LATIN AMERICAS SWAN SONG
By Paul Krugman
The spread of the global financial crisis to Latin America in
general, and Brazil in particular, has changed the complexion of the problem in several
ways. Obviously the stakes are now even higher than before, especially for the United
States; obviously, also, the fact that contagion can take place in this way makes it even
harder than before to blame the whole crisis on "Asian values" and "crony
capitalism". Beyond this, Latin Americas troubles bring out in an even clearer
fashion than before the unpleasant dilemmas that all developing countries (and perhaps
even smaller developed economies) now face.
A good way to illustrate these dilemmas is to consider a classic
analysis of macroeconomic policy in an open economy: Trevor Swans 1955 discussion of
the difficulty of reconciling "internal balance" (i.e., more or less full
employment) with "external balance" (an acceptable current account deficit) .
The "Swan diagram" analyzes the economic effects of two kinds of policies: those
that affect the overall level of domestic expenditure, such as the fiscal deficit; and
those that affect the relative demand for domestic and foreign goods.
The figure shows a standard Swan diagram. We imagine a country
with a pegged exchange rate and high capital mobility, so that interest rates are
determined by the need to avoid rapid depletion of reserves, and in effect monetary policy
is removed as a tool of stabilization. Thus the "expenditure level" policy
variable on the horizontal axis is fiscal; glossing over many complications, we can simply
think of it as the budget deficit. On the other axis we show an "expenditure
composition" variable, the cost of production in our country relative to that abroad.
What Swan pointed out was that the nature of the difficulties
facing a country depend on where in this space it resides. To see this, we draw two
curves. One curve represents conditions under which the country has "internal
balance"; as drawn, it is upward-sloping. The reason is that any rise in the
countrys relative costs would tend to reduce exports, increase imports, and thus
reduce employment; to compensate, to keep employment constant, the country would need to
have a fiscal stimulus a larger budget deficit. At any point to the right or below
this internal balance curve, the economy will suffer from too much demand for its
goods, and will experience inflationary pressures. At any point above or to the left, it
will suffer from unemployment.
The other curve shows conditions under which the country has
"external balance". It slopes downward, because an increase in spending would
other things equal increase the current account deficit; to offset this the relative cost
of production in this country would have to fall. At any point below or to the left of the
external balance curve, the country will have a current account surplus (or at least a
deficit below what is really appropriate), at any point above or to the right an
unacceptably high current account deficit.
These two curves define four "zones of economic
unhappiness", shown in the figure; only at the point where the two curves cross is
the economy without problems internal or external. (All happy economies are alike; each
unhappy economy is unhappy in its own way). A country may have an external surplus or
deficit; it may have unemployment or inflation. And by considering what kind of economic
problems a country has, one gets a clue as to what kind of policy action is appropriate.
Which brings us to Latin America. Focus on Brazil, although
Argentinas situation is similar in some respects. Brazil is clearly in the top zone
of unhappiness: there is little inflation, but high and rising unemployment, together with
a worrying external deficit. The textbook analysis clearly indicates, then, that
Brazils relative costs are too high. In principle, at least as far as macroeconomic
policy is concerned, it is not clear which way the budget deficit should go (although
realistically the size of that deficit raises enough concerns about long-run solvency that
it surely must be reduced whatever the diagram says).
How can relative costs be reduced? Well, the obvious, textbook
answer is a devaluation, which brings about an immediate reduction in costs measured in
terms of other countries currencies. And five years ago many economists
myself included might have cheerfully recommended a one-time devaluation, or a
temporary period of floating, as a way to get Brazils relative costs into the right
place. After all, Britain and Sweden did it in 1992, and nothing bad happened. Indeed, by
any measure the devaluing economies did better than the hard-currency countries.
But nobody who looks at the terrible experiences of Mexico in 1995
or Thailand in 1997 can remain a cheerful advocate of exchange rate flexibility. It seems
that there is a double standard on these things: when a Western country lets its currency
drop, the market in effect says "Good, thats over" and money flows in. But
when a Mexico or Thailand does the same, the market in effect says "Oh my God, they
have no credibility" and launches a massive speculative attack. So the question for
Brazil is, do you think that the market will treat you like Britain, or do you think it
will treat you like Mexico? And this is not an experiment that any responsible policymaker
wants to try.
And yet the economic unhappiness remains. Indeed, even if the
current speculative pressure on Brazil lets up a bit, the country will clearly be forced
both to retain high interest rates and to make massive cuts in its budget deficit
pushing it much further from internal balance, and probably causing a sharp recession. In
effect, fear of speculative attack has paralyzed macroeconomic policy, and even forced it
into acting perversely.
So what are the options? Brazil and many other developing
countries now have three possible courses of action, all extremely dangerous. They
are:
- Hold the line on the exchange rate, and rely on gradual reductions in
relative costs via productivity increases and deflation relative to the rest of the
world to restore internal balance. In principle this should eventually work.
However, the operative word is "eventually": all experience (Britain in the
1920s; France since 1987) suggests that this is an extremely protracted process. Even
aside from the sheer economic cost, can the social and political fabric stand the strain?
- Hold your breath, cross your fingers, and devalue or let the exchange
rate float accompanying this with market-friendly policies like sharp fiscal
contraction and privatizations, in the hope that the markets will treat you like Britain
instead of Thailand. But they probably wont.
- Impose temporary currency controls to prevent a speculative attack, then
use the breathing space to engage in a one-time devaluation-cum-fiscal-stabilization, in
the hope that after a little while the markets will calm down and let you return to
business as usual. But currency controls are hard to implement and enforce, they disrupt
normal trading relations, and they may impair confidence for a long time to come.
What is the right answer? Honestly, I dont really know
but neither does anyone else. What is clear is that something has gone tragically
wrong with the whole system, if these are the available alternatives.