JIMENEZ: What are the chief effects of excess volatility?
HAUSMANN: Empirical evidence suggests that excess volatility is bad for growth, bad for investment, and bad for the poor. Because the poor are typically less able to cope with high volatility, volatility tends to increase poverty and worsen income distribution. In terms of educational achievements, data at both macro and micro levels suggest that during shocks children leave school, lose time, and often don't return after the shock is gone. Education is but one example. There is convincing evidence that excess volatility is bad for all the important dimensions of development we care about.
JIMENEZ:You suggest that there is a relationship between volatility in macroeconomic policies and volatility in macroeconomic outcomes. How does this correlation work?
HAUSMANN: Policies and outcomes are deeply intertwined. In a typical industrial country, the volatility of fiscal revenues and spending implies a fiscal balance that can have an unexpected deviation, or "surprise," of about 1 percent of GDP a year. In a developing country, it is more like 3 percent of GDP a year. Now in industrial countries, the financial system is about 100 percent of GDP on average, so a typical fiscal shock is about 1 percent of a financial system. In developing countries where the financial system may be more like 20 or 30 percent of GDP, a 3 percent of GDP shock represents something like 10 to 15 percent of the financial system.
It is thus much harder for a developing country's financial system to cope with a fiscal shock. The monetary disturbance it will generate would be much larger, probably too large to be digested purely at home without major macro disruptions. In these circumstances, it is going to be so much more important that developing country governments develop the capacity to address the effect of shocks by borrowing abroad. If they cannot, these shocks can create enormous pressures on monetary policy and lead to inflation and exchange rate instability.
This is one example of how, in developing countries, the interaction of risks with limited financial markets can multiply volatility, while an industrial country would be in a position to cope with it relatively easily.
JIMENEZ: Why do developing countries lack the mechanisms to cope with volatility? How can they create them?
HAUSMANN: The absence of coping mechanisms has to do with incomplete and weak insurance and financial markets. There is a potential vicious circle, too, because high volatility may make it harder for these markets to develop.
To begin to remedy this, we have to better understand the sources of volatility. In some countries, it may be that budget institutions don't ensure a stable and sustainable management of government spending and...