Currency Crisis, Session on Brazil BACKGROUND MATERIALS

The spread of the global financial crisis to Latin America in general, and Brazil in particular, has changed the complexion of the problem in several ways. Obviously the stakes are now even higher than before, especially for the United States; obviously, also, the fact that contagion can take place in this way makes it even harder than before to blame the whole crisis on "Asian values" and "crony capitalism". Beyond this, Latin America's troubles bring out in an even clearer fashion than before the unpleasant dilemmas that all developing countries (and perhaps even smaller developed economies) now face. A good way to illustrate these dilemmas is to consider a classic analysis of macroeconomic policy in an open economy: Trevor Swan's 1955 discussion of the difficulty of reconciling "internal balance" (i.e., more or less full employment) with "external balance" (an acceptable current account deficit) . The "Swan diagram" analyzes the economic effects of two kinds of policies: those that affect the overall level of domestic expenditure, such as the fiscal deficit; and those that affect the relative demand for domestic and foreign goods. The figure shows a standard Swan diagram. We imagine a country with a pegged exchange rate and high capital mobility, so that interest rates are determined by the need to avoid rapid depletion of reserves, and in effect monetary policy is removed as a tool of stabilization. Thus the "expenditure level" policy variable on the horizontal axis is fiscal; glossing over many complications, we can simply think of it as the budget deficit. On the other axis we show an "expenditure composition" variable, the cost of production in our country relative to that abroad. What Swan pointed out was that the nature of the difficulties facing a country depend on where in this space it resides. To see this, we draw two curves. One curve represents conditions under which the country has "internal balance"; as drawn, it is upward-sloping. The reason is that any rise in the country's relative costs would tend to reduce exports, increase imports, and thus reduce employment; to compensate, to keep employment constant, the country would need to have a fiscal stimulus - a larger budget deficit. At any point to the right or below this internal balance curve, the economy will suffer from too much demand for its goods, and will experience inflationary pressures. At any point above or to the left, it will suffer from unemployment. The other curve shows conditions under which the country has "external balance". It slopes downward, because an increase in spending would other things equal increase the current account deficit; to offset this the relative cost of production in this country would have to fall. At any point below or to the left of the external balance curve, the country will have a current account surplus (or at least a deficit below what is really appropriate), at any point above or to the right an unacceptably high current account deficit. These two curves define four "zones of economic unhappiness", shown in the figure; only at the point where the two curves cross is the economy without problems internal or external. (All happy economies are alike; each unhappy economy is unhappy in its own way). A country may have an external surplus or deficit; it may have unemployment or inflation. And by considering what kind of economic problems a country has, one gets a clue as to what kind of policy action is appropriate.download