The Latin American Development Problem: An Interpretation

The economic growth experience of Latin America in the last five decades constitutes one of the most interesting episodes in modern development economics. In 1960, gross domestic product (GDP) per capita in Latin America relative to that of the United States was 30 percent. By 2009 this statistic had fallen to 23 percent. Not only is income low in Latin American countries, but it has also fallen relative to that of the technological leader. This poor economic performance contrasts sharply with other regions and countries at similar or lower stages of economic development in 1960.¹ While many countries in Latin America contribute to this relatively poor performance, some countries stand out, such as Argentina, Bolivia, Peru, and Venezuela. Broadly speaking, the facts of low and declining relative income motivate what I call the Latin American development problem. In this article, I provide an assessment and interpretation of the poor economic performance in Latin America.

Economic performance in Latin America has often been viewed as the outcome of macroeconomic adjustment, as many economies in the region have suffered numerous economic crises. High volatility in economic activity is a prevalent feature of these economies, and it may be important in explaining their poor economic performance.² Because high volatility in economic activity in the region often masks the underlying flat or negative trends in economic performance, I focus on trended data on GDP per capita. Using data for ten Latin American countries, I report the following facts about the development problem in Latin America.³ First, between 1960 and 2009, Latin America features low and declining GDP per capita relative to the United States. Second, a decomposition of GDP per capita reveals that none of the difference is explained by differences in the quantity of work hours, while less than 20 percent of the difference is explained by a lower employment-to-population ratio in Latin America. The bulk of the difference in income stems from low GDP per labor hour (that is, labor productivity) in Latin America relative to the United States. Third, when I decompose GDP per hour using an aggregate production function that includes physical and human capital as inputs, I find that almost none of the difference is explained by systematic differences in the ratio of physical capital to output and that some of the difference is explained by differences in the quality and quantity of human capital. More importantly, most of the difference stems from differences in total factor productivity (TFP). This emphasis on the role of TFP in explaining the economic performance of Latin America is consistent with the earlier analyses.⁴ I argue that in the context of a model with physical and human capital accumulation, TFP in Latin America only needs to be about 60 percent that of the United States to account for a 25 percent ratio of GDP per hour. Fourth, I report labor productivity in agriculture, industry, and services and argue that aggregate productivity differences between Latin America and the United States are not the result of sector-specific distortions. Therefore, I seek an economywide explanation for low productivity in Latin America.

Given these facts, I then consider a model in which institutions and policy distortions in Latin America cause relative measured TFP to be 60 percent of the U.S. level. The model follows Restuccia and Rogerson in extending the neoclassical growth model to allow for establishment heterogeneity.⁵ This framework has been used extensively in empirical applications of productivity differences across countries.⁶ A related framework has been used for more specific applications to the development problem such as size-dependent policies, financial frictions, restrictions to foreign direct investment (FDI), and informality.⁷ In the model, establishments differ in their factor productivity, and the reallocation of capital and labor across establishments leads to measured TFP differences. The novelty in the analysis in this paper is that on entry, establishments invest in the likelihood of higher productivity draws from an invariant distribution. As a result, institutions and policy distortions not only misallocate resources across establishments, as emphasized in the existing literature, but also...