As Brazil Agonizes Over Devaluation,
U.S. Makes a Move on Interest Rates
By DAVID WESSEL and CRAIG TORRES
Staff Reporters of THE WALL STREET JOURNAL
Some day soon, Brazilian President Fernando Cardoso and his economic
advisers will have to decide whether to let the value of the Brazilian
currency, the real, fall sharply against the U.S. dollar.
The world is watching. Brazil is seen as a firebreak in the financial
conflagration that has swept through Asia and Russia. If Brazil gets it right,
the worst of the crisis may be past. If it gets it wrong, the odds of
world-wide financial calamity increase.
Tough choice? It's exactly the kind of gut-wrenching decision that
economic policy-makers are facing all over the world -- including in the
U.S. Only 17 days ago, the Federal Reserve decided to lower interest
rates a quarter percentage point, disappointing markets, which had hoped
for a greater cut. Thursday, concerned about "unsettled conditions in
financial markets," the Fed unexpectedly cut another quarter-point,
sending markets soaring. The Dow Jones Industrial Average closed up
330.58 points, or 4.15%, at 8299.36.
Unfortunately for Mr. Cardoso, who vows he won't devalue his nation's
currency, the issue of devaluation has been the focus of an almost
theological debate for decades among the economic experts who have
thought the hardest about it. But when it comes to facts, neither side has a
preponderance of the evidence.
The case for devaluation is clear-cut: When something bad happens to
demand for a country's products or assets, the smart thing is to do what
companies do when demand falls -- cut the price. The easiest way for a
country to do that is to reduce the value of its currency against other
currencies, to "devalue." Exports are instantly cheaper to foreign
consumers, sales increase, the economy perks up.
Overpriced by 25%
Today, Brazil's imports exceed its exports by a sum greater than 4% of its
economy, and its inflation rate, though down from the early 1990s, still
exceeds that of the U.S. Those measures suggest to Harvard University
economists Jeffrey Sachs and Steven Radelet, among others, that the real
is overpriced by about 25%.
But an equally strong case can be made against devaluation: Look what
happened to Thailand, Korea, Indonesia and Russia. Devaluation was
followed by recession, high interest rates, widespread bankruptcies and
panic. Mr. Cardoso knows that pushing down the real could lead to higher
import prices and risk rekindling the devastating inflation he worked so
hard to conquer.
With money flowing across international borders more easily than it did a
decade ago, devaluation is trickier. Rich-country investors and banks lend
and invest billions in far-away markets; companies, banks and wealthy
families in those far-away countries borrow heavily from abroad. When
their governments reduced the value of their currencies, Thais or Koreans
or Indonesians who had borrowed from abroad (in dollars) to invest or
lend at home (in baht, won or rupiah) got smashed. A Thai borrower that
owed $1 million to foreigners on June 30, 1997, just before the
government devalued, owed the equivalent of 24.7 million baht; a month
later, it owed the equivalent of 31.5 million baht.
And when the borrowers are banks, as many have been, the heavier debt
burden can push them into insolvency. That, in turn, makes it almost
impossible for local exporters to get the credit they need to take advantage
of devaluation to increase their sales abroad. In short, the pain of
devaluation is worse than it was in the old days, and the benefits to
exporters are elusive.
Roosevelt and Nixon
Devaluation isn't merely an issue for emerging-market economies. Franklin
Roosevelt devalued the dollar in 1933, and the U.S. economy bounced
back from the Depression -- temporarily. Richard Nixon devalued the
dollar in 1971; critics say that helped produce a decade of inflation.
Treasury Secretary James Baker encouraged a steep decline in the dollar's
value in 1985; U.S. manufacturers cheered. Britain's Prime Minister John
Major devalued the pound in 1992, and his economy soared. Much the
same happened to Italy, Spain and Sweden.
To emerging-market economies, devaluation may be discomforting. But
the alternatives can be worse, or even nonexistent. Mexico, Korea and
Thailand devalued only after spending all their foreign-currency reserves
trying to support the price of their currencies, U.S. Deputy Treasury
Secretary Lawrence Summers regularly reminds critics. Those countries
didn't have the means to stop their currencies from falling; indeed, they
might have been better off letting their currencies go sooner, he says.
To avoid devaluation altogether, most economists believe, Mexico,
Thailand and Korea would have been forced to raise interest rates to
excruciatingly high levels, maybe even higher than their fragile financial
systems and politically shaky governments could have handled.
A Dirty Word
In some conservative circles, however, devaluation long has been a dirty
word; the idea that exchange rates ought to move like other prices is as
much an abomination as the notion that the length of an inch should vary.
"The last thing you want in money is flexibility. Money has to be a
measure. It has to be stable," says Robert Mundell, a Columbia University
economist and advocate of a return to the gold standard. Mr. Mundell,
known among colleagues not only for his intellect but for a spectacular
65-room Renaissance palazzo near Siena, Italy, that he bought in 1969,
inspired the original supply-siders -- including economist Arthur Laffer and
former Wall Street Journal editorial writer Jude Wanniski.
Adherents to the Mundell school include The Wall Street Journal's
editorial page and influential congressional Republicans, which explains
some of the antipathy to those they deride as "devaluationists" at the U.S.
Treasury and International Monetary Fund.
Their generic advice to finance ministries pondering devaluation: Don't. It
simply doesn't work. Cut the value of your currency, and the resulting
inflation will undo the apparent benefits. Better to persuade markets that
you are serious about not devaluing, and they will back off.
What has the last year of currency-market turmoil taught Mr. Mundell? "It
hasn't fundamentally changed my thinking," he says.
On that point, Milton Friedman, the Nobel laureate economist now at
Stanford University, concurs. "I don't think we've learned anything that we
didn't already know," he says. But on nearly everything else involving
exchange rates, Mr. Friedman -- who has spent the past 45 years
preaching the virtues of allowing exchange rates to move freely --
disagrees with Mr. Mundell, just as he did when the two were teaching at
the University of Chicago in the 1960s.
Bradford DeLong, an economic historian at the University of California at
Berkeley, explains the debate to his students this way: To Mr. Friedman,
an exchange rate is a price; therefore, it is an infringement on human
freedom to peg it. To Mr. Mundell, an exchange rate is a promise; to
change it is to default on a commitment.
Floating Freely
For better or worse, since the system of fixed exchange rates among rich
countries broke down in the early 1970s, the world's major currencies
have been floating freely against each other, with occasional efforts by
governments to influence their movements.
Developing countries have also moved toward more flexible exchange
rates. In 1975, according to the International Monetary Fund,
three-quarters of the output from developing countries came from nations
with fixed exchange rates; at last tally, in 1996, only 13% did.
Mexico, for instance, decided after a botched devaluation in late 1994 to
let the markets set the value of the peso. It didn't want to give speculators
a fixed target at which to shoot or to repeat the tense internal government
confrontation between those who wanted to devalue the peso and those
who didn't. President Ernesto Zedillo recently called Mexico's floating
exchange rate a "suitable" weapon to avoid abrupt devaluations and
discourage speculation.
But it hasn't been an easy ride. Since the end of June, the peso has fallen
more than 10% against the dollar. Deteriorating expectations about
Mexican inflation have pushed interest rates above 30%. The banking
system is taking another beating, and the cost of borrowing for Mexican
companies is prohibitive.
Unavoidable Jolts
Advocates of freely floating exchange rates have hoped that more-flexible
(even if not completely flexible) rates would spare the world the big jolts
that occur when fixed exchange-rate systems crack. But it hasn't worked
so well. "Contrary to conventional wisdom," IMF economists Francesco
Caramazza and Jahangir Aziz concluded in a study published last year,
"misalignments and currency crashes are equally likely under pegged and
flexible exchange rate regimes." In the 116 instances between 1975 and
1996 when currencies plunged 25% or more, half were operating with
flexible exchange-rate systems.
Recently, the huge amounts of money flowing across borders have further
undermined the case for freely floating exchange rates, or at least greatly
complicated matters. These days, exchange rates affect, and are affected
by, not only trade in corn and cars, but also trade in stocks, bonds, bank
deposits, loans, derivatives and so on.
The ability of emerging-market families and firms to borrow from abroad,
it turns out, changes the dynamics of devaluation.
"Normally, depreciation is a neat, clean, nice safety valve to allow you to
maintain full employment when the world economy deals you a bad hand,"
says Mr. DeLong, the Berkeley economist and former Clinton Treasury
official. "But if you have a lot of foreign debt, you have a choice between
raising interest rates to avoid depreciation or getting the exchange rate
down and putting your entire banking system and most of your
corporations in bankruptcy."
No Surprise
To some wise old men of economics, the tension between rigid exchange
rates and freely flowing capital comes as no surprise. "This is something
that John Maynard Keynes pointed out in 1923 when he said you can
have two, and only two, of the following three things: free movement of
capital, fixed exchange rates and independent monetary policy," Mr.
Friedman -- no Keynesian he -- says approvingly.
To Mr. Friedman, the answer is obvious: Let the currencies go and the
capital flow freely. However, to Harvard's Mr. Sachs, an advocate of
devaluation for Brazil and similarly situated economies, there is another
solution: Let the currencies go and stop the capital from fleeing, by
prodding Brazil's creditors to turn short-term loans into long-term ones.
A few economies, Argentina and Hong Kong most prominently, have
chosen a different combination. They allow capital to move freely and fix
their exchange rates to the U.S. dollar, but emasculate their central banks.
Unlike the Federal Reserve, the Argentine central bank can't cut interest
rates to resist recession. So when Mexico's woes in 1994 sent shock
waves through Latin America, Argentina couldn't cushion the blow: It lost
several banks and allowed unemployment to reach 18%. Nonetheless, the
Argentine peso is still worth exactly $1.
With similar logic, Germany, France and nine other European nations are
surrendering their national currencies to the euro, and their freedom to set
interest rates to the new European Central Bank. Italy will no longer be
able to devalue the lira (at least against its European competitors) or cut
interest rates to fight recession.
A Case for 'In Between'?
Yet to one degree or another, the rest of the world still embraces
currencies that can change value when economic conditions change,
sometimes by overt government actions, other times by allowing markets
to move them.
It still isn't clear to those who ponder such issues if that is a good idea. As
Carnegie-Mellon University economist Allan Meltzer, a Friedmanite, puts
it: "The best you can say of what economic research has produced is: You
can make a case for freely floating exchange rates if you're willing to live
with the consequences. You can make a case for fixed exchange rates if
you're willing to live with the consequences. You can't make much of a
case for anything in between."
Most of the world is "in between."
Brazil, for example, adopted the real in 1994 as part of a successful attack
on inflation. The Brazilian central bank buys and sells the real to keep its
value within a publicly announced range against the U.S. dollar. It has been
moving the top and bottom limits of this band downward by about 7% a
year, hoping this will compensate for differences between the U.S. and
Brazilian economies and avoid the need for bigger, disruptive devaluations.
In the jargon of finance, this is called a "crawling peg."
Brazilian officials repeatedly assert, as they did recently in a statement
issued jointly with the IMF, "their firm commitment to their current
exchange-rate regime." But Brazil has been losing more than $10 billion a
month as nervous foreign and domestic investors move money out of the
country.
Frugality and Cash Infusions
Mr. Cardoso, newly re-elected, hopes that government belt-tightening,
changes to its costly pension system and several billion dollars from the
IMF, World Bank and rich-country governments will calm global investors
so Brazil can avoid devaluation. But the markets know that this will be a
tough sell to Brazilian voters and politicians.
Mr. Friedman thinks Mr. Cardoso is pursuing the wrong course. "A
pegged exchange rate system" -- like Brazil's -- "with an independent
central bank is a ticking bomb and a remedy for disaster." His ally Mr.
Meltzer says, "If I were in Brazil, I'd think strongly about devaluation.
Their currency is way out of line."
Even Mr. Mundell, the defender of the gold standard, isn't sure that Brazil
should avoid devaluation altogether.
"They should now decide if they're going to have devaluation of any kind,"
he advises. "If they think they need one, for whatever reason, they should
only do it in conjunction with setting a new rate" that they promise never to
change again, an Argentine-style approach.
For Brazil to devalue its currency by 10% or 20%, and then try to resume
the old approach, he adds, "would be disastrous."
Brazilian officials said Thursday that they anticipate announcing their new
economic plan sometime after next Tuesday.
The Fed's surprise interest-rate cut gave them a welcome respite
Thursday. In response, the country's biggest stock market, Sao Paulo's
Bovespa, soared, closing up 6.7% percent. The smaller Rio de Janeiro
stock exchange closed up 4.9%. Brazilian government bonds also rose. |
