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.

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.

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.

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.

The mysterious case of the optimism about the relation between depreciation and growth

By Fabián Amico and Alejandro Fiorito* (Guest Bloggers)

The current debate about economic growth in Argentina, has accepted as dogma that the fast rate of economic growth between 2003 and 2011 had as its primary cause the devaluation in 2002, and the maintenance of a Sustainable and Stable Competitive Real Exchange Rate (SSCRER). Several economists attribute the current deceleration of economic activity to the real exchange rate appreciation.

The most analyzed economic variable is the real wage in dollars: between 2009 and 2011 the official exchange rate was devalued in 12.6%, while nominal wages in the private sector increased by 68%. In other words, the dollar value of wages increased almost 50%. In 2012 this was partially reversed.

How would a more competitive (devalued) real exchange rate stimulate growth? First and foremost it would lead to higher exports and lower imports, and then it would stimulate investment, and would generate more output and employment. The implicit assumption is that all the other components of demand would not change with the devaluation. But that is highly unlikely.

For at least 60 years it has well known that in Argentina devaluation have been contractionary. All available empirical evidence suggests that the sensibility of external trade (exports and imports alike) to variations of the exchange rate is extremely low. Yet, the inflationary and regressive on income distribution (associated to lower real wages) is considerably stronger, and, as a result, the global effect of a depreciation is contractionary. Worse even when devaluation is accompanied by fiscal austerity. The reduction of the level of economic activity has a depressing effect on investment compounding the negative effect.

Some economists suggest that the way in which devaluation generates an increasing demand for labor domestically – for a given level of activity – is related to the reduction in the relative price of the labor ‘factor’ with respect to capital. In other words, if a persistent reduction in the relative price of wages to capital goods (in dollars) were to take place, then the level of employment would increase irrespective of the rate of growth of the economy.

The devaluation of the exchange rate is, in this case, analogous to the neoclassical logic according to which a downwardly flexible real wage would eliminate the unemployment (and why wouldn’t one continue to devalue until full employment is reached?). But, in general, there is more rigid (technically) relation between capital and labor; ergo, even if relative prices change, the employment to output relation may not change significantly.

Surely, a SSCRER might have a positive role – together with other policies – in the maintenance of the external sustainability of the long term growth strategy to the extent that it contributes to export diversification and facilitates import substitution. Yet, this is a different proposition than suggesting a simple positive relation between real devaluation and growth: it really implies an exchange rate policy that is nuanced enough to maintain competitiveness, while not reducing real wages, which are the real locomotive pushing Argentinean economic growth. In sum, a ‘horizontal’ devaluation (without any type of differentiation in types of exchange rates or compensations for losers) produces an improvement in the profitability of exporters, a small effect on the volume of exports, and a contraction in the level of economic activity.

It is fairly clear that Argentina has a structural tendency to external disequilibrium between imports and exports, associated to the over dependency on primary exports, the low diversification of exports, and the composition of imports (which are entirely determined by domestic investment, and not by the real exchange rate). Domestic growth leads to increasing investment and this requires higher demand for imports of capital and intermediary goods, while exports grow at a lower pace. In other words, the propensity to import of the economy is incompatible with the countries’ export platform.

The counterpart to these arguments is that, contrary to what many defend, real exchange appreciation is expansionary, since is the other side of the coin associated with higher real wages. Note that in 2008 several economists already argued that the real appreciation was a matter of concern and that growth would stall immediately. Several argued that the time of ‘Chinese’ growth rates was over. Yet, after the 2009 crisis, in a context in which the real exchange rate had already achieved the late 1990s levels, the economy grew at record levels (9.2% in 2010, and 8.9% in 2011), while the industrial output grew even more (9.8% in 2010, and 11% in 2011). Something similar happened in Brazil and the result was, in both countries, the result of expansionary fiscal policy.

Clearly, other than the increase in real wages, it was the increasingly expansionary fiscal policy that explains the Argentinean recovery since 2003. This was for the most part unacknowledged since the government had a significant fiscal surplus since 2003, suggesting incorrectly that fiscal policy was contractionary. However, the most important component in the fiscal surplus was the increase in the tax revenues levied on exports. The government was able to use the revenues of the taxes on exports to pay the obligations on the external debt re-structured in 2005, increasing significantly its fiscal space. At the same time, the main categories of primary spending (public investment, social transfers, and wages) grew at a fast pace.

Nonetheless, there are deeper reasons for looking down on the role of fiscal policy. There is an almost complete consensus that expansionary policies in the context of an economy with an external restriction are by definition unsustainable. Instead of this ‘populist’ policies, the argument goes, it is suggested that a SCRER would be a more ‘serious’ alternative. However, the Argentinean economy, even if the main restriction to growth is given by its capacity to import, grows – as it did in the past, and as most medium and large countries do – pushed by the expansion of domestic demand. It is a structural feature, and not a policy option.

Another aspect – more circumstantial – that led to the misplaced optimism on the effectiveness of a nominal devaluation to become a real one, was the very low wage resistance exhibited by the working class back in 2002 (in the context high unemployment and labor flexibility). In the past, nobody would have accepted that proposition, since a maxi-devaluation would easily translate into a virulent wage-exchange rate spiral, with unpredictable results. And in this respect, it is possible that now, with lower unemployment, Argentina is back to its traditional situation.

The last aspect that favored the optimist views about the relation between the SSCRER and growth is the uncritical acceptance that the import substitution strategies, in general, and the processes of industrialization led by the State, in particular, were exhausted and disreputable. In this context, exchange rate policy looked like a suitable alternative in a world in which the State should have limited intervention in the economy and the process of development. Put simply, exchange rate policy (horizontal) is market friendly. Sadly, the effects of exchange rate policy are not the ones suggested by this optimistic new macroeconomic developmental consensus.

In sum, the feasible development strategies for Argentina (and for Latin America) do not simply change with the whims of fashion. The attempt to promote development by getting the prices right (the exchange rate in this case), is a vain utopia, that might have undesired consequences. The more it takes to return to the old wisdom and realism of the old Structuralists, the longer it will take to begin the practical reconstruction of a viable development strategy. This would necessarily require the intervention of the State in the difficult tasks of inducing selective import substitution, diversification of exports, modernization of infrastructure, and policies that promote technological change, within the context of high and sustained growth levels. It is not possible to leave all of these tasks to be performed by the change of one single variable.

* Researcher at CEFID-AR and Professor at UNLU, respectively.

PS: Originally published in Spanish in El Economista here, and also here. A similar view was discussed here before.

SSCRER this!

The acronym stands for Sustainable and Stable Competitive Real Exchange Rate. It has been an important contention among heterodox, and not so heterodox groups alike, that a depreciated exchange rate leads to higher levels of economic growth. This has been also based to a great extent on the comparative experience of Latin America and Asia. So far so good.

Depreciation, of course, 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. But it is important to note at least two things that heterodox economists used to know, but apparently have since forgotten (or at least some have).

One is that depreciations are inflationary, in particular because they affect costs (not demand). Yes pass-through effects are smaller, but not negligible, and they tend to be larger when wage resistance is relatively strong. In that case, if you want a more depreciated exchange rate, you must be prepared to accept higher levels of inflation, and to deal with cost-push inflation.

The other factor is that depreciation may very well be contractionary. One way in which this works out is that depreciation (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 (Diaz Alejandro dixit; classic paper by Krugman and Taylor here; subscription required). In this case, a depreciation does help reduce your external constraint, but by leading to a contraction. That, by the way, was one of the reasons why heterodox authors were against the traditional IMF package, devaluation (or wage reduction) and fiscal contraction; it was simply contractionary.

I am more concerned then, when this view of a SSCRER seems to be used to replace every other policy tool available. That seems to be the positions of some people at least in another Heterodox conference in Latin America held last week (link here). In particular there seems to be a peculiar notion that monetary and fiscal policies must be always checking the excess spending caused by the external demand obtained with the SSCRER (in this view all inflation is demand-pull), or as explained in one of the papers presented at the conference by Roberto Frenkel:

“the monetary and fiscal policies required to accompany the adoption of a SSCRER target must also have special features: the permanent expansionary stimulus that is part and parcel of the SSCRER heightens the importance of the restraining role to be played by fiscal and monetary policies.”

I remain skeptical that a SSCRER alone produces that much growth (“permanent expansionary stimulus,” wow that’s nice!). It is a peculiar reading of the Asian experience. Industrial policy, the patterns of trade integration with the main markets (in the US), and the ability to expand domestic markets with the expansion of wages, seem to play no part on the process of development in Asia. Does this mean that China has a depreciated currency, and compensates by having monetary and fiscal restraint? Really? That’s news to me!

Also it must be noted that the idea that monetary and fiscal policy must restrain excess demand implies that inflation is always a demand phenomenon, which is again peculiar among heterodox authors. The idea that devaluation is inflationary because it is expansionary (it used to be contractionary not so long ago), and so much that it leads to growth beyond capacity, and has nothing to do with costs is certainly odd.

Don’t get me wrong, I do favor in general a more depreciated exchange rate, to reduce the external constraint, but because devaluation is inflationary (on the cost side) and there often is wage resistance, one must be moderate. Also, the way to deal with inflation would be with income policies (and I mean price controls, not reduction of wages!). And because devaluation is contractionary, through its effects on income distribution, fiscal and monetary should be expansionary (check the post here; to see what fiscal adjustment has done in Brazil).

And one last thing, in Greece because they cannot devalue the ECB and the IMF have asked the equivalent thing (deflation and wage reduction) also with monetary and fiscal restraint. How is that working out for them?