TIME DYNAMICS OF STABILIZATION THEORIES AND RESPONSES TO DEBT AND FINANCIAL CRISES: AN ANALYSIS OF MEXICO, ARGENTINA, NIGERIA AND GHANA, 1960-2011 WARBURTON Christopher E.S.* Abstract
This paper uses continuous time series data from 1960 to 2011 to evaluate the contributions of foreign income to domestic macroeconomic stability. Foreign income is operationalized as income from major trading partners. Elasticity and absorption models are used to examine the effects of foreign income on domestic trade imbalances and per capita national income under narrow and broad theoretical propositions of partial and general equilibrium analyses. The reliance on foreign income is shown to be tenuous, but saving has a greater impact on per capita national income. Expansionary monetary policy may be beneficial to growth beyond immediate stabilization challenges.
Keywords: Debt Crises, Devaluation, IMF, Foreign Income, Stabilization Theories JEL Classification - F31, F32, F33, F34, G01
1. Introduction
This paper uses continuous time series data from 1960 to 2011 to evaluate the contributions of foreign income to domestic macroeconomic stability. Foreign income is operationalized as income from major trading partners. Elasticity and absorption models are used to examine the effects of foreign income on domestic trade imbalances and per capita national income under narrow and broad theoretical propositions of partial and general equilibrium analyses. Nigeria and Ghana (in Africa) and Mexico and Argentina (in Latin America) are of special interest. The paper finds that reliance on foreign income is tenuous, and that saving or investment has a greater impact on per capita national income. The empirical results further indicate that expansionary monetary policy may not be significantly detrimental to per capita income growth over extended periods of time beyond immediate stabilization challenges.
An added value of the paper is its assessment of the interaction of variables beyond their immediate implementation periods to avoid biased sampling. Consequently, the paper brings a unique historical and empirical approach to the study of stabilization issues that is not confined to a time period when it was popular or unpopular to implement certain theories. Invariably, it could take several years for the real effects of some policies to be realized. Of course, other policies are instantly objectionable for real or perceived normative reasons.
Stabilization policies are geared towards stable prices and economic growth, and the IMF was commissioned to promote such policies as one of its fundamental objectives.
History has shown that for diverse reasons members of the Fund are periodically exposed
*Chrisopher E.S. Warburton, East Stroudsburg University, PA, USA. Email: [email protected].
Acknowledgement: I am grateful to my Research Assistants, James Williams and Mykola Rudchyk, for helping me to retrieve useful information for this paper expeditiously.
to stabilization problems, and that the global economy is equally prone to macroeconomic instability or financial and economic crises. Financial crises occur outside the productive apparatus of the factors of production – land, labour and capital (excluding various forms of financial capital such as money). These crises cause sudden and dramatic changes that adversely affect prices of assets, including currencies, liquidity, credit availability and investor and/or consumer confidence, and cause the collapse of some financial institutions. The severity of financial crises can then trigger aggregate unemployment, illiquidity, loss of consumer and investor confidence, and prolonged recessions or depressions – the symptoms of economic crises. The causes of financial crises are varied and they cannot be exhaustively discussed in this paper. They could be attributed to human misbehaviour and corruption, bad governance, information asymmetry, adverse selection, and/or shocks (sudden and unanticipated financial disruptions that are temporary and not directly attributable to expected occurrences). A discussion of some of these issues in the context of market failure and financial crises has been presented elsewhere (Warburton 2013).
Policy responses to economic crises by the IMF have varied over time and space from the relatively inflexible irreducible core (orthodox) approach to heterodox approaches that include some measure of wage and price controls or expedience. In implementing these policies some macroeconomic variables have been given high priority; for example, the money supply and inflation, current and capital accounts, governance, local currency, import and export propensities, deficits, and national income.
Some of these variables are of natural interest to this paper.
Specific policy choices and exogenous factors to be evaluated in this paper are:
foreign income elasticity; monetarism or domestic and foreign inflation; and absorption or fiscal restraint in the context of general equilibrium analysis. For the sake of brevity or parsimony, a brief reference is made to capital account liberalization as part of the relatively recent approach to stabilization theory. All of these policy choices, with the exception of the elasticity approach, are intimately related to general equilibrium analysis – a simultaneous analysis of markets and aggregate economic performance. From an empirical point of view, this paper has not been structured to deal with the normative arguments that might be inferred. Even when institutions have supranational authority, they are governed by soft laws that try to equilibrate the laws of cooperation and national self-determination. Searches for the appropriate balance sometimes evoke emotive and imprecise arguments.
For quite some time, and true to the real or perceived IMF mandate that could be found in the Articles of Agreement, normative considerations were generally considered residual; this was essentially because the Articles of Agreement did not specifically and directly authorize the Fund to engage in such issues as part of its operations or policies.
Instead, specific economic theories and the revolving nature of the Fund’s resources were granted primacy. Yet some would argue that the IMF’s stabilization programmes should not be considered to be entirely bereft of ethical national considerations (Mussa and Savastano 2000) just as the IMF conducts general surveillance and makes recommendations (Mussa 1997; Weiss 2013, p. 9 ).
The rest of the paper is structured to provide: (i) an overview of the IMF stabilization literature; (ii) the historical responses of the IMF to financial and economic crises and the key variables of interest; (iii) policy objectives and empirical models to
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estimate the relevant stabilization variables; and (iv) the empirical findings and policy implications of the paper.
2. Macroeconomic stabilization and targeted econometric variables
(a) Foreign imports and domestic trade imbalance: An analysis of the elasticity approach
Imports are purchases of goods, services and foreign assets that lead to credits or income for foreign nations. On the other hand, exports are purchases of goods, services and domestic assets by foreign nations that lead to domestic credits or income. The difference between exports and imports is otherwise known as net exports or the trade balance of a nation. Elasticity is the responsiveness of one variable, say domestic consumption, to another, say foreign income. As such, the elasticity approach measures the response of a domestic trade balance to foreign imports or income. The elasticity approach is one of the earliest approaches that were adopted to deal with stabilization problems. It did not specifically and directly track the impact of devaluation on national income. Rather, it focused on demand and supply analysis: essentially, the responsiveness of foreign demand to relative price changes, the inducement of domestic supply, and the eventual reduction in the prices of foreign exports as a result of immediate contractionary demand.
Relevant time and response considerations are noteworthy in the elasticity approach.
Even if demand is inelastic, which will not necessarily facilitate a speedy improvement of the trade balance, it is conceivable that a temporary decline in the trade balance will ultimately be followed by an improvement after devaluation. Similarly, the devalued prices of exports will ultimately gravitate towards their pre-devaluation levels. The national income identity can be used to derive the trade balance (net exports, NX) and net capital outflow or net foreign investment. Consider the basic macro identity, Y = C + I + G + NX; where Y is for national income, C is for private consumption, I is for institutional investment, G is for government spending, and NX is for net exports (exports (X) – imports (M)). If Y - C - G = S (national saving), then by definition, S = I + NX and S - I = NX. That is, net capital outflow (S - I) must be equal to the trade balance or NX in equilibrium (see Mankiw 2013, p. 135 for further reading).
The temporary decline in the trade balance when foreign demand is inelastic is popularly known as the “j-curve” effect of devaluation and is depicted in Figure 1(b). Yet the trajectories of trade balances as a result of previous decisions are realistically uncertain as time progresses. This observation is supported by the evident divergence of the time path of current account balances over time, as depicted in Figures 1(b) and 2. By focusing on the trade balance and currency valuation, the elasticity approach was a partial equilibrium analysis which did not take into consideration the direct effect of currency performance on national income (de Vries 1988, p. 17). By contrast, the absorption approach was a general equilibrium analysis that focused on changes in national income.
Figure 2 shows the volatile time path of current account balances, which are, by definition, a composition of the capital account and net exports. Volatility could be the result of excessive intervention in foreign exchange markets or a “dirty float” policy and exogenous conditions in foreign countries, including trade policies.
Figure 1: Pegged Local Currency and Balance of Trade Trajectories after Devaluation
(a) Local currency performance (b) Trade balance (TB)
Exchange rate Change in TB
Overvaluation
(local currency)
+
Long-run equilibrium 0 Time undervaluation _
(local currency) 0 t
oTime
Figure 2: Time Path of Current Account Balances (1960-2011, percentage of GDP)
The repercussions of economic shocks make the definite trajectories of the value of local currencies and the time path of trade balances unpredictable; except, of course, if an assumption is made that potential economic shocks will be very mild, ephemeral and inconsequential. Alternatively, policy makers must have perfect foresight. Figure 1(a) shows three possibilities in the aftermath of currency devaluation: (i) a situation where the value of a local currency could be overvalued for a protracted period of time; (ii) a situation where the effect of the devaluation of a local currency eventually gravitates towards its long-run equilibrium; and (iii) a situation where a foreign currency could overshoot its long-run equilibrium relative to the local currency, leading to an undervaluation of the local currency (overvaluation of a foreign currency).1
1 The exchange rate overshooting model was first attributed to Rudiger Dornbusch for a different reason, which is the depreciation of a currency as a result of expansionary monetary policy.
Over time, the value of a local currency will subsequently appreciate, and households and firms will sell foreign assets as a local currency appreciates in tandem with interest rates (Dornbusch 1976). Building on the overshooting model, this work presents varied expectations of currency
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More than 20 countries have been intervening at an average rate of nearly $1 trillion annually in the foreign exchange markets for several years in order to keep their currencies undervalued to boost their international competitiveness and trade surpluses.
Consequently, many countries, including developing countries, suffer the counterpart deterioration in their trade balances and a loss of jobs (Bergsten and Gagnon 2012).
Anticipated shocks provide justification for intervention in foreign exchange markets.
Figure 2 shows that the “j-curve” effect might not be apparent over extended periods.
However, with exchange rate shenanigans by major trading partners, the subsequent improvement of the trade balance after deterioration, as depicted in Figure 1(b) (the j- curve effect), is not likely to occur. It is estimated that the acquisition of reserve holdings to cover three months’ worth of imports is reasonable. Alternatively, a very conservative estimate is the ratio of reserve holdings to aggregate short-term debt denominated in foreign currencies (Bergsten and Gagnon 2012).2 Maintaining a dual exchange rate system – an official rate and a flexible rate for transactions in private markets – would not necessarily permit exchange rate stability or an improvement in the trade balance of a country experiencing financial and economic crises. In such situations, the eventual appreciation of a devalued currency, tending to the long-run equilibrium in Figure 1(a), is not likely to happen.
(b) Deficits, money supply, and inflation: The seigniorage and hyperinflation problems
The ability of governments to buy goods and services by printing money is known as seigniorage. This is a dangerously attractive policy when the cost of printing money is significantly less than the benefits to be derived. Of course, inflation is a matter of changes in the money supply and/or price increases induced by exogenous shocks – for example, the oil crisis of the 1970s. Apparently, it might not be entirely wrong to envisage a dual causality between price changes and seigniorage in the absence of acceptable or normal sources of government revenue; meaning that external inflationary pressures could easily induce seigniorage just as seigniorage could generate or exacerbate inflationary pressures.
Since the cost of seigniorage is not fixed, it could ultimately have undesirable inflationary effects. For example, seigniorage may well be unsustainable and inflationary when demand for real money balances is not increasing. Governments will generally not engage in seigniorage, except when there is a propensity to consume goods and services without sufficient tax revenues and/or foreign reserves. Invariably, social planners turn to money presses when they can no longer borrow money at forgiving rates and/or when foreign reserves are dangerously low. Yet, there are adverse consequences if countries with inconvertible currencies unduly engage in seigniorage, because countries with
performance after devaluation (deliberate adjustment of the value of the local currency) and the impact of such variations on trade balances.
2 Trickier issues involve acquisition of excess reserves for national security matters, adverse external policies or situations requiring retaliation or precaution, and sudden capital reversals. IMF guidelines encourage governments to intervene in markets in order to counteract or sterilize the effects of disorderly market conditions associated with “hot money”; see also Bergsten and Gagnon 2012, pp. 6-7.
inconvertible currencies and the original sin syndrome (countries that cannot borrow in their own currencies) cannot induce foreign nationals and financial institutions to hold their unappealing currencies for brief or extended periods of time.
Seigniorage becomes tenuous in inflationary and contractionary situations as demand for real transaction balances plummets. The direct link between deficits, seigniorage and inflation is well established. First, consider the Obstfeld and Rogoff (1996) representation of seigniorage in two component parts:
; (1)
where P and M are for the general price level and the nominal stock of money respectively, with contemporary (t) and lag (t-1) indicators. The first expression on the right-hand side is the proceeds from inflation tax and the second is the change in the economy’s real money holdings. Alternatively, the proceeds from the inflation tax reflect an intertemporal difference in real money balances. In the growing economy, seigniorage must be greater than the proceeds from the inflation tax:
. (2)
The increase in the money supply accommodates increasing demand for real transaction balances without unnecessarily increasing inflation.
Fiscal deficits could be comprehensively linked to seigniorage and inflation (Sachs and Larrain 1993, pp. 333-334). Consider the representation of the real value of government deficits (Dt) as the real change in the money supply under the more practical floating exchange rate regime:
. (3)
The equation of exchange and its regularity conditions of invariant nominal output and velocity could be used to clarify Equation 3 and show how a stock of deficit between periods and the change in the money supply attributable to budget deficits (Dt) could trigger an increase in the inflation rate. Consider the money equation of exchange:
; (4)
substituting prices for money in the first expression of Equation 3 and multiplying the right hand side by Pt-1/Pt-1, the deficit can be re-written as:
. (5)
Defining inflation as , government deficits can be
written as
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. (6)
As such, Equation 6 defines a deficit in terms of the product of a tax base or real money balances (Mt /Pt) and a tax rate (the first expression on the right hand side), with as a representation of the inflation rate. In effect, with an invariant tax revenue base, deficits increase pari passu with the tax rate of inflation when deficits are financed through an inflation tax on real money balances; meaning that the printing of money by governments to raise revenue to finance purchases of goods and services is an inflation tax.
The unsustainable use of seigniorage is not without history. For example, the exorbitant privilege of the US dollar in the 1960s and its hegemonic position under the Bretton Woods system succumbed to speculative pressure and eventually, a two-tier gold pricing system – an official price of $35 an ounce and a flexible price in private markets – that was a prelude to the demise of convertibility under the Bretton Woods system (Levi 2009, p. 237).
Between 1971 and 1982, inflation and seigniorage in Mexico reached very high percentages, 21.2% and 23.9% respectively (Cukierman et al. 1992). Total seigniorage is estimated to be as high as $50 billion for 2011 (Ferrer 2012).
In Zimbabwe, Mugabe used seigniorage to offset a counterproductive Marxist redistributive policy. As a consequence of poorly sequenced land redistribution and inadequate capitalization, output declined, tax revenue fell, and the government responded to the shortfall in revenue by printing money. The government tried to deal with hyperinflation – inflation rates of 40 per cent per month (Reinhart and Rogoff 2009, p. 5) – by imposing price controls which accentuated the shortage of many goods and led to the development of a robust underground economy with tax evasion. The progressive decline of tax revenue induced further monetary expansion and higher inflation levels. In July 2008, the officially reported inflation rate was 231 million percent, which was probably higher than the real rate. The government abandoned its currency in favour of the dollar in March 2009.In response to economic pressures, the government reached an agreement with the IMF for the start of an economic recovery programme, supported by the 1998 Stand-By Arrangement.
The programme aimed to achieve a decline in inflation to 30 per cent by the end of 1999 (from the 47 per cent level in 1998), real GDP growth of 1.2 per cent, and a US$160 million gain in net official international reserves. This adjustment in fiscal policy was to be supported by tight monetary policy and confidence-building measures, including aligning the land reform process to the agreed strategy (Coomer and Gstraunthaler 2011).
Apart from seigniorage, external sources of money have been integral to stabilization issues. The monetary approach, and its consequent financial programming, is based on the estimation of the prospective demand for money as a result of forecasts of real GDP and assumptions about future price increases. The growing importance of external sources of money was introduced to the IMF by Robert Triffin, who argued that, by controlling domestic credit during the period of a stand-by arrangement to affect the change in money demand, policy makers could keep external accounts in balance and the change in international reserves equal to zero (de Vries 1988, p. 29). Thus, in the late 1950s, the IMF staff gradually developed a financial programming approach to evaluate
stabilization programmes when members desired the Fund’s resources.3 A caveat worth noting is that the monetarist view should not be perceived as the only causal or correlative relationship between monetary targets and the attainment of balance of payments objectives.
(c) Deficits and national income: The absorption approach – a general equilibrium analysis
Balance of payments problems are the result of disequilibrium between aggregate output of goods and services [in the current account] and absorption of those goods and services [investment consumption for those goods and services]. Absorption means a reduction in goods and services to a level that does not compromise productivity and returns on investment, including earlier commitments. A disinflationary financial policy that restrains domestic consumption could increase export capacity while slowing down the demand for imports, without inducing adverse relative price changes. However, under conditions of serious balance of payments problems, such measures may induce relative price changes because of resource allocation among competing export, import, and purely domestic industries; thereby causing unemployment when global demand is weak. In effect, devaluation should alter production and absorption patterns because of changes in resource allocation and available income.
(d) Capital account, governance, exchange rates, and national income: The advent of capital account liberalization and the East Asian crisis
The capital account is that portion of the balance of payments of a nation that records transactions involving financial and capital assets. Transactions of domestic governments such as bills, bonds, stocks and cash deposits are notable entries in the capital account.
Two categories of investments are also notable: (a) portfolio investments and (b) foreign direct investment (FDI). Portfolio investments are more fluid and could trigger financial instability when sudden capital reversibility results in the speculative attack on a pegged local currency as foreign investments depart from a country. Of course, an opportunity cost of the pegged regime is the loss of monetary independence (see Figure 3). Invariably, one of the opportunity costs of a flexible exchange rate regime, including periodic devaluations, is exchange rate stability and therefore unpredictable trade balances.
FDI is generally considered to be less fleeting and less volatile because of a commitment to the ownership of physical capital in a foreign territory; usually in the magnitude of about 10 per cent or more. But the bolted-down theory is questionable when FDI is classified as a liability of firms or when FDI is used to back financial claims.
Foreign investors could easily hedge their earnings and protect the value of their assets by borrowing in the domestic currency and pledging physical capital as collateral (Fernandez-Arias and Hausmann 2000).
3 Financial programming became practical because money and monetary policy play an important role in a member’s balance of payments developments and because data on monetary variables are relatively reliable and more timely than data on real variables (de Vries 1988, p. 30).
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Figure 3: Opportunity Costs of Exchange Rate Regimes: The Exchange Rate Trilemma or impossible trinity
Capital controls
Monetary Exchange rate stability independence
Flexible Fixed
exchange rate exchange rate Capital mobility
Source: Reinert 2012 p. 274 (minor modifications by author)
The earlier crises were predominantly related to the purchases of goods and services and were therefore representative of current account imbalances. In the late 1990s an unusual form of global crisis emerged in the form of debt and capital account imbalances in Asia. Reinhart and Rogoff capture the general thinking at the time. The Asian region had conservative fiscal policy, stable exchange rates, high rates of growth (as evidenced by the East Asian miracle), and no remembered history of financial crises. “Asia was the darling of foreign capital during the mid-1990s. Across the region, (1) households had exceptionally high savings rates that the governments could rely on in the event of financial stress, (2) governments had relatively strong fiscal positions so that most borrowing was private, (3) currencies were quasi-pegged to the dollar, making investments safe, and (4) it was thought that Asian countries never had financial crises. In the end, even a fast-growing country with sound fiscal policy is not invulnerable to shocks.” (Reinhart and Rogoff 2009, p. 19).Consequently, the collapse of the Thai baht on July 2, 1997 came as a surprise to many. “For ten years the baht traded around 25 to the dollar; then overnight it fell by about 25 percent. Currency speculation spread and hit Malaysia, Korea, the Philippines, and Indonesia, and by the end of the year what had started as an exchange rate disaster threatened to take down many of the region’s banks, stock markets, and even entire economies.” (Stiglitz 2003, p. 89).
In Thailand there was a speculative attack coupled with short-term indebtedness. As the crisis progressed, unemployment soared, GDP plummeted and some banks failed.
There was a pervasive belief that full capital account liberalization would foster regional growth. The countries of East Asia had no need for massive capital inflows, given their high savings rates; but capital account liberalization was encouraged in the late nineteen eighties and early nineties. It is fairly reasonable to argue, Stiglitz claims, that no country would have withstood the sudden and large capital reversal that accompanied the speculative attack on the baht. In the case of Thailand, the reversal amounted to 7.9 per cent of GDP in 1997, 12.3 per cent of GDP in 1998, and 7 per cent of GDP in the first half of 1999 (Stiglitz 2003, p. 99). There was an equally strong withdrawal of foreign reserves by domestic residents in the Southeast Asian countries (Cooper 1999).
The formal statement of the IMF in December 2012 is much more critical of unfettered capital flow; a reasonable and noticeable shift from the much more orthodox approach of previous years. In its advice on managing large capital flows, the IMF stresses the importance of sound institutional and regulatory structures to channel large capital inflows towards productive investment, because large capital inflows have macroeconomic consequences. As such, the first line of defence against disruptive capital inflow is appropriate macroeconomic policies: (a) lower interest rates in the absence of inflation threats or asset bubbles; (b) accommodation of currency appreciation if it is not overvalued; and (c) the accumulation of foreign exchange reserves if the level of reserves is not excessive. As such, capital flow measures can be useful for supporting macroeconomic policy adjustment and safeguarding financial system stability (IMF 2012;
Bergsten and Gagnon 2012).The role of governance in the East Asian crises is somewhat controversial. How did some countries move from a miracle to a crisis? Governance is the way and manner in which laws are promulgated, interpreted and enforced. In corrupt settings, rules and laws are inter-sectorally abused or scandalously ignored for private benefit.
As such, public sector corruption is not merely a public sector issue, but a socially depraved behaviour involving the interaction of public and private agents.The Bank of Thailand began spot and forward sales of the US dollar in July 1996 and was largely successful until May 1997 (Tongurai 2005). Forward sales of foreign currencies were used to conceal the loss in reserves in an unethical way, in that the bank maintained a fixed exchange rate having exhausted resources for later delivery (Liu et al. 2013, p. 67).
Like the US in the 1980s, Thailand steadily deregulated and liberalized its financial sector from 1992 by removing interest rate ceilings, lifting exchange controls and encouraging capital inflows. Large inflows exceeded the country’s productive capacity to generate an excess capacity as private sector credit quality deteriorated. Between 1992 and 1996 debt- to-equity ratios increased from 71 to 155 per cent (Liu et al. 2013, p. 69). In a highly leveraged environment, speculative investment in land and real estate, usually with questionable public-private sector cooperation or moral hazard, created an asset bubble in early 1992 which ultimately led to the collapse of the domestic financial system in 1997 with a contagious effect. Apart from the financial shenanigans that prefaced the crisis, the defence of the fixed exchange rate regime exacerbated the crisis situation – a balance of payments crisis defined by the central bank’s shortage of reserves and the eventual abandonment of the fixed exchange rate parity.The string of capital account crises at the turn of the century, starting with the European Exchange Rate Mechanism crises of 1992- 93 and culminating with the collapse of Argentina’s currency board in early 2002, seemed to underscore the fragility of fixed exchange rate regimes (Gosh et al. 2010, p.
17). While a fixed exchange rate regime guarantees a reasonable amount of capital mobility and exchange rate stability, as depicted in Figure 2, the opportunity cost is the loss of monetary independence, which is paradoxically associated with volatility of capital movement. Capital controls are usually intended to rein in the exuberance of capital inflows (the opportunity cost of capital controls as depicted in Figure 3).4
4The sides opposite to the three angles indicate the opportunity costs or the generally unattainable long-run outcomes associated with the three regimes.
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However, the empirical evidence across a broader sample of countries with fixed regimes suggests that currency crises may be more prevalent among countries with intermediate regimes (Gosh et al. 2010, p. 17).
(e) Government spending, governance, and sluggish economic growth: A new generation of financial and debt crises without exchange rate adjustment or indexation
Unlike the earlier crises in the developing and emerging economies of the 1980s and 1990s, the policy choices for the relatively recent financial and debt crises did not include the devaluation of major convertible currencies like the US dollar, in the case of the US, or the euro, in the case of Greece. The policy responses are evidently divergent in several respects, being fiscal contraction or austerity measures in the case of Greece, a member of an economic union that is less than optimal, and expansionary monetary and fiscal policies in the case of the US. Except that there was no currency devaluation, the response to the Greek crisis is true to the orthodox form, while the response to the US crisis is true to the Keynesian paradigm. Of course, there have been vigorous debates over the adequacy of the expansionary fiscal response.
In the US, the new crisis was inextricably linked to esoteric mortgage-backed securities and credit default swaps. The financial markets had been reasonably well regulated since the 1930s, but a wave of deregulation in the 1980s and the innovation of excessively risky instruments, so-called “securitization”, plunged the economy into crisis by the start of summer 2007. The securitization process involved a long chain that was grounded on the “greater fool theory”. It was successful as long as there were fools who would buy the toxic assets that were created (Stiglitz 2010, p. 91). Mortgage originators created mortgages that were then peddled by investment banks as repackaged new securities. A substantial number of institutional investors in the US and abroad heavily invested in the assorted forms of new securities that were contingent only on the ability of mortgage owners to pay their mortgages. Creating derivative contracts out of the synthetic securities further complicated the situation and created unduly high risk exposures.
The mortgage market was diversified and transformed by collateralized debt obligation (CDO). Lower tranches of mortgage-backed securities that were harder to sell were repackaged as CDOs and about 80 per cent of them were granted triple A rating (Financial Crisis Inquiry Report (FCIR), United States Public Affairs 2011, p. 127). The American International Group (AIG) wrote billions of dollars of protection, and by 2007 had $533 billion of protection on diverse mortgage-backed securities and CDOs (FCIR, p.
141). After the crisis hit, the company had to be bailed out to the tune of approximately
$200 billion (Stiglitz 2010, p. 10). The failure of governance has been attributed to the ubiquitous shadow banking institutions that existed in capital markets beyond regulatory control, the inability of the Fed to check the irrational exuberance of investment, the predatory lending that sustained the bubble and the information asymmetry that facilitated transactions in financial markets before and during the crisis.
There are intermediate accommodations; for example, in the intermediate period, a flexible rate can attain some measure of rate stability as well as capital mobility. For further reading see Reinert 2012, p. 274, and Mankiw 2013, pp. 381-382.
During the whole of 2006 and 2007, the federal funds rate stood at over 4 per cent.
In the course of 2008, as the financial crises and recession grew deeper, the Fed moved aggressively to cut interest rates. By the end of the year, the federal funds rate was 0.0- 0.25% (Reuss 2009, p. 47). Even with the zero-bound federal funds rate, the economy was stuck in a liquidity trap (Reuss 2009, p. 47; Krugman 2012, p. 32).5 The American Congress agreed a $700 billion bailout fund, mainly to capitalize depository institutions, and the American Recovery and Reinvestment Act a fund of $787 billion, considered to be inadequate by some economists (Stiglitz 2010, pp.62-64; Krugman 2012, pp.116-117).
By renouncing its claim to monetary sovereignty, Greece could not use the exchange rate mechanism to stabilize its economy. It has had to rely on conditional policies that are designed and promoted by stronger European governments, the ECB and the IMF, the
“troika” (Krugman 2012, p. 186). Greece had its fiscal woes. Like most developing countries of the 1980s and 1990s, it had a bloated public sector that was based on patronage. The eurozone crisis started in earnest in January 2010 with Greek spreads reaching 300 points (3 per cent) after it was revealed that the country’s public finances were far worse than originally estimated and when it became apparent that the eurozone was facing a sovereign debt crisis but lacked a framework and instruments to solve this crisis (Sapir 2011, p. 1223).
Greece had a very vibrant black market system which was significant enough to be integrated with the official market. The 2006 estimates of the Greek black market were incorporated into the more traditional estimates of GDP (Epitropoulos 2010, p. 78). Yet, a small open economy like Greece required policy responses that were characteristically more innovative than the traditional orthodox policy of fiscal restraint. The loss of monetary sovereignty and the noticeable surpluses in some eurozone countries made contractionary policies undesirable. “Even as deficit countries are pushed to savage austerity, surplus countries have been engaged in austerity programmes of their own, undermining hopes for export growth” (Krugman 2012, p. 186). Notably, the Greeks rely heavily on the import propensities of the Germans and Italians (see Table 1). The absorptive capacities of non-eurozone members who generally enjoy a very robust pattern of extra-European union trade (Warburton, 2012b) equally had worse prospects because of the global economic downturn.
In the absence of devaluation, is austerity an oxymoronic expansionary policy? In a surprising twist of events, some economists have argued that austerity without currency valuation could be expansionary; specifically because of so-called “internal devaluation”
– a situation in which wages and prices are reduced as a result of a reduction in government spending and the resulting layoffs and wage freezes. The global nature of the crisis, which reduces aggregate trade (exports and imports), and the squeeze on real wages and incomes, realistically depress aggregate demand (Van der Veen 2012, p. 30).
3. Stabilization variables, models, and econometric hypotheses
Issues relating to variable operationalizations are discussed in this section. The data for all variables are obtained from the 2012 World Bank’s World Development Indicators (WDI) except as otherwise stated (as in the case of major importers (Table 1)). The data
5 The controversial liquidity trap has been modelled in terms of interest rate, saving, and investment; see Warburton 2013.
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generally cover a period of 51 years (1960 to 2011) to provide 51 annual time series observations. In this paper, Argentina, Mexico, Ghana, and Nigeria are of empirical interest, and from the previous discussions it is evident that money supply is a critical indicator of destabilization in the form of inflationary pressures. The growth in money supply also indirectly accommodates theories of seigniorage or shortfall in tax revenues as in the case of Zimbabwe.
The broad money supply, albeit an imperfect measure, is the preferred measure of money growth. The broad money measure accounts for the sum of currency outside banks; demand deposits other than those of the central government; the time, savings, and foreign currency deposits of resident sectors other than the central government; bank and travellers’ cheques; and other securities such as certificates of deposit and commercial paper. There is an assumption that increases in the money supply through seigniorage will filter into the private sector, but also that this measure takes subsequent spending into consideration. Social planners routinely borrow money from the private sector, potentially reducing national saving and crowding out investment. As such, this variable is not only confounding, but is probative in the stabilization context. A visual inspection of the data, depicted in Figures 4(a) and 4(b), is revealing of the theoretical proposition that money growth and inflation are positively correlated.
Figure 4(a): Broad Money Growth 1961-2011 (annual percentage)
Figure 4(b): Inflation (GDP deflator, annual percentage)
The GDP deflator provides a broader measure of inflation that is suitable for macroeconomic and econometric reasons. Consumer price indices are usually narrower and exclusive of certain types of products, apart from luxury goods. They also tend to lag behind innovative changes and changes in consumer preferences over time. Implicitly, increases in aggregate prices reduce welfare, and wage indexation was a stabilization policy designed to assuage the effects of hyperinflation in Latin America. The GDP deflator is the ratio of nominal to real GDP, which is measured here as an annual percentage change. It provides information about the overall level of prices in an economy without exaggerating the prices that are attached to nominal output.
Foreign income is defined in terms of the per capita income (GDP) of the major importers of distressed economies. In the presence of some real challenges involving disaggregated sources of foreign income and geographic or affined changes in trade intensity (as a result of colonial ties and severance), it is a proxy variable in its own right.
However, the variable provides valuable information because it identifies significant sources of foreign income with some amount of historical information or long trading relationship. Table 1 provides indicators of sources of income for countries that were once suffering from crises of assorted forms.
The table shows that the US, France and Brazil are major sources of foreign income for the once distressed countries. For the sake of brevity, not all countries and crises will be studied in this paper. The discussion of recent financial crises and the role of money will suffice to provide an overview for now.
Table 1: Major importers and sources of income for the distressed economies*
Country Crises Major Importers
Argentina Hyperinflation (1990s) Brazil (21%); China (7%)
Ghana Debt (1980s) France (19.1%); Netherlands (10%); US (8.6%) Greece Debt (2000s) Italy (9.5%); Germany (7.9%); Turkey (7.9%)
Mexico Debt (1980s) US (78%)
Nigeria Debt US (29.1%); India (11.6%); Brazil (7.8%)
Thailand Financial and debt (1990s) China (12%); Japan (10.5%); US (9.6%) Zimbabwe Hyperinflation (1990s) South Africa (17.3%); China (16.9%)
* Major importers were selected from the CIA World Factbook. Some countries might have experienced assorted varieties of crises at different periods. The commencement periods of crises are approximate for the listed countries.
Data for national savings are adjusted to account for education expenditure as a percentage of gross national income (GNI) in the case of Argentina, and consumption of fixed capital in Ghana, Mexico, and Nigeria. Net national savings routinely compensates for the consumption of fixed capital (depreciation), and it may be further adjusted to obtain genuine savings after investments in human capital, depletion of natural resources and damage caused by pollution have been taken into consideration. The much more stringent measure of national savings (adjusted net national savings) takes sustainability into consideration. Since savings data for the 1960s are problematic, time series values for about 37 years and the law of averages are used to estimate some missing values. The savings variable is also a good proxy for domestic investment, given the arguments of the
19
absorption approach. It should be recalled that in equilibrium it is expected that aggregate savings must be equal to aggregate investment.
The exchange rate is operationalized as local currency unit per US dollar. In both models the exchange rate is used as a critical component to capture devaluation and its expenditure switching or income effects – the effort to reduce imports and expand domestically produced goods or exports as a result of changes in the value of a currency – a primary objective of IMF stabilization orthodoxy and, to some extent, of the heterodox approach. The data for local currency valuation cover the period 1960 to 2011.
Using changes in the value of domestic currencies, national savings as a percentage of GNI, foreign per capita income, and domestic and foreign inflation, the elasticity and absorption stabilization models are estimated with extended information; where the elasticity model is of the following form:
%∆TB = f {(log(gdpF)), πF, Ex} + ԑ, for data in levels; alternatively,6 %∆TB = f {(%∆ (gdpF, πF)), Ex} + ԑ. (7)
The trade balance or net exports (NX) is denoted as TB, gdpF is for foreign income, πF is for foreign inflation, Ex is for exchange rate (the variable that tracks the effects of devaluation or changes in local currency value over extended periods), and ԑ is the usual stochastic expression, assumed to be normally distributed with a constant variance.
Equation 7 provides the alternative percentage changes (%∆) specification. Negative trade balances and the levels data of GDP per capita necessitate a lin-log estimation of the trade balance and foreign-income relationship. The most relevant hypothesis for the elasticity approach is that foreign income does not affect domestic trade imbalances when foreign inflation and the value of local currencies are taken into consideration.
The absorption model, a general equilibrium model, estimates the incremental effects of foreign income, the money supply, domestic saving or investment, and the performance of local currencies on per capita national income. The objective is to evaluate the robustness of the effect of foreign income on national income when domestic money growth, the value of the local currency, and the amount of adjusted domestic savings (a proxy of investment) are taken into consideration. The model to be estimated is of the form:
Log(gdpD) = f {(log(gdpF)), M, SD, Ex} + ԑ, (8)
where gdpD is for per capita domestic income, M is for the growth of broad money, and SD is for domestic saving. In effect, the prior hypothesis is modified to evaluate the relationship between foreign and domestic incomes under the circumstances of
6 It should be noted that log specification for levels data measures the responsiveness of the dependent variable to incremental percentage changes in the independent variables. That is, log y
= β log x → ; so that β= .
devaluation or the relative prices of currencies. The empirical findings are reported in the next section with some policy implications.
4. Empirical findings and policy implications
In general, the empirical evidence suggests that the stabilization theories could perform reasonably well with some loss of generality. The elasticity model (Table 2) is relatively less robust for explaining variations in trade imbalances (see the R-squared and the adjusted R-squared values in Tables 2 and 3). However, the model indicates that the trade imbalances of Mexico and Nigeria could be very sensitive to changes in US income when inflation in the US and the relative prices of the domestic currencies are considered. In the case of Nigeria the trade balance could improve by a minimum of about 0.16 per cent, while in Mexico it could improve by about 0.09 per cent (in both situations, by less than one per cent).
Table 2: The Elasticity Approach
Dependent variable: Percentage change in the trade balance (1960 to 2011). Observations: 51 Method: Ordinary Least Squares (t-stat in parenthesis except where otherwise denoted)
Country Foreign income from...
Inflation in... Devaluation /depreciation
(LCU)
R-squared /Adjusted
F-Stat (p-value) Argentina Brazil
0.29 (0.16)
Brazil -0.0002 (-0.31)
1.24 (2.70)**
0.23/0.18 4.56 (0.0)
Mexico US
8.50 (3.09)**
US -0.37 (-1.81)*
-0.68 (-3.51)**
0.21/0.16 4.10 (0.01)
Ghana France
-6.08 (-2.58)**
France 1.08(6.00)**
-3.89 (-2.17)**
0.72/0.70 40.29 (0.00)
Nigeria US
16.48 (3.74)**
US 0.55 (1.42)
0.01 (0.42)
0.45/0.42 13.07 (0.0)
* Denotes 90 percent level of confidence.** A 95 percent level of confidence.
It is doubtful whether devaluation could have been the primary transmission mechanism for expenditure switching outcomes in the cases of Ghana, Mexico, and Nigeria when foreign inflation in France and the US are considered. Unit depreciation or devaluation of local currencies could have undesirable results for the Mexican and Ghanaian trade imbalances, but not the Argentine trade imbalance. Interestingly, the Argentine trade with Brazil, given the rate of inflation in Brazil and the value of the Argentine peso relative to the Brazilian real, is not very significant for the improvement of Argentina’s trade imbalance; this suggests that the expenditure switching effects of devaluation do not necessarily emanate from the major importers of countries with devalued currencies.
Controlling for inflation and foreign income in Brazil, France and the US, the results for unit changes in the Brazilian real, Ghanaian cedi and Argentine peso are mixed.
Based on imports from Argentina into Brazil, Argentina could improve its trade balance by about 1 per cent after devaluation. In Mexico and Ghana, there could be a decline of about 0 to 4 per cent after devaluation of the local currencies. This finding reinforces the view that the improvement of a country’s trade balance is contingent on a host of other factors that must support currency adjustments, including its political and economic structure, internal and external political stability, and diversification of sources of income.
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The effect of US inflation, which has been historically mild, is unfavourable for the Mexican trade balance; it worsens the Mexican trade balance by less than 1 percentage point. The relationship between US inflation and the Nigerian trade balance is insignificant, as is its relationship with those of Brazil and Argentina. Inflation in France seems to reduce Ghanaian imports and/or increase its exports to France by about 1 per cent. This finding is normal because goods and services will be relatively cheaper in Ghana, which reinforces the devaluation objective from the nominal and real perspectives. The negative foreign income effect (of about 0.06 per cent) on the Ghanaian trade balance is negligible and is probably associated with increased domestic consumption or investment because of relative price differences or the history of traditional trading patterns. The coefficient is significantly less under the absorption approach, which suggests that insignificant domestic savings could reinforce trade imbalances. The joint hypothesis tests show that the models are all significant (see the F- stat).
The absorption approach is much more robust for its inclusion of formerly excluded variables and its general equilibrium approach. Except for Argentina (with very negligible significance), the theory that money growth has an adverse impact on aggregate per capita income over an extended period of time is not supported by the evidence for Mexico, Ghana or Nigeria when foreign income, the relative prices of currencies and domestic savings are taken into consideration. As such, stimulative or properly targeted expansionary monetary policy may not be detrimental to stabilization efforts. Evidently, Argentina had significant problems with inflation, which means that the rate of money growth matters in the short-run (assuming it is not persistent).
Table 3: The Absorption Approach
Dependent variable: Percentage change in per capita income 1960 to 2011. Observations:
51.Method: Ordinary Least Squares (t-stat in parenthesis except where otherwise denoted) Country Money
Growth
Foreign income from...
Devaluation /depreciation
(LCU)
Domestic saving/
investment
R- squared /Adjusted
F-Stat (p- value) Argentina -0.000006
(-1.7)*
Brazil 0.33 (6.62)**
-0.03 (-1.5)
0.05 (2.50)**
0.63/0.59 17.15 (0.0)
Mexico 0.0
(0.27)
US 1.2(16.07)**
-0.03 (-4.84)**
0.04 (1.85)*
0.95/0.94 235.63 (0.0) Ghana -0.001
(-1.25)
France -0.30 (-5.11)**
0.36 (8.25)**
0.002 (0.59)
0.72/0.70 29.51 (0.0) Nigeria 0.001
(1.10)
US 0.16 (1.59)*
0.002 (2.84)**
0.03 (1.97)**
0.52/0.47 12.24 (0.0)
* Denotes 90 per cent level of confidence. ** A 95 per cent level of confidence.
With the exception of Ghana, the empirical results show that foreign incomes from major trading partners have the potential to increase domestic per capita income. The contributions of foreign income to the Nigerian trade balance and per capita national income remain invariant under the elasticity and absorption approaches. Marginal percentage changes in US per capita income contribute about 1 per cent to the improvement of the Mexican trade balance. Given the value of the peso, domestic savings, and increases in broad money, Argentina’s trade balance improves by
approximately 0.33 per cent when per capita income increases by 1 percentage point in Brazil.
While devaluation of the Ghanaian cedi and Nigerian naira potentially increases per capita income under the general approach, devaluation of the peso in Argentina and Mexico has not significantly increased per capita income in Argentina and Mexico. As such, increases in per capita income in Mexico and Argentina could be attributed to reasons other than the relative prices of their domestic currencies.
Given the regularity conditions associated with the general equilibrium model, the empirical evidence shows that adjusted domestic national savings favourably contributes an average of about 0.04 per cent to domestic aggregate per capita income in Argentina (0.05 per cent), Mexico (0.04 per cent), and Nigeria (0.03 per cent); implicitly this takes place through capital formation or the investment channel.
5. Conclusions
This paper finds that stabilization policies should be oriented towards saving and investment, rather than excessively contractionary policies and hopes for expenditure switching. This is partly because the effects of exchange rate policies are contingent on trade practices and other exogenous conditions that do not immediately imply increased income from foreign sources. The issue of trade infrastructure is important because even with very large trading partners, the effects of foreign income on the trade balance and per capita income are mixed. In effect, stable economic and political conditions are essential in the multiplicity of smaller economies or trading partners of countries in distress. The cumulative percentage of trade with minor partners turns out to be larger on aggregate, but the trading alliances of minor partners are diverse and uncertain.
Stabilization is time-sensitive, but with extended information the theory that foreign income is critical to correcting trade imbalances and increasing income is supported by both the elasticity and the absorption approaches. While assurances that foreign income will respond to domestic needs are tenuous, good governance, investment and innovation are more reliable assurances. The Post Bretton Woods challenges require increased IMF revenue and modifications of the Articles of Agreement to facilitate short-term global investment and growth in addition to stabilization objectives.
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