14 Points

Q: Moving to the domestic arena, what do you think are the challenges in Latin America in terms of economic growth? Which do you think should be the areas that countries in the region should be paying more attention to?

ERH: Tracing some of the history of Latin America, we can see that we first had the Import Substitution (ISI) model that to some extent failed in the 1980’s, thereby creating a series of economic crises in the region. Then we observed in the late 1980’s, and in the 1990’s, a process of liberalization that was promising in the beginning, but it was incomplete, and to the extent that this was the case, it failed in many countries. Specifically, the process of liberalization failed in the sense that it didn’t deliver the rates of growth that we were expecting. This is certainly the case in Argentina and Mexico.

But we also have countries like Brazil, which have transitioned into becoming a free market economy more slowly. As for Mexico, we observed how this country opened its economy very aggressively when it still had a lot of constraints, particularly in local competition, preventing the country from taking off. Therefore, even though the country has benefited from liberalization, the fact that those reforms could not be done has created a problem for future growth.

The other problem in Latin America is that all the countries in the region have very unstable political systems. Once countries in the region liberalized, they had to carry through an array of economic reforms that have been very “expensive” because they have taken place in the context of an inappropriate institutional and political framework. This inadequate framework has prevented countries across the region from agreeing on a set of economic principles and from pushing forward a series of reforms. To that extent, the liberalization process is incomplete.

Q: Do you have any particular example in mind in terms of an economic reform that has been very costly in Latin America?

ERH: It was not that the economic reforms were costly; it is more that these were not made. The political reform, which is very important per se, substituted economic reforms - which are necessary for free-market economies to succeed. This is certainly the case for Mexico. Mexico for example, opened its borders to free trade, privatized a vast array of state-owned companies, the government in general decided to take a less active role in the economy, but the liberalization process was incomplete. The country therefore lacks a flexible labor market and an active antitrust legislation that could help break-up monopolies in the service, telecommunications and banking sectors of the economy. This then of course interacts with the country’s ability to export and attract FDI. Finally, as a result of similar experiences across the region, countries in Latin America have not, in general, experienced the benefits of the reforms carried out in the past two decades.

Q: Are you then referring to the second-generation reforms?

ERH: Yes, but only in the sense of the timing, since the reforms that I have been referring to are a prerequisite for the success of countries when opening their borders to free trade.

Q: I would to talk about your academic work, specifically about your paper entitled ‘A Spatial Theory of Trade.’ How would you summarize the main points of your theory to non-economists?

ERH: When we think about trade, and about restrictions to trade across countries, the standard analysis is done at the country level. So the view is that if two countries institute, say, a tariff, this is going to limit the level of trade that they have with each other. In turn, the basic point that I want to make in this paper is that it is important to think about trade in a more general way: as the distribution of economic activity in space. That is, trade takes place within countries and across countries, and when you impose frictions across countries, what is going to happen is that you are going to change the distribution of economic activity within countries.

This in turn, is going to have an important effect in terms of the elasticity of trade to trade barriers. In other words, we have to pay attention to how much trade changes when you impose these barriers. Why? Well, because the map of economic activity within countries is also going to change and the bottom line is that trade and the distribution of economic activity are essentially two sides of the same coin.

Q: What are the implications of your theory for policy?

ERH: The implication for policy is that it is very important to reduce trade barriers, precisely because they are going to have an amplification effect that comes from the distribution of economic activity in a given country. Small barriers to trade are going to bring about important reductions in the volumes of trade precisely because of internal supply reactions.

This in turn is related to the benefits that a country can experience from full integration between countries. Think for instance about the European Union and the benefits that full integration carries vis-à-vis a mere reduction of trade tariffs among a certain bloc of countries.

There is another point that I didn’t make in the paper to which you have referred to, but that I have made elsewhere, which has to do with the “internationalization of the production process.” Different parts of the production process take place now in different countries or in different locations within a country, and to the extent that this is the case, trade costs become more important. The reason for this is that goods have to cross borders many times. This makes the geographic aspects of the spatial distribution of economic activity a more important determinant of trade.

Q: In terms of the state of economics as a discipline, what do you think macroeconomics has been able to explain and what do you think are the aspects that remain unexplained?

ERH: Let me start with the big success that macroeconomics has had in the last 30 years. The biggest success has been that of understanding inflation, which has been reflected in the ability of governments to control inflation. Inflation used to be a big issue, but today, it is hardly a problem except for a few underdeveloped countries.

In terms of the challenges for the discipline, macroeconomists in particular are now trying to determine how to deal with heterogeneity. It used to be the case that we used models in macroeconomic theory that told us something about the relationship between aggregate variables. Now however, we are trying to understand exactly how that translates into the distribution of firms, the location and sizes of cities, and exactly how these different and intermediate forms of organization have evolved over time and what the impact is for aggregate outcomes.

So for example, if you think about growth, the basic theory dealt with the question of how to generate this phenomenon. This debate had been reduced to tracing differences in growth across countries to different rates of productivity growth. But now we are trying to go beyond that. We know that productivity growth takes place at the firm level, and in different ways across different firms. We are therefore keen to understand how firms are behaving in terms of their innovation activity and what this implies for both the size and distribution of firms. Of course this is crucial, because if we are going to implement a particular policy with the purpose of promoting innovation in underdeveloped countries, we need to understand how the process of innovation works within different firms.

In general then, macroeconomists are interested in incorporating heterogeneity in their models and the importance of this effort cannot be understated. It is necessary to understand for instance how inflation affects different agents, or how the distribution of economic activity varies across cities, because ultimately the understanding of these issues impacts the design and implementation of policy.