Editors' Summary

Our outgoing and founding editor, Andrés Velasco, opened his summary of the Fall 2005 issue of this journal by noting that it was surprising that Latin America was "not growing more in this environment of the fastest world growth in thirty years" (p.vii). A similar disappointment with the region's growth performance motivates Mariano Tommasi's LACEA Presidential Address, which was delivered to the association's annual meeting in Paris and is published as the first article in this issue. Tommasi relates the generalized frustration with the region's restrained growth performance to the dashed expectations that many economists had with the market-oriented reforms adopted in most of the region over the last two to three decades.

This tenuous link between policy prescription and policy effectiveness spurs Tommasi to explore "what determines the ability of different polities to undertake the task of producing effective public policies." The approach summarized in the paper involves the construction of an index of "policy quality" based on six desirable characteristics of any policy—namely, stability; adaptability; coherence and coordination; the quality of implementation and enforcement; public regard (defined as "the degree to which policies pursue the public interest"); and efficiency. After placing a number of Latin American countries in the worldwide distribution of the policy quality index (conditional on data availability), Tommasi shows that despite its inevitable degree of arbitrariness, the index is correlated with a number of positive development indicators, such as economic growth, poverty reduction, and changes in the human development index.

Finally, Tommasi investigates the institutional determinants of policy quality. The results are presented largely as simple or partial correlations, owing to data limitations and the almost insurmountable endogeneity problems that plague the relations of interest. Nevertheless, he finds intriguing associations between policy quality and institutional characteristics of national congresses, of political party systems, of judiciaries, and of cabinet stability; the quality of the civil service; and the relationship between the executive branch and the rest of the state. Tommasi's final stricture will also be useful to many readers of Economía: "Advocates and advisors have to think twice before forcing a favorite policy onto a polity at the expense of violating principles such as a reasonable degree of societal consensus, congressional debate, or judicial independence."

One measure of the credibility of domestic institutions—and of a government's ability to pursue stable, coherent policies—is whether private agents in the economy are prepared to hold the domestic currency. Over the last few decades, fear of high, unpredictable inflation in a context of incomplete domestic financial markets has led a growing number of Latin Americans to both hold their savings and borrow in U.S. dollars. Governments find it cheaper to borrow in dollars because lenders have little confidence in their commitment to the long-term value of their currency: this is the so-called original sin. Domestic firms have also increasingly sought cheaper credit by borrowing in foreign currency, and savers in many countries are diversifying their portfolios and using domestic dollar deposits to hedge against inflation. Although such financial dollarization may make sense from the individual agent's perspective, it generates risk-raising externalities that may make the overall result suboptimal, and it may justify policy action to dedollarize.

In the second paper in this issue, Eduardo Fernández-Arias provides a unified treatment of the literature on dollarization and proposes a specific mechanism for market-friendly dedollarization. He identifies three main problems associated with the widespread denomination of onshore domestic assets and liabilities in a foreign currency: increased financial fragility arising from the currency mismatch between firms' liabilities and their revenue; adverse consequences for fiscal and macroeconomic policy (largely resulting from the effects of fiscal considerations on exchange rate policy choices); and the empirical association between dollarization and output volatility.

Some amount of dollarization may be beneficial in allowing for asset diversification and financial depth in the absence of perfect domestic asset substitutes. Moreover, once an economy is dollarized, any attempt to force private agents to return to the domestic currency may cause substantial disintermediation and capital flight. Bearing both sides of...