Growth and the real exchange rate

by on September 13, 2008 at 4:00 pm in Web/Tech | Permalink

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 Â…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.

1 M. September 14, 2008 at 1:41 am

I thought the growth gain was from a high real exchange rate rather than a low one. Am I missing something here?

2 Richard Green September 14, 2008 at 2:36 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.

3 SJ September 14, 2008 at 9:36 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)”

4 Tom Grey - Liberty Dad September 16, 2008 at 11:59 am

“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?

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