Wednesday, August 7, 2013

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.


  1. Hi Matias,

    great article. One question, do you think that depreciation coupled with government programmes aimed at helping those whose income gets or might get hit by the depreciation could do the trick?

    Thanks for your time

    1. Work to solve BOP problems? It might if no other country depreciates much, and if there is no wage resistance. The side effect if there is is inflation. So if you are really concerned with inflation, as Frenkel is for the Argentine case, then depreciation is a problematic solution. He would tell you need fiscal and monetary contraction to compensate the depreciation. But that would only work if inflation is caused by excess demand. But the economy is not growing much, so even Frenkel admitted that inflation is not demand pull. You cannot have the cake and eat it too.

  2. There is plenty of evidence that real depreciations reduce imports and increase exports, which is exactly what one needs when facing a balance of payments constraint while unwilling to pursue contractionary fiscal policy.

    1. Hi, actually there is very little evidence for the elasticities. What you have is that sometimes depreciations do go hand in hand with growth. As I noted in Argentina in 2002, since other factors were at play (expansion of wages and government social spending, and plenty of spare capacity). So the point is that sometimes, under specific conditions, depreciation is good. But sometimes it does not work. It's not a panacea.

    2. To be more exact, there is overwhelming evidence that import elasticities with respect to the real exchange rate are significant, statistically and economically.

      As for supply elasticities for exports, the evidence is more mixed; some studies show small elasticities, others show more sizeable ones.

  3. This is a very important point and also highly relevant t the Euro crisis. The assumption that the Marshal-Lerner condition is satisfied is critical to the idea that exit and devaluation would reliably solve the southern countries balance of payments problems, and to the idea that higher German inflation is necessary if imbalances are to be reduced without exit. If as you say -- and I totally agree -- income effects are really all that matters, then exit will not necessarily do much good for Greece and the rest, and what Germany needs is higher incomes, not higher prices.

  4. On the empirics, I think the state of the debate is expressed perfectly by this mainstream paper: ""A typical nding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML)
    condition does not hold. However, despite the evidence against the ML condition, the consensus
    is that real devaluations do improve the balance of trade."

    The empirics say elasticities are low, but the "consensus" says that they're high.


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