization and market-oriented reforms. It concludes that the latter have largely failed to deliver on the growth and productivity front, and it is therefore time to look back to the ISI era as a source of inspiration. Thus, this approach invites policy makers to abandon the excessive faith in _laissez faire_ and to go back to a more proactive government, one that is engaged not only in horizontal interventions, but also and decidedly in “vertical” (industry, sector, or cluster-focused) policies and reforms.

This paper revisits this growth debate based on the premise that both narratives can be misleading because they downplay the role of demand, aggregate or idiosyncratic, as a driver of growth. This raises identification issues that require careful consideration. At the aggregate level, the supply side approach does not fully account for the growth impact of macro and trade shocks. Yet, much of the region’s growth fluctuations have reflected changes in demand (domestic or external) rather than supply-based productivity. At the micro level, the approach tends to interpret the wide differences in revenue productivity across firms as reflecting mainly resource misallocations. Yet, as emphasized by the more recent literature on firm-level productivity, such interpretation hinges on very restrictive assumptions on underlying demands. Under less restrictive assumptions, firms can display differences in revenue-based productivity not only because of differences in production efficiency but also because of differences in demand (e.g., associated to product quality and appeal) leading to differences in prices.

As to the ISI narrative, contrasting the growth and productivity performance of LA during and after ISI only makes sense if the ISI growth trajectory was sustainable and, thus, could have smoothy evolved into an Asian-type outward-led industrialization model. By raising consumer demand for locally produced goods, hence raising their price above the international level, the import restrictions at the core of the ISI model allowed for a large, one-time, demand-driven, productivity-enhancing labor shift to the industrial sector. Yet, it also gave rise to a competitiveness gap that left manufactures producers too much inside the innovation frontier, making it difficult for them to work their way up to the frontier to compete in open international markets. Thus, rather than a “golden age”, ISI turned into an unsustainable and costly mirage that deepened the commodity dependence it had promised to reduce. Moreover, excess domestic demand planted the seeds for the loss of macro control that unleashed inflationary dynamics with 3
enormous stabilization costs in the 1980s and 1990s. The combination of the above factors helps explain the sharp post-ISI reversal of the one-time ISI gains in output, wages, and productivity.

To help uncover these identification issues and explore the implications, the paper develops four analytical tools. The first is a simple micro-anchored model that focuses on the interface between commodity exports, labor informality, and industrialization. The model (described in detail in Appendix I) shows how and why—after producing one-time gains in output, real wages, and productivity—ISI could become a low-growth trap. The second tool is a macro and tradebased growth decomposition (technical details in Appendix II). In addition to helping sort out supply from demand effects, such decomposition provides an alternative to the conventional, Solow-style factor accumulation and productivity decomposition, one that is better suited to LA’s turbulent macro history and varied trade patterns. Our growth decomposition method helps uncover the links between the sharp contrasts in trade structures and the differences in growth dynamics between LA's three main sub-regions (Mexico, South America, and Central America). The third tool is a comparator group (CG) of countries with a similar range of per capita incomes as LA countries (details in Appendix III), which is used as a point of reference to systematically assess the growth record of the region. The fourth and final tool is a regression exercise that provides country-specific benchmarks against which to compare and assess individual countries’ growth patterns, depending on the composition of their trade and key structural characteristics (regression results in Appendix IV).

At the policy level the analysis finds common ground with the two above narratives, but subject to important qualifications. While concurring with the supply side approach on the importance of enabling-environment reforms geared at enhancing the resource allocation function of markets, we are less optimistic on the size of the growth dividends to be expected from such an agenda alone. And while concurring with the ISI narrative that the state needs to become more engaged, we justify it mainly on the ever more predominant presence of supply and demand externalities rather than on the alleged success of the type of state intervention that characterized the inward-looking ISI era in Latin America. We thus argue that the state’s activity should be mainly that of a scout and a coordinator rather than a direct doer. What is needed are smart, soft touch, market-friendly interventions guided by an outward-oriented strategy and aimed at helping formal firms coordinate investments so as to more effectively expand output and formal employment, in large part by capturing external economies of scale, cluster and network benefits, learning spillovers, etc. What is not needed are heavy-handed, market-unfriendly intrusions of the state in productive activities and in resource allocation deployed in the context of a protectionist, inward-looking strategy that end up promoting rent-seeking and stifling efficiency and innovation.

Our demand lens also highlights the relevance for growth of the types of goods produced— tradable versus nontradable, commodities versus manufactures or services—as well as of the quality and attractiveness of the individual goods produced within these broader categories. The magic of growth is of course about the availability and quality of production inputs and their efficient allocation and use. But it is also about the economy’s capacity to produce attractive goods 4
that find market niches for products with demands that are more price inelastic (hence supporting higher mark-ups) and more income elastic (hence growing faster); to attract and retain people (not just capital) who may contribute to growth as consumers or producers; and the state’s capacity to stabilize aggregate demand through sound macro policies and to harness self-reinforcing, virtuous dynamics that stem from internalizing (supply as well as demand) externalities.

At the country or sub-regional level, we analyze Latin America’s growth in light of the sharp bifurcation of trade structures that materialized in the aftermath of the devastating ISIinduced crises of the early-1980s: Mexico moved decidedly to manufacturing exports, South America concentrated on commodity exports, and Central America shifted to services exports.

Mexico’s momentous shift from inward to export-led industrialization, while successful in many respects, has thus far failed to accelerate its GDP growth. Mexico’s stunning underperformance (with the second lowest average growth, after the República Bolivariana de Venezuela, in LA over the past 40 years) was due to a mix of factors, including China’s stiff competition, the US slow growth and protectionism, Mexican exporters’ struggle to broaden the value added of their exports, and Mexico’s domestic productive capacity constraints arising from its deeply fragmented economy that curtails the diffusion of know-how and feeds informality. Mexico’s growth agenda must therefore emphasize measures to overcome the demand limitations for its exports, promote entrepreneurship and innovation, broaden the spillovers of its exports on the rest of the economy, and improve the allocative function of its markets, including labor and financial services markets.

South America’s recoil to commodity exports has confronted the twin problems of volatile export prices and slow-growing export volumes. Some South American countries (Chile, Peru) have delivered relatively strong growth performances over the past four decades, but others (mainly the República Bolivariana de Venezuela, but also Argentina and Brazil) have shown symptoms of the resource curse. In the latter subgroup, the effects of volatile terms of trade have been systematically amplified by procyclical macro (especially fiscal) policies, leading to pronounced boom-bust patterns in growth rates. The slow growth in export volume, for its part, helps explain much of the differences in GDP growth across South American countries, including the flip in growth performances of Chile and Peru, with the former being the superior performer in the 1990s and the latter in the 2000s. The policy agenda in South America should therefore pay special attention to moving up the value-added in commodities, discovering and exploiting new exporting opportunities, and strengthening counter-cyclical macro policy capacity, particularly in the fiscal domain.

As regards Central America (defined to include the Dominican Republic), its shift toward services exports has delivered mixed growth results, depending on the countries’ capacity to attract, rather than expel, people and capital. The more successful countries (Panama, Dominican Republic, Costa Rica) have benefitted from human and financial inflows, including servicesseeking foreigners and FDI inflows. The less successful (Guatemala, El Salvador, Honduras) have 5
received little FDI inflows and send their workers abroad (rather than retaining them to provide services to foreigners at home). Central America’s growth agenda must therefore put a premium on boosting its capacity to attract FDI on a sustainable basis and improving incentives for workers to stay and foreigners to visit, temporarily or permanently. More generally, the entire region needs to become more attractive (i.e., being more demanded) not only to investors but also to short or long-term visitors, in particular through strengthening its rule of law, better harnessing its natural and cultural assets, and healing its social fractures.

Given LA’s biased income distribution and weak governance, mobilizing collective action (socially and politically) in support of the needed growth agenda will no doubt be a major hurdle. The social scars left by Covid-19 and the stagflationary forces and intensified uncertainty unleashed by the Russian invasion of Ukraine will clearly add to the difficulty while perhaps also raising the motivation for a comprehensive growth agenda. In any event, countries in the region should not give up on the quest to achieve higher growth. They should rather seize whatever opportunity is given by the rapidly changing global environment and be encouraged by a key lesson from international growth experiences—that a few, well designed and targeted policy interventions can give rise to a wave of investment optimism and _ignite_ growth and, once that happens, social and political support can be more easily mobilized in favor of the institutional and structural reforms that are necessary to _sustain_ higher growth over the longer-term.

The rest of this paper is organized as follows. Section II presents a brief overview of LA’s growth literature, contrasting the supply side and ISI perspectives and adding relevant nuances and complements. Section III describes the dominant and recurring features of LA’s growth under a macro and trade-based perspective. Sections IV, V and VI break down the analysis by sub-periods. Section IV explains why the ISI years (1960-82) should be viewed as a costly trap rather than a source of inspiration for today’s policies. Section V discusses how the ISI legacy undermined the supply side-oriented growth policy agenda during the last two decades of the last century (19822003). Section VI reviews LA’s growth experience during this century (2003-2020) for three main subregions (Mexico, Central America, and South America) separated by sharp differences in the trade structures and identifies subregion-specific policy implications. Section VII concludes by discussing more general policy issues, with a focus on policy directions and the reform process, rather than on country-specific policy packages.

# **II.   Perspectives on Latin American growth**

The literature on productivity and growth for the LA region can be broadly associated with two perspectives: an efficiency-oriented supply side approach, which draws on the conventional Solow-type, production function-based growth literature; and a history-oriented ISI narrative, which reinterprets the region’s growth challenges by revisiting its ISI experience. The section also briefly reviews three related and qualifying streams of literature, including on cross-sectoral labor shifts and on certain region-specific structural features such as informality and growth traps.

6
# **1. The supply side perspective**

At the aggregate level, studies of LA growth based on a Solow-type approach decompose growth into factors accumulation and total factor productivity (TFP)—where the latter is obtained as a residual, i.e., as the excess of output over what can be attributed to factor accumulation—and generally conclude that productivity explains a large, if not dominant, share of growth gaps and growth fluctuations.<sup>2</sup> The literature then seeks to identify the drivers behind LA’s growth gaps (relative to advanced economies) using panel or cross-country growth regressions that include a wide range of possible explanatory factors. It typically concludes that while the adverse growth impact of macro stabilization policies has lessened over the past decades, supply side variables (structural or institutional) have increasingly become the binding constraints on growth.<sup>3</sup> Applying the Solow-inspired approach at the firm level has led to a similar emphasis on supply-based productivity. Following in particular the work of Hsieh and Klenow (2009), this literature finds unusually wide (by advanced economy standards) productivity differences between firms, which are broadly interpreted as “resource misallocations”. The high positive correlation between per-capita income and misallocation intensity is then viewed as evidence that correcting the misallocations (i.e., shifting resources from low productivity to high productivity firms) should, in and by itself, have a significant expansionary economic impact. And the high negative correlation between the extent of resource misallocation and the quality of the enabling environment is seen as an indication that the best way to correct the misallocations is through addressing their structural and institutional roots.<sup>4</sup> Thus, at either the aggregate or micro levels, the supply side approach suggests that LA’s disappointing growth performance stems mainly from large productivity gaps resulting from the poor quality of factors of production (particularly human capital) and an inefficient allocation and use of such factors. The policy agenda that flows from this diagnosis emphasizes, therefore, the need for “horizontal” (sector-neutral) reforms aimed at improving the enabling environment (contract rights, information, taxation, regulation, etc.) for all economic initiatives, and places a premium on the goal of boosting the allocative function of markets, particularly labor markets.

The supply side narrative is, however, too narrow and can become misleading in its diagnosis and policy emphasis because it downplays the role of demand, domestic as well as external, aggregate as well as idiosyncratic.<sup>5</sup> At the aggregate level, because of the high

> 2 Good examples of LA growth studies along these lines include Blyde and Fernandez-Arias (2004), Loayza, Fajnzylber and Calderon (2005), and Alfaro and Kanczuk (2020).

> 3 See Loayza, Fajnzylber and Calderon (2005), Araujo et al (2014) and David, Komatsuzaki and Pienknagura (2020).

> 4 Contributions along these lines include Pages et al (2010); Busso, Madrigal, and Pages (2013); Leal (2014); and Saborowski and Misch (2019).

> 5 See in this connection a recent literature review on the determinants of productivity by Syverson (2010), which highlights the need to better incorporate demand as a top priority in forthcoming research on growth.

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endogeneity and missing variables that would better capture demand effects, a correct identification of causality between dependent and independent variables and supply versus demand effects is no simple matter. Thus, the supply side perspective often fails to sufficiently account for the growth implications of the recurrent macro and trade shocks and large demand fluctuations (both domestic and external) that have dominated LA’s growth history.<sup>6</sup> Similarly, at the firm level, the Hsieh and Klenow (2009) conclusion that differences between firms in revenue-based TFP measures reflect resource misallocations is critically dependent on the strong assumption that firms face iso-elastic demand functions. As shown by Restuccia and Rogerson (2017) and Haltiwanger, Kulick and Syverson (2018), and as illustrated in the model of Appendix I, it is only under this assumption that differences in revenue between firms using similar factors of production can be uniquely associated with resource misallocations. Moreover, the research inspired in the Hsieh and Klenow approach typically assumes that firms within the same industry do not compete based on different mark-ups associated with product quality differences. As a result, the higher revenues of a firm with the same factor usage as another are attributed solely to higher productive efficiency. But under less restrictive assumptions, firms with similar factors could have different revenues not only because of differences in efficiency but also because of differences in demand leading to differences in mark-ups (hence in prices) due to differences in quality and product appeal (see Appendix I for a simple overview; and Cusolito and Maloney, 2018, for a deeper discussion based on a comprehensive survey of the literature).<sup>7</sup> As a result, the supply side perspective tends to understate the growth relevance of “what” is produced, that is, of differences in the broad categories of goods being produced—tradable and nontradable, commodities, manufactures or services—as well as in the quality of individual goods produced within these categories.<sup>8</sup> Yet quality changes or lags in quality improvements can quickly translate into major shifts in demand that deeply affect firm growth but are hard to measure.<sup>9</sup> 6 While there is an important literature on the growth impairment effects of macro-financial volatility in Latin America—see, for instance, IDB (1995), Calvo (1998), and Mendoza (2010)—this literature has few direct linkages with the growth literature. For its part, the growth literature’s lack of connections with potentially key explanatory demand factors leads to puzzling enigma such as the difficulty in explaining Mexico’s lack of growth when only supply side factors are considered and China’s impact on the demand for Mexican exports is ignored.

7 For example, Canales and Garcia Marin (2018) find that 80 percent of the growth of high performing firms in Chile reflects increased demand rather than efficiency gains.

8 By focusing on economic complexity and the capabilities that support it, Hausmann et al (2007) provide one of the most visible and well-known cases in favor of the growth relevance of “what” is produced.

9 Lederman and Maloney (2012) argue that “how” goods are produced matters more than “what” is produced. However, their conceptual understanding of the “how” is congenial with our “what” and associated emphasis on the role of demand. Lederman and Maloney’s “how” not only captures efficiency and creativity in the use and combination of resources (including knowledge) within suitable production technologies, but also managerial and technological innovations geared at responding to demand, for instance, by upgrading product design with a view to raise quality and appeal as needed to seize and develop market niches with auspicious demands. Importantly, Lederman and Maloney recognize that moving from concept to empirics is not a simple matter, not least because of the difficulty in adequately measuring quality (the “what”) based on the 3- to 6-digit classifications available in trade statistics.

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# **2. The ISI narrative**

The collapse of ISI and the ensuing “lost-decade” of the 1980s led to early critical reviews of inward-looking import substitution strategies in LA, opening the grounds for the drastic policy reshuffling of the Washington Consensus.<sup>10</sup> However, a stream of literature, including Bértola and Ocampo (2013) and many ECLAC-related contributions, have recently revisited LA’s ISI experience and argued that, with the right policy tweaking, import substitution in LA could have eventually led to a successful outward-oriented industrialization, much like in Asian countries. The economic problems LA faced at the end of the 1970s are viewed as not inherent to the ISI model but rather as the consequence of factors exogenous to it (bad fiscal policies at home, shocks from abroad). And the rise of inflation is attributed to factors outside ISI, such as the rapid depreciations caused by the debt crisis and the falling terms of trade.

This narrative, therefore, advocates the return to the ISI experience as a source of inspiration, especially to tame the excessive faith in _laissez faire_ and to promote a more proactive government, one that is engaged in more vertical (industry, sector, or cluster-oriented) policies. As we will show in subsequent sections, however, this narrative also can be misleading due to its failure to adequately identify the sustainability conditions and macro/demand implication of the inward-looking ISI model as applied in the LA region.

# **3. Some structural aspects**

At least three additional streams of research deserve mention because they complement or qualify the above perspectives by focusing on structural features that are germane to LA’s growth history. A first stream, inspired by the work of McMillan and Rodrik (2011), highlights structural change, defined by the movement of resources (particularly labor) across sectors. It highlights the observed contrast between the rise in productivity growth during the ISI years (which reflected the massive movement of labor from the lower productivity agricultural sector to the higher productivity industrial sector), with the subsequent stagnation and decline in aggregate Gauging quality requires therefore appropriate proxies, whether at the macro level, as in the case of Hausmann et al (2007), or at the micro level, based on enterprise and market surveys or granular price data. Thus, as recently shown by Bernard et al. (2020) for enterprises in advanced economies, differentiating products based on the product mix and prices, as well as on the skills used in production, uncovers quality differences that are associated with very different growth performances across firms. Along similar lines, Comin et al. (2020) find that demand shifts toward expenditure-elastic sectors (rather than technical change) explain a large share of the labor market polarization in advanced economies.

10 See Baer (1972) for an early assessment of the impact of ISI policies on the LA region and Irwin (2020) for a comprehensive review of the evolution of the academic discussion on this topic.

9
productivity growth (which reflected mainly the poor performance of within-sector productivity, and the labor shift to the less productive, and arguably more informality-prone, services sector).<sup>11</sup> A second stream focuses on informality, a Latin America trademark. As noted by La Porta and Shleifer (2014), the interaction between informality and growth can be viewed from sharply contrasting angles. The first, following Hernando De Soto (1989), sees informal firms as an untapped reservoir of entrepreneurial energy, held back by ill-defined property rights and tax and regulatory distortions (such as those emphasized by Levy, 2008) that penalize formality and foster informality. The second, as described in a McKinsey Global Institute report, characterizes informal firms as parasites competing unfairly with law-abiding formal firms (Farrell 2004). The third follows the development tradition of Lewis (1954) and Harris and Todaro (1970) and sees informality as a byproduct of low growth and poverty or a corollary of a dual economy, which will be overcome mainly and gradually through the more rapid expansion of the formal sector.

A third stream highlights the potential for growth traps, where feedback loops and other self-reinforcing dynamics ensnare economic activity into a stable low-growth syndrome. This stream harks back to Cardoso and Faletto (1979) or Hirschman (1958), who described the failure of forward and backward linkage development in “enclave” or dual economies. A more recent literature has expanded these early intuitions by focusing more directly on the incentives to innovate depending upon firms’ distance from the innovation frontier. As shown by Aghion et al (2005 and 2021), Goñi and Maloney (2017), or Maloney and Zambrano (2021), firms and countries may find it too expensive to “learn to learn” to use new technologies (including through R&D) if the initial endowment of entrepreneurial capital is low. Alternatively, it may not be worth it to invest in entrepreneurial capital in an environment of high commodity-related rents (a “learning displacing” resource curse). Similarly, countries may also be trapped in a bad equilibrium if selffulfilling expectations and other forms of collective action failures prevent them from capturing the benefits of external economies of scale, synergies, learning spillovers, etc. associated with agglomeration, clustering, and critical size effects (see, for instance, Murphy, Schleifer and Vishny, 1989; Krugman, 1991; and Lanaspa and Sanz, 2001). Thus, low-growth traps widen the scope for non-linearities and tipping points, pointing toward the need for a more sectoral- or cluster-focused “big push” in public policy aimed at coordinating expectations and investments.

# **III.   LA’s dominant growth features from a macro and trade perspective**

This section uses a macro and trade-oriented growth decomposition to help uncover, for the entire 1965-2020 period, the key differentiating features of LA’s growth compared to world growth. As we will see, because LA growth was largely driven by demand rather than by uniform

> 11 See Firpo and Pieri (2016) for the case of Brazil and Alfaro and Kanczuk (2020) for the cases of Mexico and Brazil. Sanguinetti and Villar (2012) provide abundant evidence to show that within-sector productivity growth collapsed in the region after ISI because of the exhaustion of rural-to-urban labor migration and the inability of the manufacturing and services sectors to generate sustained increases in productivity.

10
supply shocks, these features do not fully fit the supply side perspective. Subsection 1 provides a brief overview of the macro and trade growth decomposition (a more technical presentation of the decomposition method can be found in Appendix II). Using this framework, Subsection 2 underlines the unique role played by demand in the growth dynamics of the region. Subsection 3 identifies three region-wide cycles—Protection (1960-1991), Stabilization (1991-2003), and Commodities (2003-2020)—and their underlying dynamics. To enhance the analysis, we assess LA’s developments using a comparator (CG) group (the composition of LA and CG groups and the criteria for country inclusion can be found in Appendix III).

# **1. A macro and trade-based growth decomposition**

Consider the following accounting identity: where the _G_ s are the logs of the backward-looking ten-year moving averages of growth rates of a country’s GDP ( _Y_ ), exports ( _X_ ), and imports ( _M_ ) of goods and nonfactor services, all relative to the rates of growth of the same variables for the world (and all measured in constant dollars).<sup>12</sup> The first right hand term in the identity is labelled “export pull” ( _EP_ ) because it can be interpreted as the traction that export expansion exerts on a country’s growth. The second term is labelled “domestic response” ( _DR_ ) because it can be interpreted as the country’s capacity to lift GDP growth above import growth (i.e., the country’s efficiency in using its imports to grow). The third term is labelled “external leverage” ( _EL_ ) because it can be interpreted as the impulse or drag on growth linked to changes in the country’s trade deficit or, alternatively, to changes in the availability of external finance. Thus, the above identity can be rewritten as: We add a terms of trade windfall term, _ToT_ , calculated as the difference between _EL_ expressed in constant and _EL_ expressed in current dollars. A country’s “growth spectrum” for any given year or period can then be expressed as the vector { _G_ , _EP_ , _DR_ , _EL, ToT_ }. As shown in Appendix II, the growth spectrum underpins a simple identification grid that helps separate supply from demand shocks according to their impact on the different components of the spectrum. We will now apply the identification grid to the effects on the growth spectrum of three basic types of shocks that will appear recurrently in the analysis of LA’s growth history.

12 We use logs of rates of growth and (generally) ten-year backward-looking moving averages to better approximate elasticities (hence the underlying fundamentals), as in Thirwall’s (1989) growth model. Ten-year moving averages provide a smoother, hence more revealing and less noisy perspective on medium-term growth dynamics than yearly observations. At the same time, the ten-year moving averages provide a richer view on cycles than lengthier averages. However, we will occasionally use longer (twenty-year) moving averages when seeking to illustrate longer term growth trends rather than cycles. Appendix II describes in more detail the growth decomposition database and provides a link where the ten-year moving averages version of the database may be downloaded.

11
Consider first a pure domestic demand shock. Because, by stimulating imports, a domestic demand shock should raise _EL,_ changes in the external leverage provide a simple indicator of domestic demand fluctuations (whether consumption or investment driven). In an economy with substantial underutilized capacity (the Keynesian case), the increase in _EL_ should be matched onefor-one by an increase in _G_ , with both _DR_ and _EP_ remaining unchanged (Figure 2c). Instead, in an economy at full employment (the Classical case), the increase in _EL_ would leave _G_ unchanged but lead to a reduction in _DR_ , as imports rise but GDP does not (Figure 2d). As economies should generally lie somewhere in between the Keynesian and Classical cases, the trademark of a demand shock is therefore some co-movement of _G_ and _EL_ , with partial opposite fluctuations in _DR_ . In the absence of a domestic supply shock also affecting _DR_ independently (as discussed next), the _net impact_ on _G_ of a domestic demand shock should thus be given by the sum _EL_ + _DR._

**Figure 2. Growth Spectra under Alternative Shocks**

<!-- Start of picture text --> a. Uniform supply shock c. Keynesian demand shock e. Underspent ToT shock<br>ToT<br>EL<br>G G<br>G<br>EP<br>EP EL<br>DR<br>DR EP<br>EL DR<br>b. Domestic supply shock d. Classical demand shock f. Overspent ToT shock<br>EL<br>ToT<br>EL<br>G<br>EP<br>G<br>DR G EP<br>DR<br>EP<br>DR<br>EL<br><!-- End of picture text --> Note: Time is measured along the horizontal axis; the change in the growth spectrum components along the vertical axis.

Consider now a pure supply shock. A Solow-type positive uniform shock should raise the economy’s output of both tradable and non-tradable goods, whether as a result of a build-up in factors of production or a boost in across-the-board productivity. Because the shock affects all goods, exports (hence _EP_ ) and GDP (hence _G_ ) should rise equally. But absent changes in domestic demand, _EL_ should not budge and, hence, the rise in imports should match one-for-one the rise in exports and output. As a result, _DR_ should also remain unchanged. Thus, the trademark of a uniform supply (Solow) shock is a co-movement of _G_ and _EP_ , with _DR_ and _EL_ hovering around zero (Figure 2a). Instead, a purely domestic supply shock that only boosts non-tradable goods will 12
raise output, hence _G_ , without affecting exports (hence leaving _EP_ unchanged). In the absence of a simultaneous demand shock, _EL_ will not change either; and since exports have not changed, nor will imports; hence the counterpart of the rise in _G_ should just be a rise in _DR_ (Figure 2b).<sup>13</sup> Consider finally a positive terms-of-trade shock (a rise in _ToT_ ). To the extent the windfall is spent, its impact on growth should be the same as that of an expansionary domestic demand shock. But the macro response will be countercyclical if the windfall is “under-spent”, i.e., when the rise in _EL_ falls short of the rise in _ToT_ (Figure 2e). Instead, it will be procyclical if the windfall is “over-spent”, i.e., when the rise in _EL_ exceeds the rise in _ToT_ (Figure 2f).

We will use the above decomposition method to look at growth levels, growth fluctuations over time, and growth differentials between countries. In the first case we will directly use the above accounting identity. In the second and third cases we will take it as a basis to calculate growth variance decompositions, in one case with respect to the yearly time series of growth spectra for a given country, in the other case with respect to the distribution of growth spectra across countries for any given period.

# **2. Key growth features**

Clearly, our growth decomposition method has more analytical value in countries where macro and trade shocks, and not only the Solow-style uniform supply shocks, play a significant role. As shown in Figure 3 this has been indeed the case for LA. The growth spectrum of the Asian Tigers (Hong Kong SAR, China, the Republic of Korea, Singapore) over the last six decades has closely matched that expected under uniform supply shocks, as described in Figure 2a: _G_ closely followed _EP,_ and both _DR_ and _EL_ hovered around zero (Figure 3a). The Asian Tigers’ growth has therefore been mainly supply-driven, hence consistent with Solow modeling. By contrast, LA is clearly a case of an unbalanced and unstable growth, with _G_ mainly driven by domestic demand (as measured by _EL_ + _DR_ ) (Figure 3b). Not only has the region’s _G_ deviated from _EP_ , especially in the 2000s but, more notably, _EL_ and _DR_ have fluctuated greatly yet moved systematically in opposite directions. This is confirmed in Figure 4, which shows the average growth spectra for the two groups of countries over the 1965-2020 period. For the Asian Tigers (Figure 4a), _G_ is mainly about _EP_ (uniform supply). In LA (Figure 4b), by contrast, _EL_ and _DR_ played the most salient roles.

> 13 A rise in non-tradable output would of course imply a rise in imported inputs. However, given the assumed absence of a simultaneous aggregate domestic demand shock, final imports would fall to match the rise in imported inputs, so as to keep total imports unchanged.

13
<!-- Start of picture text --> 05<br>0 freed ANT ots \<br>GP REL DR EL<br><!-- End of picture text --> <!-- Start of picture text --> 0.2 SI<br>K \<br>03<br>—_—s PO EL DR EL<br><!-- End of picture text --> <!-- Start of picture text --> 05 0.2 SI<br>K \<br>0 freed ANT ots \ 03<br>GP REL DR EL —_—s PO EL DR EL<br>0.35 0.05<br>03 0.045<br>0.04<br>0.25<br>0.035<br>0.2<br>0.03<br>0.15 0.025<br>O41 0.02<br>0.05 0.015<br>0.01<br>° a<br>-0.05<br>0<br>-0.1 LA<br>mG meEP DR mEL mTOT mG mEP DR EL mTOT<br><!-- End of picture text --> <!-- Start of picture text --> 0.05<br>0.045<br>0.04<br>0.035<br>0.03<br>0.025<br>0.02<br>0.015<br>0.01<br>0<br>LA<br>mG mEP DR EL mTOT<br><!-- End of picture text --> <!-- Start of picture text --> 0.35<br>03<br>0.25<br>0.2<br>0.15<br>O41<br>0.05<br>° a<br>-0.05<br>-0.1<br>mG meEP DR mEL mTOT<br><!-- End of picture text -->
<!-- Start of picture text --> 1<br>0.8<br>0.6<br>0.4 mep<br>mw DOR<br>0.2 m EL<br>oO —<br>-0.2<br>-0.4<br><!-- End of picture text --> <!-- Start of picture text -->
1.2<br>1<br>os<br>06<br>meP<br>04 =DR<br>meEL<br>0.2<br>0.4<br><!-- End of picture text -->

<!-- Start of picture text --> 0.3<br>0.2<br>0.1<br>Oo<br>F AD ad a> a9 Sos X 2 oA 2 od o> 09 A \ SF ®& ofrres<br>1 SAFPAOS? A Sees sx S SY & Fo GPRS S if es<br>ci<br>OVS ASP PPPSD NOR KF<br>-0.2<br>-0.3<br>-0.4<br>-0.5<br>-0.6<br>-0.7<br>ee(SG eeeFP<br><!-- End of picture text -->
Figure 6 further reinforces this last conclusion. When comparing LA’s _G_ and _EP relative to_ CG (i.e., the first differences between LA and CG), two features stand out: (i) LA has grown more slowly from the very start, although this difference in trend growth has narrowed over time; and (ii) the difference in growth has closely correlated with that of the export pulls, which clearly indicates that LA’s disappointing _average_ growth compared to CG was due to its uninspiring export performance. Thus, the region’s underwhelming growth reflected its deficient trade integration on either side of the trade account: _too many imports, not enough exports_ .

# **3. Cycles**

Figure 7, which compares LA to CG in terms of their _Gs_ , shows that the two groups of countries went through the same three cycles, a clear indication that they were exposed to the same world events. As shown in greater detail in Figure 8, we refer to the first cycle as the “Protection Cycle” (1960-1991) because import restrictions first rose in support of domestically oriented industrialization (the ISI years of 1960-1981), and then fell following the 1982 debt crisis, as the region liberalized in a hurry to help overcome its macroeconomic woes. We refer to the second cycle as the “Stabilization Cycle” (1991-2003) because it started on the way up with exchange rate-anchored inflation stabilization programs complemented by fiscal consolidation and important Washington Consensus-style structural reforms (particularly in the areas of trade and financial liberalization). The cycle entered its downward phase in the late-1990s as stabilization dynamics triggered real exchange rate appreciations that fed spending booms and culminated with financial crises (more on this below). Many of the larger Latin American countries (chiefly, Brazil, Chile, Colombia, Mexico and Peru) then switched to _inflation targeting_ and greater exchange rate flexibility, thereby gaining credibility and maneuvering space in monetary policy. Finally, we refer to the third cycle as the “Commodities Cycle” (2003-2020) because, with admittedly stronger macro-financial policy frameworks, GDP fluctuations were driven mainly by the global impact of China, including on commodity prices.

Yet, the amplitude of the cycles was much deeper for LA than for CG. LA’s enhanced growth volatility largely reflected the larger fluctuations in _EL_ , which in turn closely followed the fluctuations in _ToT_ (Figure 8). The remarkably close coincidence between growth booms (busts) and real exchange rate appreciations (depreciations), also shown in Figure 8, is indeed consistent with deep demand-driven fluctuations along the Stabilization and Commodity cycles. Moreover, since the early 1980s, _EL_ and _TOT_ have moved in the same direction, but _EL_ fluctuations have systematically exceeded in amplitude the _ToT_ fluctuations, a clear manifestation of pro-cyclical macro policies. Thus, much of the region’s growth volatility has been the product of its strong exposure to terms of trade shocks and its inadequate (highly pro-cyclical) macroeconomic policy management, particularly in the fiscal domain, which ended up penalizing growth by exacerbating the spending effects of terms of trade shocks. Section VI will expand on this key feature when reviewing in more detail South America’s recent growth history.

16
<!-- Start of picture text --> 0.4 a<br>Protection Cycle Stabilization Cycle Commodities Cycle<br>0.3<br>0.2<br>0.1<br>0<br>-0.1SL0°2 50° GINSoS2 SN? LSSSV?5 SVSA SSN2 PPLEoe orhooD> A SF22 f PPPSA om LILIov r>SADISLSSy”wy oh20> LKoY9 LSSisAOsy<br>-0.2<br>-0.3<br>-0.4<br>0.4 Protection Cycle Stabilizationoo Cycle Commodities Cycle 0.025<br>0.3. ra<br>ISI ' Post-ISI Fon 0.02<br>1 : 1<br>0.2. ifyoT' . oe' fFPo ~ 0.015<br>fobs :<br>0.1 a SoM 1<br>a we f : ' ‘.<br>= 1 y a 1 on 0.01<br>-0.1osPESP7;SIRSPnOS A?NN3 NSLSoa- 3° 1oh . % 3 oS D lgSI EES.tes FSato:1'1FERGIE» ‘ Y SaeSeis is+ “F° SYSSSototo11 ? SBoSaio’*Se— 0.005<br>Lt i 1 . \ f 1 5 2 1 .<br>sia? ry ! ‘ ! ' : 0<br>-0.2 siete? I : an ee t<br>sie ' } ' “eed t .<br>-0.3 urFsH 1'1 .". Qj: fFinancialcrises & IT- 1H1 -0.005<br>“0.4 Macro Hi! 1t oyMo rateExch based stabilizationbased '' -0.01<br>“Geequilibrium disequilibriumMacro Debt1 crisis & trade stabilization , | Boom !t Buse<br>. liberalization -0.015<br>SGOT eee’<br><!-- End of picture text -->
# **IV.  The ISI trap**

This section brings to light the key features of LA’s growth during the ISI years and argues that these features do not fit the ISI narrative (see Section II.2). While ISI produced a boost in growth and productivity during the 1960s and 1970s, at least in a few countries (particularly in Brazil and Mexico), its model, as applied in LA, was not sustainable. Comparing growth and productivity records during and after ISI is therefore deeply misleading as the good ISI outcomes were not long-lasting and could only be reached through policies that planted the seeds for the bad outcomes that followed. Rather than a “golden age”, ISI was a “costly mirage”.

# **1. The ISI productivity boom**

The industrialization model of Appendix I helps explain why ISI was initially successful, in at least some countries, but eventually turned into a trap. The model considers an open economy where commodities initially account for the bulk of exports whose proceeds can be used by a formal manufacturing sector to buy imports of intermediate and capital goods. A formal manufacturing sector can thus develop and eventually export manufactures. However, there also exists a large informal economy that residually employs the labor that is not formally employed. Thus, for the formal manufacturing sector to take off, its productivity and wage levels need to match or exceed those in the informal sector. Hence, unless the formal sector’s TFP exceeds some minimum threshold, outward-driven industrialization will not happen, and the economy will remain stuck in a commodity trap.

If trade protection is introduced into the model, commodity producers could use their export proceeds also to purchase locally produced (final) manufactures instead of imported manufactures. By boosting the demand for local manufactures (and hence pushing their price above the world price), this will allow—within a range of TFP values that lie below the commodity trap threshold—the formal manufacturing sector to pay wages that equal or exceed that of the informal sector. Inward-driven industrialization will thus take off and absorb the available labor. And marginal labor productivity will rise as the formal wage exceeds the informal wage. This is consistent with the observed rise in LA’s productivity during ISI, as stressed by McMillan and Rodrik (2011), which is indeed the result of a labor shift from the agricultural (or informal, in the case of our model) sector to the formal manufacturing sector. It is also consistent with the positive (yet rapidly declining) rate of TFP growth during the ISI years, as shown in Figure 9.<sup>15</sup> _But, in line_

> 15 Arguably, the decline in productivity of the 1970s and 1980s was a worldwide, nor just an LA, phenomenon. But the two phenomena might have followed similar dynamics, as the worldwide decline in productivity coincided with global trade surges (see Appendix V), following trade liberalization and the post-Bretton Woods switch from fixed to floating exchange rates. By compressing the price of tradables, the surges in global trade could have led to a labor shift from tradables to non-tradables that reduced aggregate productivity. The major rise of the largely non-tradable services sector’s share in US GDP during the 1970s and 1980s is consistent with this interpretation.

18
<!-- Start of picture text --> 03 0.01<br>Protection Cycle Stabilization Cycle Commodities Cycle<br>02 .<br>H 0.005<br>~ :4 1] oO<br>oO :<br>SPSOWASP QTM SP2© gr PPSiNDbo FSSNF PLP fr SPSPoP SAESSSSoS SSo oF SHO°<br>-0.1 i -0.005<br>-0.2 i<br>i -0.01<br>-0.3 i /<br>-0.4 HH // -0.015<br>-0.5 : -0.02<br>eG oeTF P<br><!-- End of picture text -->
<!-- Start of picture text --> ISI , Debt Crisis and Trade Liberalization<br>ve ood ttt<br>14 o wee<br>12 a<br>os re TTeeet<br>0.6 <a wgetttterecgererettPa<br>o4<br>SESVSSSssBSSLFtAPersHKPeLReeVSexeAaRSBSSBRSSSARRBRKLES&bSsDPHARHRHRARARHRHRARDRHAAAASAASASSSSSSSASSSASASAAASAASASASASSSSASASSASASSASAASBASASAABAASNSSSSSRERER R FRAHRARHRRRRARHRHARHRHRARARAARAAAAAASTRRR BSS S SBBSBSBSBRADH RAS<br>——Expanding —— Contracting seesee Max Expanding<br>verees Min Expanding --+--» Max Contracting --»--- Min Contracting<br><!-- End of picture text -->
<!-- Start of picture text --> —G «+ EP DR EL<br><!-- End of picture text --> <!-- Start of picture text --> —G ——E£P DR EL<br><!-- End of picture text -->
outwardly oriented industrialization strategy, where the state’s support for firms was linked to their exporting success, which helped firms remain at shorter distances from the innovation frontier.<sup>18</sup>

# **3. The loss of macro control**

Protectionism in the ISI years gave rise to substantial domestic demand pressures. Initially, measured inflation was low, arguably because local manufactures responded with downward quality adjustments rather than price increases: price pressures were mitigated because there was a reduction in the quality of the locally manufactured goods compared to imported goods. Thus, the closing of the economy raised output, wages, and productivity without initially raising inflation. Furthermore, domestic demand pressures did not show up as a rise in _EL_ mainly because of foreign exchange rationing: the shortages were managed on a year-to-year basis mainly through import permits. While yearly information on import permits is unfortunately not available, the initially rather stable inflation and the lack of real exchange rate appreciation are consistent with this interpretation.

However, as shown in Figure 8, the region’s average real exchange rate appreciated strongly from the early 1970s onwards as inflationary dynamics took off. And as Figure 12 shows, LA’s inflation dynamics contrast starkly with CG’s.<sup>19</sup> Whereas CG’s inflation remained low and constant during and after the ISI years, LA’s inflation started to rise in the 1970s, _well before the crisis_ . Reflecting tighter balance of payments, inflation in LA’s contracting group (countries that grew less than the world, many of which in the Southern Cone) started rising earlier than for the expanding group.

Thus, the exhaustion of the ISI project triggered a loss of macro control that set the stage for the abrupt and lengthy growth downturn that followed the 1982 eruption of the great Latin American debt crisis. The loss of macro control took place in three steps. First, the bottling up through rising protection of the expanding demand vis-à-vis inefficient and inflexible supply eventually started pushing inflation up, notwithstanding the declines in product quality. Second, the tightening of the foreign exchange constraint and associated growth deceleration of the second half of the 1970s, together with the low world interest rates, motivated a debt-financed public spending boost, which made the macro even more vulnerable by further raising inflation and appreciating real exchange rates. Third, given the weakened fundamentals, the sharp monetary 18 Thus, contrary to the historic perspective of Bértola and Ocampo (2013), we see the possibility for LA of a smooth transition from inward-oriented to outward-oriented industrialization as quite remote. Unlike in Southeast Asian countries, LA firms became increasingly addicted to the rents and absence of competition afforded by protection. Hence, attempts to induce them to become more internationally competitive hit hard political economy constraints. Mexico’s 1976 choice to develop its oil fields rather than to open its international trade, as proposed at the time by President Reagan to President Lopez Portillo, is a good illustration of such a preference for relying on the expansion of commodity exports rather than the liberalization of trade.

19 The chart breaks down LA into the same expanding and contracting groups, relative to world GDP, as in Figure 12, plus Central America; to control for imported inflation, US inflation is subtracted from all series.

22
<!-- Start of picture text --> 0.8<br>ISI Post-ISI<br>0.7<br>0.6 .<br>0.5 H<br>0.4 i<br>H Macro<br>H disequilibrium<br>0.3 :<br>Macro :<br>02 equilibrium<br>0.1<br>o H<br>au”SN SFP FPDP 6S oD ADeer BSS -\WS ee -9AV 4D>er -4 aOeDDE -9-4-4© SE 4 DDEAV -Aw4A2 22 SeDSPPPodeeo>eeSP&&ee O&eePP ©eeSPANeePP— ee2 LP<br>= | A Expanding Group ——— LA Contracting Group ===LA Central Ameria ——CG<br><!-- End of picture text -->
<!-- Start of picture text --> 0.00<br>0.000.00 = l —_—a ia l |_| i —<br>0100 voll 1982-1 1991-2003 BB3-202<br>os<br>0.300<br>0.400<br>mG mEP wOR mEL mToT<br><!-- End of picture text -->

<!-- Start of picture text -->
1.300<br>-<br>0.300<br>-0.2000.300 1960-1982ie = 1982-19! 1991-2008 His2003-2020<br>-0.700<br>mEP wDR mEL<br><!-- End of picture text -->
Note also that the sharp yet strongly correlated fluctuations of TFP and output after ISI in Figure 9 point in the (Solow-inconsistent) direction of demand-induced reverse causality: rather than output growth being caused by TFP growth (TFP growth is indeed not expected to be as volatile as displayed in Figure 9) measured TFP fluctuations were a mechanical residual of demand-induced GDP fluctuations. In other words, output fluctuations were driven mainly by demand, both domestic and external, and that led to accommodating changes in measured TFP.

Finally, note in Figure 13b that it was _DR_ (rather than _EP_ ) that made the difference in postISI growth capacity across LA countries. In other words, after LA started to liberalize trade and finance, it was the region’s capacity to use its imports more effectively (rather than its capacity to grow its exports) that mattered the most, although this feature became less pronounced during the Commodities Cycle. This confirms the findings from Figures 5b and 6 that, following the ISI collapse, the region was not able to integrate its trade satisfactorily with the rest of the world. Compared to its CG peers, not only was LA growth lower than that of CG but also the LA countries that did comparatively better in terms of output growth were the ones that imported less rather than those that exported more.

# **2. Trade liberalization: The Mexican experience**

Reflecting ISI’s legacy, trade liberalization was initially more traumatic for LA than for the rest of the world. Because the region fell much deeper behind the world competitiveness frontier during ISI, the removal of protection had on impact a wider depressing effect on local output and exerted a greater boost on imports, as the local production of importable goods was suddenly overwhelmed by foreign competition.<sup>20</sup> Thus, _DR_ (output growth minus imports growth) fell much more than in the rest of the world. Moreover, the greater distance from the competitiveness frontier hindered the region’s capacity to rapidly boost its exports through innovation and efficiency gains. Thus, both _EP_ (the capacity to raise exports) and _DR_ (the capacity to lower imports) took much longer to recover than in other parts of the world.

Figure 14 illustrates this using our growth decomposition methodology and the case of Mexico, which liberalized its trade during the mid- to late 1980s on the wake of the devastating 1982 debt crisis. Figure 14a sets a world benchmark based on 31 trade surges in high to middle

> 20 The growth and productivity impacts of trade openness are found to depend on the time horizon (short versus medium term), the scope of the impact (firm, industry, or economy wide), and firms’ (or economies’) distance from the competitiveness frontier. The micro literature generally finds positive productivity impacts at the industry level, as foreign competition promotes the most efficient firms and forces out the least efficient ones (Melitz, 2003). And the productivity response also depends on how trade shocks affect mark-ups, or outputs versus inputs; cheaper inputs generally boost productivity (see De Loecker et al, 2016, for the case of India). But the distance from the competitiveness and innovation frontier also matters a lot. For example, Cusolito et al. (2021) find that only the upper 10 percent of Chilean firms (ranked in terms of their closeness to the frontier) responded favorably to Chinese competition through greater product innovation and improved quality.

25
<!-- Start of picture text --> 0.25<br>0.2<br>0.15<br>0.1<br>0.05<br>0<br>it) 45 6 7 8 9 10111213141516171819 212223 627<br>-0.05<br>0.1<br>-0.15<br>——=G Wald s==EP World 9 -==DR World<br><!-- End of picture text --> <!-- Start of picture text --> oe<br>03<br>0.2 ee - Tt tee el<br>“<7 itedied<br>: on 2<br>of Ny _-- -_--3}rN Ce<br>ral ow”<br>7 Qoe a 2 “we” 4 5 8 3 10 11 12<br>as<br>7 Wao— <2 -=-=- “7” “7<br>0.2 “a+ cor ~ =<br>0.3<br>a4<br>5<br>a6<br>——G Mexico =EP Mexico —-DR Mexico<br>= —GWorld =— —EPWorld — — DRWorld<br><!-- End of picture text -->
<!-- Start of picture text --> CG ——tA<br><!-- End of picture text --> <!-- Start of picture text --> —A CG<br><!-- End of picture text --> <!-- Start of picture text --> —“ CG<br><!-- End of picture text -->
<!-- Start of picture text --> ao<br>Protection Cycle Stabilization Cycle Commodities Cycle<br>Debt Z<br>and TC r isisade /<br>ao Liberalization<br>'<br>so i)<br>1t Exchange Rate 1Financial‘ond IT Based Crisis<br>co i Based Stabilization 'f stabilization<br>PIP PLP ESP PPPS PPP PPPS OOD Ss TERETE<br>—uvA—c<br><!-- End of picture text --> <!-- Start of picture text --> 25<br>Protection Cycle Stabilization Cycle Commodities Cycle<br>20<br>1s<br>#0<br>Debt Crisis 1<br>Ss ' Liberalizationand Trade '\<br>fl1 Financialf Crisi 1<br>° 1i' BasedExchange StabilizationwegRate tgndpad1 Stabilization]ITIT BasedBas Boom 1Bust'<br>RaSD 2 ahieC2© 6% oO cd oh © 6% HP SVaoh CO CH AOSeAP nh WO WS<br>——LAC Spread 9 ——CG Spread<br><!-- End of picture text -->
**Figure 17. Latin America: Export Shares by Broad Type of Product**

<!-- Start of picture text --> (a) Commodities (b) Manufactures (c) Services<br>80 80 40<br>70 70 35<br>60 60 30<br>50 50 25<br>40 40 20<br>30 30 15<br>20 20 10<br>10 10 5<br>0 0 0<br>México América Central América del Sur México América Central América del Sur México América Central América del Sur<br>1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018<br><!-- End of picture text --> _Note_ : The manufacture and services series are drawn from the WDI database. The commodities series is obtained as a residual from total exports of goods and services. Central America includes Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, and Panama. South America includes Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Peru, and Uruguay. _Source_ : WDI, World Bank.

# **VI.   Growth in the 21**<sup>**st**</sup> **century**

We now explore the impact of macro and trade shocks and the role of China on the growth of LA countries during the Commodities Cycle (2003-2020). To help tighten the links between trade, macro, and growth, we look at Mexico and break down the South American and Central American countries into two sub-groups, depending on features of their trade composition. A simple regression model is used to find the systematic connections between the growth spectrum of each country and the country’s structural and trade composition characteristics. This allows us to derive country or subregion-specific benchmarks. The more specific policy implications of the links between growth, macro, and trade are briefly discussed for each subregion and the country groupings therein. More general policy implications are reviewed in Section VII.

# **1. Salient growth patterns under the Commodities Cycle**

Growth trajectories in LA during the Commodities Cycle evolved differently by subregion, in line with the bifurcation of trade structures mentioned above. To sharpen the analysis, we first push the trade-based distinction between LA countries a further notch. As shown in Figure 18, the commodities-oriented South American region can be sub-divided into two subgroups of countries depending on the concentration of their exports along three broad export categories (commodities, manufactures, and services), and in line with the clusters observed in the manufacturing-services exports space shown in Figure 18. A first group of _more basic commodity exporters_ (BCEs) comprises Bolivia, Ecuador, Peru, and Chile; a second group of _more diversified commodity exporters_ (DCEs) includes Brazil, Argentina, Uruguay, and Colombia.<sup>23</sup> Similarly, the services-oriented Central American countries may be divided into a group of _services exporters_

> 23 The concept of diversification used here relates to the composition of trade among the three aggregate types of tradable goods (i.e., commodities, manufactures or services), rather than to the diversity of products traded within each of the three types of goods.

29
<!-- Start of picture text --> 60<br>Services exporters<br>58 @ PAN<br>= DoM ®<br>S CRI<br>2<br>%S 40 Services & manufactures exporters<br>x<br>=”oc .<br>2=o 30 URY<br>a<br>Fre} COL<br>& 20 e<br>wZ RG More diversified commodity exporters<br>a>=o @ BOLECu PER‘e e BRA®<br>10 c<br>More basic commodities exporters MEX<br>Manufactures exporter<br>0<br>i) 10 20 30 40 50 60 70 80<br>Manufactures Exports (as % of Total)<br><!-- End of picture text -->
<!-- Start of picture text --> 0.5000<br>0.4000<br>0.10000.0000 | | | = — |<br>yeCapita Population Trade Openess<br>-0.1000<br>-0.2000<br>-0.3000<br>-0.4000<br>mG @E—EP wDR EL mToT<br><!-- End of picture text -->

<!-- Start of picture text --> 0.0060<br>a<br>non0.0000 an ufeeture mo dities Brice:<br>0.0080<br>wG wE—P wDR wEL mToT<br><!-- End of picture text -->
<!-- Start of picture text --> 01<br>0.05<br>0 |_| —<br>Ben ark<br>-0.05<br>-0.1<br>-0.15<br>0.2<br>“0.28<br>TMG MEP BDR MEL MToT<br><!-- End of picture text -->

<!-- Start of picture text --> 0.1 0.03<br>0.025<br>\ 0.02<br>0.05 IN‘ 0.015r<br>\\ 0.01<br>t) 2 $© A WsStaee : 2 eS S 9 ~O 0.005<br>PPP FP FD FBT PIP 4 D9"woe8 W895as K<br>0)<br>0.05<br>-0.005<br>NY, ‘oot<br>0.1 0.015<br>0.02<br>0.15 0.025<br>—H ToT<br><!-- End of picture text -->
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But Mexico also has ample room to expand exports of income elastic services.<sup>27</sup> These include cultural tourism and ecotourism as well as education, health, and old-age related services. In addition to its proximity to the US, Mexico’s abundant and welcoming labor force (provided it is properly prepared and educated, including to speak English) is another strong asset. However, the key for raising Mexico’s provision of such services is to raise the country’s _attractiveness to people_ . The latter is tightly linked to boosting the country’s rule of law (including by reducing crime and corruption), properly preserving its historical and cultural heritage, and better protecting its environment and natural wealth. Mexico faces severe challenges in all of these regards.

# **_(c)  The DR problem: Domestic segmentations_**

As shown in Figure 20a, despite Mexico’s _EP_ remaining above its benchmark in the 20032020 period, Mexico’s domestic response ( _DR_ ) fell significantly below its benchmark. Thus, the pick-up of exports resulting from trade liberalization was accompanied by a much faster rise (relative to benchmark) of imports than GDP. There are many factors behind the limited capacity of the Mexican economy to respond more widely and vigorously to export expansion including economy-wide productivity problems. This is an area of intersection between the approach followed in this paper and the more conventional Solow-inspired growth literature, which highlights the adverse growth impact of distorted labor markets, concentrated market power, infrastructure and logistics gaps, limited financial depth, weak rule of law, and knowledge acquisition and diffusion gaps.<sup>28</sup> But we are really talking about two, quite distinct, economic realities within Mexico. Its deep economic segmentation (both across firms, formal versus informal, and across regions, north versus south) has introduced a heavy bias against growth and productivity at the national level. The contrast between the sustained high growth of the Mexican states that export manufactures to the US or cater to foreign tourism and the slow growth of Mexico’s southern states or the very volatile growth of the oil exporting states is indeed a striking manifestation of deep-seated obstacles to positive propagation and spillover effects (Figure 23a).

A salient expression of chronic segmentation is Mexico’s informality problem. As shown by Figure 23b, LA countries’ informality is much higher than that of CG and clearly correlates negatively with its growth. While this relationship is clearly bi-directional, it is much steeper for LA than for CG. And Mexico stands at the bottom of the scatter. As stressed by the supply side

> 27 For recent contributions on the scope for promoting growth and productivity-enhancing services in developing economies see Di Meglio et al. (2015) and Nayyar, Hallward-Driemeier and Davis (2021).

> 28 Levy (2018) argues that Mexico’s growth has been stunted by large misallocation of physical and human capital resulting from flawed tax, labor, and social insurance policies, together with malfunctioning contract enforcement. Guerrero, Lopez-Calva and Walton (2006) and several other contributions in Levy and Walton (2009) focus on market power and rents capture in basic non-tradable input markets, including energy and telecommunications, partly a heritage of corporatist institutional arrangements, as another key root of Mexico’s lagging productivity.

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during the bust (Figures 27c and d), suggest in turn that the differences in spending pro-cyclicality had important macroeconomic implications.<sup>30</sup> Hence, a sensible growth agenda for South American commodity exporting countries must put a premium on enhancing countercyclical macro policy capacity, particularly on the fiscal side, which is easier to achieve with the support of a higher saving rate. That would enable a more prudent management of terms of trade windfalls and help immunize the economy against the boom-bust syndrome. By avoiding prolonged episodes of excessive real exchange rate appreciations followed by recurrent _DR_ collapses and allowing for more sustainable _EL_ increases, higher saving rates combined with stronger countercyclical policies would improve countries’ financial integration with the rest of the world and promote higher trend growth.

# **_(b) The EP problem: Weak export volume expansion_**

Consider now the role played by export volume expansion in avoiding commodity curse symptoms. This is nicely illustrated by comparing Chile with Peru, neighboring countries with very similar export concentration in mineral commodities. Chile was the top performer in the region during the Washington Consensus decade: between 1990 and 2000 its annual rate of per capita income growth was nearly four times that of the world (and that of LA) and around twice that of the East Asia & Pacific region. In the 2000s, by contrast, Peru delivered a better growth performance—its average growth rate for the 2003-2022 period was about twice that of Chile.

Chile’s impressive growth performance in the 1990s was almost entirely driven by a strongly positive _EP_ : its exports expanded in volume terms much more that those of Peru (Figure 28a). However, during the 2000s, despite the pull from China, Chile’s growth slowed down even as that of Peru picked up. The single most important differentiating factor was their contrasting _EP_ paths. As showed by both Figure 28a and Figure 28b, Chile experienced higher _ToT_ gains than Peru, including during the 2000s, and hence increased its spending more. Yet, this was not a sufficient cure against the growth losses associated to its contracting export volume.

The message is again clear: export expansion driven by volumes rather than prices was crucial to sustain growth in Southern America commodity dependent economies. Temporarily 30 While our trade-anchored grouping of South American countries into BCEs and DCEs helps uncover insightful patterns linking average growth performance with trade composition during the period 2003-2020 (as illustrated statistically in Table IV.1 of Appendix IV), it naturally falls far short of guaranteeing a one-to-one match between trade and growth. For example, although the DCE group grew more slowly on average than the BCE group (Figure 24), Colombia (a DCE country) grew faster than Ecuador (a BCE country). Note also that Colombia, while classified as a “more diversified” South American commodity exporter, lies at the frontier between the BCE and DCE groups in terms of the macro indicators in Figure 26. While Colombia saved a good part of the terms of trade windfall via its fiscal stabilization fund, that was not sufficient to fully dampen the expansion of domestic demand, in large part due to an unusually strong appreciation of the peso in real terms and a comparatively rapid growth of credit (see De la Torre, Ize, and Filippini, 2016; and De la Torre, Cueva, and Castellanos, 2020).

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<!-- Start of picture text --> 35<br>30<br>25<br>20<br>1s<br>10<br>.<br>°<br>2008 2009 2010 2011 2012 2013 2014 2015 2016<br>—Economy 9Construcion Sec t or<br><!-- End of picture text --> <!-- Start of picture text --> 18000<br>16000<br>14000<br>12000<br>10000<br>g000<br>6000<br>4000<br>2000<br>o<br>2011 2012 2013 2014 2015 2016<br>——Public Sector ——Private Sector ——Private Housing<br><!-- End of picture text -->
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Since capital and people can choose a country when moving into the region, the key policy implication is that services exporting countries must put a high premium on retaining and attracting people and promoting FDI inflows. Citizen security, the rule of law, and the quality of life are obviously crucial in this regard. This policy implication is of course of general importance beyond Central America, given that raising the production of high-quality, employment-intensive tradable services will have to be a key component of the growth agenda in most LA countries.

# **VII.  Focusing policy**

This final section deals with the general issues in policy, rather than with specific policy packages. The first sub-section shows that many key gaps continue to prevail and need to be addressed. The second sub-section switches glasses, briefly summarizing what it is that a demandfocused analysis brings to the growth policy discussion that is new. The third sub-section discusses the non-trivial policy implementation challenges the region faces given its institutional weaknesses and the current world environment.

# **1. Sharpening the supply-side glasses**

Figure 34 shows a wide range of competitiveness-relevant variables where the region lags significantly relative to its comparator group (CG).<sup>36</sup> These include the quality of the region’s rule of law, both in terms of outcomes (homicides, organized crime) and capacity (the police, the judiciary, and the legal and contractual framework in support of private firms); the functionality of its markets (particularly the labor market, which is arguably linked to lags in the quality of regulatory and tax regimes); the quality of its infrastructure (particularly in terms of its air, sea, land, and internet connections);<sup>37</sup> and its preparedness for rapid change and innovation (as measured by R&D expenditure, the number of new patents or the digital skills of the population, and the governments’ inability to provide a long-term vision). Since these supply gaps do not necessarily constitute a binding constraint on growth and they are as much a cause as a consequence of growth, the expected growth returns from filling the gaps are uncertain. Nonetheless, they clearly point toward potential bottlenecks that must be assessed—and, if needed, addressed—as a matter of priority.<sup>38</sup> 36 The figure was constructed using the World Economic Forum’s Global Competitiveness Index (excluding those associated with macro policy and the financial sector), which classifies indices of 130 indicators into seven categories: (i) Rule of law (security, violence, quality of police and the judiciary); (ii) Market support (the quality of laws and regulations in support of market activities); (iii) Infrastructure (transportation and communications); (iv) Social capital; (v) Innovation (the country’s and the state’s preparedness for change); (vi) Health and human rights (the attention to basic human needs and rights); and (vii) Trade openness (the country’s openness to both foreign goods and foreign factors).

37 For a recent assessment of LA’s shortfalls in infrastructure, which highlights the costly implications for growth and welfare of gaps in transport infrastructure, see Perry, Guzmán and Benavides (2020).

38 To better tailor policies to country circumstances, avoid unhelpful “laundry lists” of ill connected actions, and help identify areas more amenable to reform and with larger expected impacts, policy makers can use a variety of tools 46
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differentiation, better quality and higher brand consciousness allows producers to retain larger value by charging higher mark-ups) and more income-elastic (i.e., products whose demand grows faster relative to consumers’ income). These demand-related desiderata need to be internalized through greater innovation and special attention given to marketing, applied research and development, and higher-end FDI.<sup>39</sup> In this respect, the region’s policy agenda should be guided by, and organized around, a clear outwardly oriented growth strategy. Indeed, growth is likely to benefit from scale economies when external demand for non-commodity goods gains ground vs. domestic demand. Growth is also more likely to thrive if increasingly complex tradable goods and services gain ground over nontradable ones. In the case of commodities-reliant countries, growth involves the upgrading and building up of value based on commodity derivatives that promote the diffusion of innovative technologies and boost learning spillovers.<sup>40</sup> Third, appealing to demand also involves factors of production, not just output. In a globalized economy where capital and human talent is largely footloose and services will continue to gain in importance, it behooves Latin America not only to produce attractive goods and services but also to _become_ a more attractive region, not only to technology and financial capital but also to people and human capital. Attracting and retaining talent and services-seeking foreigners as well as retaining at home the providers of services, are key to ensuring a successful integration into global markets. Capturing the globalization upside will thus hinge on good economic policy as much as on the quality of life, which puts a premium on developing greater capacity to harness cultural and geographic assets, preserve the environment, improve digital communications infrastructure, enhance citizens security, etc.

# **3.         Getting there**

Implementing a sufficiently ambitious and comprehensive policy agenda along the lines just sketched will require, first and foremost, a critical set of actors working together, including a well-educated labor force, able and willing entrepreneurs, and proactive and smart governments. Good entrepreneurship being unfortunately a rather scarce resource in much of the LA region, it needs to be nurtured (and attracted) by all possible means.<sup>41</sup> As regard governments, they need not only to strengthen the business environment through effective horizontal (sector-neutral) policies,

> 39 Recent evidence (Bernard et al, 2020) indicates that the more successful offshoring firms in the high-income countries import from the low-income countries the more standardized, lower cost products and continue to produce locally the more innovative, higher quality items. Applying the same logic to LA’s middle-income exporting countries implies capturing more of the upper-end, more demand-elastic markets by raising the knowledge and innovationbased content of their exports.

> 40 On the superior positive externalities associated with the production of tradables, especially with rising complexity, see, for instance, Rodrik, 2008; Hausmann et al, 2014; and Hausmann, Hwang, and Rodrik, 2007.

> 41 On the underpinnings and implications of LA’s entrepreneurship scarcity, see Maloney and Zambrano (2021).

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not-too-distant past, all give ground to populist and divisive discourses. The skewed income distributions across most of the LA region, which starkly contrast (with two exceptions) with those of the CG region (Figure 35), further raises the bar by feeding mistrust about the aims, reach, and fairness of public policies.

Thus, gathering and sustaining the necessary support will require a more open and broader discussion regarding the diagnosis of why growth in most of the region has been uninspiring. The search for a consensus on what to do to spur growth will in turn need to be backed by a consensus on how to distribute its benefits and how to ensure is sustainability. Hence, forging a new social contract, anchored on more inclusive and environmentally sustainable growth, will be key. Pedagogical abilities, consensus building capacity, enlightened leadership, and strong implementation capacity will be needed to boost this quest, now more than ever.

The above is likely to be an uphill battle, not least because LA countries severely lag CG countries in terms of government effectiveness (Figure 36). However, LA policy makers need not be discouraged by the seemingly daunting challenges. They should rather be encouraged by a key lesson from international growth experiences—that a few, well designed and targeted policy interventions can give rise to a wave of investment optimism and _ignite_ growth and that, once that happens, social and political support can be more easily mobilized in favor of the deeper and broader institutional and structural reforms that are necessary to _sustain_ higher growth over the longer-term. A self-reinforcing process—whereby reform spurs growth, and growth begets reform—is not out of reach of successful policy making.<sup>43</sup> This said, the region should engage in earnest in the task of steadily building the capacities to _sustain_ growth. This will require raising the quality of the civil service and focusing on resultsoriented public policy. It will also require strengthening the constructive role that intermediate institutions and actors (academia, civil society, the business community, etc.) can play in feeding and steering the public policy debate. Improved governance arrangements should help extend the policy reform horizon beyond a given administration while facilitating the fruitful interaction of public and private entities in the definition and implementation of growth policies. This in turn calls for strong participation and control capacity of societies as well as effective checks and balances in democratic processes. While clearly lagging in terms of government effectiveness, LA tends to be ahead of CG as regard citizen participation in the electoral process and freedom of expression (Figure 36). Such democratic leanings are both a promise and a challenge. They broaden the scope for constructing more legitimate and democratically determined social outcomes. But they also set the bar higher in terms of what is demanded from the political system, thereby exacerbating the risks of populism.

> 43 Rodrik (2005) and Hausmann, Pritchett, and Rodrick (2005) show that _igniting_ growth does not require extensive institutional reform but instead rests on a narrow range of country-specific, often unconventional, policies. _Sustaining_ growth, by contrast, hinges on broader structural and institutional reform.

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