Backcasting Latin America

• Author: Luis A.V. Catão
• Position: Senior Economist in the IMF's Research Department, currently on leave at the Inter-American Development Bank
• Pages: 39-43

Page 39

Looking back at the business cycle in one of the most volatile regions requires reconstructing GDP data

Latin america is traditionally seen as economically volatile. Yet there has been relatively little work on the evolution of business cycles in the region and on how their main features compare with those of other countries and regions. that is somewhat surprising because business cycle volatility can be influenced by policy regimes, and Latin america has had a fair number of dramatic regime changes. the region potentially could provide answers to such questions as, how do major shifts in policy regimes affect the business cycle, and are common external factors key to cyclical outcomes, perhaps as much as or even more so than policy regimes? But lack of data, especially before World War ii, has hampered such research. a new technique seeks to compensate for those data deficiencies by reconstructing, or backcasting, GDP data using methods similar to those that economists have employed to identify and forecast business cycles.

We know that Latin america has swung from policy regimes that were highly open to foreign trade and capital (in the half century before the Great Depression) to regimes that were extremely closed to such outside links (in the decades following the Great Depression). then, starting in the 1970s and more decidedly from the late 1980s, there was a return to a vigorous process of financial and trade liberalization.

But there has been much debate over which, if any, of these contrasting regimes has made the Latin american economies more volatile and their shocks more persistent, magnifying both the risk and the depth of economic crises. One view, which goes back to Raul Prebisch (1950), sees cyclical volatility in the region as emanating, by and large, from financial and trade openness, because shocks to primary commodity prices and world interest rates, as well as the debt crises that often follow, tend to exacerbate output volatility. a contrasting viewPage 40 maintains that openness mitigates policy-induced volatility because of its disciplinary effects-open economies face a less acute employment and inflation trade-off (Romer, 1993) and higher costs of debt repudiation (Rose, 2005). a key question, then, is which view wins out when measured against the data?

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Another important issue is the extent to which closer international links have contributed to some commonality in business cycle behavior across the region and how commonality has evolved. this is of particular relevance to the iMF, which has responsibility for multilateral surveillance to ensure global financial stability. it is also relevant for institutions such as the World Bank and the inter-american Development Bank, which have significant portfolio exposure to the region. the strength of common business cycle factors could account for what are perceived as virulent "contagion" episodes, which make it extremely difficult for the countries to repay their debts at around the same time. Moreover, the stronger the common business cycle factor in a region, the smaller the value of risk sharing among the countries. that wouldPage 41 affect the soundness of such policy initiatives as creation of a regional development bank or cooperation among regional central banks to provide liquidity during financial crises.

Creating a new set of data

To address these questions from a broader historical perspective, researchers need business cycle indicators that span the various policy regimes. Such historical GDP data have been unavailable or unreliable for Latin america, notably for pre- World War ii years, and the deficient data can produce inaccurate inferences from interperiod comparisons of cyclical behavior in these countries, leading to potentially misleading conclusions about crucial policy issues.

Against this background, we developed a new methodology for real GDP reconstruction that seeks to fill this data gap (aiolfi, Catão, and timmerman, 2006). in this new methodology, we show that reasonably accurate estimates of the aggregate business cycle can be constructed from a sensible combination of macroeconomic, financial, and sectoral indicators for which...