The importance of luck, timing, and political institutions
Countries experiencing high inflation typically make several disinflation attempts, some of which succeed only temporarily. Perhaps the best-documented cases of failed stabilizations are in Latin America: the Southern Cone tablita experiments of the late 1970s and early 1980s (the authorities preannounced the currency's rate of depreciation in an effort to guide inflation expectations) and the heterodox programs of the mid-1980s (stabilization efforts were supported by price and wage controls). At the same time, some Latin American countries- like Bolivia in the mid-1980s and Nicaragua and Peru in the early 1990s-have enjoyed spectacular success. Outside Latin America, Israel's stabilization in the mid-1980s is a well-known success, and Iceland, having failed to tame inflation in the mid-1970s, finally succeeded in the mid-1980s.
To our knowledge, there has been only one attempt to identify empirically the reasons many disinflations ultimately fail (Francisco José Veiga's 1999 article, "What Causes the Failure of Inflation Stabilization Plans?" in the Journal of International Money and Finance). We therefore undertook a study of 51 stabilization episodes (see box and table). Our focus on the durability of stabilization and the scope of our study-in terms of sample size and the range of questions addressed-distinguish our analysis from the rest of the literature on disinflation. We found that luck, initial conditions, and political institutions were the most important factors in the success or failure of disinflation. The evolution of nonpolicy macro variables-such as the real exchange rate, GDP growth, and international reserve levels-and policy variables-such as monetary and fiscal adjustment-played a lesser but still important role. This finding may reflect the fact that macroeconomic adjustment itself depends on initial conditions and political factors and should not be interpreted as meaning that macro policies are not important.
If a country trying to stabilize prices and wages is unlucky enough to be exposed to severe external shocks-for example, a decline in demand for its exports-during its disinflation, the likelihood of failure is increased. A shock such as an increase in U.S. interest rates makes failure more likely for a country with an open capital account. These variables remain statistically significant after controlling for nonpolicyPage 13 and policy variables, suggesting that external shocks have effects beyond those that operate through domestic macroeconomic variables. Luck is thus an important factor in the eventual success or failure of a stabilization program.
The path of inflation
In countries whose stabilization programs did not meet Criterion 1 and were thus deemed to have failed (see box and table), inflation rebounded after a year.
[ SEE THE GRAPHIC AT THE ATTACHED PDF ]
The key role of prestabilization conditions confirms several predictions made in the theoretical literature on inflation stabilization, including some that, at first glance, may seem counterintuitive.
Past failures reduce the chances of success. Countries with a longer history of high inflation at the start of a stabilization program are more likely to fail. This seems to support the theory that long-lived inflation fosters the development of institutions...