Since the turn of the century, much discussion has gone into redefining our economic goals and targets. The final decade of the last millennium witnessed many developing countries battling inflation, and succeeding to a great extent in controlling this threat. Yet this success does not warrant celebration or a validation of macroeconomic policies as most of the countries failed to achieve stability in their macroeconomic outputs and sustainable growth. This is in large part because stabilization policies have focused on price stabilityâeven though real stability, as opposed to price stability, is what is ultimately important for attracting investment and achieving sustainable development. The fiscal debts of developing countries at the turn of the last decade stood at a precarious level, threatening world order.
In the middle of 2016, the once-mighty European monetary union looks vulnerable to a breakdown and even dissolution, owing to the sovereign default of Greece and the near defaults of other European economies. The obvious reason for this lies in fiscal mismanagement and imprudent macroeconomic policies. The standard macroeconomic policies have come under fire in the recent past for not being able to achieve their stated aims and objectives. This chapter aims to introduce readers to a holistic view of the macroeconomic policies in the conventional framework, and their goals and strategies as defined in literature and practice.
Macroeconomic Objectives
Our discussion starts with elaborating on the focus of macroeconomic policymaking from its objective resolution perspective. All economic philosophies argue that the general goal of macroeconomic policy is to maximize long-run societal well-being in an equitable and sustainable manner. Much of the recent discussion in academia and policy corridors has focused on intermediate variables, such as price stability or the balance of payments. However, the question arises whether these intermediate variables are important to delve into or not. Their importance is diminished now, as it is derived largely from their role as possible indicators of economic performance in terms of truly significant variables, such as growth, development and equity.
The core objectives and focus of macroeconomic policymaking from a long-run perspective theoretically lie in âreal macroeconomicsâ and the use of productive capacityâthe employment of capital and labor at their highest potential levelâand improvements in that productivity
Stabilization and Growth
What matters to the average economic person in the society is the stability and growth of their real income. The question on why growth is the main focus and motivation of an economic person is owing to the critical importance of thelong run. Even small changes in the rate of growth have a snowball effect over a period of time. An average growth of real income of 2.5 % to 3 % leads to a significant impact through compounding, and it doubles real-terms income every 28 years at 2.5 % and in 23 years at 3 %.
Economists have long argued that from firmsâ economic objectives focus more on overall stability of output and the real economy, not just price stability. This arises out of the fact that high instability generates an âunfriendlyâ domestic macro-environment that appears to be a crucial factor in explaining low rates of capital formation: firms have less incentive to invest, and growth will be lower. An argument which has been proposed in economics suggests that economic policies that lead to fuller utilization of resources today may also lead to higher incomes in the future. This implies that there may be less of a trade-off between growth and stability than orthodox economics implies.
The question to whether the issues of stabilization and growth can be separated has been explored in economics for decades. In general, it is accepted that the conduct of short-run stabilization policy has long-term effects. If the economyâs output is lowered 5 % today, the best estimate is that the output path will be 5 % lower than it otherwise would have been five years from now. This has serious implications for economic planners, as it means that most downturns have long-lasting effects, regardless of their causes.
How to manage stabilization in short run, and what policies are effective? The answer varies from country to country, depending on each oneâs experience. Korea and Malaysiaâs experience of relying on alternative measures to stabilize the economy, such as the increase in government expenditures, has worked effectively. Chile and Malaysia also used regulations on capital inflows effectively during boom periods in the 1990s. In retrospect, these policies had less adverse effects on long-term growth than relying exclusively on modifying interest rates as the monetarist economic theory suggested at the time.
Inflation
Mainstream economic strategists have long focused on price stability as one of its primary policy objectives, but there exists considerable confusion as to its role. Generally, it is suggested that high inflation supposedly occurs when the fiscal and monetary authorities in the country are not able to perform their tasks effectively. This leads to a conclusion that it is not inflation which is the main variable of concern, but its importance emerges nonetheless as an indicator of economic malperformance. In the current economic landscape, two major issues have arisen regarding the measure of inflation. Firstly, inflation has generally been an observer indicator for the policy objective itself. Secondly, the links between inflation and real variables may be weaker than previously assumed.
Economic policies have been structured in a manner where there is always a trade-off in deciding which component to choose or to sacrifice. The question arises as to whether the benefits of further reducing inflation outweigh its costs. Since late 1990âs, most countries have been able to harness inflation, with many countries experiencing relatively low inflation. When inflation is low or moderate, it has been argued that any effort to further reduce it may have smaller benefits and increasing costs, especially when traditional contractionary monetary policy is the only instrument used to fight it.
A question that is raised in most inquisitive minds is why is there so much focus on the inflation in macroeconomic policies in the modern day. Referring to classical works post-Great Depression, this overarching focus on inflation cannot be seen. This may be owing to history of hyperinflation in several Latin American countries in the 1980s and episodes of very high inflation in some transition economies of central and Eastern Europe in the early 1990s, which shook the worldviews of most developing countriesâ economic managers.
A general agreement has always existed on the massive costs that hyperinflation has on the economic well-being of a society and that hyperinflation leaves scars for decades to come. Hyperinflation, and even high and uncertain inflation, creates huge uncertainty about changes in relative prices, which can be devastating for the information quality of prices and for the efficiency with which resources are used. Behavior gets distorted as firms and individuals work to spend money quickly before it diminishes in value.
Does Inflation Impair Growth?
Amongst the literature available, there is little evidence that moderate inflation has any adverse impact on growth. In contrast, for a few countries real growth rates in high inflation periods in 1990s were far better than growth rates in seemingly similar countries that brought inflation down.
However, in general, moderate rates of inflation have been accompanied by rapid economic growth quite often, as in Argentina in 1965â1974, Brazil in 1965â1980, Chile in 1986â1996 and Poland in 1992â1998. There is a consensus amongst different economic schools of thought that beyond a certain threshold inflation moves into the red, and can potentially lead to hyperinflation, which is likely to be very detrimental to growth. Some argue that low inflation may facilitate more economic growth. Empirical evidence, though, suggests this is a fallacy, as the countries which were once considered models of economic growth faced some of their slowest economic growth phases in low inflation regimes such as Argentina in 1994â2001 and Brazil in 1996â2003.
The hard question that has been raised a multitude of times is why the experiences of countries differ in terms of the impact of inflation. Standard statistical techniques are, in theory, able to show whether inflation has been associated with lower growth or more inequality while controlling for all other variables.
Most economists agree that unexpected or volatile inflation is the bigger boon and that reactionary interest rate policies can pose a serious problem in heavily leveraged economies. A classic example of this was witnessed in the Asian financial crisis of 1997â1998 where the increase in interest rates led to widespread bankruptcies because firms were carrying large levels of short-term debt that had to be refinanced at extremely high rates. Why the firms leverage so highly is owing to historical patterns and projections. If there was a history of high volatility in inflation and interest rates, rational firms probably would not have held so much short-term leverage in the first place, and the volatility in inflation would have had far less impact.
A major problem in interpreting the data is that shocks to the economic system often lead to inflation, but inflation is not necessarily the cause of the problemâit is merely a symptom of the external shock. Inflation by its nature is an endogenous variable that should be explained within the model. The oil price shock of the 1970s led to high inflation in many western hemisphere countries, leading to slow growth and poverty increment. The underlying cause of the problem was not the inflation rate, but the higher price of oil. Since greater resources were being spent on oil, fewer resources were available for growth.
However, within the macroeconomic framework, the benefits of maintaining low inflation have to be offset against the costs. The cost is dependent on how inflation is fought. Usually, no matter what tools are used to fight inflation, unemployment tends to increase.
External Balance
Similar to our earlier discussion on inflation, external balance is an intermediate variable, less important in its own right, and more important for its impact on variables that are of greater concern, such as stability and growth. The linkage between external balances and economic growth and stability is quite difficult to generalize, as experiences of different countries have been diverse. Some countries, like the United States of America, have maintained large trade deficits over extended periods, and for long stretches without apparent problems. The current crisis in US financial markets and the possibility of a recession point to the costs of extreme imbalances. At the same time, developing countries that have foreign denominated liabilities have faced problems after only short periods of relatively moderate trade deficits.
During the Bretton Woods era, with fixed exchange rate regimes, a net importer country had to pay for the gap, by either borrowing abroad or selling international reserves. As a countryâs reserves depletes, creditors would no longer be willing to lend, leading to a crisis. This has changed a bit in the flexible exchange rate economic landscape, with the same outcome. In the case of a country seeming to be highly leveraged and moving to unsustainable debt levels, the lenders and other investors would lose confidence in the country and want their money back. The exchange rate then plunges as investors try to take money out of the country, making it even more difficult for those in the country to repay dollar-denominated short-term debt.
The external borrowings of a country have both short-term and long-term consequences, but the nature of those consequences depends on what gives rise to the borrowing. If countries borrow to finance productive investments that will generate returns in excess of the interest rate charged, then growth will be enhanced. But if on the other hand the external borrowing is targeted towards stopgap measures, to finance frivolous non-real economic expenditures, then the confidence of investors wanes, leading to a crisis situation. Simply, if capital inflows (especially short-term inflows) go to the financial economy and into consumption activities rather than productive causes, this may worry the foreign investor about a countryâs ability to repay its debts. A lack of external balance might then herald a crisis that will have enormous costs to society.
Macroeconomic Policies
The earlier stated broad objectives and intermediate targets are managed primarily through the three standard macroeconomic policy strategies that governments use, namely fiscal, monetary and exchange rate policies. As to which policy to use, and which is more effective, the debate is ongoing. Some economists argue that fiscal and monetary policies are ineffective in all countries. Others argue that they are important policy tools, although their effectiveness depends on conditions in the particular economy. In addition, how policies are pursued is important: different instruments have different implications for effectiveness, equity, development and growth.
The debate on macroeconomic policy is further confused owing to governmentsâ limited capacity to pursue one policy independently of the others. For example, under a fixed exchange rate system, the exchange rate chosen by the government might not be sustainable, given the chosen fiscal and monetary policies. This is especially true with open capital markets, since monetary or fiscal policy choices can cause capital to leave or enter the country, putting pressure on the fixed exchange rate.
As the focus of our book is on fiscal policy, we delve deeper into the fiscal policy dynamics for open economies, the model which is followed in most countries.
Fiscal Policy
Most of the debate revolving around fiscal policy focuses on the need for developing countries to maintain tight fiscal policy. A popular belief suggests that fiscal deficits should be avoided because they âcrowd outâ private investment and lead to declines in investor confidence and thus an inflationary pressure. While, at the same time, fiscal policy has proven results in favor of economic revival in times of depression. Malaysia is an example, where fiscal expansionary policies of 1998 are credited for reviving its economy during the Asian financial crisis. But this strategy may not be considered a standard response for developing countries, as many governments find it difficult or expensive to borrow the funds necessary to finance government spending, while countries that are able to borrow risk running up excessive debt burdens that could be difficult to repay in the futureâespecially when the funds are not well invested.
Sources of Fiscal Revenues and Policy Constraints
Borrowing Constraints
In todayâs world, whenfiscal policy management is talked about for developing countries mention of the International Monetary Fund (IMF) is inevitable. The founders of IMF in 1994 had realized the interdependent nature of global economic growth that was to come, and IMF was created to help countries in depressed conditions finance deficits for economic expansion. Another factor that played a role was the imperfection of global capital markets and misallocation of resources and their lack of accessibility for heavily indebted economies. The modern theory of capital markets, with asymmetric information and costly enforcement, explains why such credit rationing can occur. When it does, countries are compelled to engage in procyclical fiscal policy: they are forced to cut their deficits during economic slowdowns, exacerbating the recession.
Developing countries primarily depend on multilateral loans and foreign aid for financing budget deficits. The experience of developing countries with multilateral agencies has been constrained to procyclical policies as well. The conditionality generally attached to public sector loans often has the same effect of creating procyclical behavior. Most conditionality includes nominal fiscal targets, meaning that during recessions, when tax revenues fall, countries are forced to cut expenditures to meet their interim targets. This procyclicality of borrowings is further exacerbated by the procyclicality of aid.
Aid Delivery and Absorption
It was in 2000 that the Millennium Declaration was adopted at the United Nations, which has led to efforts to muster support to increase development assistance to 0.7 % of each developed countryâs national income. In addition, financial aid has been restructured so as to directly affect the governmentâs fiscal position through more direct budgetary support in terms of debt relief.
It is generally assumed that financial aid and bail-out packages assist in increasing spending, but for this to happen effectively they need to be absorbed in the economic system through coordination between officials in the Ministry of Finance and the Central Bank. This is owing to the fact that aid financing impacts exchange rates, interest rates and domestic prices, in similar manner as does any other capital flow. Injecting liquidity into the system through the conversion of aid to domestic currency can cause volatility in interest and exchange rates, especially when flows are volatile. Inflow of foreign currency denominated aid may produce exchange rate appreciation, which if sustained too long can lead to the infamous âDutch disease.â
In addition, the donor agenciesâ liquidity and capacity for budgetary support to economies tend to rise and fall with economic cycles in donor countries and policy assessments of the recipient countries. The consequences of this volatility can become severe owing to gaps between commitments and disbursements. Empirical work suggests that the volatility of aid flows exceeds tha...