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Economic Review

Economic Review
C O N T E N T S
Second Quarter 2004/Volume 89, Number 2

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

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Vice President, Financial

ELLIS W. TALLMAN
Vice President, Macropolicy

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Assistant Vice President, Regional

PUBLIC AFFAIRS
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Managing Editor

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Marketing and Circulation

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The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

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ISSN 0732-1813

Preface—Rethinking Structural Reform in Latin America
Stephen J. Kay and Michael Chriszt
The process of structural reform in Latin America has thus far been uneven, and various economic crises have raised doubts about reforms’ effectiveness and have caused public support for further reforms to wane. To promote and highlight research exploring structural reform’s impact on economic growth and income distribution in Latin America, the Federal Reserve Bank of Atlanta and the Inter-American Development Bank (IDB) cosponsored the conference “Rethinking Structural Reform in Latin America” in October 2003.

This issue of the Economic Review contains four articles that were among the papers presented at the conference. The preface summarizes the conference speeches, papers, and discussant comments.

Reform Fatigue: Symptoms, Reasons, and Implications
Eduardo Lora, Ugo Panizza, and Myriam Quispe-Agnoli
Following a period of ambitious promarket reforms, Latin American policymakers and the public at large have entered a period of “reform fatigue.” Initial enthusiasm for policies such as liberalized markets and a level field for investors has given way more recently to the view that ambitious promarket reforms are to blame for the region’s economic crises. The process of reform has stalled in some countries, and a few have suffered serious setbacks.

To help explore the future of reform, this article aims to document and explain the symptoms of fatigue among the public, policymakers, and opinion leaders. The authors explore the economic, social, political, and psychological reasons for the fatigue. They review numerous studies that have identified various explanatory factors, including reforms’ modest economic outcomes, the failure of reforms to improve social conditions, a leftward shift of public opinion and political coalitions, and perception biases among citizens.

The authors find that economic reasons are the primary explanation for the increasing rejection of reforms. Disillusionment with reforms, despite reforms’ overall benefits, seems to stem from people’s inability to isolate short-term macroeconomic situations from reforms’ permanent effects.

While political reasons cannot account for reform fatigue, the authors believe that politics will play a decisive role in the future of reform. They conclude that, especially in countries where promarket reforms are well advanced, eventual economic recoveries will result in further institutional and social policy reforms.

Creditor Protection and Financial Markets:
Empirical Evidence and Implications for Latin America
Arturo Galindo and Alejandro Micco
Although Latin American countries have made significant strides in reforming their financial markets, these markets remain shallow, implying a need for further reform. Stronger protection of creditor rights can improve the size and stability of credit markets and provide greater access to capital for small and medium-sized enterprises that operate under greater financial strictures.

In discussing creditor protection’s impact on the size of financial markets, the authors first document the state of Latin American creditor protection. They then discuss the effect of enhanced creditor rights on small and medium-sized firms and how the dynamics of financial markets are affected by the regulation of creditor rights. To examine the effects of adverse economic shocks on creditors, the authors study the credit cycle in various countries.

In addition to increasing the size of financial markets and stimulating economic growth, reforms that strengthen creditor protection can affect credit allocation, the authors find. Their research suggests that the rules and regulations concerning the seizure of collateral need reforming and, more importantly, that the judicial system must become more agile to assure prompt, effective, and less expensive enforcement of creditor rights. The authors note that the successful introduction of these reforms may require convincing the citizenry that creditor protections benefit not only the financial sector but the economy overall.

Financial Globalization: Gain and Pain for Developing Countries
Sergio L. Schmukler
Economies around the world are becoming increasingly interconnected by the unprecedented breadth and depth of financial globalization. Developed countries tend to be most actively involved in cross-country capital movement, but in recent years developing countries have begun to participate in the process.

This article focuses on the integration of developing countries into the international financial system. It examines recent developments and the principal agents of financial globalization as well as globalization’s effect on the domestic financial sector. Financial liberalization tends to develop the financial system, enhancing financing opportunities, reducing the cost of capital, and increasing investment and liquidity. But global financial interconnectedness also carries with it some risks, especially in the short run, because it tends to intensify a country’s sensitivity to foreign shocks.

For policymakers, the challenges center on maximizing the advantages that globalization presents while minimizing the risks. Governments participating in financial globalization tend to have fewer policy options and to become more reliant on international financial policies.
As the line between foreign and domestic capital blurs, a country’s successful participation in financial globalization will require strong economic fundamentals and a properly regulated and supervised financial system. A primary challenge of globalization, the author concludes, is to integrate all sectors and countries because nonparticipants are at a disadvantage.

A Cost-Benefit Approach to Labor Market Reform
Carmen Pagés
Labor reforms in Latin America have been scarce compared with the pace of structural reforms aimed at liberalizing product and capital markets. Some analysts contend that without continued liberalization labor market performance will fail to improve, hindering Latin American economies’ ability to compete in international markets.

This article assesses labor market regulations in Latin America, documents their recent history, and assesses their costs and benefits. The author argues that existing regulatory systems, while generating costs in terms of labor market performance, constitute the base (albeit imperfect) of social protection policies in Latin America.

Compared with industrialized countries, Latin American countries have more protective labor regulations governing working conditions and job security but lower social security benefits. Evidence from the existing literature points to sizable negative effects of mandatory benefits, particularly social security contributions, on employment. Job security provisions tend to bias employment toward prime-age workers and away from younger and less skilled workers.

Since the demand for social protection in Latin America appears to be large, the author argues that reforms that seek only labor market deregulation do not address this demand. It is tempting to conclude that the solution lies in designing and implementing less costly social protection mechanisms, but the alternatives are not exempt from costs and are not warranted to improve upon existing systems. In these circumstances, the author recommends a mix of research, policy experimentation, and policy evaluation to find solutions that maximize benefits while minimizing costs.

Regulating Housing GSEs:
Thoughts on Institutional Structure and Authorities
W. Scott Frame and Lawrence J. White
Many of the benefits that the housing government-sponsored enterprises (GSEs) transmit to homebuyers stem from an implied federal guarantee arising from the GSEs’ charter benefits and past supervisory forbearance. But this implicit guarantee also represents a risk to taxpayers if one of these GSEs—Fannie Mae, Freddie Mac, or the Federal Home Loan Bank (FHLB) System—becomes insolvent and the government provides financial assistance.

In the wake of a $5 billion accounting restatement by Freddie Mac in 2003, concerns about taxpayer liability associated with the housing GSEs have led to various legislative proposals to reorganize their regulatory oversight. This article discusses these proposals, drawing on lessons from U.S. banking regulation to identify and evaluate the points of contention.

The legislative proposals generally pertain to institutional design (where the safety-and-soundness regulator is located, how it is funded, and whom it should supervise) and institutional authorities (for example, discretion to alter capital requirements and the ability to appoint conservators and receivers).

With respect to institutional design, the authors conclude that there may not be a clearly dominant approach. In regard to institutional authorities, the authors recommend that the safety-and-soundness regulator have responsibility for approving new programs and other activities, the discretion to set both minimum and risk-based capital requirements, receivership authority, and other enforcement authorities comparable to the federal banking agencies.