Brazil is being considered the new Bundesbank. In other words, many economists are saying all over the world that perhaps Brazil is the country which is following more strictly the inflation targeting rules and models, respecting the existence of only one true instrument of monetary policy – the nominal interest rate – and treating scientifically the concept of potential output and output gap.

Consequently, in spite of the turmoil with commodity prices and the US financial crisis, it seems that Brazil is being able to contain inflation within reasonable limits, by following the rules of inflation target models coupled with floating exchange rates. As a matter of fact, without any doubt, such models consider that the nominal interest rate affects inflation through many channels, including the level of economic activity and the level of the exchange rate.

In the case of Brazil, for example, nobody doubts that a 100% nominal appreciation of the real against the dollar since 2003 was a major factor to keep inflation low, in spite of the US$ increase in commodity prices. And this appreciation was mainly due to the high level of nominal interest rates against other currencies such as the dollar, the euro, the Swiss franc and the yen.

On the other hand, there is a certain degree of preoccupation nowadays because credit is expanding very rapidly in Brazil, in spite of high and increasing nominal interest rates, and this is certainly keeping a high level of economic activity and employment, which is not necessarily what the inflation target models were predicting.

In other words, it is the impact of interest rates on the exchange rate which is helping to keep inflation low, even though credit is booming and the economy itself is booming (although the definition of a “Brazilian boom” in this century is different than 30 years ago, when the country used to grow at 10% per year – and not 5%.)

But we would like, in this article, to raise some doubts about the role and the power of monetary policy – strictly defined as a nominal interest rate policy – over inflation. Brazilian historical experience suggests that, in a country with hyperinflation memories, two-digit nominal interest rates might begin to lose their impact on inflation, to the extent that the economic agents – Central Bank watchers and/or non-watchers - begin to change their interpretation about two-digit nominal interest rate movements in the upward direction.

It is well known the Fisher equation, where nominal interest rates are different from real interest rates by the concept of “inflationary expectations”. The problem of monetary policy in countries like Brazil is that, at one point, they control of course nominal interest rates but do not control inflation expectations (or, for that matter, also do not control devaluation expectations). In consequence, at a certain (or uncertain) point in time, raising two-digit nominal rates might represent even a decline of real interest rates, when and if the expectations about inflation and devaluation begin to behave like bubbles. Yes, there are also expectation bubbles – and economists know little about that.

It is possible – but I would emphasize: just possible – that the next increase of nominal interest rates in Brazil will not impact neither the exchange rate nor economic activity. Because real interest rates will go down significantly. People will begin to fear devaluation and higher inflation. This is the dilemma that existed before the Plano Real of 1994, before the Inflation Target Model of 1999, and that might very well come back, bringing the ghosts of the seventies and eighties.

After all, why did inflation go up from two-digits in 1963/1979 to three- digits in 1980/92 and then four-digits in 1993? Were the Monetary Authorities so incompetent during those 30 years? No. What happened is exactly that nominal interest rates lost their power as a monetary policy tool and, worse, began to affect dramatically the fiscal deficit. A race started between nominal interest rates and inflation expectations. A race that was lost by economic policy.

And then came the brilliant Plano Real in 1994, followed by the Arminio Fraga Inflation Target Model of 1999 and – surprise! – inflation practically stopped. The race was stopped by a brilliant combination of economic policy measures in both cases.

However, without being too pessimistic, we fear that the ghost of inflation expectations is back and somewhat out of control. And this will only be fed now with even higher nominal interest rates. A new race is beginning: a dangerous one.

The ongoing Democratic convention with all its high-tech hoopla and homey patriotic spirit would at first glance have little relevance for Latin America, but in fact this is not the case. A Democratic president, if Obama is elected in November, would have a rare opportunity to recast U.S.-Latin American relations in ways that could be transformative for the region and a boost to the economic growth prospects of the Western hemisphere over the long-run. Along the way, the US could secure major foreign policy advances in (mostly) friendly territory at a time when its global hegemony is increasingly being challenged.

The case for re-engaging with Latin America is made cogently in an article entitled “Morning in Latin America” by the Mexican intellectual and politician Jorge Castañeda in the latest issue of Foreign Affairs. He reminds us that “Latin America is living in a moment that combines the best and worst aspects of its history: growing at a pace unheard of since the 1970s, democratic and respectful of human rights…., with poverty and inequality at long last diminishing.” At the same time, the region is beset with all sorts of internal conflict (crime, drug violence, large-scale migrations, ethnic conflicts) and even the threat of cross-border conflict.

The most recent IMF report on the region (RGE Monitor, August 27, 2008) reinforces the “morning in Latin America” theme in terms of the economic outlook. Yes, the region does seem to be slowing along with the rest of the world, but nothing seems tremendously out of whack compared to previous global slowdowns. If anything, Latin America is in much better shape to wait out this global financial crisis. Economic growth is only 4.3% in 2008 (from 5.6% in 2007), but the slowdown is not raising alarm bells. Mexico is among the slowest growers, but even the Mexicans are relieved that the damage from the U.S. seems manageable. Meanwhile, some of the eye-popping growth rates of recent years continue in places such as Peru (growth up more than 9% in Q1) and Argentina (8.4%, although slowing recently.) Growth remains solid and sustainable in Brazil, has picked up slightly in Chile, and remains strong in Uruguay and the Dominican Republic. Trade positions are sound, even with natural resource prices easing; international reserve levels in Latin America are generally at record levels; inflation is on the rise, but likely to be held in check in most places.

What difference does encouraging picture in Latin America make to a President Obama? Why should he even care about a region so far from Tbilisi or Baghdad, so much less challenging to the US than Beijing or Islamabad, and apparently so much less needy of US assistance than the struggling societies of the African subcontinent?

A strong part of the argument for re-engagement is that the issues that are of greatest concern to Latin America are going to impose themselves on the Obama agenda whether the new President places a priority on them or not. The U.S. is going to have to deal with drugs and immigration, trade disputes, and authoritarian challenges to democracy, whether it chooses to or not. A much more compelling and positive argument for greater US involvement is that it is in the long-term interests of the US to consolidate shared economic prosperity and democracy in Latin America which is as close to being its geostrategic hinterland as any region in the world.

In fact, I would argue that the U.S. is being presented with a once in a lifetime opportunity to “re-introduce” itself to the region, much as FDR did in the Good Neighbor era of the 1930s and JFK did with the Alliance for Progress initiative in the 1960s. The good will resulting from these U.S. policies toward Latin America has had positive effects on U.S.-Latin relations that are visible even to the present day. What a shame no other U.S. presidents learned from these examples.

What are the greatest areas for rapid and transformative changes in the U.S. approach to Latin America? Following Castaneda’s arguments, at least four policy initiatives should be possible within the first six months of the Obama administration.

The first would be to make good the campaign pledge to re-establish dialogue with Cuba without insisting on free elections as a pre-condition, but rather as an outcome of a dialogue with the U.S. Latin Americans have long believed, and still believe, that the Cuban trade embargo is not only cruel, but counterproductive to U.S. strategic interests. Abandoning this anachronistic stance on trade while liberalizing family contacts and remittances and encouraging US travel to Cuba, would only accelerate the democratic transition in Cuba while reintegrating a vital component of the Caribbean and North American economy.

Second, Obama has a unique chance to revive the failed Bush initiatives on immigration which died of so much mismanagement and neglect. Resolving the issue of undocumented Latin workers in the U.S. (perhaps some 15 million or more) is a huge issue to Mexico and to almost a dozen other sending nations in Latin America, including Ecuador and El Salvador. Resolution of the immigration mess means two things: a path to citizenship (or legality) for those already in the U.S. and some sort of temporary worker program to restore circularity to Latin American migrant flows. As President Oscar Arias reminds us in a recent op-ed, Latin American sending nations need a hand from the U.S., not a wall which is what they are getting.

Third, the U.S. should and must work with Latin American nations to answer the intellectual and political challenge of the “hard left” in Latin America, led by Chavez, whose voice is growing and not diminishing. When we reach the point that Honduras, perhaps the longest-standing ally of the U.S. in the entire region, decides to join ALBA while criticizing trade agreements with the U.S., it is time for the U.S. to respond to the challenge posed by resource nationalism and short-sighted populism in Venezuela and Nicaragua, Ecuador and Bolivia, and possibly Argentina as well. This “hard left” has an export strategy, Casteñeda reminds us, while the more moderate and more successful leftist leaders in Brazil, Mexico, Chile, and Uruguay are strangely quiet in their response to Chavez and ever so reluctant to tout their own strategies. The U.S. response must run along the lines of providing greater support to those successful economies and leaders whose economic strategies and commitment to democracy offer the greatest hope to the continent. Calderon in Mexico is in danger of losing his war on drugs. Where is the U.S. on this issue? Brazil is seeking closer relationship with the U.S. in energy and agriculture and in its geopolitical objectives. Why is the U.S. engagement with Lula so low key and listless? At the same time, the U.S. can do much to neutralize tensions with Latin nations that are apparently critical through constructive re-engagement with Ecuador, for example, and helping to mediate festering regional disputes in Bolivia before these boil over.

Fourth, the issue of trade is of vital importance to Latin America. Obama has brought this issue to forefront through careless blaming of NAFTA for the economic problems of Ohio, so this issue cannot be avoided. The Colombia-US FTA will still be pending in January when the new congress reconvenes. These trade deals are hardly a panacea for Latin America, but they do symbolize a shared commitment to economic growth. On the surface, it is alarming to think that Obama wants to renegotiate NAFTA and that Democrats are running against the Colombia accord, but there is a way to resolve these issues to the benefit of all. The trade agreements, including NAFTA, can be re-opened and even strengthened to the advantage of all through greater provision of legal, environmental, and human rights protections. The trade agreements can be broadened to include social and economic infrastructure finance for the signatory countries. The important point is that the U.S. serves its most fundamental national interests by deepening its trade relations with Latin America, not with carelessly tossing out the window agreements that have tied the hemisphere much closer than ever before.

You may think that a broad initiative on this order is out of the question for a new president faced with so many intractable problems in Iraq and elsewhere. It is also tempting to think that Latin America is a very long way from Denver. I am willing to wager that every Democratic delegate in that Pepsi Center is hearing Spanish spoken in the elevators, in the restaurants, in their hotels as Latin American migrants (many undocumented) perform the daily chores that keep the convention moving. These Latin citizens in our midst are daily reminders that Latin America poses challenges and also opportunities for the U.S. that cannot be ignored, no matter how much the politicians try.

The Mexican economy is a sea of relative tranquility in a convulsed world. Economic activity grew about 3% y/y in second quarter, exceeding most forecasts. The budget surplus was $8.5 billion during the same period, and Mexico is slowly diversifying its exports away from its North American partner. Mexican industry is booming, despite the downturn north of the border. Higher shipping costs are reducing competitive pressures from Asia, and the problems in Detroit are breathing new life into the Maquila sector. North American automobile manufacturers are moving more of their operations to Mexico in order to avoid higher medical and environmental costs. Therefore, the economy appears sound. However, a closer look at the situation reveals several social impasses that need to be resolved if Mexico is ever going to move up the development ladder. Unfortunately, the only way to overcome these obstacles could be with revolutionary change.

The 10^th year of the last two centuries marked revolutionary episodes in Mexico. In 1810, Mexico was the richest and most important colony of the Spanish Viceroyalties. However, the creoles were frustrated with Spain’s mercantilistic system. They were not able to trade with other nations. The colony was prevented from exporting its silver to the lucrative Asian market. At the same time, it had to buy all of its manufactured goods from Spanish merchants—thus inflating costs. Attempts to convince the crown to reform the mercantilistic system were dismissed. However, Napoleon’s invasion and occupation of Spain was the perfect opportunity to shake off the imperial yoke. A century later, Mexico again found itself with a booming economy, but with serious social pressures. The Mexican economy was under the command of a group of technocrats, known as Los Scientificos, who implemented reforms to attract foreign investment. The investment initiatives soon put most of the productive sectors under the control of foreign companies and investors. They dominated the sugar and agricultural regions in the south, frustrating a large part of the indigenous peasant community. Multinationals controlled the mining, oil, transportation and communication sectors—shunting aside local elites. They obstructed attempts by labor unions to organize. Efforts to petition the government to provide more opportunities for peasants, local business leaders and labor unions were ignored. Therefore, revolutionary fervor spread across Mexico, and the country was soon under a hail of gunpowder and lead. Today, the Mexican economy appears sound, but it is under the firm grip of the victors of the revolution. Much of the agricultural land is held by indigenous farming communes. Output and productivity levels are low. Essential services are under the monopolistic command of local business leaders, who retard competition and efficiency. At the same time, the death grip of the labor unions over the energy and electricity sectors are preventing investment and modernization. These narrow interest groups are preventing the development of the Mexican economy. Repeated attempts to introduce reforms were thwarted, thus fanning the fires of social unrest

Today, cracks are visible on the Mexican veneer. Violence is raging, as frustration from the lack of economic opportunities forces people to resort to narcotrafficking and kidnapping as a way to survive. So-called revolutionary groups are reappearing, blowing up pipelines and extorting businesses. In less than two years, Pemex will squeeze the last remaining oil out of Cantarell. This will be a body blow to the government’s fiscal accounts. The monopoly rents generated in telecommunications, media and cement may have produced some of the wealthiest men on the planet, but it saddled the economy with enormous costs and bottlenecks. The unwillingness of the victors of the Mexican Revolution to give quarter means that they will probably have to be dislodged by force. Unfortunately, the clock is running out. With less than two years to go until the 10^th year of the new millennium, history suggests that another bloody revolution may be somewhere on the horizon.

Central government total revenues surged in July to R$62 bn, above the consensus of R$57.5bn and also pushing most of the year-over-year rates of growth to the upside. The real rate of growth (IPCA adjusted) went from 7.6% and 7.2% in May and June respectively to 14.7% in July while nominal rolling 12-month rate of growth also accelerated from 15.7% to 16.4%. At the beginning of the year we estimated July YTD revenues of R$400.5 bn, but the figures are already R$406.1 bn. At that point most of the estimates were accompanied by cautious remarks on downside risks as the government failed to approve the extension of the CPMF tax.

The July data shows that most of the surprise came from higher than expected corporate taxes, other revenues and from the IOF tax on financial transactions. The increase in the contribution from the IOF tax can be attributed to higher tax rate and to the increase in consumer credit operations. While total nominal tax revenues increased 18.7% through July, IOF revenues grew by an astonishing 148.3% YTD.

The strong figures suggest a federal government primary surplus of R$7.2 bn in July which will most likely push the public sector consolidated primary surplus to R$11.5 bn in July. If we are right, total primary surplus for the year will amount to R$97.6 bn, quite higher than the R$79.6 bn in the same period of 2007 (22.7% higher in nominal terms and 16.5% in real terms).

The Brazilian public sector accounts can be taken as additional evidence that the economy is still growing quite strongly in 2008. The government should accomplish the public sector target of 3.9% of GDP without problems despite the loss of revenues from the CPMF tax.

The combination of inflation and a financial crisis in the US has complicated the outlook for dollarized countries. We can see the roller coaster that dollarized countries in particular, but also those with fixed exchange rate regimes, are now riding by looking at Panama, a country for which we have better data than for most.

As in other emerging countries, Panama’s inflation increased strongly in the past twelve months (Panel A) primarily because of an increase in food inflation (Panel B, in the graph food inflation is for Panama city). There is no monetary policy in Panama: the interbank interest rate follows closely the policy rate of the US Federal Reserve (the federal funds rate, Panel C). The US policy rate has been set with respect to the US financial crisis and it is still uncertain whether at the end of this year, the policy rate will start to respond to the surge in inflation. There is no financial crisis in Panama and the surge in inflation in Panamá is much larger than that of the US. Nonetheless, as Panama does not have an autonomous monetary policy, it has to accept the policy rates that the US decides are best for the US.

Surging inflation and decreasing nominal interest rates have plunged Panama’s real interest rates to the depths (Panel D). The drop in real interest rates looks even more far-fetched as it is happening at a time when the cycle reaches its peak (Panel E).

In the simplest textbook, the adjustment mechanisms in a dollarized economy are twofold. First, a drop in interest rates in the US leads to a capital inflow in Panama in search for higher returns. This inflow raises the price of bonds and decreases its return. The adjustment persists until the return on bonds, adjusted for the country credit risk premium, is the same in both countries. Second, higher inflation in Panama leads to a trade deficit and the deficit implies a monetary contraction. The contraction makes prices fall. These mechanisms operate until prices are the same in the two countries. The consequence is that the real bilateral exchange rate remains constant.

With capital mobility, the first mechanism works well (Panel D). But the second mechanism operates imperfectly (Panel F shows that the bilateral real exchange rate is not constant). The price mechanism does not work well even between US states, so why should we expect it work with respect to Panama? In the absence of price convergence, other mechanisms will have to come into play. Within the US, the adjustment is through labor mobility and income diversification through state-diversified equity holdings. In the case of US and Panama the adjustment is carried out by larger output and income fluctuations and IMF bail outs.

The standard deviation of Panama’s cycle is more than three times that of the US. And while the correlation of the cycle between US states is in all cases positive and in average 0.55, the correlation of Panama’s and the US cycle is -0.27 (Panel E).

The cost of fixed exchange rates and dollarization is huge without adjustment mechanisms. And it also seems to be larger when the hegemony is so concerned with a financial crisis and is struggling to keep its inflation anchor.

Since dollarized countries do not have monetary policy and are only likely to take back that power if they hit a severe crisis, the moral of this story may be drawn mostly for those countries that do have monetary autonomy. As I showed in a July 29 article in this blog, inflation targeting central banks are allowing their real interest rates to decrease. Aren’t autonomous central banks also too concerned about the nominal exchange rate and too slow to raise real interest rates? Countries with monetary autonomy should exercise their sovereignty and fight inflation, in part to give their share of price stability to the international economy and help out those that can’t.

The most recent inflation data points for Brazil are a bit encouraging in the sense that some moderation might be working through the system, mainly due to better behaved increases in food prices. More interesting, the first preview of the FGV’s IGP-M index brought a negative reading in August pushed by a deflation in the WPI (or IPA-M) a direct consequence of the downward correction in commodity prices seen since mid-July. We wonder how causality works on a simplified but well specified system containing key inflation measures as well as changes in the foreign exchange rate, monetary policy rate (Selic rate) and the CRB commodities index. Our question is whether there will be a pass-through to the official IPCA index and if this will ultimately make the BCB’s life easier.

1) Causality

We model two VARs (Vector Autoregressive) using the following variables: IPCA inflation, IPCA food inflation, IPA-M (wholesale prices index by FGV) inflation, the percentage change in the foreign exchange rate, the Selic rate and the percentage change in the CRB commodity index. VAR1 was run using the m/m percentage changes of the above variables while VAR2 uses the y/y percentage changes. After finding the optimum lag structure both models seem to be well specified and no autocorrelation in the residuals were found. We estimate two versions in order to see if seasonal effects and short-term noise, commonly present on the m/m data could have any impacts on our conclusions.

We find the following chain of causality. Results were the same for both VAR1 and VAR2:

As we can see from the simplified diagram above, IPA-M is affected by both past changes in the currency (BRL) and the CRB. Going forward, IPA-M changes will impact both the IPCA index directly and the food and beverage sub-category of the IPCA index (IPCA Food). We can also see a statistically significant causality from changes in the exchange rate into the IPCA food as well as into the IPCA index. We do not present the Selic rate causality arrows in the diagram above to make it less complicated. Although, the results are sound in the sense that IPA-M, IPCA Food, IPCA and BRL all granger cause the Selic rate, meaning the monetary authority do respond to movements on those variables. The causality between the Selic rate and the IPCA is actually bi-directional while the CRB does not granger cause the Selic directly. Quite reasonable since the CRB is supposed to represent the exogenous variable in our system.

In other words, the recent downward correction in commodity prices will likely push the IPA-M inflation to the downside, which in turn will put disinflation pressures over IPCA food as well as the IPCA index.

2) Impulse Shock Analysis

A quite interesting exercise is to take a look at the impulse responses to a shock in both CRB and IPA-M. Even though the bands nearly contain the zero line in every response to a CRB innovation (first line of charts), we should say our bands here are not quite free of heteroskedasticity anomalies. In this sense, the pattern of the solid line could be a better indication of the responses. Therefore, a shock on the CRB does produce a quite concentrated response by IPA-M for at least the first twelve months. The responses of IPCA food and the IPCA index are 13 and 15 months long when the response becomes inversely proportional to the shock, intuitively explained by the fact that the BCB might act against such a long-lived shock response.

On the meantime, the responses of an innovation on the IPA-M index by both IPCA food and IPCA index are more well defined as the lower bands actually remain above the zero line (significance level) for five and eight months respectively.

Summing up, a shock on the CRB index indicates that there will be a direct response by all the inflation indexes we analyze here. While it seems more pronounced for the IPA-M, it is also positive but not clearly significant for the IPCA food and IPCA index. On the other hand, the direct response of a shock on the IPA-M (which could arise from other sources than commodities – semi-industrialized inputs for example) is clearly significant and positive for five and eight months in terms of IPCA food and IPCA index responses respectively.

3) Exchange Rate Remarks

An interesting point is whether the collapse in commodities will mean BRL depreciation and if this effect will actually compensate the movement seen in commodities. Well, the real has lost some ground recently but on a much smaller magnitude. So far in August it has lost 3.5% against the dollar vis-à-vis a 7.0% drop on the CRB. Even assuming a more dovish BCB policy over the next months, which is unlikely, the interest differential remain quite high and the country should continue to receive important USD flows. In this sense, we see little scope for sharp depreciations, while a stable or appreciating real would not surprise us.

4) Final Conclusions:

The main conclusion from this study is that the recent fall in commodity prices, measured here by the CRB is likely to put downward pressures on the targeted inflation index IPCA. The CRB index fell 10% in July and so far this month is down by another 6.8%. Therefore, we might see the IPCA inflation benefitting from this recent drop in commodity prices, although the effects might take a couple of months to work through the system. But, is the BCB’s life easier after the fall in commodities? It really depends on how sustained is the fall and also on the fact that no rebound is seen on the near future. If we assume the recent fall in commodity prices is based on weaker fundamentals of the global economy, it might well be the case that prices will remain on the downside and also that overall semi and manufactured inputs will also see downward pressures, which will certainly push inflation to the downside in Brazil. However, the BCB is unlikely to change the pace of rate hikes in the near future. The high levels of capacity utilization still threat the overall balance between aggregate demand and aggregate supply. We think the commodities effect is positive but it’s too early to change our COPOM call, which is set for another 75 bps hike on the September meeting.

Argentine bond prices plunged more than 6% on Friday, as the market gave up hope that President Cristina Kirchner would amend her ways. Argentina suffered its worst week since the default of 2002. The Argentine EMBI+ jumped to 727, the widest spread in the region. Although there were initial hopes that the president would strike a more conciliatory tune after she lost the conflict with the agro sector, her actions showed the contrary. Former President Nestor Kirchner’s henchmen, Planning Minister Julio de Vido and Interior Commerce Secretary Guillermo Moreno, were never replaced. An attempt by the newly appointed Chief of Staff, Sergio Massa, to restore confidence in the INDEC and Administration were quickly sidelined. Given the intransigence of the Kirchners, it is only a matter of time until they are ousted. Unfortunately, abrupt changes of power in Argentina tend to be chaotic. This is the reason why the markets are bracing for a default, even though the country’s macroeconomic indicators are sound.

In addition to the Kirchners’ recalcitrance, investors were buffeted by a slew of negative news. The first was the government’s desperate issuance of more than $1 billion to the Venezuelan government at the usurious rate of 15%. The Chavez Administration immediately resold the bonds to local Venezuelan banks and investors who dumped the paper on the international market as a way to circumvent the capital controls. The deluge of Argentina bonds was one of the factors that triggered the selloff. Given the desperate act, it was not surprising that Moody’s immediately announced that it would soon cut Argentina’s outlook due to concerns about the government’s willingness to service its financial obligations. At the same time, the meltdown in the commodity markets led many investors to turn their backs on commodity producers, such as Argentina. Soybean prices plunged more than 13% last week, erasing 5% on Friday—the day of the Argentine debacle. This left very few reasons for anyone to place a bid on Argentine paper, which explained why asset prices dropped so precipitously on Friday.

President Cristina Kirchner was on a well-received tour the day of meltdown in San Juan and Mendoza, two provinces which were not affected by the agro turmoil, but there was still a sense that the clock was running out. It is no longer an issue of popularity. It is an issue of political and economic clout. The repeal of the tariff initiative was a powerful blow to the government’s purse. With soybean prices on the decline, the outlook is even worse. Although tax revenues soared 40.3% y/y in July, approximately 81% of the primary surplus was generated by soybean tariffs. Now the surplus is shrinking. The Kirchners increased spending during the crisis in order to buy friends and influence, but a reduction in government revenues will soon leave them stranded. The government froze provincial transfers last week, as well as some public spending programs. It is only a matter of time until the labor unions turns their backs on the presidential duo. The loss of economic clout translates to less political power. The Peronists are split in two, with more than half of the party under the command of former President Duhalde. This is the reason why people are doubting that the Kirchners will make it to the end of the year.

It is no longer a question of “if,” it is now a question of “when” the Kirchners will be ousted. They lost all sense of reality, inventing conspiracy theories instead of bridging their differences with the opposition. The Kirchners’ dream of remaining in office for another 12 years is a distant memory. The main debate in Buenos Aires is whether they have three or four months left in office and how chaotic will be the transition of power. Argentina has a nasty history of political collapses. The untimely demise of the military junta and the ousting of Presidents Alfonsin and de la Rua were associated with sovereign defaults and/or hyperinflation. Hopefully, this time the situation will be different. Argentina has fiscal and current account surpluses. The economy is growing and the government’s financing needs are relatively low. Argentina’s macro indicators are sound, for now. Unfortunately, the deterioration of the external environment and the rapid erosion of the domestic situation could put it in dire straits by the end of the year.

At a moment when the successful conclusion of the Doha Round seems very much at risk, the question once again arise of whether governments’ seemingly irreducible interest in forming regional trade agreements (RTAs) is a blessing or a burden for the multilateral trading system.

Policymakers all over the world are voting with their feet, choosing regionalism as the preferred mode of liberalization. The WTO reports that over 250 RTAs are already in force, with several others currently under negotiation.

Many trade economists, led by Jagdish Bhagwati (2008), are concerned with this rise of regionalism, viewing preferential trading arrangements as inimical to the world trade system. In their view, regionalism reduces the incentives of governments to liberalize trade vis-à-vis non-member countries.

Not everyone agrees with that view, and theoretical results offer support for both sides, so whether regional and multilateral trade liberalization are antagonistic or complementary, ultimately, an empirical matter. This is our approach in a recent research paper, “Does Regionalism Affect Trade Liberalization towards Non-Members?” where we offer the first attempt to evaluate empirically the effect of preferential tariffs on external trade liberalization in a large group of developing countries.

When countries form a regional trade agreement, they lower the tariffs they apply on each other, but the duties they apply on imports from outside countries can increase, decrease, or remain unchanged. We study how countries in Latin America, where regionalism forces have been particularly strong since the early 1990s, have altered their trade policies vis-à-vis countries outside the bloc after forming RTAs. Specifically, we examine whether sectors with relatively large preferences have been liberalized or protected to the same extent as other sectors. If countries raise their external tariffs (or reduce them by less) as a result of regional liberalization, such preferential arrangements should indeed raise concerns about the recent trend. If instead preferences lead to relatively lower external tariffs, then regional agreements deserve a more benign reputation than they currently have.

Regionalism is a building bloc to free trade

Our results imply that regionalism is a building bloc to free trade. There is no clear evidence that trade preferences lead to higher tariffs or smaller tariff cuts. There is strong evidence that preferences induce a faster decline in external tariffs in free trade areas. For example, if a country that follows a strict policy of non-discrimination offers free access to another country in a sector where it applies a 15% multilateral tariff, the country would tend to subsequently reduce that external tariff by over 3 percentage points. This complementarity effect is stronger in sectors where trade bloc partners are more important suppliers, precisely where trade discrimination would be more disruptive.

Regionalism is most helpful in sectors where multilateralism works best

The complementarity between preferential and external liberalization is particularly strong also in sectors in which WTO ceilings prevent increases in applied tariffs. That is, reductions in preferential tariffs induce deeper cuts in external tariffs when WTO commitments bind. Thus, our research suggests that the more effective the WTO is in terms of having members binding their multilateral import tariffs at levels near the applied rates, the more effective free trade areas become in bringing multilateral tariffs down. Or put differently, regionalism is likely to be more helpful precisely when the multilateral system works best.

It doesn’t work for customs unions

These results apply to free trade areas (FTAs), where members exchange preferences but keep independent trade policies vis-à-vis nom-members. NAFTA is probably the best known example of an FTA, which represent over 90% of the existing regional agreements. The other main type of agreement are customs unions (CUs), which are distinguished from FTAs mainly because they presume a coordination of the external trade policies of their members, as in the European Union.

Interestingly, the results depend on the type of agreement considered. When we look at how CU members adjust their external tariffs after they exchange preferences, we find no meaningful effect. External tariffs are largely unresponsive to preferential liberalization when members set them cooperatively. This is in a way surprising, since many economists tend to favour CUs over FTAs, because integration under the former is often deeper. We find that, at least to the extent that external tariff adjustments are concerned, FTAs have an edge over CUs.

Conclusion

The most important message of our research is that neither of the two main types of regional integration induce countries to adopt more protectionist policies toward outsiders. This probably helps to explain why, despite several years of intense negotiations of regional trade agreement deals, there are no clear signs that regional partners are trading more among themselves at the expense of trade with outsiders.

In that sense, our findings offer an optimistic view of the current wave of regionalism. On this issue at least, multilateralists do not seem to have much to worry about.

References

Bhagwati, Jagdish (2008). Termites in the Trading System, Oxford University Press.

Estevadeordal Antoni, Caroline Freund, and Emanuel Ornelas, Does Regionalism Affect Trade Liberalization Towards Non-Members? CEP Discussion Paper No. 868, May 2008.

Thirty years ago, the world economy was in the middle of a stagflation, a strange combination of high inflation and low economic growth. As a matter of fact, such period of stagflation lasted from 1974 to 1984 – ten years. This includes the United States, other industrial countries, and the great majority of the so-called (at that time) developing countries (later denominated emerging markets - since the nineties).

There were certainly exceptions for some specific countries, but in general the macroeconomic situation was terrible. Most of the economic analysts of that period attribute the stagflation of 1974-1984 to the double oil crisis (huge price increases in 1973 and 1979), as well as to the economic policy reactions taken by countries such as the United States, with double-digit interest rates under Paul Volcker. Almost as important: this ten-year period of stagflation succeeded a golden age of more than ten years – from 1961 to 1973, starting with John Kennedy and ending with Richard Nixon in the U.S.

Without trying to exaggerate the coincidences and similarities, we had another golden age period from 1992 to 2007, including now new players such as China, India and Russia. Is it possible that we are going to repeat what happened 30 years ago and start a long period of stagflation? The third oil crisis is already in process, with prices almost tripling in two years. But the interest rate levels are completely different – as well as inflation levels.

Given such similarities and differences, what can happen from 2008 to 2011, for example? For sure, some type of stagflation. But we have to confess that it is very difficult to analyze the potential bad behavior of growth and inflation in the next few years in developed and emerging countries. Particularly if we introduce as a footnote the fact that Barack Obama is courting Paul Volcker to come back to the economic policy game in the U.S.

When we say, however, that interest rate levels were totally different 30 years ago, we are talking about nominal levels. In real terms, it is not clear if interest rates were higher or lower in the seventies and eighties, as compared to 2008. Considering two good and opposite examples – United States and Brazil – the answers are entirely different.

Today, the US has a clearly negative real interest rate, and Brazil has the highest real interest rate in the world. The opposite was true in 1982, when Volcker led US rates to 16% per year, while Brazil started to face three-digit annual rates of inflation since 1980, against two-digit interest rates, although near 100%, as an authentic “race” between higher inflation and higher nominal rates (including the so-called Brazilian “monetary correction” or “indexation” at that time).

If we replace the general term “inflation” – which includes tradable goods, non-tradables and services - by some specific measurement of commodity price inflation, considering only some basic commodities such as oil, soybeans, corn, iron ore, etc., the problem of the “negativity” of real interest rates in the US and other industrial countries in 2008 clearly remains and it is probably even more serious. It is true that many commodity prices seem to have peaked recently, but there is no doubt that a carrying cost of 2% per year is entirely different from 16% per year. So, in spite of the impact of worldwide recessive trends on the overall demand for basic commodities, very low rates will continue to generate incentives for speculative attacks in favor of oil and soybeans, for example.

For all these reasons, it seems to be extremely useful to study carefully the seventies and the eighties, in order to understand what really happened then - and to try to guess what might happen in the next few years. This is the meaning of the title of our article: 1978 versus 2008.

However, there is a major question mark here, which is valid both for countries such as the US or Japan, as well as emerging markets such as the BRICs. One thing is to talk about positive or negative external shocks. Another thing is to analyze and try to guess the economic policy reactions in each different country to the external shocks.

This is normally the moment when the economist as a writer and analyst has a big difficulty to separate clearly his own opinion about what should be done in terms of economic policy from a cold analysis about what will be probably and really done by the policymakers themselves, as far as their actual economic policy is concerned.

Some analysts might believe that the US needs Paul Volcker and – surprisingly – even publications like “The Economist” said recently that the Brazilian Central Bank is the new Bundesbank. But, in practical terms – for fear of a major recession in both cases – the future President of the United States and/or the existing President of Brazil might not like and might not allow extremely restrictive economic policy reactions, particularly in the direction of higher and higher nominal interest rates.

And, frankly, at some point in time – just look at Brazil between 1981 and 1993 - raising nominal interest rates can be dangerous, particularly in an environment of increasing inflationary expectations. Because the economic agents might see precisely the opposite: a decline in real interest rates, in spite of higher nominal rates, due to a lost “race” between higher inflation and higher nominal rates.

As the song says: “We watch you watch us”. A new “law” in economics: there are Central Bank watchers, but the Central Bank watches the markets. Worse than that: in addition to a declining real interest rate, there starts a great volatility for real interest rates, which is terrible for real economic activity (and inflation) in general.

The major conclusion, when we compare 1978 to 2008, is that it will all depend on economic policy decisions in the next few months. But one thing is certain: just like we had a long period of stagflation from 1974 to 1984, after a golden age from 1961 to 1973, this is going to happen again. The golden age of 1992 to 2007 is over. We should be prepared for many years of going back to mediocrity: higher inflation and lower economic growth.

But major doubts persist: are we going back to double-digit inflation? To negative growth rates? This is what happened in 1974-1984.

We fear that we are going to repeat the seventies and eighties. But – perhaps using the old Pollyanna game – very few people would say that we are running the risk of a Great Depression – such as 1929-1933 in the US - or the risk of a hyperinflation – such as many European countries in the twenties (almost one hundred years ago), or Brazil more recently in 1987-1989, and again in 1992-1993. Cold comfort.