Ed Dolan's Econ Blog

How the Latin Triangle Swallowed the Euro

Back in 1996, Rudiger Dornbusch wrote a paper about the political economy of exchange rates in Latin America. He called it “The Latin Triangle”. It describes a cycle in which governments become trapped in inappropriate fixed-exchange rates that inevitably end unhappily. Latin America has put that particular form of economic instability behind it, but a new version of the Latin triangle seems to be playing itself out in Europe today, both in the weaker members of the euro area (the so-called PIIGS) and in some of the newer member states that chose fixed rates (the BELLs—Bulgaria, Estonia, Latvia and Lithuania). This post explores the implications of the Latin American experience for Europe today.

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.

15 Responses to “How the Latin Triangle Swallowed the Euro”

Farid MatukMay 11th, 2012 at 3:07 am

Other element in relation to wage differentials is produced by the incorporation of Eastern Europe labor supply in some countries of Western Europe, in particular Germany was able to hold or reduce nominal wages due to immigration from countries as Poland

rodeneugenMay 11th, 2012 at 2:06 pm

How Israel really escaped bankruptcy at 1985
To understand the example of Israel how it escaped bankruptcy at 1985, a more detailed explanation is needed. In 1977 a new liberal government came to power and tried unsuccessfully to reform the exchange rate policy from fixed and controlled to freely floated currency. This policy brought within few years annual inflation of more than hundred percent. While the government bonds were ale fixed to inflation, the private loans and mortgages, mostly guaranteed by the government, had long term fixed interest rates, without being fixed to inflation. This brought huge increase in the government deficit.
In 1980 the liberal finance minister was sauced and a new finance minister was appointed, who tried new economic policy of budget cuts and credit squeeze. But he was very unlucky. Exactly then, the crude oil price, a major import item jumped from 40 US$ to 75 US$ (2010 prices) per barrel, because of the Iranian revolution and the following Iran-Iraqi war, as you can see in the next chart.

At the same time the US$, to which effectively were fixed most of the Israeli national debts, was appreciated against the Deutsch Mark from 1.75 DM to 2.5 DM per one US$ and continued this trend up to 3.3 DM/US$ at 1985 as you can see in the next chart.

The unlucky treasury minister, (Yigal Horvitz) lost the confidence, and was replaced by a new one, who within few years brought with his policy of increasing budget deficit and monetary expansion the Israeli economy to the brink of collapse in 1985. Then a new government, headed by Shimon Peres, (who the first and last time succeeded to make a draw in elections), became the prime minister and implemented a new economic policy of government budget cuts, basic products subsidy cuts, price freeze, credit freeze and the Israeli currency was devaluated by 16% in one day to 1.5 IS per one US$, and immediately frozen for the next three months. Many other changes that may look harsh happened, but against the reality of ten to fifteen percent monthly inflation, that prevailed in the country for several years by then, all this looked as children's game. Yet, all this would be not enough, if major changes wouldn't happened in the world economy, like the US$ lost in the same year half of its value, and with it the debts of the Israeli government debts dropped accordingly, and the Israeli export to Europe become cheap. As out of magic, exactly in the same year the crude oil price, a major import item of Israel dropped to one third of its previous value and stayed there for the next twenty years. Greece to make it would probably need the same luck, but after all isn't the Christian God the same as the Jewish one?

Sergio CesarattoMay 12th, 2012 at 2:53 am

I think you miss the role of financial liberalisations and nominal exchange rate stabilisation in attracting capital flows, both in the LA experience and in the European periphery. This has typically led to housing bubbles, ephimeral growth (not in the export sector), inflation and real exchange rate appreciation, current account deficits and mounting foreign debts, higher interest rates refinance the debts and, finally, defaults. Well, not in Europe were Target 2 keeps the sistem alive. This is the series of unfortunate events (very very confusingly) told by Reinthart and Rogoff, and much better by the classic "Good by financial repression, hallo financial crisis" by Diaz-Alejandro (1985), and with regard to LA by, e.g., Frenkel and Rapetti in the Cambidge Journal of Economics 2009. Pisany-Ferry (Bruegel) has, among others (e.g. Martin Wolf), supported this view with regard to Europe.
(Università di Siena)

Ed Dolan EdDolanMay 12th, 2012 at 9:51 am

Sergio– Thanks for the link to your post. I do agree with you. I would not say I exactly "missed" the point on financial flows; I wrote "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." However, you are right to say the point is important enough that it needs even more emphasis.

lucad10May 12th, 2012 at 7:36 am

Please allow me to propose you another point of view: isn't PIIGS real x-rate appreciation due to BRIC countries x-rates devaluation ?
Instead of focusing on internal devaluation models, which already seem to put EU in depression (except Germany so far), shouldn't policies and research be focused on internal revaluation models for BRIC countries (i.e.: labour conditions improvements, etc.) ?
Furthermore, is it still acceptable that China does not implement a free floating x-rate regime ?

Ed Dolan EdDolanMay 12th, 2012 at 10:01 am

Lucad– Yes, at least some of the BRIC countries (esp. China and Brazil) have made some effort to keep their exchange rates undervalued, although they have had mixed success. (See this discussion of China, for example: ). But what I have in mind is more real appreciation of the PIIGS and BELLs within the euro area, relative to Germany, rather than appreciation of the euro relative to other currencies. The real undervaluation of the Germany currency is the big story. See my post on "How Germany Free Rides on the Euro," .

lucad10May 13th, 2012 at 6:40 am

Thanks Ed for your reply, please allow me an additional comment.

I suppose it would be interesting to get an analysis in which it is compared a GDP gap from potential values for PIIGS and BELLs caused by German and/or by China x-rate undervalution.

Although I am not able to propose you any data set, I suppose that competition from high tech products exported from Germany vs. low tech China products (i.e.: Mercedes cars vs. textile goods) may undermine GDP gap for PIIGS in a lower way.

In theory it should work also in case of intermediate goods (i.e.: mechanical machinery components import/export from Italy to Germany should still be positive).

If so, a main driver for rebalancing growth may be represented by additional steps in a real free floating x-rate regime for China (or BRIC as a whole) rather than internal devaluation policies at PIIGS.

rodeneugenMay 13th, 2012 at 1:14 pm

So if you can't reduce the production costs in the PIGSs, you suggest to increase the production costs in Germany, so it loses it competitiveness too? I wonder what will happen to Europe then? Euro probably will be devalued, but against whom, the US$ with its huge trade deficit? or maybe against the Renminbi, after the Chinese government will decide to stop to hold the lid on the pot? Probably the Euro will lose on the long run its value, but we all know that on the long run everybody dies.

Ed Dolan EdDolanMay 13th, 2012 at 3:49 pm

Not exactly. I don't want to "increase production costs" in Germany, if by that you mean making Germany less technically or organizationally efficient. I simply note that Germany's currency, like China's, is arguably undervalued, but for a totally different reason: its membership in the euro.

Also, I wouldn't want to use "devalue" or "revalue" with relation to the euro. We usually use "devalue" in regard to fixed-rate currencies. Euro is a floating currency, so we should talk "appreciate" or "depreciate." I would expect that if less competitive countries left the euro and Germany stayed with it, the euro would appreciate.

Jim PivonkaMay 14th, 2012 at 7:35 pm

"..if less competitive countries left the euro and Germany stayed with it, the euro would appreciate." And vice versa. To my mind this latter course is the simplest, and most orderly, to accomplish the desired devaluation/depreciation.

barfMay 12th, 2012 at 9:11 am

I do find it strange that i cannot escape Karl Marx in all this madness. Was it he who coined the term "stages of development"? Simply put i cannot understand the comparison between Industrialized and surplus producing Western Europe and the primarily agrarian economies of Latin America. In an Agrarian State the value of the currency really is set by the market–but in States/entities like Europe, the USA, Japan and even China now "the value of that currency is set by production." This difference is so profound to me i really think economists are VASTLY understating the peril that "the euro" represents. Simply put "we have Marx's excess production on a MASSIVE scale" emerging without the appropriate "means of exchange" in order to withstand the deflationary gales coming as a result. The "push cart war" variant in East Asia seems much more stable…based upon small states RUTHLESSLY competing over niche markets but at least maintaining some semblance of balance between "what can be made and what can be afforded as a consequence." I frankly don't even know where to begin with all these crazy real estate speculations the market is always pining for either (as mentioned above.) I mean "how many Chicago's do we need?" Anywho "the Greek vortex" appears as real as it is dangerous.

rodeneugenMay 14th, 2012 at 4:06 am

Israeli economic miracle of 1985
Thank you Ed for the article of Stanley Fisher.
Here is my response to the article. To start with, it is important to understand Israeli economic and demographic development. You have to remember 1965 Israel had population of 2 million people, at 1985 about 4 million, and in 2012 about 8 million. This huge increase in population and mainly the 1990-1991 immigration of almost 1 million mostly adult, highly educated, highly motivated, ready for hardship people, from USSR, that increased the Israeli population by almost 20%, was accompanied with even higher economic growth.

Until 1974, most of the industry, and banks were directed either directly by government, or by General Union of Israeli Workers (Histadrut) and cooperative movements, both under the umbrella of the ruling Social party. Between 1973-1977 after 1973 war, ruled still the Social Party government but under new personalities. They started a process of economic change from economics of grocery store, that was based on rules specifically created to give protection to the existing economic elites, to general rules that gradually started to canceled the protectionism. On the other front this government tried gradually to reduce the inflation that picked up, like in most of the world and more in Israel, as consequence of the high oil prices after 1973 War.
At 1977 started a new era, when new conservative government won the elections, and appointed an inexperienced treasury minister, whose first act was to release the Israeli currency from fixing it to the US$ and opened it to free fluctuation and free currency market. I remember, when the reform was prepared, the main problem of the government was how to protect itself from being depleted of the foreign reserves, but believed, the devaluation will be limited and will solve the problem of the Israeli economy. Yet the reality was very different. Since in Israel the annual inflation rate was still about 35%, the interest rate was accordingly high, instead of depleting the foreign currency reserves, short term speculative money flowed into the country, creating double effect of revaluation in real terms of the local currency (the Israeli currency was devaluated in one year by 20% against the US$, while the inflation in the same year was about 50%), and increased liquidity on the financial markets, increased even more the inflation rate that caused the farther increase in the interest rate. Finally at 1980 the treasury minister was replaced when the inflation reached already annual rate of 135 %.
While the government bonds were all fixed to inflation, the private loans mainly mortgages mostly guaranteed by the government, had long term fixed interest rates, without being fixed to inflation. This brought huge increase in the net government deficit. In the same period the government found difficulty to finance its deficit by listing its bonds, since from the early seventies, the major banks regulated their share prices by purchasing their own shares in the stock exchange market, when it had tendency to decline. This arrangement was very comfortable to the government, since the money raised by the banks, anyway financed the centralized economic system of big companies related to the government.
The public get used to purchase bank shares as a secure investment, believing, (since they were managed by the General Union of Israeli Workers, the Jewish Agency and the Government) they have guaranty from the government anyway. But then when the annual inflation reached height of 400%, the banks started to lose the resource to continue to purchase their own shares and finally at September 1983 the system collapsed.
The government out of desperation changed the bank shares valued of about 7 miliard US$ (representing then almost 30% of the Israeli GDP), for government bonds untradeable for 5 years. The Government originally wanted to fix the bonds rate to the price index, but the dollar in that time looked more stable to the public, so to try to manifest reliability, in spite of their obvious mingling, they accidentally decided to fix the bonds to US dollars. At the end of this economic carnival, the public debt reached almost 250% of the GDP. (To be precise external debt of 85% and internal debt of 140% of the GDP). Greece 2012? What a joke, an economic miracle compared to this.

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