Interests and Incentives to Delay Adjustment : Why Policymakers Fail to Address Early Signs of Trouble and How They Respond to Crises

Why are some policymakers able to adjust their policies in response to deteriorating economic conditions, while other policymakers delay adjustment as long as possible, a policy path that typically ends with an economic crisis? This paper examines this question by focusing on the area of exchange-rate policy, where delayed devaluations frequently end with a currency crisis. I argue that distributional concerns can create strong incentives for policymakers to delay adjustment as long as possible. These incentives are particularly strong when politically influential actors are vulnerable to exchange-rate adjustment and exchange-rate stability can be maintained without a tightening of monetary policy. Since delaying adjustment allows the misalignment to accumulate, however, the costs of adjustment rise and further decrease political incentives to reform. This can cause a negative spiral of delayed reform that is exacerbated by institutions that make adjustment more politically costly. When market pressures escalate, agents reevaluate their policy preferences based on the trade-off between their vulnerability to depreciation and their vulnerability to interest-rate increases. When aversion to internal adjustment is high, a currency crash becomes the most likely outcome. The paper compares the build-up and management of the Asian Financial Crisis to the current financial turmoil and currency crises occurring in Iceland, Hungary and Latvia