Latin America and the Great Depression

As many U.S. and European analysts dusted off that dismal word—”depression”—to describe the current global crisis, a majority of Latin American leaders vehemently disclaimed any possibility of seeing their economies seriously affected by external factors.

This attitude, however, is quite understandable since dominant populist leaders of the region loathe recognizing harsh economic realities. Thus they are not prepared to survey their own countries’ historical experiences to draw teachings for today’s plights.

Nevertheless, it is reasonable to think that many concerned parties—for example, sincerely concerned government officials, as well as businessmen, economic scholars and union leaders—would benefit from a thorough examination of how our republics grappled with the problems that turned up in the early 1930s.

Probing into Latin America’s multifarious national economic performances in times past might help answer questions such as which of our countries experienced the least extreme and the most extreme circumstances during the 1930s. It could also contribute to a better understanding of the international transmission of business cycles.

First Effects: Trade and Fixed Exchange Rates

On the eve of the Great Depression, Latin American economies continued to follow an export-led development model that prevailed ever since most of our nations became independent in the 1820s of the nineteenth century. Even the largest economies were still heavily trade-dependent in the late 1920s, and had relatively small industrial sectors. This model left them highly vulnerable to adverse conditions in the world markets for commodities.

Consider: During the late 1920s, three leading export products accounted for at least 50 percent of foreign-exchange earnings and one product accounted for more than 50 percent in ten countries of the twenty republics.

Virtually all export earnings came from primary products and nearly 70 percent of external trade was conducted with only four countries: to wit Great Britain, the United States, France, and Germany. The dependence of the public sector on foreign trade taxes was also high. In Chile, for example, it was over 50 percent during the 1920s.

Furthermore, the slow growth of British economy in the 1920s—as well as the adoption by Great Britain of an overvalued parity for the pound sterling—was a blow to many of our countries that traditionally had looked to Great Britain as a market for their primary products.

On the other hand, the emergence of the United States as the dominant economic power was little consolation for those of our republics that sold their goods in competition with U.S. farmers. The new role of the United States as a global economic power did not bring about any reduction of its protectionist tendencies. Indeed, the main change in the world trading system in the 1930s was the growth of protectionism. The notorious U.S. Smoot-Hawley tariff and Great Britain’s retreat behind a system of imperial preference left Latin America facing discriminatory tariffs in both its largest markets.

At the same time, however, the United States rapidly expanded as a major source of foreign capital for Latin America.

The initial Latin American response to the collapse of 1929 was the orthodox reaction under a gold-standard exchange rate system. The reduced foreign demand for Latin American goods caused gold and foreign exchange to flow out of Latin America faster than they came in. Thus, internal deflation added to the impact of the collapse of exports. The collapse of exports led to a great fall in employment. Departure from the strict gold standard rules of the period would have a strong effect on the ensuing Latin American foreign debt crisis.

The abandonment of gold standard rules after 1931 led to a series of debt defaults throughout the region. Depreciation of the exchange rate made the burden of the debt on the budget simply intolerable.

By 1934, only Argentina, Honduras, Haiti and the Dominican Republic had not defaulted. Having already paid off its debt, Venezuela did not need to default. That is only five countries out of twenty.

Yet in a manner that would have been unthinkable in the 1980s, the international financial markets allowed nonpayment. The reason for this was the numerical importance of individual bond holders. Unlike the 1980s, when all kinds of institutions predominated, these individual bond holders had little bargaining power. Consequently, nonpayment soon increased foreign exchange availability by as much as 20 percent.

The appearance of dynamic American capital markets came about at an opportune moment in view of dwindling capital surplus from traditional European markets. Some scholars have deemed this credit surge a mixed blessing. According to economic historian Victor Bulmer-Thomas,

In the smaller republics the new lending was intertwined with U.S. foreign-policy objectives, and many countries found themselves obliged to submit to U.S. control of the customs house or even national railways to ensure prompt debt payment. In some of the larger republics reached such epidemic proportions that it became known as “the dance of the millions”. Little effort was made to ensure that the funds were invested productively in projects that could guarantee payment in foreign exchange, and the scale of corruption in a few cases reached pharaonic proportions. U.S. officials might occupy then customs house in pursuit of fiscal rectitude but they had little or no control over U.S. bankers issuing bonds to cover widening public-sector deficits.1

The onset of the Great Depression is usually associated with the stock-market crash on Wall Street in October 1929, but for Latin America some of the warning signals came earlier. Commodity prices in many cases peaked even before the crash, as supply—which had been restored after the WWI disruptions—started to outstrip demand. The price of Brazilian coffee, for instance, reached its maximum in March 1929; Cuban sugar, in March 1928; and Argentine wheat, in May 1927.

The boom in the stock market leading up to the Wall Street crash was accompanied by an excess demand for credit and a rise in world interest rates, raising the cost of holding inventories and reducing demand for many of the primary products exported by Latin America. The rise in interest rates put additional pressure on Latin America via the capital market. Flight capital—attracted by higher rates of interest outside the region—increased, while capital inflows declined as foreign investor took advantage of the more attractive rates of return offered in London, Paris or New York. The whole financial system came under severe pressure.

The fall in the value of financial assets after the 1929 stock market crash reduced consumer demand. Loan defaults led to a squeeze on new credit. Interest rates began to fall in late 1929, but importers were unable or unwilling to rebuild stocks of primary products fearing more credit restrictions and a steeper fall in demand. The fall in primary-product prices was truly dramatic and every Latin American country was affected.

Between 1928 and 1932 the unit value of exports fell by more than 50 percent in most of the countries for which data is available; the only countries with a modest fall in unit values were Venezuela and Honduras (oil, bananas), where the prices were administered by foreign companies and were not an accurate reflection of markets forces.

Financial Sector Recovery

The global depression that began at the end of the 1920s was transmitted to Latin America through the external sector but, to be sure, there was also an equally impressive and rapid recovery to the Latin American financial sector. Depression in Europe and the United States meant a catastrophic crisis of the financial system of the developed countries, with runs on deposits and bank collapses a common experience. By contrast, Latin America came through the worst years of the Depression with only modest damages to its financial system.

The stability of the Latin American financial system was all the more remarkable in view of the close relationship between many banks and the export sector. The close links between banks in Latin America and foreign financial institutions had also led to a high degree of dependence on foreign funds.

Yet several factors helped to mitigate the situation and contributed to the survival of the Latin American banking system. Probably the most powerful reason for this was the wholesale financial reforms of the 1920s, spurred on in many cases by Professor Edwin Walter Kemmerer. He was responsible for the creation of many central banks and other typical institutions of a modern monetary system, as well as elements of a modern taxation system.

The reforms advocated by the celebrated “Bank Doctor” led to the creation of a much more centralized financial system which already had clearly defined rules by the time the Great Depression came about. Once the abandonment of the gold standard rules became universally acceptable, a minority of smaller countries in the region pegged their currencies to the U.S. dollar. Most republics opted for a managed multiple exchange-rate system.

In 1945, after the Bretton-Woods Conference, the newly formed International Monetary Fund (IMF) found that thirteen of the fourteen countries in the world that operated multiple exchange-rate systems were in Latin America.

The novelties introduced in the financial system meant that in many countries cash-reserve ratios were far above the legal limits, so it was easier to absorb the inevitable decline in deposits. The existence of exchange control kept a number of banks from having to make payments of interests or capital to foreign creditors that might have bankrupted the institutions.

Another reason for the survival of the banking system was its role in funding Latin American governments’ budget deficits during the 1930s. Bank funding of the deficits contributed in a large extent to the rise of prices throughout Latin America after the 1930s, but inflation remained moderate. Eventually, the export sector recovered and the banks were able to return to a more normal relationship with many of their traditional clients.

Government Responses

It can be said that in Latin America the Great Depression years took the form of a strong imperative for change and that the general record of capacity for change was impressive. In the face of a generally hostile external environment, most republics did well to rebuild their export sectors. Obviously, this response capacity varied greatly across countries.

With the important exceptions of Argentina and Colombia, most countries based their recovery from the Depression mainly on the export sector.

In Colombia, the export sector growth during the late 1930s was overshadowed by a remarkable rise of the manufacturing sector, particularly in textile production. In Argentina, the export sector—meat, wheat—stagnated in real terms, but recovery was made possible thanks to the performance of the nonexport sector, notably industry, transport and construction. Mexico benefited from major reforms in land tenure as well as from an expanding nationalized oil industry.

Though Brazil recorded an important export recovery towards the end of the 1930s, its economy began to shift in favor of industry.

In Cuba, however, the impact of the Great Depression was devastating. The New Deal trade agreement eased U.S. manufacturers’ access to the Cuban market while the entrenched dependence on sugar forced the economy to remain completely tied to that good thus ensuring failure for any diversification project.

Conclusion

The Great Depression forced many Latin American governments and economic élites to make tough decisions in exchange-rate, monetary and fiscal policies. These choices marked a stark departure from the model that had prevailed in the region for nearly a century. We could say that the new model entailed an “industrialization response” to the crisis.

Thus Argentina, Brazil, Mexico, Colombia and, to a lesser extent, Chile and Uruguay took advantage of extraordinary conditions of limited duration faced by the manufacturing sector once the domestic demand began to recover.

In the rest of our countries, though in a comparatively less pronounced way, the expansion of land and labor permitted a significant diversification in agriculture. In most cases, default on the debt was possible without sanctions because neither loans nor direct investment could be expected in those hard times.

As Rosemary Thorp points out in her 1998 book Progress, Poverty and Exclusion: An Economic History of Latin America in the XX Century, “The flexible if unkind world of the 1930s allowed ‘recovery’ through bankruptcies, squeezing of margins and even hunger in the form of reduced wages… Inflation did not eliminate the benefits of exchange-rate devaluation so exports could be stimulated… All this foreshadows in mirror image the telling of a very different tale 50 years later”.

Changes brought about in response to the impact of the Great Depression were sufficient to permit the 1930s to be described as marking the definitive Latin American transition from export-led growth to inward-looking development.