Latin America´s Post-Pandemic Trilemma

November 2, 2022

Latin America´s Post-Pandemic Trilemma

GAI visiting fellow Eduardo Levy Yeyati argues that Latin America faces three major post-pandemic challenges. First, the region needs to adjust to contain inflation and reduce fiscal deficits and indebtedness. Second, it must revert the deterioration of social indicators. Last, the region’s leaders should rebuild –or rewrite– the social contract.

Latin America faces three major post-pandemic challenges. First, the region, hard pressed by rising borrowing costs that narrow an already drained space, needs to adjust to contain inflation and reduce fiscal deficits and indebtedness. Second, it must revert the deterioration of social indicators. After a promising performance in the 2000s, subpar growth and rising poverty and inequality have been a concern for the region even before the blow of the pandemic, exhausting the social space. Last, the region’s leaders should rebuild –or rewrite– the social contract, as discontent with liberal democracy, mistrust in the political system, and a generalized sense of unfairness push voters to the extremes, breeding support for inexperienced outsiders and magical populists while limiting the political space for moderate policies.

One thing is clear: while in the aftermath of the previous global crisis in 2009 the economic debate focused on the tradeoff between fiscal unwinding and economic recovery, in the post-pandemic era economists can no longer think of macroeconomic stability without considering the social and political fronts.

Inflation: The Litmus Test

The perfect storm of post-pandemic inflation represents a true litmus test for this policy conundrum. To grasp the complexity of the problem, it is worth noting that inflation today is a product of an unusual and adverse combination of drivers.

On the demand side, it is clear at this stage that the fiscal stimuli were at the root of the surge in inflation in 2022. These include the pandemic transfers financed by money issuance or debt, the passivity of central banks, and the persistence of liquidity conditions that brought international rates to historically low levels. Surprisingly, there was a consensual view that debt did not have fiscal or welfare costs, and there was support to the fiscal spending spree even from the fiscally conservative IMF.

On the supply side, the pandemic generated supply chain inflation: disruptions and rearrangements in global production chains that created input supply deficits and higher prices for goods and services. It also brought with it a change in consumption and labor supply patterns, the consequences of which are still unclear. To this we should add the "imported inflation" due to the impact of Russia's invasion of Ukraine on the prices of food and energy, as well as fertilizers, not a minor element for exporters of agricultural products. We should also consider factors such as the global financial downcycle and the increased volatility triggered by the Fed's rate hikes, which led to the devaluation of most currencies against the U.S. dollar and, to varying degrees, to its pass through to inflation. Finally, there is inflation inertia, particularly in inflationary countries like Argentina, and in partially indexed ones like Chile or Uruguay. This inertia is the asymmetric response of prices that move up a notch with each of these factors –fiscal impulse, monetary looseness, external cost shocks, the exchange rate– but do not retreat when the shock dissipates, This inertia increases the length and the sacrifice of the disinflationary process, particularly if inflation persistence leads to the de-anchoring of expectations.

Demand shocks such as the one resulting from excessive fiscal stimulus are typically addressed with a mix of fiscal and monetary policies This is easier said than done in countries coming from years of growth underperformance, pandemic suffering, social unrest, and disintegration of political representation that limit the social and political space to undergo fiscal consolidation. As a result, in most cases the main burden falls on the central banks, leading to monetary over-tightening and fiscal under-adjusting.

The Impossible Formula

In this light, it is apparent that central banks will not be able to contain inflation solely with monetary policy, except at the cost of an enormous, and probably unnecessary, economic loss. The global outlook is not going to help in the near term: while the end game for international rates is still uncertain, changes like the war in Ukraine ending or the Fed pivoting in 2023 –perhaps the two main potential triggers of an exit from the stagflation in the region– are rather slim.

If we believe, as I do, that the global outlook will not improve or deteriorate significantly in the next few quarters, we are left with the initial question: how to reconcile the three challenges in a realistic way?

The normative answer entails in many cases a qualitative change in the way we think about public policy.

The pandemic brought to the foreground two weaknesses that have silently plagued the region for decades. First, the lack of state capacity to deliver good quality services, evident in the unequal implementation of the COVID-19 response due to slow health and vaccination campaigns, or the extended school closures and education losses due to logistical and digital gaps. Second, a dual labor market with most outsiders in low-wage, high-turnover jobs with limited benefits and a structural dependence on fiscal transfers.

This precariousness, deepened with the pandemic, combines with a unique quality of Latin America: a region that is not only developing – and poor and unequal – but also, with a few exceptions, democratic. A region where politics cannot deviate too much from – or ignore for too long – the voters’ most immediate needs and demands. A case in point: Colombia’s 2021 tax reform, which had to be modified from the initial proposals around VAT and personal income taxes towards a more modest version focused on higher corporate taxes and new taxes on natural resources after social tensions left 17 dead, fatally weakened the government, and paved the way for the outsider Petro´s victory.

Perhaps more today than in the past, economists need to think politically. In most countries what is needed is fiscal restraint built around progressive tax reforms complemented by more efficient public services, greater state capacity, inclusive labor reforms, political transparency, and business competition to offset the perception of unfairness and widespread privileges.

Would this be enough? Is there a practicable way to deliver what amounts to an intricate political balancing act that would ultimately determine whether the region can avoid another lost decade?

A positive answer to Latin America´s post pandemic trilemma is today far from obvious, as it lies as much in the sensibility and sensitivity of economic policies as it does in the quality of local politics.