IN ECONOMICS

HEN Guillermo Calvo was a young student But he and several IMF colleagues, including Carmen in 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 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 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 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 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 . 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. It stand why, Calvo turned to models developed by Columbia col- was at the IMF that Calvo's interest in policy issues was trig- leagues and John Taylor. Their models, which gered, many of his colleagues say. But he demurs a bit. "It took Calvo had earlier dismissed, tried to incorporate so-called me a long time to find my own voice. I was always concerned sticky prices and wages, which resist change even if underly- about these policy issues, but I didn't have what it takes to do ing conditions change. Calvo initially found the models "too it by myself. The IMF gave me the opportunity to work in an complicated" but later "simplified them in such a way that it environment, where, because it's a bureaucracy, you tend to became a child's game" to account for sticky prices in a general collaborate more. Cooperation is key. I was coming from aca- equilibrium model. The 1983 paper took a while to take root, demia, where competition is the word, where being unique he says, because colleagues kept trying to explain develop- and original is what is prized." ments using the standard model with flexible prices and wages. At the IMF, he collaborated with a number of mainly But by the 1990s, MIT's Roberto Rigobon said, Calvo's model younger scholars—among them Carlos Vegh, Enrique had become the "workhorse" of . Mendoza, Guidotti, Leiderman, and Reinhart. With Guidotti, Time inconsistency and incorporating sticky prices in he worked on public debt issues, which led to his later work general equilibrium theory may represent Calvo's most on liability dollarization. With Vegh, he perfected the sticky important contributions to macroeconomic theory, but his price model. And with Mendoza, he worked on trade issues. "They were known as Calvo's boys and girls," said Talvi, a more recent collaborator who was not an IMF colleague. The name of the game None of Calvo's boys and girls complemented his skill Guillermo Calvo and colleagues have shown a knack for set better than Reinhart—now a University of Maryland coining or popularizing phrases that have been incorpo- professor—whom he calls "a wonderful applied econometri- rated by economists and even nonspecialists: cian and a first-rate economist." The two collaborated on a Sudden stop: A large, unexpected, and widespread col- number of projects, including the 1993 paper they wrote with lapse in capital flows that is often unrelated to the eco- Leiderman that challenged the prevailing belief that Latin nomic fundamentals of a country and is usually highly American countries were receiving large capital inflows thanks damaging. Sometimes the phenomenon is abbreviated to structural reforms and sound monetary and fiscal policies. as "3S," for systemic sudden stop, to emphasize the wide- "I went to Latin America, and everybody was saying the spread nature of the problem during crises. same thing—that money was flowing in because [countries] Fear of floating: Aversion by a country to allowing the were doing the right thing. But Peru was getting a lot of market to determine the value of its currency (freely float) money and it had the Shining Path [insurgency]. And some because so many companies and individuals have assets countries had fixed exchange rates, while others floated. and liabilities denominated in dollars that a depreciation So, I looked around and thought: Something's fishy here. in the currency would seriously hurt those who had not Everybody's getting money and they're doing things that are hedged their positions. The term originated in a paper of very different, and don't tell me that all of them are in good the same name that Calvo and Reinhart wrote in 2002. shape." Calvo returned to Washington and told Reinhart he Phoenix miracle: An economy that "rises from the was convinced there was a common factor and that it was ashes" of an output collapse caused by a sudden stop. Generally the economy regains its precollapse output external. They enlisted Leiderman and the three went after level within two years but does not return to its long-run the "usual suspects": U.S. interest rates and the business cycle. growth path. The name derives from the mythical bird And as Calvo puts it, "Everything kept falling into place." that was consumed in flames and reborn from its ashes. That the IMF published their paper (and subsequent research in the same mode) was not an indication that the

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©International Monetary Fund. Not for Redistribution institution endorsed the conclusions. In fact, Calvo says, the issues, capital flows, debt maturity, and inflation stabiliza- three of them got "a lot of flak" from colleagues. But, sure tion. Then Deputy Managing Director Agustin Carstens, now enough, U.S. interest rates began to rise and in December 1994 Finance Minister of Mexico, observed that "Guillermo's abil- the so-called Tequila Crisis erupted in Mexico after the country ity to reduce complex problems to their essential elements sharply devalued its currency. The crisis sent Calvo into fever- has taught us that complex models are for lesser minds In ish production, and he soon concluded that although Mexico's Guillermo's hands, the chaos of reality has always yielded problems were sparked by a devaluation, it was not experienc- simple and illuminating models." ing a currency crisis but a crisis in the capital market—where companies and governments raise long-term funds. His next Filling in the theoretical blanks The external environment has been tranquil for most of this decade, and developing countries have again been growing. "If the Great Depression was the But the risks of crisis remain, Calvo says, and macroeconomic result of central bank incompetence, theory has little to offer policymakers if sudden stops return. "The standard macro theory that we teach in graduate school as many economists believe, then nowadays is not a theory inspired by the Great Depression. It's inspired by the great stability that the United States in crises in today's emerging markets are particular has exhibited over so many years." Calvo and colleagues Alejandro Izquierdo and Talvi found rooted in central bank impotence." eerie echoes of the Great Depression of the 1930s in research- ing their 2006 paper on what they dubbed the "Phoenix paper, "Varieties of Capital-Market Crises," argued in essence miracle"—the seemingly ineluctable ability of underdevel- that Mexico was not an isolated phenomenon. He said many oped economies to "rise from the ashes" of a dramatic output emerging market countries were vulnerable in different ways collapse caused by a sudden stop. They found strong parallels to the whims of international investors because of underde- between the conditions surrounding recent crises in emerging veloped financial sectors, the constant exposure of the bank- markets and the Great Depression. The devastated economies ing sector to panicky depositors, and the phenomenon of returned within a couple of years to their precollapse output, "contagion"—in which investors don't differentiate among but not to the growth path they had been on before the crisis. emerging markets but pull out funds without regard for the A crucial problem for emerging market economies is that underlying circumstances of individual countries. their central banks are often powerless to help much. The Calvo's theories emphasized the financial sector as the large swings in interest rates that usually accompany turmoil source of instability. Whenever the financial sector is intro- render the standard, incremental tools of monetary policy duced into the model, there are many theoretical ways that ineffective. And because underdeveloped financial markets a country can be attacked, said Miguel Kiguel, an Argentine force firms and governments to borrow heavily in dollars or economist who was a student of Calvo's at Columbia in the other foreign exchange, central banks have a limited ability early 1980s. Banks may be more important "than a budget to keep the systems solvent in a crisis by becoming lenders deficit or a current account deficit." What Calvo postulated of last resort. Countries also often have a grave "fear of float- is now common wisdom, said Rigobon, but at the time it was ing" their currencies, because firms that owe dollars but earn radical. "It's like an Alfred Hitchcock movie," he said. "The local currency would be devastated by a big devaluation. If special effects don't seem like much today," but they were the Great Depression was the result of central bank incom- path breaking when they appeared. He said that much like petence, as many economists believe, then crises in today's Calvo's 1983 model, the profession was a little slow to appre- emerging markets are rooted in central bank impotence. ciate his 1996 insights. It took the 1997 Asian financial crises Calvo hopes to help emerging market policymakers by tak- and subsequent ones in Eastern Europe and Latin America to ing advantage of the current tranquility to develop a theoretical persuade many economists that emerging markets had a spe- underpinning for monetary policy in countries with under- cial set of problems that were rooted in the financial system. developed financial systems and virtually no lender of last Calvo admits that over the years he has been at analytical odds resort. "A nice art collection and quiet surroundings," he says, with the IMF, but during his time at the institution he always "don't make a first-worldcentra l bank. It's not enough." • had support and time to carry out his research. "Look at the number of papers I wrote. I never stopped writing papers." And James L. Rowe is on the staff of Finance & Development. he continues to write them at a dizzying pace. "He still thinks and processes things through papers. He has an idea, he writes References: a paper. Most people would talk about it over lunch. Guillermo Chart, V.V., ami Patrick J. Kehoe, 2006, "Modern Macroeconomics writes a paper," said his friend and colleague Rodriguez. in Practice: How Theory Is Shaping Policy," Journal of Economic So it was appropriate that, in 2004, its institutional skep- Perspectives, Vol. 20 (Fall), pp. 3-28. ticism long in the past, the IMF honored Calvo by inviting Mendoza, Enrique, 2005, "Toward an Economic Theory of Reality: An numerous colleagues to contribute papers to a two-day semi- Interview with Guillermo A. Calvo," Macroeconomic Dynamics, Vol. 9 nar to celebrate his intellectual leadership on, among other (February), pp. 123-45.

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