POLITICAL CYCLES/STABILIZATION result of appreciation bolstered by the oversupply of credit and the re- duction of the real interest rate.The difficulties in financing growing current account imbalances induce governments to adopt fiscal and monetary policies that are inconsistent with the exchange rate regime.14 If this happens,the sustainability of the peg comes into question,either because perceptions of the indefensibility of the arrangement become widespread or because foreign-exchange reserves are insufficient to sus- tain the deficit.Either way,attacks on the currency bring down the par- ity,whether on the basis of self-fulfilling prophecies or of objective conditions.At this point,a balance-of-payments crisis occurs and the boom turns into bust. The dynamics of money-based stabilization(MBS),which uses a sharp contraction of the money supply as the primary policy tool in an orthodox program,differs in striking fashion.15 In this case,tightening of monetary policy leads to increased real interest rates,reduced do- mestic absorption,and an improved trade balance.Although inflation often falls,this takes time and is accompanied by severe recessionary ef- fects on output and employment.The money-based stabilization pro- gram in Spain from 1977 to 1980,for example,led to a sharp drop in GDP growth,falling inflation,and rising unemployment,over a cycle that lasted two years.Chile and Argentina in the mid-1970s are promi- nent examples of money-based stabilizations in Latin America with clear recessionary consequences. These stylized facts were initially intended to describe experiences in a handful of Latin American countries,and recent research has ques- tioned the tendency to generalize them into an "ERBS syndrome,"con- testing the alleged empirical regularities associated with the two stabilization strategies.6 Even so,a recent critical study along these lines does concede the existence of"a distinctive consumption boom during ERBS's,"confirming a pattern of real exchange rate appreciation Though conducive to inconsistent fiscal policies,not all exchange rate-based stabilizations are necessarily accompanied by such policies,and thus not all end with a bust in the medium run.For ex- ample,Mexico's Pacto of 1987,initiated nine months before the presidential election,was accompa- nied by fiscal adjustment.The downward inflation trend continued after the election,and the regime endured for several years.Similarly,Argentina's currency board arrangement appeared for quite a while to provide enduring stability,but its collapse in 2002-as well as the Mexican Tequila crisis of 1994-95-cast doubt even on these"success"stories.As Michael Klein and Nancy Marion observe, while there is large variability in the duration of pegs resulting from stabilizations,few escape an even- tual dramatic collapse;Klein and Marion,"Explaining the Duration of Exchange Rate Pegs,"NBER Working Papers 4651 (1994). is Kiguel and Liviatan (fn.2);Calvo and Vegh (fn.12). For example,William Easterly,"When Is Stabilization Expansionary?Evidence from High In- flation,"Economic Policy 22(April 1996);and A.Javier Hamman,"Exchange-Rate-Based Stabiliza- tion:A Critical Look at the Stylized Facts,"IMF Staf Papers 48 (December 2001).result of appreciation bolstered by the oversupply of credit and the re￾duction of the real interest rate. The difficulties in financing growing current account imbalances induce governments to adopt fiscal and monetary policies that are inconsistent with the exchange rate regime.14 If this happens, the sustainability of the peg comes into question, either because perceptions of the indefensibility of the arrangement become widespread or because foreign-exchange reserves are insufficient to sus￾tain the deficit. Either way, attacks on the currency bring down the par￾ity, whether on the basis of self-fulfilling prophecies or of objective conditions. At this point, a balance-of-payments crisis occurs and the boom turns into bust. The dynamics of money-based stabilization (MBS), which uses a sharp contraction of the money supply as the primary policy tool in an orthodox program, differs in striking fashion.15 In this case, tightening of monetary policy leads to increased real interest rates, reduced do￾mestic absorption, and an improved trade balance. Although inflation often falls, this takes time and is accompanied by severe recessionary ef￾fects on output and employment. The money-based stabilization pro￾gram in Spain from 1977 to 1980, for example, led to a sharp drop in GDP growth, falling inflation, and rising unemployment, over a cycle that lasted two years. Chile and Argentina in the mid-1970s are promi￾nent examples of money-based stabilizations in Latin America with clear recessionary consequences. These stylized facts were initially intended to describe experiences in a handful of Latin American countries, and recent research has ques￾tioned the tendency to generalize them into an “ERBS syndrome,” con￾testing the alleged empirical regularities associated with the two stabilization strategies.16 Even so, a recent critical study along these lines does concede the existence of “a distinctive consumption boom during ERBS’s,” confirming a pattern of real exchange rate appreciation POLITICAL CYCLES/STABILIZATION 49 14 Though conducive to inconsistent fiscal policies, not all exchange rate–based stabilizations are necessarily accompanied by such policies, and thus not all end with a bust in the medium run. For ex￾ample, Mexico’s Pacto of 1987, initiated nine months before the presidential election, was accompa￾nied by fiscal adjustment. The downward inflation trend continued after the election, and the regime endured for several years. Similarly, Argentina’s currency board arrangement appeared for quite a while to provide enduring stability, but its collapse in 2002—as well as the Mexican Tequila crisis of 1994–95—cast doubt even on these “success” stories. As Michael Klein and Nancy Marion observe, while there is large variability in the duration of pegs resulting from stabilizations, few escape an even￾tual dramatic collapse; Klein and Marion, “Explaining the Duration of Exchange Rate Pegs,” NBER Working Papers 4651 (1994). 15Kiguel and Liviatan (fn. 2); Calvo and Végh (fn. 12). 16For example, William Easterly, “When Is Stabilization Expansionary? Evidence from High In- flation,” Economic Policy 22 (April 1996); and A. Javier Hamman, “Exchange-Rate-Based Stabiliza￾tion: A Critical Look at the Stylized Facts,” IMF Staff Papers 48 (December 2001). v56.1.043.schamis 3/2/04 4:29 PM Page 49