NBER WORKING PAPER SERIESESTABLISHING CREDIBILITY:THE ROLE OF FOREIGN ADVISORSSebastian EdwardsWorking Paper 11429http://www.nber.org/papers/w11429NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138June 2005This is a revised version of a paper presented at the National Bureau of Economic Research’s Inter-AmericanSeminar on Economics to be held at the Colegio de Mexico, December 2-4, 2004. I thank Roberto Alvarezfor his comments and assistance. The views expressed herein are those of the author(s) and do not necessarilyreflect the views of the National Bureau of Economic Research. ©2005 by Sebastian Edwards. All rights reserved. Short sections of text, not to exceed two paragraphs, maybe quoted without explicit permission provided that full credit, including © notice, is given to the source.Establishing Credibility: The Role of Foreign AdvisorsSebastian EdwardsNBER Working Paper No. 11429June 2005JEL No. F30, F32ABSTRACTIn this paper I analyze the role of foreign advisors in stabilization programs. I discuss from ananalytical perspective why foreigners may help a developing country's government put in place asuccessful stabilization program. This framework is used to analyze Chile's experience with anti-inflationary policies in the mid 1950s. In 1955-58 Chile implemented a stabilization package withthe advice of the U.S. consulting firm of Klein-Saks. The Klein-Saks program took place in a periodof acute political confrontation. After what was considered to be an initial success -- inflationdeclined from 85% in 1955 to 17% in 1957 -- the program failed to achieve durable price stability.I argue that the foreign advisors of the Klein-Saks Mission gave initial credibility to the stabilizationprogram launched in 1955. But providing initial credibility was not enough to ensure success.Congress failed to act decisively on the fiscal front. Consequently the fiscal imbalances that hadplagued Chile for a long time were reduced, but not eliminated. I present empirical results on theevolution of inflation, exchange rates and interest rates that support my historical analysis.Sebastian EdwardsUCLA Anderson Graduate School of Business110 Westwood Plaza, Suite C508Box 951481Los Angeles, CA 90095-1481and [email protected] I. Introduction The adoption of stabilization programs is usually a painful process, both politically and economically. History is replete with instances where, even at the light of obvious and flagrant macroeconomics disequilibria, the implementation of stabilization programs is significantly delayed. Why do policymakers and/or politicians prefer to live with growing inflationary pressures and implement price and other forms of highly inefficient controls, instead of tackling the roots of macroeconomic imbalances? Is the prolongation of inflation the consequence of mistaken views on the mechanics of fiscal deficits and money creation, or is it the unavoidable result of the political game? Why after months of apparent political stalemate, all of a sudden stabilization programs that closely resemble others proposed earlier are adopted? These questions are at the heart of the political economy of stabilization and inflationary finance.1 In recent years the analysis of these issues has attained new interest, as a number of authors have applied the tools of game theory to the study of macroeconomic policymaking. Although important theoretical progress has been achieved in the explanation of some of these phenomena, the amount of empirical and historical work on the subject is still rather limited.2 The purpose of this paper is to investigate an important historical stabilization episode in Chile, one of the countries with the longest history of chronic inflation in the world. Starting in the late 19th century, Chile suffered recurrent and increasingly frequent inflationary outbursts. Of the many stabilization programs adopted to tackle this problem, the 1955-58 package implemented with the advice of the U.S. consulting firm of Klein-Saks, is, undoubtedly, one of the most fascinating ones.3 Its interest is based on a number of factors: first, at the time the program was put in place inflation had reached the extremely high annual level (for that time) of 85% (see Table 1). Second, the policies adopted contradicted the newly dominant orthodoxy in Latin America that associated 1Latin American debates on inflation and stabilization have traditionally emphasized political economy angles. It is only recently, however, that these issues have begun to be tackled using a formal economics framework. 2 For a masterful presentation of recent advances on the political economy of macroeconomics policy making see Drazen (2000). 3It is certainly a stabilization attempt that has attracted considerable attention from academic economists. See, for example, Hirshman (1963), Felix (1960), Edwards (1986).2 inflation to structural problems.4 Third, the Klein-Saks program took place in a period of acute political confrontation. Fourth, the episode is interesting because after what was considered to be an initial success -- inflation declined to 38% in 1956, and was further reduced to 17% in 1957 -- the program failed to achieve durable price stability (see Figure 1). Finally, what makes this episode particularly noteworthy is that the program proposed by the Klein-Saks mission was very similar to anti-inflationary plans that had been previously elaborated by several government agencies, including the Ministry of Finance and the Central Bank, in the period 1954-55. However, while these earlier stabilization efforts were rejected by Congress, most (but not all) of the Mission’s program was approved by Congress. This characteristic of the episodes raises the issue of the role of foreign advisors in the design (and implementation) of economic policy. In this paper I argue that the foreign advisors of the Klein-Saks Mission gave initial credibility to the stabilization program launched in 1955. These foreign advisors played the role of independent, non-partisan, technocratic arbiters. It was precisely because they were foreigners that they could raise above the political fray, and suggest a specific program, whose main components were rapidly approved by a highly divided Congress. The fact that the program was very similar to one proposed earlier by the government – and that was rejected by Congress --