Summary of WP/92/73
“Losing Credibility: The Stabilization Blues” by Pablo E. Guidotti and Carlos E. Végh
Governments often resort to the exchange rate as the nominal anchor in inflation-stabilization programs. However, such programs have frequently ended in costly balance of payments crises, mainly because the convergence of domestic inflation to the rate of devaluation proved to be a long and tortuous process. The expectation of a devaluation to correct large real exchange rate appreciations has hung over the programs like a sword of Damocles, becoming, more often than not, a self-fulfilling prophecy.
More subtle is the pattern that “credibility” has followed in many exchange rate-based stabilizations. Even in programs that eventually fail, credibility seems to increase initially as the highly visible nominal anchor provides a sense of stability, inflation begins to fall, and an agreement among different pressure groups on how to close the fiscal gap permanently seems within reach. As time goes by, however, the continuing real appreciation of the domestic currency, together with the apparent inability of the political process to deal with the fiscal problems, begins to erode credibility, and speculation about a possible devaluation arises.
This paper attempts to formalize this dynamic pattern of credibility. A framework is developed in which a political economy game and a balance of payments crisis model interact to provide a natural definition of credibility; the paper shows how economic and political variables evolve in such a way that credibility increases at the beginning of an exchange rate-based stabilization and then falls rapidly.
The model incorporates two important characteristics of major stabilization plans. First, and somewhat neglected in the theoretical literature, exchange rate-based programs often follow a two-stage approach. In the first stage, a nominal anchor is established, and some partial measures toward reducing the fiscal deficit are adopted. In the second stage, which may take several years or may in fact never occur, the rest of the fiscal adjustment is carried out. The second feature is the sustained real appreciation of the domestic currency, which is caused by the sluggish adjustment of the inflation rate to the rate of devaluation.
The dynamics of the stabilization plan are thus characterized by an appreciating real exchange rate, an increasing nominal interest rate, and rising public debt. Interestingly, this scenario characterizes both successful and unsuccessful exchange rate-based stabilizations.