The "Vicious Circle" Hypothesis: The Greek Case

Panayotopoulos, Dimitris Article The "Vicious Circle" Hypothesis: The Greek Case Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Panayotopoulos, Dimitris (1983) : The "Vicious Circle" Hypothesis: The Greek Case, Kredit und Kapital, ISSN 0023-4591, Duncker & Humblot, Berlin, Vol. 16, Iss. 3, pp. 394-404, https://doi.org/10.3790/ccm.16.3.394 This Version is available at: https://hdl.handle.net/10419/292971 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Introduction The double digit inflation all countries (industrial, developed and developing) have experienced during the last decade is attributed: a) to the sharp rise in the oil prises in the late 1973 and again 1979, b) to the considerable increase in the commodity prices, and c) to the adoption and implementation of the floating exchange rate regime by almost all the industrial and developed countries since early 1973. By passing the two oil price shocks and the commodity price hike, due to their undisputed role in aggravating and feeding the inflation of last decade, the focus is on the role and the impact of the flexible exchange rate regime on world inflation. This system of exchange rates has been adopted by almost all countries, and specially by all industrial countries, and it is in effect up to this day, uninteraptedly, since its implementation in early 1973. The inflationary impact associated with the working of the flexible exchange rate regime has been attributed, by some economists, even proponents of the adoption of this system of exchange rates, to the removal of the "discipline arguments" with which the system of flexible exchange rates is associated with. John F. O. Bilson1 in his paper "The Vicious Circle Hypothesis" says: "the move to a flexible exchange rate regime removes the balance of payments constraint on the money supply mechanism and hence eliminates the last barrier to an inflationary spiral. For the first time in history the central banks of the major industrial countries do not face any external constraint in their ability to increase the stock of the high-powered money". A. D. Crockett and M. Goldstein in their paper "Inflation Under Fixed and Flexible Exchange Rates",2 after making and overall evaluation of the discipline argument (pp. 531-537), do accept the relative inflationary 1 Bilson (3), p. 5. 2 Crockett and Goldstein (6). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 The "Vicious Circle" Hypothesis 395 impact of the flexible exchange rate system over that of fixed exchange rates regime. However, their answer to the question they impose "Are flexible exchange rates more inflationary than a system of fixed exchange rates?" is: "It all depends".3 They do accept, though, that: "there does appear to us to be a case . . . for supposing that flexible exchange rates make it easier for inflationary pressures to arise and to be accomodated than do fixed rates".4 However their overall conclusion reads as follows: "the type of exchange rate system has relatively little influence on the average rate of world inflation".5 The inflationary impact of the flexible exchange rate regime is attributed to the greater monetary autonomy that a country enjoys operating under this system compared to that of the fixed exchange rates. This greater monetary autonomy a country enjoys under the system of floating rates is not to be understood, though, on the basis of the limited or complete absence of its central bank's intervention in the foreign exchange market, as this system presupposes,6 but rather it has to be understood as the central banks' ability and responsibility in choosing and implementing its own monetary policy independently from the policy choice made by other central banks, i.e. the removal of the "discipline argument". The extent of the monetary autonomy a country enjoys operating under the system of flexible exchange rates and the way it affects its exchange rate has created ambiguities both on theoretical and empirical grounds. A passage from the Annual Report of the Bank for International Settlements is vivid on the complexity of the issue: "According to one view, the greater monetary autonomy which countries enjoy under a floating regime implies that exchange rate movements will passively reflect the inflation rates which countries 'choose' to maintain relative to inflation in other countries. 3 Ibid, p. 537. 4 Ibid, p. 537. 5 Ibid, p. 537. 6 Theoretically, under the system of flexible exchange rates the central banks do not intervene in the foreign exchange market fact which permits the monetary authorities to have greater room for conducting the monetary policy they choose for domestic purposes. The experience, though, since the implementation of the system of floating exchange rates in early 1973, is exactly the opposite, i.e. the central banks of all countries and mainly those which their currencies are heavily traded in the foreign exchange market have intervene in many times and to a great extent since the implementation of the system of floating exchange rates. 26* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 396 Dimitris Panayotopoulos While there is considerable truth in this view, experience has shown that the interrelationships between inflation and floating rates are much more complex. The casual relations run in both directions and often tend to be self-reinforcing. This stems from the fact that movements in exchange rates may often be the result of changes in such factors as confidence, expectations and the monetary/fiscal policy mix. Hence they can, through their influence on import and export prices, exert an independent effect on the rate of domestic price and wage inflation. The influence is particular strong in open economies with large trading sectors and in economies where wage respond promptly to changes in the consumer price level".7 Which one of the above two views holds true, namely, if the causal relation runs from prices to exchange rates or if it runs from exchange rates to prices, it is an empirical issue. The depreciation/price inflation spiral, the so-called "the vicious circle hypothesis", has been investigated in numerous studies. These studies found statistical evidence of the working of the "vicious circle hypothesis" using the Sims-Granger causality test to exchange rate - price relationship. Bilson in his paper has raised objection as to the correctness of this causality test. Specifically he questions the causality test on the ground that it "ignores the fact that the exchange rate is an endogenous variable. The causality test may indicate that exchange rates "cause" prices when the correct explanation is simply that exchange rates respond more rapidly than prices to changes in underlying economic conditions".8 Further, in the conclusion of his paper he emphasizes that the expansionary monetary policy is the cause for both the exchange rate depreciation and the domestic inflation. Specifically: "Although it appears that the exchange rate causes subsequent movements in prices and wages, the paper has demonstrated that the probable cause of both the depreciation of the exchange rate and the inflation of domestic prices is an expansionary money supply".9 The Bank of International Settlements is attributing as well to domestic developments and specifically to the monetary policy, the cause of why some countries "got into the vicious circle".10 The purpose of this paper is to investigate if Greece has got into a vicious circle by applying the Granger causality test. Despite the two theoretical 7 Bank for International Settlements, Annual Report, 1976, p. 31. 8 Bilson (3), p. 3. 9 Ibid, p. 33. 10 Bank for International Settlements, Annual Report, 1977, p. 38. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 The "Vicious Circle" Hypothesis 397 objections11 raised by Bilson concerning the applicability of the SimsGranger causality tests for the statistical verification of the interrelationship existing between exchange rates and prices it seems that, for reason given immediately below, the first of his objections, i. e. the endogeneity of both the exchange rates and prices, is not valid in the case of Greece, at least. As it has been argued elsewhere by the author12 the money supply is not the decisive factor in determining the exchange rate of drachma. First, the interest rate is not subject and it is not determined by the free interplay of the market forces in the money market, but, on the contrary, the level of the interest rate is "administered" by the monetary authorities. Second, the free capital movement, especially the outflow of funds, is totally prohibited in Greece. Thus, the absence of these two important factors can reasonably be considered responsible for the "exogeneity" of the exchange rate of drachma. Consequently, the Sims-Granger causality test can be validly applied to verify the interrelationship existing between exchange rates and prices, since one only of these parameters is endogenous (i.e. prices) while the other (i.e. exchange rates) can reasonably assumed, with the rationale given above, to be exogenous. n. Testing the Hypothesis Testing for causality between the exchange rate and prices in Greece under both exchange rate regimes, that is under the flexible exchange rate regime and under the fixed exchange rate regime, the Granger causality test is applied.13 The Granger test is preferred over that of Sims test for the following reasons: a) the Granger test requires only past values of the independent variable, so the length of the lag structure is determined by the user, and b) since the paper aims at verifying the interrelationship between exchange rates and prices under both exchange rate regimes, the Granger test has the advantage of interpreting more easily the existing causality between the variables under different exchange rate systems.14 11 The first of these objections has been presented above, p. 3. The second objection associated with the vicious circle hypothesis is that it "neglects the expenditure - reducing role of the exchange rate in the adjustment process". Bilson, p. 4. 12 Panayotopoulos (9), p. 373. 13 Granger, C. W. I. (7). 14 On the same line of reasoning are the arguments of Mixon, Pratt and Wallace (8) for preferring and making use of Granger test over that of Sims test. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 398 Dimitris Panayotopoulos The Granger causality test estimates equations in the form: n m (1) Xt = a0 + 2 bj Xt-j + 2 Cj Yt-j + et i = i j = i and m n (2) Yt = d0 + 2 9j Yt-j + 2 kj Xt-j + ut i = i j = i If the cj's (j = 1, . . . , m) are assured to be equal to zero, i.e. Ci = c2 = . . . = cn = 0, it is inferred that Y does not causes X and thus equation (1) is reduced to n (1') Xt = a0 + 2 f>j Xt-j j = i The Granger causality test is conducted as follows. Initially, equation (1') is tested where the dependent variable X is regressed on its lagged values. This is referred to as restricted equation. Then, equation (1) is tested, where the dependent variable X is regressed on its lagged values and on the lagged values of an added variable Y. This is referred to as unrestricted equation. The null-hypothesis, that is Ci = c2 = . . . = cn = 0, in equations (1) and (1') is tested using the F-statistic. If it turns out the value of the F-statistic of the estimated equations to be significant, i.e. greater that the critical F' value, then it is inferred that Y causes X. If the opposite hold true then it is inferred that Ydoes not causes X. The F-statistic is of the form: (SSRq - SSRk)/Q - K FQ-K,n-Q (SSRQ)/n - Q where K is the number of restrictions placed on equation (1') and Q is the number of restrictions placed on equation (1) and n the number of observations. III. The Empirical Tests In the context of the present paper the interrelationship between the exchange rate (Drachma) and the domestic prices is tested under both exchange rate regimes, i.e. under the system of flexible exchange rates applied after 1973 and under the systems of fixed exchange rates that prevailed before 1973. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 The "Vicious Circle" Hypothesis 399 The break down in the time series in 1973 might be objected since Greece held its currency fixed to the U.S. dollar up to February 1975 (the fixed parity between drachma and U.S. dollar was interrupted for a short period only, from October 1973 to January 1974). This argument is not valid for the following reasons: First, despite the fact, that Greece is conducting her international trade mainly in the U.S. dollar, the Greek drachma depreciated to a considerable extend vis-a-vis the currencies of all other countries (i.e. French Franc, Deutschmark, etc.) with which the volume of trade (goods and services) cannot be considered negligible. Second, since all the industrial countries let their currencies float, in early 1973, the prices of the imported goods (and services) are assumed to have affected, since then, the domestic price level (the import prices affect almost instantly the domestic price level). Third, domestic factors support as well the break down of the time series in 1973. Namely, since 1973 consumer prices started raising very fast as opposed to the period before 1973. Despite the arguments given above to justify the break down of the time series, under consideration, in two subperiods taking as a cut off point the year 1973, the Chow test, which comprises a formal method to decide upon the possibility of pooling or not the data, was performed. The Chow test, using as cut-off point the year 1973, indicated that the data cannot be pooled. Thus, the time series were divided in two subperiods. One for the time period before 1973, during which the fixed exchange rate system was in operation, and the other for the time period after 1973, during which the flexible exchange rate system was adopted. The data used in the empirical test are monthly observations of the variables, not seasonally adjusted. A log-linear relationship is assumed between the variables. Because the causality test requires covarience stationarity the data have been converted to first differences. Various methods are employed to transform the non-stationary time series to covarience stationary series since the causality test requires the variables to be jointly covarience stationary. One widely used method is the one proposed by Box and Jenkins.15 They suggest that the elimination of nonstationarity can be achieved making use of the filter (I - B)d, with (d) equal to 1 or 2. 15 Box-Jenkins (4). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 400 Dimitris Panayotopoulos Various researchers make use of the Box-Jenkins approach each one using different form of filter, depending on the nature of the variables used. In this paper the Box-Jenkins approach is not utilized. The estimated equations using the Granger causality test are the following: 12 12 (3) (CPI)t = a0 + 2 6, (CPl)t.j + 2 § (EXR)t-j i = i j = i and 12 12 (4) (EXR)t = dQ + 2 h (EXR)t.j +2 Cj (CPl)t-j j = i j = I with 12 month lagged structure, where: CPI: the ratio of the Greek and the German consumer price indices EXP: the Drachma/Deutsch mark exchange rate. These equations are used to investigate the interrelationship between exchange rate and prices. To investigate the relationship between money supply and exchange rate the following equations are estimated: 12 12 (5) (M)t = a>o + 2 bj (M)t-j + 2 ^ (EXR)t^ 3=1 j=1 and 12 12 (6) (EXR)t = d0 + 2 bj (EXR)t-j + 2 (M)t_j j = i j = i with 12 month lagged structure where: M: the ratio of the Greek and German money supply narrowly defined. The rationale for using the Drachma/Deutsch Mark exchange rate is twofold. First it has to do with the substance of the test undertaken and, second it is associated with the statistical limitations imposed by the data. As far as the first of the above arguments is concerned the answer reads as follows: The Greek inflation rate constantly far exceeds that of Germany. The inflation rate differential working against Greece is an important variable in the decision making process of the Greek Central Bank in establishing the Drachma/Deutsch Mark exchange rate coping with the competitiveness of Greek exports and the cost of the imported goods. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20 The "Vicious Circle" Hypothesis 401 On the other hand, Germany is the single most important trade partner of Greece. In terms of the merchandise trade, the value of Greek exports represents the 19% of its total exports and the imports from Germany the 14% of Greece's total imports. If the value of the invisible trade is also included (tourism, worker's remmitances, etc.) then the value of the international transactions between these two countries far exceeds the above figures. As far as the second argument is concerned the statistical limitations in using the Drachma/U.S. dollar exchange rate is to be noted. The Drachma/ U.S. dollar exchange rate remained fixed during the period before 1973. This fact makes impossible for a statistical test to be undertaken for the period before 1973 and thus the comparison between the two exchange rate regimes, which is the purpose of this paper, cannot be achieved. VI. The Results In the following Table 1 the results of the estimation of the above equations are given where the relative price level, the relative money supply, and the exchange rate of Greece and Germany are used for the period before the implementation of the flexible exchange rate in 1973, i.e. 1965 - 1972, and for the period after the implementation of this exchange rate system, i.e. 1973 - 1980. Table 1 No. of Equat. Functional Relationship Time Period FStatistic (3) Relative price level regressed 1973 - 1980 3.6897* on exchange rate (Drch/DM) 1965 - 1972 .3372 (4) Exchange rate (Drch/DM) 1973 - 1980 .6088 regressed on relative price level 1965 - 1972 .2804 (5) Relative money supply regressed 1973 - 1980 .7299 on exchange rate (Drch/DM) 1965 - 1972 .4081 (6) Exchange rate (Drch/DM) 1973 - 1980 2.2892** regressed on relative money supply 1965 - 1972 .6413 Data Sources: OECD; Main Economic Indicators; Bank of Greece; Monthly Bulletin. The degrees of freedom (12,59) are the same for all equations in both time periods. * Significant at 1 % level; ** Significant at 5 % level. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.16.3.394 | Generated on 2023-01-16 12:49:20