Key Points from The Costs of Inequality in Latin America

The Costs of Inequality in Latin America: Lessons and Warnings for the Rest of the World by Diego Sánchez-Ancochea

Inequality has historically contributed to many social ills, from low economic growth to weak democratic institutions and high levels of violence. Populism, financial crises, bad jobs, social polarization: Latin America has struggled with all these problems for more than a century.

It is not only that inequality has shaped political and economic institutions in Latin America; these institutions have in turn contributed to more inequality. For example, labor market duality (with large differences between good and bad jobs) has led to growing income gaps between workers. Politics and economics have also reinforced each other: inequality has contributed to the election of leaders who, in their search for easy solutions, have ended up triggering economic crises and ultimately favoring the wealthy.

All Latin American countries have a similar history: they became colonies of Spain and Portugal during the sixteenth century, gained independence during the nineteenth century, and then had to deal with similar obstacles to building effective institutions. The state is weaker than in developed countries: corruption is an endemic problem, changes in rules and regulations are common, and policies are often inconsistent. They have always had to deal with influential external actors, including the US, and struggled with external dependence. Latin American countries also share some cultural traits, including a common language (with the exception of Brazil … but Portuguese and Spanish are similar), and many social similarities. They are some of the most urbanized countries in the developing world, and most have large non-white minorities.

the lack of economic dynamism has much to do with the control of policymaking by the wealthy—politics and economics can seldom be separated. The top 1 percent successfully pressured for low taxes: most Latin American states collect less than they should, given their level of development.

given these exclusionary policies and lack of economic dynamism, it is not surprising that citizens have repeatedly supported populist responses. Leaders like Juan Domingo Perón in Argentina in the 1940s and 1950s or Hugo Chávez in Venezuela more recently promised to provide good jobs and adequate social benefits to the poor and the urban middle classes. Unfortunately, their governments often ended up implementing unsustainable economic policies, while proving unable or unwilling to systematically confront the power of the wealthy—a lesson voters in developed countries would do well to remember.

Inequality, labor market dualism, financial crises, and political instability are growing everywhere. Wealthy countries like the US look more and more like Latin America and—if they do not reverse direction—could suffer many of the same negative interactions over the long run. Unfortunately, avoiding the costs of inequality will become harder and harder: Latin America shows that reversing the income gap is difficult precisely because of negative political and economic feedbacks.

Between 2003 and 2013, most Latin American countries improved their distribution of income, precisely at a time when income gaps were increasing in the rest of the world. Some of the drivers of this recent improvement are not particularly relevant for wealthy economies but may be important for developing countries. In some Latin American countries, the poor became the subject of social rights for the first time in history, contributing to a rapid increase in their income. The power of electoral competition to promote some level of inclusion is a second useful lesson.

Maybe the distribution of income was no worse in Latin America in the middle of the nineteenth century than in England during the Industrial Revolution; rapid economic transformation in Manchester, London, and other British cities did create wealthy winners and millions of losers, as Karl Marx eloquently explained. Yet it is clear that in Latin America institutions and policies were organized in favor of the powerful from early on: huge latifundios, underinvestment in primary education, and restrictive voting rights were the norm across the region.

When the first wave of globalization met Latin America’s traditional institutions, inequality accelerated. In Argentina, Brazil, Chile, and Uruguay the Gini coefficient increased by at least five percentage points between 1870 and 1920. Rich landowners found new opportunities to make large amounts of money through exports.

governments without resources cannot fund much-needed investments in social programs and infrastructure.

Latin America’s problems, including uneven investment in education, difficulties in taxing the wealthy, economic crises, and informal labor markets, are increasingly evident in other parts of the world and seem more widespread and entrenched than ever.

the elite had no incentive to innovate. Exporting agricultural goods and/or various mining products was much more profitable than trying to produce manufactures. Between 1850 and 1912, primary exports grew by an annual average of 3.3 percent with a particularly fast expansion in Argentina (6.1 percent) and Uruguay (5.6 percent). Meanwhile, the manufacturing sector struggled to become more productive.

The contrast with East Asia could not be more striking. In Latin America inequality contributed to underinvestment in education which, in turn, hampered the creation of a more dynamic economy. Countries such as South Korea, Taiwan, and Singapore—historically less unequal—have invested many resources in primary and secondary education since the middle of the twentieth century. A more skilled labor force helped them to promote the new economic sectors (from heavy industry to semiconductors) that were behind their economic miracle.

“for the most part, the children of the politically influential people attend private primary and secondary schools. Thus they do not directly feel the deficiencies of the public school system, because their interests are not directly and immediately affected by the success or failure of public schools. This reduces the sense of urgency that might otherwise lead influential parents to press decision makers to make tough policy choices.”

Latin America the private sector is responsible for only one-third of total spending in research and development (R&D) compared to 50 percent in Asia and 70 percent in the OECD.

the large economic gap between a few powerful business groups with limited interest in innovation and a large number of small, unproductive firms with no resources to invest is behind Latin America’s backward position. In 2011, spending in research and development was just 0.33 percent of GDP; in contrast, it was 1.1 percent in Asia and 2.0 percent in wealthy countries. The number of licenses and patents—which have increased rapidly in Asia in the last decade—is also extremely low. Unfortunately, without innovation it is hard to sustain economic growth and a dynamic transformation of the economy.

First, the elite’s control of mass media—both newspapers and TV—has allowed them to shape public debate and build opposition against tax hikes. Multiple op-eds and TV programs repeat the same half truths about the negative impact of taxes on investment, the link between taxes and corruption, and the need to limit state regulation.

Second, the use of revolving doors is quite common in Latin America. Entrepreneurs and business managers spend their professional lives moving from the private to the public sector and back.

Third, as we saw in the case of Chile, the business elite often has close links to political parties, contributing to their campaigns and lobbying through formal and informal channels. Although most governments have advanced in the regulation of campaign financing, large corporations and powerful individuals still transfer millions of dollars to presidential and legislative candidates.

Social programs not only compensate for the negative effects of external shocks and economic adjustment, but also enhance competitiveness. Universal social policies promote human capital, expand aggregate demand, and improve social capital. They contribute to higher economic growth and the creation of more dynamic sectors—something Costa Rica has shown for years. On the other hand, underfunded states are more prone to economic crises and may be regularly forced to implement costly austerity policies.

In unequal societies like those in Latin America, reaching agreement on economic adjustment between different social groups—which are far apart in terms of income and worldview—is almost impossible; there is too much distrust and not enough social cohesion. Confronted with such difficulties, governments prefer to maintain the status quo, hoping that the economic situation improves or postponing painful reforms until another administration is elected. Rodrik tests these arguments with a series of quantitative exercises, finding a positive correlation between income inequality and bad macroeconomic policies as well as between income inequality and economic growth collapses.

Keynes’s recipe—which has worked more often than not—has seldom been followed in Latin America. Instead, in times of crisis most governments have reduced public investment, cut social programs, and increased interest rates—making the construction of factories more expensive. In doing so, they have contributed to unemployment, poverty increases, and a further worsening of the income gap. Pressures from international institutions like the IMF and the World Bank, lack of access to borrowing, and right-wing ideology explain these mistaken policy choices.

In the US, the Republican Party has allied with the business elite to promote regressive tax reforms. Democrats have failed to systematically campaign against tax reductions, partly because they are increasingly dependent on funds from the wealthy. Even in more equal countries, growing income concentration has gone hand in hand with lower public revenues:

A direct relationship between a charismatic leader and the people, a certain disregard for stable institutions and political parties, and the promotion of anti-elite grievances characterized Peronism. A similar type of leadership—which many have called populist—is evident in Latin America across time and space: from Getúlio Vargas in Brazil in the 1940s to Hugo Chávez in Venezuela in the 2000s.

Inequality has thus contributed to weak, unresponsive and/or unstable political institutions which, in turn, lead to a further worsening of income distribution through several channels. First, populist experiments have often resulted in economic crises with significant costs for the low-income majority. Second, right-wing authoritarian governments have consistently adopted regressive measures, thus benefiting the wealthy significantly. In Pinochet’s Chile, for example, the Gini coefficient increased from less than 44 in the early 1970s to 59 in 1988. Third, weak democracies have protected the wealthy and often failed to significantly expand economic and social rights.

The economic elite feared people’s participation in politics; they were worried that poor voters would elect leaders who supported high income taxes and generous social programs. As a result, they did everything in their power to avoid real democracy.

As Perón’s authoritarian tendencies intensified, the Argentinian democracy entered into the kind of death spiral that political scientists Steven Levitsky and Daniel Ziblatt describe in their book How Democracies Die.25 A constitutional reform allowed the re-election of the president, strengthened presidential power, and modified electoral rules in Perón’s favor.

If populism contributed to inclusion and participation, why do I regard it as a political cost of inequality? The answer is simple: populist movements often triggered political instability and institutional volatility. Perón, Vargas, and the other populists loved conflict: politics was all about black and white, the “people” against the “oligarchs,” and the “nation” against the “empire.” While this was partly understandable in the context of income concentration, it left little room for debate and compromise.

Why did the business elite consent to, and at times even support, democratization? Two reasons are particularly relevant. First, authoritarian regimes became less attractive.

Second, the business elite made sure that the new regimes would not harm their economic interest and political power.

the expansion of neoliberal policies became a safeguard for the elite.54 On the one hand, economic liberalization reduced the freedom of new governments to adopt radical policies. If a leftist president increased taxation or the minimum wage significantly, it had to deal with capital flight and other economic difficulties. On the other hand, the World Bank and other powerful international lenders forced countries to accept neoliberal policy packages. Some areas, such as monetary policy, also moved outside governments’ purview, as central banks across the region became independent.

Protests against the expansion of markets and the lack of true democracy gradually increased.

Soon enough, street protests translated into the election of left-of-center presidents in what was then called “the Pink Tide.”

The Latin American experience illustrates the high political costs of inequality in the political sphere. The wealthy have always refused to support real democracy for fear of redistribution. In response, the poor have often searched for populist solutions that have failed to change power relations or strengthen democratic institutions over the long run. The problems, however, do not finish here: limited democracies, populism, and authoritarianism have in turn contributed to more inequality.

Populist regimes’ contribution to income distribution over the long run has also been problematic for at least three reasons. First, in their attempt to improve things, some populist governments have ended up triggering costly financial crises. Perón’s first administration provides a good illustration of this problem. In his first years in office, real wages increased by 50 percent. Initially, this expansion did not create problems because international agricultural prices—and, as a result, Argentinian exports—were growing quickly as well. Yet when external conditions deteriorated in 1949, Argentina moved from a trade surplus to a deficit and the country’s reserves were quickly depleted. Resources for industrialization also dried up as agriculture entered into crisis. Perón initially increased the money supply to keep the economy going, resulting in a 31 percent inflation rate in 1949. In the end, the attempt to redistribute income too quickly led to a crisis that forced a painful—and inequality-inducing—stabilization of the economy after 1950.76 The Brazilian progressive economist and former Minister of Finance Luiz Carlos Bresser-Pereira offers a compelling explanation of the “populist cycle.” Initially, governments adopt expansionary policies, including a strong exchange rate (to make imports cheap), higher public expenditure, and higher wages. Not surprisingly, economic growth accelerates as consumption and investment increase. Unfortunately, the positive trend is short-lived. Little by little—or quite quickly, if there is also a negative external shock like the one Argentina suffered under Perón—all economic indicators deteriorate: a trade deficit appears as imports grow faster than exports. The budget deficit increases as spending surpasses taxes. The money supply and inflation follow. All these problems consistently lead “to a severe crisis, sometimes accompanied by, at least, a change of ministers if not a coup d’état and inevitably … a radical change in economic policy.” The impact of the crisis and of the neoliberal policies that follow on income distribution is often catastrophic.

Second, many populist leaders have shown little interest in building independent social movements. From Brazil under Vargas to Venezuela under Chávez, most governments of this kind have coopted trade unions and limit dissent.

Third, the incessant polarization promoted by populists is hard to sustain over the long run. All these leaders have mastered the art of dividing the country between the “people” and the oligarchy, between a majority of supporters and a minority of enemies. Think about Hugo Chávez proclaiming “It is not me, it is the people” or Rafael Correa joyfully shouting “Ecuador voted for itself” after his 2009 electoral victory.79 Although their strategy may at times have been justified (there is a sharp gulf between the winning elite and the rest in Latin America), it has consistently generated mistrust and conflict.

The French economist Thomas Piketty suggestively links this political convergence on economic ideas to transformations in the party system: the US and many European countries have moved, he argues, from class-based competition to competition between different elites. In the 1950s and 1960s, left-wing parties were supported by unskilled, poorly paid workers, while most high-income, high-educated individuals voted for the right. Since the 2000s, left-wing parties have become an instrument of the “intellectual elite,” while right-wing parties are primarily supported by high-income individuals (the “business elite”). Meanwhile, low-income voters no longer feel represented by mainstream political parties, searching for more radical alternatives instead.

In violent societies, low-income groups suffer disproportionately, both emotionally and financially. In segregated societies, there are large education gaps between rich and poor and few cross-class social networks. In mistrustful societies, the opportunities to build coalitions between the poor and the middle class—required to expand redistributive social programs—are severely hampered. In this way, structural inequality has perpetuated itself in Latin America through various social vicious circles.

Why do Latin Americans mistrust institutions so much? There are many reasons, including high levels of corruption and poor public service delivery. Yet inequalities in income and political opportunities are probably primary drivers. Most people resent their place in society and do not feel represented by political institutions; in fact, almost four out of five Latin Americans are convinced that governments rule for the benefit of the powerful and are uninterested in the preferences of voters—a much higher percentage than in other parts of the world.

low-trusting individuals were less likely to support equity-enhancing state interventions. These groups are likely to believe that children from other families will not put in the effort to learn and achieve good results. They often see the poor as cheaters and, as a result, do not support redistributive programs.77 Unfortunately, this triggers another vicious circle: inequality leads to low trust which, in turn, prevents citizens from supporting redistributive policies, thus resulting in even more inequality.

As the sociologist Robert Putman famously noted in the early 2000s—after two decades of growing inequality—Americans are now “bowling alone,” living solitary lives and finding few opportunities to mix with other classes.85 In this context, political polarization has intensified, making the creation of cross-class coalitions in support of redistribution harder than ever.

Structuralism provided a new interpretation of inequality. In their view, the only way to understand income distribution within each Latin American country was to consider the way the global economy was organized. Most technological innovations took place in countries like the UK, France, and the US—the “center”—and in many sectors simultaneously. These economies not only grew more but were also diversified and had many high-productivity sectors. Workers in all kinds of activities, from textiles to steam engines and from wine to steel-making, were highly productive and, as a result, relatively well paid. In contrast, countries in Latin America, Africa, and much of Asia—the “periphery”—were specialized in agricultural and mining products and relied on innovations from abroad. In the periphery, many economic activities—particularly within the manufacturing sector—were underdeveloped and most wealth was concentrated in the export sector. Most jobs were informal and poorly paid.

Formal and informal education, Freire argued, reproduces oppression and limits dissent. He warned against the “banking concept of education,” which is based on the idea that the primary goal of students is to accumulate knowledge. “Instead of communicating, the teacher issues communiques and makes deposits which the students patiently receive, memorize, and repeat,” Freire explained in Pedagogy of the Oppressed.14 According to this model, students should focus on memorizing the multiplication tables, the capitals of the world, and all kinds of historical facts—but should not be encouraged to question why this is useful or important.

A liberating education should be built on dialogue. Students should participate in the process at every step of the way: when designing the curriculum, when learning new concepts, and when doing problem-solving exercises. The process of dialogue should help to break the barriers between teacher and pupil, promoting a less authoritarian and more democratic relationship. The good teacher should always link theory and practice, allow students to question her/him and promote joint discovery. How different is this approach from the way most schools are organized even today! The end goal of education in contexts of oppression and inequality is to free students from dominant thinking, encouraging them to change the world. Freire often called for a transformative education that simultaneously encouraged respect. “The ideal is to promote the transformation of rebellious consciousness into revolutionary consciousness. To be radical without becoming sectarian. To be strategic without becoming cynical. To be skillful without becoming opportunistic. To be ethical without becoming puritanical,” he eloquently explained to his niece.

what are the factors that influence your income? Economists usually consider three. Factor 1: the wealth and education you have—often called endowments. Some people have a lot of property, stocks, and other financial assets. Others have no savings at all. Large landowners coexist with individuals with no land. Some people enter the labor market after years of study, while other workers have not even finished primary education. Factor 2: the income you make from your job and all your assets. Introductory economics books use the concepts of supply and demand in different markets to explain this. For example, your wage depends on how many people with a similar level of education to yours there are. If your skills are in high demand and there are few people like you, your wage will be relatively high. By contrast, if you do not have unique skills, you will face competition from many others. If you own land in a highly sought-after area of a city, you can rent it at a higher price than if it is in an unpopular one.

Factor 3: the redistribution of income through taxes and social spending. Your final income will depend not only on your wages and the return of your savings, but also on how many taxes you pay and which social benefits you receive. In most but by no means all countries, taxes and social spending together contribute to reducing the income gap between rich and poor.

“There’s just no evidence that raising the minimum wage costs jobs,” explains the Nobel Prize-winning economist, Paul Krugman—instead they lead to “better morale, lower turnover, increased productivity.”

History tells us that an active state that interacts constructively with the private sector is particularly important. Most examples of successful economic transformation—Scandinavia, South Korea, Taiwan, China—relied on what economists call industrial policy. Even in the US, often (wrongly!) considered a free market paradise, the state drove most significant innovations—as convincingly shown by Mariana Mazzucato in The Entrepreneurial State.

The impact of this process of financialization on inequality across the world cannot be overstated. “The success or failure of the financial sector has had serious effects on the rest of the economy and most of its returns have gone to the wealthy driving inequality,” argues a contributor to the market-friendly Forbes magazine.32 Four channels have been particularly important. First, by pressuring companies to produce short-term profits, financial markets have contributed to periodic firings, growing flexibility in labor arrangements, and low wage growth. Second, high wages in the financial market have been one of the drivers of inequality at the top. For example, financial deregulation contributed to a 20 percent increase in the pre-tax earnings of the wealthiest 10 percent in the UK and a 10 percent growth in Japan.

To be effective, democracy has to go beyond free, regular elections. Truly democratic institutions must provide political equality: every citizen must have access to high-quality information and to a say—at least potentially—in the political process. This means that mass media cannot be controlled by a few interest groups and that the right to mobilize, to protest, and to organize must be protected. Campaign financing has to be regulated so that powerful individuals cannot buy presidential candidates or congressional votes. Political parties must be both strong and diverse so that they can exert effective opposition when they are not in power and can also offer true policy alternatives to choose from.

About Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.
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