There is a fallacy at the root of most of the discussion of the European economic crisis, and it is that countries like Greece would have the option to grow their economies through exchange rate depreciation, were they outside the Eurozone. In reality, exchange-rate depreciation always depresses output in small open economies, because there is zero elasticity of substitution between internationally traded goods and services and domestically produced goods and services, either in consumption or in production. There are no expenditure switching effects of a devaluation; devaluation “works” by depressing real income and imports, by enough to eliminate the excess demand for foreign exchange.
There are well over a hundred countries in the world that are smaller than Greece by population or similar measure, including Barbados where I am Governor of the Central Bank. It is now reluctantly accepted at the IMF, the World Bank and in international policy circles, that these small open economies are disproportionately affected by global shocks that raise import prices and cut demand for their exports, and it is costly for them to build resilience to adverse influences from abroad. What is still not fully acknowledged in the debate on the current Eurozone crisis, a debate largely driven by those in large economies, is that small open economies cannot make up for lost export demand in an international recession by switching to local demand, through currency depreciation. That is because the range and scope of their imports vastly exceed those of the exports of small economies. Economies of scale and scope in information and communication are universal and these economies have found that they have the human and material resources to be internationally competitive in only a handful of activities (see Carter 1997).
In a large economy that produces a wide range of import substitutes, currency depreciation can lead to a switch from imports to domestic substitutes, that already exist, or can be produced on a sufficient scale to be internationally competitive. Small open economies do not have this option. This has implications for short-run stabilisation and anti-inflation policy, for debt management and for sustainable growth strategies. In the short run, policymakers in these economies have to accept that a decline in foreign exchange revenue will mean a decline in real domestic income and spending. (The shock may be mitigated if the country has an excess of foreign exchange reserves which may be used to sustain consumption and imports for a while, or if there is capacity for prudent foreign borrowing.) Under floating exchange rates, if the authorities misguidedly attempt counter-cyclical expansion, the resulting excess foreign exchange demand pushes down the currency; however, because so few imports are produced domestically, depreciation does not reduce the demand for foreign exchange, until the rate depreciates enough to reduce real income back to the level before the fiscal expansion. (In reality, income and imports have to fall much further than this, because of capital flight and the loss of credibility which usually accompany a devaluation.)1
The hard foreign currency constraint for small open economies also has implications for fiscal sustainability and debt management. The fiscal strategy cannot be sustained if it creates an excess demand for foreign exchange through high external debt service or by pumping up aggregate demand and imports. The criterion of fiscal sustainability which is most critical is the forecast impact on the foreign exchange market, via debt service and aggregate expenditure effects. The preoccupation rating agencies have with ratios of debt-to-GDP, to the neglect of the balance of external receipts and payments, amounts to taking your eye off the ball to check the movement of a fielder.2
Thirdly, the hard foreign currency constraint implies that the pace of growth in SOEs is set by the expansion of the foreign exchange sectors. They supply the finance for the growth of imports of consumer, intermediate and capital goods. The growth strategy must therefore centre on the competitiveness of the export sectors, and investment that will increase the capacity to produce exports of goods and services. We should bear in mind that the small open economy is a price taker in the international markets in which it sells, so it cannot increase its competitiveness by reducing its prices, only by increasing capacity and productivity. What is more, currency depreciation tends to reduce the growth potential of the economy, because it introduces an additional uncertainty which acts as a deterrent to the investment needed to build production capacity.3 Much is made of the fact that currency depreciation increases the profitability of exporters by reducing the real cost of domestic value added, without acknowledging that this is an miserable strategy – the country may sell more abroad, but it earns less real income by doing so.
The essential point missing from the recent debate, is that small open economies are different: international economic shocks hit them especially deep and hard, and in the short term they have little choice but to absorb the blows and try to remain on their feet. Above everything, they should protect the value of the currency, by allowing the shock to feed through to a fall in real income. If there is to be active fiscal management, it should be in the service of maintaining the exchange rate anchor by matching import spending to foreign exchange inflows. Targeting the money supply or inflation, with a flexible exchange rate – the conventional policy prescription – produces a worse result. There is no additional foreign exchange earned or saved, real income falls by as much as is necessary to balance the external accounts in any event, and exchange rate depreciation imposes an avoidable inflation penalty that becomes entrenched in expectations.
Strategies for sustained growth are possible for small open economies, whatever the state of health of the international economy, precisely because their share of demand is so small, and they can market selectively in the areas where demand is least cyclical. To be sustainable, growth strategies must be crafted on the basis of the comparative advantages which human and material endowments offer to each small economy, and should include exploiting of market niches and moving up the value chain.
Carter, Adrian (1997), "Economic size, openness and export diversification: a statistical analysis", Central Bank of Barbados Economic Review, December.
Garber, Peter and Michael Spencer (1995), “Foreign exchange hedging and the interest rate defense”, IMF Staff Papers, 42(3):490-516.
Pindyck, Robert (1991), "Irreversibility, Uncertainty, and Investment", Journal of Economic Literature, xxix:3.
1 Typically, the exchange rate depreciates only after attempts to defend it have failed. See Garber ad Spencer 1995.
2 For those of you unfamiliar with cricket: this is a bad move.
3 The adverse effects of exchange rate uncertainty on investment are well recognised in the literature. See Pindyck 1991.