Key Lessons from the Crisis and Way Forward

Transcription

1 Research Conference on Key Lessons from the Crisis and Way Forward 16 th -17 th February 2011 Room II, International Labour Office, Geneva Session 1: The Crisis: Where do we stand? Post-crisis macroeconomics and the global development agenda: Which way now? Iyanatul Islam Abstract This paper focuses on the r ole that m acroeconomic policies can pl ay i n su pporting t he attainment o f the M illennium D evelopment G oals (MDGs) and t he so cial pr otection floor initiative (SPF-I). The standard macroeconomic framework that prevailed in the pre-crisis era and co ntinues to pr evail t oday focuses on i nflation, debt s and de ficits. T he pos t-crisis macroeconomic framework needs to reflect on how sustainable resources can be harnessed to support public investments in health, education and infrastructure that are crucial in attaining the M DGs and t he SPF-I. Complementary i nitiatives include a more flexible approach t o i nflation t argeting, financial i nclusion, co mpetitive and st able r eal e xchange rates, pr udent c apital a ccount management, e conomic diversification and l abour m arket governance.

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3 Post-crisis macroeconomics and the global development agenda: Which way now? 1 Iyanatul Islam 2 1. Introduction The global development agenda as it currently stands has two core elements: (a) attainment of the Millennium Development Goals (MDGs and (b) the social protection floor initiative (SPF-I). The MDGs were, of course, endorsed by UN member states in 2000, but as the target date for attainment is only five years away (2015), renewed attention is being given to them. The SPF-I is of much more recent vintage and was endorsed by the UN system in April This was driven by the perception of the global inadequacy of social protection systems. Thus, 50 percent of the world s populations do not have any access to social security, while 80 percent do not have access to adequate social security coverage. 3 It is commonly acknowledged that growth alone will not lead to the attainment of the MDGs and the SPF-I. Hence, a wide range of policy initiatives, cutting across both macro and microeconomic dimensions, are required. This paper focuses on the role that macroeconomic policies can play in supporting the two core elements of the global development agenda. The standard macroeconomic framework that prevailed in the pre-crisis era and continues to prevail in the post-crisis era focuses on stability and predictability in the attainment of key nominal targets pertaining to inflation, debts and deficits. This is necessary, but not sufficient, for growth to be sustained. In any case, as noted above, growth alone will not be sufficient to make significant progress towards the attainment of the MDGs and SPF-I. In particular, the post-crisis macroeconomic framework needs to move beyond a preoccupation with nominal targets and reflect a lot more on how sustainable resources can be harnessed to support public investments in health, education and infrastructure that are crucial in attaining the MDGs and the SPF-I. This needs to be complemented by other initiatives entailing a more flexible approach to inflation targeting, an emphasis on financial inclusion, maintaining competitive and stable real exchange rates, a strategy of economic diversification and improving labour market governance. 2. The standard macroeconomic framework: An overview The developing countries experienced a growth revival in the 2000s after the lost decades of the 1980s and much of the 1990s as can be seen in the case of the LDCs in Figure 1. Such a growth revival was also associated with a significant reduction in both growth and inflation volatility as can be seen in the case of the LDCs in Figure 2. These declines in growth and inflation volatility have Paper prepared for presentation at Research Conference on Key Lessons from the Crisis and the Way Forward, th February, 2010, ILO, Geneva. Excellent research support provided by Sarah Anwar in the preparation of this draft is gratefully acknowledged. Chief of Country Employment Policy Unit, ILO, Geneva. These estimates are from the database maintained by the Social Security Department, ILO, Geneva. 1

4 been associated with substantial improvements in fiscal and current account balances across all regions of the world between the 1990s and 2000s. Figure 1: LDC Median Growth and Inflation MedianInflation and Growth (annual %) s 1990s 2000s Median GDP growth (annual %) Median Inflation, GDP deflator (annual %) Decade Source: World Development Indicators, World Bank Databank, 2010 While a multiplicity of factors were responsible for the growth revival, most notably a global boom ushered by a surge in external resources, one could argue that such a record can be partly attributed to the standard macroeconomic framework that was so dominant in the pre-crisis period. It was launched through the structural adjustment programmes of the 1980s and 1990s. Between 1980 and 1998, a total of 958 structural adjustment lending programmes were implemented by the Bretton Woods institutions in the developing world (Easterly, 2001). By 1999, the era of structural adjustment lending came to an end and was replaced by poverty reduction strategies (PRS). While hundreds of PRSs have been negotiated and implemented since then, the focus on macroeconomic stability remained intact. It appeared that, in the wake of the Great Recession, there would be a paradigm shift. One sizefits-all targets fell out of favour during with the pragmatic imperative during the crisis of putting in place countercyclical fiscal and monetary policies under very diverse contexts. In the case of LDCs, the policy advice offered by the IMF during was that countries with fiscal space should allow both automatic stabilizers and discretionary fiscal policy to support countercyclical measures (Berg et al., 2009). This emphasis on counter-cyclical measures proved short-lived. The current emphasis is on fiscal austerity programmes to rein in recession-induced debts and deficits in developed countries and the need for inflation control and continued fiscal prudence in developing countries (Global Monitoring Report, 2010, chapter 3). 2

5 Figure 2: LDCs Inflation and Growth Volatility Volatility Inflation volatility GDP growth volatility s 1990s 2000s Decade Source: World Development Indicators, World Bank Databank, 2010 Two key nominal targets have characterized the operational design of the standard macroeconomic framework: (a) the attainment of low, single-digit inflation and (b) prudential limits on public debt to GDP ratios supported by low fiscal deficits. The primary rationale is that stability and predictability in these targets engenders and sustains market confidence enabling the private sector to undertake critical savings and investment decisions that play a key role in growth and employment creation. Concerns about attaining the targets on inflation, debts and deficits have shaped the design of fiscal and monetary policies in developing countries and the utilization of aid inflows in public expenditure programmes. As the IMF s Independent Evaluation Office for 29 PRGF countries in SSA observes (Independent Evaluation Office, 2007, pp.8):.inflation control and domestic debt management have been key drivers of (aid) programmed spending levels. Program documents frequently cite the control of inflation as a factor in explaining program design, especially the setting of monetary and fiscal targets. And interviews with staff confirm that inflation remains a key driver of program design. Desk reviews show that domestic debt considerations loom large in PRGFs with most programs limiting domestic financing of the government amid concerns about inflation, debt sustainability, and private sector crowding out. The study also notes that cross-country analysis shows that on average SSA PRGFs have targeted inflation rates below 5 percent. As noted, the conventional framework has made a contribution to substantially improved macroeconomic balances in the developing world in the 2000s and that such an improvement has in turn contributed to the growth revival during that period. On the other hand, one should highlight the asymmetric nature of the macroeconomic stability-growth nexus: instability kills growth, but a restoration of stability has not necessarily led to an appropriate pattern of growth that is rapid enough to bring about a sustainable reduction in poverty and engender durable employment 3

6 creation. Not surprisingly, the attainment of the MDGs by 2015 remains an unfulfilled aspiration for the developing world as a whole, although there is considerable diversity around regional norms. 3. The limits of the standard macroeconomic framework The developing world escaped the worst consequences of the Great Recession. Large and populous economies such as China, India and Indonesia have quickly recovered and are growing at robust rates. Nevertheless, if one focuses on low income countries as a whole, the attainment of the MDGs and SPF-I still cannot be ensured, despite the growth revival of the 2000s and relatively quick recovery in the wake of the Great Recession. Indeed, a target growth rate of 7 percent is often suggested for the attainments of the MDGs. LDCs generally have not reached the target growth rate even during the global boom of the 2000s. What role can macroeconomic policies play in attaining the two core elements of the global development agenda? A discussion of this highly topical issue needs to be preceded by a discussion of the limits of the standard macroeconomic framework. As noted, a major feature of the conventional macroeconomic framework is the quest to attain nominal targets pertaining to inflation, debts and deficits. This has certainly contributed to improved macroeconomic imbalances, but this improvement did not translate into large enough growth and employment dividends in the region that could reverse the deleterious consequences of the lost decades of the 1980s and 1990s. Indeed, for a sample of 29 Sub-Saharan African (SSA) countries with access to PRGFs, per capita income in the mid-2000s were still lower than they were in 1980, while aggregate poverty remained roughly constant over the last twenty years. (Independent Evaluation Office, op.cit, pp.8). 4 In light of these somber statistics, it is perhaps not surprising that rethinking in macroeconomics in the post-crisis period is underway and that there is a greater appreciation of the limits of the conventional macroeconomic framework (Blanchard et al., 2010; White, 2010). A brief summary of the salient limitations is useful at this juncture. The heavy reliance on nominal targets is not rooted in robust evidence. For example, the emphasis on prudential limits on public debt-to-gdp ratio that plays such a key role in contemporary discourse on fiscal consolidation is not based on solid evidence (Chowdhury and Islam, 2010). While counter-cyclical policies became the norm in , the standard framework in general has been associated with the pursuit of pro-cyclical policies in Africa and other regions in the developing world. The available evidence suggests that such pro-cyclical policies have been inimical to job creation. For example, in the case of Tanzania, a moderate reduction of its generally high degree of pro-cyclical spending could have added almost 170,000 jobs per year over the period which is equivalent to 10 percent of its current employment level. (IILS, 2010). Developing country policy-makers often face significant constraints on their capacity to use monetary policy to influence aggregate economic activity and hence the aggregate inflation 4 PRGF pertains to poverty reduction growth facility and represents concessionary finance for LDCs run under the auspices of the IMF. It is now known as PRGT or poverty reduction growth trust. 4

7 rate. The effective implementation of monetary policy requires (a) a well developed bond market and (b) policy autonomy of monetary authorities. One study of 45 African countries finds that 17 have either narrow or no market for public bonds. In addition, 17 participate in a common currency area, thus precluding the effective use of national monetary policies. (Weeks, 2010). The emphasis on using monetary policy to attain predetermined inflation targets is an appropriate approach when inflation is driven by excess demand, but much less so when temporary inflation surges occur due to supply-side shocks which happened during the late 2000s as a result of the sharp increase in food, fuel and energy prices. Inflation targeting creates incentives for policymakers to restrain imported inflation by using the exchange rate as a nominal anchor. This, combined with unrestrained capital inflows, imparts a bias in favour of real exchange rate appreciation which damages export competitiveness. An unintended consequence of the standard framework is that it can restrict fiscal and policy space in countries in the region to pursue the attainment of MDGs and implementation of SPF-I. One study shows that two-thirds of the countries in the African region had excess capacity in the 2000s (as measured by the deviation of potential output from actual output) as a result of the emphasis put on the attainment of nominal targets pertaining to inflation, debts and deficits. (Njuguna and Karingi, 2007) The available evidence shows that there has been a secular decline in public investment in LDCs since 1990 (Figure 3), despite the fact that such investment makes a significant contribution to growth and employment. This can be attributed, at least in part, to the preoccupation to reign in debts and deficits during the structural adjustment era of the 1980s and 1990s. The consequence was that many governments cut capital expenditure while trying to preserve current expenditure. (Roy et al., 2006). Figure 3: LDC Public Investment (percent of GDP) Public Investment (% of GDP) Year Source: World Development Indicators, World Bank Databank, 2010 The standard macroeconomic framework pays insufficient attention to the critical and complementary roles played by strategies to encourage economic diversification and to 5

8 strengthen labour market institutions. When these strategies are in place they can confer multiple benefits ranging from stable unit labour costs to supporting aggregate demand through enhanced purchasing power. 4. Aligning macroeconomic policies with the global development agenda: some suggestions A key point in present debates is whether incremental changes, rather than a radical overhaul of the standard macroeconomic framework, are sufficient and adequate to align current policies with the global development agenda. Even incremental changes will take time to evolve and will require political will in countries to engage in policy experimentation. This section summarizes the elements of a macroeconomic framework that that has the potential to lead to significant progress in the attainment of the core aspects of the global development agenda by engendering more sustainable resources for public investment and by improving growth and employment prospects. These are issues that should be subject to more detailed research and social dialogue in the countries concerned. The discussion commences with fiscal policy and then proceeds to deal with complementary policy initiatives. The role of fiscal policy is to mobilize domestic and external resources within a framework of fiscal sustainability to support enhanced public investment in health, education and infrastructure that are critical in attaining the MDGs and in the implementation of SPF-I. This represents a departure from the current emphasis on treating fiscal and debt sustainability as the sine qua non of fiscal policy with its implication that core development goals play a secondary role (Kumhof et al., 2010). The Growth Commission (Commission on Growth and Development 2008, pp.30-35) suggests public investment rate of around 7 percent of GDP in infrastructure is needed as an important element of a national development strategy. Yet, the data suggests that barely 2 to 3 percent of GDP is invested in infrastructure in many developing countries and emerging economies. This is clearly a policy challenge given that 50 percent of firms in Asia and Africa cite lack of access to electricity as a major constraint on their business operations (Table 1). Addressing these concerns Table 1: The relative importance of access to infrastructure, finance and labour regulations as constraints on private sector development: global and regional averages Region percent of firms identifying a major constraint Electricity Transport Finance All EAP EECA LAC MENA OECD SASIA SSA Labour regulations Source: World Bank Enterprise Surveys, 2010 update, based on more than 100,000 firms and 118 countries. 6

9 requires determined public action to cope with the public investment deficit that has built up over decades. Hence, a resource mobilization strategy pursued through improved budgetary execution and enhanced tax-to-gdp ratios in countries with a low tax burden are core planks of a development strategy. This can be complemented by other initiatives, such as public-private partnerships. Domestic resource mobilization needs to be supported by enhanced development assistance from donors. Hence, maintaining aid commitments, and exploring feasible options for identifying alternative sources of reliable and low-cost development finance to supplement traditional sources, is an important element of a development-friendly macroeconomic framework. As noted, the reconfiguration of fiscal policy plays an important part in devising a developmentfriendly macroeconomic framework. At the same time, complementary initiatives are needed. In the domain of monetary policy and inflation targeting, policy-makers in the region might wish to adopt a more flexible approach and focus on broader goals and objectives. It is worth resurrecting the original intent and spirit of the IMF s article IV consultations which called on member states to attain reasonable price stability within a framework of growth-promoting policies. The precise interpretation of what is reasonable price stability should be tailored to country-specific circumstances in order to avoid a one-size-fits-all target. As part of this flexible approach to inflation targeting, one should avoid attempts to curb cost-push inflation through restrictive monetary policies because they are usually ineffective in taming inflation and, by raising the cost of borrowing, undermine investment and growth prospects. Indeed, the median real lending rate in LDCs has risen between the 1990s and 2000s (Figure 4). Furthermore, LDCs are afflicted by rising interest rate spreads. Figure 4: Change in median LDC Interest Rates Interest Rate (%) Lending interest rate (%) Real interest rate (%) and80s 1990s 2000s Decade Interest rate spread (lending rate minus deposit rate, %) Source: World Development Indicators, World Bank Databank, 2010 Moving beyond inflation targeting also means taking account of the extent to which lack of access to finance acts as a binding constraint on growth. Table 1 reveals that private sector firms in developing countries usually regard lack of access to finance as a major impediment to business operations and their employment creating potential. Hence, central banks and financial authorities 7

10 Box 1: The exchange rate regime and its implications for growth and employment in Malawi A study commissioned by the ILO shows that macroeconomic policy, particularly exchange rate policy, matters a great deal in affecting economic growth and employment creation. The study maintains that Malawi has a tradition of attempting to maintain a stable nominal exchange rate, i.e., fixing the value of the Kwacha in terms of US dollars The official purpose of maintaining a stable exchange rate is primarily to reduce inflation, with the government arguing that this anti-inflation dimension of exchange rate policy is worth preserving because export supply is not very responsive to the exchange rate. This might be true in the short-term, but ignores the role that a competitive real exchange rate plays in supporting structural transformation in the medium-term. The study shows that, given the higher inflation rate in Malawi relative to its trading partners, attempting to maintain a nominal exchange rate leads to a real appreciation and also induces volatility. There is also evidence that the real appreciation is associated with a sharp jump in import penetration from 44 percent of GDP in 2007 to 53 percent of GDP in The study urges policy-makers to recognize that with a competitive and predictable real exchange rate regime firms would most likely have created more jobs, invested more and diversified more in Malawi. have an obligation to enhance financial inclusion without forsaking their prudential obligations and their role in safeguarding price stability. Enhancing financial inclusion means (1) increasing access to finance for the private sector, especially small and medium-sized firms; (2) encouraging the development of well regulated and efficient microfinance institutions (MFIs) that can respond to the financing needs of poor and vulnerable households who seek durable self-employment. In the sphere of exchange rate regimes and capital account management, the aim should be the adoption of institutional arrangements that sustain real exchange stability, given the evidence that the real exchange rate exerts a powerful influence on structural transformation. (Rodrik, 2008). More specifically, a study on SSA using data for the 1970 to 2004 period shows that real exchange rate overvaluation reduces growth and impedes export diversification. (Elbadawi et al., 2008). As Box 1 shows in the case of Malawi, moving towards a competitive and stable real exchange rate regime is an essential component of a pro-employment macroeconomic framework. In cases where unrestrained capital flows poses a policy challenge, a more prudent approach to capital account management might be justified as this opens up policy space for initiatives that create employment. (Ostry et al., 2010). 40 percent of African countries have significant restrictions on the capital account, (Berg et al, 2009) but for the remaining 60 percent there is little or no evidence that capital account liberalization has necessarily provided them with the capacity to boost growth. (Cerra et al., 2009) Macroeconomic policy needs to be embedded in a holistic development strategy that seeks to promote economic diversification. Such diversification is necessary to sustain productivity-driven increases in real wages that are at the core of improving the living standards of workers and their families. This is where policy-makers face in some parts of the developing world face a major 8

11 challenge. One study, for example, shows that in the vast majority of SSA economies, more than half of exports consist of just two primary commodities. (Chandra et al., 2007) Furthermore, when various statistical measures are used, the SSA region has the lowest level of export diversification. (Clarke, 2005). Policy-makers are, of course, fully aware of the need to engage in export and economic diversification. Countries such as Kenya and Uganda have made substantial progress in economic and export diversification by moving into high value-added agricultural activities. In general, policy-makers in the developing world might wish to consider the construction of a framework of labour market institutions which help produce wage outcomes that, from a macroeconomic perspective, are conducive to maintaining aggregate demand and sustainable growth. (ILO-IMF, 2010, pp.75). This issue has gained a great deal of salience because declining wage share and rising wage inequality in the pre-crisis period in many developed and developing countries have contributed to global imbalances that were at the core of the global financial crisis of The construction of labour market institutions that strikes the right balance between protecting workers rights and promoting growth will need to ensure that real wages in aggregate grow more or less in line with productivity. (ILO-IMF, op.cit).this will mean strengthening mechanisms for wage determination through reinvigorated minimum wages policy, social dialogue and collective bargaining at the enterprise and industry level and tripartite consultations and negotiations on economic and social policies. Strengthening of the wage determination process along such lines is likely to lead to stable unit labour costs. This can confer triple benefits: (a) preservation of international competitiveness, (b) sustaining aggregate demand by acting as a bulwark against declining wage share and (c) sustaining reasonable price stability. 5. Concluding remarks This paper discussed the role that macroeconomic policies can play in supporting the two core elements of the global development agenda as manifested in the MDGs and the SPF-I. The standard macroeconomic framework that prevailed in the pre-crisis era and continues to prevail in the post-crisis era highlights the need for stability and predictability in the attainment of key nominal targets pertaining to inflation, debts and deficits. The rationale is that this boosts investor confidence and promotes growth. Boosting investor confidence is necessary, but not sufficient, for growth to be sustained. In any case, growth alone will not be sufficient to make significant progress towards the attainment of the MDGs and SPF-I. In particular, the post-crisis macroeconomic framework needs to move beyond a preoccupation with nominal targets and reflect on how sustainable resources can be harnessed to support public investments in health, education and infrastructure that are crucial in attaining the MDGs and the goals of the SPF-I. This needs to be complemented by other initiatives entailing a more flexible approach to inflation targeting, an emphasis on financial inclusion, maintaining competitive and stable real exchange rates, a strategy of economic diversification and improving labour market governance. 9

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