Can Latin America Learn from Europe’s Mistakes? Divergence in Regional Economic Integration

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By Collin Constantine (Kingston University) and Johanna Renz (University of Oxford)

A powerful core and a powerless periphery – these are features of the European Monetary Union (EMU). The union has gone much further than Latin America and the Caribbean (LAC) in its integration efforts and has suffered from a severe economic crisis. Since LAC’s economic integration is still ongoing, it can and should learn from the EMU’s mistakes before it is too late.

The EMU is often viewed as a role model for regional integration. Other regions, like Latin America and the Caribbean (LAC) follow its steps and are also moving towards political and economic integration. Though more fractured than the EMU, organisations such as MERCOSUR and CARICOM illustrate that there are serious commitments to integration in the region. The Eurozone crisis, however, has shown that the EMU is not quite the perfect and inspiring model that we once thought. Here, we demonstrate the parallels between the asymmetries in productive structures within the EMU and within LAC and illustrate how these create centre-periphery [1] power relations in the Eurozone. Finally, we present some key lessons that LAC can learn from the Eurozone crisis.

Starting off unequally
Why can we compare the Eurozone and LAC in the first place? Both have asymmetric productive structures, meaning that countries within the regions differ vastly in the type of products they produce. In the Eurozone, the value added share in high, medium and low technology manufacturing varies significantly (Table 1). For the selected countries, the relative value added share in high tech manufacturing declines relative to Germany between 1999 and 2009 – this clearly indicates a divergence in productive capabilities. Other indicators also point to a structural asymmetry. The Productive Structure Similarity Index (PSSI) [2] shows that there was a clear divergence from 1999-2011 between Germany on one hand and Greece, Portugal and Ireland on the other. This divergence has deepened since the recent financial crisis. The Export Structure Similarity Index tells a parallel story for the same time period.

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There is also a divergence in current account balances between centre and periphery countries (Figure 1). There are many competing explanations for this divergence but the dominant discourse blames ‘irresponsible’ households and governments, and hence recommends fiscal austerity and wage cuts. The imbalances expanded from 2002-2008 but have since narrowed – owing to draconian austerity policies. We argue that the divergence in productive structures highlighted above and the difference in current account balances are closely related.

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Productive asymmetries and current account imbalances also exist within the LAC region (see Figure 2), which can lead to similar centre-periphery inequality as in the Eurozone. Though the region as a whole is dependent on natural resources, there are important productive asymmetries (see Table 2). We divide the region into the following – the Big Three: Argentina, Brazil and Mexico, the Medium Four: Chile, Colombia, Peru and Venezuela and the Smaller Eleven: Bolivia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Nicaragua, Panama, Paraguay and Uruguay. Predictably, the Big Three dominate in the exports of high tech manufacturing with approximately 30% of total manufacturing exports being high technology in 2000 – this is in contrast to less than 5% in the Medium Four. The Big Three also outperform in medium tech manufacturing exports, with 40% of total exports in this category – as opposed to approximately 20% in the Medium Four and the Smaller Eleven. In low-tech exports, the Smaller Eleven is the star player followed by the Big Three and the Medium Four. The data points to a divergence between the Big Three and the remaining countries in LAC, similar to the divergence in the Eurozone.

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Trying to merge unequals – asymmetric integration in the Eurozone
Why are asymmetric productive structures problematic? The asymmetries become challenging under monetary integration, which inevitably creates a core-periphery dynamic. In our view, the central problem of the Eurozone is the attempt to lump these different productive structures together under a monetary union without a fiscal union. This is more problematic than the often-discussed divergence in unit labour costs (ULC) [3] or fiscal profligacy.

Free trade among countries on different technological frontiers is primarily the exchange of commodities with different value – countries that export lower value goods find themselves unable to pay for their higher value imports. In the absence of financial integration, countries on a lower technological frontier restrain their demand for imports to prevent account imbalances. But in the EMU, savings are recycled and emerge as debt accumulation in deficit countries – setting the stage for a debt crisis.

Monetary integration leads to capital inflows into periphery countries. This makes growth in these countries possible, without forcing them to transform to high-technology sectors, but it creates lock-in effects in low-technology industries. For instance, the housing bubble in the periphery reallocated resources towards construction – a non-tradable sector with limited potential for productivity growth. Additionally, cheap credit in the South increases economic growth, reduces unemployment and crucially, increases wages. Thus, contrary to popular arguments, higher ULC in the periphery are a consequence rather than a cause of external imbalances (see here and here).

One size does not fit all – the Eurozone’s response to crisis
The different productive structures were bundled together in a monetary union when the crisis emerged. Under this circumstance, they were forced to respond uniformly; and power – rather than economic analysis – guided the responses.  For instance, fiscal austerity was imposed on the periphery since the analysis points to fiscal profligacy as the primary cause of trade deficits. However, the reverse must be true – fiscal surpluses in the core must have contributed to their trade surpluses, which would logically lead to mandated fiscal expansion. But the prevailing policy wind focused exclusively on austerity. Similarly, if wage cuts are necessary for recovery in the periphery, surely, wage growth is fundamental in centre countries. Yet, only wage cuts are gaining traction.

Higher ULC in the periphery meant that their rate of inflation was higher than in core countries. It follows that the management of monetary policy required the ECB to choose between divergent inflation rates as a guide for policy. Consistent with the centre-periphery dynamic, the ECB’s interest rate policy closely followed the inflation rates that prevailed in Germany. Consequently, the ECB kept interest rates low and further inflated the inflationary boom that manifested in the periphery – deepening the divergence (see here and here).

Notwithstanding the role of productive structures in shaping external imbalances, the latter is not necessary for a sovereign debt crisis – the economic policy framework of the Eurozone can do bad all by itself. It imposes strict limits on debt, inflation and deficits, or more fundamentally, it restricts the role of fiscal and monetary policy in the economy. The failure of the ECB to stand behind member states and the urgency of austerity created the Eurozone sovereign debt crisis – or more specifically, a debt crisis in the periphery. As the crisis deepened, the ECB was forced to undertake quantitative easing but this proves to be ineffective in terms of recovery in the real economy. Also, the crisis has deepened the centre-periphery inequality since the EU policy framework has not changed direction, but in fact has become more rigid and doctrinaire.

Learning from the mistakes of others: Lessons for LAC
The case of the EMU has illustrated that asymmetric integration can manifest centre-periphery dynamics, especially in times of crises. In order to avoid such inequalities in LAC, we can draw some relevant lessons from the Eurozone case. Before further integration, regional bodies in LAC need to undertake rigorous assessment of the productive structures of member states to ascertain the depth of both relative and absolute divergence. This should be the primary factor that determines the form and extent of industrial policies. As shown previously, there are significant technological differences in LAC, so a regional investment bank should be central to any LAC integration charter, as strategic investments could help technological upgrading of the less advanced economies in the region.

Further, any integration agreement needs to ensure that fiscal and monetary policies are counter-cyclical. This is necessary to prevent recessions from turning into depressions and banking crises into sovereign debt crises – as it was the case in the Eurozone. An important lesson to learn from the crisis is that monetary policy in a currency union needs to expand beyond inflation targeting. The housing bubble in the periphery led to a construction boom – this labour-intensive sector increased ULC and inflation. Fundamentally, effective monetary policy does not focus solely on inflation but expand to asset price targeting, bank regulation and even inequality.

All things considered, our analysis shows how similar both Europe and LAC are with respect to regional differences in productive structures. Given the recent crisis in the Eurozone, LAC should strongly consider these centre-periphery differences before integrating further.

[1] Centre-periphery power relations refer to the power struggle between developed and less developed countries.

[2] The PSSI ranges from 0 (identical productive structures) to 1 (absolute divergence in the sectoral composition of the economy)

[3] According to the OECD, unit labour costs is a measure of the output an economy receives relative to wages, the average cost of labour per unit of output.

This article was first published on VOX LACEA.

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