RF: What is your opinion of central banks in developing countries adopting inflation targets?
Calvo: When developing countries adopt an inflation target it's usually because there is a lack of credibility. So they are forced to stick to a system that is very rigid. That has some benefits, but it also makes it quite difficult to deal with shocks and, unfortunately, developing countries can experience quite crippling shocks. For instance, let's say there is a financial shock and you need to rescue the banking sector. The intense focus on controlling inflation may make that very difficult. So an inflation target could push the central bank toward pursuing policies that are counterproductive and ultimately unsustainable from a political point of view. That's why I cannot be too excited about inflation targets in developing countries.
I should say that I'm also not a big supporter of the United States adopting an inflation target. There have been cases, such as the period immediately following the stock market crash of 1987 and the collapse of Long Term Capital Management in 1998, where the Fed pursued policies that were good for the economy but that would have been difficult to implement had it been committed to a rigid inflation target.
RF: What is your opinion of Hernando de Soto's The Other Path? What lessons can policymakers in Latin America take from that book?
Calvo: The main lesson is that regulations must be simplified as much as possible in order to encourage the development of the formal sector and, thus, most likely enhance the pace of technical progress. However, I am skeptical that a major overhaul of government regulations will have a major effect in the short or medium term. The reason is that the informal sector strongly relies on tax evasion and, unless you implement a major tax moratorium — accompanied by substantially lowered tax rates —firms are likely not to move to the formal sector, even if all the red tape is eliminated. Moreover, a moratorium is likely to have detrimental moral hazard implications.
RF: Could you comment on the "global savings glut" hypothesis and its implications for the path of the U.S. current account?
Calvo: In general, I am sympathetic to that argument. I think it fits the fact well. Now what could be causing it? It's possible that it could be a consequence of some of the crises we had in the 1990s. In particular, those crises might have induced Asian countries to save more, giving them the ability to finance spending in countries like the United States. Could this situation be stable? I think it could be. I think we could go along in this way for quite a while without there being a global crisis. My concern is that if there were a hiccup in the financial markets, it would not be the United States that would be most severely hurt, as some have argued. Rather, I fear that emerging markets would be hit hard. In the eyes of most investors, the United States, despite its current account deficit, is still a very stable, attractive place to put their money. If there were trouble, I think they would turn to the United States as a haven.
RF: How has your academic work helped you as a policy adviser?
Calvo: I think it has been very useful. The analysis we have to do is often very complex and there will be many things that you will not understand fully. But I have gone back time and again to basic macroeconomic principles to develop a framework for looking at the policy questions I encounter. Also, the work that sprang up from the rational expectations revolution has helped me think about problems regarding credibility. Even if I don't take the rational expectations stories verbatim, they provide a very simple but powerful way of understanding how people think about the future and how to structure policy responses. You might not get every detail right, but at least you will be working within a reasonable framework and set of parameters. In contrast, if you do not have a strong grasp of theory, I think you will eventually find yourself adrift.
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