EXCHANGE RATE-BASED STABILIZATION IN WESTERN EUROPE: GREECE, IRELAND, ITALY, AND PORTUGAL

I. INTRODUCTION An extensive literature, mainly drawing from the experience of high-inflation Latin American countries, has identified a characteristic expansionary phase following the adoption of inflation stabilization policies based on an exchange rate commitment (ERBS; see references below). During this phase, output and private consumption growth accelerate, while the real exchange rate appreciates and the current account deteriorates. This work suggests that choosing the exchange rate as the nominal anchor may allow countries to avoid (or at least postpone) the output contraction that typically follows so-called "money-based" stabilization programs.(1) The purpose of this paper is to analyze the experience with ERBS in four moderate-inflation Western European countries to address the question of whether the response of the economy to stabilization policies conforms to that of high-inflation countries. Particularly, we are interested in establishing whether stabilization had an expansionary effect in the short run, and whether stabilization was successful. At the beginning of the 1980s, four Western European countries, Italy, Ireland, Portugal, and Greece, undertook inflation stabilization programs centered around an exchange rate commitment. Ireland and Italy joined the European Monetary System (EMS) at its inception in 1979, thereby committing to a fixed central parity with the European currency unit (ECU). Portugal did not formally join the EMS until April 1992, but the escudo was pegged to a basket of five European currencies after October 1990. Finally, in 1989 the Bank of Greece began to follow a "hard drachma" policy, by which the currency was allowed to depreciate relative to the ECU by less than the full inflation differential; starting in 1995 the target exchange rate for the year was announced publicly. To our knowledge, Ades et al. (1993) is the only other study that seeks to determine whether the typical features of ERBS in high-inflation countries also emerge in industrial countries. Their study focuses on the ERM experience of Denmark, France, and Ireland during 1980-1989, and finds that inflation stabilization was contractionary in France and Ireland, but expansionary in Denmark, where optimistic expectations about the path of disinflation led to small nominal wage increases that, in the event, led to a reduction in real wages and to output expansion. Low nominal and real interest rates, also resulting from optimistic inflation expectations, further contributed to output growth. Our study differs from Ades et al. (1993) in various dimensions: the set of countries is different (except for Ireland), and it includes the four countries with the highest rates of inflation in the European Union at the beginning of the EMS. The period under consideration in our study extends to more recent years, including the ERM crisis of 1992. Also, we offer a more extensive review of the stabilization programs, examining the behavior of the main macroeconomic variables as well as other policy changes that accompanied inflation stabilization. The paper is organized as follows: In the next section, the literature on ERBS is briefly surveyed; section III reviews the stabilization programs in Italy, Ireland, Portugal, and Greece; section IV compares the programs with the ERBS stylized facts; and section V concludes. II. THE LITERATURE ON EXCHANGE RATE-based STABILIZATION A large literature exists on ERBS, focused on the experience of countries plagued by high and chronic inflation (inflation rates above 3040% a year) and by severe macroeconomic instability. These experiences share several elements that set them apart from the prototypical outcome of money-based stabilization in developed countries: after the exchange rate is fixed or an exchange rate target is announced, inflation usually falls regardless of the accompanying policies, but convergence to the inflation rate of the peg currency is slow and incomplete; as a result, the CPI-based real exchange rate appreciates considerably. …