The conference brought together renowned academics and policymakers who have been associated with Calvo during his illustrious career. Some of Calvo’s former colleagues at Columbia University—where he began his academic career in the early 1970s—gave fascinating behind-the-scenes accounts of Calvo’s early professional blossoming.
Delivering the opening remarks, Agustín Carstens (IMF Deputy Managing Director) struck a theme that resonated throughout the conference. He said, “Guillermo’s ability to reduce complex problems to their essential elements has taught us that complex models are for lesser minds—for those who cannot grasp the essential elements out of a given reality. In Guillermo’s hands, the chaos of reality has always yielded simple and illuminating models.”
Calvo played a particularly crucial role, noted Andres Velasco (Harvard University), in bringing policy issues relevant to Latin America to the forefront of academic discussion. As Velasco put it, “[if] there is one person responsible for bringing modern economics to bear on the problems of the nations south of the Río Bravo, that person is Guillermo Calvo. He brought rigor and discipline to the business. He also made it intellectually respectable.”
Monetary and exchange rate policy
Is inflation targeting suitable for developing countries? One of Calvo’s concerns with such a framework is that giving too much discretion to policymakers in a weak institutional environment could lead to poor macroeconomic outcomes. Frederic Mishkin (Columbia University) acknowledged that emerging market countries often have weak fiscal, financial, and monetary institutions; exhibit varying degrees of currency substitution and liability dollarization; and are vulnerable to sudden stops in capital flows and terms of trade shocks. But he argued that inflation targeting could still serve emerging market countries well, provided they put due emphasis on strengthening institutions and on finding ways to deal with large exchange rate fluctuations.
Presenting a paper coauthored with Ariel Burstein and Martin Eichenbaum, Sergio Rebelo (Northwestern University) focused on the effect of large devaluations on real exchange rates in emerging markets. They found that when measured “at the dock,” prices of tradable goods basically rise in the same proportion as the nominal exchange rate. This is critical because, when measured at the retail level, tradable goods prices include distribution costs, which are nontradable and respond very little to large devaluations. Rebelo concluded that the real depreciation of the domestic currency is not due to the failure of the law of one price for tradable goods but rather to the small response of nontradable goods prices.
To fix or to float?
Should an open economy peg its currency to a strong world currency, or let the currency float? The standard response, based on the Mundell-Fleming model, is that the exchange rate arrangement should depend on the type of shock hitting the economy. If shocks are predominantly real in origin, flexible exchange rates are optimal because they allow a quicker adjustment of relative prices through changes in the nominal exchange rate. If shocks are predominantly monetary, however, then fixed (or predetermined) exchange rates are preferable, because adjustments to the nominal money supply are automatically carried out by the central bank. As Calvo has put it, this is a result that “every well-trained economist carries on the tip of [his/her] tongue.” Two conference papers dealt with challenges to this basic tenet.
Maurice Obstfeld (University of California at Berkeley) took issue with a recent finding by Michael Devereux and Charles Engel that holds that even if an economy is hit by real shocks, fixed exchange rates may be preferable if the nominal prices of both exports and imports are pre-set in the domestic currency. Obstfeld argued that if nontradable goods are added to the model, then flexible rates become optimal again because the nominal interest is freed to serve as a monetary stabilization instrument.
In presenting his paper with Rajesh Singh and Carlos A. Végh, Amartya Lahiri (New York Federal Reserve) had a very different angle on the problem. Arguing that asset market imperfections are likely to be as important as, if not more important than, goods market frictions in developing countries, he described a model of flexible prices, in which some economic agents do not have access to capital markets. In such a world, the standard results are turned on their head: flexible rates become optimal if monetary shocks dominate, while fixed rates are preferable if real shocks dominate. Ultimately, the choice of exchange rate regime should depend not only on the type of shock (real versus monetary) but also on the type of friction (goods market versus asset market).
What do the data say?
In spite of much research on the effects of different exchange rate regimes, the empirical evidence is far from conclusive, to say the least. Two conference papers provided important insights into this topic. In his paper with Igal Magendzo, Sebastian Edwards (University of California at Los Angeles) studied countries that either were fully dollarized (like Panama) or are part of an independent currency union (like the Eastern Caribbean Currency Union). He found that both categories of countries had lower inflation than countries that have a domestic currency. In addition, dollarized countries had lower growth and higher volatility than countries that have their own currency. Currency unions, in contrast, had higher volatility but higher growth.
Assaf Razin (Cornell University and Tel Aviv University), based on joint work with Yona Rubenstein, argued that to disentangle the effects of exchange rate regimes on growth, one had to control for the possible growth effects of the probability of a crisis. After doing so, Razin showed empirical evidence that indicates that the switch from a float to a peg is conducive to higher growth. In the data, however, the overall effect on growth from such a switch may be offset by the larger probability of a crisis under a peg.
Crises, contagion, and pessimism
Ever since Mexico’s December 1994 crisis, Calvo has led the way in analyzing the causes and implications of financial crises. In her paper with Pritha Mitra, Padma Desai (Columbia University) inquired into why some countries recover more readily than others from financial crises. They found that export performance before a crisis appears to be a critical variable in predicting the speed of recovery. Through investor expectations, export performance explains most of the difference in postcrisis interest rate and exchange rate movements between two countries. In contrast, fiscal position and national saving do not seem to matter as much.
Graciela Kaminsky (George Washington University), presenting joint work with Carmen Reinhart, analyzed how financial turbulence in emerging market countries can spread across borders and concluded that it spreads globally only if it affects some major financial centers; otherwise, its effect is, at most, regional. For example, during the Asian crisis, Japanese banks’ exposure to Thailand—and their subsequent curtailment of lending to other Asian countries—played a critical role in spreading the crisis.
Velasco, in joint work with Alejandro Neut, illustrated how changes in asset prices resulting from changes in sentiment rather than fundamentals can be self-validating. Imagine, he said, that stock market prices fall. If investment is subject to collateral constraints, this decline reduces the value of firms and, hence, investment. But lower investment implies smaller returns in the future, which, in turn, reduces stock market prices and thus validates the initial fall. Hence, Velasco argued, bouts of pessimism can be self-fulfilling—a scary thought indeed.
Another field in which Guillermo Calvo made important contributions is optimal taxation. In particular, in joint work with Pablo Guidotti, he showed that, under certain conditions, unanticipated increases in government spending are optimally financed with unanticipated inflation. Michael Kumhof (IMF) tackled this issue in the context of how to finance a fiscal crisis optimally. In his model, unanticipated inflation is socially costly because it reduces financial intermediation. Kumhof concluded that a heavy reliance on inflation is optimal only if the fiscal shock is transitory; more permanent shocks are optimally financed mostly through distortionary taxes.
Enrique Mendoza (University of Maryland), in joint work with Linda Tesar, focused on the tax implications of European financial integration, which has led to a situation of harmonized indirect taxes but markedly different factor taxes. In particular, the prediction of a “race to the bottom” in capital taxes did not materialize. Mendoza argued that when countries compete over capital tax rates by adjusting labor taxes to maintain fiscal solvency, there is, in fact, no race to the bottom, and factor tax rates predicted by the model roughly match the observed ones.
Economies in transition
During his tenure at the IMF, Calvo worked extensively on the transition process from planned to market economies. Some of this work—jointly produced with Fabrizio Coricelli (University of Siena)—emphasized the possible role of a credit crunch in explaining the output collapse at the beginning of the transition period. In joint work with Igor Masten, Coricelli revisited this issue in the context of the macroeconomic performance of central European countries preparing to join the European Union (EU). He concluded that the relative underdevelopment of credit markets in these countries is partly responsible for low output growth and high volatility. EU membership will allow these economies to further build their financial systems.
Stanley Fischer (Citigroup and former IMF First Deputy Managing Director), in a paper he presented jointly with Ratna Sahay (IMF), examined the role of institutions and initial conditions in the transition process. In particular, Fischer rejected the charge that international financial organizations—and mainstream economists—paid inadequate attention to institution building. Institution building was taking place alongside macroeconomic stabilization policies, he said, and the econometric evidence suggests that institution building did, indeed, contribute to growth.
Political economy and end games
Based on joint work with Peter Isard, Allan Drazen (University of Maryland and Tel Aviv University) argued that an often-cited reason that IMF programs go off track is a lack of so-called program ownership, which loosely refers to a country’s lack of commitment to a given set of reforms and stabilization policies specified in an IMF program, independent of incentives provided by multilateral organizations. Drazen provided a theoretical framework for the role of public discussion in building and demonstrating ownership, which, in turn, points to various directions in which IMF program design can be strengthened.
Finally, Michael Dooley (University of California at Santa Cruz) presented a model (based on joint work with David Folkerts-Landau and Peter Garber) to explain the current Chinese policy of keeping the domestic currency undervalued in real terms. In Dooley’s view, this policy’s objective is to gradually absorb an unproductive labor force of around 200 million. Foreigners may be willing to bear the costs of this “beggar thy neighbor” policy in exchange for some form of access to markets. The end game would have the Chinese real wage converge to the world real wage once the excess labor has been absorbed. At that point, China will presumably be able to compete in world markets at the prevailing world real wage.
In a closing panel discussion chaired by Raghuram Rajan (Director of the IMF’s Research Department), Guillermo Perry (World Bank Chief Economist for Latin America) and Ricardo Hausmann (Harvard University) commended Calvo and his coauthors for their efforts to explain the difficulties emerging market countries face in carrying out appropriate fiscal and monetary policies when they are confronted with problems of time inconsistency, sudden reversals in capital flows, and a fear of letting exchange rates float. Calvo himself had the last word, remarking on the strength and influence that participants at this conference had in giving substance and serious underpinnings to critical policy discussions in Latin American and elsewhere, which often translated into actual policy decisions.