Putting Second-Generation Reforms to the Test

By Kay, Stephen | EconSouth, Fall 2003 | Go to article overview

Putting Second-Generation Reforms to the Test


Kay, Stephen, EconSouth


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. …

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Putting Second-Generation Reforms to the Test
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