Make Argentina Crash Again

 

My article for The American Prospect on the Argentina situation was just published online. Argentina is far from being out of the woods. The expectation that the country will stabilize prices, float its currency, and build up reserves, and restart economic growth is a chimera. Despite market support for Milei’s program, the crisis remains unresolved. In my article, I explain why the challenges persist, an why this will end like the previous three neoliberal experiments, with a crash. While an immediate crash may not be on the horizon, it is somewhat inevitable. It's a matter of when, not if. And it may very well be with the next president, if the U.S. continues to financially prop Milei's government.

Note that contrary to the IMF, or Barry Eichengreen, who actually provided the IMF justification for floating rates more generally (as he explains there), I don't think to abandon the dirty float (band in this case) would be a good idea.* On that I think Milei's administration is correct. I even think that some degree, even more I think, of a reintroduction of exchange rate controls (the government reintroduced some controls on individuals, I must add) is necessary. Something that supposedly the IMF also favors. Capital controls as a macro-prudential measure in times of crises.

I also want to make clear that this is mostly about the current macroeconomic circumstances. The point is not to return to a world of Bretton Woods, with fixed exchange rates, and capital controls. It is clear that Brazil, for example, did much better than Argentina, with a dirty float and no capital controls. But, as noted by Fabian Amico, in a talk at Universidad Nacional de Moreno, recently, Brazil accumulated reserves in a different macroeconomic scenario.

Brazil accumulated foreign reserves (see graph), maintaining a positive interest rate differential (the domestic interest rate minus the foreign reference rate, the U.S. one, the expected depreciation, and a measure of country risk). We discussed that with Amico and Serrano a few years back (in Spanish). Note that as capital inflows allowed Brazil's central bank to accumulate dollars, the real appreciated in nominal terms. In Argentina where both left and right of center governments have 'appreciation fear' (and their fear is about the real rate, let alone the nominal one), that would be politically difficult.

Exchange rate depreciation at this point would lead to accelerated inflation, and to contractionary pressures. Of course, there might be a situation (they had more than a few over the years) in which, with low country risk, and high interest rates at home, leading to a higher differential that allows for the profitability of holding peso denominated assets to be higher than holding dollars, we might finally get on the road to stability. That would be orderly macroeconomic policy, and not draconian fiscal adjustment. At any rate, that doesn't seem to be the case right now.

Over the long-term, it is very clear that all the previous experiments with this kind of policy (fiscal austerity, financial deregulation, and trade liberalization) ended up in a crash. There is also little reason to believe that this time it will be different. 

* It goes without saying that I would also be against dollarization, something that Milei promised in his campaign in 2023, and that has been recently floated by Laurence Kotlikoff in the Financial Times. This suggests that the old bipolar consensus has not been completely abandoned in more mainstream circles.

Very brief note on the Brazilian real and the fiscal package

 

The Brazilian real depreciated last week (full meltdown might be a bit of a hyperbole), and in many quarters there has been a suggestion that it is now undervalued, and that would somehow be connected to the dangers associated with the fiscal position, and the willingness of the Lula government to push the spending cuts, and the tax changes, with cuts for those at the bottom of the income distribution and hikes at the other end (more on the fiscal story in a bit).

The obvious reason for this is that the Brazilian basic interest rate was coming down from its post-pandemic high, and probably, and in spite of all the pressure from progressives and heterodox economists, it was a bit too low. As it can be seen, as the SELIC rate came down, the exchange rate started, eventually, to depreciate. This will have some impact on inflation, but it is nothing that should be of any significant concern. A higher SELIC, and a few interventions by the Brazilian Central Bank (BCB) should be more than enough to stabilize the exchange rate.

The fiscal situation does not require any adjustment, and certainly not one for next year, and not at the expense of reducing government outlays on education and health. Brazil managed to grow more than predicted by markets since Lula's election, because the fiscal rules were taken with pragmatism and the adjustment has been delayed. If the government goes through with the spending cuts, expect growth to decelerate, and the fiscal accounts to worsen.

This is exactly what Dilma tried in her first government, then backtracked, and then adopted in the aftermath of her victory in 2015, leading to the worsening of the fiscal results, and the impeachment (not that this is on the table; but the political future certainly is if Lula cannot deliver growth and better income distribution). Btw, the changes in the taxes are a good thing.

Modern Money Theory (MMT) in the Tropics

Paper has been published as a PERI Working Paper.

From the abstract:

Functional finance is only one of the elements of Modern Money Theory (MMT). Chartal money, endogenous money and an Employer of Last Resort Program (ELR) or Job Guarantee (JG) are often the other elements. We are here interested fundamentally with the functional finance aspects which are central for any discussion of fiscal policy and have received more attention recently. We discuss both the limitations of functional finance for developing countries that have a sovereign currency, but are forced to borrow in foreign currency and that might face a balance of payments (BOP) constraint. We also analyze the limits of a country borrowing in its own currency, because there is no formal possibility of default when it can always print money or issue debt. We note that the balance of payments constraint might still be relevant and limit fiscal expansion. We note that flexible rates do not necessarily create more space for fiscal policy, and that should not be in general preferred to managed exchange rate regimes with capital controls. We suggest that MMT needs to be complemented with Structuralist ideas to provide a more coherent understanding of fiscal policy in developing countries.

Read full paper here.

Exchange rate depreciation and exports: the evidence

In this blog we discussed several times the reasons why exchange rate depreciation is not necessarily a panacea for current account problems (see for example here and here on Argentina depreciation before the last one with the Macri administration, here on the Europe, here in general about the idea of a Sustainable and Stable Competitive Real Exchange Rate or SSCRER, and here on the role of the exit from the Gold Standard during the Depression). Exchange rate skepticism suggested that depreciation often works because it is contractionary, and it worked by causing a recession and reduced imports. The optimists, like the so-called New Developmentalists pointed out to the positive impact on exports.

Now a new paper by Filippo di Mauro and others (h/t Pablro Bortz) at Vox.eu shows that the exchange rate has a reduced role in the explanation of exports shares for European and Asian countries. As the authors suggest:

"An obvious reason for the low explanatory power of price competitiveness is that a large part of trade involves intermediates products – i.e. inputs used within rather well established global value chains (GVCs) – and is thus far less influenced by pure exchange rate considerations."

That is the steady increase in Chinese global export shares have less to do with their currency manipulation (something briefly discussed here) and more to do with the strategic decisions of firms on where to locate their supply chains. The authors conclude:

"By disentangling the impact of exchange rate changes on trade results, we have shown that the underlying assumption of the ‘currency wars’ discussion – that devaluations bring about substantial export gains – may be severely flawed."

The evidence seems to suggest that depreciation does not stimulate the type of substitution that would lead to external equilibrium, neither on the import or export side, and that a devalued currency is no substitute for industrial policy. Of course evidence, once John Eatwell noticed, has not solved any economic debate so far.

Global depreciation since the collapse of oil prices

One figure is worth a thousand words (negative number imply depreciation).

So, if you think China devalued a lot...

Source here.

PS: On Twitter some have argued that some depreciations are overestimated. My point remains. China did not depreciate much, comparatively. And besides as noted before there might be a connection between depreciation in the periphery and lower commodity prices.

Chinese slowdown and the world economy

The Conference Board argues that Chinese official data should be taken with some skepticism. Nothing new there. They have adopted a new measure, which implies "Chinese economic growth at a more realistic 3.7 percent" for the recent past. In this scenario, interestingly enough, "it’s likely that the bulk of China’s slowdown has already taken place since 2011, even if unapparent in official statistics." So the picture is probably worse than the official one (as shown below, from The Economist)

So China will grow at about 4% and has already been growing at that pace for a while, if one believes the Conference Board (in the official data above one might think there is more space for a slowdown, but clearly it has gone already down too). The big questions are whether this will continue, and what would be the impact for the global economy (and the US).

Arguably the slowdown is the result of the transition from an export-led development strategy to a domestic, consumption centered economy, compounded by the problems of an unregulated banking sector, the infamous shadow banks. Note, however, that most problems are associated to domestic demand, and debt in domestic currency. China still has current account surpluses and huge external reserves, even if the latter have decreased. So the problems of a typical developing country, which cannot grow given the external constraint, are nonexistent. Also, it is true that some firms have debts in dollars (and revenue in yuan), and the depreciation of the yuan poses problems, but again the People's Bank of China has enough dollars that rescuing and absorbing the costs of exchange rate risk should be a minor issue. This is not to say that a further slowdown is impossible, but if it continues it should be counted as a policy mistake, not a structural constraint.

On the effects on the world economy my impression is that there is also a great deal of exaggeration. China is the second largest economy in the world, for sure, and has become central for the global economy in many ways. But its role in the global economic problems has been overstated. In Brazil, for example, the Chinese slowdown played virtually no role, as I discussed here. In the US the usual complain is that the depreciation of the yuan is behind deindustrialization, and that the Chinese crisis, that has led to a more depreciated currency, is hurting the manufacturing recovery. I am skeptical of the argument. The figure below shows manufacturing employment and a broad trade weighted exchange rate for the US.

As it can be seen the decrease in manufacturing jobs, which started in the early 2000s (before that it was more or less constant; see discussion here) is connected to the entry of China in the World Trade Organization (WTO). But the collapse of manufacturing jobs went hand in hand with a depreciation of the dollar. And some of the, admittedly slow and small, recovery since the 2008 recession has gone with an appreciation of the dollar. This indicates that Free Trade Agreements (FTAs) and the WTO play a more important role than exchange rates.

China is important, but the notion that it will derail the US recovery seems incredibly hyperbolic. My bet is the US will continue its slow recovery, and the Fed will increase interest rates at an even slower pace than they suggested, as the last meeting indicated.

Peter Temin explains the Great Recession and the slow recovery

A bit more on Peter Temin and David Vines book on Keynes. The explanation of the Great Recession is based on a traditional negative shock to the IS curve. Temin famously wrote the response Friedman and Schwartz Monetarist view of the Great Depression, his Did Monetary Forces Cause the Great Depression?, in which a contraction of consumption, and the IS, rather than the contraction of money supply and the LM was seen as the central story.*

 So the same is essentially at work now. They say:

“the IS curve in the US moved left a great distance after the Global Financial Crisis and the adjustments that followed. It moved so far that the new IS curve no longer crossed the LM curve at a positive interest rate.”

As can be seen below.

I can live with the representation of the Great Recession as a collapse of the IS (and yes the negative slope might be explained by other elements of demand, not investment, being inverse related to the rate of interest, like consumption or housing investment). I'm more troubled by the notion that the slow recovery is caused by the negative rate of interest, which in this case precludes the intersection of the IS and LM (note that, contrary to Krugman's negative rate, the equilibrium would not be the full employment one). But I do agree with the implied solution, not defended very forcefully, to my surprise, in the book, i.e. expansionary fiscal policy to bring the economy back to full employment.

In part, Temin and Vines do not defend fiscal policy strongly, because they bring the issues of an open economy to the forefront of the discussion, using James Meade's notion of internal and external balances. It's far from clear that they think this applies to the US, but in general their solution for a country with an external problem and unemployment, would be depreciation and austerity. In their words:

“The indebted country requires a combination of the two policies. Devaluation will increase exports and reduce imports. Austerity—just the right amount—will reduce home demand for goods and leave room for the production of extra exports and the home-produced goods that replace imports. The right combination of policies will move the economy to the intersection of the external balance line and the internal balance line, or even further down the internal balance line into the region of external surplus if the country is to begin repaying its debt.”

Note that without austerity the economy would overheat. That's a lot of confidence in the expansionary power of devaluation. As noted here several times, a devaluation can be contractionary, and it often 'solves' the balance of payments problem for that reason. Devaluation and austerity, by the way, were, and still are, the traditional policy measures imposed by the IMF on indebted countries. The implication seems to be that a combination of devaluation with austerity would produce, in the US too, a healthier recovery. The book is strangely positive on austerity, because of the external balance requirements, a position that, at least in this recession, other New Keynesians like Krugman and DeLong have temporarily abandoned.

And their analysis in the book about the post-war boom, the so-called Golden Age, is also not very good. Temin and Vines, even though they recognize the role of the Marshall Plan, emphasize the positive role of the IMF in promoting growth, and suggest that the IMF is an improved version of Keynes' proposal at Bretton Woods. In their words:

“The cooperation stimulated by American generosity in the Marshall Plan was a hallmark of postwar European progress... The IMF—an improved version of Keynes’ Clearing Union—eventually became a crucial policy-making institution... The IMF, which Keynes helped to design, was central to the restoration of growth.”

The Marshall Plan, which depended not just on generosity, but on fear of the Soviets, was clearly central. The role of the IMF in a global recovery of the 50s and 60s is hard to defend though. And Keynes Plan did not involve punishing indebted countries, which is what depreciation and austerity do, quite the opposite. In fact, Keynes was relegated to the debates on what became the World Bank at Bretton Woods, while Harry Dexter White was the central figure in the creation of the IMF. And the World Bank was, until the 1980s, a more benign instrument of US external economic policy, one might add.

But Temin and Vines also botch that one, and say:

“The World Bank, which was less central than the IMF, facilitated long-run growth. The World Bank was designed to help re-create the international pattern of productive trade that Keynes had described in The Economic Consequences of the Peace.”

Yes, the World Bank was created to recreate the pre-war pattern of trade, with the periphery selling commodities, and the center manufactures, and the British as the hegemonic... Oh wait. Yeah that makes no sense either.

* In later research Temin came closer to Eichengreen in putting the Gold Standard at the center of the Great Depression. For example, in his Lessons from the Great Depression. The seeds of his positive view on the role of depreciation are associated to his view that the abandonment of the Gold Standard was at the heart of the recovery. For a critique of that go here.

The Gold Standard and the Depression

I have been teaching on this topic this week. One of the accepted views on the Depression is that countries that depreciated earlier recovered faster from the crisis. The classic paper by Eichengreen and Sachs sort of established the result.* The notion is the traditional one. Depreciation leads to lower prices in foreign currency, increased competitiveness and higher exports. Graph below shows the correlation between depreciation (since the exchange rate is measured as the foreign price of domestic currency, lower rate means depreciation).

The indexes show the difference between the exchange rate and export volumes in 1929 (100) and 1935. So in 1935 France had not left the Gold Standard and the exchange rate remained at 100, while the exports were close to 50% of their 1929 level. There seems to be a clear negative relation between the exchange rate depreciation and export performance. However, note that in the United Kingdom a depreciation of about 40% implied exports at around 75% or so of the 1929 level. Only Norway and Finland seem to have higher exports in 1935 than in 1929. This was not an external demand led recovery.

This suggests that if depreciation had a role it was more likely related to the space that breaking with the Gold Standard rules provided for domestic authorities to pursue expansionary policies at home. Note that in this context, the depreciation, as much as higher tariffs and other trade related policies, are less relevant for their role in stimulating external demand, than by their role in protecting domestic production.

In the US the group of economists that were in favor of the depreciation of the dollar (see the letter by Harvard economists J. Raymond Walsh, Lauchlin Currie, John B. Crane, John M. Cassels, Robert Keen Lamb and Alan R. Sweezy in support of FDR's depreciation policy in 1934; and yes that includes Currie, later advisor to Eccles, and Paul's brother Alan, a Keynesian, not a Marxist), were also in favor of domestic fiscal expansion, which was at the end of the day Keynes point too. You can see Keynes arguing why the abandonment of the Gold Standard would be a good thing here, at the beginning of John Kenneth Galbraith's documentary.

This is still an important point, since there are significant lessons, at least it seems to me, for the European periphery story, in particular Greece. Depreciation alone cannot do the job. But a combination of import substituting policies, to reduce external constraint problems, with expansionary demand policies might work.

* There are also issues related to the role of the Gold Standard in causing the Depression, since the crisis was international, and many authors think that this suggests that it must have international causes. Hence, the Monetarist contraction story, or the Keynesian consumption collapse story (including the more radical version in which income distribution plays a role) would be incomplete. In this view, the relatively high rate of interest, related to the not credible inter-war Gold Standard, would be the cause of the depression. This view, as I noted before, seems closer to Keynes' Treatise on Money than his GT.

Internal devaluation and the Greek crisis

Last month, using the ILO's Global Wage Report, I noticed that real wages in Greece had collapsed by an outstanding 24% since 2009. Further, I suggested that my guess was that this internal devaluation was NOT the cause of the improvement in the current account (CA), which as can be seen below did in fact improve (2014 is an IMF estimate).

The question is whether real exchange rate depreciation, in this case a reduction of real wages, since the  nominal exchange rate is fixed (so to speak) with respect to other Euro countries, was a significant force behind the improvement in the CA balances.  Note that the improvement is basically all due to the collapse of imports, since the growth of exports (both shown below) has been basically zero (again 2014 figures are estimates).

Lower real wages had an impact, if they did, on demand, not in leading to higher exports associated to lower domestic costs. In other words, less demand associated to lower wages and a collapsing domestic economy is what has allowed for the rebalancing of the external accounts. If there are any doubts, below you can see the high correlation between GDP growth and the collapse in import growth.

This suggests that devaluation, be that internal as it has been so far, or external as leaving the Euro might imply, is not necessarily enough to solve the current crisis.

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.

Is Venezuala's SICAD II Resolving Exchange Rate Problems?

 By Mark Weisbrot

All economies have major structural and policy problems, but some problems are more important and urgent than others at particular times. In Venezuela, the most important economic problem is in the exchange rate system. A fixed exchange rate system with periodic devaluations tends to be more crisis-prone than other exchange rate regimes, especially in a country like Venezuela where inflation has historically been higher than that of its trading partners. This is particularly important right now because opposition leaders who have called for the overthrow of the government have pointed to 57 percent inflation and widespread shortages of consumer goods as justification for (often violent) street protests over the past two months. Although the protests have failed to attract the working and poorer people who are most hurt by the shortages, they are still a major complaint – as is inflation – for most Venezuelans.

Read rest here

20 years of the Tequila Crisis

In December it will be the 20th anniversary of the Tequila Crisis, which inaugurated a series of external crisis in developing and transition economies, in Asia, Russia, Brazil, Turkey and Argentina. Here a short note (in Spanish) for a Mexican on-line magazine (Paradigmas).

Don’t Cry for Argentina--Not Yet!

In the new issue of Dollars & Sense my short article on the Argentine crisis. Subscription required. Previous post on the same topic here, here and here.

The New Old IMF

The 'new' IMF still demands devaluation and fiscal adjustment. Like the old. From their new agreement with Ukraine, according to the New York Times:

"The agreement, announced in Kiev, the Ukrainian capital, will hinge on the country taking steps to let the value of its currency float downward, to cut corruption and red tape, and, crucially, to reduce huge state subsidies for the consumption of natural gas."

This is consistent with what the IMF says in last in one of the last World Economic Outlook reports. The IMF suggests that the current risks for the global economy fall into five categories, namely (IMF, 2013a, p. 14): “(1) very low growth or stagnation in the euro area; (2) fiscal trouble in the United States or Japan; (3) less slack than expected in the advanced economies or a sudden burst of inflation; (4) risks related to unconventional monetary policy; and (5) lower potential output in key emerging market economies.” Note that even though it is suggested that stagnation in Europe is a problem, it is argued that (Ibid. p. 19): “fiscal plans for 2013 are broadly appropriate in the euro area.”

The concern with fiscal policy in the United States and Japan is that these countries (Ibid, p. 19): “need strong medium-term plans to arrest and reverse the increase in their public debt ratios,” and the Fund suggests the reform of entitlement programs as the way forward for fiscal adjustment, which would burden the old, the young and the poor more than any other social groups. The last three risks are all associated with the notion that there is a danger of rapid adjustment to full capacity and inflationary pressures resurging earlier than expected.

Moreover, there is a clear gap between the somewhat mixed message of the WEO reports in terms of what policy space allows in terms of fiscal policy and what the actual practice of the IMF has imposed on countries under agreements. Article IV consultations and Letters of Intent for the recent advanced countries that have Extended Fund Facility Arrangements with the IMF (e.g. Greece) demonstrate specific long-term structural changes that are terms of the loan. The Staff Report for the 2013 Article VI consultation for Greece suggests that (IMF, 2013b, p. 1): “Progress on fiscal adjustment has been exceptional by any standard, with the cyclically-adjusted primary balance having improved cumulatively by about 15 percent of GDP during 2010–12. Labor market reforms are helping to realign nominal wages and productivity; this internal devaluation has reduced the competitiveness gap by about half since 2010.” Fiscal adjustment and price and wage reductions are the basis of the solution, very much as in the past. If there is any change in the IMF policy advice it is difficult to find in its policies.

Jane D'Arista - Tapering of Quantitative Easing Is Throwing Emerging Markets into Chaos

From The Real News Network

Emerging markets have been reeling since the beginning of the new year. The currencies and stock markets of Argentina, South Africa, Turkey, among other countries, have declined substantially, prompting their central banks to increase interest rates to stem the outflow of capital. The emerging-market rout, the worst start to a year on record, is widely believed to be related to the winding down of the U.S. Federal Reserve's quantitative easing program.Now joining us to discuss this is Jane D'Arista. She's a research associate with the Political Economy Research Institute, or PERI, at the University of Massachusetts, Amherst, where she also cofounded an economist committee for financial reform called SAFER, or Stable, Accountable, Fair and Efficient Financial Reform.

See here

Are emerging markets going to collapse? Why is Dr. Doom wrong

The series of devaluations in the currencies of a few developing countries (I prefer the term to the one in the title, which became popular in the 1990s, when Neoliberal policies required selling bonds in international financial markets, and, hence, emerging markets sounded more marketable than underdeveloped country) has led to a lot of speculation about the collapse of the boom in the periphery. The graph below shows that depreciation has been between moderate to severe, depending on the country (source by The Economist).

The Argentine peso and the Turkish Lira lead the pack, by far. Nouriel Roubini, the so-called Dr. Doom, has suggested that the problems have a common cause, based political problems, and loose fiscal policy leading to external deficits. According to Roubini (here):

"Many emerging markets are in real trouble. The list includes India, Indonesia, Brazil, Turkey, and South Africa – dubbed the “Fragile Five,” because all have twin fiscal and current-account deficits, falling growth rates, above-target inflation, and political uncertainty from upcoming legislative and/or presidential elections this year. But five other significant countries – Argentina, Venezuela, Ukraine, Hungary, and Thailand – are also vulnerable. Political and/or electoral risk can be found in all of them, loose fiscal policy in many of them, and rising external imbalances and sovereign risk in some of them."

In all fairness the fragility of some of the countries is exaggerated, and the reasons are simply wrong. Yes it is true that current account deficits are in normal circumstances a very dangerous stance for developing countries that must borrow in foreign currency; however, the low rates of interest in the center, associated to a slow recovery from the crisis in the US and a terrible collapse in Europe, together with increasing international liquidity, implies that many countries have been able to finance their external imbalances.

The fiscal situation is also not pressing, and at any rate is only relevant to the extent that it affects the level of activity and imports. And as noted by Roubini, these countries are either not growing fast (like Brazil, which has primary surpluses) or decelerating (like India, where nominal deficits as a share of GDP have also decreased). Also, inflation is certainly NOT high in the majority of these countries (again Brazil and India do have single digit inflation levels,* even if the inflation rate is above the target, and that prompted central banks in both countries to hike interest rates).+

The expectations of tightening of US monetary policy, and the possible effects that this might have on developing countries has also been exaggerated. Again, according to Roubini:

"the Fed’s tapering of its long-term asset purchases has begun in earnest, with interest rates set to rise. As a result, the capital that flowed to emerging markets in the years of high liquidity and low yields in advanced economies is now fleeing many countries where easy money caused fiscal, monetary, and credit policies to become too lax."

the Fed’s tapering of its long-term asset purchases has begun in earnest, with interest rates set to rise. As a result, the capital that flowed to emerging markets in the years of high liquidity and low yields in advanced economies is now fleeing many countries where easy money caused fiscal, monetary, and credit policies to become too lax.
Read more at http://www.project-syndicate.org/commentary/nouriel-roubini-explains-why-many-previously-fast-growing-economies-suddenly-find-themselves-facing-strong-headwinds#FWMzOLXkvghCXMDY.99
"the Fed’s tapering of its long-term asset purchases has begun in earnest, with interest rates set to rise. As a result, the capital that flowed to emerging markets in the years of high liquidity and low yields in advanced economies is now fleeing many countries where easy money caused fiscal, monetary, and credit policies to become too lax."



"the Fed’s tapering of its long-term asset purchases has begun in earnest, with interest rates set to rise. As a result, the capital that flowed to emerging markets in the years of high liquidity and low yields in advanced economies is now fleeing many countries where easy money caused fiscal, monetary, and credit policies to become too lax."

If you agree with Roubini, the solution would be contraction in all these peripheral countries. Devaluation and fiscal adjustment to ease the current account and fiscal imbalances, as the old (and I would argue the new) IMF used to demand.

However, it is hard to foresee a strong recovery in the US, and a steep, or even a mild, increase in interest rates by the Fed, now under Janet Yellen's command. That obviously does not mean that capital flight might not take place in some countries, and that a few of them would actually face external crises. Yet, it seems unlikely that the situation in the center would completely reverse and lead to a generalized collapse of the peripheral countries. In fact, I would argue that a bigger risk would be a severe collapse in Europe, leading to a flight to safety (i.e. US dollar denominated bonds), even with very low rates in the US, and then a new round of external crises. That's why regulation of capital flows is needed, as demanded by Kevin Gallagher (see here) and not austerity for the periphery, as Roubini wants.

* Also, there is no evidence that inflation around 6 or 7% is any worse than inflation at 4 or 5% in terms of growth or unemployment.

+ There are countries in which the story is more problematic. Argentina, discussed here and here, is certainly one, but interestingly enough it would be a case where the external accounts are actually not that bad.