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IN ECONOMICS HEN Guillermo Calvo was a young student But he and several IMF colleagues, including Carmen in Buenos Aires in the late 1950s, he de- Reinhart and Leonardo Leiderman, disagreed. They argued spaired of ever understanding economics. that countries were not being showered with foreign financ- wThere was a lot of talk about economics at ing because they were running sound monetary and fis- home because his father worked for the central bank. But cal policies, but because external factors, such as a benign as much as he tried to make sense of it, he couldn't, at one global environment and low U.S. interest rates, sent capital point concluding that economics was beyond him. Still, he in search of a higher return. Were those external factors persevered, and during an introductory economics course, to change, they postulated in a controversial 1993 paper, he said, he "suddenly began to understand and to see how investment in emerging market countries—whether abste- beautiful it was." Later, at the direction of Julio Olivera, mious or profligate—could suddenly turn tail. then head of research at the central bank where Calvo won Not long after, the global environment did change, and a competitive appointment, he repaired to the bank's li- Calvo and his colleagues proved largely right. Starting with brary, an English dictionary at his side, and he read and Mexico in 1994 and ending with Argentina in 2001, a string read and read dense economic and mathematical treatises of emerging market countries, many of them in Asia, were written "in a language I hardly knew." rocked by what he has dubbed a "sudden stop"—a large, A Master of Theory and Practice James L, Rowe interviews economist Guillermo A. Calvo His perseverance paid off. Calvo became one of the pre- unexpected, and widespread interruption in capital flows, eminent scholars of both modern macroeconomic theory often unrelated to economic fundamentals (see box, page 6). and the economics of emerging markets, especially those As a result, policymakers in developing countries learned a in Latin America. Speaking at an IMF conference to honor painful lesson: they would almost assuredly fail to attract for- Calvo in 2004, Andres Velasco, then a Harvard professor, eign investment if they followed bad policies, but there was now Chile's finance minister, said that if there was a single little assurance that they would not face the same fate if they "person responsible for bringing modern economics to bear followed good ones. The New York Times quickly dubbed on the problems of the nations south of the Rio Bravo, that Calvo a "prophet of financial doom" for accurately predict- person is Guillermo Calvo." Calvo's early theoretical work ing Mexico's 1994 collapse. And although his latest paper was in the thick of the three developments that economists examines "recovering" economies, Calvo, at 65, remains as V.V. Chari and Patrick J. Kehoe recently identified as the keys focused as ever on the potential for emerging market crises. to improved macroeconomic theory over the past 30 years: the critique that incorporated people's expectations about Straddling academla and policy policy, insights into time inconsistency and its attendant During his 30-year career, Calvo has moved back and forth credibility issues, and better modeling of the economy to between academic and policy-oriented organizations. At the account for such distortions as "sticky prices." end of 2006, he opted to leave the policy fray again, resign- Calvo's later policy messages have been ominous and ing after six years as chief economist for the Inter-American often at odds with many of his colleagues, especially dur- Development Bank (IADB), to return—along with his ing the prosperous period of the early 1990s, when most economist wife Sara—to Columbia University in New economists—including those at the IMF, where Calvo was York, where he began his academic career three decades then in residence—believed that how well a country con- ago, a freshly minted Ph.D. from Yale University. Over the ducted its economic policies determined how well it was years, he has also been a professor at the Universities of treated by foreign investors. The conventional wisdom then Pennsylvania and Maryland, with research appointments was "that if you do your homework, the capital markets will and visiting professorships sprinkled in. He long has had a always be on your side," Calvo said. weighty influence on the policy debate—from the IMF, the 4 Finance & Development March 2007 ©International Monetary Fund. Not for Redistribution first paper, a highly theoretical note on capacity utilization that appeared in 1975 in the American Economic Review, was sparked by conditions in Colombia, where he had lived several years before. Sometimes noneconomic issues can motivate Calvo's theorizing. It was a game he played with his sib- lings that Calvo said was one source of inspiration for his 1978 contribu- tion to the then-nascent study of time inconsistency—a concept that explains how well-meaning policymakers can still make bad policy. Calvo recalled that, as a child, when he would show his brother and sister pictures of him- self when he was younger and ask, "Who's this?" they would say, "That's you." He would reply, "No it isn't," explaining that now he was a differ- ent person in different circumstances from when the picture was taken. "It was very clear that you could think of human beings as a sequence" of incar- nations, and that made it easy for him to understand how policymakers could undermine their long-term strategy. That's because the official making the decision today is facing different conditions than when he made the ini- tial promise. In 1977 Edward C. Frescott and Finn E. Kydland showed that a government that sets down a long-term policy plan (monetary or fiscal) will, if it has the chance, probably change its plan later to reflect changing circumstances. A year later, Calvo, working indepen- dently of Prescott and Kydland (who in 2004 won a Nobel Prize in part for IADB, and academia. Yet Calvo has had but one formal brush their work on time inconsistency), showed that the govern- with policymaking, as an adviser to Argentina's finance minis- ment is likely to make these inconsistent discretionary deci- try in 1996, and it lasted only two months. sions "even though the government has exactly the same Cairo's research agenda is generally regarded as being preferences" as the public. divided into two chapters. For the first half of his career, he was For Calvo, the important point is that, by attempting to a theoretician inspired by the world around him; for the sec- make the best discretionary decisions at any given time— ond half, a policy-oriented economist with a theoretical bent. "reoptimizing," as economists put it—policymakers can sub- Pablo Guidotti, dean of the school of government at vert their good long-run policy promises, causing them to Universidad Torcuato Di Telia in Buenos Aires and a former lose credibility. That's because once they deviate from their IMF colleague, calls Calvo "a very theoretically minded econ- commitment, say, to an anti-inflation strategy, no matter omist who likes simple and elegant models." As Calvo himself how good their reasons, the public no longer believes them. puts it: "My rule is always simplify, simplify, simplify. After People's expectations change and then they act to protect all, we're making models. It's not reality." themselves, say, by demanding higher interest rates in antici- Still, Cairo's muse has always been reality, according to pation of higher inflation. That forces policymakers into fur- Ernesto Talvi, head of the Uruguayan research institute ther self-defeating steps that can leave a once-good long-run Ceres. He never made theory for theory's sake. Even Calvo's policy in shambles. Finance & Development March 2007 5 ©International Monetary Fund. Not for Redistribution Time inconsistency—with its effect on expectations and interests were wide and he "wandered all over the economic credibility—isn't a major issue in advanced economies, Calvo landscape," said Carlos Rodriguez, a Columbia University said, but "most economists would agree that it is central to colleague in the 1970s and now president of Universidad del emerging markets" and, in fact, "helps explain why countries CEMA in Buenos Aires. Calvo produced theoretical papers have hyperinflation." As a result of the theoretical work on on, among other things, capacity utilization, hierarchical time inconsistency, many nations have reduced the amount ladders in organizations, structural unemployment, interna- of discretion allowed decision makers—making central tional trade, real interest rates and real exchange rates, and banks more independent of politicians and adopting publicly even the economics of justice. stated inflation targets and stability goals from which it is hard to deviate. Finding his voice The next major challenge Calvo faced was making sense of In 1986, after 13 years at Columbia, Calvo moved to the developments that did not square with prevailing general equi- University of Pennsylvania. But it was a short-lived change librium theory, which uses mathematical equations to show of scenery. Jacob Frenkel, then the IMF's research director, how the entire economy works together. Argentina—whose enticed Calvo to move to the IMF, where, between 1988 and manifold economic crises have regularly inspired its native 1994, he wrote numerous papers on exchange rates, emerg- son—sharply devalued the peso in 1981. Prices should have ing markets, and the post-Soviet transition in Eastern Europe changed in response, but they did not. As he tried to under- from command economies to ones more market-oriented.

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