Elasticity Pessimism: Economic Consequences of Black Wednesday Sebastian Bustos and Martin Rotemberg∗ October 2018 Abstract We document the ramifications of a large devaluation episode: the U.K.’s “Black Wednes- day” in 1992. Relative to synthetic counterfactuals, U.K. export and import prices in pounds increased by roughly 20 percent, a similar magnitude to the nominal devaluation. Inflation de- clined after the devaluation, although the prices of fuels increased. Contrary to the conventional belief that the UK experienced an export led boom after the devaluation, we find no evidence that exports or nominal GDP increased. We also find no evidence of a “J-curve:” imports declined immediately after the devaluation, and stayed persistently below their counterfactual value. We test a wide variety of theories of elasticity pessimism, and find that none do well at explaining patterns in the data. ∗Bustos: Harvard University, 79 JFK Street, Cambridge, MA 02138; [email protected]. Rotemberg: New York University, 19 West 4th St., New York NY 10012; [email protected]. We are grateful to Alex Segura, who started the project with us, as well as Alberto Abadie, Jonathan Eaton, Raquel Fernandez, Gita Gopinath, Ri- cardo Hausmann, Jeff Frankel, Mark Gertler, Rachel Glennerster, Robert Lawrence, Virgiliu Midrigan, Lant Pritchett, Dani Rodrik, Julio Rotemberg, Larry Summers and Rodrigo Wagner for helpful comments. On September 16, 1992, the British Pound devalued in nominal terms by around 20 percent after speculators successfully pushed the U.K. out of the European Exchange Rate Mechanism.1 The conventional wisdom is that the devaluation caused a “boom,” since it was followed by increased growth.2 However, we show that the economies of similar countries who did not devalue experienced similar growth rates. This result is consistent with a growing body of empirical studies of exchange rate movements that find muted responses on exports (Obstfeld and Rogoff, 2000; Ruhl, 2008; Leigh et al., 2017). We use Black Wednesday as a laboratory to test a variety of leading theories which have been developed to explain this empirical regularity, but find that none do well at explaining the patterns in the data. First, we show how the devaluation affected real prices. The local prices of imports and exports at the dock increased after the devaluation, by almost as much as the nominal price of dollars (Burstein et al., 2005). While British ministers explicitly maintained the peg in order to avoid inflation (Bonefeld and Burnham, 1996), the British CPI decreased relative to its counterpart in comparable countries, with energy the only sector with a significant increase.3 We argue that the surprising decrease in inflation may be due to the (ex-post successful) implementation of an inflation target following the devaluation. Having documented the effect of the devaluation on real exchange rates and prices, we turn to trade flows. The existing empirical literature on the topic tends to either (a) fail to reject the null that real devaluations do not affect the trade balance (Rose and Yellen, 1989), or (b) find that devaluations are followed by a J-curve (or a “horizontal-S” curve), with an immediate decline in the trade balance followed by its gradual improvement (Branson, 1972; Junz and Rhomberg, 1973; Backus et al., 1994; Alessandria et al., 2015). In contrast, we find that imports (in dollars) immediately declined after the devaluation and stayed persistently lower for several years, while both export quantities and values did not increase relative to comparable countries. Devaluations (and exchange rate movements more broadly) have underlying causes, which them- selves may affect the local economy. In this setting, the proximate cause of Black Wednesday is well understood: speculators correctly predicted that the Bank of England would be unwilling to maintain its (relatively nascent) obligations to the exchange rate mechanism (ERM), leading to a “self-fulfilling” currency crisis (Eichengreen and Wyplosz, 1993; Eichengreen et al., 1995). The 1All nominal exchange rates in this paper are in local currency units per dollar. 2For instance, a 2005 statement by Lord Norman Lamont, who was Chancellor of the Exchequer in 1992, high- lighted the “enormous gains the economy experienced” after the devaluation, a view shared by the financial and local press (including the Economist, the Financial Times, the Guardian, and the Telegraph), and the Office of National Statistics. Furthermore, at the time the devaluation was expected to have a beneficial effect for the British economy, hence the well-known (if probably apocryphal) “story of the British Chancellor of the Exchequer ‘singing in the bath’ (Frankel, 2004). Much of the the academic research we’ve found on the topic (Hughes-Hallett and Wren-Lewis, 1995) has also argued that the devaluation was associated with economic benefits, which Gordon (2000) describes as the “conventional view.” Furthermore, it is well-known that nominal GDP for the U.K. did increase (Sumner, 2016) after the devaluation. There were no corresponding financial or political crises in the U.K.(Cooper, 1971; Frankel, 2004) nor was the devaluation part of a package of policy reforms aimed at boosting the economy. 3Campa and Goldberg (2005) find that increases in consumer prices tend to be smaller in magnitude than changes in the exchange rate. Burstein et al. (2007); Alessandria et al. (2010); Forbes et al. (2016) develop theories of why prices move slowly in the direction of exchange rates, by respectively appealing to stickiness, inventory behavior, and the underlying cause of the price change, but all of the theories predict relative price increases after a devaluation. 2 very fact that the U.K. abandoning its peg led to a large devaluation implies that the currency was overvalued. To account for this potential bias, we we compare the U.K. to countries with ex-ante similar levels (and trends) of currency mismatch or exchange rate movements, and find similar results on trade flows. A depreciation is a relative change: for the UK’s currency to depreciate (in real terms), the currencies of at least some of its trading partners must have appreciated (in real terms). This type of spillover makes it difficult to use the standard tools of the treatment effects literature (Rubin, 1974). We alleviate this concern by studying the effects of the U.K.’s devaluation within markets, and find that the results are robust to focusing on within destination, within-sector, and within-destination-within-1-digit-sector flows. Comparing outcomes within markets also avoids bias coming from contemporaneous shocks to other countries or sectors to which the U.K. was relatively exposed, such as the establishment of the European Single Market in January 1993 and the liberalization of Eastern European countries over the period. Many explanations for limited effects of exchange rate movements appeal to the relatively transitory nature of price shocks (Hooper et al., 2000; Ruhl, 2008; Drozd et al., 2014; Fitzgerald and Haller, 2014). An advantage of this setting is that, the U.K. devaluation was large, unexpected, and persistent and its effects stay relatively similar over the next five years. Figure 2 shows that the 12-month forward price of the pound fell at the devaluation (it had been increasing in the summer of 1992), and then stayed persistently lower. Since imports responded quickly to the devaluation, models whose predictions include “nominal prices should not affect trade flows” are generically unable to rationalize our results. In order to evaluate theories of the effects of exchange rate movements, we implement tests in the spirit of Rajan and Zingales (1998). The theories we study all have empirically testable predictions about how the effects of the devaluation will vary across sectors. For instance, exchange rates may not affect trade flows if prices are sticky in a foreign currency (such as the trading partners’ or in dollars), since foreign consumers would not change their consumption if the prices they faced did not change.4 If sticky foreign prices were the underlying friction preventing exchange rate movements from affecting trade flows, then the U.K.’s devaluation would have increased exports relatively more in sectors that are known to not have sticky foreign prices, such as sectors with a world price, prices in pounds, or with high exchange rate pass-throughs. We test each of these theories in turn, and find no increases in the dollar value of exports for commodities traded on exchanges nor tourism expenditure, and find no significant evidence that trade flows in sectors with higher measured pass-throughs (Gopinath and Rigobon, 2008) responded more to the devaluation. We estimate the U.K.’s counterfactual no-devaluation outcomes using a weighted average of countries who did not devalue, with the weights chosen to most closely match the pre-devaluation characteristics of the U.K., a method known as synthetic controls (Abadie and Gardeazabal, 2003; Abadie et al., 2015).5 4See, for instance, Krugman (1986); Burstein and Jaimovich (2012); Burstein and Gopinath (2014); Asprilla et al. (2015); Casas et al. (2016). 5Firpo and Possebom (2016) provides a thorough bibliography of papers using the method. Several papers generate 3 The synthetic control method is appropriate given the event-study nature of our setting, and in Appendix Section 8.1, we describe a parsimonious model that describes both potential mechanisms for how a devaluation can affect outcomes and why a synthetic control-type approach is useful for generating counterfactuals. Synthetic controls require weaker identification assumptions than time-series or panel regressions, since as Abadie et al. (2015) discuss, they are unbiased even in the presence of time-varying unobservable confounders. For comparison, the identifying assumption for difference-in-differences regressions is that had the devaluation not happened the U.K.’s outcomes would have followed a parallel path to the observed average of the control units.