The Latin triangle
Dornbusch’s model, shown here in a slightly modified diagram, is simple. The horizontal axis measures real GDP relative to its natural value. The vertical line through A and B is positioned at full employment. The vertical axis shows the real exchange rate, with appreciation upward. Dornbusch emphasizes that under a fixed exchange rate regime, real wages increase as the currency appreciates. That happens because the nominal wage tends to keep pace with domestic inflation while appreciation lowers the relative price of imported goods. Any point above the diagonal line through A and C requires an unsustainable rate of foreign borrowing. Its negative slope reflects the fact that either an increase in real GDP or an increase in the real exchange rate cause the current account to move toward deficit.
The cycle begins from point A, where the external balance is sustainable and output is at the full employment level. With a fixed exchange rate, any rate of inflation faster than that of the country’s trading partners will cause real appreciation. The current account begins to move toward deficit and the economy moves upward from A toward B.
The reasons for the real appreciation vary from case to case. In the Latin American examples of Mexico, Chile, and Brazil that inspired the original model, real appreciation is the result of inflation momentum. Fixing the exchange rate slows inflation via the nominal anchor effect, but either because of doubts about the credibility of the anchor or institutionalized indexation of wages and prices, inflation does not stop immediately.
The situation was a little different for the peripheral countries of the euro area, where there was no prior hyperinflation. In some countries, labor market rigidities and slow productivity growth contributed to more gradual inflation and real appreciation. In others, increased financial inflows were the main driver. Domestic firms and households were eager to take out cheap, euro-denominated loans, and foreign investors, lulled by a perception of reduced country risk, willingly supplied the wherewithal.
Whatever the cause of inflation and real appreciation, the move from A toward B shifts the current account toward deficit and causes a rapid increase in foreign indebtedness. Sometimes, as in Greece and Portugal, the government is the big borrower. Sometimes, as in Spain and Latvia, it is the private sector.
As the country moves upward from point A, its financial situation becomes more fragile. Eventually, with or without the catalyst of some external shock, it reaches point B, where further borrowing becomes impossible or prohibitively costly.
One possible response would be immediate devaluation, in the hope of moving back toward A. However, that option is politically unattractive. For one thing, high real wages and cheap imports are likely to have made the fixed exchange rate highly popular among consumers. In addition, millions of households will have taken out loans denominated in foreign currencies, and would face insolvency in case of devaluation. A government that wants to hold onto power will have to try to maintain the fixed exchange rate.
With devaluation off the table, the remaining alternative is a sharp turn toward fiscal austerity. In the short run, that will move the country toward point C, with falling GDP and rising unemployment. If the austerity is sufficiently stringent and kept in place long enough, nominal prices and wages may begin to fall. In principle, such an internal devaluation could move the country down along the line from C toward A.
The political economy of the triangle
At this point, politics begin to take over from economics. A successful internal devaluation is very hard to pull off. For one thing, it requires more flexibility of labor and product markets than most economies of Latin America or Europe provide. More importantly, it is politically difficult. Internal devaluation and structural reforms of labor markets are not what people want. Given a chance, they will vote against both devaluation and austerity.
That seems to be what has just happened in Greece. The Greek voters spoke with a strong voice: They liked point B of the Euro-Latin Triangle just fine, and they want to go back. Promises of pie in the sky easily drew more votes than appeals to reality. Much the same thing happened in France, moderated only by a voting system that guarantees an actual winner. Francois Hollande won by promising to end austerity and to stay in the euro. Marine Le Pen’s call to leave the euro may have cost her the chance to beat Sarkozy in the first round, a goal that once seemed within reach.
In Chile, Mexico, and Brazil, the three Latin American case studies that Dornbusch examined, crises ended with reasonably orderly devaluations. The crises in Europe will be harder to resolve. Devaluation is a more difficult option for the PIIGS or the BELLs. Their situation is more similar to that of Argentina, which was unable to escape its currency board arrangement without a default.
Implications for Europe
The Latin triangle, then, is a trap from which there is no easy escape. Once a country reaches point B, devaluation becomes costly, both politically and economically. Even if the country is not locked into a currency union or a legally binding currency board arrangement, paying off the accumulated private and public debt after devaluation will be expensive. The only alternative is a long, painful, and politically costly internal devaluation. In either case, there is a strong risk of default.
Since escape from the Latin triangle is difficult, it is best not to get caught in the first place. A country that wants to use a fixed exchange rate to stop inflation should have an exit strategy ready from the start. Israel is a case in point; it used a fixed exchange rate to end its 1985 inflation, but then moved in stages to a more flexible exchange rate corridor and finally a floating rate. In doing so, it avoided excessive real appreciation. Poland is another country that initially attacked inflation using the exchange rate as a nominal anchor, but later switched to a crawling peg and finally a float.
As in Israel and Poland, control of inflation was the initial motivation for fixed exchange rates in the BELLs, but they did not have exit strategies. By staying with their currency boards after they had brought inflation under control, they exposed themselves to sharp real appreciation during the boom that followed accession to the EU. As a result, they have had a rough ride through the recent global crisis.
If a country does opt for a permanently fixed exchange rate, it must defuse the Latin Triangle by adopting appropriate fiscal and financial policies when its economy is still close to point A. Once it is headed toward point B, it may be too late.
Appropriate fiscal policy has to be both countercyclical and symmetric. That requires running a substantial budget surplus during the expansion phase of the business cycle. Doing so is difficult for two reasons.
First, surpluses during expansions do not win elections. The public sees the budget as healthy as long as it is in or close to current balance even if the structural balance is negative. As the economy moves toward a positive output gap at the peak of the business cycle, the politically profitable course for the government in power is to use growing revenues for tax cuts or new spending programs. If it does not do so, it is liable to lose the next election to some opposition party that does make those promises.
Second, the EU’s asymmetrical growth and stability pact puts all the emphasis on limiting deficits during contractions without requiring surpluses during booms. That combination is an invitation for political parties to compete to see who can run up the most debt. Meanwhile, insufficient fiscal restraint during expansions leads to inflation higher than the average for the currency union, which in turn means real appreciation. It is a recipe for crisis.
Proper management of financial inflows is also difficult. Once a country enters a currency union, it no longer has an independent monetary policy. The best it can do is try to restrain excessive credit growth by requiring banks to tighten credit standards, setting minimum down payments for home mortgages, and the like. Such measures are likely to be politically unpopular and not always effective.
Unfortunately, all of this sounds like 20-20 hindsight, and it is. The Latin triangle model is useful for understanding how many countries of Europe arrived in their current difficult situations. It provides recommendations for others on how to avoid the trap of overvaluation and excessive debt. But it offers little that is helpful for countries that need to extricate themselves from situations they should not have allowed themselves to get into in the first place.
Sailors say the best way to avoid being swallowed by the Bermuda triangle is to stay away from it. The same is true of the Latin version.