Friday, October 3, 2014

What macroeconomic policies were relevant for unemployment reduction in Latin America?

I was reading the book by Giovanni Andrea Cornia on Falling Inequality in Latin America, which suggests that the reduction of the skill premium and macroeconomic policies, together with the expansion of social assistant, in particular but not only by left of center governments, is behind the trend. I'll have more on some of the issues related to the skill premium, which rely heavily on both neoclassical labor market and trade theories. However, the chapter on the macroeconomic causes of reduced inequality caught my eye. The chapter, a previous version can be found here, written by Mario Damill and Roberto Frenkel says that:
"A competitive RER [Real Exchange Rate] provides a conductive environment for growth and development. This view has long been stressed by development economists* and recently documented in many econometric studies. The growth-enhancing attributes of a competitive RER operate through the enhancement of tradable sector profitability."
The idea is that a depreciated currency allows for more exports, less imports, a more relaxed current account, and higher levels of activity and employment. The real depreciation is expansionary. Also, the paper suggests that fiscal policies had been during the last decade more restrictive, and presumably this was a good thing. They say:
"...many countries implemented fiscal rules, fiscal responsibility laws or took discretional decisions oriented at correcting the pro-deficit bias of the past. In many countries these changes contributed to a generalized improvement in fiscal results as well as to a declining trajectory of the outstanding public debt."
Not clear why public debt in domestic currency was a problem. Arguably, they think that fiscal restraint was relevant for supposedly allowing for more price stability, since Frenkel usually has argued that inflation has been caused by excessive demand, which was also conducive to reduction in inequality.

However, the evidence in favor of these views is very thin at best. In fact, the whole mechanism by which a depreciated RER would lead to higher growth, lower unemployment and some improvement on income distribution, which is the change in relative prices and the effects on exports and imports, is never discussed. As I pointed out before, the best evidence still suggests that depreciation is contractionary (see the paper by Fiorito, Guaita and Guaita here, in Spanish).

In order to provide evidence for the positive effect of the RER on growth Damill and Frenkel used a partitioned regression. First they regress growth of GDP on the real exchange rate, they make a residual variable, GDP not affected by RER, and then regress unemployment change on the residual GDP and the RER, in what they term a variation of Okun's Law (sic). They find that unemployment is affected by the exchange rate, but to say that the model is misspecified, and that suffers from an omitted-variable bias is an understatement.

The current account in Latin America improved mostly because of a positive terms of trade (TOT) shock, and was not the result of a depreciated RER, which at any rate as the authors note, was almost at the same level as before the boom by the end of 2000s [that's why Frenkel keeps asking for depreciation to promote growth]. The improved TOT were relevant because they allowed for fiscal expansions without leading to current account problems, and on top, the expansion of the economy allowed for increasing tax revenue and balanced fiscal accounts. In other words, the fiscal rules were not the cause of primary fiscal surpluses, but the result of the economic boom.

Fiscal expansion, and the expansion of real wages, were certainly more important for the reduction of unemployment. The authors are correct, however, in emphasizing the role of employment generation in reducing poverty and inequality. Note, also, that as real wages expanded all countries experienced RER appreciation, but the evidence suggests that income expansion is what led to a reduction in current account surpluses. That's why depreciation cum fiscal adjustment, that Frenkel correctly connects (in Spanish) with IMF policies, are not the solution.

By the way, unemployment fell because GDP grew, and the old and simple Okun's Law, without the exchange rate, still works very well.

* In fact, many development economists starting with Hirschman and the Diaz-Alejandro, later formalized by Krugman and Taylor, suggested the opposite, that depreciation was contractionary. See here.

1 comment:

  1. Okun's law is a trade off between unemployment and growth. And if there's a currency depreciation, purchasing power will be affected in short time.


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