Aggregate Volatility in Modern Latin America : Causes and Cures

Latin America has experienced deep transformations during the 1990s. In many countries of the region traditional imbalances have been largely abated, privatizations are widespread, openness of both trade and financial accounts has been largely accomplished, supervisory and enforcement institutions are steadily improving, pension systems have been modernized, and so on. Symptoms of success abound. An important exception to this rosy scenario is the untamed and widespread volatility of real and financial variables. Rather than attempting to characterize every possible shock and amplification mechanism, this paper offers a parsimonious account of volatility in countries that have already tamed most of the traditional sources of macroeconomic instability in Latin America. It builds on two widely observed weaknesses: (i) weak links with international financial markets, and (ii) underdeveloped domestic financial markets. Once interacting, these two ingredients not only explain the observed volatility but they also generate clear externalities that require policy intervention. This framework thus provides a clear foundation for policy analysis. Most other shocks and deficiencies are leveraged - even made possible - by these two factors. Moreover, to the frustration of highly competent policymakers, the environment becomes intolerant of policy mistakes