Apologies for what may look like hair-splitting to non-academics. In a separate post I'll summarize my suggestions on how to look at Brazil. Thanks to Ellen for her comments. > At 12:18 PM 10/26/98 -0800, Colin wrote: >> This is a false dichotomy. You can argue that there are >> real forces acting on exchange rates without adopting >> an equilibrium model or asserting that markets are >> efficient. (Jim D makes a similar point.) I would strongly >> agree with Ellen that >> equilibrium models, especially of the PPP variety, are >> misleading. But this is not the same thing as saying >>that the thing is "purely" speculative. > > To say that exchange rates have widespread economic effects > and to believe that, in some perfect world, exchange rates > would equilibrate imports and exports or match the price of > beans in Mexico to the price of beans in Texas, I don't understand how the first proposition relates to the second. The first, "that exchange rates have widespread economic effects," is so obvious as to be noncontroversial. The second looks like a statement of Purchasing Power Parity (PPP) which neither Ellen nor I think useful. > should not blind us to the fact that, in the actual world > of 1998, the proximate cause of exchange rate behavior is > speculative trading in international currency markets. My last message said this — that speculators may well be the proximate cause. No disagreement here. > In this world, the predominant forces acting on the exchange > rate are the supply and demand of bets made by > traders in international banks and hedge funds. But this is a different statement. If this is a statement about why a currency happens to come under attack at a particular time, we may look to speculators, (though again there is evidence in lots of cases that domestic capital flight is the main problem). But if you want to understand why the Mexican peso, to take an example, was vulnerable in late 1994 you have to look at the RER appreciation experienced over several years and the associated need to borrow ever-larger amounts. So if you want to understand why the peso crashed in December 1994 you need to start with an analysis of what went on in the real economy over the previous five years, and then work out the role of the associated foreign borrowing over that period of time. The overall policy ends up looking like a Ponzi scheme, by definition unsustainable, and from that point of view the proximate cause of the breakdown is not all that important. > Nor is this an academic point. It is precisely because > the "free-market" system in international finance provides > no room for the exchange rate to moderate the very real > strains and stresses of international trade that > countries find themselves in the situation of Brazil. I don't understand this. I don't think the IMF, to take the most obvious exponent of this orthodoxy, tries to stop countries from floating their currencies, which precisely allows "the exchange rate to moderate ... stresses of international trade." But perhaps a different point is intended. >> In the case >> of Brazil, for example, you can simply point out that >> substantial real exchange rate (RER) appreciation has >> hurt exporters and encouraged imports, and that the >> country's ability to get foreign credit to plug this gap >> is limited. The fact of RER appreciation and its effects >> on trade do not rely on a notion of equilibrium or market >> efficiency. > > Recognize here that Brazil's efforts to stabilize it's > dollar exchange rate was DEMANDED BY SPECULATIVE INVESTORS > who would hold funds in real only if the government > promised to "fix" the nominal exchange rate. Those very > same investors also demanded that Brazil allow full and > free convertibility the better to flee the country when > and if the government reneged on its promise. When the This raises an interesting question of political economy, about the relative power imputed to foreigners and to domestic governments. Here is an alternate reading: Brazil's government elected to pursue a policy of growth based on attracting short-term foreign capital. Doing that does require a peg and full convertibility, exactly as Ellen notes. But here the responsibility lies with Brazil. I don't know of a simple way to resolve this difference in emphasis and there are global-structuralists who would argue that they amount to the same thing anyway. Certainly the fact that not every third world country follows these policies, and that at any given period even within Latin America you can find a variety of national policies in place, suggests that these foreign speculators do not run things. > economic stresses of a hard real became obvious, > investors blamed the government for "overvaluing" the > real and presented themselves as the hapless victims > of GOVERNMENT mismanagement. The identical scenario > has played out over the years in countries too numerous > to mention. > >> This is a larger debate that we may not want to rehearse, >> but again on my dichotomy point: the fact that speculators >> are the proximate cause of a collapse does not mean they >> are fundamentally responsible. Any time you have large >> RER appreciation with a fixed exchange rate, and the >> central bank has limited foreign reserves, you become >> easy pickings for speculators. But this is like walking >> out of your house and leaving the front door wide open – >> sooner or later you'll get robbed. So you have to start >> by asking what policies created this extreme vulnerability. > > My point exactly. What policies created this vulnerability? > Full and free convertibility and the lack of a international, > non-market agency to assist in trade finance. Countries have > nowhere to go but to the rentiers and speculators, who then > demand both full convertibility and fixed exchange rates. > The combination is impossible to manage -- even with big > reserves -- look at Korea. Well my point is that most of the fault lies with the policies followed by domestic governments like that of Brazil (or S. Korea), and that tinkering with finance is likely to do little good. >> Further, the majority of capital flight – or the looting >> of the central bank's foreign reserves if you like stronger >> language – is in most cases carried out by domestic wealth- >> holders, not by people like Soros. Discouraging the >> activities of the Soroses, even if you could do it, would >> have little effect on this. > > Right. This is why capital controls (inward and outward) > are ultimately more useful than Tobin taxes. I would go a lot farther and say that the problem lies in skewed wealth distributions that mean that most savings are carried out by a tiny minority that is only too ready to expatriate wealth. In the case of Mexico I would argue that this wealthy minority has been able to constrain gov't policy and make any limitation on convertibility a taboo. > Though as Jim > points out, Tobin taxes could generate lots of revenue. I think this is unrealistic but that's another topic. Anyone who is interested in this can find much discussion on it over the last year or so in the PKT archives. Best, Colin
