Research and Shorter Analysis

CLAE staff, visiting scholars, and their coauthors conducted research on topics related to current account and financial crises, banking, capital flows and capital account liberalization, undocumented immigration, the informal economy, and the interaction of political and economic pressures. The work included CLAE and Research Department working papers and articles submitted for publication in books and outside journals. Center staff members also contributed to the Dallas Fed's Economic and Financial Review and Southwest Economy.

Exchange Rate, Current Account, and Financial Crises

Some of the most extensive CLAE research and analysis has been on exchange rate, current account, and financial crises. Latin America offers some of the world's best-known examples of such crises, but even the study of lower profile Latin American financial events helps us understand how these phenomena operate.

"Argentina's Recovery and Excess Capital Shallowing of the 1990s" deals with one of the more widely known financial crises. Finn Kydland and Carlos Zarazaga test for differences between how Argentina's economy would have operated in the 1990s had it followed standard free market neoclassical assumptions and how it actually performed.

Kydland and Zarazaga find that Argentina's productivity growth rates during the '90s generated lower investment levels than a neoclassical economy would have. Because of this subpar development of physical capital—the "capital shallowing" of the paper's title—a basis for sustained expansion did not materialize. This appears to be one reason Argentina could not recover from the economic slump and financial crisis that still plague the country.

In another modeling comparison with ideally neoclassical behavior, Kydland and Zarazaga examine the country's protracted crises of the 1980s. "Argentina's Lost Decade" addresses what complicated the country's efforts to escape a depression after a crash in Argentine export prices and a severe world credit crunch. In the authors' shallowing piece, distortions that discouraged investment made sustained growth increasingly difficult during the 1990s. The economists' study of Argentina's 1980s crisis suggests that the characteristics of the nation's capital markets played an important role in that decade.

"Argentina's Lost Decade" finds that because the country has relatively open capital markets, the fall in total investment needed to reach a postcrisis equilibrium is large compared with that of more financially closed countries. In the latter, economic downturns depress interest rates. Because investment goes up when interest rates go down, an interest rate drop cushions what would otherwise be a crash in investment. But in an open capital market like Argentina's, the same output fall would not push down interest rates as much. The international financial interconnections that result from capital market openness mean that local interest rates are determined more by world rates than by local supply and demand factors. Because world credit markets impeded the decline of local credit prices, investment had no cushion and so fell further in the 1990s. Labor market rigidities were a second adjustment problem in the 1980s. Labor market flexibility could have led to greater long-term growth, but government payments discouraged job shifts.

"Banking and Currency Crisis Recovery: Brazil's Turnaround of 1999" takes a different approach. William Gruben and John Welch examine how Brazil emerged so quickly from the economic problems surrounding its 1999 devaluation.

Brazil's textbook exchange rate crisis involved persistent deficits and financial market expectations of more to come. What made the postdevaluation turnaround so fast was that the banking system had been steadily strengthening for five years, the result of an increase in Brazil's supervisory and regulatory authority to enforce sound banking practices. To ensure sick banks would have sufficient funds to pay off nervous depositors, capitalization rules were made more stringent than those of the Basel Accord and then strengthened even more.

In addition, concerns over private-sector sluggishness encouraged Brazil's banks to lower their loans as a share of total assets and move into government paper. By the time the megadevaluation occurred, the government had created a way to hedge most private-sector foreign obligations. As a result, the devaluation did not trigger the wave of loan defaults that occur during many exchange rate crises. Banks had already shifted their portfolios away from private-sector lending anyway. Their heavy capitalization meant the banks would have been well protected even if loan defaults had risen rapidly. This environment allowed the central bank to pursue policies restrictive enough to assure potential investors that inflation or further devaluation would not erode the value of their funds. Once this foundation was laid, and markets were convinced it was permanent, growth could follow quickly.

In "Yesterday's Crisis Countries: Where Are They Now?" Gruben further explores the interconnections between financial institutions, financial markets, and exchange rate crises. Unlike Brazil, many countries in crisis were torn between stabilizing their exchange and inflation rates with hard-money policies and minimizing their banks' nonperforming loan problems with softer monetary policies. After initial indecisiveness during the 1994–95 Tequila Crisis, Mexico went the hard-money route and turned its economy around quickly. Indonesia pursued soft-money policies punctuated by intermittently tighter episodes. The result was not only a slower recovery than Mexico's but one that largely occurred only because of a jump in world oil prices.

Not all large exchange rate devaluations occur under crisis conditions. Some are simply fiscal moves that while reflective of problems, are made well before the onset of serious financial pressure. In "Venezuela Addresses Economic Stress," Gruben and Sherry Kiser note that much of the government's income is in dollars. Because a large share of Venezuelan debt is typically denominated in local currency (bolivares), the government sometimes seems to devalue its currency almost casually, as a way of lowering the dollar value of its debt. When the dollar has been pegged and then devalued, the share of dollar-denominated government income required to service the bolivar-denominated debt falls.

Banking

Banking research, particularly as it applies to crises and credit shortages, is always an important component of CLAE research. In "When Does Financial Liberalization Make Banks Risky? An Empirical Examination of Argentina, Canada, and Mexico," Gruben, Koo, and Moore examine connections between the absence of depositor discipline (in which depositors pull their money from banks with asset quality problems) and risky lending. This connection does not invariably hold. But when liberalizations of government banking policy or bank privatizations motivate banks to compete for market share, the inverse relation between depositor discipline and risky lending clicks in.

"Banking and Finance in Argentina in the Period 1900–35," by Leonard Nakamura and Carlos Zarazaga, shows the consequences of Argentina's involuntary evolution from dependency on foreign (mainly British) finance to relative self-sufficiency. Domestic finance did not fill the void left by the decline of London and the breakdown of the world financial system in the interwar period. Neither the Buenos Aires Bolsa nor private domestic banks developed rapidly enough to fully replace British investors as efficient channels for financing private investment. Consequently, investable Argentine funds were increasingly concentrated in a single institution, Banco de la Nación Argentina. This created a lopsided financial structure vulnerable to rent seeking and authoritarian (governmental) capture. Nevertheless, several measures—including gold reserves, interest rates, money supply, bank credit, and market capitalization of domestic corporations—attest to Argentina's high level of financial development.

Capital Flows and Capital Account Liberalization

Capital flows and capital account liberalization are often closely related in Latin America to commercial banking, but recent CLAE research addresses the topic with regard to central banking.

In "Capital Account Liberalization and Inflation," Gruben and Darryl McLeod challenge the contention that opening the capital account to inflows of foreign funds triggers bursts of inflation. If the principal result of capital account liberalization were simply inrushes of foreign funds that created large increases in the money stock, that would, indeed, be possible. After all, inflation is too much money chasing too few goods. But when international capital inflows and outflows are possible, investors can move their assets from a country where monetary policy looks menacing to a country with less confiscatory and more stable policies. Open capital markets allow currencies to compete more intensely. This competition means a central bank's ability to inflate its currency is much more limited than when the capital account is closed, so inflation may on average be lower.

That is exactly what Gruben and McLeod find in a 114-country study that includes most of those in Latin America. Not only is there a negative relation between the openness of a nation's capital account and its inflation rate, but there is also a negative relation between the act of opening the capital account and changes in inflation.

Undocumented Immigration

The topic of undocumented immigration is of special interest in the Eleventh Federal Reserve District, which shares more than 1,000 miles of border with Mexico. Most Bank research on undocumented immigration deals with immigration to the United States from Mexico.

Undocumented immigration has grown along with border enforcement in the United States for over thirty years, leading some to conclude that U.S. border policies have been ineffective. In "Coyote Crossings: The Role of Smugglers in Illegal Immigration and Border Enforcement," Mark Guzman, Joseph Haslag, and Pia Orrenius offer an alternative view, extending the literature by incorporating both the practice of people smuggling and a role for nonwage income in a two-country, dynamic general equilibrium model.

The authors define conditions under which two steady-state equilibriums—or persistent migration patterns—can exist. In one pattern, U.S. physical capital is relatively low and illegal immigration is high. In the other, physical capital is relatively high and illegal immigration is low. To evaluate how the system would work, the authors model two types of shocks: a positive technology shock to smuggling services and an increase in border enforcement. In the low-capital steady state, the capital–labor ratio declines with technological progress in smuggling and illegal immigration increases. In the high-capital steady state, a technology shock causes the capital–labor ratio to rise and the effect on migration is indeterminate. The authors show that an increase in border enforcement is qualitatively equivalent to a negative technology shock to smuggling. They also show that a developed country would never choose low levels of border enforcement rather than an open border. Moreover, a high level of enforcement is optimal only if it significantly decreases capital accumulation. The economists also find that under certain conditions an increase in smuggler technology will lead to a decline in the optimal enforcement level.

In "Do Amnesty Programs Encourage Illegal Immigration? Evidence from IRCA," Orrenius and Madeline Zavodny examine whether allowing certain undocumented immigrants to legalize their status leads to additional illegal immigration. The study focuses on the effects of the 1986 Immigration Reform and Control Act (IRCA), which granted amnesty to more than 3 million undocumented immigrants. Apprehension of people illegally crossing the U.S.–Mexico border declined immediately after the law's passage but returned to normal during the period illegal immigrants could file for amnesty and the years thereafter. Moreover, apprehensions did not rise during the filing period, as would be expected if people immigrated to the United States to fraudulently apply for the program.

This suggests the amnesty program did not encourage illegal immigration. IRCA reduced illegal immigrant apprehensions in the short run, perhaps because after the law was passed, potential migrants thought it would be more difficult to cross the border or get a job in the United States. Despite some lawmakers' predictions, amnesty also did not appear to encourage illegal immigration in the long run in the hopes of another such program.

Another Orrenius–Zavodny paper, "Self-Selection Among Undocumented Immigrants from Mexico," tests for what decides who migrates and when in terms of skill levels. The results show that push factors, such as downturns in the Mexican economy, have the most influence on whether high-skill workers immigrate to the United States from Mexico. Pull factors, such as high wages, have a greater effect on low-skill workers. Other things equal, when an economic downturn hits Mexico, the number of undocumented immigrants leaving there for the United States rises and the share of immigrants who are highly skilled goes up. When Mexico experiences an economic upturn, other things equal, the number of undocumented workers coming to the United States from Mexico goes down, but the share of low-skill workers increases. When the U.S. minimum wage goes up, the number of undocumented workers from Mexico increases and the share of such workers who are low skilled increases. Moreover, the stricter the border enforcement, the higher the skill level of the average undocumented worker. Access to a network of previous immigrants appears to lower the cost of migrating but has no differential effect on skill level.

The Informal Economy

An important strand of CLAE research involves the problems informal sectors present for developing economies.

Erwan Quintin's "Contract Enforcement and the Size of the Unofficial Economy" describes a model economy in which the size of the informal sector declines as the enforcement of financing contracts in the formal sector increases. The paper assesses how the availability of financial intermediation for agents who would otherwise operate in the informal sector might motivate them to operate in the formal sector.

In this model, agents who operate in the informal sector can avoid taxes, but they have no access to official contract enforcement and so their borrowing opportunities are much constrained. Quintin compares quantitative implications of the model with the evidence of informal-sector production in developing nations. He finds that tax enforcement alone cannot generate a large unofficial sector, but contractual imperfections can do so and account for several features typical of the organization of production in developing countries.

"Are Labor Markets Segmented in Argentina? A Semiparametric Approach" evaluates the hypothesis that workers in the informal sector make lower wages than they would in the formal sector. Using various definitions of informal employment, Sangeeta Pratap and Quintin find that on average, formal-sector wages are higher than informal-sector wages. But the subject is more complicated that it first appears. Applying parametric tests, the authors find that a formal-sector wage premium remains even after controlling for individual and establishment characteristics. However, the parametric approach results in econometric problems that can be solved with semiparametric methods. With such methods, the estimates of the formal-sector premium are small, statistically insignificant, or even negative. This means that once the authors correct for econometric problems, they find no evidence that Argentina's labor markets are segmented along formal-sector versus informal-sector lines. Informal-sector workers do not make less once skill levels are accounted for.

A related study by Pedro Amaral and Quintin, "The Implications of Capital–Skill Complementarity in Economies with Large Informal Sectors," notes that formal-sector workers in most developing nations have more experience and education and higher earnings than workers in the informal sector. While this is commonly thought to mean low-skill workers face barriers to entry into the formal sector, there is little direct evidence these barriers are significant enough to matter.

Amaral and Quintin's paper describes a model with significant differences between formal and informal workers even though labor markets are perfectly competitive. In equilibrium, the informal sector emphasizes low-skill work because informal managers have less access to outside financing, so they substitute low-skill labor for physical capital. The financial contract enforcement problems discussed in the earlier Quintin paper express themselves in the Amaral and Quintin paper through the mix of labor that informal-sector firms use compared with what they would choose in a world where credit is readily available and all firms operate in the formal sector.

Political Pressures and the Latin American Economies

The interaction of political and economic pressures has been another CLAE focus. In "Is Mexico Ready to Roar?" Quintin compares Mexico with the East Asian tigers, pointing out that in 1965 Korea's income per capita was half Mexico's but is now more than twice that country's. Some reasons for the change are obvious. Korea has invested far more in education and plant and equipment. Mexico collects much less tax as a share of GDP—even less than many Latin American countries—and so spends less as a share of GDP. As much as half of Mexico's economy does not pay taxes, leaving the financing burden to the rest.

A major cause of the problem is the Mexican government's weak enforcement of contracts between private-sector parties, which makes financial institutions reluctant to lend to the sector. This, in turn, discourages potential taxpayers from paying taxes. In other countries, an important reason firms enter the private sector is so they can produce tax receipts and other documentation that will allow them to borrow money.

Political problems are also the focus in the Zarazaga and Kiser article "Latin American Market Reforms Put to the Test." Consistent with the theorem of the second best, they note that introducing reforms in some markets but not others is not necessarily better than a little government intervention in all of them. While Latin America has made great progress in financial and trade liberalization, the region's governments lack the political commitment to deregulate labor markets. The result is not enough jobs for workers displaced by the trade liberalizations.

In "The Politics of Brazil's Financial Troubles," Gruben and Quintin show how market fears over the 2002 presidential election rapidly raised interest rates and suppressed exchange rates in Brazil, increasing the volatility of the cost of doing business.

"Financial Globalization: Manna or Menace? The Case of Mexican Banking" outlines how Mexico's mid-1990s Tequila Crisis resulted in political pressure to open the nation's banking system to foreign owners. After decades-long proscriptions on any but the smallest foreign footholds, about four-fifths of Mexico's banking assets are now controlled by foreign firms. Despite concerns about foreign ownership, Robert Bubel and Edward Skelton find that efficiency and capital adequacy have been the result.

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