Where is the elasticity? (or more on devaluation and growth)

Since 2007 mainstream economists, and often some heterodox (or more precisely eclectic) authors, have suggested that the Argentine economy is on the verge of collapse (see for example my good friend Bresser-Pereira here or this). A typical argument made by both orthodox economists (some of which favored the Convertibility Plan of the 1990s) and the more unconventional is that real exchange rate (RER) appreciation is at the heart of the Argentine problems and the more recent lack of growth.

I have discussed this before here with respect to the so-called Sustainable and Stable Competitive Real Exchange Rate literature (see here). The argument for a SSCRER was put forward by Frenkel and Taylor in a well-known paper, but the notion has many defenders (see the good paper by Blecker and Razmi from Setterfield's essential book on growth), including more conventional authors like Rodrik. At the risk of being repetitive let me point out the pros and cons of the arguments for devaluation.

Depreciation protects local industry and leads to a boost to domestic production, and also, by leading to an increase in exports, reduces the external constraint of the economy. That would be the substitution effect associated to the change in the relative prices. Yet depreciation also (everything else constant) reduces wages, increases the profits of exporters, and leads (yes, the economy is wage-led) to a reduction in spending and lower levels of activity. In this case, a depreciation does help reduce your external constraint, but by leading to a contraction. The second effect, associated to an income effect, was well-known by heterodox authors, having been developed by Albert Hirschman and Carlos Diaz-Alejandro (for the Argentine case) and then formalized by Krugman and Taylor (see here; subscription required).

At the end of the day it is an empirical question. All the evidence seems to suggest, at least for the Argentine case (here paper by Fiorito and others in Spanish; but it seems to be more general, see here) that income effects tend to be larger than substitution effects, and hence one might be concerned about possible contractionary effects of a depreciation.

In the case of Argentina, it is clear that the expansion of the volume of exports goes hand in hand with the expansion of the world GDP (Figure below).

The relation between the real exchange rate and exports is less clear. As it is shown below after the large real depreciation in 2002, growth in the volume of exports goes hand in hand with significant appreciation.

No doubt defenders of depreciation will argue that the big depreciation in 2002 was essential for export growth afterwards (see Rapetti here who argues that "competitive RER was a key factor behind Argentina’s recovery and growth"). But if you put the depreciation in the wider macroeconomic context of 2002, and compare with the current one, you are bound to have second thoughts.

The depreciated nominal exchange rate in a context of high unemployment (around 22%) did not lead to inflationary pressures, since wage demands were subdued (and hence the nominal depreciation translated into a large real one). Second, spare capacity meant that the protection afforded by the real depreciation led to a huge expansion of domestic production, spurred by the expansion of domestic demand (higher real wages and expansion of fiscal spending, particularly in social programs). Exports actually don't seem to move much with the depreciation. There is no econometric evidence for large elasticity of exports with respect to the exchange rate, in the short or long-run (if someone has it please, please, pretty please with a cherry on top share it; it's been frustrating to have an argument with people that argue a point for which there is no known evidence).

Note that all the above mentioned conditions are not in place now. Unemployment is considerably lower (around 7% or so), and the expansion of real wages and government spending have slowed down (so much so, that in the last year the economy has stalled). So maybe we need less Frenkel and Taylor and more Krugman and Taylor to understand what is going on in Argentina right now.

Path Dependency and Hysteresis

I promised to discuss the difference between these two concepts a while ago. The idea of path dependency is related to Joan Robinson’s famous objection according to which equilibrium is not an actual outcome of real economic processes, and it is for that reason an inadequate tool for analyzing accumulation.  Her view would suggest that path dependency should be seen as a property of models that break with conventional methodological stances, and, in particular, with the dominant neoclassical school.

It is important to note that mainstream defenders of the idea that ‘history matters’, like Paul David (of QWERTY fame), tend to disagree with the view that path dependency implies a rupture with neoclassical economics. David (2001, p. 22) says, in this regard: “imagine … my utter surprise to find this approach being attacked as a rival paradigm of economic analysis, whose only relevance consisted in the degree to which it could be held to represent a direct rejection of the normative, laissez-faire message of neoclassical economics!”  For David, path dependency is a property of dynamic and stochastic processes and cannot be used to assert anything about models and propositions derived in static and deterministic setting [which is, apparently, what he thinks neoclassical economics is all about].

Mark Setterfield's research might hold the key to this issue, by differentiating hysteresis [a concept from physics, that shows that mainstream economists do have physics envy!] and path dependency, and suggesting that the former, more typical of mainstream models, is a special case of the latter, more general and the concept often linked to heterodox models. He suggests that hysteresis is a variation of traditional equilibrium analysis, which implies that some displacements from equilibrium would be self-correcting while others would not. Hysteresis results from the non-uniqueness of equilibrium and under certain conditions the economic system would adjust to a new equilibrium. On the other hand, Setterfield argues that the typical path dependent model is based on cumulative causation, a concept that harks back to Gunnar Myrdal and Nicholas Kaldor’s contributions to economics. In this case, transitory shocks always have permanent effects.

A simple example might illustrate the difference between the more restricted notion of hysteresis and cumulative causation. In the conventional mainstream description of labor markets, an increase in unemployment insurance that allows workers to hold out longer for better paid jobs increases the natural rate of unemployment. After a fall in demand (an external shock), if structural changes to the labor market like higher benefits take place, the level of unemployment will increase and eventually fall, as real wages fall, but to the new and higher natural rate [think of Gordon's Time Varying NAIRU]. Hysteresis implies that history matters, but the system is still self-adjusting.

The quintessential example of cumulative causation is associated to the Kaldor-Verdoorn Law, which says that output growth leads to rising labor productivity. Thus, higher demand leads to higher output growth, which implies higher productivity, lower costs, and higher income in a virtuous circle of expansion. There are several possible expansion paths, depending on the strength of the multiplier-accelerator forces and the Kaldor-Verdoorn coefficient, rather than a single equilibrium to which the system adjusts. There is no adjustment to an optimal equilibrium level, no natural rate fixed or varying. The heterodox notion demands the rejection of the natural rate.