2009 African Caucus2009 African Caucus

Global Crisis and Africa - Responses, Lessons Global Crisis and Africa - Responses, Lessons Learnt and the Way ForwardLearnt and the Way ForwardFreetown, Sierra LeoneFreetown, Sierra Leone12-13 August 200912-13 August 2009

The Global Financial Crisis and The Global Financial Crisis and Countercyclical Fiscal Policy Countercyclical Fiscal Policy

John WeeksJohn WeeksProfessor EmeritusProfessor Emeritus

University of LondonUniversity of London

Centre for Development Policy and ResearchCentre for Development Policy and Research

Global contextGlobal context

Growth of OECD countries has declined dramatically, Growth of OECD countries has declined dramatically, bringing down the sub-Saharan countries:bringing down the sub-Saharan countries:

OECD OECD sub-Sahara sub-Sahara

2007 2.9% (actual)2007 2.9% (actual) 6.0% (actual) 6.0% (actual)

2008: 2.4 (actual)2008: 2.4 (actual) 3.7 (actual) 3.7 (actual)

2009: 0.8 (estimate) 3.0 2009: 0.8 (estimate) 3.0 (calculated) (calculated)

2010: -4.1 (projection) 0.9 (calculated)2010: -4.1 (projection) 0.9 (calculated)

Note: OECD growth from www.oecd.org Note: OECD growth from www.oecd.org

Growth of OECD countries and the sub-Saharan region, Growth of OECD countries and the sub-Saharan region, 1961-2009 (OECD Actual, SSA forecast 2007-2009)1961-2009 (OECD Actual, SSA forecast 2007-2009)

-5.0

-3.0

-1.0

1.0

3.0

5.0

7.0

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

2005

2009

SSA(t)

OECD (t-1)

2007

[Adjusted R2 = .39, coefficient = .44][Adjusted R2 = .39, coefficient = .44]

Preventing declinePreventing decline

African governments have two general policy African governments have two general policy options. They can ‘hope-for-the-best’, continue options. They can ‘hope-for-the-best’, continue with policies designed for a robust world with policies designed for a robust world economy, and await international recovery. economy, and await international recovery.

This would place primary emphasis in macro policy This would place primary emphasis in macro policy on preventing inflation, setting a target for the on preventing inflation, setting a target for the fiscal deficit, and a free-floating exchange rate.fiscal deficit, and a free-floating exchange rate.

This option would represent a triumph of hope This option would represent a triumph of hope over experience. over experience.

When the world economy is contracting a fiscal When the world economy is contracting a fiscal policy guided by fears of inflation results in a policy guided by fears of inflation results in a contraction of domestic demand to aggravate contraction of domestic demand to aggravate the contraction in exports. the contraction in exports.

The other optionThe other option

Countercyclical fiscal policy:Countercyclical fiscal policy: An active fiscal policy to counterAn active fiscal policy to counter

the international downturn through the international downturn through management of the public budget to management of the public budget to

compensate for fluctuations in compensate for fluctuations in

export demand. export demand.

A new policy consensus is emerging in favour A new policy consensus is emerging in favour of countercyclical responses to the world of countercyclical responses to the world downturn. downturn.

Policy makers in Africa can take advantage of Policy makers in Africa can take advantage of and follow this emerging view. and follow this emerging view.

This presentation considers how the This presentation considers how the governments of Africa might design and governments of Africa might design and implement such a policy.implement such a policy.

How a fiscal stimulus package works:How a fiscal stimulus package works:

Arguments against an Arguments against an active fiscal policyactive fiscal policy

An active fiscal policy implies deficits and:An active fiscal policy implies deficits and:1. Deficits are inflationary1. Deficits are inflationary2. Deficits reduce (‘crowd out’) private spending2. Deficits reduce (‘crowd out’) private spending3. Deficits squeeze other expenditures through 3. Deficits squeeze other expenditures through

the servicing of the public debtthe servicing of the public debtThese are not automatic outcomes, but These are not automatic outcomes, but

‘contingent outcomes’ that depend on the state ‘contingent outcomes’ that depend on the state of the economy, the size of the deficit and how of the economy, the size of the deficit and how it is financed.it is financed.

Arguments against an Arguments against an active fiscal policy for African countries:active fiscal policy for African countries:

1. Balance of payments constraint1. Balance of payments constraintOvercome with devaluationOvercome with devaluation

2a. Deficit: Inflation threat2a. Deficit: Inflation threatThe inflationary threat is minor in a depressed The inflationary threat is minor in a depressed economy because of excess capacity and imports economy because of excess capacity and imports ‘absorption’.‘absorption’.

2b. Deficit: ‘Crowding out’ private investment2b. Deficit: ‘Crowding out’ private investment

Mechanism: Public borrowing competes with Mechanism: Public borrowing competes with private sector for creditprivate sector for credit

i) will not occur when expenditure is funded i) will not occur when expenditure is funded by borrowing directly from central bank by borrowing directly from central bank (monetising the deficit)(monetising the deficit)

ii) design new public expenditures to ii) design new public expenditures to complement private expenditures.complement private expenditures.

Argument for an active fiscal policyArgument for an active fiscal policy

An economy with idle resources is inefficient.An economy with idle resources is inefficient.

The necessary condition for allocative The necessary condition for allocative efficiency is that an economy operate near its efficiency is that an economy operate near its productive potential.productive potential.

The most important function of macro policy The most important function of macro policy is to guide the economy to its productive is to guide the economy to its productive potential.potential.

An active fiscal policy can be prudent and An active fiscal policy can be prudent and responsible, responsible,

withoutwithout need for deficit targets or limits. need for deficit targets or limits.

The four elements The four elements of an active fiscal policy:of an active fiscal policy:

1. Goal1. Goal

2. Design2. Design

3. Implementation3. Implementation

4. Monitoring4. Monitoring

A stimulus policy for African countriesA stimulus policy for African countries

1. Goals1. GoalsShort termShort term::

Prevent decline of the economy and the Prevent decline of the economy and the poverty that causespoverty that causes

Medium termMedium term::

Maintain economic efficiency by keeping the Maintain economic efficiency by keeping the economy close to potential outputeconomy close to potential output

The constraints/risks:The constraints/risks:

1. Unsustainable fiscal deficit1. Unsustainable fiscal deficit

2. Unmanagable trade deficit2. Unmanagable trade deficit

3. Excessive inflation3. Excessive inflation

Preventing decline in GDP would be Preventing decline in GDP would be achieved by the combination of:achieved by the combination of:Public expenditurePublic expenditure

andand

DevaluationDevaluation

Consistent withConsistent with

1. small increase in [fiscal deficit/GDP]1. small increase in [fiscal deficit/GDP]

2. no increase in [trade deficit/GDP]2. no increase in [trade deficit/GDP]

3. moderate inflation3. moderate inflation

2. Design2. Design

The stimulus package would be a temporary The stimulus package would be a temporary measure undertaken in the downturn of the global measure undertaken in the downturn of the global cycle. cycle.

Taxes are a clumsy instrument for demand Taxes are a clumsy instrument for demand management. management.

Public expenditure offers the more effective Public expenditure offers the more effective mechanism to compensate for export demand mechanism to compensate for export demand fluctuations.fluctuations.

A A country’s medium and long term growth rates are country’s medium and long term growth rates are determined by the development of capacity, skills and determined by the development of capacity, skills and technical change. technical change.

Public investmentPublic investment contributes to increasing capacity, it contributes to increasing capacity, it is unwise to use it as a countercyclical instrument. is unwise to use it as a countercyclical instrument. Using them as a Using them as a countercyclicalcountercyclical instrument would instrument would waste of resources. waste of resources.

Current expenditureCurrent expenditure has the flexibility for an effective has the flexibility for an effective countercyclical policy. countercyclical policy.

Design: summaryDesign: summary

1. If a country’s potential growth rate is low, increase 1. If a country’s potential growth rate is low, increase private & public investment. private & public investment.

2. Simultaneously use current expenditure for the short term 2. Simultaneously use current expenditure for the short term demand to reach the potential created by past investment. demand to reach the potential created by past investment.

3. Much of current expenditure is inappropriate for 3. Much of current expenditure is inappropriate for countercyclical policy because it is long term.countercyclical policy because it is long term.

4. 4. Effective countercyclical expenditures use employment Effective countercyclical expenditures use employment intensive techniques that create projects with low capital intensive techniques that create projects with low capital cost that can be initiated and terminated quickly.cost that can be initiated and terminated quickly.

3. Implementation3. Implementation

A ‘countercyclical’ expenditure that becomes A ‘countercyclical’ expenditure that becomes permanent negates its purpose. permanent negates its purpose.

Initiation and termination could be triggered Initiation and termination could be triggered by a policy rule based on macroeconomic by a policy rule based on macroeconomic indicators. indicators.

The specific indicator will vary by country, The specific indicator will vary by country, determined by the development and structure determined by the development and structure of the economy.of the economy.

4. Monitoring4. Monitoring

A countercyclical policy requires monitoring A countercyclical policy requires monitoring rules to ensure that a stimulus is sufficientrules to ensure that a stimulus is sufficient

ANDAND

Stops when it is no longer needed.Stops when it is no longer needed.

Funding of countercyclical programmesFunding of countercyclical programmes

The countercyclical fiscal stimulus in most African The countercyclical fiscal stimulus in most African countries must be funded by public sector borrowing. countries must be funded by public sector borrowing.

If the increase in the deficit is not consistent with If the increase in the deficit is not consistent with other policy goals, such an inflation guideline or size other policy goals, such an inflation guideline or size of the domestic public debt, increased grants could be of the domestic public debt, increased grants could be sought to fill the funding shortfall. sought to fill the funding shortfall.

Exchange rate managementExchange rate management

The exchange rate adjustment should be The exchange rate adjustment should be consciously managed:consciously managed:

1) to prevent a widening trade gap, by 1) to prevent a widening trade gap, by increasing the relative price of tradables;increasing the relative price of tradables;

Countercyclical policy in Latin America in Countercyclical policy in Latin America in the 1960s and 1970s failed by generating the 1960s and 1970s failed by generating unsustainable trade deficits.unsustainable trade deficits.

2) to prevent excessive exchange rate induced 2) to prevent excessive exchange rate induced inflation.inflation.

The purpose of the weakening currency is to The purpose of the weakening currency is to increase exports and decrease imports. increase exports and decrease imports.

This will provoke inflation by the amount of This will provoke inflation by the amount of the devaluation times the propensity to the devaluation times the propensity to consume.consume.

While necessary, the exchange rate induced While necessary, the exchange rate induced inflation can destabilise the economy. inflation can destabilise the economy.

Exchange rate policy: summaryExchange rate policy: summary

Exchange rate management is necessary to Exchange rate management is necessary to ensure that the desired increase in the price of ensure that the desired increase in the price of traded commodities does not destabilise the traded commodities does not destabilise the economy.economy.

If the increase in expenditure is ‘too large’ If the increase in expenditure is ‘too large’ and the currency adjustment ‘too small’,and the currency adjustment ‘too small’,

the stimulus generates a excessive fiscal and the stimulus generates a excessive fiscal and trade deficits.trade deficits.

If the increase in expenditure is ‘too small’ If the increase in expenditure is ‘too small’ and the currency adjustment ‘too large’,and the currency adjustment ‘too large’,

The stimulus improves the fiscal and trade The stimulus improves the fiscal and trade deficits, but exceeds the inflation target.deficits, but exceeds the inflation target.

Adjustment dynamics:Adjustment dynamics:

To be feasible the fiscal stimulus must have To be feasible the fiscal stimulus must have ‘Goldilocks zone’ ‘Goldilocks zone’

in whichin which

The fiscal deficit and trade deficit are within The fiscal deficit and trade deficit are within their policy guidelinestheir policy guidelines

andand

Inflation is below its guideline maximum.Inflation is below its guideline maximum.

Implications for donors policyImplications for donors policy

Success in countering the global recession Success in countering the global recession requires that donors grant recipient requires that donors grant recipient governments the policy space to use fiscal governments the policy space to use fiscal policy effectively.policy effectively.

1) reform conditionalities and ‘benchmarks’ by 1) reform conditionalities and ‘benchmarks’ by ending ‘stand-alone’ targets and ceiling set for:ending ‘stand-alone’ targets and ceiling set for:

- - Fiscal deficitsFiscal deficits

- F- Foreign reserve holdingsoreign reserve holdings;;

- - Inflation ratesInflation rates; and; and

- - Monetary supplyMonetary supply

Replace with flexible growth-related policy Replace with flexible growth-related policy guidelinesguidelines. For example, set an inflation . For example, set an inflation guideline for the medium not short term.guideline for the medium not short term.

2) increase donor predictability on delivery of 2) increase donor predictability on delivery of assistance because a fiscal stimulus is assistance because a fiscal stimulus is frequently ‘finely tuned’ and late delivery of frequently ‘finely tuned’ and late delivery of assistance could provoke macroeconomic assistance could provoke macroeconomic instability.instability.

3) Shift the focus of ODA negotiations from 3) Shift the focus of ODA negotiations from reform to recovery.reform to recovery.

Preventing poverty: Preventing poverty: Fiscal policy for recovery & growthFiscal policy for recovery & growth

A carefully calibrated stimulus package plus A carefully calibrated stimulus package plus donor flexibility can combine to overcome the donor flexibility can combine to overcome the effects of the global crisis. effects of the global crisis.

A stimulus package involves risks. These are A stimulus package involves risks. These are minor compared to the effect of the global minor compared to the effect of the global depression on poverty and public welfare.depression on poverty and public welfare.