Knowledge Bank

This paper examines the external and domestic determinants of the economic crisis experienced by the Central American nations in the 1980s. Both long-term, structural trends, and short-term, unfavorable shocks contributed to the crisis. Protectionist import-substitution industrialization caused stagnation and reduced flexibility in adjusting to external shocks. Borrowing abroad made it possible to postpone required adjustments. Most reconstruction programs recommend massive flows of foreign financial assistance for Central America. The paper critically reviews the role of financial assistance, particularly in the light of political-economy pressures that lead to fiscal deficits, and claims that too much aid causes delays in needed policy reforms. Given the urgency of becoming competitive in world markets, the paper is pessimistic about the role of the Central American Common Market, beyond providing free trade within the region.