Micro-Macro Interactions, Competitiveness and

Sustainability
By
Jos Mara Fanelli
CEDES, September !!!
0
I"#$%D&C#I%"
The continuous implementation of market-oriented reforms and the
increasing influence of globalization have been two salient characteristics of the
nineties in Latin America (LA). As a conseuence! toda"! the structure of the LA
economies presents substantial changes. The" are considerabl" more open to
international trade and capital flows and domestic markets are much freer than
in the postwar period. #n this new scenario! ke" macroeconomic indicators such
as the inflation rate showed an encouraging evolution while the growth
prospects improved as compared to the debt-crisis period. #n spite of this!
however! the old challenge of achieving a sustained growth rate that could
graduall" close the income gap with developed countries appears to be no less
difficult than in the last decades. There are two relevant obstacles that the
market-oriented reforms have encountered. The first is that markets are
underdeveloped in LA. There e$ist important failures in the factor! services and
goods markets that tend to affect significantl" the optimalit" of the market
outcome. The second is that institutional development is weak and! thus!
government interventions and regulations tend to be inefficient. The
combination of these two factors represents a serious obstacle to the
development of a denser market structure capable of e$ploiting the potential
benefits of market liberalization. #n a conte$t of market failures and weak
institutions! polic" makers have a limited capacit" to manage the comple$
interactions between productivit" growth! macroeconomic stabilit" and
integration in the global econom" that arises in the process of growth. The"
cannot rel"! without uncertaint"! on either free markets or government
institutions.
A ma%or difficult" for understanding the development process and
improving polic" design is the absence of an anal"tical framework within which
productivit"! stabilit"! integration in the world econom"! and institutional
problems can be integrated. The &ashington 'onsensus (&') attempted to
deliver such a framework in the eighties (&illiamson! ())0). The &' put
together the lessons drawn from the anal"sis of concrete development
e$periences and the theoretical contributions of the *liberalization+ approach
to development theor". #t was e$tremel" effective at revealing the
inefficiencies and inconsistencies of the older development paradigm based on
(
import substitution and state intervention and at establishing new guidelines
for policies oriented at liberalizing repressed markets and reducing the size
and functions of the state. #n fact! part of its popularit" was due to its abilit"
to present an integrated framework for polic" design in a wide range of areas
which embraced both economic and institutional factors. A good number of
developing countries put into practice the polic" recommendations of the &'
and succeeded in eliminating man" of the inefficiencies of the old
development model such as high and widel" dispersed protection rates!
e$cessive involvement of the state in production and elevated inflation rates
Toda"! however! the &' approach and globalization are under scrutin".
After ten "ears of reforms the outcomes in terms of growth! productivit"! and
macroeconomic stabilit" are falling short of e$pectations. The process of
catching up with the developed world is far from secure and social euit" is b"
no means improving. #n fact! an important weakness in the &' approach was
that the sources of a sustained increase in productivit" were not clear enough.
This is apparent in the &',s polic" recommendations. #t is generall" e$plicitl"
assumed that market deregulation and outward orientation (i.e. *undistorted+
integration in the world econom") should be sufficient conditions to ensure an
upward trend in productivit"
(
. -ut the recent LA e$perience suggests!
nonetheless! that market deregulation alone ma" not suffice to take full
advantage of the creativit" of the private sector and to enhance productivit"
growth. #n this regard! a central flaw of this vision is that it downpla"s the role
of market failures and real ad%ustment costs. The assumption that product and
factor markets will function well following liberalization ma" be unwarranted in
the case of developing countries! where imperfections are pervasive in the
markets for knowledge! labor! infrastructure services and finance. These markets
have a determinant influence on the evolution of productivit". Likewise! the &'
also tends to downpla" the permanent effects that the sizeable macroeconomic
diseuilibria that usuall" follow liberalization can have at the microeconomic
level! such as the lost of accumulated skills and length" periods of
unemplo"ment.
-ut! be"ond the uestion of the *long-run+ evolution of productivit"! in
the second half of the nineties! the Teuila! Asian and .ussian crises gave rise
to new uestions about the precise wa" in which developing countries could
take advantage of globalization and the market econom" while avoiding their
perils. /ne of the most important sources of uncertaint" in this regard was the
(
0or a t"pical presentation of the &',s reform program see &orld -ank (())1) and for a criticism! 0anelli!
0renkel and Ta"lor (())2).
2
fact that! somewhat une$pectedl"! some of the highl" successful outward-
oriented countries! like 3orea and other *tigers+! e$perienced steep
macroeconomic diseuilibria which matched some of the characteristics of
Latin American instabilit"! such as currenc" attacks! financial fragilit" and deep
falls in the activit" level. These facts made it evident that imperfections e$ist in
the functioning of international capital markets which can %eopardize even the
most successful countries and that! under such circumstances! outward
orientation per se is not enough to protect a given countr" from e$posure to
capital flows volatilit". Likewise! on the domestic side! the crises show that
macroeconomic instabilit"! financial fragilit" and the capital structure of the
firms are closel" associated.
The uncertainties about recent developments in LA are no less important.
A few e$amples e$tracted from the recent e$perience of LA countries will
suffice to show the character of such uncertainties. Argentina followed an
audacious &' strateg" and grew much faster than in the eighties. -ut its
econom" was severel" hit b" both the Teuila and the Asian4.ussian crises. The
reforms were unable to radicall" eliminate the tendenc" to generate *e$cessive+
current account deficits which had been a structural characteristic of the
Argentine econom" during the import substitution period. Toda" the uestion is
whether the econom" will be able to sustain the average growth path of the
nineties. 'hile! which also followed consistentl" a &' strateg"! has showed an
outstanding growth record for more than a decade and was practicall" unaffected
b" the 5e$ican devaluation. The 'hilean authorities! however! were unable to
isolate the econom" from the turbulence in emerging markets in ())6-)) and it
was clear that the 'hilean econom",s low degree of e$port diversification leaves
the countr" too e$posed to terms-of-trade shocks. #n fact! neither Argentina nor
'hile had been able to break their traditional dependence on the surplus of
natural resources to finance their net imports of sophisticated industrial products.
/penness was basicall" beneficial to the development of non-traditional e$ports
in natural resource-intensive sectors. 0inall"! 5e$ico,s and -razil,s e$perience
in the nineties! the two ma%or economies in the region! were much less
encouraging. Their rates of growth were lower than those of 'hile and Argentina
and the" underwent periods of serious macroeconomic diseuilibria.
#n sum! in toda",s LA! the problems of lagging productivit"! financial
fragilit" and balance of pa"ments are at the core of economic polic" discussions.
#n such discussions! the concepts of competitiveness and sustainabilit" of the
growth process pla" a prime role. -ut the meaning of the two concepts is far
from clear in common usage. /ne important flaw is that! be"ond important
1
e$ceptions!
2
there is no s"stematic anal"sis of the relationship and interactions
between competitiveness and sustainabilit"! on the one hand! and productivit"!
macroeconomic euilibrium and international integration on the other. This
paper represents an attempt to begin to fill this gap. # will e$plore the h"pothesis
that the consideration of micro-macro interactions ma" be of relevance to
understanding the issues at stake. # use the notion of micro-macro interactions as
defined in a previous work on the issue (0anelli and 0renkel! ())7). #t basicall"
entails five main h"potheses8

#. 5acroeconomic diseuilibria ma" have permanent effects on the
microeconomic structure.
##. The interaction between nominal and real magnitudes have real effects.
###. &hen markets are incomplete! finance matters for the real side.
#9. 5arket failures generates coordination failures at the macroeconomic
level.
9. #nstitutional underdevelopment is an obstacle to market creation and to
the government suppl" of coordination instruments to make up for market
failures.
#n a recent paper (0anelli! 2000) # have anal"zed the LA e$perience in the
nineties and found a fact which! at first sight! seems striking8 the reforms have
radicall" changed the region,s economic structure in man" important wa"s but!
at the same time! the evidence suggests that other no less important structural
characteristics subsisted. 0or e$ample! there was a substantial positive change in
the macroeconomic d"namics but the trade specialization pattern strongl"
resembles the pre-reform period. A second motivation to write this paper was to
develop anal"tical concepts which could be useful to understand this and other
st"lized facts of the LA e$perience. :pecificall"! # believe that the micro4macro
approach to competitiveness and sustainabilit" ma" be useful in e$plaining wh"
in LA economies it is freuentl" observed that
1
8
5acroeconomic instabilit" hinders productivit" growth. -ut macroeconomic
stabilit" is neither a sufficient condition nor the fuel of sustained growth.
2
:ee for e$ample! ;aue et al. (())7) and .os (())6).
1
These st"lized facts are based on the empirical evidence that can be found in 0anelli (2000)! 0anelli and
5edhora (2000) and 0anelli and <onzalez .ozada (())6).
=
The evolution of nominal variables matters to decisions affecting real
variables and! conseuentl"! the monetar" and e$change rate regimes are not
neutral for the micro structure and! hence! for growth.
The imperfect access to international capital markets has a strong effect on
productivit" growth via its effects on risk and the intertemporal allocation of
resources.
The imperfect access to international capital markets creates liuidit"
constraints and makes *competitiveness+ critical for short-run
macroeconomic euilibrium and a source of permanent concern of polic"
makers.
There freuentl" occur *twin crises+ which usuall" have long lasting
negative conseuences on financial deepening and macroeconomic
d"namics.
>ominal factors affect competitiveness basicall" via its effects on the
e$pected value and the volatilit" of relative prices and! particularl"! the real
e$change rate.
The trade specialization pattern at the micro level contributes to determining
macroeconomic stabilit" and growth via its influence on the current account
and the *sustainabilit"+ of the process.
5icro financial factors matter at the macro level (i.e. the c"cle and overall
evolution of productivit") via their influence on the firms, capital structure
and investment behavior.
0inancial factors matter to productivit" and competitiveness to the e$tent
that there ma" be an anti-innovation or anti-trade bias in the allocation of
financial resources.
The paper has two sections. :ection # develops a framework to
understand micro-macro interactions. #t emphasizes the role of price
rigidities! liuidit" constraints and international financial market failures.
:ection ## applies the framework to define more precisel" the concepts of
competitiveness and sustainabilit". There is a s"stematic e$amination of the
7
linkages of such concepts with macroeconomic factors! productivit" and
financial stabilit".
#n concluding this introduction! perhaps we should stress that our
criticism of the traditional approach does not mean we should start from scratch
so as to better understand the interactions of productivit"! stabilit" and openness.
#n the first place! in spite of its flaws! the &ashington 'onsensus has clarified a
variet" of issues! particularl" those related to static economic efficienc" and
macroeconomic stabilit" originating in monetar" and fiscal imbalances.
:econdl"! some heterodo$ contributions! both anal"tical and empirical! have
shed light on ke" aspects of developing economies. /n the anal"tical side! there
were new advances in trade! finance and growth theor" which e$plicitl" take
into account the e$istence of market failures and! therefore! are speciall" useful
for the anal"sis of developing economies which have incomplete market
structures. Likewise! researchers working in the technological and industrial
organization areas have studied the determinants of competitiveness and
productivit" in developing countries and have showed the limits of the
neoclassical approach for anal"zing the d"namics of technical change! trade and
competitiveness in the developing world.
=
0rom our point of view! these
contributions are promising steps towards the construction of a post-&ashington
'onsensus approach. This new approach to development problems will surel"
incorporate man" of these recent contributions as its building blocks.
4
:ee! for e$ample! ;aue (())7)! <uerrieri (2000)! .os (())6).
?
I' MIC$%(M)C$% *I"+),ES )"D DIC-%#%MIES
#rend and cycle
;"pothesis # assumes that macroeconomic diseuilibrium ma" have
permanent effects on the microeconomic structure and on growth potential. #n
the discussion about economic polic"! this h"pothesis is taken for granted.
;owever! at the anal"tical level! there is a certain scarcit" of studies offering a
rationale for it. @erhaps! the reason to the scarcit" of anal"ses of micro4macro
linkages is that until recentl" economic theor" made a sharp distinction between
the econom",s growth trend and c"cles. Traditionall"! business c"cle theorists
have anal"zed detrended data and considered the trend as e$ogenous to the c"cle
and growth theorists have focused on characterizing a long-run growth path.
/ne important weakness of this approach is that it cannot account for the
e$istence of stochastic trends (Aghion and ;owitt!())A). The view that! under
certain circumstances! macroeconomic diseuilibrium can have permanent
effects on the microeconomic structure (0anelli and 0renkel! ())7) implies that
temporar" shocks ma" be embedded in long-run paths and hence this view is
consistent with the approach of some endogenous growth models. #t is
interesting to note! in this regard! that although there is a consensus on the fact
that e$cessive macroeconomic instabilit" and sluggish growth in developing
countries (particularl" in Latin America) have not been independent phenomena!
there have been no s"stematic attempts until recentl" to anal"ze the effects of
either volatilit" or prolonged4deep diseuilibrium periods on the growth trend.
7

#t must be stressed! nonetheless! that temporar" shocks can either hamper
or benefit growth. 0or e$ample! if the real e$change rate is artificiall"
maintained at a low level for an e$tended period! it ma" hamper the productive
capacit" of the tradable sector permanentl". -ut we can also easil" think of
situations in which a temporar" boom can have permanent positive effects.
:uppose there is a surge in capital inflows which reduces the interest rate and! as
a conseuence! credit-constrained firms e$perience a long period of e$cess
liuidit". #t is possible for the higher investment rate which will result from a
softer liuidit" constraint to have permanent favorable effects on productivit"! if
learning and skill accumulation are complementar" to ph"sical capital
7
The notion that trend and c"cle should not be sharpl" separated! nonetheless! has a long tradition. This is
particularl" so regarding the structuralist approach and the use of three-gap models to account for the lack of
growth in the eighties in LA! during the debt crisis. /n this issue! see Ta"lor (()A)) and Ta"lor (()61)
A
accumulation. 5echanisms of this kind have been present in the e$periences of
countries like Argentina and @eru in the nineties. #n conclusion! when trends are
assumed to be stochastic! not onl" the temporar" shocks that hit the econom"
but also the characteristics of the short-run macroeconomic ad%ustment path ma"
have long-lasting effects. This fact is a primar" source of concern to polic"
makers.
An obvious necessar" condition for the micro4macro interactions to be
empiricall" relevant is that macroeconomic diseuilibrium e$ists. This makes
our approach inconsistent with several dichotomies which are usuall" e$plicitl"
assumed in economic theor" and are often implicit in polic" discussions. This is
the reason wh" ;"pothesis ## states that the dichotom" between real and
nominal magnitudes is not valid! while ;"pothesis ### affirms the inconvenience
of separating financial from real decisions. &e will discuss these issues briefl".
#.e Dic.otomy bet/een "ominal and $eal Ma0nitudes
The discussions about the interactions between nominal and real variables
have a long tradition in macroeconomics. #ndeed! one fundamental reason for
the e$istence of macroeconomics is that the data disconfirm the predictions of
traditional microeconomics which sa" that the absolute value of variables such
as the overall price level or the uantit" of mone" do not have a bearing on the
real side. #n this sense! ;"pothesis ## is not stating an"thing new. There is!
however! a difference between the conventional macroeconomic literature and
the issues we discuss under the heading of micro4macro interactions. #n
macroeconomics it is normall" assumed that whatever be the influence of
nominal variables on real values! the" are onl" felt in the short run. #n the long
run the influence of nominal variables must fade awa" because the euilibrium
values of real variables is independent of nominal magnitudes. #n contrast with
this view! # assume e$plicitl" that the long-run euilibrium values can be
affected b" short-run diseuilibria and that it is precisel" because of this that the
trend and the c"cle ma" not be independent.
# will present ;"pothesis ## in a wa" that will be useful for the later
discussion of the choice of the e$change rate and monetar" regime. # will use
a simple model to e$emplif" the nominal4real dichotom" and how short-run
diseuilibria ma" induce permanent real changes. #n a small open econom"! if
we assume perfect arbitrage in the markets for goods! services and financial
assets and perfect foresight! in euilibrium it must be true that8
6
(() B - C!
(2) B - g !
(1) r B rC D .
Euation (() states that the relative @@@ condition holds and! so! the rate
of depreciation of the domestic currenc" () e$actl" euals the difference
between the domestic () and the international (C) inflation rates. Likewise! if
prices are fle$ible and financial markets are functioning properl"! mone" will be
neutral and the inflation rate will eual the difference between the rate of growth
of the nominal suppl" of mone" () and the econom",s growth rate (g). Fnder
perfect capital mobilit"! the uncovered interest rate parit" condition must hold
and! hence! the nominal interest rate in domestic financial markets (r) must eual
the sum of the international nominal interest rate (rC) and the rate of currenc"
depreciation.
#f we assume that the representative agent lives in a 5odigliani - 5iller
world in which the 0ischer,s :eparation theorem holds! it is ver" eas" to
characterize the microeconomic structure on the basis of the *reduced form+
e$pression for the growth rate8
(=) g B g (rC- C)
<iven the technolog"! the rate of growth of the econom" depends on the
international real interest rate. #n this world! the work of the entrepreneur is
not that difficult. :he should undertake all pro%ects which are profitable at rate
rC! without bothering about how to finance them or what the temporal
preferences of the owners of the firm are. @erfect capital markets will make
the plans of principal and agents and consumers and investors consistent.
0or a small econom" open to capital and trade flows! rC and C are
given and! hence! it is possible to determine the euilibrium rate of growth of
the econom" using euation (=) e$clusivel" and without reference to the
others. >otice the strict dichotom" between the *micro+ structure represented
b" euation (=) and the *macro+ structure represented b" (()! (2) and (1).
)
Fnder these circumstances! causalit" runs unilaterall" from *micro+ to
*macro+ since it is possible to determine the rate of growth of the econom"
without even mentioning nominal magnitudes and macroeconomic variables.
&ith perfect capital markets and fle$ible prices! macro does not matter to the
euilibrium value of real variables.
The macroeconom" onl" reall" matters to nominal magnitudes. /nce
we have solved the euilibrium rate of growth in euation (=)! there are four
variables to be determined8 ! ! and r. :ince onl" three euations are left!
the s"stem is indeterminate and one variable must be chosen e$ogenousl". #t is
precisel" in deciding how to use this degree of freedom that the so-called
polic" trilemma (Eichengreen! ()))) appears8 #t is not possible to preserve
free capital mobilit" (e. 1)! the stabilit" of the e$change rate (e. () and an
independent monetar" polic" (e.2) at the same time. #f the polic" maker
chooses to control the nominal value of the e$change rate! she will lose
control over monetar" polic" because ! and r will be endogenousl"
determined. #f she chooses either to target r or or to control it will not be
possible to fi$ . ;owever! under these conditions it is hard to understand wh"
the authorities are facing a trilemma at all. &hatever the decision about the
nominal anchor of the s"stem! the euilibrium value on the real side (i.e. the
growth rate) will be strictl" the same. An" influence of macroeconomic
variables over microeconomic decisions should take place! the dichotom"
between euation (=) and the rest must be violated. That is! for the authorities
to face a trilemma! a market failure must e$ist.
#n the literature! it is common to assume either price rigidities which
precludes conditions (() and4or (2) from holding or capital market
imperfections which will affect! at least! the parit" in euation (1)
?
. The two
h"potheses! however! are not completel" independent under normal
circumstances. :uppose! for the sake of the argument! that prices are sluggish
because of imperfect competition. Fnder such circumstances! becomes
e$ogenous while the rate of variation of the real e$change rate () is now an
endogenous variable because relative @@@ ceases to hold. &e need to rewrite
euation (() as8
((,) B D - C.
?
/n these issues and the problem of the e$change rate regime choice! see 0rankel (()))).
(0
;owever! if the real e$change rate varies and we accept temporal
deviations from the euilibrium relative @@@ rule!
A
it will affect the current
account. :pecificall"! a lagging real e$change rate will induce an increasing
current account imbalance and! thus! there will be a tendenc" for the countr",s
*leverage+ (for e$ample! the debt4 <G@ or debt4e$ports ratios) to increase.
Fnder these circumstances! creditors will take account of the fact that relative
price diseuilibria ma" be long lasting and! hence! that there ma" be
transactions at *false+ prices. .ational investors will take into consideration
that the" live in a world in which diseuilibrium and unfulfilled e$pectations
e$ist! a world of uncertaint" in which contracts ma" be violated. #t would be
ver" artificial to maintain the assumption that investors and creditors do not
care about macroeconomic imbalances. The" will perceive that a lower real
e$change rate means less competitiveness! a higher current account deficit!
greater leverage and! hence! an increased risk of default. As soon as we leave
the perfect market world! the problems of competitiveness and growth
sustainabilit" appear. #n this new world it would be more realistic to replace
euation (1) with8

(1,) r B rC D D !
where is the *countr" risk+ premium. /n the bases of our previous
arguments! it seems reasonable to write that depends on the leverage
observed in the previous period (d
t-(
) and ! thus8

(7) B (H d
t-(
)
.isk must be taken into account in investment decisions insofar as it
affect the cost of capital. Therefore! the euation for the growth rate becomes8
(=,) g B g (rC - C D )!
#mperfect price fle$ibilit" and a positive countr" risk rate completel" change
the role of macroeconomic factors. #n the first place! it is not possible to
determine the growth rate using onl" euation (=I) and! in this wa"! the
dichotom" between the micro structure and the macroeconom" is broken. #n
this new scenario! the polic" choices of the authorities regarding nominal
values is no longer irrelevant to the real side. #f the authorities opt for a fi$ed
A
/n the issue of the velocit" of ad%ustment of the real e$change rate toward euilibrium and the @@@! see
0root and .ogoff (())7) and Edwards and :avastano (())))
((
e$change rate regime! euation ((I)! alone! defines the value of the real
e$change rate and the direction of causalit" completel" changes. >ow! it runs
from macro to micro. #f! on the other hand! the authorities choose a fle$ible
e$change rate regime there will not be a precise direction of causalit" and the
value of all variables will be determined simultaneousl". There will be a two-
wa" interaction between micro and macro factors.
#t is precisel" under these conditions that the election of the e$change
rate regime becomes a source of concern and creates dilemmas. 0or e$ample!
assume that a countr" fi$es the nominal e$change rate at an artificiall" low
level in a conte$t of stick" prices and! therefore! e$periences a mounting
current account deficit which! in turn! e$ert an upward pressure on the countr"
risk. This will erode both investment and the euilibrium of the fiscal budget.
#n man" cases! the economies facing problems of current account and fiscal
sustainabilit" in the nineties opted for a regime change and let the nominal
e$change rate float such as in the cases of -razil and 5e$ico. The rationale
for the change was that the e$ternal imbalance is basicall" a macroeconomic
problem8 A *wrong+ e$change rate erodes the competitiveness of the econom"
and prevents the countr" from competing successfull" in international
markets. 0rom the static point of view the polic" is correct since! if an
euilibrium e$ists! there is alwa"s an e$change rate which leaves the balance
of pa"ments in euilibrium and permits the countr" to full" e$ploit its
comparative advantage. &h"! then! did man" countries not opt for this
solutionJ /ur guess is that the" feared that the depreciation of the currenc"
would induce permanent changes on the microeconomic structure. This
concern is much easier to understand when d"namic factors are taken into
account.
The e$perience of developing countries shows that to ensure
competitiveness countries need much more than %ust getting the real e$change
rate right. The e$perience of Latin American countries in the eighties is
particularl" relevant in this regard. The s"stematic use of devaluation as a
means of improving competitiveness and achieving euilibrium accelerated
inflation and damaged financial intermediation! thereb" increasing volatilit" in
both prices and uantities. #n this wa"! the upward correction of the real
e$change rate could onl" be achieved at the cost of a sharp worsening in the
macroeconomic setting. The effects of increased volatilit" and the
deterioration of financial conditions on investment were devastating. There
was a generalized fall in the investment4<G@ ratio in the entire region. This!
in turn! resulted in the stagnation of productivit" and the widening of the
(2
productivit" gap between Latin America and other more successful developing
countries such as the Asian >#'s. The ultimate conseuence of the attempt to
get the real e$change *right+ in a conte$t of high uncertaint" and severe
financial constraints had %ust the opposite effect that was sought8
'ompetitiveness was severel" and permanentl" hindered b" the lagging
evolution of productivit". #n this sense! one lesson is that it must be taken into
account that correcting relative prices has a cost. #n this case! the most
relevant cost was higher volatilit". #f the multilateral lending institutions had
considered this point in the eighties! the" would have increased the suppl" of
financing in order to smooth the reuired correction of the real e$change rate
in the short run. #n this regard! the ad%ustment package designed for 5e$ico in
())7 and 3orea in ())A represented an important step forward and proved to
be much more effective than the ad%ustment technolog" utilised in the eighties.
# believe that the polic" dilemmas associated with the choice between
alternative e$change rate regimes are deemed critical because polic" makers
know that the ad%ustment paths under alternative e$change rate regimes are
different. #f the effects of the ad%ustment path on the long run euilibrium are
non-neutral! the adoption of a particular e$change rate regime matters to the
evolution of competitiveness. Let us take the e$ample of the recent crises in Asia
and Latin America. The balance of pa"ments diseuilibria t"picall" arose in the
conte$t of (appro$imatel") fi$ed e$change rate regimes. Fnder such
circumstances! there were two basic polic" reactions. The most usual option was
the devaluation of the currenc" and the change in the e$change rate regime.
/ther economies (notabl" Argentina and ;ong 3ong)! on the contrar"! did not
resort to devaluation and privileged the maintenance of the regime over the need
to correct the e$change rate parit" to preserve competitiveness. Gevaluation
proved to be ver" effective at correcting e$ternal imbalances in the short run.
&h"! then! have there been countries which did not devalueJ The case of
Argentina is ver" interesting in this regard. The diagnosis behind the decision to
maintain convertibilit" was that changing the regime would be too costl". That
is! would induce undesired mutations at the microeconomic level. The most
important costs were considered to be the higher volatilit" of ke" relative prices
and the increase in the fragilit" of the financial s"stem. These costs would more
than offset the benefits of correcting the misalignment of the e$change rate in
the short run. #ndependentl" of whether or not the Argentine authorities were
right in their assessment of the costs and benefits of a regime change! the
Argentine case clearl" shows that relative prices are not the onl" channel
through which macroeconomic factors influence microeconomic decisions and
competitiveness. 9olatilit" and instabilit" also matter to them. The Argentine
(1
case suggests that under certain circumstances there is a kind of trade-off
between the mean and the variance of the real e$change rate. To be sure! we do
not mean that the level of the real e$change rate does not matter. &e suggest that
the wa" in which a certain correction is achieved is non-neutral to the real side
and! hence! micro-macro interactions should be carefull" evaluated when
designing economic polic".

/ne important conclusion that our anal"sis of micro4macro interactions
suggests is that competitiveness means more than %ust getting the relative prices
(and! particularl" the e$change rate) right. The presence of fragmented or
missing markets and weak institutions in developing countries determines that
e$ternalities! spillover effects! financial constraints and strategic interactions
between economic actors are pervasive. Fnder these circumstances! when a
negative macroeconomic shock occurs! the market forces (i.e. relative price
changes driven b" e$cess demand) which should automaticall" restore
euilibrium are too weak. As a conseuence! there will be a tendenc" for the
diseuilibrium to set in motion destabilizing forces such as deep recessions
and increased volatilit" accompanied b" high and persistent inflation and4or
unemplo"ment. # think this is an important reason wh" macro diseuilibria in
developing countries are deeper and more unstable than the diseuilibria
observed in economies with a more complete market structure.
#n sum! # think that to give a rationale for man" practical concerns in
developing countries! it is necessar" to break the dichotom" between real and
nominal variables and to account for the fact that macroeconomic diseuilibrium
ma" induce permanent changes in the micro structure. This view implies
abandoning the long tradition in the field of international economics of sharpl"
separating trade and the KmicroK uestion of optimum resource allocation from
monetar" and macroeconomic issues. The t"pical international economics
te$tbook is divided into two parts. The first anal"zes the real econom" with a
KmicroK perspective! omitting the e$istence of mone"! financial intermediation
and current account diseuilibria. The second part studies open econom"
macroeconomics. #n this part! the trade specialization pattern pla"s no role and
output is highl" aggregated. :ome of the agents, financial decisions (domestic
vs. foreign bonds) come to the forefront and macroeconomic problems like the
correct level of the real e$change rate! aggregate domestic absorption! portfolio
decisions and balance-of-pa"ments euilibrium take center stage. #t is not clear
what the relationship between the first and the second part is or how the results
of each part are modified b" the results obtained in the other.
6
As a conseuence
8
:ee as paradigm! 3rugman and /bstfeld (())().
(=
of this dichotom"! in the literature on trade! the problem of achieving a
sustainable macroeconomic euilibrium is conceived of as being largel"
independent of the uestion of competitiveness. Trade imbalances can alwa"s be
corrected through fiscal! monetar" or e$change rate policies because
competitiveness problems (i.e. recurrent current account crises) have their roots
in inadeuate macroeconomic policies rather than in weak productive structures.
#.e Dic.otomy bet/een t.e $eal and t.e Financial Side'
#f we assume that it is possible to e$plain the competitive performance of
a firm without making an" e$plicit reference to financial issues! we are
implicitl" assuming that 5odigliani-5illerLs theorem and TobinsL and 0isherLs
separation theorems hold. The compan"Is funding decisions are irrelevant to the
choice of pro%ects. The present value of each pro%ect is independent of the wa"
in which it is financed. This assumption is too strong in the conte$t of most
developing countries because there are highl" significant failures in factor and
capital markets. Accordingl"! ;"pothesis ### states that in developing countries!
it is a-priori misleading to assume that the firms seeking to e$ploit a competitive
advantage can alwa"s finance their productive pro%ects. #n strong contrast with
the world of perfect capital markets! in the developing world a firm which is
potentiall" competitive ma" be forced to forgo investment opportunities either
because of liuidit" constraints created b" credit rationing! or because interest
rates are abnormall" high as a conseuence of market imperfections or an
e$cessivel" volatile macroeconomic setting. #n such a world! *real+ decisions
should not be isolated from financial ones (0azzari! ;ubbard! <lenn and
@etersen! ()66).
#n the developing world! market segmentation is the rule rather than the
e$ception. #t is ver" eas" to find two firms with the same potential levels of
competitiveness but ver" different performances. /ne might be able to finance
pro%ects ver" easil" while the other might not because of e$tremel" high interest
rates or credit rationing. /ften in developing countries! suppliers of raw
materials and intermediate goods provide their bu"ers with credit! especiall"
small- and medium-sized ones who do not have access to credit from financial
institutions (@etersen and .a%an! ())?). 5arket segmentation ma" be ver"
harmful. #t ma" be a serious obstacle to the development of strong and
competitive firms and financial intermediaries which! in turn! contribute to
generating and perpetuating the dual economic structures we observe in
(7
developing countries. This issue can be anal"zed from both a static and a
d"namic perspective.
0rom the static point of view! in a conte$t of segmented capital markets it
is not natural to assume that marginal productivit" conditions hold and all
factors of production are used with the same profitabilit". 0inancial institutions
are supposed to screen for the best pro%ects and monitor their development.
'onseuentl"! if ke" segments of the capital markets are missing it implies that
there will be less screening and monitoring and! hence! a worse allocation of
resources. A compan" that has no bank monitoring ma" incur in an inefficient
allocation of real resources and have suboptimal risk management. #n a modern
capitalist econom" the financial institutions have the important task of
eualizing the profitabilit" in the use of the resources in all uses. The weaker the
financial institutions! the weaker are the forces pushing to eualize the
productivit" with which a given factor is used in different sectors and regions
and! thus! the higher is the probabilit" that a dual economic structure results.
0rom a more d"namic point of view! financial intermediaries have
another critical task8 Kpicking the winnersK in a decentralized wa". #n this
regard! finance matters to growth because financial institutions contribute to
fostering productivit" and hence absolute advantage. 0inancial intermediaries
can spur technological innovation b" identif"ing and funding those
entrepreneurs with the best chances of successfull" implementing innovative
products and production processes. #n this wa"! the development of financial
institutions and markets is a critical and ine$tricable part of the growth process
(Levine! ())A). 0ollowing the thinking of :chumpeter and the more recent
literature on finance and endogenous growth! .a%an and Mingales (())6) state
that capital markets make a contribution to growth b" reallocating capital to
the highest value use while limiting risks of loss through moral hazard!
adverse selection or transaction costs.
/ne weakness in the literature on growth and financial deepening!
however! is that it is not completel" clear wh" financial deepening is low in
developing countries. 0rom the micro4macro perspective we adopt here! it is
necessar" to introduce the role of macroeconomic factors. #n particular! we
have seen the negative effects of the higher volatilit" of prices and uantities
and of changes in the foreign investors, sentiment. #n this perspective! it is also
important to consider the effects in the opposite direction8 The lack of
financial deepening is an important source of macroeconomic diseuilibria.
The difficulties in managing liuidit"! risk and the intertemporal allocation of
(?
resources! increases the probabilit" that transactions are carried out at false
prices. Likewise! the lack of financial deepening represents a tight constraint
on polic" making. A good e$ample are the difficulties that man" LA countries
encountered when tr"ing to sterilize capital inflows in the nineties. :o large
where this flows compared to the e$isting stock of domestic bonds that the
sterilization attempts uickl" led to unsustainable increases in domestic
interest rates.
Mar1et Failures and Macroeconomic dise2uilibrium
#n a world of perfect markets! there are virtuall" no restrictions on the
range of contracts that can be signed. #n the real world of developing
economies! however! uncertaint"! informational as"mmetries and difficulties in
enforcing contracts e$ post limit the contracts which are feasible e$ ante. &e
have anal"zed how imperfections ma" generate micro-macro interactions that
ma" hinder the ualit" of the domestic market structure. The restrictions posed
b" imperfections in the international setting are also severe (/bstfeld and
.ogoff! ())?).There are two speciall" negative characteristics. The first is
marked segmentation. :ome developing countries face upward sloping suppl"
curves while others are rationed out. The second is volatilit". The stochastic
processes governing the evolution of prices and uantities show periods of
instabilit" and! conseuentl"! the market conditions can change abruptl". Even
countries with a reasonable access under normal conditions ma" e$perience
periods of credit rationing. These characteristics make the h"pothesis that
developing countries are price takers in capital markets particularl" inadeuate
/ne important conseuence of the failures in international capital markets
is that the" create liuidit" constraints. ;"pothesis #9 highlights this fact as a
source of coordination failures and! hence! of macroeconomic diseuilibrium. #
stress the link between market failures and liuidit" constraints because the
theoretical literature emphasizes other aspects. The literature! usuall" privileges
the stud" of the conseuences of imperfections on risk management and the
intertemporal allocation of resources and demonstrates that a countr" is better
off when it can use the international markets to take advantage of the
differences between the *autark"+ and the international price of risk and of
future consumption. These results are ver" important because the" clarif" the
wa" in which missing markets ma" erode an econom",s growth capacit". #n
addition to this! # believe it is necessar" to highlight that in a world of
incomplete markets true uncertaint" e$ists and! hence! liuidit" constraints
matter. The tightness of the liuidit" constraint a countr" faces is a function of
(A
the conditions under which it can obtain financing to manage une$pected short-
run financial sueezes. And such conditions! in turn! are not independent of the
degree of market completeness. This point is critical in the LA conte$t! as the
region,s recurrent problems with balance of pa"ments testif".
&e can use euations (()-(=) to e$emplif" the wa" in which failures in the
microeconomic structure can generate liuidit" constraints and micro-macro
interactions. 0or the sake of simplicit" we will illustrate this with the case of
credit rationing. Fnder credit rationing! the countr" is condemned! at least
temporaril"! to a situation resembling autark". This has two immediate
conseuences. 0irst! the countr" will face an e$ternal liuidit" constraint and
0isher,s separation will not hold an"more. #t ceases to be true that all profitable
pro%ects will be undertaken. /ne can easil" imagine! for e$ample! that there will
be a ma$imum current account deficit (or capital account surplus) that the
countr" can run. #f there are pro%ects that are profitable at the rate rC and the
liuidit" constraint becomes binding! such opportunities will simpl" be lost.
:econd! the interest rate will be domesticall" determined. Fnder these
circumstances! we must replace euation (1) with an euation for the
euilibrium in domestic capital markets8
(1,) G (r! ) B 3D: (r!)
&here G is the fiscal deficit! : is the surplus of the private sector and 3 is
the ma$imum amount of foreign credit under rationing. &e are also obliged to
change euation (=) accordingl"8
(=,,) g B g (r! )
#t can easil" be seen that the e$ternal liuidit" constraint (3) breaks the
dichotom" between nominal and real variables because euation (=,,) alone does
not allow us to solve the euilibrium value of g. As we have alread" seen! this
gives rise to micro 4macro interactions. >otice! on the other hand! that under
rationing! the econom",s rate of growth now depends on the amount of net credit
available to the countr". #n this wa" a countr" can show low growth rates not
because of a lack of potentiall" profitable pro%ects but because profitable
investment opportunities are missed due to the shortage of finance. This link
between growth and liuidit" ma" clarif" the reason wh" E'LA' takes the
trouble to calculate the level of the e$ternal transfer from abroad received "earl"
b" LA countries. >otice! also! that when countries face an upward suppl" curve!
(6
the changes in in euation (=,) have the same effect of creating a link between
the growth rate and fluctuations in the investor,s market sentiment.
<iven the simple structure of our model! the main real effects of changes
in 3 are felt on the growth rate. The appearance of the liuidit" constraint has
the effect of introducing a wedge between the *effective+ and the *notional+
growth rate. That is! the observed growth rate will be lower than the *notional+
rate that would be observed if international markets were perfect. #n this sense!
our approach naturall" calls for the application of the diseuilibrium notion used
in macroeconomics (Lei%onhufvud ()6(! -enass" ())1) to a growth setting. #n
macroeconomics! diseuilibrium pertains to the realm of the short run. #t is
assumed that the imperfections that give rise to diseuilibrium (i. e. price or
interest rate rigidities) will disappear in the long run. #n the micro-macro
approach! on the contrar"! short-run diseuilibria ma" have long-lasting
conseuences. The" can permanentl" hinder the market structure and! hence! the
microeconom". #t is onl" a uestion of logic to conclude that this could induce a
permanent reduction in the *effective+ growth rate. 0or e$ample! we have
stressed above that when financial markets are segmented! it cannot be assumed
that euilibrium marginal productivit" conditions hold. The eualit" between the
marginal productivit" of capital and the market interest rate will cease to hold.
And! if the markets in general are not functioning properl"! it is natural to e$pect
that a given factor of production can either be utilized with different
productivit"4price combinations in different sectors and regions or go
unemplo"ed. 0rom m" point of view! this kind of *long-run diseuilibrium+ is
one important reason for the *dual+ economic structures which are commonl"
observed in developing countries. The pervasive failures in the market structure
precludes the *traditional+ sector from catching up with the *modern+ one!
thereb" creating the observed intrasectoral productivit" differences. #t is obvious
that there are institutional tools that could help the market achieve a better
allocation of resources. 0or e$ample! governments usuall" develop institutions
that allocate credit to small businesses or establish funds to fuel the regional
catching-up process. ;owever! as ;"pothesis 9 states! in developing countries
organizational problems are as pervasive as market failures and! hence! non-
market solutions are often useless. .ent seeking and corruption are usuall" not
the e$ception when institutions are poorl" monitored. #n this wa"! the dual
econom" is the conseuence of neither the market nor the institutions doing the
%ob.
/bviousl"! we could easil" complicate the model to allow for short-run
effects of changes in 3 or and generate the more usual difference between the
()
short-run notional and effective values. 0or e$ample! in a conte$t of sluggish
price ad%ustments! a shortage of foreign e$change would affect the activit" level
and! hence! unemplo"ment. #n fact! this is the kind of ad%ustment highlighted b"
the three-gap models developed to e$plain macroeconomic d"namics under the
e$treme rationing which e$isted during the debt crisis. Although gap models
would be somewhat rudimentar" under the present setting of free capital
movement and deregulated markets! the basic idea that there e$ists a linkage
between financial market imperfections! growth and macroeconomic
coordination failures is still valid! as the notion of long-lasting diseuilibria is
implicit in the gap notion.
&e have seen that in spite of the theoretical critiues! competitiveness and
sustainabilit" are usuall" present in economic polic" discussions. # believe that it
is precisel" the incomplete market setting plagued with liuidit" constraints and
insufficient price fle$ibilit" which creates the conditions for the *mistaken+
obsession with competitiveness and sustainabilit" to appear recurrentl". #n
effect! if markets are incomplete! there is no guarantee that financial markets
will correctl" price risk. Fnder such circumstances! there will be a permanent
latent suspicion that the observed asset,s market prices ma" be wrong and that
debtors ma" have difficulties with or ma" refuse to honor their obligations. #n
this wa"! an invisible but strong link between market underdevelopment and
uncertaint" emerges. And! when uncertaint" is high and news that could worsen
the debtor,s financial position becomes known! some creditors (speciall" those
less informed) ma" opt for flight to ualit". /ne immediate conseuence of the
flight to ualit" will be that the countr" will face a sudden worsening in credit
market conditions and will e$perience a tightening in the liuidit" constraint
(-ernanke! <ertler and <ilchrist! ()A1). The debtor countr",s abilit" and
willingness to pa" will be under scrutin". @ossibl"! some *countr" specialists+
will begin to e$press their concern about the sustainabilit" of the growth process
and about the need to enhance *competitiveness+. This d"namic resembles the
mechanisms of transmission of monetar" polic" shocks through the net worth
channel highlighted b" -ernanke (())2! ())7). #n -ernankeIs approach the
financial indicators of the firms! such as their leverage level! influence the credit
conditions the firms face. #n the case of developing countries! the role the
debt4euit" ratio pla"s in the case of a firm with a high e$ternal finance
dependenc" ratio is pla"ed b" the debt4e$ports or debt4<G@ ratios which are
used as pro$ies of capacit" to honor the debt services and! hence! as pro$ies for
sustainabilit".
20
#n a world of imperfect contract enforcement and limited information!
reputation has a positive value. 'onseuentl"! the authorities will have a strong
incentive to meet the countr",s obligations. #f interest rates are momentaril"
unusuall" high or the countr" is rationed out in credit markets! it will pa" off to
generate liuidit" b" other means. :pecificall"! a temporar" increase in the real
e$change rate might do the %ob. <iven price sluggishness! an e$peditious wa" to
do it would be via nominal depreciation. -" means of inducing a short-run
deviation of the real e$change rate from its long-run euilibrium path! the
countr" could suddenl" become *highl" competitive+ and get some e$tra cash.
To meet obligations with the countr",s own mone" is a sensible wa" to show
that the countr" is e$periencing liuidit" rather than solvenc" problems.
Gevaluation! in this sense! ma" be assimilated to the behavior of an individual
firm which decides to liuidate stocks at a price below the cost %ust to honor
bank debt and thereb" preserve the value of its reputational capital. #n sum!
short-run macroeconomic diseuilibrium becomes functional to preserve
reputation and send the signal that the e$ternal sector is sustainable. This
d"namic! however! can have perverse conseuences insofar as it increases the
volatilit" of relative prices and! particularl"! of the real e$change rate. #f the
foreign investor sentiment is rather volatile! it will induce a lot of noise in the
evolution of relative prices and it can be ver" costl" for a market econom" in
which price,s most important task is to conve" information with the lowest
degree of noise.
#n sum! when financial market failures are introduced into the anal"sis it
can be understood wh" *competitiveness+ and *growth sustainabilit"+ pla" a
central role in economic polic" discussions and wh" both concepts are
intimatel" related. #n the ne$t section we will further anal"ze the relationship
between competitiveness and sustainabilit" and use the LA e$perience of the
nineties as a wa" to test its utilit". -efore concluding this section a word about
;"pothesis 9 is in order. #n our rationale of ;"potheses ### and #9! the lack of
market development pla"s a salient role. /ne important polic" lesson that
follows is that the most important task in developing capitalist economies is not
market liberalization but market creation. #n this wa"! insofar as a critical input
of market creation is institution-building! it makes sense to include ;"pothesis 9
as an essential part of the framework to anal"ze micro-macro interactions.
;owever! it is not our intention to discuss institutional issues in this paper.
2(
II C%M3E#I#I4E"ESS )"D S&S#)I")BI*I#5
3rugman (())?) argues that competitiveness is a rather irrelevant
concept and that the increase in national productivit" is what matters to the
improvement of the standard of living! independentl" of the productivit" of
the rest of the world. There are two strong arguments against the idea that a
countr" can be permanentl" more competitive than all the others. The first is
the ver" well-known principle of comparative advantage. Ever" countr" is
competitive in something. The second is ;ume,s anti-mercantilist idea that the
attempt to be more competitive in ever"thing is self-defeating. A countr"
cannot show a continuous surplus in its current account without harming its
overall competitivenessH the monetar" side of the econom" would induce the
appropriate relative price changes. >either does the concept of sustainabilit"
seem to be strictl" necessar" from an anal"tical point of view. The
intertemporal approach to the balance of pa"ments onl" needs the concept of
solvenc"! that is! that a countr" does not pla" a @onzi game.
&h"! then! are the concepts of competitiveness and sustainabilit" so
popular in the economic polic" discussions in developing countriesJ # think
there are three reasons! which are closel" related to the points stressed in the
previous sections. The first is the e$istence of liuidit" constraints in a world
of imperfect markets and uncertaint". The second is the necessit" for polic"
makers to signal their willingness and abilit" to pa" in an uncertain
environment! speciall" when their behavior is under scrutin" because of a
worsening in the countr",s future prospects. And the third reason is that
competitiveness! growth potential and abilit" to pa" are not independent
phenomena in developing countries. This section discusses these points in
more detail.
#.e #/o Meanin0s o6 Competitiveness
#n the discussions on economic polic" in developing countries! the
concept of competitiveness is used with two different meanings. According to
one! the concept refers to short-run macroeconomic imbalances. The other use
alludes to long-run problems of stagnant growth. These two uses of the word
are not necessaril" contradictor" but it is worthwhile to e$amine the
22
relationship between them further to avoid confusion and! also! to establish
their linkages with growth sustainabilit".

&hen the concept is used in reference to the short run! it is usuall" in
the conte$t of mounting current-account diseuilibria and upward moving
countr" risk premia. #t is assumed that if a countr" surpasses a given current
account deficit4<G@ ratio (for e$ample! the so-called :ummer,s rule)! it has a
*competitiveness problem+ and should introduce changes to increase the
traded sector,s suppl" and improve the e$ternal balance. This could occur! for
instance! after an une$pectedl" large worsening in the terms of trade or a rise
in the international interest rates. Fnder these circumstances! fiscal and
monetar" ad%ustment-cum-devaluation will freuentl" be recommended. #n a
diseuilibrium conte$t in which creditors e$press concern over a countr",s
solvenc" and the latter faces a tight liuidit" constraint! the authorities ma"
find it worthwhile to increase its competitiveness in the short run in order to
signal both its willingness and its abilit" to honor the debt services. &e have
discussed this previousl".
Ftilized in this conte$t! the phrase8 */ur countr" is tr"ing to gain
competitiveness+ makes sense. #t means that the countr" is tr"ing to correct a
previous misalignment of domestic demand and relative prices or even to
induce an overshooting in the ad%ustment of those variables in order to
increase its foreign e$change cash flow in the short run. The phrase refers to a
short-run diseuilibrium situation. The authorities do not mean *we are tr"ing
to become more competitive than ever"one for ever+. #nstead! the" mean to
induce a change in the countr",s abilit" to compete in the short run via
reductions in domestic costs. The authorities could either aim to correct a
previous deviation from euilibrium or intend to *artificiall"+ enhance the
abilit" to compete b" inducing a temporal deviation from the consistenc" that
must e$ist in the long run between a countr",s productivit" level vis-a-vis its
competitors! on the one hand! and the countr",s domestic costs vis-a-vis those
competitors on the other.
A countr" cannot simultaneousl" show -razil,s productivit" level and
maintain <erman",s real wages. -ut it could occur for a while at the cost of an
increasing net indebtedness. This kind of situation is freuent in a conte$t
where there can be misalignments in the real e$change rates because of the
real4nominal interactions that we discussed in the previous section. Along the
same line! an econom" could induce a short-run *over-enhancement+ of its
competitiveness inducing a real-e$change rate overshooting in order to reduce
21
its net indebtedness and! hence! improve its financial position. This makes no
sense in a world of certaint" where solvenc" is not an issue! but it is a sensible
one in an uncertain setting in which creditors have the difficult task of
ascertaining a countr",s abilit" to pa". #f investors are monitoring the
evolution of the countr",s financial fragilit" indicators! it could pa" off to
induce a diseuilibrium to enhance liuidit" in the short run.
The second meaning makes reference to long-run problems. #n
developing countries! *development+ means! in the first place! approaching
the per capita <G@ of industrialized countries and! hence! developmental
success means reducing the income gap between the countr" under
consideration and the wealthier ones. #n this wa"! achieving a rate of growth
in overall productivit" which is higher than the average rate observed in the
developed world becomes a ke" target for economic polic". A countr" whose
productivit" increases surpasses the rest of the world,s is a competitive
countr". #n this conte$t! however! appealing to the concept of competitiveness
does not seem to be too compelling. #t would be! at most! a fanc" wa" of
labeling productivit" differences between countries. The picture changes!
however! if we take into account two issues. 0irst! the *endogenous growth+
approach to the linkages between the trade specialisation pattern and growth
and! second! the relationship between growth prospects and the abilit" to pa"
in an uncertain world.
At the micro level! it is normal for a growing econom" to e$perience
rising and falling abilit" to compete in different industries! since productivit"
growth is not an uniform process across sectors. ;owever! if the countr" is
losing competitiveness in man" industries simultaneousl"! the loss of
competitiveness can be caused either b" a misalignment of domestic costs or
b" low average productivit" growth vis-a-vis the rest of the world. #f the
problem is the misalignment of relative prices! depreciation of the currenc" or
deflation ma" be the cure. ;owever! if the problem is lagging productivit"! we
should not take it for granted a priori that changing the real e$change rate will
help to enhance competitiveness. &hen we take into account the micro
dimension of the problem! it is clear that if a countr" specializes in the least
d"namic industries (with flat learning curves! low returns to scale! small scope
for innovation) it will en%o" little productivit" growth and will lose
competitiveness. #f this is the case! it is plausible to think that changing
relative prices could at best be onl" part of the response from a long-run
perspective. The real problem lies in the fact that the specialization pattern
generates a lagging path of productivit". #n this sense! long-run
2=
competitiveness means the abilit" to gain market share through productivit"
enhancement rather than b" *artificiall"+ lowering domestic costs. 0or
e$ample! if the authorities attempted to gain competitiveness b" setting real
wages below the level of real wages in countries with similar productivit"
levels! the outcome would probabl" not be long lasting. #n the long run!
market forces would likel" force a rise in real wages given the consistenc"
that tends to e$ist between productivit" and wages. #n this wa"! gaining
competitiveness via productivit" rather than via low real wages is much more
credible. 'ertainl"! in a world of uncertaint" it is not that eas" to determine the
*correct+ level of domestic costs. -ut! if a countr" is increasing its market
share without reducing real wages! that would be a strong indication of rising
productivit" and! hence! of growth potential. Therefore! in an uncertain setting
in which it is ver" difficult to assess a countr",s growth prospects! it is onl"
natural that long-run competitiveness becomes an indicator of growth
potential.
As we have alread" noticed! %udging a countr",s abilit" to pa" is
difficult when there is uncertaint". &e argued that one wa" of signaling an
abilit" to pa" is to strengthen liuidit" in the short run. -ut! obviousl"! the
countr" must also be able to honor its debt services in the long run. And for
this! it is solvenc" rather than liuidit" that matters. /ne critical indicator of
solvenc" is the countr",s growth prospects and! since there is a strong linkage
between long-run competitiveness and growth! the former becomes a
determinant of the investor,s perception of growth sustainabilit". This creates
a linkage between long-run competitiveness and credit-worthiness. #n such a
conte$t! an economic polic" oriented at increasing the countr",s market share
in global e$ports makes sense. The enhancement of competitiveness in the
long run ensures sustainabilit" and reduces the probabilit" of being rationed
out. #n sum! this means that trade specialization patterns! productivit" growth
and current-account sustainabilit" are not independent phenomena. #n a sense!
sustainabilit" is the name for long-run competitiveness.
Competitiveness, imper6ections, and t.e sustainability o6 0ro/t.'
:hort-run competitiveness has strong linkages with liuidit" and long-
run competitiveness with solvenc". #n practice! nonetheless! it is ver" difficult
to disentangle in which sense competitiveness is being used. :ometimes it
refers to a short-run misalignment of relative prices creating balance-of-
pa"ment difficulties and at other times it refers to a tendenc" for the countr" to
27
show a lagging growth in productivit" compared to the rest of the world and!
hence! to e$perience sustainabilit" problems. 0rom m" point of view! the
origin of this confusion is the fact that *competitiveness+ is a comple$ issue
which has price and non-price dimensions and which embraces micro and
macro elements which interact with each other. To conclude our discussion! #
will tr" to classif" the different dimensions of competitiveness and
sustainabilit". To separate the long- and short-run components! # will make use
of the diagram in 0igure # and of 3aldor,s distinction between price and non-
price determinants of competitiveness.
I"SE$# FI,&$E I
/ne important feature of developing economies is the high degree of
uncertaint" and the abundance of enforcement and as"mmetric information
problems. #n such an environment! the solvenc" of a countr" is ver" difficult
to evaluate. The upper half of 0igure #! highlights the elements which are
associated with this fact. The thick arrow going from competitiveness to
sustainabilit" means that! in a situation in which the econom",s solvenc"
might turn doubtful and fall under scrutin"! competitiveness matters to growth
sustainabilit". /n each side of this arrow! there is a bo$. /ne represents the
macroeconom" and the other the imperfections in the international capital
markets.
The arrow %oining the macroeconom",s bo$ with competitiveness
represents the kinds of phenomena we have alread" discussed! such as the
short-run real e$change rate or aggregate demand misalignments. The
macroeconom" includes8 first! the characteristics of the e$change regime and
the degree of price fle$ibilit"H second! the monetar" and fiscal regimes and the
e$tent of financial market segmentationH and! third! the characteristics of the
stochastic processes generating the observed values of macroeconomic
variables! including volatilit". The arrow pointing to sustainabilit" suggests
that under certain circumstances short-run macroeconomic imbalances and4or
volatilit" of aggregate variables ma" raise doubts about the countr",s
solvenc".
The bo$ corresponding to failures in international capital markets and
the arrows %oining it with the other bo$es highlight two facts that we have
alread" anal"sed. 0irst! the failures in the world,s capital markets give rise to
2?
liuidit" constraints which make short-run competitiveness relevant for both
macroeconomic euilibrium and financial stabilit". :econd! the
incompleteness of capital markets are a source of uncertaint". Fncertaint"
creates the link between long-run success in world markets and the evaluation
of a countr",s abilit" to pa".
/n each side of the competitiveness bo$! there is a rectangle. The" state
that the structural characteristics of the traded sector and of the integration in
the global econom" affect the countr",s abilit" to compete in both the short
and the long run. The traditional theor" of international trade emphasizes
efficient resource allocation and endowment as the main e$planation for a
countr"Ls specialization pattern. The pattern of specialization and trade does not
depend on absolute but rather relative production costs which! under certain
conditions! are determined b" relative factor endowments. The KnewK trade
theor"! however! has assumed awa" perfect markets and clarified the role of
economies of scale! e$ternalities! learning b" doing! technical progress! product
differentiation and oligopolistic and monopolistic competition. #n addition! the
real world is plagued with protectionism and regional agreements and the
developing countries, domestic economies show marked inter and intra-
sectoral differences in productivit" due to the presence of the alread"-
mentioned dualit" phenomena. #n such a world of imperfect market structures!
government intervention and dualit"! the wa" in which a countr" integrates in
the world econom" is relevant to competitiveness. 0or e$ample! the developed
countries, protectionism in agriculture and the 5ercosur agreement pla"
critical roles in determining Argentina,s specialisation pattern and overall
competitiveness.
The structural features of the traded sector and integration affect
competitiveness in man" wa"s. -ut there are three points that should be
highlighted in the present conte$t. The first is that the specific features of the
trade specialisation pattern ma" affect productivit" growth and! hence! have a
bearing on growth sustainabilit". A natural-resource-e$porting countr" ma"
show a lagging productivit" pattern. According to :achs and &erner (())7)!
Gucth-Gesease effects ma" render the *static+ euilibrium inefficient if it
impedes the econom" from developing backward and forward linkages!
learning! and taking advantage of e$ternalities. The second is that a countr"
specialising in natural resources ma" show higher variance in net foreign
e$change cash flows. #n an incomplete market setting in which developing
countries face serious obstacles to risk diversification! higher variance means
higher risk. 0or e$ample! a countr" which depends on the surplus generated b" a
2A
small set of products with high price volatilit" to close the e$ternal gap! can be
more unstable than another with a more diversified surplus structure (0anelli!
2000). #n this wa"! the trade specialization pattern might be a source of
macroeconomic instabilit" per se. The third is that a countr" which depends on a
volatile surplus of primar" products to finance capital imports ma" e$perience a
volatile accumulation of ph"sical capital and that ma" hinder growth.

3rice and non-price competitiveness
A convenient wa" to introduce into the anal"sis the distinction between the
short- and long-run factors affecting competitiveness is to distinguish between
price and non-price competitiveness. This is the reason wh" the bo$
corresponding to competitiveness is divided into two parts. @rice
competitiveness measures a countr",s abilit" to increase its share in world
markets b" selling at a lower price than its competitors. #f price
competitiveness were all that mattered! a countr",s market share would rise
(fall) as its real e$change rate or unit labor cost fell (rose) vis-N-vis the rest of
the world. The limitations of price-competitiveness indicators! however! came
to the forefront when 3aldor (()A6) found that the industrialised countries
which gained market share (&est <erman" and Oapan) were also the ones that
e$perienced a rise in unit labor costs vis-N-vis its competitors. 3aldor,s
*parado$+ suggests that non-price factors determining competitiveness must
also be taken into account (0agerberg!()66) .
)
The five ovals in the center of
the diagram show the price and non-price components of competitiveness. The
main determinants of the former are domestic costs and productivit"! while
those of the latter are product differentiation (ualit" and variet")! financing
and capacit" to deliver.
&e have alread" discussed that there must be a consistenc" between an
econom",s absolute advantage! determined b" its overall productivit" level!
and domestic costs. :hort-run macroeconomic factors such as price fle$ibilit"
and the e$change regime! are critical in this regard and so are others! longer-
run determinants of domestic costs such as the ta$ structure and institutional
)
The inclusion of pro$ies of technological activit" (.PG investments! patents granted) and productive
capacit" (capital stock growth! investment rates) in regressions e$plaining market shares or trade flows
"ielded the *right+ signs for the estimated coefficients of price-competitiveness indicators (0agerberg (()66)!
Amendola et al. (())1) and AgQnor (())A)). The anal"tical underpinnings of non-price competitiveness
determinants are to be found in the new theories on trade and growth as e$plained! for instance! b" ;elpman
and 3rugman (()67) and <rossman and ;elpman (())(). /ther contributions stem from endogenous growth
theor". 0or a comprehensive and consistent presentation of this issue! see Aghion and ;owitt (())A).
26
factors (bureaucrac"! regulations and the like). This e$plains the arrow %oining
institutions and domestic costs.
The inclusion of non-price factors in the picture naturall" leads our
discussion toward the long run and reuires an approach more akin to the
:chumpeterian view of development. :pecificall"! this reuires recognising
the ke" role of technolog" and innovation and of financial constraints. #n
:chumpeterian models of growth in an open econom" the rate of technical
progress and the pattern of international trade are %ointl" and endogenousl"
determined and d"namic comparative advantages becomes a critical factor
(Aghion and ;owitt! ())A). :"stemic factors also need to be integrated into
the anal"sis because technological development significantl" depends on the
e$istence of a suitable environment for entrepreneurship! investment in
human and ph"sical capital! learning! and innovation. The lowest rectangles
in 0igure # show the most relevant s"stemic factors that are usuall"
highlighted in the literature8 the stock of ph"sical and human capital! the
institutional infrastructure! the level of financial deepening! and the ualit" of
the national s"stem of innovation. As the arrows %oining the different s"stemic
elements show! the" are not independent of each other. #nstitutions are critical
to the development of financial intermediaries and of a strong national
innovation s"stem as the literature on transaction costs and industrial
organisation has demonstrated. 0inancial institutions! in turn! are crucial to
investment to the e$tent that the" pla" a ke" role facilitating risk management
and the intertemporal allocation of resources. Likewise! in a :chumpeterian
world! entrepreneurs and innovators criticall" depend on credit markets.
This completes m" schematic presentation of the factors that have a
bearing on competitiveness and sustainabilit". # will conclude establishing the
linkages with the discussion on micro4macro interactions in the previous
section. Let us first e$amine the effects which run from macro to micro and
which ma" induce long-lasting changes. /n the basis of 0igure #! we can
imagine several channels through which macroeconomic variables ma"
contribute to shaping the morpholog" of the microeconomic structure. # would
like to stress how macroeconomic variables can affect productivit" and the
s"stemic determinants of non-price competitiveness.
Assume an unstable macroeconomic setting in which macroeconomic
diseuilibria of considerable size are recurrent and! hence! the evolution of
prices! uantities and financial variables is rather volatile. This will be ver"
harmful to the relative prices, abilit" to transmit information and provide
2)
agents with the correct incentives for investment and innovation. &hen prices
are too nois"! the market structure weakens. :ome markets disappear while
others become too thin. 0or e$ample! high inflation and uncertaint" are
primar" causes of low financial deepening. The" also e$plain the tendenc" for
the length of contracts to shorten and the investors, propensit" to fl" to
ualit". Likewise! an environment of uncertaint" is not the best for the
development of a strong institutional network. An uncertain environment is
one characterized b" unfulfilled e$pectations and contracts which are thereb"
difficult to meet e$ post. >either is it a suitable environment for the
strengthening of fiscal institutions. .ecurrent fiscal crises are inimical to
investment in human capital and the consolidation of the national s"stem of
innovation.
This kind of setting ma" create a severe anti-risk,taking bias in the
selection of investment pro%ects with its conseuences on the non-price micro
determinants of competitiveness and productivit"! such as the level of
financial deepening! the abilit" to learn and innovate! and the capacit" to
develop institutions. 0or e$ample! suppose that trade liberalization eliminates
an anti-e$port bias in the structure of relative prices. #n the new scenario one
would e$pect that firms will be restructured to take advantage of the trade
opportunities offered. -ut assume! additionall"! that the transition period
toward the new euilibrium is characterized b" a certain degree of
macroeconomic instabilit" and financial fragilit". #n such an environment! the
firms will face difficulties in obtaining the necessar" funds for restructuring.
#n a segmented market! it is highl" probable that onl" multinationals and
larger national firms will be able to finance their pro%ects. 5an" potential
entrepreneurs will suffer from the scarcit" of funds generated b" the flight to
ualit" and will be rationed out of the market. #f their pro%ects can be
undertaken b" larger firms! there will be distribution effects but social
profitabilit" will not suffer that much. #f! on the contrar"! larger firms do not
undertake the pro%ect because the" do not know how to do it! have problems
of scale or an" other reason! there will be a net loss for societ". The abilit" to
compete will be permanentl" affected. These kinds of micro-macro
interactions ma"! perhaps! e$plain wh" man" developing countries e$perience
serious difficulties in developing an entrepreneurial class and a more complete
market structure. These con%ectures are in line with the h"pothesis that finance
matters and! specificall"! matters to comparative advantage. #n fact!
combining .a%an and Mingales, (())6) assumptions about e$ternal
dependenc" ratios with the anal"ses of trade specialization pattern and firmsI
10
capital structure! we have found additional support for the h"pothesis that the
level of financial deepening impacts competitiveness and trade patterns.
0inall"! the forces which run from micro to macro are intimatel" related
to the kinds of market failures and institutional weaknesses we have identified
in this paper. #t must be taken into account that market incompleteness creates
coordination failures at the aggregate level and that the market structure is
much more incomplete in developing than in developed countries. This gives
rise to economic settings in which attaining the aggregate consistenc" of
decentralized plans is more difficult and! hence! coordination failures are more
freuent while macroeconomic diseuilibria tend to be deeper. Geveloped
countries have sophisticated non-market institutions and fiscal and monetar"
tools which proved to be appropriate and powerful at preventing diseuilibria
or! at least! at limiting their magnitude and duration. The low ualit" of its
institutions have freuentl" impeded developing countries from successfull"
using non-market stabilizing instruments.
The final outcome of weak markets and institutions is higher volatilit"
of stochastic processes. 0rom our discussion it follows that! on the financial
side! international market failures and lack of domestic financial deepening
pla" a critical role. The" feed volatilit" to the e$tent that the" create liuidit"
constraints and make it ver" difficult to manage risks and intertemporal
allocation. /n the real side! we must highlight the lack of price fle$ibilit" and
short-term contracts. &e have also seen that dualit" and a freuentl"
rudimentar" specialization pattern are microeconomic elements that ma" have
a permanent bearing on coordination failures and volatilit".
1(

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1=