Fewer barriers to labor movement – a recipe for industrialization and growth in Central America?

The Industrial Revolution was a defining moment in economic history, which ignited a period of Great Divergence, allowing industrializing nations to break away from the rest. Naturally, industrialization is often considered an engine of growth. But deindustrialization is also a robust fact of economic development.  After reaching a peak, the share of industry in the economy eventually starts waning. This fall causes considerable anxiety as policymakers worry that absent an effective strategy that can arrest the sector's slide, future economic growth will be in jeopardy. As a result, industrial expansion is often a component of several growth policies. This focus on the sector transcends the boundaries of developing (Made in China 2025; Make in India) and developed (American Jobs Plan) nations.

What should governments do to foster industrialization?

Will a standard approach work, or will country-specific policies be more effective? In a recent working paper, I try and tackle these questions by focusing on six Central American economies. These countries are small, with populations ranging between 4–17 million people. Previous country-level analyses of industry trends cover only a handful of economies, with small and low-income economies like those in Central America particularly under-represented. If factors driving deindustrialization differ across the countries – as I find them to be – then adopting a standard approach and using learnings from earlier studies will be of limited use. 

Data shows that deindustrialization has permeated Central America. Except for Panama, the industrial employment shares have contracted in each regional economy, with an average decline of 2.5 percentage points (pp). Several factors could explain this fall in industrial share:

1. A rise in industrial imports substituting domestic production could have caused trade-induced deindustrialization.
2. This decline could have been demand-driven, i.e., driven by a contraction in the industrial share of final consumption.
3. Industrial shares could have declined because of a rise in labor market barriers that prevent workers from entering the sector.

The analysis shows that the often-cited trade-led deindustrialization hypothesis does not apply to Central America. Rather than creating headwinds, trade has usually aided industrial expansion. Nicaragua and El Salvador are the two exceptions where the trade hypothesis holds. But the channel's quantitative impact is benign in both cases. Final consumption, too, shifted towards industrial goods in general, creating tailwinds for the industry. Instead, the primary reason why Central America underwent deindustrialization is that it became increasingly difficult for labor to enter the sector. (Note that workers face barriers when trying to enter the services sector too, and in every country except Nicaragua, these have been on an uptrend too). Though ubiquitous, the channel's impact varied across countries. For instance, if other channels remained dormant, a rise in barriers would have compressed industrial employment shares by more than 5 pp in Panama and El Salvador. In contrast, the corresponding decay in Costa Rica would have been less than a pp.

The above findings suggest that targeting labor market barriers can foster industrialization in Central America. There are two policy alternatives here . One entails a sector-neutral approach that seeks to eliminate barriers in both industry and services. The other is to take a sector-specific approach that focuses solely on reducing the industrial barriers.

The sector-neutral approach can boost the industrial employment share by 3.5 pp on average (Figure 1A, red bars), with modest gains in El Salvador and Honduras (1.3-1.7 pp). Potential expansions are much higher in Nicaragua (6.6 pp) and Panama (4.4 pp). On the other hand, the industry experiences considerably higher inflows under the sector-specific approach (Figure 1A, gray bars). Each regional economy experiences robust double-digit gain, with Panama (32 pp) outperforming the others.

The sector-neutral approach eliminates barriers in industry and services, whereas the sector-specific approach targets the industrial barriers only.

Yet, as previously mentioned, industrialization is only an interim target and is helpful only to the extent that it helps achieve the end goal – boosting growth . The sector-neutral strategy that eliminates barriers in both industry and services reduces inefficiencies associated with resource allocation. However, my estimates of such efficiency gains for Central America are not sizable. The output boost generated by the policy is only 2 percent on average, with figures for individual countries lying between 0.3 to 3.2 percent (Figure 1B, red bars).

On the other hand, the sector-specific approach that targets only industrial barriers leads to an economic contraction in five of the six regional economies (Figure 1B, gray bars). What causes this negative fallout is that selectively targeting one sector still leaves the economy distorted. Barriers in either sector do not individually bear an inverse relationship with economic efficiency. As it turns out, the distorted economies with only barriers in services are relatively more inefficient than the initial distorted states. Hence, to attain efficiency gains, it is critical to make it easier for labor to enter both industry and services.

Does it make sense for Central America to adopt a policy that promotes industrialization through reductions in labor market barriers?

Unfortunately, there are many risks associated with such an approach. First, as already noted above, a sector-focused approach that selectively targets industrial barriers can lead the economy to a more distorted state, causing a decline in output. Second, the barriers can originate from several sources, making their identification extremely difficult. This identification problem can make even a sector-neutral approach a risky proposition, as a misidentification might lead to interventions that not only do not reduce barriers but also waste scarce resources. On the other hand, even if the policy successfully carries out the difficult tasks of identifying the sources and implementing necessary interventions, the expected efficiency gains remain meager.

Given the risks associated with the wedge-driven industrialization policies, perhaps a better strategy will be to concentrate on productivity growth , which certainly is not easy to achieve. But given the marginal gains from the barrier mitigating policies that promote industrial expansion, it might be prudent to pursue this ambitious task as it has a direct and relatively more significant impact on growth. One must note, however, that achieving industrial productivity improvements may not always be the most straightforward option. Because productivity in the non-industrial sectors, especially services, lies far behind the global frontier in many countries, it might be easier to achieve productivity growth in them.