I have dedicated many years to thinking about the causes and consequences of macroeconomic volatility and about the policies to tame it. This is an issue that is close to my heart because Venezuela has one of the most volatile macro-economies in the world in terms of the instability of output, inflation, the real exchange rate and so many other important economic variables that affect welfare, growth and inequality.
My first major report as Chief Economist of the Inter-American Development Bank (IADB) was entitled Overcoming Volatility. The idea is that volatility is the consequence of a country’s policy framework and of the impact of this framework on the way a country absorbs shocks, such as changes in the terms of trade, weather events or elections.
This led me to study the pro-cyclicality of policies on all fronts. With Michael Gavin, Ernesto Talvi and Roberto Perotti I explored the pro-cyclicality of fiscal policy. With Michael Gavin I explored the issue of bank credit booms and crises. With Alberto Alesina, Rudi Hommes and Ernesto Talvi, I explored the role of budget institutions in determining fiscal outcomes. Finally, I worked on the implications of budget institutions for macroeconomic volatility in the 1997 flagship report of the IADB and published a book with the OECD on the same topic.
The work on fiscal procyclicality led to an important finding: some countries have procyclical policies because their ability to borrow is also procyclical: they have market access in good times and not in bad ones. Why? The hypothesis I explored led me to the work on debt denomination and original sin. Countries that have a net foreign debt and cannot denominate it in local currency tend to adopt more rigid exchange rates, accumulate more foreign international reserves, have lower credit rating than their fiscal fundamentals would justify and face more volatile output and capital flows. In a recent paper with Ugo Panizza we showed that the recent improvement in emerging markets is due to the fact that they are borrowing less, not to the fact that they can now borrow in their own currency.
With Ugo Panizza and Roberto Rigobon I explored the causes of the excess volatility of developing countries. We found that it is not due mainly to the fact that they face larger external shock, but to the fact that they are less resilient to them. With Roberto Rigobon, I developed a theory of the resource curse based on the idea that the volatility of commodity prices leads to a volatile real exchange rate that makes investment in other tradables more risky and leads to inefficient specialization. In a paper with Francisco Rodriguez and Rodrigo Wagner we showed that Growth Collapses are associated with external shocks that are received by countries poorly positioned in the Product Space.
Related Publications: Economic and Social Progress Report 1995: Overcoming volatility, The Long-Run Volatility Puzzle of the Real Exchange Rate, Macroeconomic volatility and economic development