Message from Latin America: Austerity, then Growth

by Samuel George on April 26, 2013

Given the general similarities between the Latin American sovereign debt crisis of the 1980s and the European sovereign debt crisis today, a number of commentators have sought to compare the two. Others have questioned whether this comparison is even valid. After all, Latin America is very different from Europe, and the 1980s were very different from the 2010s. Habitually underdeveloped, Latin America emerged from its debt crisis with ample space for rapid development. Such slack does not exist in Europe. Meanwhile, the unified nature of the eurozone creates opportunities and challenges that were not part of the Latin American experience.

However, as I argued in my paper Surviving a Debt Crisis: Five Lessons for Europe from Latin America Latin American policy makers and central bankers were forced to disentangle precisely the same Gordian knots that we face today. Some of their efforts succeeded, others failed—and all told, they left a body of work that is absolutely relevant to the current crisis in Europe. The principal lesson is clear: pounding austerity into a recession does not work. Such policies cost Latin America what is now known as the “Lost Decade,” and it was not until Latin American policymakers incorporated growth into the strategy that the region began its long trek towards recovery. In short, it is not austerity or growth but austerity then growth that is required. Europe—on pace to lose a decade itself—would do well to take notes.

When examined from a bird’s-eye view, Europe’s current sovereign debt crisis and Latin America’s sovereign debt crises of the 1980s follow a similar pattern. Both crises began when a series of countries that had historically suffered severe macroeconomic fluctuations were suddenly able to borrow extensively and cheaply on the international markets. While the “good times” rolled, the general perception was that they would keep rolling. That is to say, as long as property values were high in Marbella and Dublin, policy makers saw no need to tackle painful reforms. Finally, once this model proved unsustainable, afflicted countries staved off default by accepting bailout packages contingent upon austerity packages.

Like Europe today, the initial response in Latin America was austerity, and the results were underwhelming. The region muddled through years of poor growth while development stagnated. It was not until 1985 that the dialogue—let alone the policy—expanded to incorporate growth. However, this policy shift eventually facilitated Latin America’s resurgence. Current Brazilian-Chinese trade tops $60 billion and Mexican-U.S. trade eclipses $350 billion, while the Pacific Pumas (Mexico, Colombia, Peru, Chile) are signing free trade agreements the world over.

Given its current trade proclivity, it is easy to forget that the Latin American economic philosophy of the 1950s, 1960s, and 1970s was far more insular. Under import substitution industrialization (ISI), Latin America nurtured state-owned enterprises and protected its economies from competition. However, when these policies led to crisis, Latin America proved willing to fundamentally reconceive the foundation of its economy in order to leverage international comparative advantages. Europe needs to do the same, because the status quo is unsustainable.

Unfortunately, the European response to the sovereign debt crisis thus far has focused overwhelmingly on fiscal contraction. Growth may be “part of the dialogue” or a biannual conference topic somewhere in Brussels, but the policy has zeroed in on taxes, public wage cuts, and weakened labor protection.

The result has been three years of stagnancy. Europe has fumbled to the extent that one would be forgiven for thinking that this is the first time the world has faced these problems. The lesson from Latin America suggests that Europe has been sucked into a false debate of austerity versus growth. While it is true that a degree of European austerity is necessary, just as it was in Latin America during the 1980s, it must be understood as an emergency brake slammed on economies that are spiraling out of control; once brought to a halt, a strategy is needed to restart the engine. Part of this can come from much-discussed structural reforms, but looser monetary policy needs to be on the table as well.

Austerity without growth will yield only reform backlash. Nationalists in core Europe will rail against supposedly indolent southerners while their counterparts in peripheral Europe will demand the removal of repressive economic policies enforced by the powerful core. As the crisis trudges on, both arguments will find increasingly receptive audiences. Such a backlash, replete with unfortunate historical overtones, could result in an erosion of European integration from both sides. Luckily, as described in my full study, the Latin American experience of the 1980s offers a roadmap for recovery. Will anybody bother to follow it?

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