first stage

second stage

As the paper has already gone into detail in its analysis of the first stage’s repercussions on a small, semi-open economy, it should now be possible to proceed with the analysis of the other stages of the stereotyped cycle without delving further into such details.

During the cycle’s second stage, domestic prices of exportables and import substitutes should rise pari passu with international prices, and those of nontradables are subject to even more violent shocks than those received during the first stage: practically the same, or larger, input costs; even higher interest payments; and substantially larger adjustments in nominal wages and taxes. All these factors necessitate additional adjustments (and larger ones than were required during the first stage) in prices for the sector as a whole. With full indexation, domestic nontradables prices should tend to rise faster than the corresponding prices in the rest of the world.

Nominal interest rates should also rise in response to higher international interest rates, and higher domestic inflation rates are forced upward by the increases in prices of import substitutes and nontradables, but the rate of increase in exportables prices should be lower than in the first stage; the selection of baskets is, again, crucial, since the larger the distortions in favor of exportables, the larger will be the distortions in global inflation indices during the first and second stages. Normally, global inflation rises during this second stage, contributing to the elevation of domestic nominal interest rates. Interest rate differentials with the rest of the world tend to be reduced; and capital flows, although they remain positive, tend to be smaller than they were during the first stage.

Real exchange rates should tend to show a small deterioration when measured by the ratios of the respective prices of exportables and import substitutes, on the one hand, and the price of nontradables, on the other, but the exchange rate should continue to be much higher than it was in the steady state. Traditional measurements may show either an improvement or a further deterioration, depending upon the distortions introduced by the weighting of exportables.

Output and employment may continue expanding marginally, but this result depends basically upon which has a greater effect—nominal interest payments, on the one hand, or capital inflows and dishoarding, on the other. In economies closed to capital movements, output and employment tend to be reduced during this stage.

Turning to the sectoral effects and starting with the evaluation of the public sector budget, it is clear that the budget should show further nominal deficits. The size of these deficits, however, will be larger or smaller than those seen in the first stage, depending upon the following factors: the relative speed of adjustment of wages and taxes in accordance with indexation systems; the increased cost of real expenditures; and, especially, the amount of net nominal interest payments both domestically and abroad. In the example, the size of the nominal deficit remains relatively stable; but in real life, with larger public (domestic and external) debts, further enlargement of the nominal deficit would be likely.

The central bank, though, tends to show a larger operational surplus and larger receipts in its reserves. At the same time, nominal demand for base money should continue to expand owing to higher inflation rates and slightly less negative real domestic interest rates. Total flow demand for base money, however, depends as much on domestic factors as on foreigners’ demands for domestic deposits. If capital flows are smaller than during the first stage, global flow demand for base money may also be smaller. Obviously, the counterpart of such a disequilibrium in the domestic money market is the accumulation of international reserves.

Nominal profits of financial institutions should continue expanding, notwithstanding increased costs in the form of wages and taxes and the maintenance of nominal spreads. Basically, these increased profits come from larger credit operations and, in particular, from the increment in the implicit subsidies on sight deposits, which generally increase as nominal interest rates increase.

Net nominal profits of all productive sectors should decrease in the second stage, responding basically to the increase in nominal interest rates. Wage input and tax adjustments are approximately compensated for by increases in finished product prices, but increased interest rate payments involve an additional transfer to savers and to foreign creditors. Obviously, the larger the net indebtedness of any sector and the larger the increase in the nominal interest rate, the smaller will be nominal profits. As explained before, most of these interest payments should be considered advance payments of real debt and, as such, should not modify real profits; nominal accounting tends, therefore, to introduce strong distortions.

Real wages, with nominal adjustments based on past inflation rates, should, in this second stage, maintain levels similar to those reached at the end of the first stage. Deficiencies in cost of living indices may alter this general statement, since nominal wage adjustments will be larger the larger the weight of exportables in such an index. If nominal wages, dividends, and taxes all tend to increase at approximately the same rate, global real consumption will tend to depend exclusively on nominal interest payments, nominal variations in the value of assets and liabilities, and the magnitude of capital flows. In this second stage, capital flows and dishoarding should be smaller, and interest rate payments greater than during the first stage, with the result that consumption should also decrease. This decrease in consumption, in real terms, is reflected in the balance of payments in the form of a larger trade account surplus. The overall balance of payments result depends more on the magnitude of the government’s net indebtedness and on the tendency to hoard than on the evolution of real exchange rates.

third stage

This is the stage of the cycle when most of the externally generated problems of commodity exporting countries tend to show up. During the third stage, the rate of increase of commodity prices slows down, and prices may even decline in nominal terms. Prices of other goods and services continue increasing at rates slightly lower than those registered during the second stage. Nominal interest rates also remain very high and even tend to increase, while real interest rates tend to reach unprecedented levels.

Domestic prices of exportables and import substitutes tend to rise as a consequence of developments in international markets, and nontradables prices are subject to two opposite forces—on the one hand, increases in wages, taxes, and the costs of some inputs, and on the other hand, a decrease in the cost of commodity inputs and a decline in aggregate demand.

The implicit deterioration of the terms of trade during the stage may also create uncertainties and generate capital outflows. This is particularly so if, during the first two stages, capital inflows took the form of external indebtedness rather than dishoarding (nobody knows the amount of private international asset holdings, while data on total indebtedness are readily available). In these circumstances, domestic interest rates should rise above international interest rates, and real interest rates should become extremely high. Furthermore, the scarcity of domestic credit caused by capital outflows should certainly be reflected in larger spreads and additional external borrowing—that is, net capital outflows might not be reflected in reductions in external indebtedness but, on the contrary, would be reflected in larger private hoardings and smaller foreign holdings of domestic assets.

Global inflation, as measured by indices, should—ceteris paribus—decelerate during this stage, particularly in those countries with commodity-based indices. In these circumstances, real exchange rates, measured by traditional methods, may show an improvement, while those measurements based on the ratio of prices between tradables and nontradables, or based on direct evaluation of producers’ balance sheets, should show marked deterioration. During this third stage, output and employment should decline following the reversal of the terms of trade and the outflow of capital.

Debtors should be most severely affected during this stage, and since the public sector is the principal debtor in the economy, it should not be surprising if during the third stage budget deficits tend to become much larger in nominal terms, forcing increases in public indebtedness. If one examines the public sector accounts, it is possible to see why this is so, since while wages, taxes, and nominal expenditures all tend to rise at approximately the same rate (a phenomenon leading to an increase in the fiscal deficit), interest rate payments tend to rise significantly faster, which adds to the nominal deficit. During this stage, there is a tendency to finance part of this deficit by borrowing abroad.

In the central bank accounts, however, an increase in nominal interest rates implies a larger operative surplus; but, at the same time, the larger financial requirements of the government, coupled with a decrease in the growth rate of the flow demand for base money (basically, as a consequence of capital outflows), should lead to a significant loss of international reserves. These increases in the external indebtedness of the public sector and in the registered external debt of the private sector, in combination with reserves losses and a deterioration of the terms of trade, should normally reinforce speculation against the domestic currency.

The financial sector should, in principle, be the sole domestic sector to benefit during this third stage. Larger spreads and higher nominal interest rates should significantly increase the nominal profits of financial institutions, particularly as a consequence of the implicit subsidy on sight deposits. However, credit risks should also be increasing during this stage, especially those on credits to producers of exportables.

With commodity prices falling and production costs rising, the rate of return on investments in the export sector should decline and even become negative. Nominal financial costs should constitute one of the most important elements in this deterioration of profits. Adjustment of the sector’s balance sheets for inflation, made on the basis of general indices, might improve this negative result somewhat, but this adjustment would be erroneous, since real interest rates for the sector should be even higher than nominal rates.

Nominal profits of producers of import substitutes and nontradables should also decline, but by less than those of exportables producers, since the prices of the former goods tend to rise faster than those of the latter. “Inflation adjusted” profits should increase, since for the import substitutes and nontradables sectors real interest rates tend to be lower than nominal interest rates. The reduction in aggregate demand for nontradables plays an important role in the profitability loss on these goods.

Real wages should rise marginally during this stage as a result of adjustments based on past inflation rates and the deceleration of inflation during the current stage. However, the decline in employment in the nontradables sector should compensate for part of this increase in wages. With real profits declining, total wages stable, and capital outflows, total aggregate demand and, in particular, consumption should decline compared with the previous period. The more severe the lack of confidence in the domestic currency, the larger should be the outflow of capital and the larger the reduction in consumption. In fact, if capital outflows are large enough, consumption might be even lower than in the steady state.

The balance of payments must reflect all these contradictory forces. Exports should decline, both in value and in volume, following the decline in world prices and substitutability in demand. The behavior of imports during this period depends crucially upon the behavior of capital outflows: the larger the capital outflow, the smaller should be aggregate demand and, therefore, imports. In the absence of commodity speculation⁴ and compensatory expansionary policies by the government, imports should decline, both in value and in volume. Finally, with larger interest payments and massive capital outflows, the overall balance of payments should be in deficit—a result that would be consistent with money market equilibrium requirements.

These developments at the third stage seem to be totally coherent with developments in the world economy during 1981 and 1982 and, in particular, with the problems faced by Latin American countries.

fourth stage

During the fourth, and last, stage of the stereotyped cycle, international prices should tend to remain stable. After their decline during the third stage, commodity prices should either remain stable or rise slightly if the decline during the third stage was too large. Nominal interest rates should fall, while real interest rates should decline significantly while remaining positive, especially for commodity producers.

Domestically, with a smaller dispersion of international prices and with smaller wage adjustments (owing to the decline of commodity prices during the third stage), price behavior should be remarkably stable.

Although domestic interest rates should fall, they will probably remain above international interest rates owing to lack of confidence in the value of the domestic currency and to persistent capital outflows.

Aggregate demand should weaken further during this stage as a consequence of capital outflows, and nontradables prices should be very stable. However, wages might play an important role in the maintenance of disequilibria, since the shorter the lags between wage adjustments and the greater the distortions of cost of living baskets, the greater are the chances that nominal wages will overshoot and, because of the downward inflexibility of nominal wages, the greater the chances of a serious balance of payments disequilibrium and of losses in sectoral competitiveness. In these circumstances, exchange speculation might reach massive proportions, amplifying the decrease in demand and the sacrifices implicit in adjustment policies.

The fiscal deficit should be reduced during this stage, since stable nominal expenditures and reduced interest payments, coupled with increased nominal taxes, should more than compensate for the corresponding wage adjustments.

The central bank should also confront a reduction in its operative surplus and a reduction in the excess flow demand for base money. With smaller (but still positive) capital outflows and a smaller (but also still positive) fiscal deficit, monetary equilibrium should only be consistent with additional reserve losses.

Profits of financial institutions should be considerably reduced during this stage, in response to lower nominal interest rates and higher wages. Spreads, however, should remain larger than normal. The main problem for financial institutions during this stage should be increased losses on account of bad loans that are the result of two consecutive stages of serious deterioration in profits for most sectors, and particularly for commodity producers.

Finally, if capital outflows are positive but smaller than those registered during the previous stage, and interest payments are also positive but smaller, the balance of payments should show a smaller global deficit, including a small surplus in the trade account and a smaller deficit in the current account. Imports should decrease, both in value and in volume.

Mohsin S. Khan

This is a most interesting paper containing a number of ideas, some of which will be fairly familiar to international economists, and other ideas that may seem unusual, perhaps even controversial. The paper starts with the observation that a number of Latin American countries have experienced similar economic problems in recent years, even though domestic policies and circumstances were quite different in each of them. The author goes on to argue, although in a somewhat conjectural fashion, that these economic problems must be the result of common external factors. This is probably a correct inference, and one can certainly find empirical support for it.

A number of recent studies, some of which have been done at the Fund, find strong statistical relationships between the main macroeconomic aggregates of developed and developing countries. For example, growth rates in developing countries appear to be linked to growth rates in the industrial world (Goldstein and Khan).¹ Most studies of the inflationary process in developing countries also find a significant role for foreign inflation. Finally, it has been demonstrated that changes in the terms of trade have a strong impact on the current account balances of developing countries (Khan and Knight).² One could come up with other examples, but it should suffice to say that on balance there is considerable evidence of linkage or, to use the author’s terminology, “interdependence” between developing countries and the rest of the world.

The paper makes a reasonably persuasive case for the proposition that such interdependence in the goods and capital markets has increased in the past few years. Whether one can proceed from this to say that this can be attributed to the adoption of generalized floating is, however, not readily apparent. It could be argued that the progressive and deliberate removal of restrictions on trade and capital flows made developing countries more susceptible to foreign influences in the 1970s than did generalized floating per se. To make the case that floating resulted in a greater degree of interdependence, one would have to abstract from domestic policy changes and exogenous external shocks, such as the oil price increases, and this is quite difficult to do. Consequently, one has to be cautious in making this causal connection between the floating of exchange rates of the developed countries and increasing integration.

The main purpose of the paper is to analyze the nature and degree of interdependence between a small, semi-open (Latin American) developing economy and the rest of the world under alternative exchange rate regimes. Basically, this is done by tracing out the effects—both at the macroeconomic level and, to a limited extent, the sectoral level—of a particular type of external shock. Most of the analysis is conducted for the fixed exchange rate case, and there is a very cursory treatment of the polar case of freely floating rates. In fact, the latter would hardly seem to be relevant to the case of developing countries, particularly the ones in Latin America. It would have been far more realistic to discuss the fixed exchange rate case with some other type of hybrid regime where the exchange rate moved according to a rule, say to maintain purchasing power parity. Variants of some type of exchange rate rule have certainly been utilized by several countries in the region on occasion. The author is well aware of these schemes and in fact was closely involved with the preannounced exchange rate experiment in Argentina during 1979–81.

The issue of interdependence is examined within the framework of a stylized general equilibrium model that is believed to fit a broad range of Latin American economies. The overall structure is quite standard, although there are some interesting features not typically found in such models. The model itself contains three goods—exportables (which are taken to be primary commodities), importables, and nontradables. Demand for each of these is determined by relative prices and, although this is not explicitly stated, by the stock of real money balances or real wealth. The domestic supply of these goods is fixed. Prices of exportables and importables are given by the foreign price level times the exchange rate; excess demand for importables determines imports; and excess supply of exportables equals exports. Any disequilibrium in the nontradables sector leads to changes in the price of nontradables. So far this is all very straightforward, and the model would be relevant for most countries—developing and developed alike.

The economy being modeled also has a reasonably developed financial system, so that it can be assumed that so-called financial reforms have already occurred. Interest rates are determined by market forces, and the private sector can hold assets at home or abroad. The latter assumption is very crucial, since currency substitution and private capital movements in response to changes in actual and expected relative rates of return play an important role in the workings of the model. The public sector can also borrow domestically, either from the banking system or from the public through the sales of bonds, or contract external debt. While there is nothing surprising here, this assumption of a well-functioning financial system relatively free from distortions does limit the applicability of the model to only a few developing countries. Government controls over interest rates, credit flows, and capital transactions are still the norm in Latin America, so that the model would properly fit only a very small number of economies.

The author then takes this model and superimposes three special characteristics regarded as necessary to fit Latin American economies. First, wages and financial instruments are assumed to be indexed in some form to the rate of inflation. Such indexation is fairly commonplace in Latin America and thus must be taken into account. Incidentally, in describing the indexation issue, the author goes into a very interesting discussion of the choice of basket to be used in constructing price indices to calculate the real rate of interest and in defining cost of living changes for wage earners and the rest of the economy. This discussion brings out quite clearly the distortions that can be created by using incorrect baskets to measure aggregate price indices.

Second, lags in government revenues in response to a rise in prices are assumed to be generally longer than the corresponding lags in expenditures. This, of course, creates a negative fiscal drag. As inflation rises, for whatever reason, governments are assumed to attempt to maintain the real level of expenditures while real tax revenues tend to fall behind. This creates a fiscal deficit without any conscious action being taken by the authorities. The negative fiscal drag effect has been documented for Argentina (Tanzi)³ and other developing countries (Aghevli and Khan).⁴

Finally, the model assumes that even though there are no restrictions on capital movements interest arbitrage is not perfect. In other words, domestic interest rates (adjusted for exchange rate expectations, risk, transaction costs, etc.) tend to be a good deal higher than foreign interest rates on supposedly comparable instruments. The paper does not state explicitly why interest parity does not emerge, but simply imposes this condition artificially on the model. There have been a number of theoretical arguments advanced explaining this lack of perfect arbitrage, but the issue is far from settled. However, even a very casual look at the experiences of countries such as Argentina, Chile, and Uruguay would make one quite sympathetic to the assumption.

Apart from the macroeconomic relationships underlying the model that have been discussed above, special mention ought to be made of the careful spelling out of the intersectoral relationships. The author goes to considerable length in detailing how the government, the monetary authorities, the financial system, the real sector, and the public all interact. This is by far the most innovative part of the paper, and while the relationship and results can be questioned, there is no doubt that sectoral aspects are important and deserve much more attention than they have hitherto received. The author should be commended for having made a start in this direction.

There are a number of problems, of course, with the type of model that the author has decided to work with, and this comment will focus basically on three main ones. First, it seems that all goods in the model are final goods, and there are no intermediate inputs. This is a very strong assumption to make for a developing country that typically relies on intermediate imports (raw materials, capital equipment, etc.) as inputs in the production process. The absence of intermediate imports tends to weaken the external linkage and, at the same time, has a bearing on the effects of changes in external prices (or in the exchange rate) on domestic output. Devaluation, or a rise in foreign prices, could also be deflationary if the economy was heavily dependent on basic or necessary imports. This possibility is excluded from consideration by the model as it is presently specified.

The second problem relates to the treatment of output. It is never made clear whether output is fixed or not. The paper states at one point that relative prices do not affect supply, which could be taken to mean that output is constant. As such, there are no real effects of any type of shock, external or internal, and the discussion in the paper about variations in output and employment owing to such shocks does not appear to be pertinent. Later on in the paper, one finds that while the domestic supply of tradables is fixed, the supply of nontradables seems to vary. Certainly in the example presented in the Appendix, the supply of nontradables is variable. What causes it to change is never made clear. One way of dealing with this issue would be to fix trend, or potential, output but let deviations of actual output from this trend value be determined by relative prices. This would be more realistic, since it would allow output to vary in the short run and, at the same time, would make unnecessary the difficult task of specifying sectoral production functions.

Third, the model is strictly speaking an accounting model and has no explicit functions, parameters, or elasticities to speak of. In a sense, the approach is similar to the antecedents of the monetary approach to the balance of payments. The latter also grew out of a set of accounting relationships and identities, with the basic behavioral relationships specified later. The problem with this type of accounting approach is that the results are conditional on the choice of initial values, and one does not know whether the set of values chosen is realistic or not. In such circumstances, it is always advisable to engage in a sensitivity analysis and vary the initial values to see what differences result. It would be useful to know whether this was done and what emerged.

Taking this model, a particular simulation experiment is conducted. The actual experiment is supposed to reproduce the international picture faced by Latin American countries during 1979–82. The author identifies a stereotyped economic cycle in this period that has four stages. In essence, this cycle involves a rise in international inflation and interest rates and then a subsequent fall. Commodity prices, being flexible spot prices, are more volatile than the prices of other goods and services, so that there are sharp changes in the terms of trade for developing countries. Starting from a steady-state position and assuming a fixed exchange rate, this cycle is imposed on the model and a pseudo-dynamic (since the cycle involves the four distinct stages) path is traced out for the system. Since the model is quite complex, the verbal description of the dynamic process following the external shock is quite difficult to follow. One obvious suggestion would have been to put in some simple charts that displayed the paths followed by the variables in question. This would certainly have led to a better appreciation and understanding of what exactly was going on.

Given the model, the results of the simulation seem to be generally sensible. There are, however, a couple of results that deserve mentioning. First, it is interesting to note that an increase in foreign interest rates results in a fiscal deficit because of the rise in interest payments on external public debt. This point has not been widely recognized by model builders and deserves to be. The counterpart to the interest payments is the increased interest earnings of the central bank on its stock of international reserves. Whether these two should be netted out in some sense, perhaps through a transfer to the public sector from the central bank, is an interesting question. Second, in the example in the Appendix, the price of exportables rises by 10 per cent while the price of importables by only 5 per cent. One would have thought that both should have risen at the same rate, given the structure of the model, so this discrepancy deserves some explanation. Last, on the downside of the cycle, foreign interest rates decline but domestic interest rates remain high. However, capital outflows now occur rather than inflows, so that somehow exchange rate expectations seem to have been brought in. This sudden introduction of exchange rate expectations warrants explanation and elaboration.

At the end of the paper, there is a short and quite cryptic discussion of what would happen if, instead of being fixed, the exchange rate were allowed to float freely. Some of the results naturally change, but although the conclusion that floating insulates nominal variables and not real variables from nominal external shocks is not particularly surprising, it does not follow directly from the model. The author argues that variations in output and employment are larger under floating, but as was said before, if output does not respond to changes in relative prices, how can such a conclusion be drawn?

In conclusion, the paper has much to offer from a theoretical standpoint. At the same time, it contains the insights of someone who has been closely involved in policy formulation for a number of years and has obviously thought carefully about the issues. While one may not agree with all of the conclusions, one has to commend the effort to formalize views and judgments about the functioning of a small, semi-open economy. It is certain that some of these ideas will start to show up in the growing literature on stabilization in developing countries.

Michel Aglietta

Mr. Arriazu presented a very substantial analysis of the repercussions of international economic instability on Latin American countries. He rejected the pertinence of internal causes—inadequate exchange rate policies and excessive government spending—and emphasized the importance of external constraints in his explanation of the economic difficulties facing these countries. The special method he used derives from this hypothesis.

An international cycle, according to Mr. Arriazu, takes place in four phases. These phases can be distinguished from the relative evolution of international raw materials prices vis-á-vis other commodities prices and interest rates. This criterion is justified by the hypothesis according to which fluctuations in materials prices constitute the main effect of external shocks on these economies. The effects of the cyclical shock are meticulously analyzed, and the dynamic sequence undergone by the concerned countries is described.

What renders this analysis complex and makes it difficult to follow is also what makes it greatly interesting. The author does not work solely with a global pattern. He identifies the sectoral distortions caused by the great variability of nominal prices. However, this technical and sophisticated paper does not discuss economic policy matters. The impression given is that all Latin American countries are at the mercy of the external forces that dominate the world economy and have no freedom of choice. Such a conclusion may, unfortunately, be right. However, one cannot help wondering if this conclusion is not a fallacious by-product of the method the author has adopted. Indeed, the relationships described are deliberately presented as mechanical. Whatever they do, neither the private sector nor the state seems to be able to counteract these evolutions. Besides, in a framework that pretends to take economic structures into account in order to stress sectoral repercussions, it is odd that no distinction is drawn among countries on the basis of the variation in the resistance of their economic structures to shocks. Such an omission could lead one to underestimate the wide variation in the repercussions of shocks on different countries on account of differences in their exchange rate regimes. It could also lead one to overlook the peculiarities of the present Latin American situation, which is dominated by debt constraints. These constraints can provoke strong reactions—among lenders as well as borrowers—that alter the cycle itself. At present, we are perhaps in a very important, long-lasting phase of declining growth that has resulted from the large amount of debt that has accumulated and that is not the result of standard cyclical evolution.

Now, I shall deal with each of these two points in more detail.

Exchange rate regimes and sectoral distortions. It is possible to take advantage of cyclical phases by investing in the export sector when relative prices are favorable. The accumulation of capital has—as long as it reinforces export production capacity—an irreversible and favorable effect, which ensures that a country’s export sector will have expanded when the cycle ends. To convert transitory gains in the world market into a permanent improvement of the productive system, domestic relative prices should be altered to channel profits to economic agents able to decrease the country’s dependence on imports or to increase its exports, at least within the following cycle. The success of such measures depends crucially on the state’s domestic pricing policy for agricultural products, its control of public spending, and its choice of exchange rate regime. Increased resilience in the face of international fluctuations can only stem from a high degree of food self-sufficiency and from a diversification of industrial production. The achievement of these two goals would allow a reduction in raw materials costs in the production of exports.

Thus, maintaining an overvalued currency—using a fixed exchange rate policy in order to limit the inflationary repercussions of the rise in world prices—can lead to disaster. If it is coupled with high interest rates that attract short-term capital flows and stifle industrial profits, this exchange rate policy weakens export industries and import substitution industries. The gains from the transitory improvement in the terms of trade—in the first phase described by Mr. Arriazu—are not invested in the sectors that could improve the country’s competitiveness. They are instead either absorbed by the financial sector or dissipated in imports of luxuries. Moreover, an overvalued currency forces firms in the international sector to put intolerable pressures on real wages.

To alleviate this pressure, the authorities set very low prices on agricultural and food products—that is, they subsidize them. Thus, agricultural income deteriorates considerably. There is a consequent speeding up of the ongoing disorderly exodus from rural to urban areas. Necessities are subsidized in order to keep their prices low, and the continued existence of a large unemployed urban population is assured by minimal assistance. Thus, public spending is increased to the point where the situation becomes hopeless, and the state has to use the gains received from the terms of trade to finance public spending. Such a policy, which weakens the economy during the favorable phases of the cycle, paves the way for a serious crisis during phases when the terms of trade turn against the country. The balance of payments deficit then adds to the budget deficit. The latter is financed by inflationary money creation. Then an exchange rate crisis becomes inevitable, which, in its turn, provokes a brutal recession—the only means of reducing imports.

If the exchange rate is fairly well managed, the pattern can be substantially altered. If this is so, there cannot be a unique pattern, contrary to Mr. Arriazu’s hypothesis. The difficulty of carrying out such a policy is how to bring about a regular and orderly depreciation of the currency and maintain an undervalued currency without fostering destabilizing speculation. This aim can only be achieved if internal policies are deliberately geared to production capacities in the labor-intensive sectors in order to make use of the comparative advantage provided by a cheap labor force. The relative price of agricultural products is the crucial variable. If individual farmers can be assured of a decent income, this will make it possible to maintain a balance between rural and urban populations and to reduce the country’s dependence on imported food. The experience of Southeast Asian countries is proof of this. Within this context, a high level of productive investment maintains growth, which, in turn, stimulates productivity improvements. These improvements will prevent inflation—which is fed by permanent currency devaluations—from getting out of hand. Also, cyclical evolution could be much smoother than it is when there is an overvalued currency. The high investment rate will give the economy an increased capacity to adapt.

Problems caused by excessive debt. Most of the Latin American countries have overborrowed, leading to the building up of tensions and the creation of considerable uncertainty. A climate of rivalry is fostered between debtors and creditors as soon as default threatens. The appearance on the economic scene of the insolvency problem fosters instability in the behavior of private agents and forces governments to take action. The usual hypothesis of a predictable set of cyclical linkages with given behavior and economic policies becomes highly questionable. Overvaluation of currencies for too long can only worsen the problem by releasing destabilizing speculative forces. It then becomes necessary to look directly at the interaction between the financial fragility of countries and the behavior of foreign lenders. The international financial market can no longer be regarded as a reserve of capital communicating with the borrowing countries by means of variations in the interest rate. On the contrary, overborrowing can lead to dramatic changes in creditors’ expectations that can foster instability in the market.

A rupture occurs in the asset and liability structure when no interest rate whatsoever can clear the credit market. This can happen when default becomes likely and leads the two sides of the market to adopt conflicting strategies. First and foremost, debtors are anxious to renew debts or, in other words, to finance assets that do not yield the cash flow that was expected from them when they were bought. Debtors are also compelled to enhance their liabilities in order to pay off increased financial costs.

Creditors do not know whether the money they are lending will be invested productively or dissipated in private or public consumption. This uncertainty alters the nature of the interaction between debtor and creditor. An anonymous market can no longer determine appropriate lending rates. Creditors become obsessed with the quality of their loans, which can lead them to excessively restrict credit. Moreover, the accumulated debt is a factor of uncertain weight that is influenced by the probability of default, which is linked to the amount of future debt. But current creditors ignore what the future debt—which depends on the borrower’s strategy—will be.

The more new lenders the borrower is able to attract, the more freedom this strategy permits. Thus, current creditors, who have neither control over nor knowledge of their borrowers’ future debts, become very cautious. They require risk premiums and shorten the maturities of their loans. This shortening of maturities increases the debt service burden, which, in turn, causes a deterioration of the current account and a stifling of growth.

When the debtor-creditor antagonism reaches fever pitch, the choice of an exchange rate regime has become secondary. The appropriate method of dealing with the situation is to appoint a mediator. There are two reasons why this would be helpful. First, a mediator would be able to guarantee borrowers a debt rescheduling compatible with their export capacities. Second, a mediator would be able to reassure lenders by putting limits on future loans and by controlling the uses made of these loans by borrowers.

Stopping runaway borrowing without provoking a collapse of debtor countries is a delicate exercise in international monetary cooperation. However, it is the only means of alleviating the negative repercussions of cyclical fluctuations.