Markets and populism in Latin America

As the year draws to a close, Latin America clearly stands out as the region with the world's worst stock-market performance, down around -19% versus +12% for the world as a whole. This is happening despite the economic damage having been smaller than in Europe and despite lower exposure to oil than other emerging markets. There are obviously many explanations behind this, such as financial vulnerability and weaker fiscal effort. However, I want to focus on one that has drawn a lot of attention lately: the risk of populism.

Populism is as old as democracy itself, but it wasn't until we gained a better understanding of economic fluctuations and macroeconomics in general that its disastrous long-term effects became clear. In very simple terms, a policy is called populist when it seeks to harm the interests of the elite in order to defend those of the common citizen. Unfortunately, as history has shown time and again, these policies generally achieve the goal of harming the elite, but not their vindicating purpose regarding the well-being of the common citizen, who usually ends up even worse off. This is a vicious cycle, since bad policies generate lower growth and greater inequality, once again increasing the incentives for populist policies.

An extremely clear example of this is the string of policies the Argentine government has adopted over the past year, approving wealth taxes, suspending bill payments, imposing layoffs, freezing salaries, partially nationalizing companies and much more. Although all of those policies seem to benefit people in the short term, both experience and economic theory show us that in the medium term they generate weaker incentives to invest, work and grow.

As the history of the 20th century clearly demonstrates, the region is fertile ground for populism, and economic crises like the current one naturally increase its risk by deepening economic inequalities. On the other hand, in much of the region, including Chile, there is strong political fragmentation resulting from the incompatibility of proportional electoral systems with presidential political regimes, which creates perverse incentives and exacerbates political polarization. The clearest example of this is what has happened in Peru over the past month.

But not all is lost. In recent decades, institutions in Latin America have strengthened, the body of economic evidence against adopting populist measures has accumulated, and voters have become better informed. Today we know that, regardless of political stripe, there are no shortcuts to achieving greater equality and well-being for the general population; it requires good, well-managed public policy.

A paradigmatic example of this is Ireland's tax structure which, despite having a fully pro-business approach with low rates, results in very low levels of inequality after taxes and transfers are applied.

This will probably be the toughest test in years for the region's financial markets, and how this challenge is navigated will depend on citizens' responsibility through the tools of democracy.