77068 WHEN DO HETERODOX STABILIZATION PROGRAMS WORK? Lessons from Edxperience Miguel A. Kiguel Nissan Liviatan What advantagesand disadvantagesdoes the heterodox strategy offer to sta- bilization programsin countrieswith chronichigh inflation?Heterodox stabi- lizationprograms,in our definition, are those that support orthodox policies- that is, tight fiscalpolicy and a fixed exchangerate-with the initial,temporary use of incomes policies-that is, price and wage controls. This evaluation, based on several heterodox programs, successfuland unsuccessful,from the 1960sand 1980sin Latin Americancountriesand Israel, affords four principal lessons: • The rapid reduction in inflation at the beginningof heterodox programs (which usually comes about at small cost) is the easy part; the problem is to maintain price stability over time. * Incomes policies in heterodox stabilization programsare justified only in countries with high chronic inflation, where persistent inflation is more pervasiveand problematic. * There is a case for a biggerfiscal adjustment in heterodox than in ortho- dox programsbecauseof the risk that a program with price controls may be misperceivedas a populist devicefor achievingprice stability without adjusting. * The failure of a heterosdox program is more likely to destabilize inflation than is the failure of an orthodox program. The World Bank Research Observe?, vol. 7, no. 1 (January 1992), pp. 35-57 ©) 1992 The International Bank for Reconstruction and Development/THE WORLD BANK 35 O rthodox methods of checkinginflation in countries with chronic high inflationhaveencounteredformidableobstacles.Disinflationis usually slow,and its costs ifhterms of unemploymentare high. Heterodoxtac- tics were devised to surmount these difficulties. Heterodox Programs: What Are They? The epithet "heterodox" has been rather loosely used by economists to describetypes of stabilizationprogram. The term means differentthings to dif- ferent people. Bruno and others (1988),for example, include in their sample of heterodox programs experimentsas diverse as the Austral Plan, the Cruzado Plan, and the Israeli program of 1985; Ocampo (1987)includes the Peruvian populist experiment of 1985 in his study of heterodox programs. In our view, a heterodox stabilizationprogram is one whose main objective is to achieverapid and sustained disinflation.The design of the program com- bines tight fiscaland financialpoliciesand a fixed exchangerate (the orthodox part) with the temporary use of price and wage controls (typicallyin the form of a freeze).The controls are a temporary deviceto bring inflationdown rap- idly and to cushion some of the unemploymentcosts; once the controls have served their purpose, they are dismantledover time, and the program proceeds along orthodox lines. Typicallythe exchange rate becomes the main nominal anchor in the second stage. 1 Orthodox programs are those that primarily rely on tight fiscal and mone- tary policies to bring down inflation, and do not include incomes policies. Someof them (exchange-rate-based stabilizations)use a fixed or preannounced exchange rate; others (money-basedstabilizations)rely on tight money and a floating exchange rate. Sincemost orthodox exchange-rate-based programs are preceded by a money-basedstabilizationstage-in which tight moneyis relied on for stopping inflation (for instance, in Chile and Argentina in the mid- 1970s)-the main difference betweenorthodox and heterodox programs is the strategy for stopping inflation in the first stage. Inflation comes down slowly under orthodox programs and rapidly under heterodox. Only two recent programs satisfy our definitionof heterodox: the Israelipro- gram of 1985 and the Mexican Pacto de Solidaridad of 1987-88 (figurela). Both programs used incomes policies initially to achievea rapid reduction in inflation; in both cases the exchange rate was the main nominal anchor and was fixed at the beginning;and both maintained the fiscaladjustmentthrough- out. Both programs succeededin keeping inflationdown for an extended peri- od. The extent of the controlsdifferedbetween the two countries: in Israel, for example, controls were economywide, whereas in Mexico the government alloweda large number of pricesto be freelydetermined.But these differences were of degree and not of substance: the philosophywas the same. The Israeli program is analyzed in detail by Bruno and Pitterman (1988), Bruno and 36 The World Bank Research Observer, vol. 7, no. 1 (January 1992) Meridor (1991), and Liviatan (1988, 1990), and the Mexican program by Ortiz (1991); see also Kiguel and Liviatan (1989). Outside this strict definition, we include in the discussion several other pro- grams that embody the heterodox approach to a greater or lesser extent. Brazil implemented an irnportant and quite successful stabilization program based on incomes policies in the mid-1960s (figure lb). Unlike the later stabi- lization of the 1980s-the Cruzado Plan-the program of the 1960s paid due attention to the fiscal accounts. In addition, the earlier program differed from the later because controls were introduced gradually and were mostly voluntary and because the initial reductions in inflation were not as spectacular. (The pro- gram is discussed in more detail in Simonsen 1974 and Cardoso and Fishlow 1990, among others.) Figure 1. Inflation, Devaluation, and Attempts to Stabilize la. TIvo Heterodox Experiments: Israel (1985) and Mexico (1987) Israel Percent in monthly terms 35 30 - Inflation 25- 20- 15 Stabilization Devaluation I 10 5 Al -5 1985 1986 1987 1988 1989 1990 Source:IMF (variousyears). Mexico Percent in annual terms 20 Devaluation 15 - Stabilization 10 0 1986 1987 1988 1989 1990 Source: Data from Banco de Mexico. Miguel A. Kiguel and Nissan Liviatan 37 Figure 1. Inflation, Devaluation, and Attempts to Stabilize (continued) lb. Brazil (1965) Percent in quarterly terns 50 40 - Devaluation 30 - 20 /\ I4 Stabilization 10 i\ I,z Inflation_'. -10,. , , , . . . . . . . 1962 1964 1966 1968 1970 1972 1974 IMF(various Source: years). Some programs started out heterodox and addressed the budget deficit at the beginning, but later changed course and relaxed the fiscal stance. These pro- grams are included in our study because they illustrate the similarities between macroeconomic developments during the early stage in those programs that persist and those that do not. Within the latter category (which we call non- persistent heterodox programs) we include two programs of the 1960s (the Argentine 1967 program under Finance Minister Adalbert Krieger Vasena and the Uruguayan program of 1968) and the 1985 Austral Plan in Argentina (see figure lc). Finally, we look at two populist programs: the Cruzado Plan in Brazil in the 1980s and the Peruvian program of 1985 (figure Id) (see Dornbusch and Edwards 1989 for a more extensive discussion). These so-called stabilization programs used price and wage controls and a fixed exchange rate to stop in- flation but ignored the fiscal side completely. Indeed, many populist programs combined controls with expansionary fiscal and monetary policies and with in- creases in real wages, with disastrous macroeconomic consequences. These pro- grams are included to compare their evolution with the very different outcomes of the nonpersistent heterodox programs. Problems with Orthodox Strategies The heterodox approach has generally been adopted to confront the infla- tionary rigidities that are characteristic of countries with chronic high inflation. Kiguel and Liviatan document the difficulties in their discussion (1988) of 38 The World Bank Research Observer, vol. 7, no. 1 (January 1992) Figure 1. Inflation, Devaluation, and Attempts to Stabilize (continued) lc. Nonpersistent Heterodox Programs: The Krieger Vasena Program (Argentina, 1967), the Uruguayan Program (1968), and the Austral Plan (Argentina, 1985) Krieger Vasena Program Percent in quarterly terms 30 25-_ /lDevaluation 20- I Stabilization 15- 10- 5 - 0/ -5 1964 1966 1968 1970 1972 Source: IMF(variousyears). Uruguayan Program Percent in quarterly terms 150 125 I Devaluation 100 - l 75\ _ 1 Stabilization 75- 50- J 25 Inflatio 0 1965 1967 1969 1971 1973 Source: IMF(variousyears). Austral Plan Percent in monthly terms 200 Inflation 150 - Devaluation 100 J~~~~~~tabilization 50- 0 1984 1985 1986 1987 1988 1989 1990 Econ6micas Source: Indicadoresde Conjuntura (Fundaci6nde Investigaciones Latinoamericanos). Miguel A. Kiguel and Nissan Liviatan 39 Figure 1. Inflation, Devaluation, and Attempts to Stabilize (continued) ld. Two Populist Programs:The Cruzado Plan (Brazil, 1986) and the Peruvian Program (1985) Cruzado Plan Percent in monthly terms 90 80 - Inflation X 70- 60 - 40 - -,tablization 30- 20 10 Devaluation 0 -10 1986 1987 1988 1989 1990 Source: Conjuntura (Fundac,oGetulioVargas). Economica Peruvian Program l538%-. Percent in monthly terms 114% 60 50 - 40 ~ SailztinDevaluation 30- 20 - 10 1983 1984 1985 1986 1987 1988 1989 1990 Source: IMF(various years). various orthodox stabilization programs. The slow and often small reductions in inflation are common both to programs that used money and to those that used.the exchange rate as the main nominal anchor. Paradoxically, in some cases, a reduction in the budget deficit was accompanied by a permanent in- crease in inflation. 40 The WorldBankResearchObserver, vol.7,no. I (January1992) The Mexican Experience The Mexican experiencebefore the Pacto (1987)is a good example of the frustration with orthodox programs characteristicof countries that eventually opt for the heterodox strategy.Table 1 summarizesthe main macroeconomic developmentsin Mexico in the 1980s.The fiscalaccountswere corrected early and impressively; the deficitin the operational balance (11 percent of gross do- mesticproduct [GDP] in 1981)was virtuallyeliminatedby 1983.2 But the drastic reduction in the deficitwas accompaniedby large devaluationsthat pushed in- flation up from 28 percent in 1981to 100 percent in 1983. In an attempt to reduce inflation, the policy shifted in 1984 to using the exchange rate as the nominal anchor. This strategy had only moderate and temporary effects in re- ducinginflation(althoughthe fiscalaccountsremainedsound).In fact, inflation rose again in 1986 when the exchange rate rule was abandoned and replaced by a policy of aggressivedevaluationsto deal with the plungein oil prices.The accelerationof inflationcontinued in 1987,a year in which the governmentran a surplus in its operational balance. The Mexican experience makes it clear that a correction in the budget deficit-although necessary-is not sufficientto bring down inflation.A budget surplus might not be enoughfor the purpose. A well-designed stabilizationpro- gram needs to balancethe correctionin the fundamentalswith a policyto man- age the nominal anchors. In Mexico, however,the success was meager even when the exchange rate was used as nominal anchor, especiallybecause the nominal anchor proved weak when the economy faced an adverse external shock. The failure of various orthodox strategies to control inflation in the after- math of the debt crisis is perhaps the main reason Mexico finally decided to follow the heterodox approach. The Mexicansadopted this course reluctantly, sharing many of the concernsabout the use of controlsraised by critics of these programs. Nevertheless,encouragedby the successof the Israeliprogram, they finallydecided to try the heterodox alternative. The Nature and Causes of Inflationary Rigidities The difficultiesexperiencedby Mexico are characteristicof countries with chronic inflation.In these countries inflation tends to display rigidities(or in- ertia), as has been widelydiscussed(see,for example,Dornbusch and Simonsen 1987; Tobin 1987, chap. 29). For our purposes it is useful to distinguishtwo types of rigidities.A first type, which we will call institutional, is a consequence of backward indexation, staggered contracts, and the like (see, for example, Fischer 1977, 1983; Taylor 1979;Lopez and Bacha 1983). A second "expectational"rigidity arises from lack of convictionon the part of the populacethat the governmentcan bring down inflationin the long term. Past failures to adjust and maintain the fiscal balance as required to support Miguel A. Kiguel and Nissan Liviatan 41 kQ Table 1. Macroeconomic Indicators for Mexico, 1980-89 Indicator 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1. Inflation,devaluation,and interest (percentin annualterms) a. cpi inflation 26.3 28.0 58.9 101.9 65.5 57.7 86.2 131.8 114.2 20.0 b. Officialdevaluation 0.9 6.5 130.2 112.9 39.7 53.2 137.9 123.5 64.7 8.2 c. Interestrate on loans* 20.7 28.6 40.4 56.6 51.1 56.1 80.9 86.7 67.6 20.5 d.cpi inflation (Dec.to Dec.) 29.8 28.7 98.9 80.8 59.2 63.7 105.7 159.2 51.7 19.7 e. Officialdevaluation (Dec.to Dec.) 2.2 12.6 268.3 49.1 33.8 93.0 148.5 139.3 11.5 16.3 2. Monetarystatistics(percent) a. Ml as share of GDP 11.2 10.8 10.9 8.4 8.1 7.6 7.3 6.5 5.6 6.2 b. M3 as share of GDP 30.1 33.6 37.4 33.2 33.7 31.2 35.9 37.8 31.4 34.5 c. Seigniorage - Mlt 2.7 2.7 4.2 2.4 3.0 2.5 2.9 3.5 2.1 1.0 d. Change in Ml 33.4 33.3 54.1 41.4 62.3 53.8 72.1 129.7 58.1 40.1 e. Change in M3 45.6 53.7 78.6 61.4 70.4 46.7 100.2 159.4 69.0 49.3 f. Monetarybase 41.1 45.1 90.4 58.1 54.1 17.5 47.7 70.3 42.3 10.6 i g. Consolidatedmonetarysystem domesticcreditt 39.0 48.8 100.9 56.4 51.2 69.2 101.0 104.2 - - h. Central bank domesticcreditS 37.0 43.5 157.6 41.7 31.1 49.0 61.3 13.7 2 3. Aggregate demand (percentageof GDP at current prices) o a. Private consumption 65.1 64.4 61.6 60.9 63.1 64.5 68.5 65.6 70.0 69.7 b.Public consumption 10.0 10.7 10.5 8.8 9.2 9.2 9.0 8.7 8.5 9.0 c. Investment 24.8 26.4 22.9 17.5 18.0 21.2 18.7 18.6 19.2 20.0 d. Exports 10.7 10.4 15.3 19.0 17.4 15.4 17.2 19.7 16.0 16.2 4. Economic activity (percentage change in real terms) , a. GDP growth 8.3 7.9 -0.6 -5.3 3.7 2.8 2.0 1.4 1.1 2.9 b. Unemployment 4.5 4.2 4.1 6.7 6.0 4.8 4.3 3.9 3.6 - c. Private consumption 7.5 7.4 -2.5 -5.4 3.3 4.2 -1.4 -0.9 1.9 5.1 d. Public consumption 9.5 10.3 2.0 2.7 6.6 -2.3 0.1 -0.5 -0.9 -1.0 e. Investment 14.9 16.2 -16.8 -28.3 6.4 8.2 -12.0 -0.7 - - f. Exports 6.1 11.6 21.8 13.6 5.7 -4.0 1.5 12.2 Table 1. Continued 5. Relative price indices (1980=100) a. Real wage II 100.0 109.5 105.7 72.7 67.2 70.0 64.7 63.0 62.0 63.3 b. Real exchange rate 100.0 84.2 115.2 123.7 102.5 98.5 145.1 157.5 130.3 118.4 c. Terms of trade 100.0 106.5 103.2 96.5 97.2 96.3 63.8 - - - 6. External sector (millions of U.S. dollars) a. Trade balance -2,830.0 -4,099.0 6,795.0 13,762.0 12,941.0 8,451.0 4,599.0 8,433.3 1,754.3 -662.8 (i) Exports 16,066.0 19,938.0 21,230.0 22,312.0 24,196.0 21,663.0 16,031.0 20,656.2 20,657.6 22,746.9 (ii) Imports 18,896.0 24,037.0 14,435.0 8,550.0 11,255.0 13,212.0 11,432.0 12,222.9 18,903.4 23,409.7 b. Current account balance -8,162.0 -13,899.0 -6,218.0 5,419.0 4,238.5 1,236.7 -1,672.7 3,966.5 -2,442.6 -5,449.4 iz c. Current account (percentage of GDP) -4.4 -5.8 -3.7 3.8 2.5 0.7 -1.3 2.7 -1.6 -2.5 d. Change in international reserves 1,151.0 1,012.0 3,188.0 -3,117.0 -3,384.0 2,423.0 -132.0 6,929.4 -7,127.0 271.5 7. Public sector (percentage of GDP) a. Total expenditure 33.5 39.7 44.5 41.0 39.3 39.9 45.3 45.5 41.3 35.9 b. Expenditure excluding interest payments 30.0 34.7 36.3 28.6 27.4 28.4 28.7 25.8 24.5 22.7 c. Total revenue 26.9 26.7 28.9 32.9 32.2 31.2 30.3 30.6 29.8 30.5 d.Total deficit 6.6 13.0 15.6 8.1 7.1 8.7 15.0 14.9 11.5 5.4 e. Operational deficit 5.6 11.7 8.3 1.3 0.6 1.0 1.8 -2.0 4.5 1.7 f. Primary deficit# 3.1 8.0 7.4 -4.3 -4.8 -3.3 -2.2 -5.0 -5.9 -8.3 g. Domestic public debt 8.6 10.7 12.6 16.5 18.0 16.6 26.4 22.2 20.5 25.0 h. Foreign public debt 18.8 20.0 38.9 43.0 36.8 37.0 59.9 67.2 48.9 41.8 CPI, consumerpriceindex. - Not available. * Interestrate on loans is the averagecost of fundscompoundedannually. t Seigniorage = Ml(t)-Ml(t-I)/GDP(t). i Consolidated monetarysystemdomesticcredit is line 32 in IMF (variousyears). § Central bank domesticcredit is total claims on the governmentand privatesector less governmentdeposits. 11Real wage is the purchasingpower in relation to the overallconsumerpriceindex. # Primarydeficit= 7(b)-7(c). Source: Bancode Mexicoexcept: 2(e,f), 6(a,d) IMF (various years) 5(c), 7(e) World Bank (Comisi6n 4(b) CEPAL Econ6micapara AmericaLatina y el Caribe) 7(f,g)Bancode Mexico 1987 4(c,d,e,f) World Bank, National Accounts Data Base 1985-89 REC 1990 .1 5(a) Mexico National MinimumSalaryCommission low inflation are one obvious reason for this credibility problem; a second, less understood source of mistrust is the suspicion that the government might de- viate from the announced targets for the nominal anchor-the exchange rate or monetary rules-if wages and prices increase beyond the target level. The government's nonfiscal objectives (such as maintaining full employment or ex- ternal balance) could, in a discretionary regime, lead it to accept increases in inflation to avoid higher real wages, or to step up the rate of devaluation to avoid overvaluation of the domestic currency. (The use of inflation to achieve nonfiscal objectives is analyzed in detail in the literature on policy games; see Barro and Gordon 1983a and 1983b, among others.) How Does the Heterodox Strategy Address These Problems? What, in theory, are the virtues of the heterodox approach? The prevailing view in the literature (see, for example, Bruno and others 1988; Ocampo 1987; Alberro and Ibarra 1987; Blejer and Cheasty 1988; Heymann 1987; Cardoso and Dornbusch 1987; Fischer 1987; Solimano 1990) is that (1) price and wage controls can be useful to support disinflation initially when the inflation process displays inertia, (2) the initial costs of bringing down inflation in this way are usually small compared with those in orthodox programs, and (3) the success of a heterodox program in the longer term primarily depends on maintaining the fiscal adjustment (the orthodox part) throughout. But these studies provide only a partial evaluation of heterodox programs because they concentrate on the initial stage of the programs-the first or at best the second year. With this relatively short-term horizon, the evaluations have overlooked some of the longer-term consequences. From the medium- or long-term perspective, the first question to be an- swered is: how, if at all, does the early and rapid reduction of inflation through controls on wages and prices enhance the prospects for stabilization? We argue that the controls in the first phase can improve the fiscal accounts by reversing the fall in government revenue that usually accompanies an increase in inflation (the Olivera-Tanzi effect), and that the initial period of low inflation gives the government a grace period in which to prove its commitment to eliminating the budget deficit in a sustainable way. Second, what costs are entailed for later developments? A significant poten- tial cost, in our view, is the damage that the use of controls to avoid recession in the first stage of disinflation may do to the credibility of the government in the longer term. Will a government unwilling to accept the costs of bringing down inflation through orthodox methods be willing to accept these costs, and any difficulties associated with their deferment, later on? Incomes policies are controversial. Economists are skeptical about their use in stabilization partly because of their frequent misuse in populist programs to 44 The World Bank Research Observer, vol. 7, no. 1 (January 1992) bring down inflation while avoiding any adjustment in the fundamentals (see Dornbusch and Edwards 1989), and partly because they may distort the allo- cation of resources. In fact, many economists would argue that sustained elim- ination of the budget deficit is sufficient to bring down inflation; whether or not controls are used is irrelevant. The empirical evidence, however, shows that reducing the budget deficit is necessary but not sufficient for bringing down inflation in the short or even in the medium run. Price and wage controls are not necessarily the solution, but in some circumstances heterodox programs may be the right way to go. Dealing with Institutional Rigidities Incomes policies are included in heterodox programs to overcome the rigid- ities in inflation. Their usefulness largely depends on the causes of the rigidities. And they are not necessarily the most effective instrument to deal with this problem, because the long-term costs of their inclusion in programs could well exceed the short-term benefits reaped from overcoming the rigidities early on. When rigidity is ascribed principally to backward indexation-as in Brazil- an initial realignment of prices (to get the "right" set of relative prices) and wages accompanied by the elimination of indexation is all that is needed. A three- or four-month freeze of prices and wages is certainly not required to break this cycle. Once the right relative prices are in place and indexation is eliminated, any persistence of inflation must be attributable to other sources. But it is very hard to determine the right set of relative prices-even harder in low-inflation economies, where nominal contracts are long and staggered, than in high-inflation economies, where contracts are short and highly synchro- nized. There are examples of programs in low-inflation economies (such as the Krieger Vasena program in the 1960s in Argentina) that used fairly sophisticat- ed rules to avoid disparities in real wages across sectors, but the ensuing com- plications and misjudgments may outweigh the gains. The case for using incomes policies in low-inflation economies is weak. A stronger case can be made for using incomes policies in high-inflation economies, where decisions on prices and wages are synchronized and the risk that a freeze would create large disparities in relative prices and wages is cor- respondingly lower. A legitimate question is why an orthodox shock would not be equally or more effective, particularly given its proven efficacy in stopping hyperinflation. The answer is that there are other factors generating persistence of inflation, mainly lack ol credibility in the program, that are more acute when tackling chronic high inflation than when hyperinflation is the target (see Kiguel and Liviatan 1988). The problem of lack of credibility cannot be solved by a short wage-price freeze and a simple formula that gets relative prices right. Expectations wield a strong influence over inflation. Setting prices and wages involves making pre- dictions about future inflation that cannot simply be based on past inflation: Miguel A. Kiguel and Nissan Livia,tan 45 in forming their expectationsabout inflation, agents look at the whole history of inflation in the country-particularly such aspects as the outcome of previ- ous stabilization attempts (generallydismal) and the way in which inflation was affected by external shocks. Governmentsneed time to prove their com- mitment to sustaining a stabilizationprogram. In heterodox programs the ini- tial freeze lasts about six months. This indicatesthat the main motivation for the use of incomes policiesis to deal with credibilityproblemsrather than in- stitutional factors (such as backward indexation). Dealing with Expectational Rigidities FISCAL ASPECTS. When private agents have little faith in an announced fiscal adjustment, they will set prices accordingly.Their pessimisticexpectations are thus likely to maintain the momentum of inflation, leading to overvaluation, current account deficits,and other difficulties.Incomespolicies may then use- fully be introduced to counter the costs of these repercussions(see Perssonand van Wijnbergen1989).Since it takes time to demonstratethe commitment to fiscal adjustment, the controls will need to be in place longer than would be neededfor dealing with institutional rigidities.Ideally,by the time controlsare removed,the durability and extent of fiscal adjustment should be clearer. In the more successful programs the fiscal situation improved during the period of price controls. In the Israeli program the fiscal deficit turned into a surplus. A crucial move was the abandonment of a large, sacred aviation project--the Lavy-a measurethat few thought politicallyfeasible. The expe- rience in Mexico is somewhat different because the fiscal adjustment was largely complete before the program was launched. Nevertheless,the govern- ment introduced additional tax measures and continued its efforts to restruc- ture the public sector through privatization. In the successful Brazilian program of the 1960sthe fiscal accounts likewiseimproved during the period of controls. In the nonpersistent programs, the period of controls was not used to ad- vantage. In the Austral Plan, for example,the initial improvementin the fiscal and quasi-fiscalaccounts (that is, the operational balance of the central bank) was not sustained. To the contrary, initially the total budget deficitas a share of GDP was reduced from about 10 percent in the first half of 1985 to 2.5 per- cent in the second. This trend began to be reversed in the first half of 1986 (in the first quarter, the deficit exceeded 4 percent of GDP), and by 1987 the deficit already exceeded 6 percent. Although the fiscal deficit remained much smaller than before the Austral Plan, the reluctance to deal with the budget deficit once and for all perhaps reflected a corresponding reluctance to fight inflation persistently. The same deterioration of the fiscal accounts during the period of controls occurred in the Argentine and Uruguayan programs of the 1960s. 46 The World Bank Research Observer, vol. 7, no. 1 (January 1992) NOMINAL ASPECTS. Sound fiscal policies in the initial stage are essential to building credibility on the fiscal side, but they are of little help in establishing credibility on the nominal side. Because the nominal anchor (the exchange rate) can easily be maintained for a short time, especially when prices and wages are frozen, the private sector has no guarantee that the government will continue to defend it in the face olf adverse expectations once price controls are lifted. In other words, the controls postpone the establishment of credibility on the nominal side: the government can demonstrate its commitment to the nominal anchor only once prices are freely determined. The key to the credibility of the nominal anchor is whether the government will maintain its rules for it if confronted by persistent inflation arising from adverse expectations. Increases in prices and wages do not necessarily take place because private agents expect the initial improvement in the fiscal ac- counts to be reversed. Such increases could equally occur because producers, who set nominal prices in advance for fixed periods, fear that these prices might be eroded through an unannounced devaluation in order to increase em- ployment or improve the balance of payments-a justifiable anxiety, because this was precisely the strategy used in the past to deal with adverse external shocks (for example, in Brazil and Mexico in 1982-84). The problem is gener- ally exacerbated because it is difficult to know in advance when and how much the government is willing to compromise in order to reduce the costs of disin- flation. The perception that the government might deviate from the announced tar- get for the nominal exchange rate was perhaps most clear during the Pacto in Mexico. The policy adopted there was to announce the values of future ex- change rates for a period of about six months. When the period was about to expire, a new rule was announced for the next half year. Nominal interest rates have nevertheless remained very high-certainly above international levels- reflecting the perceived risk that the government would deviate from the an- nounced exchange rate policy. This expectation was probably not directly re- lated to a fiscal problem (since the operational budget deficit remained small, and the surplus in the primary fiscal balance was sustained), but rather re- flected skepticism that the exchange rate rule could be maintained in the face of persistent deterioration in the current account of the balance of payments (see table 1). (This deterioration in the current account is characteristic of ex- change rate stabilizations; see Kiguel and Liviatan forthcoming) 3 Far from solving the credibility problem with regard to nominal anchors, in- comes policies could exacerbate it. The early use of controls could be read by the private sector as a signal that the government is not willing to stick to the rules for the nominal anchors (for instance, to the exchange rate rule) if con- fronted with adverse expectations. This type of credibility problem requires that the government demonstrate its willingness to absorb the costs-overval- uation and recession-associated with defending the nominal anchors. Miguel A. Kiguel and Nissan Liviatan 47 How Effective Is the Heterodox Strategy? A feature common to all the programs considered above is that, regardless of whether they effect any fiscal adjustment, inflation comes to a halt almost immediately. Figure 1 illustrates that this phenomenon is observed in serious programs (such as those in Israel and Mexico), nonpersistent programs (the Austral Plan, the Krieger Vasena program, and the Uruguayan program of 1968), and populist programs (the Cruzado Plan and the Peruvian program of 1985). The initial effect on inflation therefore has nothing to say about the sustain- ability of the stabilization; the indications must be sought in other macroeco- nomic variables. Populist programs are easy to recognize because of the expansionary monetary and fiscal policy and unusually large increases in real wages (detailed in Dornbusch and Edwards 1989). Persistent and nonpersistent programs are harder to distinguish, as Blejer and Liviatan (1987) illustrate in their comparison of the outcomes during the first year of the stabilization pro- grams in Argentina and Israel of 1985. Within that time frame they conclude that "the programs were similar in their designs and their effects" (p. 409). The similarities, which were especially strong during the first three quarters of the two programs, include policy variables such as the budget deficit and the nom- inal exchange rate and endogenous variables such as real money balances, in- terest rates, real wages, the real exchange rate, the premium for the black market exchange rate, unemployment, industrial production, and the trade balance. Likewise, both the Krieger Vasena program in Argentina and the Uruguayan program of 1968, which were eventually abandoned, started in a very promising way and remained sound for a relatively long time (about two years). Both seemed to have a reasonable chance of success initially, and the outcomes were very similar to the more successful Brazilian program of the 1960s. Although the differences between persistent and nonpersistent programs become clearer over time, it is not always easy to distinguish them in the early stages. That governments abandon programs despite the quite substantial costs of failure is puzzling. It may be that policymakers underestimate the costs of dis- inflation and abandon the programs once they recognize their mistake. Or po- litical support for stabilization may be substantial when inflation is high but evaporate once specific groups are hurt by policies-such as budget cuts- introduced to maintain price stability. The uncertainty about whether a program will be sustained exacts a cost. Agents will always consider failure possible to some extent-a credibility prob- lem that will be reflected in high interest rates or overvaluation of the domestic currency. Both Israel and Mexico have faced a real appreciation during the sta- bilization process. They have also faced high real interest rates for a protracted period. 48 The World Bank Research Observer, vol. 7, no. 1 (January 1992) Advantages of the Heterodox Controls One potential advantage of the heterodox strategy over the money-based or- thodox strategy is that the initial costs of reducing inflation are low. Other ben- efits are the gains from reversing the Olivera-Tanzi effect, the improvement of fiscal credibility, and the possibility of adding momentum to the program as a whole. Low INITIAL COSTS. The relatively small initial costs of bringing down in- flation in heterodox programs contrast with those of money-based orthodox stabilization programs such as the Chilean program of the mid-1970s. The costs in that program came early on in the form of a deep recession and massive unemployment. CSee Edwards and Edwards 1987 and Corbo and Solimano 1991 for a description of this program.) In heterodox programs the costs of stopping inflation usually appear later. The first stage, when tight controls are in place and inflation falls at little or no cost in terms of unemployment, is the easy part. The problems start when controls are relaxed, and the appreciation of the domestic currency leads to a deep recession, to a loss of competitiveness that hurts the export sector, and to the high interest rates necessary to maintain attractive rates of return on do- mestic assets to avoid capital flight. The difficulties for disinflation arise because the overvaluation that took place during the expansionary period needs to be corrected without losing con- trol of the main nominal anchor: the exchange rate. A large devaluation could restore competitiveness but might erode confidence in the government's deter- mination to sustain the stabilization program. Such a devaluation could be held to indicate that the government is not prepared to pay the price of overvalua- tion and would rather accept rekindled inflation. Both of the successful heterodox programs of the 1980s experienced overval- uation. Both have continued to use the exchange rate as the nominal anchor, but neither the Israeli device of unannounced step devaluations to avoid further appreciation nor Mexico's preannounced crawling peg has successfully solved the problem of overvaluation. REVERSING THE OLIVERA-TANZI EFFECT. With regard to fiscal matters, hetero- dox programs can derive advantages from the Olivera-Tanzi effect working in reverse-a consideration particularly important in countries where inflation is high. These gains are hard to quantify: in Israel they were estimated to be about 1.5 percent of GDP; under the Austral Plan at about 2 percent of GDP. There were additional gains, especially in the Austral Plan, from raising prices for public enterprises at the outset to levels that greatly improved the finances of these firms. Though potentially important, the benefit from a reversed Olivera-Tanzi effect should be treated with caution because it is not a true signal of the fiscal Miguel A. Kiguel and Nissan Liviatan 49 effort. A program that relies solely on this effect for fiscal improvement is likely to fail, since the deficit will remain low only if the government succeeds in keeping inflation down. Any shock that destabilizes inflation will increase the deficit, making the inflation process self-sustained. Furthermore, to the extent that public sector enterprise prices are not adjusted during the period of con- trols, their finances will deteriorate. The gains from the reversed Olivera-Tanzi effect should therefore play a relatively small part in the fiscal adjustment. In Israel, for example, the effect was responsible for approximately a quarter of the improvement in the fiscal accounts; in Mexico its impact was negligible. In the Austral Plan, by contrast, much of the improvement in the fiscal accounts came from the reversed Olivera-Tanzi effect, in conjunction with the increased prices in public sector enterprises. IMPROVED FISCAL CREDIBILITY.The initial fall in inflation can help establish fiscal credibility in two ways. First, as mentioned earlier, the government can use the freeze to prevent a persistence in domestic inflation (due to lack of credibility) that would lead to distortions in relative prices, while it performs the fiscal adjustment. Second, low inflation makes it easier in practice to calculate the size of the budget deficit and in this sense it can make this pro- cess more transparent (see Tanzi 1989). It is hard to know the size of the budget deficit when inflation is high-for one thing, there is more room for using accounting tricks to mask the true state of the fiscal accounts. Sharon (1990) argues that in Israel the reduction in inflation was instrumental in keeping track of what was happening in the fiscal accounts. High inflation also complicates calculation of real interest rates, since these depend on the choice of the deflator (which could be the actual or the expected rate of in- flation). ADDING MOMENTUM TO THE PROGRAM. A fourth possible advantage of the heterodox approach is that the initial fall in inflation might spur the introduc- tion of additional measures to strengthen the program. Spending cuts or tax increases may be harder to accept while inflation remains high than when they are seen to support a reduction in inflation that has already taken place. Support for the Alfonsin government during the first months of the Austral Plan, for example, was widespread enough to sustain intensified fiscal reform. The government failed to seize this opportunity however, perhaps because it thought that the initial fall in inflation could be maintained without further action. The experience of the Austral Plan indicates that the quick reduction in in- flation could work in one of two ways: it could help advance the adjustment if the government is determined to undertake it, but it could equally postpone adjustment if the early, transitory success is taken as evidence that stabilization is there to stay. 50 Observer,vol.7, no. 1 (January1992) The WorldBank Research Disadvantages of the Heterodox Controls The criticisms most cormmonly advanced of the heterodox strategy are that (1) the controls could become a substitute for fiscal adjustment; (2) the controls could lead to misallocation of resources; (3) once in place, the controls are dif- ficult to remove; and (4) it is particularly difficult to assess progress. SUBSTITUTING FOR FISCAL ADJUSTMENT. The initial improvement in inflation and the small unemployment costs can create complacency about fiscal condi- tions, and this complacency may undermine the success of the program. Popu- list programs are a glaring example of the attempt to gain price stability without fiscal adjustment. In the Cruzado Plan and the Peruvian program the combination of controls with expansionary policies that created generalized ex- cess demand for goods and services rapidly led to repressed inflation, wide- spread shortages, and the emergence of black markets. In the end, of course, prices exploded. In Peru this led to hyperinflation; in Brazil to an outburst in inflation that was checked by a new round of controls. Fiscal overadjustment is helpful in underscoring the intentions of the gov- ernment. The case for overadjustment is developed more fully in Rodrik (1989) in relation to trade liberalization programs. Because populist programs abuse controls, heterodox prograLms need to take a tighter fiscal stance to show that they mean business. In addition, the fiscal overadjustment supports a situation in which supplies must be excessive overall in order to avoid shortages during the period of controls. In practice, the differences between heterodox and pop- ulist programs became apparent shortly after the programs were launched. Key differences were the attitude toward real wages and toward the importance of fiscal (and sometimes monetary) policy, and the fact that generalized shortages were averted in heterodox programs. Persistent and nonpersistent programs were not distinguished in this way, because shortages did not arise in either of them, and real wages in both followed a similar course. MISALLOCATION OF RESOIJRCES. In our view, this disadvantage of the hetero- dox strategy is less important than the others. The criticism that wage and price controls lead to misallocation of resources is valid for countries that use controls in the long term, but weaker for countries that adopt heterodox pro- grams, which use controls only temporarily. In addition, in most heterodox programs (even the nonpersistent ones) controls were not rigorously imposed: although firms were not free to increase prices without prior government au- thorization, they were authorized to raise prices whenever it was clear that their prices were out of line with costs. TENACITY OF CONTROLS. The criticism that controls are hard to remove once they are in place is valid for heterodox programs. It applies also more generally to programs that announce rules for nominal variables (especially the exchange Miguel A. Kiguel and Nissan Liviatan 51 rate). Exchange-rate-based stabilizations typically fix the exchange rate for longer than was originally intended. The problem arises because a departure from the original rule could be interpreted as a signal that the government is abandoning its nominal policies. The outcome is a period of overvaluation, with its well-known costs. In programs that start with price controls the two problems go together. The Uruguayan program of 1968 provides useful insights in this respect (see Finch 1979; Viana 1988). The program, like other heterodox programs, started with a reduction in the budget deficit, a fixed exchange rate, and a price and wage freeze. The fiscal and external situations deteriorated over the years, and after some time it was clear that adjustments were needed in the program. These adjustments were postponed mainly because, with elec- tions imminent, the authorities were reluctant to free prices and wages and de- value the exchange rate. Eventually and inevitably, the program collapsed with maxi-devaluations and record levels of inflation. The lesson is that even pro- grams that appear to be heterodox early on may deviate from their original intent. DIFFICULTIES IN ASSESSING PROGRESS. It is always hard to predict at the outset whether a stabilization program-orthodox or heterodox-will succeed. In Bolivia, for example, the orthodox stabilization of August 1985 that brought hyperinflation to a halt followed unsuccessful stabilization efforts that had not differed greatly. And even this successful program confronted a serious reversal toward the end of the year, when hyperinflation briefly reemerged. The difficulty is compounded in heterodox programs by the fact that low inflation is maintained through controls. In the absence of prices determined in the markets, it is harder to discern whether the program is working because the fundamentals are in order and low inflation is there to stay, or because con- trols are in place. The answer has to wait until controls are removed and in- flation finds its new equilibrium. In the meantime, the credibility problem is bigger in a heterodox program. The Role of Controls: A Reassessment The role of controls in heterodox stabilization programs poses something of a puzzle. The fact that controls do not lead to shortages or marked distortions in relative prices could be taken as evidence that they are not binding-and if they are not binding, why are they needed? Before answering this question, it is useful to point out that programs in countries with chronic inflation that did not use controls have always failed to reduce inflation sharply in the short run. In contrast, the quick and drastic reduction in inflation observed in heterodox programs shows that controls played an important role. In our view, controls in the initial stage in heterodox programs are a coor- dinating device in the movement to low inflation (see Dornbusch and Simonsen 52 The World Bank Research Observer, vol. 7, no. 1 (January 1992) 1987). The literature on the inflation tax (for instance, Bruno 1989 and Bruno and Fischer 1990) provides a useful framework in which to analyze this issue. Consider an economy that initially is in a high-inflation equilibrium and at full employment, where expectations are being fulfilled and the government is using the revenue from money creation to finance its budget deficit. The Bruno and Fischer studies show that two equilibria can be consistent with the same budget deficit. If the economy is initially at the high-inflation equilibrium, controls could be used to move the economy to the low-inflation equilibrium-a move that does not require in principle any change in the budget deficit. Controls thus act as a coordinating mechanism: the announcement that controls are in place could be enough to reverse inflationary expectations, thus allowing the economy to remain in the low-inflation equilibrium. In this exercise shortages do not occur because there are no pressures that would create excess demand and the economy remains at full employment. The idea that controls worked in heterodox programs because they repressed inflation (as in populist pro- grams) is largely misleading. Controls acted as a shock treatment, as a guide- line for a prompt downward revision of inflationary expectations, and this was at least credible in the short run. The analytical framework discussed above tells only part of the story be- cause it assumes that once the initial difficulty-moving to the low-inflation equilibrium-is surmounted the economy will tend to stay at equilibrium. Bruno argues that the low-inflation equilibrium can be made stable in this way if it is supported by an appropriate fiscal adjustment. We know, however, that there is an additional difficulty in sustaining low inflation: the issue of the cred- ibility of nominal anchors. The initial reduction in inflation is only the begin- ning; persistence is needecl to sustain stabilization. When Are Heterodox Programs Appropriate? Heterodox programs are appropriate in a limited number of cases. On the "not recommended" list are, first, countries with low inflation that suddenly experience an outburst of high inflation. Examples are Costa Rica and the Philippines in the early 1980s. Both countries traditionally had low inflation but experienced a short inflationary spiral following devaluations undertaken in response to the debt cr'isis. Generalized price and wage controls are not a good idea in such instances because inflation is correctly perceived to be tem- porary. The expectational component in the inflation process does not become important, and the episode can therefore be treated with orthodox remedies. The speed with which inflation was brought down in Costa Rica and the Philippines illustrates that this was indeed the right approach. Hyperinflation is a second case in which the orthodox strategy is preferred. Because in these episodes inflation is explosive and does not display inertia, in- comes policies are not necessary to restore price stability (see Kiguel and Miguel A. Kiguel and Nissan Liviajan 53 Liviatan 1988). Finally, the orthodox approach is also preferable in economies in which inflation rates are low or moderate-somewhere between 20 percent and 40 percent. In these economies, generalized controls are unlikely to gener- ate a large reduction in inflation principally because contracts are typically long and staggered, whereas in high-inflation economies they are short and highly synchronized. A freeze would leave great disparities in relative wages and pric- es, penalizing those with the oldest contracts. The problem is difficult to handle in practice, because so much information is required, 4 The single situation in which the heterodox strategy may be useful, then, is in economies suffering from chronic high inflation, such as those that opted for this policy in the 1980s. There is a caveat, however: launching a heterodox pro- gram that is later abandoned can be dangerous-more costly, even, than simply postponing stabilization. The failure of the Austral Plan and of other programs that relied on incomes policies, such as the Cruzado Plan, illustrates these risks (see figures lc and Id). In both, the failures were followed by a period of unstable inflation that ended up in hyperinflation (see Kiguel and Liviatan 1990b). These similarities were not accidental. In our view, the cycles of inflation and stabilization were the result of the repeated use of incomes policies as a stabilization instrument fol- lowing the failure of the plans. *rheprograms, in demonstrating that controls can effectively stop inflation in the short run, set the stage for the recurrent use of incomes policies. But once the private sector began to anticipate this policy, it started to inflate prices to forestall the damage a price freeze might do to profits. These reactions further destabilized inflation, leading ultimately to hy- perinflation in both countries. The traditional hyperinflations, such as those of Europe in the 1920s and more recently in Bolivia, were primarily a fiscal phenomenon; the hyperinflations in Argentina and Brazil in 1989 and 1990 are more directly attributable to the failure of the heterodox experiments. The outcomes differed as well: neither Argentina nor Brazil succeeded in stopping hyperinflation in its tracks, despite using the same kind of orthodox prograrn (based on very tight monetary policy and a significant fiscal adjustment) that had succeeded in the traditional episodes. Thus the heterodox era added a new chapter to the history of failed attempts to check inflation in Argentina and Brazil. The lesson is that the heterodox strategy offers a one-time opportunity which, if handled properly and persever- ingly, could lead to lasting stability--though not without costs. Misused, the controls will impede rather than facilitate the task of stabilization. Notes Miguel Kiguel is on the staff of the Country Economics Department of the World Bank; Nissan Liviatan is a professor of economics at the Hebrew University, Jerusalem. The authors are grateful to Jariya Charoenwattana for her valuable research assistance. 1. In disinflation programs, the path of a nominal variable, typically money or the exchange rate, is announced to influence the evolution of prices. This variable is the nominal anchor. 54 The World Bank Research Observer, vol. 7, no. 1 (january 1992) 2. The primary balance is defined as the difference between total revenue and noninterest ex- penditure. The operational balance is the primary balance minus the real cost of servicing the public debt. 3. In Mexico the deteriorationi was perhaps larger because the stabilization program was ac- companied by liberalization of international trade. 4. It is surprising that Tobin (:1987)does not recognize these difficulties, and many of the other difficulties analyzed in this article, when he makes the case for incomes policies for the United States. The idea that there are costless ways of bringing down inflation is naive. 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