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Cycles, Economic Structures and External Constraints: A Structuralist Study on the Causes of Economic Volatility in Latin America — Danilo Spinola

Post-doctoral researcher at the United Nations University – Maastricht Economic and Social Research Institute on Innovation and Technology (UNU-MERIT). E-mail: sartorello@merit.unu.edu.

Summary

The main objective of this book is to understand the causes behind the endogenous volatile behavior of Latin American economies in a New-Structuralist perspective. Many distinct authors argue that the repetition of strong boom-bust dynamics is a structural problem in the economic development of Latin America. In this research we search for the underlying causes of this behavior, discussing volatility as an endogenous phenomenon, intrinsic to the characteristics of these fragile economies.

We assess this research question following empirical and theoretical approaches. The empirical approach initially consists on identifying the main characteristics of economic growth cycles in Latin America from real Gross Domestic Product (GDP) data. Secondly, we test the assumptions of the models developed in this book. Thirdly we check how the economic system behaves when there are exogenous shocks to some specific variables.

The theoretical part of this research develops itself from growth models, offering explanations of the causes of Latin American endogenous volatility based on the growth cycle theory literature. In terms of the theoretical framework, this book is based on three main classic pillars, all somehow related to the Structuralist theory: (1) The Goodwin model, composed of endogenous cycles that emerge in the relationship between economic growth and income distribution; (2) The Balance of Payments Constrained Model (BPCM), that relates economic growth to external constraints, and (3) The Prebisch-Singer hypothesis (center-periphery framework), relating economic growth and development traps to the position of a developing economy in the international division of labor (global economic system). Since the early contributions figuring as pillars of this research, a whole tradition of Structuralist, Post-Keynesian, and Evolutionary works has been developed forming the core of the New-Structuralist framework. In this book we interrelate these approaches using more recent models developed in the New-Structuralist framework to the Latin American case. Our research is based on the open-economy Goodwin growth model tradition.

Latin America is a particular region in which economic instability has always been a characteristic of its development process. Periods of short-term booms and harsh crises alternate repeatedly, creating a permanently unstable environment that is one of the central causes of the lack of long-run development perspective in the region. The mainstream discussion of the real business cycle theory relates the causes of the volatile behavior to the presence of exogenous shocks, focusing on how changes in commodity prices, political shocks, and individual decision mistakes affect the growth process. However, the repetition of this oscillatory pattern in the development process let us raise the following questions: Is this constant behavior caused only by external shocks? Or, as claimed initially in the classical work of Schumpeter, is there also an endogenous element, that is structural and intrinsic to these economies, from which this volatile pattern emerges? In this book we follow an empirical (chapters 1 and 4) and a theoretical (chapters 2 and 3) approach to identify, question, debate and explain some underlying mechanisms behind the cyclical endogenous dynamics of economic systems, with a special focus in Latin America.

In the case of exogenous shocks, the diagnostic should focus on how to reduce exposure and increase resilience (absorbing exogenous disturbances). As those authors argue, there is no consensus yet about the underlying causes of macroeconomic volatility. This is a very important knowledge gap that motivates this research, and this lack of consensus results in many widely disparate views. These views come both from the mainstream perspective, which argues that erratic policy is the only significant source of macroeconomic volatility, to those with a more heterodox approach attributing this volatility to external shocks affecting vulnerable economies (no role for domestic policies).

Endogenous volatility – repetitive oscillations directly related to cycles – has its roots in a number of characteristics that are part of the “DNA” of economic systems. These characteristics are related to the institutional and structural conditions of the economies, to their historical development, political structure, and geographical conditions, among others. Those elements define patterns of fragility, and how the internal boom-bust dynamics operates. Exogenously, a weak fragile economy has a low resilience to external shocks. As an example, a commodity shock such as a huge decrease in oil price, generates a strong recessive effect in countries in which economic structure is mainly focused and specialized in natural resources, especially oil extraction. The effect is however much smaller in a diversified industrial economy. Endogenously, fragile economies generate oscillatory cyclical patterns related to their own economic behavior, caused by balance of payments constraints, financial instability, growth and distribution dynamics, technological innovation-diffusion – among other possible explanations.

The analysis of the cyclical behavior lets us understand the structural elements about economic volatility. Structural in the sense that the oscillations emerge from the own characteristics of these economies, from their specific conditions and their insertion into the international environment. This recurrent oscillatory behavior is stable, and many authors set it as one of the main constraints to the process of long-run economic development in the region. The growth pattern in Latin America is known for producing short periods of growth followed by constraints that result in adjustments that lead the economy to interrupt its economic development process. As highlighted by Hausmann & Gavin (2011), while the average depth of crisis in industrial countries is on average -2%, for Latin America it reaches -8%, which results in deeper average crisis even when compared to Asia (-3.5%) and Africa (-6%).

Concerning the distinct types of cycle just mentioned, in Chapter 1 we raise the question about the specificity of Latin American cycles. To answer that, we apply empirical time-series methodologies to real GDP data to extract these cycles using filter analysis. We identify the types of cycles for each country/region by the length of the cycles, grouping them using cluster analysis. The questions about the causes behind this volatility, nonetheless, stay unanswered.

Many Structuralist authors have tried to explain the causes of high economic oscillation in Latin America. They claimed that the structural causes of volatility in Latin America are related to its peripheral position in the international division of labor. This is caused by external fragilities related to these countries’ specialized and low-technology intensive productive structure. The fragilities result in a lower resilience to external shocks, a main source of volatility. In this sense, authors from the Structuralist theory argue that the historical development of Latin American economies gave them an idiosyncratic aspect that makes these countries more fragile. However, the explanation is still centered in the presence of exogenous shocks.

In order to create an interpretation to explain the endogenous mechanism that generate cycles in a structuralist way, in chapters 2 and 3 we bring some classic economic traditions that have proposed to explain the underlying causes behind these cycles. The literature review discusses authors that modelled economic cycles as dynamic systems in the growth theory tradition. The interpretation presented in this book is based on three main theoretical pillars: endogenous volatility represented by the Goodwin Cycles, external constraints represented by the Balance of Payments Constrained Model (Thirlwall model) and a decline in terms of trade that traps low- and middle-income countries represented by the Prebisch-Singer hypothesis.

Finally, in chapter 4 we come back to the theoretical debate about the role of price effects in economic growth and apply it to our region of interest, Latin America. An empirical analysis on how different changes in the economic variables impact in the economic system allow us to better understand the adjustment mechanisms and economic dynamics in Latin America. In order to observe this impact, we apply a Vector Error Correction Model (VECM) analysis to the BPCM-related macroeconomic variables for the four biggest Latin American countries, checking some model assumptions and some adjustment dynamics to the long-run (permanent shocks and some impulse-response analysis). We empirically test the BPCM assumption of price-neutrality, check if foreign income has positive effects on domestic income, and if (and how) other macroeconomic variables affect growth, real exchange rate, and the trade balance of the selected countries (Argentina, Brazil, Colombia, and Mexico).