Journal Issue


International Monetary Fund. External Relations Dept.
Published Date:
January 1990
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Sebastian Edwards

Real Exchange Rates, Devaluation, and Adjustment

The MIT Press, Cambridge, MA, USA, 1989, xi + 371 pp., $32.50.

Lance Taylor

Varieties of Stabilization Experience

Oxford University Press, New York, NY, USA, 1988, vi + 180 pp., $39.95.

Joan M. Nelson and contributors

Fragile Coalitions

The Politics of Economic Adjustment

Overseas Development Council, Washington, DC, USA, 1989,159pp., $24.95.

The work of the Fund and the Bank in assisting member countries in their adjustment or stabilization efforts continues to inspire a wide variety of economic and political studies. Sebastian Edwards’ book analyses in depth one instrument of adjustment—exchange rates. The book starts out from the useful distinction that exchange rates that are satisfactory at one time may become unsatisfactory (overvalued) for two reasons: unfavorable changes in economic conditions that lower the equilibrium real exchange rate and monetary disturbances that, by inflating the price level, raise the actual real exchange rate. Under both sets of circumstances, devaluation is the correct policy response; but under the second set, devaluation will not provide a lasting solution unless overly expansive macroeconomic policies are brought under control.

These propositions have been part and parcel of the Fund’s approach to adjustment from the earliest days of the institution. The main interest in this book, as far as policymakers are concerned, lies in the author’s systematic analysis of 39 devaluation episodes in 25 developing countries between 1962 and 1982. This analysis is preceded by the construction of rather formidable models to demonstrate the effect in the real exchange rate of real and financial variables, as well as an attempt to measure the respective influences of these variables (or proxies for them) by cross-country correlations.

An impressive amount of information is provided for each devaluation episode, including preceding terms of trade changes (no evidence found of systematic deterioration), preceding rise in the real exchange rate (rather small on average, but perhaps distorted by price controls), trade and payments restrictions, and parallel market premiums. On average for the countries analyzed, it is also found that their policies with respect to credit creation and public sector deficits were unduly expansionary in the three years leading up to devaluation.

The book also addresses at length the question whether devaluations are contractionary. A model that indicates “a nontrivial possibility for devaluations to reduce aggregate output” is tested statistically by cross-country regression for 12 developing countries over the period 1965–84. The significant negative coefficient found for the nominal exchange rate leads the author to conclude “that, with other things as given, devaluations in these countries have exerted important negative pressures on real output.” But the correlation (which contains many other variables) strikes one as unconvincing on the face of it. For example, the negative correlation between growth and nominal exchange rates (which runs counter to the book’s thesis that overvaluation hurts growth) may merely reflect the fact that in the last few years of the period, most of the countries covered had both low growth rates and collapsed exchange rates.

In his concluding chapter, Edwards stresses the contractionary effects that inflationary policies have prior to devaluation, as a result of the distortions, such as the imposition of exchange controls, to which they frequently give rise. These, the author underlines, are “the costs of not adjusting” (italics in original).

Taylor’s Varieties of Stabilization Experience is the outcome of a study by WIDER (The World Institute for Development Economics Research) to search for policy packages, alternative to those recommended by the Fund, that would achieve desirable adjustment and growth at a lower social cost than the actual packages negotiated by countries with the Fund. For this purpose, 18 country papers were commissioned from authors described as having “theoretical stances different from the Bank’s and the Fund’s.” Perhaps not surprisingly, the “principal finding” of these authors is reported to be “that programs of the Fund/Bank type are optimal for neither stabilization nor growth and income redistribution in the Third World.”

A major part of the book is taken up by a review of “stabilization theory.” The contribution that stabilization theory can make to adjustment can be in either of two forms. It can provide a simple general model which is believed to be applicable, grosso modo, to a large proportion of the cases to be dealt with, subject to verification and the measurement of parameters on the basis of available data. That has, in most cases, been the Fund’s approach. Or stabilization theory can make an inventory of all that could happen and end up with “a checklist of factors relevant to policy design.” That was the WIDER approach, and Taylor’s checklist is found on pp. 69–74. To judge the quality of the country studies, one will have to await their publication. Taylor’s brief summaries suggest both interesting insights and the grudging admission of instances of success of policies that are at variance from the author’s (or perhaps the authors’?) policy preferences. Thus, in Kenya, “increased real interest rates helped hold down the level of activity, without strong inflationary results” (p. 85); in Colombia, “liberalization, faster depreciation, and austerity did not turn out to be as stagflationary as expected” (p. 95).

The summaries of the country studies are also too sketchy to establish the validity, or otherwise, of their “principal finding” cited above. The alternative stabilization policies that would apparently have been preferred by some of their authors (more import control by quotas, multiple exchange rates, reduction in interest rates, export subsidies) appear to hark back to a past era of development economics. Taylor is on firmer ground in advocating that the Bretton Woods institutions pay more attention than they have done until recently to adjustment packages that would protect the lowest income groups.

Joan Nelson’s compilation of papers makes it clear how difficult it is for the Fund, or other outsiders, to pursue this distributional aspect of adjustment. As she stresses, protecting the poor is usually a fairly low-priority objective for the political leaders in developing countries. The resources needed for this purpose must typically be found at the expense of somewhat better-off groups of the population which often have greater political clout. To be politically sustainable, adjustment may therefore have to serve a wider clientele than the absolute poor.

This is only one instance of the general approach highlighted in these papers that an adjustment policy can only be sustained if the government can build a sufficiently wide coalition in support of it. This may involve compensation payments to politically potent losers in the reform effort, even where such payments conflict with equity or “economic efficiency.”

Especially as adjustment is found to be a multiyear process rather than a quick fix, governments must increasingly weigh the requirements of adjustment against other economic, as well as political, concerns. One of the interesting issues arising in this connection—discussed in two of the papers in this volume—is the relative success of democratic versus authoritarian regimes in overcoming inflationary pressures.

The final paper, by Miles Kahler, analyses the impact of the Fund and the Bank on the policies of adjustment. He argues for widening the policy dialogue beyond the “converted” officials in the treasuries and central banks, and suggests greater reliance on the opportunities for noncrisis dialogue in the context of Article IV consultations.

J.J. Polak

Michael Bruno, Guido de Telia, Rudiger Dornbush, and Stanley Fischer (editors)

Inflation Stabilization

The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico

The MIT Press, Cambridge, MA, USA, 1988, xi + 419 pp., $27.50.

This interesting and highly informative book covers the experience with the heterodox shock programs for dealing with high rates of inflation in Argentina, Bolivia, Brazil, and Israel in the period 1985–86. As noted in the preface of the book, several of the authors were among the actual architects of the programs—including José Luis Machinea in Argentina and Michael Bruno in Israel—which means that the papers provide additional insights into how policies were formulated.

The programs involved varying degrees of orthodox financial restraint together with heterodox controls on nominal variables such as prices, wages, or the exchange rate. Prior to the adoption of the first of the programs—by Argentina in June 1985—it was believed that the achievement of price stability in countries with a long history of inflation and deeply embedded inflationary expectations would be a lengthy and painful process. As described in the papers, however, the programs were initially very effective in bringing inflation to a halt, were politically popular, and, with the exception of Bolivia, were associated with a substantial upturn in economic activity (even in Bolivia the rate of decline in output slowed in the period after adoption of the program). The papers are also convincing in arguing that the programs that incorporated the strongest and most sustained fiscal adjustment—in Bolivia and Israel—were the most successful in keeping inflation low.

The main papers on each country describe in detail the prevailing situation at the time the programs were introduced, the main features of the programs—including measures to deal with the income distribution effects of a sudden drop in inflation when financial, wage, and other contracts had built in high rates of expected inflation—and the macro-economic effects of the programs. The papers also provide substantial amounts of data that will be useful to other researchers in verifying the conclusions of the authors or testing additional propositions. In addition, the papers prepared as commentaries on the main studies include interesting theoretical work that is helpful in explaining the programs and their effects. Particularly intriguing is a model of stabilization presented by Alex Cukierman, which attempts to explain how the heterodox elements of the program reduced the output and employment costs of adjustment in Israel.

That is not to say, of course, that the experience of these four countries, or the papers describing that experience, gives us the definitive answers on dealing with inflation in countries with a long history of instability. In this context, it is interesting to note one of the conclusions of the Argentine study, written two years after the heterodox shock program was implemented and two years before Argentina would experience one of the worst bouts of inflation in its history in May-June 1989. While noting that inflation was showing signs of picking up from the low levels achieved in the immediate aftermath of the shock program, the authors concluded that “the Argentine economy is in a better position to face the structural changes necessary to set the foundations for long-term stabilization.”

The experience of the four countries, as recorded in this book, demonstrates that a long history of inflation is not an excuse for failing to attack the inflation problem in a decisive way. It is also obvious that much remains to be learned about establishing the basis for dealing with the fundamental causes that led to inflation in the first place and that will, if not treated, be responsible for its re-emergence. The proximate cause of the breakdown in the program in Brazil, less than one year after it was introduced, is probably correctly identified as failure to address the underlying fiscal problem. An explanation of the eventual breakdown of the Argentine program is less easy to come by, and relates to the difficulty of establishing an independent monetary authority with the sole responsibility of establishing price stability, and able to convince the public sector, private producers, and trade unions of the serious consequences of wage, price, and other behavior that is inconsistent with macro-economic stability.

Brian Stuart

Elhanan Helpman and Paul R. Krugman

Trade Policy and Market Structure

The MIT Press, Cambridge, MA, USA, 1989, ix + 191 pp., $24.95.

This book, an overview of models of the effects of trade policy in imperfectly competitive markets, synthesizes some of the major contributions made in this field by well-known economists such as Jagdish Bhagwati, James Brander, Avinash Dixit, Jonathan Eaton, Gene Grossman, Richard Harris, Barbara Spencer, and Anthony Venables. While not particularly original, it serves as a guide for the graduate student and the economist regarding the current state of thinking in this field.

The authors discuss the consequences of import protection under different combinations of imperfect competition at home and abroad: domestic monopolies or oligopolies (with and without cooperative behavior) facing competitive foreign exporting firms; competitive domestic firms facing foreign monopolies or oligopolies; competition in third markets for exports between monopolistic domestic markets in which domestic firms with market power compete with foreign firms with market power; and trade policy in the presence of two-way trade that may arise from monopolistic competition in differentiated products or for strategic reasons.

Perusal of the implications of the combinations of market structure highlights the variety and complexity of the realities of imperfect competition facing the policymaker. The authors focus on three themes—the effects of trade policy on market power, the strategic effect of trade policy on competition, and the effect of trade policy on consumer choice. The results are startling—and seemingly “perverse”—as the effects of trade policy on output, prices, and trade may be quite different from what those schooled in perfect competition would normally expect. Thus, for example, under certain conditions of imperfect competition, protection reduces domestic output, subsidies to imports improve the terms of trade, and tariffs lower domestic prices.

A crucial question for the policymaker is whether the above results justify rejection of free trade policies. The authors answer firmly in the negative. Although some models can be used to support neo-mercantilist policies—tariffs to improve the terms of trade or export subsidies to give firms strategic advantage—slight variations on these models eliminate or even reverse their conclusions. A review of quantitative work suggests that the gains from optimal deviations from free trade are fairly small. Furthermore, governments would in practice find it difficult to decide which model is the most relevant, as the design of an advantageous trade policy requires information of a kind that is simply not available, and there is plenty of room for policy errors that may lead to eventual losses rather than gains. The authors conclude that the political economy of trade policy is therefore not changed by the new models—the case for free trade can continue to be made on the grounds that it represents a good rule of thumb given uncertainty about alternatives, difficulties of managing political intervention, and the need to avoid trade wars.

Naheed Kirmani

Ali M. EI-Agraa

The Theory and Measurement of International Economic Integration

St. Martin’s Press, New York, NY, USA, 1989, xiii + 388 pp., $55.

The economics of integration emerged as a special branch of international economics in the first decade after World War II, largely propelled by the discussions that led to the formation of the European Common Market. Since then, this literature has expanded at a rapid pace, as customs unions and other preferential trading arrangements proliferated worldwide. In view of the ongoing efforts in the European Community (EC) to accelerate the integration process, this subject will continue to command significant attention over the coming decade.

This book provides an extensive overview of the theoretical and empirical literature on integration. It is mainly aimed at an academic readership with a substantial academic background and its strength lies in the analytical survey coverage of many major articles in this area. Since it is primarily a survey, however, it also shares many of the biases and weaknesses of the traditional literature in terms of topics covered or neglected and points emphasized. For example, most analytical work on integration is grounded in the same theory of international trade that advocates the pursuit of free trade on a nondiscriminatory basis as the best policy course. Why, then, are so many countries currently engaged in the pursuit of regional integration? The conventional response, also offered in this book, is that there exist constraints that prevent the use of first-best policy instruments and market imperfections or externalities that extend across national borders. Except for vague reference to “infant industry arguments,” however, these constraints and externalities are rarely identified explicitly, so that the advantage of pursuing regional integration over reliance on other policies to redress these market imperfections remains unclear.

The theoretical literature stresses three main economic effects of integration: (1) static resource allocation effects (arising from trade diversion and trade creation); (2) terms of trade effects (for economic blocs with appreciable international market power); and (3) dynamic effects arising from the capture of intra-union economies of scale. Past empirical studies, however, have mostly confined themselves to measuring the extent of trade diversion and trade creation. Another shortcoming of the empirical literature pointed out by the author is that most attention has been focused on developed countries (especially the EC and European Free Trade Area), even though the LDCs provide many more examples of attempted integration (though few have been as active and none as comprehensive as the EC).

With respect to developing countries, the author concludes that, on the basis of expected trade creation/diversion and terms of trade effects, there is no justification for establishing customs unions that merely seek to promote protected industrialization through trade diversion. But he also suggests that significant gains may be available to LDCs through economies of scale that could justify such trade diverting unions. Most past empirical work, with its narrow focus on static effects, therefore, is judged to be of little relevance for LDCs. If regional economies of scale were that significant, however, it is puzzling to find that no major industries have emerged so far in any of the regional associations among LDCs.

Ulrich Lächler

Marchés International des Capitaux by Francois Leroux

L’Université de Quebec, Sillery, Quebec, Canada, xiv + 378 pp., $34.

The rapid growth of capital markets since the early 1970s, accompanied by a broad range of innovations and developments, had led to a plethora of instruments now available to borrowers. This book presents a survey of such instruments, placing them within the context of the crucial events of the last 15 years, including the energy crisis, large balance of payment deficits, exchange rate and interest rate instability, debt crisis, and deregulation.

The author begins by describing the international environment, emphasizing the development of the Eurodollar market. He also reminds the reader of the often forgotten fact that, since the 1960s, US banks have sought to shift a portion of their business from a regulated framework to a deregulated environment offered to them on the London market.

Several chapters are then devoted to syndicated Euroloans, a preferred form of debt instrument for many countries lacking access to other segments of the capital market. The distinguishing features of this instrument are elaborated, as are its advantages and its potential drawbacks. The discussion of banks’ decision-making processes, as well as the general market climate, shows clearly how lenders and borrowers could simultaneously make mistakes—the former by granting too many advances and the latter by exceeding their payment capacity. The importance of commissions to be paid by borrowers is also stressed.

Following the attractive pedagogical approach that is such a hallmark of the book, three chapters deal with international securities markets. The remaining chapters then mainly set out to explore the various changes taking place in the markets as well as the new instruments. The author draws an interesting comparison between the international debt crisis and the changes in the markets. The desire by some banks to retreat from the markets served to change the pattern of competition by allowing brokerage firms to take on a leading role. Acting in fast-growing securities markets that were benefiting from the shift of loanable funds, these firms introduced new forms of intermediation when investors expressed a preference for negotiable instruments. These chapters deal with such new instruments as note issuance facilities, revolving underwriting facilities, and multi-option funding facilities;—as well as markets for Eurocommercial and Euroshares.

Michel Dessart

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