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Populist Policies and Balance-Of-Payment Crises in Emerging Economies

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Populist Policies and Balance-Of-Payment Crises in Emerging Economies Populist Policies and Balance-of-Payment Crises in Emerging Economies Alejandro Nakab∗ UC San Diego March 2018 Abstract Many emerging economies experience recurrent macroeconomic fluctuations where ex- pansions { characterized by increasing consumption and government spending but de- creasing foreign reserves { are followed by balance-of-payment crises. We develop a heterogeneous agent GE small open-economy model calibrated for a semi-industrialized economy where governments tend to avoid currency depreciations due to its distributive effects following a populist approach of macroeconomic management. In the model, the government transfers resources from capitalists to workers through fiscal policy and exchange market interventions, generating short-term expansions and redistribution { even in the presence of negative external shocks{ but with balance-of-payment crises in the medium-term, which transfers resources back to capitalists and exporters. More- over, we show that the model's generated pattern is consistent with 25% of all large depreciation episodes in developing countries in the period between 1950-2016. ∗Email: [email protected]. I am grateful to David Lagakos, Valerie Ramey and Natalia Ramondo for invaluable discussions and advice. I am also grateful to Marc Muendler, Tommaso Porzio and seminar participants at UCSD for helpful comments. 1 Introduction Since the 1930s, many emerging economies have experienced macroeconomic fluctuations with some common features. Particularly, there were expansions with decreasing foreign reserves associated with populist policies where governments tended to avoid currency de- preciations, which ultimately led to a balance of payment (BOP) crisis and a recession (Braun and Joy(1983), Sachs (1990) Dornbusch and Edwards(1990) and Edwards (2003)). After some absent years, there has been a resurgence of populist politicians in many devel- oping economies as is particularly the case in some Latin American countries (Acemoglu, Egorov and Sonin 2013). As Dornbusch and Edwards (1990) defined: \Macroeconomic populism is an approach to economics that emphasizes growth and income distribution and deemphasizes the risks of inflation and deficit finance, external constraints and the reaction of economic agents to aggressive non-market policies." In this paper, we propose a model to formalize these ideas discussed in this older literature in a modern heterogeneous agents GE model. We study the impact of these populist policies and analyze their distributive effects, focusing on the interaction between re-distributive policies based on exchange market interventions and the external constraint (the economy's foreign currency availability). Fixed exchange rate regimes required constant central bank interventions to prevent the exchange rate from moving. Although in the last decades many countries tended to “offi- cially" migrate to floating regimes, in practice, central banks systematically intervened in exchange markets (Calvo and Reinhart 2002). In fact, record accumulation of reserves post 2002 has much to do with countries' willingness to stabilize exchange rates in a world with greater capital mobility (Ilzetzki, Reinhart and Rogoff 2017). In most cases, interventions try to limit appreciations rather than depreciations, following a mercantilist view of de- fending a devalued exchange rate to protect domestic industries (Levy-Yeyati, Sturzenegger and Gluzmann 2013). Nonetheless, the constant loss of foreign reserves before these crises suggest the opposite, meaning exchange market interventions preventing real exchange rate depreciations. These populist cycles in which expansions were followed by BOP crises were vastly doc- umented for South American countries but it was not documented for other countries.1 Therefore, by conducting a case study analysis and using updated data, we first document these patterns for large devaluation episodes for South America in more recent years and for many others African and Asian countries as well. Using yearly data from the World Bank In- 1Among others Braun and Joy(1983), Dornbusch and Edwards(1990) and Edwards (2003) study the macroeconomic fluctuations in Latin American countries. 1 dicators for every country between 1960 and 2015, we first define a BOP crises as a situation where the real exchange rate depreciates more than 30% within a year. We document that in 25% of the 145 large devaluations episodes, countries suffer a decrease in international reserves for at least 2 years (3 years for most cases) before the BOP crises. Then, we restrict the analysis to those devaluation episodes and find that previous years to the BOP crises are associated with (1) large and increasing government spending and consumption which drop sharply at and after the crises and/or (2) negative term of trade shocks several years before the crises. We interpret these dynamics as populist policies, in which policy makers tend to avoid currency devaluations by intervening in the exchange market boosting consumption at the expense of international reserves. We start by constructing a GE small open-economy model with a representative agent (RA) based on Burstein, Neves and Rebelo (2003) and Burstein, Eichenbaum and Rebelo (2007), but extend it by adding foreign reserves and analyzing its behavior when specific fiscal and monetary policies are undertaken. Following the observation that the described pattern is mostly observed in middle-income countries that are net exporters of primary goods and low-skilled intensive goods and net importers of capital goods, we calibrate the model to a semi-industrialized economy with those characteristics. Then, we analyze the features the model must have to generate growth with decreasing foreign reserves. The impulse response functions show that if there is a positive shock to productivity or terms of trade, the economy will experience an increase in output and foreign reserves, generating a positive correlation between these two. We find that we need one of two things to reproduce output growth with decreasing foreign reserves in this model. The first option is a households' preference shock coming from a decrease in the household discount factor or a decrease in the willingness of households to hold money, which does not seem to be a plausible story behind these recurrent macroeconomic fluctuations. The second is to have an increase in money supply jointly with exchange market interventions to avoid a real exchange rate depreciation. Nonetheless, although the model matches the sign of the correlations from the data, the impulse response functions from these shocks and policies cannot match the timing of the BOP crises. In the model, we find a first expansion and a slow convergence back to the steady state which do not correspond to the expansion followed by a sharp exchange rate depreciation. Given that the RA model fails to match the timing of the BOP crises, we then proceed to include heterogeneous agents. We model an economy with two types of agents: workers with no access to bond markets but who can hold money and capitalists who have access to foreign bond market and who can hold real balances. With this heterogeneous agents model we aim to understand the economic dynamics coming from populist policies, analyzing its income 2 distribution implications at each part of the cycle. We model populist policies as (1) transfers from capitalist to workers driven by increases in taxes and lump-sum transfers between groups and as (2) direct transfers to workers financed by a central bank that issues money to cover a fiscal deficit, both with and without exchange market interventions.2 We find that populist policies provoke changes in mean propensities of consumption and money holding in the aggregate. Particularly, the policies generate a decrease in aggregate savings due to agents having different borrowing constraints and different preferences over real balances.3 Therefore, we provide a deeper explanation for preference changes in the aggregate caused by government policies that redistribute resources. Moreover, when the government intervenes in the exchange market, preventing the exchange rate to devalue while running a fiscal deficit, the model more accurately matches the data pattern, showing one large devaluation episode and recession once the exchange market intervention ends. We then redirect our attention towards populist reaction to external shocks. We show the impulse response function to a negative terms of trade shock followed by different exchange market intervention policies. We show that with no intervention, the terms of trade shock generates a decrease in production with a sharp devaluation and a real wage decrease. Fur- thermore, we find that the more aggressive the intervention in the exchange market is, the lower the real depreciation and the fall in GDP are. In the extreme case, the economy could even experience an expansion with a small real depreciation at the shock if the government spends all its reserves in a short time span, but with a recession once the government stops the intervention. Populist governments can postpone BOP crises to protect workers, even in the presence of negative terms of trade shocks, but for only a short period of time. Finally, as we analyze the income distribution dynamics, we find that we can represent class conflict with a particular measure of real wage (nominal wage over nominal exchange rate, which co-moves with the real exchange rate), which will be a sufficient statistic to know how the real income of each class behaves for each policy chosen. We conclude that populist policies tend to increase the real income of workers and decrease the real income of capitalists and that devaluations increase the real income of capitalist and decrease the real wage of workers. Thus, that cycle alters the wealth and income distributions, increasing the labor share in the presence of populist expansions and decreasing it in BOP crises. 2We sustain the idea that an increase in the size of the public sector, which is one of the most common choices of populist governments, tends to create the same dynamic that an increase in direct transfers to workers financed by taxes or an increase in money supply to cover the fiscal deficit.
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