2009 African Caucus Global Crisis and Africa - Responses, Lessons Learnt and the Way Forward Freetown, Sierra Leone August 2009 The Global Financial Crisis and Countercyclical Fiscal Policy John Weeks Professor Emeritus University of London Centre for Development Policy and Research

Global context Growth of OECD countries has declined dramatically, bringing down the sub-Saharan countries: OECD sub-Sahara OECD sub-Sahara % (actual) 6.0% (actual) 2008: 2.4 (actual) 3.7 (actual) 2009: 0.8 (estimate) 3.0 (calculated) 2010: -4.1 (projection) 0.9 (calculated) Note: OECD growth from

Growth of OECD countries and the sub-Saharan region, (OECD Actual, SSA forecast ) [Adjusted R2 =.39, coefficient =.44]

Preventing decline African governments have two general policy options. They can ‘hope-for-the-best’, continue with policies designed for a robust world economy, and await international recovery. This would place primary emphasis in macro policy on preventing inflation, setting a target for the fiscal deficit, and a free-floating exchange rate.

This option would represent a triumph of hope over experience. When the world economy is contracting a fiscal policy guided by fears of inflation results in a contraction of domestic demand to aggravate the contraction in exports.

The other option Countercyclical fiscal policy: An active fiscal policy to counter the international downturn through management of the public budget to the international downturn through management of the public budget to compensate for fluctuations in export demand.

A new policy consensus is emerging in favour of countercyclical responses to the world downturn. Policy makers in Africa can take advantage of and follow this emerging view. This presentation considers how the governments of Africa might design and implement such a policy.

How a fiscal stimulus package works:

Arguments against an active fiscal policy An active fiscal policy implies deficits and: 1. Deficits are inflationary 2. Deficits reduce (‘crowd out’) private spending 3. Deficits squeeze other expenditures through the servicing of the public debt These are not automatic outcomes, but ‘contingent outcomes’ that depend on the state of the economy, the size of the deficit and how it is financed.

Arguments against an active fiscal policy for African countries: 1. Balance of payments constraint Overcome with devaluation 2a. Deficit: Inflation threat The inflationary threat is minor in a depressed economy because of excess capacity and imports ‘absorption’.

2b. Deficit: ‘Crowding out’ private investment Mechanism: Public borrowing competes with private sector for credit i) will not occur when expenditure is funded by borrowing directly from central bank (monetising the deficit) ii) design new public expenditures to complement private expenditures.

Argument for an active fiscal policy An economy with idle resources is inefficient. The necessary condition for allocative efficiency is that an economy operate near its productive potential. The most important function of macro policy is to guide the economy to its productive potential.

An active fiscal policy can be prudent and responsible, without need for deficit targets or limits.

The four elements of an active fiscal policy: 1. Goal 2. Design 3. Implementation 4. Monitoring

A stimulus policy for African countries 1. Goals Short term: Prevent decline of the economy and the poverty that causes Medium term: Maintain economic efficiency by keeping the economy close to potential output

The constraints/risks: 1. Unsustainable fiscal deficit 2. Unmanagable trade deficit 3. Excessive inflation

Preventing decline in GDP would be achieved by the combination of: Public expenditure andDevaluation Consistent with 1. small increase in [fiscal deficit/GDP] 2. no increase in [trade deficit/GDP] 3. moderate inflation

2. Design The stimulus package would be a temporary measure undertaken in the downturn of the global cycle. Taxes are a clumsy instrument for demand management. Public expenditure offers the more effective mechanism to compensate for export demand fluctuations.

A country’s medium and long term growth rates are determined by the development of capacity, skills and technical change. Public investment contributes to increasing capacity, it is unwise to use it as a countercyclical instrument. Using them as a countercyclical instrument would waste of resources. Current expenditure has the flexibility for an effective countercyclical policy.

Design: summary 1. If a country’s potential growth rate is low, increase private & public investment. 2. Simultaneously use current expenditure for the short term demand to reach the potential created by past investment. 3. Much of current expenditure is inappropriate for countercyclical policy because it is long term. 4. Effective countercyclical expenditures use employment intensive techniques that create projects with low capital cost that can be initiated and terminated quickly.

3. Implementation A ‘countercyclical’ expenditure that becomes permanent negates its purpose. Initiation and termination could be triggered by a policy rule based on macroeconomic indicators. The specific indicator will vary by country, determined by the development and structure of the economy.

4. Monitoring A countercyclical policy requires monitoring rules to ensure that a stimulus is sufficient AND AND Stops when it is no longer needed.

Funding of countercyclical programmes The countercyclical fiscal stimulus in most African countries must be funded by public sector borrowing. If the increase in the deficit is not consistent with other policy goals, such an inflation guideline or size of the domestic public debt, increased grants could be sought to fill the funding shortfall.

Exchange rate management The exchange rate adjustment should be consciously managed: 1) to prevent a widening trade gap, by increasing the relative price of tradables; Countercyclical policy in Latin America in the 1960s and 1970s failed by generating unsustainable trade deficits.

2) to prevent excessive exchange rate induced inflation. The purpose of the weakening currency is to increase exports and decrease imports. This will provoke inflation by the amount of the devaluation times the propensity to consume. While necessary, the exchange rate induced inflation can destabilise the economy.

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

If the increase in expenditure is ‘too large’ and the currency adjustment ‘too small’, the stimulus generates a excessive fiscal and trade deficits. If the increase in expenditure is ‘too small’ and the currency adjustment ‘too large’, The stimulus improves the fiscal and trade deficits, but exceeds the inflation target.

Adjustment dynamics: To be feasible the fiscal stimulus must have ‘Goldilocks zone’ in which The fiscal deficit and trade deficit are within their policy guidelines and Inflation is below its guideline maximum.

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

1) reform conditionalities and ‘benchmarks’ by ending ‘stand-alone’ targets and ceiling set for: - Fiscal deficits - Foreign reserve holdings; - Inflation rates; and - Monetary supply Replace with flexible growth-related policy guidelines. For example, set an inflation guideline for the medium not short term.

2) increase donor predictability on delivery of assistance because a fiscal stimulus is frequently ‘finely tuned’ and late delivery of assistance could provoke macroeconomic instability. 3) Shift the focus of ODA negotiations from reform to recovery.

Preventing poverty: Fiscal policy for recovery & growth A carefully calibrated stimulus package plus donor flexibility can combine to overcome the effects of the global crisis. A stimulus package involves risks. These are minor compared to the effect of the global depression on poverty and public welfare.