Economic Reform
Regime Changes

What triggers a fiscal stabilization? Why, after lengthy consideration, does a country eventually decide to fix its exchange rate? Does prompt action raise or reduce its chances of success? These were a some of the questions addressed at a CEPR workshop on `Regime Changes and Economic Reform', held in association with the Innocenzo Gasparini Institute of Economic Research. The workshop was organized by Francesco Giavazzi, Professor of Economics at the Università degli Studi di Bologna, Director of the Institute and Co-Director of the Centre's International Macroeconomics programme. The workshop took place at the Institute in the Abbazia di Mirasole, Milano, on 14 January. Financial support for the meeting was provided by grants from the Commission of the European Communitites under its SPES programme to the Centre's research programme on `Financial and Monetary Integration in Europe' and to the Institute of Economic Research.

Although all the papers presented at the workshop were theoretical rather than empirical, they were nevertheless motivated and informed by recent empirical studies of countries' experiences of stabilization programmes and in particular by recent events in Eastern Europe and the Soviet Union.

Allan Drazen (University of Maryland) presented a joint paper with Alberto Alesina entitled `Why are Stabilization Policies Delayed?'. They noted that the common observation that stabilization policies occur when the cost of waiting becomes `too high' fails to answer why society waits at all, if waiting is equally costly. They suggested that delays may occur when the expected costs of a stabilization programme fall unevenly across society: if the social group that gives in first will bear a larger burden, then it will have an incentive to wait, in the hope that somebody else will give in and pay the costs entailed.

Giuseppe Bertola (Princeton University, IGIER and CEPR) then presented his joint paper with Allan Drazen on `Trigger Points and Budget Cuts: Explaining the Effects of Fiscal Austerity'. Their analysis was motivated by the evidence presented in Giavazzi and Pagano's earlier study of Danish and Irish stabilizations (CEPR Discussion Paper No. 417). Bertola and Drazen explained how the correlation between public and private spending is positive when public spending is high, but negative when public spending is low. In their model, government spending follows an upward-sloping stochastic process which the public believes may fall sharply when it reaches a `trigger point'. Optimizing consumption behaviour in this model implies a theoretical relationship between public and private spending which is very similar to the one observed empirically.

Gérard Roland (Université Libre de Bruxelles) presented a paper written with Mathias Dewatripont on `Economic Reform and Dynamic Political Constraints', which was motivated by the observed pace of economic reform in the ex-socialist countries of Eastern Europe. They considered the case of a reform-minded government facing a bureaucracy that will suffer redundancies and face an increased workload if the reform is successful. They studied reform programmes under the alternative political constraints of unanimity and majority rule. Their analysis suggested that the role of democratic constraints as an obstacle to efficiency- enhancing economic reforms in a dynamic context should not be over-estimated. They noted the relevance of their results to the political economy of current economic reforms in Eastern Europe.

Allan Drazen (University of Maryland) presented the final paper of the workshop, `Do Exchange Rate Freezes Induce Business Cycles?', in which he maintained that the real effects of government policy depend critically on the expectations they generate: the real effects of an exchange rate freeze that is not fully credible are due to the expectation of its collapse rather than to the freeze itself. Expectations of a devaluation following the collapse of a fixed exchange rate provides an incentive for the massive importation of consumer and producer durables while the rate remains frozen. This will lead to a boom in domestic economic activity if imports largely consist of consumer durables that are complementary with non-traded goods or of inputs to production. An exchange rate freeze that persists significantly longer than expected will induce a decline in economic activity in its latter phase, so the uncertainty about the timing of the regime's collapse is critical.