Can Latin America prosper by reducing the size of government?

• Author: Lizardo, Radhames
• Position: Report

This article examines the effect of government consumption on economic growth in 23 Latin American countries over the years 1974-2003. Employing the Armey Curve, we show that the typical Latin American government is spending beyond the optimal point. Using panel data mad a Fixed effects (FE) model, we find that increases in government consumption lead to unambiguous decreases in economic growth.

An Overview

An important policy goal of governments is to improve the economic well-being of their citizens. However, as can be seen in Figure 1, Latin America's share in world output (GDP) dropped significantly during the 1980s. This decade has been called the "lost decade" for Latin America, with per capita real income actually shrinking from 1980 to 1989.

While the Latin America region has suffered from lack of economic growth, other regions of the world have experienced economic growth, especially during the last 20 years. Figure 2 depicts the growth of East Asia's share of world economic output and contrasts it to that of Latin America's. From 1970 to 2005, Latin America's share of world output grew from 6.09 percent to 6.35 percent (an increase of 4.3 percent) while East Asia's share, for the same period, went from 16.26 percent to 22.46 percent (an increase of 38.13 percent). The comparative exercise suggests that even after the implementation of more free-market economic policies during the late 1980s and 1990s, Latin America economic growth has been suboptimal. It could be argued that this is one of the reasons several countries of the region have recently veered toward less capitalist economic systems. (1)

[FIGURE 1 OMITTED]

One of the fastest-growing economies in the world, China, is eating away an important source of Latin American economic growth with an upward shift in the exports of manufactured goods, especially in textile and other tradable goods. China has 'already surpassed Latin America and the Caribbean in global exports. Figure 3 documents the growing importance of exports in China's GDP relative to Latin America's export/GDP share. In 1970, Latin America and China both had an export/GDP share of about 1.9 percent, but by 9.004, China's share had risen to 28.48 percent while Latin America's share was 18.02 percent. (2) Such a trend is expected to continue unless effective economic reforms are put in place.

[FIGURE 2 OMITTED]

Along with sluggish economic growth, the Latin America region suffers from a severe inequality of income distribution both within and between countries. Figure 4 displays significant variation in annual real GDP per capita in the region ranging from $480 for Haiti to over $18,000 for the Bahamas in 2006.

Economists and other social scientists have tried to figure out the causes of disparities in living standards and the lack of economic growth. Some experts have suggested that corruption, excessive debt, political instability, low investment in human capital, and emigration account for low levels of economic prosperity in Latin America (3) Others have attributed the suboptimal economic growth to exchange-rate volatility (Hausmann, Panizza, and Rigobon 2006; Kaminsky and Reinhart 1998); bad monetary policy (Wallich 1985); insufficient foreign direct investment (FDI) (Goldberg and Kolstad 1995); inequality (Birdsall and Londoso 1997); lack of economic freedom (Islam 1996; Farr, Lord, and Wolfenbarger 1998; Fraga 2004; Miles, Feulner, and O'Grady 2005); and lack of democracy (Barro 1996, Leblang 1997).

[FIGURE 3 OMITTED]

[FIGURE 4 OMITTED]

Figure 5 presents the average real GDP per capita (RGDP) of the G-7 (group of seven industrialized nations of the world) and of the 23 Latin American countries included in this article for 2003. The more than 3 to 1 gap in income between the two sets of countries is evident. Figure 6 presents average government consumption (GC) as a share of real GDP for both blocks of countries for 2003. Latin America has a much higher level of government consumption (more than 23 percent of GDP) than the most prosperous nations of the world (slightly more than 15 percent of GDP).

The Armey Curve analysis suggests that the optimal consumption by the average Latin America government is about 13.7 percent of the annual real GDR substantially below the existing 23 percent. Panel data reinforce the message from the Armey Curve: an increase of 1 percent in GC as a share of real GDP leads to a reduction of economic growth from - 0.22 percent to - 0.28 percent under different model specifications.

[FIGURE 5 OMITTED]

Our study corroborates the conclusion of other studies concerning the negative relation between economic growth and government consumption, and also the positive relationship between economic growth and investment put forward by Barro (1991). Our results are consistent with the notion that the typical Latin America government wastes too many resources in ineffective bureaucracy and harms the well-being of their citizens.

Hypothesis and Theoretical Issues

In this article, we conjecture that the atypical proportion of real GDP consumed by the typical government in Latin America is a significant impediment to economic growth. When the government controls a substantial part of the economy, space for private investment is limited, which has a negative spillover effect on productivity.

[FIGURE 6 OMITTED]

In addition, nonproductive public spending (government waste) is an impediment to economic growth. This hypothesis can be represented as follows:

(1) [GE.sub.1] =[PE.sub.1] + [UE.sub.1],

where [GE.sub.1] represents total government expenditure in period t; [PE.sub.1] is the amount of productive government expenditure, such as effective investment in human capital, infrastructure, and law and order; and [UE.sub.1] represents the amount of unproductive government expenditure, such as excess bureaucracy, giveaways, useless government programs, and outright misappropriations of public funds. The ideal situation is when [UE.sub.1] = 0; however, this is not realistic. We expect [GE.sub.1] to be higher than the optimal level...