Putting second-generation reforms to the test

Despite the implementation of sweeping structural reforms, economic growth in Latin America has slowed significantly since the late 1990s. Second-generation reforms--which include judicial, social security, regulatory, labor, tax, education and political reforms--are needed, but many obstacles exist. How will the region meet this challenge?

After the economic stagnation of the 1980s--the so-called Lost Decade--Latin American governments instituted structural reforms intended to revive economic growth. This set of policies emphasized property rights, fiscal discipline, trade and financial-sector liberalization, competitive exchange rates, privatization and deregulation.

These reforms brought renewed investor confidence to the region and led to a surge in investment and economic growth. However, financial-sector volatility also increased as the region suffered downturns following the Mexican peso crisis in 1995 and the Asian and Russian crises later in the decade. Economic growth has slowed significantly since the late 1990s, and Latin America continues to suffer from high rates of poverty and inequality.

Policymakers now recognize that "second-generation" reforms-which include tax reform, flexible labor markets, capital account opening, central bank independence, social safety nets, anti-corruption measures, improved corporate governance, and targeted poverty reduction--are needed to build an institutional foundation that can sustain economic growth and protect against external shocks. Unfortunately, there is no clear-cut prescription for precisely how such institutions should be structured.

Even with solid agreement on a desired policy outcome, such as a reduction in poverty, how to achieve such an outcome is not always obvious. Furthermore, restitutions are often country-specific and not easily transferred elsewhere. And, given growing public dissatisfaction with the process of reform, the future of these second-generation reforms is far from certain.

Taking control?

The debate over whether or not governments should rely on capital controls provides an example of the challenge of instituting a second-generation reform when consensus is lacking. Foreign investors prefer unrestricted access to markets, and capital controls tend to create disincentives to investment. Yet governments may seek to introduce capital controls in order to contain volatility. (The chart on page 16 shows how volatile capital flows to the region were in the 1990s.) Chile took this step when policymakers instituted capital controls between 1991 and 1998 in an effort to slow capital inflows, encourage longer-term investments and reduce exchange rate appreciation.

Some economists, like Joseph Stiglitz and Jagdish Bhagwati, argue that capital controls can be valuable tools for imposing stability given the potential volatility in international capital markets. Other economists, including Sebastian Edwards, argue that capital controls are ineffective and impose significant costs on small and medium-sized firms (larger firms are better equipped to evade capital controls). Edwards suggests that sequencing reforms is a key issue and that capital controls should be gradually relaxed toward the end of the process of market-oriented reform, but only after adequate supervisory controls are in place.

The debate over capital controls was revived again in June 2003 when Argentina announced that it was imposing capital controls to counter market speculation and stabilize the peso. At the time, the International Monetary Fund had no objections, but U.S. Secretary of the Treasury John Snow opposed the move, arguing that it was a mistake because it would discourage capital from entering the country.

Restrictions on capital flows have also been a key point of debate during recent U.S.-Chile and U.S.-Singapore negotiations over trade agreements. Chile and Singapore wanted to reserve the right to impose capital controls in the event of a crisis, while the U.S. position was that all restrictions on capital should be banned. The final agreements contained compromises: Short-term restrictions on capital are permitted; however, if restrictions are in place for more than a year, investors will be permitted to sue for damages.

Even if there is agreement that a particular economic model works well in one country, the model cannot necessarily be transferred in cookie-cutter fashion to another country. As economist Dani Rodrik notes, growth strategies require considerable local knowledge, and policy experimentation might be required in order to determine which reforms will work best.

Will it play in Peru?

Political factors, which tend to play a critical role in restricting the reach of second-generation reforms, also make policy experimentation a necessity. Some policy measures that work well in one country are simply not politically viable when transferred to another setting.

First-generation reforms such as stabilization programs or deregulation and fiscal reforms were often imposed by presidential decree during financial crises. For example, Argentine presidents issued a total of 25 emergency decrees prior to 1989, but President Carlos Menem issued 308 such decrees from 1989 through 1993 during a period of significant reform. Although constitutional scholars questioned the practice, Menem used the decree as an everyday tool to implement unpopular reform measures.

While first-generation reforms generally involve sweeping measures, second-generation reforms tend to cover more complex institutional issues, such as regulation, education and judicial reform. Developing such reform measures requires reaching a consensus, which in turn requires careful and time-consuming political negotiations. These negotiations can take years; such reform initiatives often get placed on the back burner.

The political process is further complicated by the fact that, while first generation reforms carried out under a dire economic situation may affect the overall economy, second-generation reforms tend to threaten the specific interests of powerful political constituencies. Educational reform initiatives are one example. As political scientist Patricio Navia and economist Andres Velasco note, teachers in Latin America "have been in a state of semipermanent warfare against governments that have attempted to meddle in their affairs." If the brunt of the pain of such reforms is borne by a politically organized constituency, it will act to defend its interests, and reformers will face strong opposition as they work to implement change.

The reform index in the sidebar on page 17 shows that labor reform has lagged far behind other structural reforms in the region, largely because efforts to introduce greater flexibility into labor markets have encountered resistance on the part of organized labor. Tax reform has fared better, but still lags behind other reform indicators in the region. Tax reform has also proved to be challenging as policymakers struggle to reallocate the tax burden among various societal interests. Other second-generation reforms, including social security reform, have also become mired because they tend to threaten key interest groups like civil servants.

Some analysts have looked to cognitive psychology to explain why structural reforms become bogged down. Pioneering research by the team of Nobel Prize laureate Daniel Kahneman and the late Amos Tversky found that individuals are more willing to take risks to recover a loss than to protect their gains. Political scientist Kurt Weyland argues that this pattern can explain why presidents tend to back away from structural reforms even after having administered a successful "shock" program.

Once the recovery has taken place, leaders become less willing to take risks. Weyland suggests that this was precisely the case in the early 1990s in Argentina and Peru: After both economies recovered following bold reforms, presidents Menem and Fujimori became more risk-averse, and the process of structural adjustment slowed.

In recent months several politicians attempting to carry out structural reforms have been rebuked. To cite only the most recent examples, Ecuador's oil workers went on strike in June 2003 to oppose a government initiative favored by the International Monetary Fund that would allow greater private-sector participation in the country's state-owned oil sector. In February 2003, Bolivian President Sanchez de Lozada issued a fiscal austerity proposal that imposed new payroll taxes that angered civil servants and led to rioting that left 22 people dead. In Peru the government's ambitious privatization program came to a halt in 2002 after protests against the privatization of state-owned utility firms.

Brazil: The test case?

While the level of political commitment to second-generation reforms may waver, and political opposition may slow the process, reform in the region continues. Currently all eyes are on Brazil, where Luis Inacio Lula de Silva was elected president in 2002 after pledging to improve social equity while preserving fiscal discipline.

After initiating a new antipoverty program known as Zero-Hunger, the new administration placed social security and tax reforms at the top of the policy reform agenda. The tax reform would simplify the tax code and redistribute the tax burden, and the social security reform would rein in soaring pension deficits and introduce greater equity. Both measures have generated intense political opposition from interest groups that would stand to lose out under these reforms, and in early July 2003, federal civil servants went on strike to protest. As of this writing, both proposals enjoy popular support, but whether the Lula administration can get these measures passed remains an open question.

In many respects, the Lula administration's proposed reforms are a litmus test of second-generation reforms in Latin America. If a very popular left-of-center president like Lula cannot accomplish such reforms, it does not bode well for other governments in the region. However if Lula is successful in achieving his reform agenda, other leaders might imitate the politically popular president and hasten their pursuit of additional second-generation reforms.

Second-generation reforms: Wait and see

After the Lost Decade of the 1980s, when the region's economies shrank an average of 0.8 percent per year, Latin American governments introduced structural reforms that led to a surge in trade and investment. Economic growth during the 1990s, however, was less than robust, averaging just 1.6 percent per year for the region as a whole (compared to 2.9 percent growth per year between 1960 and 1980), and the region's economies remained vulnerable to domestic and external economic shocks. The fact that the first-generation structural reforms were not accompanied by improved social equity or reduced poverty has led to widespread disappointment and weakened political support for reform. There is now increasing recognition that growth cannot be sustained without second-generation reforms.

Continued progress in achieving second-generation reforms is also a major concern for foreign investors. For example, without an impartial judicial system that can safeguard property rights, foreign investors pay a higher risk premium. The fact that investors are confident of receiving an impartial hearing in Chilean courts has spurred foreign investment there while a lack of confidence in the judicial systems of other countries has been a major deterrent to investment.

Yet consensus over such reforms is frequently lacking. Even when governments have clear policy goals, these reform measures can run into political opposition from entrenched interest groups. Often, governments facing an imminent crisis have been able to impose a series of drastic macroeconomic reforms, but when times improve, the countries face treacherous political obstacles as they try to introduce second-generation reforms. In the coming months, leaders throughout Latin America will keep an eye on Brazil, where the Lula administration's reform initiatives have become the bellwether for second-generation reforms in Latin America.

The Staggered Pace of Reform

As the chart demonstrates, structural reforms in Latin America have been implemented at an uneven pace. According to an index created by economist Eduardo Lora of the Inter-American Development Bank, financial sector liberalization improved dramatically during the period between 1989 and 1994. The process of privatization in the region got underway in earnest in 1989 and continued at a fairly steady pace through 1999. In the case of trade reform, little improvement has been seen since the early 1990s. Two second-generation reforms appear in the index; one, tax reform, has shown little movement in recent years, and the other, labor reform, has stagnated.

The Surprise Reformers

Lucio Gutierrez, a political outsider, was elected president of Ecuador with the support of left-wing and indigenous groups that agreed with his anti-globalization and antidollarization platform. Yet, after taking office, Gutierrez did an about-face. He appointed an orthodox finance minister and signed an agreement with the International Monetary Fund that promised large budget surpluses and opened the state-owned utility and oil companies to greater foreign and private-sector participation.

Gutierrez is the most recent of a series of Latin American leaders who were elected after running populist, anti-reform campaigns, only to become ardent reformers upon taking office. During the 1989 Argentine presidential campaign, Carlos Menem supported a nationalist and redistributive state-led development model, but by 1991 he was advocating the free market orthodoxy of his opponent. In Peru, Alberto Fujimori followed the same pattern in his 1990 campaign against Mario Vargas Llosa--he attacked Vargas Llosa's plan for structural reforms only to adopt virtually the same measures once in office.

These candidates pursued what Patricio Navia and Andres Velasco term a "Nixon in China" strategy. The fiery populists could convince voters that they had been persuaded of the vital importance of pursuing structural reforms, just as President Nixon, an avowed anti-Communist, could convince the American people that the United States should pursue a more cooperative relationship with its Cold-War rival China.

However, the rise of Luis Inacio Lula de Silva in Brazil demonstrates that presidential candidates may no longer have to conceal their policy preferences to find favor with voters. After losing three previous presidential campaigns, Lula moderated his rhetoric and pledged to implement social reforms while respecting fiscal targets and maintaining price stability. Lula's choice of a prominent business executive as his vice-presidential candidate confirmed his political shift to the center. The strategy worked. Lula won by a landslide and continues to receive very high popularity ratings.

Investors first panicked at the prospects of a Lula presidency, but once he took office and demonstrated his commitment to maintaining the fiscal policies of his predecessor, President Fernando Henrique Cardoso, investors exhibited renewed confidence in Brazil's prospects.

This article was written by Stephen Kay, the coordinator of the Atlanta Fed's Latin America Research Group.

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