The recent evolution of the exchange rate in Brazil: a Minsky moment

by Paulo Gala

The current crisis has quite clearly shown the so-called dual nature of the exchange rate: on the one hand, the relative price between tradables and non-tradables, and, on the other hand, the price of a financial asset. It also becomes increasingly clear that the determination of the exchange rate has essentially a financial dynamics, especially in a context of open capital accounts. From the perspective of prices of tradables and non-tradables, the country was getting into a problematic situation, as the real exchange rate appreciation was making it increasingly difficult to insert domestic production in the world economy. Brazilian prices, once converted to dollars, reached surprisingly high levels, thus eliminating the competitiveness of our industries, even the most efficient ones. This can be observed in the reversal of the manufacturing trade balance, with an explosion of imports and a stagnation of exports. Our trade surplus was more and more dependent on high commodity prices, in a bubble that now seems to have burst. The recent path of the current account showed clearly that the Brazilian currency was becoming misaligned towards overvaluation. The explosive increase in the dollar price of Brazilian non-tradables certainly did not result from an increase in productivity and wages, as we would like it to be. Numerous papers showed that the Brazilian currency was relatively overvalued, whether in terms of measures of PPP (Purchasing power parity) deviations, or in measures such as BEER (Behavioural Equilibrium Exchange Rates). How then to explain the appreciation path that put the exchange rate increasingly “out of place”? Now comes the financial nature of the exchange rate. As the country received the investment grade and investors showed a strong appetite for investments in emerging countries, there was a flood of capital to Brazil. Last year only the capital account accumulated a surplus in excess of US$90 billion. Investments in the stock market, securities, and derivatives caused an increasing appreciation of the Brazilian currency, which seemed more and more undervalued in the eyes of financial market. The period of relative stillness in the world markets during the last few years stimulated the "Minskyan" spirits of the financial agents that were increasingly betting on uncertain positions in emerging markets. In Brazil, the exchange rate continued to appreciate as long as these operations were highly profitable. Domestic companies betting on derivatives related to the appreciation of the Brazilian real, as well as capital flows to the stock market and securities, caused one of the highest exchange rate appreciations in the emerging world in the last years. And now the “Minsky moment” comes, in which deleveraging and deflation of assets predominate. The appreciation movement built during 2 years is undone in 2 weeks. In a troubled way, to say the least, the exchange rate returns to a more reasonable position in terms of prices of tradables and non-tradables. For those who have been studying Keynes and Minsky, there is nothing new in this type of financial dynamics. It is worth mentioning, however, the negative consequences of the type of arrangement we are living in today. As the relative price between tradables and non-tradables, the exchange rate strongly affects the country's technological dynamics, as long as it impacts decisions regarding investment, production, and innovation. The level of the real exchange rate plays a fundamental role in macroeconomic dynamics from a long-term perspective. By influencing the determination of sector specialization, particularly regarding incentives to industry, the impact of the exchange rate level on the dynamics of productivity is high. Exchange rate overvaluations are particularly harmful to processes of economic development, since they substantially reduce the profitability of production and investment in manufacturing tradable sectors. By reallocating resources to non-manufacturing sectors, especially to the production of commodities (with decreasing returns to scale), and to non-tradable sectors, exchange rate overvaluations eventually affect the economy's whole technological dynamics. To conclude, it is worth mentioning the impacts of exchange rate volatility in the economy's performance. In an open capital account setting, the exchange rate is financially determined and depends on the traditional Minskyan “boom” and “bust” dynamics. The relative price between tradables and non-tradables is now determined in the financial market, with very complex dynamics. That is to say, the profitability of manufacturing production, which it is essential to long-term economic development, begins to depend on the whims of financial markets.

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Paulo Gala received Master and PhD degrees in Economics from the Sao Paulo School of Economics, Getulio Vargas Foundation. He is the author of several papers, articles and book chapters on the following subjects: Macroeconomics, Development Economics and Economic Methodology. Currently, he is a professor at the Sao Paulo School of Economics, Getulio Vargas Foundation. pgala3@gmail.com

Debating a new order

There’s a bunch of articles in the Guardian, starting last month with Jeffrey Sachs ‘Amid the rubble of global finance, a blueprint for Bretton Woods II’, Ha-Joon Chang replies to this article adding on many more points on trade and development that have been missed by Sachs – a strengthened IMF without reform of its missions and governance structure is likely to make matters worse, MDGs are important but development needs upgrading a country’s productive capabilities etc. Check out the whole series at Comment is Free

Changing times!

by Sumita Kale

The times.. they are a changing…breaking news that the US surrenders power to appoint World Bank President. It would be interesting to get readers’ opinions on why this change is happening at this particular point in time. One angle comes from an article written last year, Who rules the World Bank ,that gave the link between Wall Street and the rationale for US control: ‘Selection of the Bank’s President is based on an unwritten “gentlemen's agreement” reached when the Bank and Fund were created at the 1944 Bretton Woods conference: the US chooses the head of the World Bank while western European countries name the head of the IMF. “This prerogative was initially granted not only because the United States was the Bank’s largest shareholder but also because it was the key guarantor and principal capital market for Bank bonds,” Catherine Gwin notes. US control, it was reasoned, would instill confidence on Wall Street to invest in Bank securities – a principal source of Bank funds. However, capital markets have long since gone global and the Bank has diversified its portfolio. The Wall Street rationale for US control of the Bank’s top seat no longer exists.’ With the turbulence in the financial markets and talk of the end of the American Empire, the events at the World Bank are significant....could this be a sign of the changing power equation in the world? Or does it just signify the end of relevance of the World Bank?

Readers’ comments welcome!!

Fear, hope, and great transformations

By LaDawn Haglund Look just about anywhere in the U.S. economy today, and you will find bad news. Emergency after emergency strikes the financial system, resulting in multi-billion dollar taxpayer bailouts of Bear Stearns, Freddie Mac, and Fannie Mae, and now the collapse of Lehman Brothers. The housing market is in free-fall, with foreclosures at record highs. Unemployment is at its highest level since 2003, while underemployment continues to plague the working poor. The “misery index”, that is, the sum of the unemployment rate and the inflation rate, is rising faster than it has in nearly 30 years. Meanwhile, increasingly intense hurricanes fueled by global warming wreck costal cities as we fumble around, hopelessly inadequate to the task of reducing our dependence on fossil fuels, the main culprit behind the acceleration of greenhouse gases. It is at moments like these that I can’t help but remember Karl Polanyi. In his 1944 book, The Great Transformation, Polanyi referred to land, labor, and money as “fictitious commodities.” Applying excessive market rationality to these realms, he argued, distorts the substantive relationship between the economy and society in ways that create insecurity and threaten the social fabric. What we are experiencing is the predictable result of a societal restructuring that made market exchange the key organizing principle in places it doesn’t belong. Eventually something has got to give: business-as-usual is likely to lead to a breakdown in our financial, ecological, and/or human systems. Back here in Arizona, I am living a mild version of this narrative. A steadily increasing cost of living and a stubbornly fixed salary (due to spending cutbacks in education) has made it difficult for me to make my mortgage payments. Expensive gasoline adds to the woes, and not even my Prius can save me (though I am grateful to the Japanese for developing such a nice hybrid vehicle). Recently, when I was really feeling a pinch, I tried to refinance my house. But alas, in this economy—with a burst housing bubble, imploding mortgages, and foreclosures aplenty—my sorry case was met with a kindly “thanks, but no thanks.” So I find myself struggling to make ends meet like millions of other Americans. But what does this admittedly sad but ultimately manageable problem have to do with development economics? After all, at least I have a job, a car, and a house. I am certainly not poor. I have access to credit. And if worse came to worst, I would have numerous options: Look for a better job. Sell the house. Take the bus. These basic possibilities are not available to millions of the world’s poor. But bear with me, dear reader. I will explain. You see, over the last several decades, the United States has been experiencing a rich-country version of the market fundamentalism that was thrust upon the developing world by Washington in the 1980s and 1990s. This fundamentalism led to deregulation of the financial system, the removal of safeguards against speculation and greed, the dismantling of social safety nets, the easing of environmental regulations, and increasingly, the privatization of risk . The exception, of course, is the fiscal austerity policies that forced developing countries to limit deficit spending—the Bush Administration has not held itself to those same pesky standards, especially when it comes to spending on warfare. Given the terrible consequences for humans and the earth, it is particularly perplexing that market fundamentalism has gone so far for so long. As I argue in my manuscript, Limiting Resources: Market-Led Development and the Transformation of Public Goods, it is not just an ideological project spearheaded by political elites. It is at the core of economic thinking. In contrast to popular understandings of “public goods”—where education, health care, water, and infrastructure are ensured by government, with an implicit social agreement to promote well-being and justice for the people—economists are trained to evaluate public goods devoid of social content. “The public” (you and I) is reduced to prisoners’ dilemmas and collective action problems, while state intervention is incorporated mainly as a last resort to remedy market “failure.” One result of this thin understanding of the full social significance of public goods has been a turn to markets wherever possible, via unbundling, contracting, granting concessions, and privatization. At the same time, taxes have been reduced to levels that cannot sustain robust social programs. The resulting excessive reliance on markets has virtually depleted the pool of resources considered “public” and precluded important non-market alternatives, in developed and developing countries alike. The effects of “free” markets in money, land, and human beings (Polanyi’s “fictitious commodities”) in the United States illustrate the danger: Money. The abstraction “money” has only a tenuous connection with the real economy, as any trader will tell you. Regulation is imperative for checking usury and speculative finance, i.e., not allowing money to be just another commodity. The Asian and subsequent financial crises are a stinging reminder that money cannot fill an empty stomach. The current meltdown on Wall Street was preceded by decades of deregulation and the growth of a “shadow banking system” that now reaches far beyond our fair shores. The looming crisis is likely to be equally far-reaching. At this late stage, we can only hope that the severe dislocations resulting from efforts to institute a “self-regulating market system” in the 19th century—World Wars and a Great Depression—do not make a return in the 21st. Land. Despite unequivocal evidence that human-induced global warming is threatening not only stronger storms but also “heat waves, new wind patterns, worsening drought in some regions, heavier precipitation in others, melting glaciers and Arctic ice, and rising global average sea levels,” the Bush Administration has been unwilling to intervene in order to reduce emissions of greenhouse gases, cooperate with other countries on climate change, or invest adequately in alternatives. Though there were some meager incentive programs, these were all designed to not “rock the boat” of traditional market activity and adhered to the twisted logic that growth would ultimately protect the earth and lead to sustainability. Unfortunately, the magnitude of the climate crisis calls for visionary leadership at the highest levels—something that is clearly not going to come from this administration. Human life. Our abysmal, market-based health care system in the United State speaks volumes regarding how well markets protect human life. The United States ranks lower than every OECD country in infant mortality except Turkey and Mexico, and lower in life expectancy than all except Eastern Europe and Mexico. Even countries with much more modest resources, like Cuba and Costa Rica, do better because of public investment, according to a recent World Health Organization report. A litany of horror stories supports the conclusion that a for-profit medical system is inhumane and relatively ineffective in delivering “goods” essential to human life. In terms of labor, we see rising productivity levels being matched with stagnating wages, making it harder and harder for working people to make ends meet. According to Polanyi, society survives the disruption caused by attempts to institute a self-regulating market system through intervention and re-introducing non-economic norms and values to economic activity. This process often entails harnessing the state to ameliorate negative externalities and achieve positive ones. For example, regulation can limit the pursuit of money for money’s sake, as speculators look to “flip that house” (and reap huge profits) or Wall Street brokers demand greater and greater returns. Meanwhile, state-led development and investment in alternative technologies are going to be essential for finding ways to stop abusing the earth—sucking oil from its bowels through a pipeline while suffocating it with stinging pollutants through a tailpipe. Alternative energy is the future, and we need state action to get us there. Finally, state investment in strong social safety nets can help us care for one another where markets do not, and cannot. Rather than leaving us to fend for ourselves in some warped Social Darwinist experiment, we can create institutionalized safeguards to protect our frail bodies and fragile lives from the worst suffering and threats to our well-being. With a U.S. presidential election less than two months away, it is becoming increasingly clear what is at stake. “More of the same” market fundamentalism of John McCain’s party could be very bad for the sound and just management of money, land, and labor. But are Americans ready for the real changes needed to turn this ship around? After all, we are the poster children of over-consumption, and we tend to vote for political leaders with a willful disregard of the catastrophic consequences of our addictions: cheap oil, cheap food, and cheap goods. Let’s hope that the magnitude of the current crisis will awaken us to the issues that really matter. LaDawn Haglund received her Ph.D. in Sociology from New York University in 2005. She is Assistant Professor in the School for Justice and Social Inquiry in the Arizona State University, USA.