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Finance & Development
A quarterly magazine of the IMF
March 2007, Volume 44, Number 1

People in Economics

A Master of Theory and Practice

James L. Rowe interviews economist Guillermo A. Calvo

When Guillermo Calvo was a young student in Buenos Aires in the late 1950s, he despaired of ever understanding economics. There was a lot of talk about economics at home because his father worked for the central bank. But as much as he tried to make sense of it, he couldn't, at one point concluding that economics was beyond him. Still, he persevered, and during an introductory economics course, he said, he "suddenly began to understand and to see how beautiful it was." Later, at the direction of Julio Olivera, then head of research at the central bank where Calvo won a competitive appointment, he repaired to the bank's library, an English dictionary at his side, and he read and read and read dense economic and mathematical treatises written "in a language I hardly knew."

His perseverance paid off. Calvo became one of the preeminent scholars of both modern macroeconomic theory and the economics of emerging markets, especially those in Latin America. Speaking at an IMF conference to honor Calvo in 2004, Andrés Velasco, then a Harvard professor, now Chile's finance minister, said that if there was a single "person responsible for bringing modern economics to bear on the problems of the nations south of the Rio Bravo, that person is Guillermo Calvo." Calvo's early theoretical work was in the thick of the three developments that economists V.V. Chari and Patrick J. Kehoe recently identified as the keys to improved macroeconomic theory over the past 30 years: the critique that incorporated people's expectations about policy, insights into time inconsistency and its attendant credibility issues, and better modeling of the economy to account for such distortions as "sticky prices."

Calvo's later policy messages have been ominous and often at odds with many of his colleagues, especially during the prosperous period of the early 1990s, when most economists—including those at the IMF, where Calvo was then in residence—believed that how well a country conducted its economic policies determined how well it was treated by foreign investors. The conventional wisdom then was "that if you do your homework, the capital markets will always be on your side," Calvo said.

But he and several IMF colleagues, including Carmen Reinhart and Leonardo Leiderman, disagreed. They argued that countries were not being showered with foreign financing because they were running sound monetary and fiscal policies, but because external factors, such as a benign global environment and low U.S. interest rates, sent capital in search of a higher return. Were those external factors to change, they postulated in a controversial 1993 paper, investment in emerging market countries—whether abstemious or profligate—could suddenly turn tail.

Not long after, the global environment did change, and Calvo and his colleagues proved largely right. Starting with Mexico in 1994 and ending with Argentina in 2001, a string of emerging market countries, many of them in Asia, were rocked by what he has dubbed a "sudden stop"—a large, unexpected, and widespread interruption in capital flows, often unrelated to economic fundamentals (see box). As a result, policymakers in developing countries learned a painful lesson: they would almost assuredly fail to attract foreign investment if they followed bad policies, but there was little assurance that they would not face the same fate if they followed good ones. The New York Times quickly dubbed Calvo a "prophet of financial doom" for accurately predicting Mexico's 1994 collapse. And although his latest paper examines "recovering" economies, Calvo, at 65, remains as focused as ever on the potential for emerging market crises.

The name of the game

Guillermo Calvo and colleagues have shown a knack for coining or popularizing phrases that have been incorporated by economists and even nonspecialists:

Sudden stop: A large, unexpected, and widespread collapse in capital flows that is often unrelated to the economic fundamentals of a country and is usually highly damaging. Sometimes the phenomenon is abbreviated as "3S," for systemic sudden stop, to emphasize the widespread nature of the problem during crises.

Fear of floating: Aversion by a country to allowing the market to determine the value of its currency (freely float) because so many companies and individuals have assets and liabilities denominated in dollars that a depreciation in the currency would seriously hurt those who had not hedged their positions. The term originated in a paper of the same name that Calvo and Reinhart wrote in 2002.

Phoenix miracle: An economy that "rises from the ashes" of an output collapse caused by a sudden stop. Generally the economy regains its precollapse output level within two years but does not return to its long-run growth path. The name derives from the mythical bird that was consumed in flames and reborn from its ashes.

Straddling academia and policy

During his 30-year career, Calvo has moved back and forth between academic and policy-oriented organizations. At the end of 2006, he opted to leave the policy fray again, resigning after six years as chief economist for the Inter-American Development Bank (IADB), to return—along with his economist wife Sara—to Columbia University in New York, where he began his academic career three decades ago, a freshly minted Ph.D. from Yale University. Over the years, he has also been a professor at the Universities of Pennsylvania and Maryland, with research appointments and visiting professorships sprinkled in. He long has had a weighty influence on the policy debate—from the IMF, the IADB, and academia. Yet Calvo has had but one formal brush with policymaking, as an adviser to Argentina's finance ministry in 1996, and it lasted only two months.

Calvo's research agenda is generally regarded as being divided into two chapters. For the first half of his career, he was a theoretician inspired by the world around him; for the second half, a policy-oriented economist with a theoretical bent.

Pablo Guidotti, dean of the school of government at Universidad Torcuato Di Tella in Buenos Aires and a former IMF colleague, calls Calvo "a very theoretically minded economist who likes simple and elegant models." As Calvo himself puts it: "My rule is always simplify, simplify, simplify. After all, we're making models. It's not reality."

Still, Calvo's muse has always been reality, according to Ernesto Talvi, head of the Uruguayan research institute Ceres. He never made theory for theory's sake. Even Calvo's first paper, a highly theoretical note on capacity utilization that appeared in 1975 in the American Economic Review, was sparked by conditions in Colombia, where he had lived several years before.

Sometimes noneconomic issues can motivate Calvo's theorizing. It was a game he played with his siblings that Calvo said was one source of inspiration for his 1978 contribution to the then-nascent study of time inconsistency—a concept that explains how well-meaning policymakers can still make bad policy. Calvo recalled that, as a child, when he would show his brother and sister pictures of himself when he was younger and ask, "Who's this?" they would say, "That's you." He would reply, "No it isn't," explaining that now he was a different person in different circumstances from when the picture was taken. "It was very clear that you could think of human beings as a sequence" of incarnations, and that made it easy for him to understand how policymakers could undermine their long-term strategy. That's because the official making the decision today is facing different
conditions than when he made the initial promise.

In 1977 Edward C. Prescott and Finn E. Kydland showed that a government that sets down a long-term policy plan (monetary or fiscal) will, if it has the chance, probably change its plan later to reflect changing circumstances. A year later, Calvo, working independently of Prescott and Kydland (who in 2004 won a Nobel Prize in part for their work on time inconsistency), showed that the government is likely to make these inconsistent discretionary decisions "even though the government has exactly the same preferences" as the public.

For Calvo, the important point is that, by attempting to make the best discretionary decisions at any given time—"reoptimizing," as economists put it—policymakers can subvert their good long-run policy promises, causing them to lose credibility. That's because once they deviate from their commitment, say, to an anti-inflation strategy, no matter how good their reasons, the public no longer believes them. People's expectations change and then they act to protect themselves, say, by demanding higher interest rates in anticipation of higher inflation. That forces policymakers into further self-defeating steps that can leave a once-good long-run policy in shambles.

Time inconsistency—with its effect on expectations and credibility—isn't a major issue in advanced economies, Calvo said, but "most economists would agree that it is central to emerging markets" and, in fact, "helps explain why countries have hyperinflation." As a result of the theoretical work on time inconsistency, many nations have reduced the amount of discretion allowed decision makers—making central banks more independent of politicians and adopting publicly stated inflation targets and stability goals from which it is hard to deviate.

The next major challenge Calvo faced was making sense of developments that did not square with prevailing general equilibrium theory, which uses mathematical equations to show how the entire economy works together. Argentina—whose manifold economic crises have regularly inspired its native son—sharply devalued the peso in 1981. Prices should have changed in response, but they did not. As he tried to understand why, Calvo turned to models developed by Columbia colleagues Edmund Phelps and John Taylor. Their models, which Calvo had earlier dismissed, tried to incorporate so-called sticky prices and wages, which resist change even if underlying conditions change. Calvo initially found the models "too complicated" but later "simplified them in such a way that it became a child's game" to account for sticky prices in a general equilibrium model. The 1983 paper took a while to take root, he says, because colleagues kept trying to explain developments using the standard model with flexible prices and wages. But by the 1990s, MIT's Roberto Rigobon said, Calvo's model had become the "workhorse" of macroeconomics.

Time inconsistency and incorporating sticky prices in general equilibrium theory may represent Calvo's most important contributions to macroeconomic theory, but his interests were wide and he "wandered all over the economic landscape," said Carlos Rodriguez, a Columbia University colleague in the 1970s and now president of Universidad del CEMA in Buenos Aires. Calvo produced theoretical papers on, among other things, capacity utilization, hierarchical ladders in organizations, structural unemployment, international trade, real interest rates and real exchange rates, and even the economics of justice.

Finding his voice

In 1986, after 13 years at Columbia, Calvo moved to the University of Pennsylvania. But it was a short-lived change of scenery. Jacob Frenkel, then the IMF's research director, enticed Calvo to move to the IMF, where, between 1988 and 1994, he wrote numerous papers on exchange rates, emerging markets, and the post-Soviet transition in Eastern Europe from command economies to ones more market-oriented. It was at the IMF that Calvo's interest in policy issues was triggered, many of his colleagues say. But he demurs a bit. "It took me a long time to find my own voice. I was always concerned about these policy issues, but I didn't have what it takes to do it by myself. The IMF gave me the opportunity to work in an environment, where, because it's a bureaucracy, you tend to collaborate more. Cooperation is key. I was coming from academia, where competition is the word, where being unique and original is what is prized."

At the IMF, he collaborated with a number of mainly younger scholars—among them Carlos Végh, Enrique Mendoza, Guidotti, Leiderman, and Reinhart. With Guidotti, he worked on public debt issues, which led to his later work on liability dollarization. With Végh, he perfected the sticky price model. And with Mendoza, he worked on trade issues. "They were known as Calvo's boys and girls," said Talvi, a more recent collaborator who was not an IMF colleague.

None of Calvo's boys and girls complemented his skill set better than Reinhart—now a University of Maryland professor—whom he calls "a wonderful applied econometrician and a first-rate economist." The two collaborated on a number of projects, including the 1993 paper they wrote with Leiderman that challenged the prevailing belief that Latin American countries were receiving large capital inflows thanks to structural reforms and sound monetary and fiscal policies.

"I went to Latin America, and everybody was saying the same thing—that money was flowing in because [countries] were doing the right thing. But Peru was getting a lot of money and it had the Shining Path [insurgency]. And some countries had fixed exchange rates, while others floated. So, I looked around and thought: Something's fishy here. Everybody's getting money and they're doing things that are very different, and don't tell me that all of them are in good shape." Calvo returned to Washington and told Reinhart he was convinced there was a common factor and that it was external. They enlisted Leiderman and the three went after the "usual suspects": U.S. interest rates and the business cycle. And as Calvo puts it, "Everything kept falling into place."

That the IMF published their paper (and subsequent research in the same mode) was not an indication that the institution endorsed the conclusions. In fact, Calvo says, the three of them got "a lot of flak" from colleagues. But, sure enough, U.S. interest rates began to rise and in December 1994 the so-called Tequila Crisis erupted in Mexico after the country sharply devalued its currency. The crisis sent Calvo into feverish production, and he soon concluded that although Mexico's problems were sparked by a devaluation, it was not experiencing a currency crisis but a crisis in the capital market—where companies and governments raise long-term funds. His next paper, "Varieties of Capital-Market Crises," argued in essence that Mexico was not an isolated phenomenon. He said many emerging market countries were vulnerable in different ways to the whims of international investors because of underdeveloped financial sectors, the constant exposure of the banking sector to panicky depositors, and the phenomenon of "contagion"—in which investors don't differentiate among emerging markets but pull out funds without regard for the underlying circumstances of individual countries.

Calvo's theories emphasized the financial sector as the source of instability. Whenever the financial sector is introduced into the model, there are many theoretical ways that a country can be attacked, said Miguel Kiguel, an Argentine economist who was a student of Calvo's at Columbia in the early 1980s. Banks may be more important "than a budget deficit or a current account deficit." What Calvo postulated is now common wisdom, said Rigobon, but at the time it was radical. "It's like an Alfred Hitchcock movie," he said. "The special effects don't seem like much today," but they were path breaking when they appeared. He said that much like Calvo's 1983 model, the profession was a little slow to appreciate his 1996 insights. It took the 1997 Asian financial crises and subsequent ones in Eastern Europe and Latin America to persuade many economists that emerging markets had a special set of problems that were rooted in the financial system.

Calvo admits that over the years he has been at analytical odds with the IMF, but during his time at the institution he always had support and time to carry out his research. "Look at the number of papers I wrote. I never stopped writing papers." And he continues to write them at a dizzying pace. "He still thinks and processes things through papers. He has an idea, he writes a paper. Most people would talk about it over lunch. Guillermo writes a paper," said his friend and colleague Rodriguez.

So it was appropriate that, in 2004, its institutional skepticism long in the past, the IMF honored Calvo by inviting numerous colleagues to contribute papers to a two-day seminar to celebrate his intellectual leadership on, among other issues, capital flows, debt maturity, and inflation stabilization. Then Deputy Managing Director Agustín Carstens, now Finance Minister of Mexico, observed that "Guillermo's ability to reduce complex problems to their essential elements has taught us that complex models are for lesser minds. . . . In Guillermo's hands, the chaos of reality has always yielded simple and illuminating models."

Filling in the theoretical blanks

The external environment has been tranquil for most of this decade, and developing countries have again been growing. But the risks of crisis remain, Calvo says, and macroeconomic theory has little to offer policymakers if sudden stops return. "The standard macro theory that we teach in graduate school nowadays is not a theory inspired by the Great Depression. It's inspired by the great stability that the United States in particular has exhibited over so many years."

Calvo and colleagues Alejandro Izquierdo and Talvi found eerie echoes of the Great Depression of the 1930s in researching their 2006 paper on what they dubbed the "Phoenix miracle"—the seemingly ineluctable ability of underdeveloped economies to "rise from the ashes" of a dramatic output collapse caused by a sudden stop. They found strong parallels between the conditions surrounding recent crises in emerging markets and the Great Depression. The devastated economies returned within a couple of years to their precollapse output, but not to the growth path they had been on before the crisis.

A crucial problem for emerging market economies is that their central banks are often powerless to help much. The large swings in interest rates that usually accompany turmoil render the standard, incremental tools of monetary policy ineffective. And because underdeveloped financial markets force firms and governments to borrow heavily in dollars or other foreign exchange, central banks have a limited ability to keep the systems solvent in a crisis by becoming lenders of last resort. Countries also often have a grave "fear of floating" their currencies, because firms that owe dollars but earn local currency would be devastated by a big devaluation. If the Great Depression was the result of central bank incompetence, as many economists believe, then crises in today's emerging markets are rooted in central bank impotence.

Calvo hopes to help emerging market policymakers by taking advantage of the current tranquility to develop a theoretical underpinning for monetary policy in countries with underdeveloped financial systems and virtually no lender of last resort. "A nice art collection and quiet surroundings," he says, "don't make a first-world central bank. It's not enough."


Chari, V.V., and Patrick J. Kehoe, 2006, "Modern Macroeconomics in Practice: How Theory Is Shaping Policy," Journal of Economic Perspectives, Vol. 20 (Fall), pp. 3–28.

Mendoza, Enrique, 2005, "Toward an Economic Theory of Reality: An Interview with Guillermo A. Calvo," Macroeconomic Dynamics, Vol. 9 (February), pp. 123–45.

James L. Rowe is on the staff of Finance & Development.