Currency depreciation is said to stimulate aggregate demand by increasing its net export component. On the other hand, it is said to discourage aggregate supply by increasing cost of imported inputs. The ultimate impact is ambiguous on theoretical grounds. A recent review article reveals that in developing countries, devaluation or real depreciation is indeed contractionary in the short run. In the long run, however, devaluation is neutral in most countries. Emerging economies have received no attention and we try to fill this gap in this paper.
In this paper we consider the experience of nine emerging countries of Belarus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Russia, and Slovak Republic with currency depreciation. Using the bounds testing approach to cointegration and error-correction modeling that distinguishes the short-run effects from the long-run effects, the results turn out to be country specific. In the short run we find that real depreciation is expansionary in Belarus, Latvia, Poland, and Slovak Republic; contractionary in Czech Republic, Estonia, Hungary, and Russia; and has no effect in Lithuania. In almost none of the countries, the short-run effects lasted into the long run.
The first three sentences are completely wrong. Currency devaluation doesn’t work by boosting the trade balance, it works by boosting domestic nominal value added, i.e. NGDP, which is unambiguously positive. The huge US depreciation of 1933 initially made the trade balance “worse” even as output soared in response. There’s a whole literature on the income effect. Lars Christensen has a new post discussing other examples.
I’ve never trusted cointegration, partly because the results often seem so implausible. Consider Latvia and Estonia, two very similar Baltic economies. Both failed to devalue in this crisis. Both went for a real depreciation via internal devaluation. Both had severe slumps. And one difference; Estonia is recovering faster than Latvia. And what does “cointegration” tell us? That Latvia’s internal devaluation was “expansionary” and Estonia’s internal devaluation was “contractionary.” Does anyone believe that?
FWIW, I’m 100% with Krugman about Spain and Greece needing a devaluation. I’m 100% with him that Iceland was helped by devaluation. I’m 50% with him on Estonia and Latvia. As I read the evidence those two are doing considerably better than Krugman suggests, but considerably worse than their fans claim. On that Iceland dust-up, has anyone noticed that that CFR article claimed Iceland’s RGDP fell 5% in 2007:4, and yet their graph shows a much smaller decline?
[Update: Tyler Cowen has a new post which allows me to explain my “50%” comment. A good AD policy doesn’t necessarily keep output stable, rather it keeps it close to the natural rate. For big countries the natural rate tends to grow fairly smoothly over time. So if comparing the US and France I’d be much more than 50% in agreement with Krugman. But for very small economies the path of RGDP tends to be much less stable. Tyler mentions the possibility of a “bubble” in the pre-crash Baltic states output. That’s one issue, although I ‘d rather call it “output above the natural rate,” as I’d hate to see the dubious ‘bubble’ concept migrate from finance into macro. In addition, an AD shock for the global economy becomes a real shock for small countries, which they can’t overcome with easy money. Thus if Latvia focuses on making wood flooring for European house construction, it will be hit hard even with an optimal AD policy. That’s a real shock for Latvia, even if the broader eurozone crash was a nominal problem. I’m 100% with Krugman on Iceland, as they had no agenda to eventually join the euro (as Estonia just did) and hence the cost/benefit of devaluation tipped massively in favor of devaluation.]
On the other hand I’m less impressed with Krugman’s transition from a 1990s defender of economic orthodoxy (the whole point of trade is to destroy jobs by boosting productivity) to a 21st century supporter of the lump of labor fallacy:
In any case, however, Romney wasn’t that kind of businessman. He didn’t build businesses, he bought and sold them – sometimes restructuring them in ways that added jobs, often in ways that preserved profits but destroyed jobs
And don’t anyone write in and claim he meant to say; “Not that there’s anything wrong with preserving profits and destroying jobs.”