Modern theories of stabilization policy typically focus on the strategic interaction between policy-makers and the public in a repeated game, where information is imperfect and reputation and punishment play important roles. Such theories do little to account for the success or failure of `once-for-all' stabilization policies, such as the ending of hyperinflation in the 1920s and the famous Poincaré stabilization in France in 1926, where policy-makers' strong performances yielded no reputation benefits in a subsequent round.

In Discussion Paper No. 454, Research Fellow Rudiger Dornbusch considers why governments might sometimes embark on a stabilization programme whose success is uncertain. Even if policy-makers can calculate the fiscal adjustment required to assure the stability of prices and the exchange rate without doubt, any programme can be undone by the next government. This potential lack of persistence feeds back to the current policy actions required to make the programme survive; and even a well-designed programme may not withstand an exogenous shock such as a major unexpected deterioration in terms of trade.

Dornbusch abstracts from the failure of stabilization programmes because wrong policies are chosen and concentrates on the case where they fail because the realization of certain variables relevant to the success of the programme turns out to be unfavourable. Uncertainty may arise because of randomness either in the responses to given policy instruments or in the underlying economic variables. In his model of a one-shot stabilization, the equilibrium programme has a non-zero ex ante probability of failure, so credibility is always less than full, and he considers a number of factors that raise or lower the probability that a stabilization programme will succeed.

Dornbusch finds that the probability of success increases with the initial stock of reserves and the availability of foreign loans, but that it falls as the marginal cost of adjustment increases, as for example in societies that are politically highly polarized. The probability of success increases with the cost of the programme's failure and with the responsiveness of the trade balance to adjustment effort, while the impact of increased volatility on the probabilities of adjustment and collapse is ambiguous. If reserves are relatively large, the optimal adjustment effort may actually decline, and increased volatility may raise the probability of a collapse, since the probability of collapse rises for a given adjustment effort.

Dornbusch concludes that this set of predictions taken together constitutes a positive theory of adjustment, which could be tested against a set of stabilization programmes whose a priori probabilities of success are determined from the characteristics of the countries concerned.

In Discussion Paper No. 455, Dornbusch considers the cases of stabilization policies implemented in countries suffering from extreme monetary instability of the sort faced by Argentina, Brazil, Peru, Poland and Yugoslavia in early 1990. In other countries such as Bolivia such programmes had already run their course, while Mexico had avoided the extreme experience by opting for stabilization early and decisively.

Dornbusch argues that policy-makers in financially vulnerable countries should not over-react to the threat of inflation by adopting a posture of zero inflation at any price, although inflation can easily become unstable and it is therefore essential to understand exactly where this instability resides. Complacency may have disastrous social costs as the middle class effectively disappears, social institutions are corroded, and the tax system and social relations are undermined by corruption and fraud. Historical experience also indicates that political change towards more participatory democracy has not traditionally contributed to economic stability, since expectations of improved opportunities and living standards have been sustained by printing money. Europe had that experience in the 1920s, as did the Soviet Union in 1919-21, Allende in Chile and Solidarity in Poland. Attributing financial disorder to a `weak' government is too simple, since once destructive inflation has run its course the `politically impossible' actions that such governments were unable to undertake earlier are accomplished through the imposition of stern measures to rebuild confidence and stability. Democratic institutions do not facilitate hard choices, and democratic countries have therefore almost always adopted special procedures to adopt and implement the hard measures necessary for stabilization.

Dornbusch maintains that a clear line must be drawn between a policy of accepting moderate inflation because the cost of disinflation rises steeply and those of either setting no limit on inflation or merely repressing it temporarily. Fiscal austerity is necessary if a stabilization programme is to last, and incomes policy essential if it is to start. Finally, structural reform and foreign support will play useful roles in ensuring the that stabilization once achieved is followed by a transition to growth, and that the risk of protracted stagnation is thereby averted.

In Discussion Paper No. 456, Dornbusch discusses the preconditions for such a resumption of growth in further detail. While it is conventionally assumed that these include fiscal austerity, competitive real exchange rates, sound financial markets and deregulation, the need to distinguish between necessary and sufficient conditions is often neglected. Adjustment is strictly necessary, but it may not be sufficient: if asset holders can postpone the repatriation of capital and investors can delay initiating projects, there is an important coordination problem not recognized in classical economics.

Dornbusch argues that the design of suitable policies requires the identification of the essential measures to ensure stabilization and the restoration of growth, and also the contribution of the external environment more specifically, the potential roles of debt relief and foreign loans.

The `official' view of the IMF that if the `right' policies are in place, then stabilization will rapidly pay off in growth is supported by the experience of Korea and Turkey in the early 1980s, Brazil in 1964-7 and Chile in the late 1970s. Others cite the recent experience of Mexico or Bolivia, however, to argue that the transition from stabilization to growth remains difficult to understand and even more difficult to accomplish.

Dornbusch identifies the five key elements in the design of a stabilization programme to be: the choice of post-stabilization inflation target, the extent and manner of fiscal stabilization, the choice of monetary policy, the level of the exchange rate, and the use of incomes policy. The subsequent resumption of growth will depend critically on the maintenance of a competitive real exchange rate and on productivity growth. Prudent financial restructuring will also be required to establish stable and at most moderately positive real interest rates. Moreover, countries that have undergone significant financial instability will probably require external support to overcome the coordination problem and restore confidence.

Credibility and Stabilization
Experiences with Extreme Monetary Instability
Policies to Move from Stabilization to Growth
Rudiger Dornbusch

Discussion Paper Nos. 454-6, September 1990 (IM)