policy roots of country income inequality in latin america: analysis of structural reform following...

7/30/2019 Policy Roots of Country Income Inequality in Latin America: Analysis of structural reform following the 1980s Latin

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The Graduate Programs in Sustainable International Development

The Heller School for Social Policy and Management

Brandeis University

Policy Roots of Country Income Inequality in Latin America:

Analysis of structural reform following the 1980s Latin American debt crisis

Submitted by

Sarah Lynch

A paper submitted in partial fulfillment of the requirements for the

Master of Arts Degree

in

Sustainable International Development

Academic Advisor Date

Director, Programs in Sustainable International Development Date

In signing this form, I hereby DO ( ) or DO NOT ( ) authorize the Graduate Programs in SID to make this paper

available to the public, in both hard copy and electronically via web.

Student Signature Date

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Table of contents

Abstract 3

Executive Summary 4

Acknowledgements 5

Abbreviations 6

Introduction 7

Background and development context 8

Methods 13

Literature review 15

Substantiative discussion 18

Conclusion and implications 24

References 26

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Abstract

This paper address the question whether policy reforms made under structural adjustment programs

following the 1980s financial debt crisis in Latin American are related to levels of country incomeinequality. It examines empirical evidence presented by similar studies, and compares these findings to

an independent analysis of the relationship between policy measures and macroeconomic indicators of

reform and measures of inequality. In particular, it uses panel regression analysis to examine policyreform in the areas of trade liberalization, fiscal discipline, and monetary stabilization, and the extent to

which estimates are robust to different definitions of inequality.

The results of this analysis do not find a consistent relationship between the policy reforms included in

the study and country income inequality which are robust across different measures of inequality. They

do not find sufficient evidence to suggest there is a relationship between trade liberalization or fiscaldiscipline and country income inequality, though they would suggest that reforms in the area of

monetary stabilization are associated with higher inequality.

This study suggests that further analysis of the joint effects of these policies is necessary to test theclaim that short-term losses related to inequality which result from these policy reforms are outweighed

by their long term, though many studies reviewed support the argument that reforms are generally

regressive in nature.

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Executive summary

This study examines the relationship between structural reforms which occurred in Latin America

following the 1980s financial crisis and the relationship these policies have with levels of inequality.This study presents the empirical evidence presented by similar studies and tests the hypotheses that

structural adjustment policies intended to stimulate economic growth and reduce deficits have a

positive relationship with levels of income inequality, using regression analysis of indicators of policyreform against measures of inequality.

The selected policy measures and macroeconomic indicators have been categorized into three generalareas of reform, including trade liberalization, fiscal discipline, and monetary stabilization. It

hypothesizes that reforms in areas of trade liberalization and fiscal discipline are associated with higher

inequality, and those in monetary stabilization are associated with lower inequality. To ensure results ofthe analysis did not hinge on the definition of inequality, I used three measures of inequality: the Gini

Index, Theil Index, and EHII.

The main findings of this analysis confirm some of the study's hypotheses, and challenge a number ofothers. They do not suggest there is a consistent relationship between trade liberalization and inequality

which is robust across different measures of inequality. These results do not provide sufficient evidence

to suggest there is a relationship between fiscal discipline and country income inequality, though theywould suggest that reforms in the area of monetary stabilization are associated with higher inequality.

This study examines the World Bank's claim that short-term losses related to inequality which resultfrom these policy reforms are outweighed by their long term benefits by setting countries on the path to

sustainable growth. The majority of evidence found by other studies challenge this claim, arguing that

the benefits of these policies have been shared disproportionately by the wealthy, and that these policies

themselves are not sufficient to reduce levels of inequality. The findings of this analysis may suggestthere are unanticipated causal relationships to support either side, though it warrants further

investigation into the joint effects of these policies.

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Acknowledgments

The author would like to thank Dr. Ricardo Godoy for his guidance, editorial and technical assistance

with this study, and Marion Howard for her support throughout the program.

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Abbreviations

EHII Estimated Household Income Inequality

FDI Foreign direct investment

IMF International Monetary Fund

M2 Money & quasi money

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Introduction

The 1980s and 1990s in Latin America witnessed a significant shift toward the development agenda

outlined by the Washington Consensus, and serves as a primary example for the intensity and speed atwhich developing nations have switched from state planning to market-driven growth under the

direction of multilateral agencies such as the World Bank and International Monetary Fund (IMF).

The Latin American financial crisis known as the lost decade began in the late 1970s and early

1980s, which lead to the collapse of many economies under unmanageable foreign debt and

macroeconomic instability. The perceived failures of state intervention and inappropriate domesticpolicy in the developing world invoked strong agreement among major international actors like the

U.S. government to advocate a reform agenda calling countries to practice fiscal discipline and rely for

the most part on market forces to guide the economy.

The development model pushed forward by conditionalities for receiving foreign assistance and debt

relief placed by the IMF and World Bank on trade, monetary, and fiscal reforms under structural

adjustment programs lead to a shift in the orientation of many economies from protectionist, importsubstitution towards liberalized, export-dominant models. Strict austerity measures and shifts in tax

bases were also implemented to slow rising deficits and remove state intervention in the market.

The region's economic recovery from this crisis has fallen short of many expectations, and growing

criticism of structural reform argue it has failed to bring Latin American countries out of debt without

widening the gap between the rich and poor (Perkins, 2013). It has invoked a growing opposition tothis agenda, particularly trade liberalization and reductions in public spending. Some nations including

Chile and Costa Rica have rejected or repealed such policies, claiming they have caused a significant

drop in growth and well-being.

Though Latin American countries represent a diversity of economies and levels of development, the

differences between their recoveries from a similar indebtedness suggests there is a relationship

between the policies under which growth occurred and levels of poverty and inequality. It is essential toaddress inequality in the discussion of economic policy because this relationship is closely tied to

growth and poverty. While some policies associated with reducing inequality are argued to inhibit

economic growth, inequality itself is also believed to be detrimental to growth.

Without considering the impacts of inequality, growth should raise living standards and reduce poverty.

However, when growth is associated with rising inequality part of the gains from growth will be offset

by the negative impact of rising inequality (Wodon, 2000). Higher levels of inequality may concentratewealth in the highest percentile, which reduces the benefits of growth to the poor. This suggests that

whatever growth policies may achieve, if they are associated with rising inequality, poverty might not

be reduced by growth.

Advocates of structural reform, such as the IMF and World Bank, have increasingly acknowledged that

many of these policy measures have generated losses among the poor. They argue these policies willoffset any short-term losses by setting countries on the path toward sustainable growth (SAPRIN,

2002). However, recent history has shown the losses have not been short-term, after years of

adjustment there is little evidence that they reduce poverty or inequality, and the predicted

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macroeconomic benefits have not been achieved.

To truly measure the effects of structural adjustment programs on levels of inequality, we would first

have to create a model which would allow us to separate their effects from a variety of internal and

external forces influencing inequity before and after these policies were implemented for each country.Though it is nearly impossible to deconstruct the effects of complex packages of reforms, we can

examine these linkages by measuring the relationships between some of its components and outcomes

such as country income inequality.

This study explores how policy reforms associated with structural adjustment programs are related to

levels of country income inequality in Latin America. The paper begins with a brief summary of thecontext in which these changes occurred, and an outline of the main areas of reform. It will then discuss

the issue of inequality in Latin America and its implications for economic policy. The following section

presents the methodology used for this study and limitations to this approach. It continues with areview of existing literature and arguments for key issues in this area of study. The main section will

present the results of an empirical analysis on the association between structural adjustment reforms

and levels of country income inequality. The paper concludes with a discussion of the main ideas

emphasized by this analysis, and the implications these may have for future policymaking anddevelopment. The overall objective of this study is to offer some explanation as to the source of

inequality, and how this issue may be addressed most constructively.

Background and development context

The Latin American financial crisis known as the lost decade began in the late 1970s and early

1980s, leading to the collapse of many economies under unmanageable foreign debt. Aid, particularlyfrom the IMF, was given on conditionality that structural adjustment programs be implemented. The

majority of reforms entailed monetary, fiscal, and trade policies which promoted austerity measures

and shifted many economies from import substitution towards export-oriented, liberalized trade.

A major shift in structural policies in Latin America occurred between the mid-1980s and late 1990s,

and the economic recovery from this crisis has not been uniform across countries. Differences ineconomic growth, poverty, and inequality have been influenced by many factors, though this paper

focuses particularly on attributing these outcomes to different policy reforms. Though the debt crisis

affected most of Latin America, LA should not be considered a single economic block, but a diverse set

of countries with widely different sized economies, at various levels of social and economicdevelopment.

Several factors were involved in the cause of the financial crisis and massive accumulation of debt.Leading up to this point most countries applied state-driven development strategies, characterized as

the import-substitution industrialism model. This was heavily state controlled and included

interventions for the protection of domestic markets. The 1970s were also a time of heavy borrowingby Latin American governments. Large amounts of foreign capital from an oil boom were given out as

loans indiscriminately, regardless of their ability to be repaid. Early signs of trouble began with the first

oil shock of 1973 and subsequent rising of inflation. The region also experienced a number of other

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shocks, including military overthrows of government, guerrilla activity, and industrial strikes (Saha,2002).

Multilateral aid agencies and organizations such as the IMF and World Bank offered aid on condition

that structural reforms be implemented. They were first introduced in Argentina, Uruguay, and Chile inthe mid-70s, which initially deepened the crisis in these countries, resulting in hyperinflation and

economic stagnation (Lora, 2012).

The US Federal Reserve launched an anti-inflation package in 1979 which drastically hiked up the US

interest rate and triggered a debt crisis across the world. This hit Latin America especially hard because

of its heavy borrowing at variable interest rates. These rates of these loans increased rapidly as well,contributing to the already large debt burden. This lead to a period of recession and socio-political

conflict during the 1980s, resulting in rampant inflation, burgeoning debt service costs, rising

unemployment and widespread social unrest (Saha, 2002 p.84). Reforms had been implemented inBolivia, Costa Rica, Mexico, Peru, and Venezuela by the mid-1980s, and most countries had taken up

World Bank and IMF structural adjustment programs by the 1990s.

More favorable views of it emphasize its role in balancing budgets, reducing widespreadhyperinflation, reducing the overvaluation and black market premiums on exchange rates, eliminating

forms of price control (Perkins et al., 2013). However, this was often in the face of popular protest

against liberalization reforms and the privatization of state-owned enterprises (Saha, 2002).

The economic growth experienced since then has not met the expectations of the IMF and the World

Bank. In the early 1990s, advocates of market-oriented reforms expected they would generate growthrates in Latin America and the Caribbean similar to those in emerging East Asian countries (Loayza,

2005). Critics argue that economic growth rates are neither higher nor more equitable under this set of

policies, and the pressures on market deregulation and cuts to public spending have worsened poverty

and inequality reference.

Structural Reforms

Structural adjustment programs began as individual country-by-country programs, but evolved into a

comprehensive view of what successful development involved later known as the WashingtonConsensus. (Perkins et al., 2013. p.148). This created an agenda of reforms necessary to receive

funding from multilateral agencies, primarily aimed to reduce or remove price distortions generated by

government intervention in the economy.

Structural adjustment programs are complicated packages of policy measures, each containing an

average of 40 conditionalities. The IMF recommended an almost identical policy package to all Latin

American Countries, focused on devaluation, reduction of fiscal deficits, decreases in real wages,relaxation of controls on trade and capital flows, and the elimination of subsidies and other government

interferences (Pastor, 1987). This package of policies are criticized to be particularly problematic and

inappropriate in the midst of a global economic slow-down, and argued to ignore the combination ofpolicy failures in different countries leading to the crisis, and placed blame primarily on domestic

mismanagement and concentrated on domestic adjustments (Pastor, 1987).

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The majority of reforms focused on liberalization of domestic markets to encourage trade, liberalizingfinancial systems and labor markets, opening markets to international financial flows, and withdrawing

state control from economic activities. The goals of this reorientation were improving efficiency,

facilitating the working of markets and reducing the distorting effects of state intervention (Lora,

2012). These are categorized in a number of different ways in other studies, though this paper dividesthem into three general areas of reform:

1. Trade liberalization

Opening trade has many potential benefits, and countries gain from exploiting their area of comparative

advantage, leading to higher productivity and specialization. It also expands potential markets andfacilitates the diffusion of technological innovation. By eliminating restrictions on imports and exports,

lowering barriers to trade opens sectors to foreign competition and investment. This includes tariff and

non-tariff barriers such as licensing, quotas, and anti-dumping laws. Between the mid-1980s and early1990s, Latin America saw reductions of at least 15 points in average import tariff rates (from 41.2

percent in 1985 to 13.2 in 1991, and less than 10 percent in 2005 (Lora, 2012). Reforms to liberalize

the financial sector posed fewer restrictions on banks, reduced fees on transactions. Most counties have

maintained these incentives for foreign investment and free trade zone agreements.

2. Fiscal discipline

Supported by loans, government spending expanded under import substitution. Structural reforms

intend to rebalance budgets by curbing spending and increasing revenue. These include reductions in

government subsidies, public services, and the privatization of public companies to the private sector.Tax reforms until the late 1990s were deep, shifting the tax base to raise revenue while attracting

business development. Countries adopted value added consumption taxes to moderate the distorting

effects of taxation on production and investment decisions, and extreme marginal rates on personal

income were cut substantially (Lora, 2012. p. 10).

3. Monetary stabilization

Policies in this include eliminating controls on interest and exchange rates, and rations on the use of

foreign exchange or currency quotas for imports. State interventions to ration the use of foreign

exchange usually create multiple foreign exchange markets. This may result in extreme differencesbetween the free market and most regulated exchange rates, which would reflect deep monetary

imbalances (Lora, 2012).

Structural reforms intend to reorient economies and stimulate growth by eliminating inefficiency

caused by government intervention, and opening markets to free trade, and the speed and extent to

which Latin American countries reformed was remarkable. Several countries adopted more trade andfinancial liberalization policies and put through more privatizations and tax reforms within a short time

(especially until the mid-1990s) than other transitioning economies of East Asia did in three decades

(Rodrik, 1996). Should structural reforms produce economic growth as expected, it is assumed thatgains from trade will benefit both consumers and producers, increasing net welfare.

The speed and depth of reforms has varied not only across structural policy areas, but across countries

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(Lora, 2012). To compare differences in outcomes under structural adjustment programs, a system maybe used to categorize countries by the extent to which reforms were made. This study has adopted the

model used in a World Bank working paper studying the effects of structural adjustment programs

(Kakwani, 1990), which provides a more accurate view of how involved countries were in lending

programs. This classification of countries is presented in Table 1.

Table 1. Classification of lending and reform status for Latin American countries

Classification Definition Countries

[A] Countries that received structural adjustment loans:

IAL

(Intensely adjusting countries)

Began lending in or before 1985, andeither received three or more loans, or hadcompleted two adjustment programs.

BoliviaBrazilChile

ColombiaCosta RicaMexico

Pre-1986 Received less than three loans before1985.

EcuadorPanama

Uruguay

Post-1985 Received loans from 1986-1988. ArgentinaHonduras

[B] Countries that did not receive structural adjustment loans:

NAL +

(Non-adjusting countries)

Experienced an increase in average annual

per capita GDP growth during 1980-1987.

Dominican Republic

ParaguayPeru

NAL -

(Non-adjusting countries)

Experienced a decrease in average annual

per capita GDP growth during 1980-1987.

El Salvador

GuatemalaNicaragua

Venezuela

Source: adapted from classification system by Kakwani (1990)

The first group which did not receive loans, NAL + may represent countries which did not need the

assistance of the IMF or World Bank, or had at least avoided it during this time. The second group,

NAL - may possibly be considered candidates for adjustment programs. Kakwani suggests that

considering most countries began lending after an economic downturn, the NAL - countries areprobably the closest one can get to a counterfactual (p.6).

In contrast to the major policy changes brought on by structural adjustment programs, changes in termsof labor reforms have been few and of limited scope (Lora, 2012. p. 18). Many of the protections

workers had were dismantled, and a greater labor-market flexibilization saw increasingunemployment, the greatest rates taking place in the lower-income population groups (SAPRIN, 2002.p. 50). Without social protection systems (such as restrictions on hiring, temporary contracts, and firing

costs), workers faced disadvantages such as higher payroll taxes and minimum wages falling relative to

productivity.

While it may be expected that workers ultimately benefit from structural reforms because they

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encourage economic growth, these policies also influence the distribution of gains and losses fromgrowth. Financial crisis and economic depression are undeniably bad, but it is possible that the benefits

from improved economic performance realized by the general population are outweighed by the price

they pay in terms of livelihoods, cost of living, and social services.

Country income inequality

The issue of social and economic inequality has arisen as a political topic in the U.S., particularly with

protest movements in 2011, concerning the distribution of wealth in the top 1%, the power of private

interest in government, and corruption in the financial sector. While the incomes for the vast majorityof people have stagnated in a downturn of the global economy, the incomes of the wealthiest have

grown substantially. According to Rosnick (2012), the increase in income at the 90th percentile in

most countries is dwarfed by the increase in income at the 99 th percentile, 99.9th percentile, and eventhe 99.99th percentile. In fact, in some OECD countries the 90th percentile worker barely kept pace

with the rate of productivity growth in the economy, meaning that they were not, on net, beneficiaries

of any increase in inequality. (p. 2).

This issue is not only crucial to address for the alleviation of poverty, but for economic development

strategy as well, due to the relationship between growth and inequality. The challenge with addressing

this issue is the potential impacts that inequality may have on future economic growth, though policiesintended to stimulate growth may themselves be worsening levels of inequality. According to the

induced-growth argument, higher initial country income inequality may result in lower subsequent

growth. However, economic distortions hampering growth may result from redistributive policiesnecessary to reduce inequality and poverty. (Wodon, 2000. p. 41). This suggests that polices intended

to stimulate economic growth may actually inhibit future growth if they result in rising inequality, as

their effects run contradictory to one another. It may also suggest that applying a single set of policy

measures across countries with differing levels of inequality may not be the most effective approach.

Without considering the impacts of inequality, growth should raise living standards and reduce poverty.

However, when growth is associated with rising inequality, part of the gains from growth will be offsetby the negative impact of rising inequality. Higher levels of inequality may concentrate wealth in the

highest percentile, which might reduce the benefits of growth to the poor.

This issue is crucial in the analysis of the performance of Latin American countries amidst the financial

crisis, as levels of inequality have changed over the years. The need to consider rapid policy changes is

supported by evidence that most of the increase [in inequality] took place between 1986 and 1989

(Wodon, 2000. p. 4). Although Latin America is considered middle-income status, it has huge massesof people in severe poverty, and its societies are some of the most unequal in the world. They have

some of the highest Gini indices, Brazil being the second highest in the world (after Sierra Leone) with

an index of 60. Guatemala and Paraguay are also above 59, six more are above 50, and the remainingcountries fall between 40 and 50 (Saha, 2002. p. 109). This is compared to the indices of Western

European countries between mid-20s to low 30s. Even the US, which is the most unequal industrialized

country has an index of 40.8, which is lower than the lowest in Latin America (Saha 109). Gini indiceshave risen substantially since the 1980s, in three of the largest Latin American countries; Brazil,

Mexico, and Colombia. The Gini index of country income inequality rose as well in Chile and El

Salvador (Saha 109).

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Examining these differences may shed light on the causes of inequality and the relationship they have

to approaches taken to stimulate economic growth. It may also provide insight on the factors which

help to reduce inequality. This is important to address because inequality may reduce the prospects of

the poor of escaping poverty through growth because the higher the initial inequality, the lower theshare of the poor in the benefits of growth (Wodon p41). In terms of policymaking, the alleviation of

poverty may require that reducing inequality take priority over growth.

Methods

This study combines several methods of research as well as independent work. These includereviewing literature from peer-reviewed studies, and official reports and statistics by international

institutions. The information collected for this study is supplemented with previous coursework in the

fields of economics, sustainable development, trade policy, and data analysis. This topic has been

addressed in several other papers and empirical work throughout undergraduate and graduate courses,and the focus of my academic study has been crucial in developing a greater understanding of this

subject.

Considering the many external forces influencing a country's development, it is difficult to precisely

measure the effects of structural adjustment programs using observational data. This includes

estimating what effects may be attributed to them, or how changes in policy affect the outcomes.Because we cannot conduct randomized trials on these policies changes, there is no counterfactual or

way to determine what would have happened in the absence of them. Using a categorization system

such as the one shown in Table 1, may be one way to create an approximate control group (the

NAL-) to compare outcomes across countries.

The accuracy and availability of data present a number of difficulties in analytic work, and acquiring a

continuous series of data with common methodologies for collection or calculation was a challenge.Because developing countries are more likely to be missing data, they may be underrepresented in such

studies, which might bias results. This is true for the data used in this study, particularly with measures

of inequality in Latin America.

All observations in this study are measured at a country-level, which offers a degree of simplicity and

allows for cross-country comparisons. However, the interpretation of this data should consider the

method in which it is collected and the limitations of using national averages. Measures of countryincome inequality generally rely on data at the individual or household level, which contains well

known biases of random and systematic measurement error.

Household or individual income data may not accurately reflect levels of wellbeing due to fluctuations

in paid work or employment in the informal sector. Underreporting tends to be more severe when

poverty measures are based on income rather than consumption levels, though data on consumption ismuch less available in areas such as Latin America (Wodon, 2000). This problem of underreporting

also applies to national economic data. Although it is relatively reliable in accuracy, it may be less

precise in developing countries with greater participation in the informal economy. (Wodon, 2000).

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The choice of Latin American countries in this study was partly determined by the amount of

data available, their involvement in the financial crisis, and the status of their economy. This sample

includes Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador,

Guatemala, Honduras, Mexico, Nicaragua, Panama, Peru, Paraguay, El Salvador, Uruguay, andVenezuela. All of the information for this analysis is contained in a dataset which had been used in

prior academic work. This data was gathered from multiple sources including the World Bank and IMF.

It includes time series data from these 18 Latin American countries from 1960 to 2012. Definitions andsummary statistics for the variables used in the analysis are provided in Table 2.

Table 2. Summary Statistics

Table 2. Definition and summary statistics of variables used in the regression of policy measures and macroeconomic indicators

associated with three areas of structural reform on country income inequality in 18 Latin American countries, 1960-2012.

Variable Definition Obs Mean SD Min Max

A. Dependent variables

Gini index Annual country Gini coefficient in percentage points as calculated byWIDER (estimated using decile data and reported Gini, in household and

individual income or consumption inequality).

370 50.18 6.58 29.90 68.20

Theil Index Theil's T statistic is computed as the product of states population share,

quotient of state average income, and natural logarithm of quotient of state

average income

439 0.05 0.03 0.01 0.26

EHII Estimated household income inequality (EHII) are estimates of gross

household income inequality, computed from a regression relationship

between the Deininger & Squire inequality measures and the UTIP-UNIDO

pay inequality measures, controlling for the source characteristics in theD&S data and for the share of manufacturing in total employment

(Deininger & Squire, 1996).

439 41.76 5.90 26.14 62.32

B.Explanatory variables

I. Trade liberalization

Trade tax Total annual taxes on international trade (import duties, export duties,

profits of export or import monopolies, exchange profits, exchange taxes),

as percentage of GDP

360 2.57 1.60 0.41 9.31

Trade openness Sum of annual exports and imports of goods and services measured as a

share of gross domestic product.

906 52.30 30.10 9.06 198.77

Terms of trade Annual median ratio of export prices to import prices, calculated as the

value of a country's exports relative to imports (exports / imports * 100). A

measurement greater than 100% indicates an accumulation of capital,measurements less than 100% indicate net capital is leaving the country.

651 106.79 29.76 33.75 253.28

II. Fiscal discipline

Subsidies

(as % revenue)

Sum of annual subsidies, grants, and other social benefits include all

unrequited, nonrepayable transfers on current account to private and public

enterprises; grants to foreign governments, international organizations, andother government units; and social security, social assistance benefits, and

employer social benefits in cash and in kind.

456 4.22 5.96 -43.44 46.30

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Table 2: Continued

Debt service Total annual debt service (principal repayments + interest paid on long-term,

short-term debt in currency, goods, or services + repayments to IMF), aspercentage of exports of goods, services and primary income

661 25.18 16.72 0.14 156.86

Foreign directinvestment

(FDI)

Annual net inflow of investment in an enterprise in economy foreign toinvestor, as percentage of GDP

709 2.09 2.42 -12.21 17.13

III. Monetary stabilization

Money & quasi

money (M2)

Annual average money and quasi money supply (currency outside banks +

non-government demand deposits + savings + non-government foreigncurrency deposits), traditional measure of financial depth

Overvaluation Annual average percentage difference of deviation of actual real exchangerate (REER) from PPP. Used as a proxy for outward orientation

642 122.14 219.60 43.52 5526.61

Black market

premium

Annual average percentage difference between the black market rate for

foreign currency and the pegged official exchange rate

669 120.07 1951.11 -10.24 49990.00

Inflation Inflation as measured by the consumer price index reflects the annual

percentage change in the cost to the average consumer of acquiring a basket

of goods and services that may be fixed or changed at specified intervals,such as yearly.

762 75.87 562.63 -3.90 11749.60

C. Control variables

GDP Gross domestic product (current U.S. dollars, in billions) 929 7.06 1.99 2.30 2.50

Year Year of survey (1960-2012) 52

Country 18

Literature review

The following section will discuss four main bodies of literature: measures of country incomeinequality, measures of policy reform, economic growth as a determinant of inequality, and policy

measures as determinants of growth. This will present the findings and differing arguments made in

relation to these areas.

1. Measures of country income inequality

One main concern in empirical studies of country income inequality is the lack of consistency in whichdata is measured. Income inequality may be measured using data on gross or net income (before or

after tax), consumption or expenditure, on either household or individual levels. Almost all studies donot measure inequality in a consistent way, mostly due to the limitations of data available. A study by

Stephen Knowles (2005) proposes there are potentially serious problems with data quality (particularly

in older studies), and that much of the empirical work on inequality should be interpreted with cautionbecause of this inconsistency.

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Knowles finds the significant negative correlation often found between income inequality and growth

across countries may not be robust when income inequality is measured in a consistent manner,

though it finds evidence of this correlation in developing countries using consistent measures (p. 1).

However, other studies including Borro (2000), claim the use of consistent measures does not affectresults. Some studies attempt to avoid such problems with inconsistent measurement by transforming

data. Studies by Perotti (1996), and Deininger and Squire (1998) find different results using

transformations, though Knowles claims it is not an adequate fix to this problem (as cited in Knowles,2005. p. 1).

In addition, Knowles argues that the measurement of inequality may exaggerate the degree of incomeinequality relative to countries using different measures. He states that Latin American countries more

frequently have data on gross income distribution for individuals, which is expected to produce a

higher Gini coefficient than other measures (p. 4). Forbes (2000) points to attenuation bias as a sourceof measurement error. She notes that if more unequal countries underreport their inequality statistics,

and also tend to grow more slowly, this could generate a negative bias in cross-country estimates of

inequality on growth.

Inequality measures may also be misleading whether they are reported using population-weighted

figures or equal country weights. For example, the World Bank Technical Paper on Poverty and Policy

in Latin America and the Caribbean by Wodon (2000), finds no clear pattern towards changes ininequality over time when using equal country weights. However, the outcome changes when using

population-weighted measures, indicating that changes in inequality in LAC reflect in part the weight

of Brazil and Mexico, where inequality increased between 1986 and 1989, and then receded onlypartially (p. 37). In addition, using country-level measures may hide important within-sector

variations in inequality, as rates tend to be higher within urban than in rural areas in Latin America.

National level estimates may be even higher if they take into account the inequality between urban and

rural areas (Wodon, 2000).

The use of different inequality measures is also challenged. One study by Rosnik and Baker (2012)

argue against the OECD's recently published report on inequality over the last three decades. Thisanalysis claims the OECD is missing most of the story because of the measurements of inequality used

(ratio of annual wage of the 90 th percentile to 10th percentile worker), and that most of the gains were

much further up the income ladder (p. 1). This study finds that gains to the very high earners asopposed to the merely high earners form a substantial part of the growth in inequality.

This study includes three measures of inequality; the Gini index, Theil index, and Estimated

Household Income Inequality (EHII). These were chosen because each uses different methods ofcalculation, and often present differing pictures of inequality. This approach is taken in an effort to

ensure the results of the analysis do not hinge on the definition of income inequality.

2. Measures of policy reform

Empirical work studying the effects of structural adjustment programs often note the issue of finding an

adequate series of policy variables. Specifically, this addresses the difference between variables whichmay be directly influenced by policy decisions (such as tariff rates, taxes, and bank reserve ratios), and

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those which measure economic outcomes of policy choices (such as the ratio of imports to exports, andrates of inflation). The latter are influenced by policy decisions and a variety of other internal and

external phenomena including the business cycle, terms of trade or foreign interest rates.

One study by Lora (2012), argues that this has prevented accurate measures of the magnitude ofreforms, as well as the relative importance of the various areas of reform, and distinguishing between

the effects on growth of the structural reforms themselves and those derived from macroeconomic

stabilization (p. 26). This study uses a revised set of indexes to measure the effects of policies in fivedifferent areas.

This study acknowledges the limitations with using variables which are indirectly determined by policychoices and external factors, and has included a set of both policy measures as well as macroeconomic

indicators which structural reforms intend to influence.

3. Economic growth as a determinant of inequality

Many studies have found a negative correlation between income inequality and GDP growth, thoughimprovements in data allowing panel studies have produced results challenging this widely-held

opinion. Perkins (2013) confirms that early studies found statistical evidence to support that high initial

inequality, especially of landholdings, was associated with slower subsequent growth. But later studies,using larger data sets and different econometric techniques, either found no such effect or even an

opposing one.

Knowles (2005) finds no evidence of a significant relationship between income inequality and growth,

though this study does find evidence for a significant negative relationship between inequality of

expenditure and economic growth (p. 4).

Forbes (2000) challenges the negative relationship when controlling for time-invariant country-specific

effects, and finds that in the short and medium term, an increase in a country's level of income

inequality has a significant positive relationship with economic growth, which is robust across samples,differences in variable definitions, and model specifications.

Forbes also argues that this negative relationship depends on exogenous factors, such as levels ofdevelopment and political systems. The study cites other models which find positive relationships

(Grilles Saint-Paul & Thierry Verdier, 1993), (Benabou, 1996), and hypothesizes that more unequal

societies may vote for higher expenditures on public services that promote growth, and that inequality

increases during times of technological innovations, which concentrate wealth among high-abilityworkers.

4. Policy measures as determinants of economic growth

The common thread of all the recommendations made by the Washington Consensus is that growthwas inhibited by major distortions in the market, distortions for the most part introduced by

inappropriate government policies (Perkins, 2013. p. 148). Removing these distortions was seen as the

key to accelerating growth, and that government failure, rather than market failure, was considered the

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primary impediment to economic growth and development.

A number of studies have examined the link between these policy reforms and economic growth. One

of which, by Jeffrey Frankel and David Romer (1999), tests whether the same variable used in this

study for trade openness (trade as a proportion of GDP) causes growth. They find that a 1 percentage-point increase in the ratio of trade to a country's GDP increases income per capita by at least 0.5

percent.

David Dollar (1992), constructed an indicator of trade policy orientation based on real exchange rate

distortion and volatility, and found that during 1976-1985 developing countries that were most open to

trade had an average annual growth rate of 2.9 percent per capita, compared to the most closed portionof the sample countries experienced negative growth of -1.3 percent.

One of the most well-known studies by Jeffrey Sachs and Andrew Warner (1995), constructed acomposite indicator of openness to trade which classified countries as either open or closed based a

number of trade policy indicators. They found openness to have a substantial influence on growth, and

that open countries (between 1970 and 1989) grew at least 2 percentage points faster on average than

closed countries

Francisco Rodrguez and Dani Rodrik (2000) challenge the validity, interpretation and robustness of

these policy indicators used by Sachs and Warner, and claim that the evidence for the relationshipbetween openness to trade and growth is inconclusive.

Substantive discussion

Estimation strategy

To estimate the association between income inequality and three areas of structural reform (Trade)liberalization, (Fiscal) discipline, and (Monetary) stabilization, I use the following model:

[1] yct = + 1Tradect+ 2Fiscalct+ 2Monetaryct+ 3Cct+ ct

where y is a measure of country income inequality, (Trade), (Fiscal), and (Monetary) are vectors of

policy measures and macroeconomic indicators as explanatory variables, Cct includes a vector of

control variables, and ct is the regression residual. The subscripts c and t stand for country and time.

The following section will describe the variables as they are categorized.

A. Dependent variable (y)

Inequality is measured in three ways, using the Gini Index, Theil Index, and Estimated Household

Inequality Index (EHII). As discussed in the literature review, using different methods to calculateinequality will produce different results. In addition, the sample size for each measure differ widely in

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the countries and years represented, which might produce different estimates of the effects of policieson country income inequality.

B. Explanatory variables (trade, fiscal, monetary)

This study focuses on a set of variables for policy measures which may be deliberately controlled by

the government, as well as variables for macroeconomic indicators which policy reforms attempt to

change. These indicators cannot directly measure the reforms, but may suggest whether their intendedeffect is significantly related to inequality. These have been organized into the three general categories

of reforms, related to trade liberalization, fiscal discipline, and monetary stabilization.

I. Trade liberalization:

One variable for policy measures includes tax on international trade as an indicator of trade

liberalization. Variables also included a measure of the total value of traded goods relative to acountry's GDP, which is commonly used as an indicator of openness. Terms of trade is another

indicator of a country's capacity to trade.

II. Fiscal discipline:Two variables for policy measures include the relative amount of a country's revenue spent on

subsidies, and the relative amount a country pays to service external debt. Another variable is

included to measures the amount of foreign direct investment received by a country, which mayresult from preferential corporate or income tax rates.

III. Monetary stabilization:The variable for money and quasi money supply (M2) is a traditional measure of financial depth.

Other variables include exchange rate overvaluation, which captures the impact of monetary and

exchange rate policies that distort the allocation of resources between the exporting and domestic

sectors (Loayza, 2005. p. 42). Another indicator is the rate of black market premium, or the excesswhich must be paid to purchase foreign exchange in illegal markets which indicates the use of fixed

exchange rates. Inflation is another measure macroeconomic or price stability, which indicates the

quality of fiscal and monetary policies.

C. Control variables (c)

Control variables include: (i) dummy variables for year and country to sweep away time and location

invariant fixed effects, and (ii) baseline GDP since it is associated with country growth and country

income inequality.

Hypotheses

My hypothesis is that structural reform programs, as a whole, are associated with higher inequality,

though the three areas of reform are expected to be correlated differently in the following ways:

H1. More liberalized trade will be associated with greater inequality, and reducing taxes on trade

will be related with higher inequality. I also expect to find a positive coefficient for openness to trade.

Because export-oriented economies are more vulnerable to declining terms of trade, I expect it to have

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a stronger negative association with inequality.

H2. The vector of variables related to fiscal discipline will have the largest (positive) effect on

inequality. Reducing subsidies will increase inequality, and an increase in public funding redirected

toward debt service will also increase inequality. FDI is also expected to lead to a greater consolidationof wealth and increase inequality, though to a lesser extent than the other variables for this vector.

H3. Monetary stabilization is the one area of reform expected to benefit the poor and decreaseinequality. The lack of financial depth, indicated by lower money and quasi money supply (M2)

increases the risk of financial crisis, and is expected to increase inequality. Higher overvaluation, black

market premium, and inflation are all expected to be associated with price distortions that particularlyhurt the poor and increase inequality.

Results

I begin by analyzing the association between each explanatory variable and each of the three measures

of inequality, controlling for baseline GDP, time- and country-fixed effects. Table 3 contains the OLSregression results and Table 4 compares the results with the expectation from the hypotheses.


We find a positive relationship between tax on international trade and all three measures of inequality,though only the EHII is statistically significant at the 90% confidence interval. Contrary to the

hypothesis, this suggests that a 1% increase in taxes relative to GDP is associated with a 0.018%

increase in inequality. We also find a significant positive relationship between trade openness and

inequality using the Gini index, as expected. This suggesting that a 1% increase in the ratio of importsand exports to GDP is associated with a 0.05% increase in inequality. The EHII produces a similar

insignificant result, though the Theil index shows a negative, but insignificant relationship. The

coefficient of terms of trade is both positive and insignificant using the Gini index and EHII, but theTheil index shows a significant negative relationship with inequality. As hypothesized, we find that a

1% increase in terms of trade is associated with a 0.217% decrease in inequality. This shows a much

stronger relationship than the two insignificant results. As a whole, these results do not suggest there isa consistent relationship between trade liberalization and inequality which is robust across different

measures of inequality, as we find only one significant coefficient for each variable and differing signs

across insignificant coefficients.


We do not find any evidence of the relationships between inequality and subsidies or foreign direct

investment from these results. However, we find negative coefficients of debt service with all three

measures of inequality, two of which are significant. This suggests that 1% increase in the amount acountry spends on debt service relative to its income is associated with a 0.02% or 0.15% decrease in

inequality (using the Gini and Theil index, respectively), which runs counter to H2. Overall, these

results do not provide sufficient evidence to suggest there is a relationship between fiscal discipline and

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country income inequality.


We find one highly significant negative relationship between M2 and inequality using the Theil index,

which is much stronger than the insignificant positive and negative relationships found with the other

inequality measures. This supports the hypothesis that greater financial depth is good for the poor, andthat a 1% increase in money supply is associated with a 0.163% decrease in inequality. The relationship

between overvaluation and inequality was expected to be positive, though we find a highly significant

negative association using the Theil index (the others show both insignificant negative and positiverelationships). This result suggests that a 1% increase in overvaluation, indicating lesser outward-

orientation, is associated with 0.192% decrease in inequality. Similarly, we find a significant negative

relationship between black market premium and inequality using the Gini and Theil indexes, the EHIIis also negative but insignificant. This challenges the hypothesis that dismantling controls on exchange

rates would benefit the poor, and suggests that a 1% increase in black market premium is associated

with a 0.01% or 0.04% decrease in inequality. Lastly, we find two highly significant negative

coefficients of inflation using the Gini index and EHII, the Theil index is also negative butinsignificant. These both suggest a 1% increase in inflation is associated with a 0.01% decrease in

inequality, though this was hypothesized to disproportionately hurt the poor. As a whole, these results

would suggest that reforms in the area of monetary stabilization are associated with higher inequality.

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Table 3. Main Regression Results

Table 3. Policy measures and macroeconomic indicators associated with structural reform as determinants of inequality

OLS Regression results of policy measures and macroeconomic indicators in three areas of reform on three measures of income

inequality in 18 Latin American countries, 1960-2012

Explanatory

variable

Gini index Theil index EHII

[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12]


Trade tax 0.005(0.02)

0.014(0.05)

0.018*(0.01)

Trade openness 0.050**(0.02)

-0.057(0.10)

0.045(0.03)

Terms of trade 0.006(0.04)

-0.217**(0.11)

0.015(0.03)

N 178 361 268 258 422 397 238 420 394

R2 0.68 0.61 0.61 0.72 0.59 0.59 0.88 0.67 0.68


Subsidies 0.010

(0.01)

-0.031

(0.03)

0.011

(0.01)Debt service -0.020*

(0.01)-0.153***(0.04)

-0.011(0.01)

FDI 0.008(0.01)

0.016

(0.02)

0.001

(0.00)

N 172 291 309 186 421 313 178 407 319

R2 0.73 0.61 0.67 0.57 0.60 0.70 0.55 0.68 0.68


M2 0.018(0.01)

-0.163***(0.06)

-0.001(0.01)

Overvaluation -0.004(0.02)

-0.192***(0.07)

0.007(0.01)

Black market

premium

-0.010**

(0.00)

-0.042***

(0.02)

-0.001

(0.00)Inflation -0.013***

(0.00)-0.015(0.02)

-0.014***(0.00)

N 368 270 196 287 437 398 303 339 435 387 304 356

R2 0.59 0.58 0.65 0.60 0.55 0.54 0.54 0.58 0.67 0.66 0.72 0.56

Notes: Observations measured annually from 1960 to 2012 for 18 Latin American countries. All values are in natural logarithms.

All estimates control for baseline GDP and time- and country-fixed effects.

Robust standard errors in parentheses, *** p


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One possible explanation for these discrepancies may be that the policy reforms were not implemented

or possible to implement in a uniform manner. Latin American governments were criticized for their

maintenance of overvalued currency and reluctance to switch to floating exchange rates, though

addressing problems such as hyperinflation took much more of a concerted effort.

Overall, we find very few results are significant and robust across different measures of country income

inequality. In addition, the model's simplicity and extremely limited sample size for all of theseestimates suggests these results should be interpreted with caution.

Table 4: Summary of Empirical Results and Expectation from Hypotheses

Table 4. Summary of Empirical Results and Expectations from Hypotheses

Hypotheses Sign of expected association with inequality Estimated coefficient from Table 3

H1: Trade liberalization

a. Trade tax (-) higher taxes, lower inequality (+)* column 9 is significant

b. Trade openness (+) greater openness, higher inequality (+)** column 2 is significant

c. Terms of trade (-) increasing terms of trade, lower inequality (-)** column 7 is significant

H2. Fiscal discipline

a. Subsidies (-) higher subsidies, lower inequality (0) none are significant

b. Debt service (+) higher debt service, higher inequality (-)*,*** columns 2, 6 are significant

c. FDI (+) greater FDI, higher inequality (0) none are significant

H3. Monetary stabilization

a. M2 (-) greater money supply, lower inequality (-)*** column 5 is significant

b. Overvaluation (+) greater overvaluation, higher inequality (-)*** column 6 is significantc. Black market premium (+) higher premium, higher inequality (-)**,*** columns 3, 7 are significant

d. Inflation (+) higher inflation, higher inequality (-)***,*** columns 4, 12 are significant

Source: See Table 3 for regression results. *,**,*** denote statistical significance at 90, 95, 99% confidence intervals

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Conclusion and implications

It is troubling that Latin America has not experienced as strong an economic recovery as anticipated,

though what seems more unfortunate is that it spent more over the last 20 years servicing external debtsthan it has on basic education, health, and social services, combating poverty, and building

infrastructure (Saha, 2002). These are all essential elements which make achieving sustainable

development possible. Foreign debt also provides international financial institutions a certain degree ofpolitical leverage, and countries may be pressured to adopt policies which may not serve the best

interests of its people.

In general, the packages of reforms have appeared to focus primarily on domestic policies which may

have played relatively smaller roles in the cause of the financial crisis, and have ignored the global

nature of the crisis and external factors contributing to the excessive debt and financial shocks. Ratherthan address policy inadequacies in international flows of capital, they have become increasingly

unregulated. Financial-sector liberalization is argued to have contributed more to economic crises and

increased vulnerability to external shocks through irresponsible bank lending, volatility of foreign and

domestic capital, bailouts of the private system with public funds, and worsening debt (SAPRIN,2002).

As indicated in the literature reviewed on this subject, there still remains an uncertainty as to the natureof the relationship between economic policy and inequality. While there may be some growing

acknowledgement of the issue of inequality on the part of the World Bank and IMF, there appears to be

very little progress made in the way of the policy framework advocated to address it. Saha (2002) citessome recent changes in position on the need for integration between economic and social dimensions of

development. As early as 1991, the World Bank's World Development Report indicated that a shift was

needed from the earlier neoliberal approach to a more socially sensitive approach, in which the state

was to play a greater role (p. 86). The 1996 Conference on Development, co-sponsored by the WorldBank, IMF, and Inter-American Development Bank, noted the urgent need for a second generation of

reforms which supported institution building and a stronger proactive role for the state in managing

development (Saha, 2002. p. 87).

However, it is my belief that these acknowledgements may be of little consequence due to the fact that

the basic policy framework advocated by the World Bank has not changed. Though they recognize therelationship structural reforms have with rising inequality, the World Bank continues to argue that the

macroeconomic gains from the implementation of adjustment policies offset any short-term losses

among certain population groups and sectors by setting countries on the path toward sustainable

growth. (SAPRIN, 2002. p. 185). This statement implies that inequality is result of these policies,though it is regarded as a short-term problem which will inevitably be self-corrected.

The World Bank reports that over the short-term, fiscal retrenchment is alleged to have hurt the poorvia cutbacks in public expenditure programs largely devoted to them, but this negative effect is seen to

be more than counterbalanced by the positive impact on reduction of inflation (Wodon, 2002. p. 21).

They also suggest that the cutbacks in public sector employment also appear to have negativelyaffected the poor in the short-run, but over the medium- and longer-term, the net effects on the poor

are seen to depend on the rate and composition of overall economic expansion, employment creation in

the private sector, and the adequacy of safety nets and educational programs for cushioning the

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transition to a new productive structure (Wodon, 2002. p. 21).

The evidence supporting this claim is not widely confirmed in the literature reviewed, particularly in

the case of Latin America. One study by the Structural Adjustment Participatory Review International

Network (SAPRI, 2002) finds radically different results, claiming that the overall impact of adjustmentpolicies include increased current-account and trade deficits and debt, disappointing levels of economic

growth, efficiency and competitiveness, misallocation of financial and other productive resources, the

disarticulation of national economies, destruction of national productive capacity, extensiveenvironmental damage, greater intensity and pervasiveness of poverty and inequality, higher

concentrations of wealth, and far fewer opportunities for the poor (p. 185).

However, the results of this analysis suggest the association between these policy reforms and

inequality may support some claims on either side of this issue. There may be a great deal of

unobserved causal relationships influencing these outcomes, and that further study into the joint effectsof these indicators is recommended.

The issue of inequality should continue to be studied at greater length within the greater context of

policy as it is inexorably linked to the goals of economic growth and the reduction of poverty.Addressing the issue of inequality constructively may not be possible without first gaining a better

understanding of the relationship between inequality and the strategies currently being used to promote

economic growth.

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References

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Dollar, D. (2000). What Explains the Success or Failure of Structural Adjustment Programmes? The

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Dollar, D. (1992). Outward-Oriented Developing Economies Really Do Grow More Rapidly: Evidencefrom 95 LDCs, 1976-1985.Economic Development and Cultural Change, 40(3): 523-544.

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Caribbean: Stylized Facts, Explanations, and Forecasts. Washington D.C., World BankPublications.

Lora, E. (2012). Structural Reforms in Latin America: What Has Been Reformed and How to MeasureIt. (IDB Working Paper). Inter-American Development Bank.

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Roberts, K. M. (2012). The Politics of Inequality and Redistribution in Latin America's Post-Adjustment Era. (Working Papers: UNU-WIDER Research Paper #8). World Institute for

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Data Sources

Inter-American Development Bank, Latin American and Caribbean Macro Watch Database

(http://www.iadb.org/Research/LatinMacroWatch/lmw.cfm).

UNU-WIDER World Income Inequality Database, UTIP-UNIDO Dataset, Estimated Household

Income Inequality Dataset, IMF World Economic Outlook Database, and World DevelopmentIndicators Database (http://utip.gov.utexas.edu/data.html).

World Bank, Economic Policy & External Debt Databank (data.worldbank.org).

World Bank, The Lost Decades: Developing Countries' Stagnation in Spite of Policy Reform 1980-

1998 Dataset (http://go.worldbank.org/4D1S9KQUP0).

policy roots of country income inequality in latin america: analysis of structural reform following...

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