1 October 1, 2003PP 253/ARE 253, Fall 2003 Alain de JanvryResponses to economic crises: Stabilization and adjustment policiesI. Issues:Growth important for poverty reduction (impact on inequality unclear)Instability of growth (crises) bad for poverty and for inequality.Questions that need to be addressed:What are the symptoms and causes of crises?How do countries respond to economic crises?How to re-establish macroeconomic equilibria? Stabilization policies.How to restore growth? Adjustment policies.How to avoid future crises?II. Causes of disequilibria1. External shocks: shortage of foreign exchange (D for $ > S of $)∑ Debt crisis (Latin America and Africa 1980s): excessive borrowing (easy money following the oil priceboom and debt-led-growth), rising interest rates (i) on outstanding foreign debt (U.S. anti-inflation policy),and ceiling on new debt (loss of confidence by international lenders), leading to defaults on debt servicing.∑ Sudden halt in FDI/FPI and capital repatriation (Peso crisis Mexico 1994, Asian crisis 1997, confidencecrisis Brazil 2002). Speculative crisis on expected devaluation.∑ Price shocks: falling prices of exports (coffee (Central America crisis 2002), minerals), increasing pricesof imports (oil shock 1970s). Devaluation Mercosur countries makes Argentine goods over-priced in theinternational market, leading to a decline in export earnings.∑ Falling foreign aid inflows: debt fatigue (fall in aid Africa).∑ Falling flow of remittances from workers abroad (tightening of U.S. border, Gulf crisis).2. Internal unsustainable policies (D > S)∑ Overvalued exchange rate (e Ø) encourage imports and discourages exports, leading to balance of tradedeficit (Argentina crisis 2001 with Currency Board and fixed exchange rate in spite of inflation))∑ Extensive government subsidies without fiscal resources (populism) creating public debt and inflation.∑ Price distortions (e.g., on i, food prices) benefiting consumers, creating excess demand and shortages.∑ Soft budget constraint on public sector firms inducing moral hazard behavior among managers: governmentquasi-fiscal deficit creating public debt and inflation.∑ Bubble economy (Asian financial crisis 1997): excessive borrowing by domestic firms (lack of bankregulation) and inefficient investments (cronyism), creating debts that cannot be repaid.III. Symptoms of disequilibria1. Inflation, hyperinflation (˙P).2. Balance of current accounts deficit (balance of trade < 0, debt service payments ≠) and falling balanceof capital accounts (FDI/FPI Ø, foreign borrowing Ø, K outflight ≠).1 1 Recall that:Balance of trade (BoT) = E - MBalance of current accounts = BoT + Net remittances + Net I income from abroad - Debt service paymentsBalance of capital accounts = FDI/FPI + Foreign borrowing (debt) + Aid - K outflightBalance of payments = B of current accounts + B of capital accounts.E.g.: U.S.: BoT < 0, BoCA < 0, BoKA > 0, BoP = 0.E.g.: Japan, Taiwan: BoT > 0, BoCA > 0, BoKA < 0, BoP = 0.2 October 1, 20033. Fiscal budget (B) deficit leading to money creation and borrowing on the domestic market.Government borrowing on the domestic financial market crowds-out private borrowing and investment byraising i.IV. Needed adjustments to reduce disequilibriaStart from material balances equation: at equilibrium D = S, orNational Expenditures = K outflight debt repayment)Tax Rev. aid new debt National RevenuesDPCIG ePMe ePX ePE eFDI FPI e SME=++()++ + =+()++ +++ ==$$()(()(), orExpenditures Revenues Tax Rev.K outflight – – – Aid Debt repayment New debt(Private deficit) (Public deficit)(Trade deficit)Capital accounts deficit-=-=+-()+-()+-()++-ªDS PCI X PG eP M PEe FDI FPI eME$$()()()0If expenditures and in excess of revenues, we need to:∑ Reduce the private deficit.∑ Reduce the public deficit.∑ Reduce the trade (and current accounts) deficit.∑ Reduce the capital accounts deficit.To do this, we need to:∑ Decrease demand (short run)∑ Increase supply (long run)Reduce deficits: Stabilization (short run)Ø DemandAdjustment (long run)≠ SupplyPrivate deficitØ C, Ø I≠ XPublic deficitØ G≠ Tax revenuesTrade deficitØ M≠ ECapital account deficitØ K outflight, ≠FDI, FPI, aidØ debt repayment, ≠ new debtC = consumption, I = investment, X = output after tax, G = government expenditures, Tax = tax revenues,M = imports, E = exports.V. Demand management (stabilization): ØC, ØI, ØG, ØM (IMF crisis-management programs)1. Devaluation : e = pesos/US$ ≠, i.e., the dollar becomes more expensive in terms of domestic currency.Consequences of devaluation: ≠E, ØM; tourism by foreigners ≠; tourism abroad by nationals Ø. Helps reducethe trade deficit.2. Fiscal austerity: ØG.i) Ø Current expenditures: Ø subsidies, Ø welfare programs, Ø soft budget constraint, Ø governmentemployment.Consequence: since it will Ø skilled labor employment, is it politically feasible?ii) Ø Public investment (Public I).Consequence: since it will Ø unskilled labor employment, is it politically easier but problematic for long termgrowth?Consequence: Helps reduce the public deficit.3 October 1, 20033. Restrictive monetary policy: Ø money supply, Ø credit.Consequence: ≠ i induces Ø in C and I. Helps reduce the private deficit.4. Wage repression: Ø real wage (w), e.g., lag in adjusting the minimum wage to inflation.Consequence: Ø C. Helps reduce the private deficit.5. Price management (heterodox approach)Put temporary controls on prices to contain inflation (but hard to enforce, and need to use the period of controls toreduce the public (Ø G) and private (Ø C and I) deficits).6. Decrease capital outflight and increase FDI, FPI: ≠i to attract capital from abroad. Dilemma betweendevaluation and recession.7. Decrease debt repayment and negotiate access to stand-by loans: default, debt rescheduling,, debtrenegotiation, debt swaps. Conditionality lending.8. Put in place social safety nets to manage the political feasibility of reforms and reduce welfare cost on the poor:Social funds.VI. Supply management (adjustment): ≠X, ≠Tax Rev, ≠E (World Bank development programs, WashingtonConsensus)1. Liberalization and deregulation1.1. Trade liberalization: transform quotas and permits into tariffs, ØM tariffs (≠ M), ØE taxes (≠ E).Hopefully will increase exports more than imports.1.2. Domestic price liberalization: remove price
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