Exchange rate, output and employment: revisiting the contractionary devaluation hypothesis Saúl Keifman Universidad de

1. Exchange rate, output and employment: revisiting the contractionary devaluation hypothesisSaúl KeifmanUniversidad de Buenos Aires

2. I. Introduction • Purpose: discuss the relationship between the exchange rate and employment. • Motivation: understand some recent behavioral changes in the Argentinean economy to intervene in the current macropolicy debate. • Debate: what to do with the exchange under a current account and balance of payments surplus. Two opposite views: (a) Heteredox economists support Kirchner’s competitive (undervalued) real exchange rate policy to sustain output and employment expansion, relying on sterilization and some capital controls. (b) Orthodox economists propose a clean float and inflation targeting, which would lead to significant real appreciation.

3. Novelty: in the past, heteredox Argentinean economists, criticized IMF adjustment programs based on structuralist models that proved that devaluations were contractionary, contrary to their current view. • Approach: this paper attempts to revisit the current relevance of the theory of contractionary devaluations which arose from structuralist macroeconomics in the seventies and that has been recently discarded by many of their former proponents. Though the article refers to the Argentinean case, we believe this revisionist exercise presents a more general interest for two reasons: (1) The contractionary devaluation hypothesis was very popular in the developing world. (2) From a methodological viewpoint this paper presents macroeconomic models that take into account the structural characteristics of a specific country.

4. II. Devaluation and employment. Structuralism from the seventies to the new millennium • Structuralism: comprehensive vision of developing countries problems in opposition to orthodoxy. • Contractionary orthodox adjustment and stabilization programs applied in Latin America inspired alternative macroeconomic models. Two outstanding examples: (a) Structural inflation theory (b) Contractionary devaluation theory. • Background: in a Keynesian open economy model, achievement of internal balance (full employment and price stability) and external balance (sustainable current account balance) required two kinds of policies: expenditure-switching policies, to reallocate expenditure between tradable and nontradable goods, and expenditure-reducing policies, to control aggregate expenditure or absorption. If Marshall-Lerner conditions held, devaluations would improve trade balance and also raise output. Devaluations would be expansionary.

5. Right policy mix depended on initial imbalances. • But orthodox recipe for balance of payments deficits always recommended a currency devaluation combined with tight monetary and fiscal policies (e.g. IMF during developing countries foreign debt crisis in the early ´80s or in “emerging market” crises during the ´90s). Note that even if devaluations were expansionary, the treatment of a balance of payments crisis under conditions of idle capacity and high unemployment, should not include expenditure-reducing policies, that is to say, a fiscal and monetary contraction, since the latter would hinder the achievement of internal balance.

6. The theory of contractionary devaluations explain the recessionary bias of orthodox adjustment programs: Ferrer (1963), Díaz-Alejandro (1963, 1965) and Braun and Joy (1968). It is based on some typical features of the Argentinean economy in the sixties and fifties: (1) The export good is the wage-good: food; (2) Domestic food supply is inelastic but foreign food demand is perfectly elastic; (3) The price elasticity of the domestic demand for food is less than one; (4) Manufacturing production is oriented to the domestic market and its supply curve is very elastic; (5) Imported goods are not substitutes for, but rather complementary to domestic production (nonproduced manufacturing inputs); (6) Workers have a marginal propensity to spend on domestic goods greater than urban and rural property owners.

7. Structuralist explanation emphasizes the redistributive mechanism. A devaluation makes food more expensive and reduces real wages. This has a larger impact on the domestic demand for other goods (manufactures) because of the low price elasticity of domestic food demand. Given the inelasticity of the exportable good supply, its price increase does not induce higher output or employment in the food sector. The fall in workers’ manufactures demand is not offset by a higher demand from higher profits or rents in the exportable good sector. This can be due to the post-Keynesian assumption that workers have a marginal propensity to consume higher than capitalists, or because higher savings are not translated into a higher demand for domestic capital goods (negative accelerator effect in manufacturing or the increase in the interest rate), or because higher profits or rents in the exportable sector are channeled to import goods demand.

8. The contractionary view of devaluation spread outside Latin America Krugman and Taylor (1978), and became popular in the ’80s (Hanson, 1983; Katseli, 1983) providing a robust critique to the excessive adjustment external caused the orthodox recipe and known as “overkill”. • Krueger (1983) replied the critique by blaming the contractionary effect of devaluations on the “distortions caused by the import substitution strategy”. In her view, opening up the economy would give domestic industry enough competitiveness as to be able to substitute imports efficiently in response to a devaluation. • Before the ´90s, most Argentinean macroeconomists supported the contractionary view of devaluations regardless of their agreement with structuralism in toto. The macroeconomic experience from the ´60s to the ´80s had been consistent with the former.

9. The severe consequences of the currency board regime, locally known as Convertibility which set a one to one parity between the Argentinean peso and the US Dollar, from April 1991 to December 2001, had a deep impact on heterodox and structuralist economists views. • The appearance of two-digit unemployment rates since 1993 in a context of strong real appreciation of the peso and the strong negative impact of currency depreciation in Brazil (Argentina’s main trade partner) on Argentinean manufacturing output in the late nineties, weakened the contractionary devaluation view. • The fast recovery of output and employment which started in the second quarter of 2002 just after the devaluation had a devastating effect on the former. • As a result, some structuralist and heterodox authors such as Roberto Frenkel and Aldo Ferrer emphasized the paramount importance of relative prices and the need of a “competitive [undervalued] exchange rate” to foster output and employment expansion.

10. Curious fact: structuralist and orthodox economists traded places in terms of their attitudes towards the relevance of real exchange rates! • In the ´60s, in a world of fixed exchange rates and low international capital mobility, orthodox economists recommended devaluations to “get prices right”, in order to stimulate the production of exportable agriculture. Structuralist economists dissented not only for their contractionary effects but also because they distrusted price incentives as they emphasized role of “structural features” such as land tenure and the technological and financial support from the state. • Since the ´90s, in a world of financial globalization, more liberal trade and flexible exchange rates, the new monetarist orthodoxy associated with the “equilibrium approach to exchange rates” considers that the real exchange rate and the current account balance are irrelevant.

11. Given the historically conditioned character of structuralist models, this turn does not necessarily go against the methodological principles of the structuralist approach. • Insofar as the structure of the Argentinean economy has changed, it should not be discarded that its behavioral relations have changed too. However, in contrast to the hypotheses developed in the ´60s and ´70s that were supported by formal models and detailed discussions about the features of the Argentinean economy, the recent turn has not offered comparable foundations so far.

12. III. Summary of three macroeconomic models • We built three structuralist models intended for Argentina that examine the relationship between the real exchange rate (given by the ratio of the exchange rate to the nominal wage rate) and employment (see Appendix). We summarize the main assumptions and qualitative results. • The models attempt to capture some structural changes in the economy to assess its theoretical impact on the relationship between the exchange rate and employment: (a) Production of food, the exportable good is price sensitive (a stylized fact). (b) We explicitly take into account the impact of trade liberalization (semi-closed economy versus open economy) and the presence of domestic production of importable manufactures.

13. In all models we obtain an aggregate labor demand that we identify with an employment function under the simplifying assumption that labor supply is greater than labor demand at the prevailing market wage and inelastic to wages. • The effect of real devaluation (an increase in the exchange rate/wage ratio) on employment is positive at the minimum level of the exchange rate/wage ratio. For some values of the model parameters, devaluation will always be expansionary but for not for others. The employment function could have interior maximum, so that devaluation would be expansionary for low levels of the exchange rate and contractionary for high levels of the exchange rate. In other words relationship could have and inverted U shape (see Figure, the 1).

14. FIGURE 1 Employment Exchange rate/wage rate

15. An important result is that the possibility of an inverted U-shape employment function is independent of the tariff level, which refutes Krueger’s conjecture that devaluation cannot be contractionary in an open economy. • A decrease in tariffs shifts the employment function downwards and to the right (Figure 1), so that: (1) Employment will be lower in a more open economy (given the nominal exchange rate and wage rate). (2) The exchange rate to wage ratio that maximizes employment will be higher in a more open economy. • The shift of the employment function caused by tariff reduction implies that there is an interval of the exchange rate/wage ratio for which devaluation would go from being contractionary before the tariff reduction, to expansionary, after the tariff reduction, although with lower levels of employment.

16. IV. An interpretation of the Argentinean experience • The traditional structuralist interpretation placed emphasis on a monotonically decreasing relationship between the exchange rate and employment, that was consistent with the Argentinean experience until the nineties. • The recent structuralist interpretation, that has captured the experience of the last decade, proposes a reversion of the relationship posed before, and stresses a monotonically increasing relationship between the exchange rate and employment. The change in stance is made without discussing the probable determinants of the reversion. • Our point is that employment function could be an inverted U.

17. Two central features of the “Convertibility” policy experiment were: (a) Strong real appreciation of the peso, which implied an important reduction of the exchange rate/wage ratio. (b) fast, across the board, and deep trade liberalization. • The significant fall in the exchange rate/wage ratio could have led the economy from the decreasing interval to the increasing interval of the employment function. • On the other hand, the shift of the employment curve caused by tariff reductions probably strengthened the former effect because the slope of the employment function turned from negative to positive in some interval of the exchange rate/wage ratio. • The recent structuralist interpretation and ours have some similar local predictions. But, they might have different policy implications. The recent structuralist view assumes that a higher real exchange rate will always be beneficial for employment. Of course, there would still be a conflict between the real exchange rate and real wages, something very important for income distribution and poverty.

18. According to our interpretation, there could be a level of the real exchange rate that maximizes (ceteris paribus) the level of employment. If the current real exchange rate was greater than the employment maximizing level, there would be room to increase both real wages and employment, because the economy would lie in the decreasing interval of the employment curve. • From our point of view, the moderate real appreciation that followed the initial overshootingof the nominal and real exchange rate after the collapse of the currency board was not necessarily damaging to employment creation (let alone, income distribution). On the other hand, if an attempt was made to raise the real exchange rate to reverse the moderate appreciation with the purpose of raising employment, the effects could be contrary to those expected.

19. V. Conclusions • This paper has two goals. On the one hand, to stimulate the discussion of macroeconomic models intended to capture each country’s specific traits, in our case, Argentina, thus resuming the structuralist methodological tradition. • On the other hand, we are interested in pointing out that macroeconomic policymaking should not be based on an empiricism of trends and variables associations which could be shortlived, and emphasize the need to do more research on these issues in order to make policies that help best to overcome our severe social crisis. For example, such empiricism led to under-estimate the job creation ability of output growth in the last decade, by extrapolating the nineties low employment-output elasticity. Post-convertibility strong recovery in output and employment buried this hypothesis. To be cautious, we believe that we should not limit ourselves to the extrapolation of recent trends in employment and exchange rates. Instead, we should attempt to understand them in a comprehensive analytical framework.