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Growth and the real exchange rate
Dani Rodrik, who is back at blogging, also has a new paper. Here is the abstract:
I provide evidence that undervaluation of the currency (a high real exchange rate) stimulates economic growth. This is true particularly for developing countries. There is also some evidence that the operative channel is the size of the tradable sector (especially industry). These findings suggest that tradable goods suffer disproportionately from the government or market failures that keep poor countries from converging towards higher-income levels. I present two categories of explanations as to why this may be so, focusing on (a) institutional weaknesses, and (b) product-market failures. A formal model elucidates the linkages between the level of the real exchange rate and the rate of economic growth.
No, mercantilism has not made a comeback. Public choice economics has. The most plausible mechanism is that most poor countries have dysfunctional interest groups. Exporters are a relatively growth-enhancing set of interest groups. So if your policies favor exporters, the quality of your interest groups will increase over time. Your policy will stay good or get better and your growth will go up. In other words, what Toyota wants is pretty good for Japan. China's hope is that its new businessmen want to keep some modicum of freedom, and so on.
Of course low real exchange rates trickle away over time, as domestic prices rise and markets restore the real exchange rate of their choice. But low real exchange rates are probably a good proxy for other export-friendly policies, such as predictable regulation and investment in infrastructure. And so low real exchange rates are only doing part of the work in driving growth and probably not even the biggest part. If we had an index of "export friendliness" for the countries in this sample, maybe the power of the low real exchange rate would go away. This explains why wealthier countries, who don't have dysfunctional interest groups to the same degree, also don't see comparable growth benefits from low real exchange rates. Rodrik even points out on pp.14-15 that the countries with the worst governance indices see the biggest growth gain from low real exchange rates. (By the way, in the public choice story the improvements in the quality of your interest groups and in your policy don't come until later and thus they are not captured in the current level of the quality of governance index.)
Brad DeLong comments here and here and here.
Posted by Tyler Cowen on September 13, 2008 at 04:00 PM in Web/Tech | Permalink
Comments
I thought the growth gain was from a high real exchange rate rather than a low one. Am I missing something here?
Posted by: M. at Sep 14, 2008 1:41:58 AM
"I thought the growth gain was from a high real exchange rate rather than a low one. Am I missing something here?"
Yes, you are.
Overvalued exchange rates liquidate the tradable goods sector and lead to crashes. See Argentina up to the default.
Undervalued exchange rates build real economies that aren't forced into periodic contractions via an external constraint. See Japan, Taiwan, South Korea, China, etc.
Posted by: Peter Schaeffer at Sep 14, 2008 2:05:34 AM
Another issue with pursuing growth like this is that the neighbour whom is being beggared may object...eventually. Japan and Korea benefited greatly from US tolerance of their exchange rates due to the desire to keep them safe from communism (successfully). But when Japan was still going strong, and was unquestionably a 1st world country in the mid 1980s, the US became less tolerant. In recession, with a free trader as president and a Democrat congress aligned with US motor unions, you can see why they weren't that happy about effectively subsidising this growth anymore.
The real problem wasn't the external pressure that lifted the exchange rate, but the internal pressure from the interest groups. This required the compensatory fall in interest rates that led to the bubble and subsequently the malaise.
So I guess you have to be sure your interest groups are sorted out before you have to stop beggaring thy neighbour.
Posted by: Richard Green at Sep 14, 2008 2:36:14 AM
The pertinent question is... should I return to reading Dani Rodrik? I can't quite remember how long ago I deleted him from my RSS feed, perhaps more than six months ago... in fact, I can't quite remember the reason (perhaps his "second-best" justifications).
I could find out by myself of course, but wouldn't it be better to find out what people think (as if any person changes their basal ideological position in six months...)?
Posted by: josh at Sep 14, 2008 9:09:55 AM
M Says: "I thought the growth gain was from a high real exchange rate rather than a low one. Am I missing something here?"
Peter Schaeffer Says: "Yes, you are. Overvalued exchange rates liquidate the tradable goods sector and lead to crashes."
Peter Schaeffer and Tyler are both guilty of using sloppy terminology.
Rodrik is correct, and unambiguous in how he says it: "undervaluation of the currency (a high real exchange rate)"
Posted by: SJ at Sep 14, 2008 9:36:16 AM
@Josh - I don't think Dani has changed much over the last 6 months. So if you hated his blog then, you will now. That said, he may be one of the smartests and also probably the heterodox development economist with the best mainstream econ creds right now, so I think even if you vigorously disagree with him all the time you'd be foolish not to read him.
I'm not at all convinced by Tyler's mechanism. The banking sector, for example, doesn't like undervaluation at all and they should be a pretty decent interest group.
I think Brad de Long is onto something - the advantage of undervaluation is that you can do it with less capable administrations, so basically it works for middle income countries. And the fact that it slowly takes care of itself via rising domestic prices might actually be helpful, because that constitutes a credible commitment to end this particular form of industrial policy which is very hard to commit to with traditional industrial policy.
Posted by: Sebastian at Sep 15, 2008 11:29:58 PM
"Overvalued exchange
rates are associated with shortages of foreign currency,"
= high local value to USD. From Dani. (few local buys lots of USD)
"undervaluation of the currency (a high real exchange rate)"= low local value to USD (it takes lots of local to buy USD)
So the undervalued currency means a high local real exchange rate (lots of local to buy USD). Like China.
"Of course low real exchange rates trickle away over time, as domestic prices rise and markets restore the real exchange rate of their choice. " is the the undervalued currency?
Posted by: Tom Grey - Liberty Dad at Sep 16, 2008 11:59:52 AM
