Macroeconomics of structural adjustment and public finances in developing countries
A heterodox perspective
The Authors
Deepak Nayyar, Jawaharlal Nehru University, New Delhi, India
Acknowledgements
The author would like to thank Jose Antonio Ocampo and Joseph Stiglitz for useful comments and valuable suggestions. He is also grateful to Amit Bhaduri and Lance Taylor for helpful discussion on the subject over the years.
Abstract
Purpose – This essay aims to analyze the process of structural adjustment in developing countries. Its focus is on macroeconomic stabilization in the short-term, but the analysis is situated in a wider context to consider how it relates to the implications of structural reform in the medium-term and the prospects for economic growth in the long-term.
Design/methodology/approach – The paper begins by setting out the contours of the orthodox, the Keynesian and the heterodox perspectives on stabilization and adjustment to highlight the differences. Such different perspectives on macroeconomic theory and policy, it suggests, are attributable to differences in objectives, assumptions and beliefs. These are made explicit.
Findings – The paper argues that the relationship between stabilization and growth is characterized by inter-connections rather than trade-offs and suggests that outcomes depend on modes of adjustment. It also provides a macroeconomic analysis of government deficits and public finances, which are critical in the process of adjustment. This highlights the macroeconomic significance of government deficits and points to the fallacies of deficit fetishism based on accounting frameworks. The intersection of economics and politics in the design and implementation of macroeconomic policies is also explored.
Practical implications – Going beyond a critique of orthodox stabilization programmes, it shows that there are alternatives in macro-management for economies in crisis, for which it is necessary to shift the focus from the financial to the real economy, from the short-term to the long-term, and from equilibrium to development.
Originality/value – The paper develops a heterodox perspective on the macroeconomics of structural adjustment and public finances. And, it sets out an alternative framework which straddles time horizons, to understand the restructuring of economies over time.
Article Type:
Conceptual paper
Keyword(s):
Economic growth; Inflation; Developing countries; Economic stability.
Journal:
International Journal of Development Issues
Volume:
7
Number:
1
Year:
2008
pp:
4-28
Copyright ©
Emerald Group Publishing Limited
ISSN:
1446-8956
The last quarter of the twentieth century witnessed a striking change in the concerns of macroeconomics. In industrialized countries, the conventional concern of macroeconomics was maintaining short-term equilibrium. The objectives of full employment and price stability were sought to be achieved through fiscal and monetary policy instruments. The slowdown in growth shifted the focus to productivity increase and economic growth in the long-term. In developing countries, the traditional concern of macroeconomics was economic growth in the long-term, with an emphasis on savings and investment. The focus shifted to macro-management in the short-term after many developing countries, as also transition economies, ran into debt crises or other forms of macroeconomic disequilibrium, if not turbulence.
The objective of this essay is to analyze the process of structural adjustment in developing countries that experienced such crises. In doing so, it seeks to focus on macroeconomic stabilization in the short-term, but this discussion is situated in a wider context to consider how it relates to the implications of structural reform in the medium-term and the prospects for economic growth in the long-term. It also endeavours to provide a macroeconomic analysis of government deficits and public finances, which are critical in the process of stabilization and adjustment. Going beyond a critique of orthodox stabilization programmes, it shows that there are alternatives in macro-management for economies in crisis, which would be conducive to development.
The structure of the paper is as follows. Section 1 outlines the contours of the orthodox, the Keynesian and the heterodox perspectives on stabilization and adjustment to highlight the differences. Section 2 discusses problems of transition from crisis to stabilization and from stabilization to growth, mostly in terms of theory, but with some reference to experience. Section 3 considers the relationship between stabilization and growth, which is characterized by inter-connections rather than trade-offs, to suggest that much depends on modes of adjustment. Section 4 examines the concept of twin-deficits, which is at the core of the orthodox belief about adjustment, to trace the underlying economic causation that shapes outcomes. Section 5 analyses government deficits to show that it is necessary to focus on their macroeconomic significance rather than on accounting frameworks, and points to the fallacies of deficit fetishism. Section 6 explores the intersection of economics and politics in the design and implementation of macroeconomic policies. Section 7 develops an alternative framework, which straddles time horizons, to understand the restructuring of economies over time. Section 8 concludes.
1 Macroeconomic adjustment: different perspectives
In a situation of deep macroeconomic disequilibrium, whether it is a balance of payments crisis or a sharp acceleration of the rate of inflation, stabilization is an imperative. This is widely accepted. Yet, economists cannot agree on how this is to be done. The extensive literature on the subject, which draws on both theory and experience, is characterized by widely divergent perspectives on macroeconomic adjustment. Obviously, the most important differences lie in the prescriptions. But there are significant differences even in analysis and diagnosis. It is possible to make a distinction between three such perspectives: the orthodox perspective, the Keynesian perspective and the heterodox perspective. There is, of course, some differentiation, just as there are fine nuances, within each of these perspectives. Nevertheless, the differences between the three schools of thought, in theory and policy, are clear enough. It is interesting that these differences are much more visible in the academic debate than in the real world. For in practice, stabilization policies have been essentially similar across a wide range of developing countries and transition economies, primarily because most economies in crisis have been guided by the IMF and the World Bank in their stabilization and adjustment programmes.
In these programmes of macroeconomic stabilization, there are two fundamental objectives. The first objective is to pre-empt a collapse of the balance of payments situation in the short-term and to reduce the current account deficit in the medium-term. The second objective is to curb inflationary pressures and expectations in the short-term and to reduce the rate of inflation as soon as possible thereafter. The principal instruments of stabilization are fiscal policy and monetary policy, which seek to reduce the level of aggregate demand in the economy, often used in conjunction with a devaluation, which seeks to stem destabilizing expectations. This perspective is, of course, based on the presumption that the problems are attributable to rising fiscal deficits, the associated monetary expansion and an unsustainable exchange rate.
In response to a macroeconomic crisis, stabilization is often combined with adjustment and reform. Such programmes of structural adjustment, based on policy reform advocated by the international financial institutions, are concerned with the supply side in an endeavour to raise the rate of growth of output. Structural reform seeks to shift resources:
- From the non-traded goods sector to the traded goods sector and within the latter from import competing activities to export activities.
- From the government sector to the private sector. Apart from resource allocation, structural reform seeks to improve resource utilization by:
- increasing the degree of openness of the economy; and
- changing the structure of incentives and institutions, which would reduce the role of state intervention to rely more on the market place, dismantle controls to rely more on prices, and wind down the public sector to rely more on the private sector.
It should be obvious that these are the essential components of orthodox stabilization programmes drawn up as part of an arrangement with the IMF and structural adjustment programmes drawn up as part of an arrangement with the World Bank. Such programmes were adopted by most countries in Latin America, Sub-Saharan Africa, South Asia and Eastern Europe in response to macroeconomic crises. It is worth noting that it was not possible for a country to enter into a stabilization programme with the IMF unless it entered into a structural adjustment programme with the World Bank. In spite of this cross-conditionality, which meant that one was not possible without the other, the relationship between macroeconomic stability and structural reforms has been largely ignored in the conventional literature on the subject.
The prescriptions of the IMF and the World Bank are derived from orthodox economics. The orthodox perspective, in turn, is based on neoclassical economics which assumes competitive markets, profit-maximizing firms and rational consumers. In this world of abstractions, economies function smoothly in an efficient manner. The episodes of unemployment are only temporary, as there are strong restorative forces. Given the belief that economies, almost always, are at full employment, orthodoxy worries about inflation rather than unemployment. And inflation is seen as policy-induced. It could be the outcome of an expansionary fiscal policy or monetary policy. There is a presumption that government expenditure, whether on consumption or on investment, is unproductive. What is more, fiscal deficits are counter-productive because they erode investor confidence and lead to lower investment. An expansionary monetary policy, it is believed, results in higher prices, not more output, because money affects only price levels and has no impact on output levels. The focus, then, is on inflation and deficits, which are sought to be addressed through a restrictive fiscal policy and a tight monetary policy. In conformity with the monetarist view, the emphasis is on the quantity of money, which translates into domestic credit control in IMF financial programming. Of course, in this belief system, governments are a part of the problem rather than a part of the solution. Even so, it is recognized that if there is a macroeconomic crisis, stabilization policies are essential.
The Keynesian perspective provides a sharp contrast because it is concerned about unemployment and stagnation, which are sought to be addressed through expansionary fiscal and monetary policies. The focus, then, is on levels of employment and output. Thus, in an economic downturn, the prescription is to increase government expenditure, reduce taxes and lower interest rates to stimulate the economy (Keynes, 1936). In developing countries, Keynesians have some preference for monetary policy because lower interest rates and easier credit access would stimulate investment and foster growth. The emphasis is on the interest rate and not on money supply. However, it is recognized that when an economy is in a severe downturn, or when there is large excess capacity, or when there are supply constraints, an expansionary monetary policy may fail to induce investment. In such circumstances, the Keynesian view advocates the use of fiscal policy. Stepping up government investment is seen as the best method, for it would bring tangible results and yield social benefits. It would also foster growth. However, in the short-term, even unproductive investment or consumption expenditure by the government would lead to an expansion of output through the multiplier effect. Obviously, for a developing country in an economic downturn, short-term macro-management would be conducive to growth in the medium-term if it encourages investment. It may be possible to stimulate private investment through lower interest rates or easier credit access. But this process can be supported by increases in public investment. Indeed, in developing countries, public investment, particularly in infrastructure, crowds-in private investment. The merits of such a counter-cyclical approach are obvious. Of course, there are two implications of expansionary macroeconomic policies that must be recognized. For one, excessive stimulation may lead to inflation but this is acceptable within limits if it leads to higher levels of output and employment. For another, expansionary policies could enlarge the current account deficit in the balance of payments and it may be difficult to find the requisite external finance following a debt crisis.
The heterodox perspective differs not only from the orthodox view but also from the Keynesian view. It explores alternative approaches and unconventional methods to stabilize the economy, combat inflation, increase employment and stimulate growth
Conversely, an increase in aggregate demand can also have positive effects on the supply side. This deserves explanation. An increase in market size facilitates the realization of scale economies, thus bringing about a cost reduction, just as a reduction in costs, hence prices, induces a demand expansion. Over time, the underlying factors are dynamic scale economies and increases in labour productivity. This cumulative causation which is complex but virtuous is often termed the “Kaldor-Verdoon Law” (Kaldor, 1978). Such cumulative causation can also be the opposite of virtuous.
Such different perspectives on the macroeconomics of adjustment are attributable to the following reasons. First, different schools of thought stress different objectives. For some, price stability is an end in itself. For others, the essential objective is to increase growth and reduce poverty. For most, however, controlling inflation is a means whereas more rapid, stable and equitable growth is the end. Second, different schools of thought differ in their understanding of, or belief about, how an economy functions or adjusts. This leads to genuine differences in thinking about outcomes. Third, different schools of thought make different assumptions. Sometimes these differences in assumptions remain unstated because they are implicit rather than explicit. Inevitably, this accentuates the differences.
2 Problems of transition
In any process of stabilization, adjustment and reform, economies experience problems of transition so that their return to a path of sustained growth, combined with stability in the price level and the balance of payments situation, is not assured. It is possible to consider such problems of transition at two levels
The fundamental problem of transition arises from the fact that the speeds of adjustment on the demand side and on the supply side are considerably different. Fiscal adjustment and monetary discipline can be used to squeeze aggregate demand so that, in response to inflation, the speed of adjustment on the demand side is fast. The response of demand to expansionary fiscal and monetary policies is just as rapid. On the other hand, the speed of adjustment on the supply side is inevitably slow, because resources are not perfectly mobile across sectors or substitutable in uses; moreover, prices, particularly of factors of production, are not completely flexible. This is so even if all the price incentives of a market economy can be brought to perfect function. The problems are accentuated in economies characterized by structural rigidities which obviously constrain the response to structural reforms. Supply adjustment based on an expansion of output requires structural change through creation of capacity, alleviation of infrastructural bottlenecks, streamlining of input supplies, reorientation of public utilities, and so on all of which take time. In contrast, supply adjustment based on a contraction of output is, in some instances, as rapid as demand adjustment. Therefore, the dynamics of demand are fast in both expansion and contraction, whereas the dynamics of supply are slow in expansion but faster in contraction. These asymmetries have four macroeconomic implications which are crucial in the process of stabilization and adjustment.
First, stabilization policies which are meant to reduce demand may, at the same time, reduce supply even more, for the simple reason that a substantial fiscal adjustment and a tight monetary policy squeeze both investible resources and working capital. As an economy contracts from both sides, the current account deficit may possibly be reduced but inflation would not be restrained. Second, insofar as aggregate demand remains greater than aggregate supply, or the sectoral composition of demand does not match the sectoral composition of supply, and balance of payments constraints prevent excess demand from being met through imports, inflation persists. Third, the initial effects of structural reform, particularly in situations where the balance of payments constraint is binding, may lead to a contraction of output in some sectors before an expansion of output in other sectors. This tends to increase excess demand in the system and exacerbates the problem of inflation. Fourth, fiscal contraction and monetary discipline which squeeze aggregate demand in the short-term may constrain supply responses in the medium-term. Yet, without a foundation of macroeconomic stabilization in the short-term, policy reform simply cannot produce the desired results in the medium-term. This is the crux of the problem when economies begin on adjustment processes in a situation of deep macroeconomic disequilibrium.
On the demand side, the optimistic scenario implicit in IMF stabilization programmes is that inflation would come down and the current account deficit would be reduced, while the economy would adjust at a macro-level through a fall in prices and a rise in output. This outcome, however, is by no means certain. Nor is the transition from crisis to stabilization. In fact, it is perfectly possible that fiscal austerity and monetary discipline may not reduce the current account deficit and the rate of inflation. Reduced fiscal deficits do not always translate into reduced current account deficits if the impact of the consequent deflation is largely on non-traded goods, so that reduced domestic absorption may not stimulate exports and dampen imports. Restrictive monetary policies, which combine a credit squeeze with high interest rates, do not always curb inflation if inflationary pressures and expectations are influenced not only by excess liquidity but also by real disproportionalities or structural rigidities, and if price formation is based on mark-ups, administered-pricing and cost-indexation rather than market-clearing
On the supply side, the optimistic scenario implicit in liberalization programmes guided by the Bretton Woods institutions is that structural reform would impart both efficiency and dynamism to the growth process in the medium-term. The transition from stabilization to growth, however, is by no means assured. The sequence and the pace of restructuring must be such that it can be absorbed by the economy. If this is not the case, things can go wrong. Trade policy reform may stimulate output by creating economic efficiency gains, but it can also move an economy from a situation of too much protection to a situation of too little protection and if the manufacturing sector is unable to cope with such a rapid transition the outcome may be forced de-industrialization. Industrial de-regulation, which removes barriers to entry and limits on growth, may increase competition among firms and improve resource utilization. However, it often leads to retrenchment or closures and cannot wish away barriers to exit, particularly in economies where income levels are low, unemployment levels are high and social safety nets are absent. De-regulation in the financial sector, unless it is paced with care, can be perilous not just in terms of bubbles that burst or scandals that surface, but also if it diverts scarce resources from productive uses into speculative activities. Public sector reform, which is based on the sale of government assets and rudimentary forms of privatization, may not resolve the real problems of efficiency or productivity, but it can end up socializing the costs and privatizing the benefits. Capital market liberalization imposes constraints on macroeconomic policies. Lower interest rates can no longer be used to encourage domestic investment, just as higher government deficits can no longer be used to expand aggregate demand, for fear that this might provoke massive capital outflows. And such integration into international financial markets, often premature, makes the economy far more vulnerable
The actual experience of stabilization, adjustment and reform programmes in Latin America and Sub-Saharan Africa, guided by the IMF and the World Bank in a medium-term perspective, also reflects problems of transition. The critical evaluation of these programmes in the literature on the subject points to significant dangers
The experience of stabilization and adjustment in the transition economies of Eastern Europe, during the early 1990s, was similar. And the outcomes were almost the same (Amsden et al., 1994). It would seem that the IMF and the World Bank did not learn from their experience in Latin America and Sub-Saharan Africa during the 1980s. In fact, not much changed in Latin America during the 1990s
In evaluating experience across countries it is difficult to define and then identify “success” or “failure” because actual outcomes span a wide spectrum from moderate successes at one end to real disasters at the other. But the diverse experiences do establish that the transitions from crisis to stabilization and from stabilization to growth are characterized by a discernible set of problems.
Macroeconomic adjustment and structural reform are not simply a matter of academic discourse. In the period of transition, these processes impose a real burden of adjustment that is distributed in an asymmetric manner. Without correctives, the burden of adjustment is inevitably borne by the poor. For all the rhetoric about social safety nets, economies in crisis simply do not have the resources for this purpose. It cannot suffice to assert, as governments often do, that the burden of such adjustment would have to be borne by the affluent simply because it is the rich who have the incomes to immunize themselves from the burdens of structural change. It is obvious that there can be no adjustment without pain, but pain for whom? This is why correctives are necessary. Inflation tends to make the rich better off as it redistributes incomes from wages to profits and the poor worse off as it erodes their incomes which are not index-linked. The soft options in fiscal adjustment tend to squeeze public expenditure in social sectors where there are no vocal political constituencies, as the sources allocated for poverty alleviation, health care, education and welfare programmes decline in real terms. Restructuring on the supply side, which follows structural reform, inevitably imposes a burden on wage labour. Such outcomes borne out by evidence available can only hurt the poor
3 Stabilization and growth
The meaning of stabilization in economics is much the same as in medicine: just as medical treatment seeks to stabilize the health of a patient in critical condition, economic management attempts to stabilize an economy in deep crisis. The focus of the literature on macroeconomic stabilization, however, is narrow. Much of the discussion is on stabilization of prices. Some of the discussion is on stabilization of balance of payments situations. There is almost no reference to stabilization of output levels or income levels. What is more, the time horizon for such discussion is the short-run. However, what concerns people is the stability of their incomes in the short-run and the growth of their incomes over time. Growth matters because it is cumulative. If the growth in GDP, in real terms, is 2.5 per cent per annum, income doubles in 28 years. But if this growth rate is 5 per cent per annum, income doubles in 14 years. And if this growth rate is 7.5 per cent per annum, income doubles in nine years.
It is essential to recognize that stabilization cannot and should not be separated from growth. There are important reasons. First, short-run stabilization policies have long-term consequences. Second, the relationship between stabilization and growth is characterized by inter-connections rather than trade-offs. Third, the objective must be stabilization with growth which cannot be reduced to an either-or choice.
In this context, it is important to recognize two limitations of the orthodox belief system. First, for economies in crisis, orthodox economists advise that governments should not attempt to attain full employment. Instead, governments are urged to accept the pain of adjustment, in the form of lower output today, for a higher output tomorrow. This recommendation conforms to the strong spring analogy: the harder you push the spring down, the greater the force with which it bounces back. But critics believe that a weak spring is a more appropriate analogy for the economy, for when it is pushed too hard, it may simply remain there if its restorative forces are destroyed. These are mere analogies but statistical analysis provides some support for the critics (Ben-David and Papell, 1998; Lutz, 1999). Second, orthodox economists place an excessive emphasis on price stability, which is simply not appropriate. Such thinking may have been shaped by the experience of hyper-inflation in Latin America during the 1980s and in Eastern Europe during the early 1990s. And hyper-inflation did indeed mean huge costs and devastating consequences for economies. But this hyper-inflation was tamed. And countries in Asia, as also Africa, have rarely, if ever, experienced hyper-inflation. Indeed, rates of inflation in Asia and Africa have been moderate. Available evidence suggests that moderate rates of inflation have been associated with rapid economic growth in many countries across the developing world
The implications and consequences of stabilization policies in the short-run for economic growth in the medium-term depend, in part, on the mode of adjustment in the economy at a macro level.
Economies can adjust at a macro level either through changes in prices or through changes in incomes. In a world of wage-price flexibility, which conforms to the orthodox view, the outcome would be price adjustment and the path from stabilization to growth would be smooth. In a world of wage-price rigidities, which conforms to the Keynesian view and the heterodox view, the outcome would be income adjustment. Such beggar-thyself policies are bound to have a negative impact on growth.
Economies in crisis can adjust either through an increase in output or through a decrease in expenditure. Adjustment through output expansion would obviously have a positive impact on growth. This would be easier in situations where there are underutilized capacities. Adjustment through expenditure reduction would obviously have a negative impact on growth. In so far as economies in crisis are likely to be output-concerned, economic retrenchment, in which countries are forced to cut expenditure, is the more probable outcome. Such macroeconomic adjustment can only place the economy on a slower growth path with effects that would persist in the medium-term.
Economic growth can come from an increase in the productivity of investment, but only in part. Ultimately, sustained economic growth also requires an increase in the investment-GDP ratio. In an open economy, at a macro level, the excess of investment over savings corresponds to the excess of imports over exports. The strategy conducive to growth, then, would be to raise the investment-GDP ratio. For economies that are prone to debt crises, or do not have adequate access to external financing, this higher investment rate should be sustained by raising the export-GDP ratio and the domestic savings-GDP ratio, instead of by allowing a compensatory increase in the import-GDP ratio supported by foreign capital inflows. This underlines the significance of increasing exports and raising domestic savings. The former is recognized. The latter is forgotten. Following a debt crisis, or faced with limits on external financing, an economy could also adjust by lowering its investment-GDP ratio, so as to manage with a lower import-GDP ratio that can be supported by available external finance, given the export-GDP ratio and the domestic savings-GDP ratio. This mode of adjustment would obviously not be conducive to growth.
In developing countries, it is more than likely that the mode of adjustment may not be growth-friendly. The reason is that, under normal circumstances, there is a pro-cyclical pattern to macroeconomic policies. This is particularly true of fiscal policy
The social costs of pro-cyclical fiscal policies are high. In downturns, cuts in public expenditure squeeze investment in infrastructure and reduce allocations for social sectors, which can only dampen growth in the long-term. In upturns, readily available finances may be used for investments that yield low returns or even for unproductive consumption expenditure. In general, stop-go cycles are bound to reduce the efficiency of government spending. Yet, there are strong, embedded, incentives or disincentives for governments to adopt pro-cyclical fiscal policies. In a downturn, therefore, such pro-cyclical policies can only accentuate difficulties in the short-run and dampen growth in the medium-term.
The probability of such outcomes increases with orthodox stabilization programmes, which advocate pro-cyclical macroeconomic policies: a restrictive fiscal policy and a tight monetary policy. This is just the opposite of anti-cyclical macroeconomic policies adopted as a rule by governments in industrialized countries. It is also counter-intuitive in so far as it is the opposite of what students of macroeconomics learn across the world. As a result, growth is dampened, if not stifled (Easterly et al., 2001).
Clearly, then, it is both necessary and desirable to explore alternative methods of stabilization, which would minimize the negative impact on growth and, if possible, foster growth. In this endeavour, it is important to learn from mistakes in orthodox policies and from experience with unorthodox policies.
A contractionary fiscal policy is often associated with cuts in public investment which constrain growth in the medium-term, in part, because such cuts squeeze investment in infrastructure and, in part, because such cuts dampen private investment. Similarly, a tight monetary policy used to stabilize prices can constrain growth by making funds for investment more expensive and less available. In developing countries, higher interest rates dampen private investment. But that is not all. High interest rates can also lead to more failures in firms and banks. All this inhibits future growth.
Obviously, it would be preferable to consider alternative methods of stabilization. Fiscal adjustment should not rely excessively on expenditure reduction but should also attempt to increase income of the government. At the same time, it is essential to raise the level and rate of investment in the economy. For this, an increase in public investment, particularly in infrastructure, is perhaps the most effective method, because it could stimulate private investment and ease supply constraints. Similarly, stepping up public expenditure in social sectors would not only protect the poor or the vulnerable but would also help maintain aggregate demand wherever necessary. Easier access to credit, even if selective, or the use of controls on capital inflows, instead of relying on higher interest rates alone, would also reduce the adverse effects of stabilization on growth. What is more, the anti-cyclical stance of such methods, taken together, would be supportive of growth in the medium-term.
Economic policies do matter. And, for an economy in crisis, whether government raises or lowers expenditure, or raises or lowers interest rates, makes an enormous difference. The mix of policies is obviously important but the trade-off between stabilization and growth is much less than orthodoxy suggests.
4 Deficits and adjustment: identities and causation
The economic philosophy of orthodox stabilization programmes rests on the belief that the internal imbalance in the fiscal situation and the external imbalance in the payment situation are closely related. The macroeconomics of this relationship can be reduced to a simple proposition based on the national income accounting identity: ex post, the current account deficit in an economy is the sum of (a) the difference between investment and saving in the private sector and (b) the difference between expenditure and income in the government sector
This proposition, derived from the national income accounting identity, forms the analytical basis of the concept of twin-deficits in orthodox macroeconomics conceptualized and popularized by the IMF. The conclusion drawn is that any reduction in the current account deficit in the balance of payments of an economy requires a reduction in the fiscal deficit of the government. It is possible to reduce this proposition to an even simpler formulation. If the private sector is assumed to make both ends meet, so that income equals expenditure and, given consumption, saving equals investment, the deficit in public finance would be exactly equal to the deficit in the current account in the balance of payments. The excess of expenditure over income in the government sector, then, is matched exactly by an excess of expenditure over income for the economy as a whole which is met by borrowing from abroad. But, as we have seen, even if saving and investment in the private sector are not equal, there is a correspondence between the current account deficit of an economy and the fiscal deficit of its government.
It must be stressed that an accounting identity does not, and cannot, establish economic causation. For a definitional equality is a mere truism. It is not an explanation. Consider, for example, the statement: “It rains on a rainy day.” This is a truism. It does not explain why it rains or when rain can be expected. Similarly, the twin-deficit definition does not identify any mechanism by which a reduction in the fiscal deficit will lead to a reduction in the current account deficit. For an understanding of macroeconomic systems, the accounting relations of macroeconomic aggregates need to be combined with an economic analysis of causal determinants. The nature of relationships between variables (what is autonomous and what is induced) and the direction of causation (what determines what) are both a function of the institutional setting. In principle, the mechanism, if it exists, must work either through prices or through quantities or through some combination of both. In practice, the nature of causation would be determined by the institutional context in the economy.
The price adjustment story runs as follows. Given revenues, an increase in government expenditure will mean a higher government deficit, causing inflation, hence raising prices of goods produced at home. As a result, at a given exchange rate, people will buy cheaper foreign goods rather than domestic goods which will widen the trade (current account) deficit, until the government deficit and the external deficit match one another or correspond to restore the definitional identity. A similar mechanism would also work in the opposite direction. A reduction in the government deficit would then correspondingly reduce the trade (current account) deficit by improving the price competitiveness of domestic goods in the world market. This simple theoretical construct can be embellished in many ways with models or statistics. But the basic story line remains. And this is the story line that the IMF advocates.
But there is an alternative story based on quantities, or outputs and incomes, rather than prices. The income adjustment story runs as follows. As the government reduces its expenditure, hence deficit, the purchasing power in the economy falls, directly in the government sector, and then, indirectly, in the private sector for producers and workers who supply to meet the demand from government. The result, through the multiplier, is a magnified fall in purchasing power, much larger than the original reduction in the government deficit. This contraction in purchasing power means a shrinking market at home for domestic producers, leading to a spreading loss of income and employment all around. It is this falling income which reduces imports until the trade (current account) deficit is reduced again to match, or to correspond with, the government deficit. A similar mechanism would work in the opposite direction. And this is the story line that orthodoxy ignores.
There is much that we can learn about this process of adjustment from the experience of orthodox stabilization programmes. A large number of countries in Latin America, Africa, Asia and Eastern Europe have undergone stabilization, as part of an arrangement with the IMF, over the past 25 years. Available evidence suggests that a substantial reduction in the government deficit reduces the trade deficit very significantly through a reduction in the level of economic activity, employment and output, rather than by simply reducing the rate of inflation in the country attempting stabilization. Thus, reduced government deficits may end up reducing trade deficits, only at considerable social cost, through a reduction in output and employment which is accentuated by multiplier effects. It would seem that the income adjustment story is more probable, and no less plausible, than the price adjustment story
The orthodoxy about twin-deficits simply assumes that macroeconomic systems are characterized by price adjustment and not income adjustment. This, in turn, rests on the convenient assumption that stabilization through deflation, which reduces government deficits, will not affect output, and even if it does, the impact would be little. The quantity theory of money provides the analytical foundation for this belief on the premise that any fall in the quantity of real output is exogenous, and full employment is always maintained. This thinking is reinforced by the belief that reduced government deficits reduce monetary expansion which lowers prices. But we know that reduced government deficits can also reduce output through the multiplier effect. This is validated by experience in country after country. Therefore, it is not plausible to expect smooth price adjustment and to assume away harsh income adjustment.
It is clear that the concept of twin-deficits is misleading as an analytical construct because an accounting identity does not establish economic causation. But that is not all. It may not even provide an accurate description of real world situations. Starting from the same identity, it can be said that, for any given expenditure-income gap in the government sector, there would be a one-to-one correspondence between changes in the current account deficit (surplus) and the saving-investment gap in the private sector. In so far as the three gaps must sum to zero, much depends on which one is relatively stable. And if the government deficit (surplus) is relatively stable, the twin-deficits story could be missing out on the reality that the current account deficit (surplus) is shaped by the private sector. It is plausible to suggest that this may be so in much of Asia.
5 Macroeconomics of public finances
In analyzing the macroeconomics of structural adjustment, the discussion so far has simply referred to the fiscal deficit of the government. This generic term conceals more than it reveals. There are different measures of deficits in government finances, which are often used in an inter-changeable manner. This can be misleading. Even at the risk of stressing the obvious, therefore, it is worth making an analytical distinction between the gross fiscal deficit, the monetized deficit, the revenue deficit and the primary deficit (Nayyar, 1995).
The gross fiscal deficit measures the difference between revenue receipts plus grants and total expenditure plus net domestic lending, where the latter exceeds the former. In simpler words, it is the difference between the total income and the total expenditure of the government which is financed by borrowing. Therefore, it also provides a measure of the increase in public debt during the year. It is the most complete measure of the deficit in government finances.
The monetized deficit is that part of the gross fiscal deficit which is financed by government borrowing from the central bank. In most developing countries, borrowing from the central bank is the primary source of reserve money. Thus, for any given money multiplier, the monetized deficit is the main determinant of the increase in money supply in the economy.
The revenue deficit or the revenue surplus measures the difference between the revenue receipts of the government (made up of tax revenues plus non-tax revenues) and the non-investment (consumption) expenditure of the government. It seeks to focus on the revenue account in the gross fiscal deficit by excluding the capital account. The distinction between the capital account and the revenue account is most simply stated as follows: transactions which affect the net wealth or debt position of the government enter into the capital account while transactions which affect the income or expenditure of the government enter into the revenue account. Therefore, the revenue deficit provides a measure of government borrowing that is used to support consumption. In this sense, it is an important index of whether a fiscal regime is sustainable.
The primary deficit is the gross fiscal deficit minus interest payments. This is important for two reasons. For one, interest rates can be volatile and are sometimes beyond the control of governments in developing countries. For another, in countries where government debt is large as a proportion of GDP, interest payments constitute a large, pre-emptive, component of government expenditure
Macroeconomic policy is guided by a focus on intermediate variables such as deficits in government finances. But this can be misleading if accounting frameworks are inappropriate. Even appropriate accounting frameworks are not enough. The reason is simple. Such measures are like a thermometer. If it shows that the body temperature is above normal, it signals that something is wrong. But a thermometer does not provide a diagnosis for a patient. Similarly, an accounting framework can never provide a complete diagnosis, let alone a prescription, for an economy.
The accounting frameworks in use for deficits in government finances are an almost perfect illustration of this problem. And the problem is compounded because different measures are used for different purposes in a manner that is far from consistent. For a meaningful analysis of policy, therefore, it is essential that the use of accounting frameworks is determined by their macroeconomic significance. If the objective is to measure the total borrowing needs of the government, the gross fiscal deficit is the most appropriate. If the objective is to consider the implications of a deficit in government finances for monetary expansion, as an index of inflationary pressures, the monetized deficit is the most appropriate. If the objective is to assess whether a fiscal regime is sustainable over time, the revenue deficit is the most appropriate. If the objective is to examine what governments can do, or have done, to improve the fiscal situation, the primary deficit is the most appropriate.
This conceptual clarity is necessary. But it cannot eliminate ambiguities or anomalies altogether. It is worth citing some examples. First, the distinction between deficit financing of public consumption versus public investment is not always clear cut. The reason is simple. The conventional accounting notion of public consumption includes expenditures on health and education which, if well executed, have a large investment component. Second, in developing countries, the IMF has sought to focus on the overall public sector deficit, which includes not only all tiers of government but also government-owned firms. Such a consolidated budget for the public sector in an economy means that an increase in borrowing by public sector firms leads to an increase in the overall public sector deficit. In Europe, however, the IMF does not include borrowing by public sector firms in the government sector. This asymmetrical treatment embedded in accounting frameworks creates anomalies. Third, accounting frameworks in use by the IMF encourage governments to privatize public sector firms, in so far as capital receipts from such asset sales are absorbed in the budget to reduce the gross fiscal deficit of the government, even when such privatization is not otherwise necessary or desirable. From the perspective of the public sector, it would be preferable to use the proceeds from the sale of government equity, at least in part, to restructure public enterprises. In terms of macroeconomic management, it would obviously be desirable to use receipts from such asset sales to reduce (repay) public debt. But conventional accounting frameworks do not provide any credit for such sensible macroeconomics.
Such accounting frameworks also provide the basis for performance criteria that are used by the IMF in monitoring its stabilization programmes. The consequence is a concern about deficits in government finances that borders on fetishism. It is essential to recognize the fallacies of such deficit fetishism
Orthodoxy believes that reducing gross fiscal deficits is both necessary and sufficient for the macroeconomic adjustment. This is a myth. The size of the fiscal deficit, or the amount of government borrowing, is the symptom and not the disease. And there is nothing in macroeconomics which stipulates an optimum level to which the fiscal deficit must be reduced as a proportion of GDP. Indeed, it is possible that a fiscal deficit at 6 per cent of GDP is sustainable in one situation while a fiscal deficit at 4 per cent of GDP is not sustainable in another situation. The real issue is the allocation and end-use of government expenditure in relation to the cost of borrowing by the government. Thus, government borrowing is always sustainable if it is used to finance investment and if the rate of such investment is greater than the interest rate payable.
In an ideal world, there should be a revenue surplus large enough to finance capital expenditure on the social sectors, as also on defence, where there are no immediate or tangible returns. This would ensure that borrowing is used only to finance investment expenditure which yields a future income flow to the exchequer. So long as that income flow is greater than the burden of servicing the accumulated debt, government borrowing remains sustainable. In the real world, however, government borrowing is sometimes used, at least in part, to support consumption expenditure. In these circumstances, the rate of return on investment, financed by the remainder of the borrowing cannot be high enough to meet the burden of servicing the entire debt. This problem is often compounded by IMF conditions in stabilization programmes which raise the cost of government borrowing. For one, governments are forced to cut back sharply on borrowing at low interest rates from the central bank so as to reduce monetary expansion. For another, financial deregulation means that governments have to borrow at a significantly higher cost, from the commercial bank system and the domestic capital market, as interest rates on government securities are raised to market levels
There is a similar fetishism about monetized deficits. It serves little purpose to eliminate the monetized deficits for fear of inflation if the government continues to borrow as much from elsewhere, instead of the central bank, but at a much higher cost. There are other important macroeconomic consequences of such monetarism. For one, it makes public debt much less manageable and reduces fiscal flexibility for governments as interest payments pre-empt a much larger proportion of government expenditure. For another, high interest rates, which may not dampen government borrowing in the short run if not in the medium-term, crowd-out private investment, as rates of return on borrowed capital used to finance investment need to be much higher.
6 Political economy of policy design
Macroeconomic policies are neither formulated nor implemented in a vacuum. It is, therefore, important to recognize the significance of the political context. In any programme of stabilization and adjustment, there are winners and losers. And even if the benefits, which accrue to some, are greater than the costs, which are imposed on others, there are political consequences. For the compensation principle exists only in text books on welfare economics. In reality, the gainers do not compensate the losers. The political process sets out incentives and disincentives for governments. Citizens assess the economic performance of governments. In democracies, voters exercise their choice at the time of elections, which is shaped, at least in part, by the performance of the economy. Even in undemocratic or authoritarian regimes, governments are ultimately accountable to the people. Therefore, what governments can or cannot do in the sphere of macroeconomic policies is also shaped in the realm of politics.
The design and implementation of fiscal policy is often shaped by the constraints embedded in political economy. More often than not, adjustment through fiscal policies takes the form of reducing the expenditure rather than increasing the income of the government. Governments in developing countries find it very difficult to increase their income through tax revenues, because important political constituencies with a voice have the capacity not only to evade or avoid taxes but also to resist taxes. Orthodoxy does not help matters. For, typically, tax rates are lowered without any systematic effort to improve compliance or broaden the base for taxation. The Laffer Curve belief system is not the only culprit. Tax revenues, as a proportion of GDP, also stagnate, if not decline, since import tariffs are systematically reduced in the process of import liberalization, which is an integral part of stabilization programmes. In contrast, governments in developing countries find it somewhat less difficult to decrease their expenditure, although there are asymmetries. It is easier to cut investment expenditure than to cut consumption expenditure, just as it is easier to reduce public expenditure on social sectors where the economic constituencies are not as organized as elsewhere and the consequences are discernible only after a time-lag.
There is a similar intersection of economics and politics in the sphere of monetary policy. The orthodox view does recognize this but the recognition is limited to the macroeconomic significance of monetized deficits and the independence of central banks (Alesina and Summers, 1993). This is no doubt important, but there is more to the political economy of monetary policy. Interest rates are particularly important, for they can be used not only to stimulate investment or aggregate demand but also as a strategic instrument to guide the allocation of scarce investible resources in a market economy. But constraints embedded in political economy reduce degrees of freedom in the use of interest rates. Property-owning democracies with extensive rentier interests, in developing countries, almost as much as in industrial societies, prefer higher interest rates not only because of higher income from financial assets but also because a wider middle class fears that inflation might erode the real value of their accumulated savings (Bhaduri, 2002). In developing countries that have carried out capital account liberalization, sources of foreign capital inflows also prefer higher interest rates and lower inflation rates. It is not surprising, then, that any lowering of interest rates is resisted by an emerging rentier class in domestic financial markets which has a political voice, just as any lowering of interest rates is constrained by an integration into international financial markets which also become significant political constituencies for Finance Ministers. Differential interest rates, which were used effectively in East Asia, are no longer an option after the deregulation of domestic financial sectors. Yet, in segmented and imperfect capital markets, access to credit may turn out to be unequal between sectors or groups depending upon political voice or influence.
There is an interesting twist in the tale, for those excluded by the economics of markets are included by the politics of democracy
Stabilization and adjustment, inevitably, have an impact on income distribution at a macro level. But this issue is almost entirely ignored in the orthodox literature on the subject. There is an implicit underlying view that economics should be concerned with efficiency. Hence, if there are any adverse consequences of macroeconomic policies in terms of distribution or welfare, it is theorized that these can be corrected by efficient lump-sum transfers. But orthodoxy believes that this decision must be made in the realm of politics and not in the sphere of economics. In reality, however, issues of distribution cannot be separated from issues of efficiency. And it cannot suffice to say that the outcomes of economic policies should be moderated by social policies. A dichotomy between economic and social policies is inappropriate. In fact, no such distinction is made in industrial societies where there is an integration, rather than separation of economic and social policies.
In sharp contrast, the impact of economic policies on income distribution is centre-stage in the heterodox schools of thought. In this world, the effects of macroeconomic policies are significantly influenced by who gains how much from expansionary policies and who loses how much from contractionary policies. Their respective propensities to consume or to save are also important determinants of outcomes. These consequences are not confined to the short-run, for the consumption decisions of the households and investment decisions of firms, which are influenced by macroeconomic policies, also shape the prospects of growth in the medium-term.
The distributional implications and the social consequences of macroeconomic policies are often neglected. This needs to be corrected. In the short-term, it might be about the distribution of the burden of adjustment. In the medium-term, it might be about cuts in subsidies which squeeze the private consumption of the poor or cuts in public expenditure for social sectors which curb the social consumption of the poor. In the long-term, it might be about the distribution of benefits from economic growth where employment expansion and employment creation are particularly important.
7 Restructuring of economies over time
The restructuring of an economy over time has three dimensions: the management of demand, the management of incentives and the development of capabilities and institutions. The objective of managing demand is to influence the level and composition of demand, hence output and employment, in the economy, mostly in the short-term. The objective of designing incentives is to induce supply responses and coax productivity increases, mostly in the medium-term. The objective of building capabilities at a micro-level and institutions at a meso-level is to create a milieu that imparts efficiency and dynamism to the growth process, mostly in the long-term
Each of these dimensions of restructuring has a close correspondence with the respective time horizons. But it is not possible to separate demand, supply and capabilities or institutions in this manner because there is an interdependence and an interaction which leads to spillovers. It would take too long to set up a complete matrix. Some examples would suffice. For instance, aggregate demand management in the short-term, which is part of a stabilization programme, may squeeze supply responses in the medium-term. Similarly, incentive management, say in the form of import liberalization, may impact the level of demand in the short-term at a macro-level if it switches expenditure away from home-produced goods and may affect capabilities in the long-term if it enforces closures rather than efficiency at a micro-level. And, state intervention meant to support the development of capabilities and institutions in the long-term, say strategic industrial policy, may affect incentive structures in the medium-term and aggregate demand in the short-term.
In this wider context, economic liberalization shaped by orthodoxy, through the influence of the IMF and the World Bank, has three limitations. First, it is overwhelmingly concerned with the management of incentives and the supply side in a medium-term perspective. Some attention is paid to the management of demand in the short-term, but this is limited to the quest for stabilization in a narrow sense in so far as the aim is to stabilize price levels rather than output levels. There is almost no recognition that the development of capabilities and institutions has a long-term significance. Second, it does not recognize the interdependence and interaction between these three dimensions of restructuring that straddle time horizons. In fact, it is necessary to recognize possible contradictions so as to avoid them and potential complementarities so as to exploit them. Third, it makes a commonplace, yet serious, theoretical error in the design of policies, for it confuses comparison of equilibrium positions with change from one equilibrium position to another. It simply does not consider problems that arise in transition from the starting point to the ultimate destination.
The management of demand, mostly internal but also external, is based on fiscal policy and monetary policy combined with exchange rate policy. It is concerned with stabilization. But the mix of stabilization policies is often inappropriate. Aggregate demand management through fiscal adjustment and monetary policy should squeeze imports and consumption of the non-poor, instead of investment and consumption of the poor. In a situation where incomes are low, consumption levels of the poor need to be protected by restraining inflation and maintaining public expenditure destined for the poor. The mode of adjustment on the demand side is crucial, for it can either stimulate or stifle growth. Therefore, fiscal adjustment should not rely excessively on expenditure reduction but should also attempt to increase income of the government. At the same time, it is essential to raise the level and the rate of investment in the economy. For this, it is necessary to increase public investment, particularly in infrastructure where private investment (whether domestic or foreign) is not readily forthcoming. As far as possible, such public investment should be financed out of higher tax and non-tax revenues. To some extent, borrowing can also be used for this purpose, provided that investments financed by borrowed resources yield adequate returns. The size of the fiscal deficit is less important than the use or the cost of borrowing. It is the revenue deficit, which requires borrowing to finance government consumption expenditures that must be progressively reduced and rapidly eliminated. The fetishism about reducing the fiscal deficit despite a burgeoning revenue deficit, or eliminating the monetized deficit despite the much higher cost of borrowing, is entirely misplaced. Similarly, the reliance on unsustainable and unstable capital inflows, through capital market liberalization, to finance current account deficits is a mistake. Direct foreign investment which provides non-debt-creating and investment-financing capital inflows is preferable as a source of external finance. But it has implications for domestic capabilities in the long-term that must be recognized.
The management of incentives, motivated by the objective of minimizing costs and maximizing efficiency at a micro-level, is based on a set of policies that are intended to increase competition between firms in the market place. Domestic competition is sought to be provided through deregulation in investment decisions, in the financial sector and in labour markets. Foreign competition is sought to be provided through openness in trade, investment, capital and technology flows. There are the obvious correctives. For one, the speed of change must be calibrated so that it can be absorbed by the economy. For another, the sequence of change must be planned with reference to an order of priorities. In both, whether speed or sequence, deregulation and openness must be consistent with the other dimensions of restructuring in the short-term and in the long-term. There are, however, problems beyond simple correctives that must be addressed and resolved. First, it is essential to establish rules that govern markets, for the market is a good servant but a bad master, whether in the sphere of industrial deregulation, trade liberalization or financial sector reform. Second, a focus on sectoral components of reform may lead to a situation where the structure of incentives as a whole is inappropriate. For instance, the mix of tax reform and financial liberalization rewards finance capital more than industrial capital. But industrial capitalism is made on shop floors and not in stock markets. It is important to avoid the dangers of what Keynes described as “casino capitalism”. Third, it must be recognized that incentives may be necessary but are not sufficient and that there is nothing automatic about competition. In other words, policy regimes can only create an enabling framework but cannot deliver outcomes. The creation of competitive markets that enforce efficiency may, in fact, require strategic intervention through industrial policy, trade policy or financial policy (Amsden, 1989; Singh, 1994, Ha-Joon, 1996).
The development of capabilities and institutions is an essential foundation for international competitiveness. This is clearly established by the experience of the successful latecomers to industrialization, particularly in Asia but also elsewhere (Lall, 1990; Dahlman et al., 1987; Bell and Pavitt, 1992). It would seem that the third dimension of restructuring is often neglected altogether, even by those who wish to capture the benefits from integration with the world economy or dream of becoming global players. This must be corrected so that the long-term objectives of development receive much-deserved attention. In this context, there are three points that deserve emphasis. First, the importance of education in particular and human resource development in general cannot be stressed enough. It is vital. Second, the acquisition of technological and managerial capabilities is absolutely essential. It must be ensured that the structure of incentives helps in building, and does not end up stifling these capabilities. Third, the creation of institutions that would regulate, streamline and facilitate the functioning of markets is clearly necessary. This requires planning and takes time. In each of these pursuits, strategic forms of state intervention are of the essence. Therefore, the government simply cannot afford to abdicate its role in the belief that markets know best. It is only a creative interaction between the state and the market, which evolves in a dialectical manner with the passage of time, that can foster the development of capabilities and institutions in the process of industrialization
8 Conclusion
It would seem that the concerns of orthodox macroeconomics are much too narrow. What is more, orthodoxy does not recognize the specificities in time and in space that characterize developing countries and transition economies. It is, therefore, necessary to explore alternatives in the management of economies in crisis, from a different perspective. This should shift the focus from the financial to the real economy, from the short-term to the long-term and from equilibrium to development. It is imperative that the objective of macro-management should extend beyond managing inflation to restoring full employment. In developing countries, which have not yet reached a stage of full employment, macroeconomic policies should be conducive to employment expansion and employment creation. Similarly, it is essential to recognize that open economy macroeconomics is not simply about exchange rates or capital flows. Indeed, thinking must extend beyond the external sector of economies. The reason is that developments in the external sector spill over into the national economy with significant implications and consequences. It is, of course, important to think about the macroeconomic objectives of internal balance and external balance in the short-term. But it is just as important to think beyond the short-term, about macroeconomic policies that are conducive to economic growth, increased productivity and employment creation in the long-term. In doing so, it is important to remember the distinction between means and ends. Stabilization is a means. So is macro-economic management. For that matter, so is economic growth. It is development, for the well-being of people, which is an end.
Equation 1
Equation 2
Equation 3
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Corresponding author
Deepak Nayyar can be contacted at: deepaknayyar@mail.jnu.ac.in