l 434b0
P ROCE E DING S O F TH E W O R L D BANK ANNU AL CONFE RE NCE
ON D E VE LOPME NT E CONOM ICS 1 990
FILE C0PY
Macroeconomic Policy and Growth:
Some Lessons of Experience
W. Max Corden
This paper asks how macroeconomic policies affect growth. It draws on the experiences
since 1974 of seventeen developing countries-Brazil, Cameroon, Chile, Colombia,
Costa Rica, C6te d'Ivoire, India, Indonesia, Kenya, the Republic of Korea, Mexico,
Morocco, Nigeria, Pakistan, Sri Lanka, Thailand, and Turkey. First, the paper looks at
the effects of the foreign-financed public spending booms of the 1 970s, which tended to
destabilize economies and lead to debt crises, initially raising and then lowering growth
rates. Next, the paper compares reactions to the 1980-82 crises and adjustment poli-
cies in four countries that were relatively successful-Colombia, Turkey, Thailand, and
Indonesia. The paper reviews the varying experiences with inflation of the countries in
the study and assesses the effects of inflation on growth. The generally low-inflation
countries experienced short bursts of high inflation caused by external shocks. Finally,
the paper analyzes the relation between inflation and exchange rate regimes and
describes the exchange rate policies of Indonesia and Mexico in detail. The paper draws
a number of policy lessons-notably the need to do cost-benefit analyses for public
investments, the need to avoid "euphoria" when the economic outlook appears favor-
able, and the need to react speedily to crises. Nominal exchange rates should be
adjusted to avoid unstable real rates, and a flexible exchange rate policy should be
combined with a commitment to a noninflationary monetary policy.
How do macroeconomic policies affect growth in developing countries? Can we
derive some lessons of experience to guide us in determining which policies are
relatively more favorable to growth?
To gain some insights into this subject, I survey seventeen developing coun-
tries, most of which have gone through episodes of public spending booms,
crises, and adjustment since 1974. 1 am able to take this overview because this
paper is a by-product of a World Bank research project on macroeconomic
policies, crisis, and growth in the long run, which involves comparative studies
of seventeen developing countries over a long period (usually since the
W. Max Corden is professor of international economics at the Paul H. Nitze School of Advanced
International Studies of Johns Hopkins University and a consultant to the World Bank. He wishes to
acknowledge comments on an earlier draft by Vittorio Corbo, John Cuddington, and William Easterly.
© 1991 The International Bank for Reconstruction and Development / THE WORLD BANK.
S9



60  Macroeconomic Policy and Growth
mid-1960s).1 My aim is to see what we can learn about the effects of macro-
economic policies on growth, both in the short and long terms. However, I do
not try to explain why governments pursued various macroeconomic policies at
different times; I am not engaging in political economy.
The methodology of this paper is eclectic. Unlike much generalizing and
model-building in academic development economics, the present study is not
based on the experience of only one or a few countries. Nor does it take an
econometric approach that conceives of many countries as representing, in some
sense, a common population. Rather, it attempts to take into account the
detailed experiences of a large number of countries.2 This approach is charac-
teristic of much World Bank research. Of course, in a conference paper one can
include only so much detail, evidence, and qualification. Thus the "lessons" I
relate at the end of each section of this paper should be understood as based on
much more evidence than I can present here. Similarly, they should be seen as
subject to numerous qualifications that I also cannot elaborate here. In short, I
am posing these lessons as a basis for discussion.
The paper draws extensively on the experiences of sixteen of the countries in
the World Bank study: Brazil, Cameroon, Chile, Colombia, Costa Rica, C6te
d'Ivoire, India, Indonesia, Kenya, Mexico, Morocco, Nigeria, Pakistan, Sri
Lanka, Thailand, and Turkey. The seventeenth country in the World Bank
study is Argentina, but it is such a special case that I mention it only sporadically
here.3 I have brought in Korea, however, so the total number of countries
studied is still seventeen. Korea is notable because it has had experiences similar
to those of many of the other countries, but, as is well-known, its policy reac-
tions and growth outcomes have been exceptionally favorable. Table I presents
some basic data on growth rates, inflation rates, investment ratios, and external
debt for these seventeen countries.4
In the last eight years or so, the academic literature on macroeconomic poli-
1. I am indebted to the authors of the forthcoming country studies, as well as to numerous published
papers on some of these countries. Here I would particularly like to note the country studies contained in
Sachs and Collins (1989) and Sachs (1990). The work of synthesis, drawing on the various country
experiences, is still in process, and is being done by Richard Cooper, Ian Little, Sarath Rajapatirana, and
myself. This paper has drawn on our ongoing work, and I am indebted to my co-authors. The views and
judgments expressed here are purely my own at this time, and may not coincide with my views or those of
my co-authors when this work is completed.
2. I am in sympathy with Reynolds (1985), who has sought an understanding of growth through in-
depth historical studies of many countries and has looked for some comparisons and generalizations from
these. He argues that "it is wrong to regard cross-section analyses as a satisfactory substitute for longi-
tudinal studies" (p. 13).
3. Inevitably, I shall refer to Argentina in the section on inflation.
4. All large developing economies (except Egypt, Korea, and Venezuela) are included in the project,
nine in all. A large economy is defined as any nonsocialist developing economy with a GDP greater than
US$30 billion in 1987 (billion equals 1,000 million). Medium-size economies (US$10 billion to US$29
billion) are Cameroon, Chile, Morocco, and Nigeria. Small economies are Costa Rica, C6te d'lvoire,
Kenya, and Sri Lanka.



Corden 61
Table 1. Growth, Inflation, Investment Ratios, and Debt: Seventeen
Developing Countries
(percent)
Gross domestic    Total external
1980-1988               investment as a     debt as a
Average annual   Average annual    percentage of     percentage of
growth in per    rate of inflation     GDP              GDP
Country            capita GNP          (CPr)       1980    1988    1980    1988
Korea, Rep.            6.9               8.7        31.7   32.6    48.7    22.0
Thailand               4.1               5.9        26.4   25.8    25.9    36.1
India                  3.7               9.4        22.8   21.5    11.9    22.3
Pakistan               3.7               7.2        18.5   17.6    42.5    45.6
Cameroon               3.1               9.5        18.9   14.0    36.8    33.7
SriLanka               2.8             13.0         33.8   22.8*    46.1    75.1*
Indonesia              2.6             10.0         24.3   28.0    28.0    69.0*
Turkey                 2.1             50.1         21.9   19.0    34.2    57.7*
Morocco                1.8              8.1         24.2   24.2    56.2   105.9*
Colombia               1.3             23.2         19.1   17.5    20.9    46.5*
Chile                  0.8             21.9         21.0   15.9    45.2    96.6*
Brazil                 0.6            212.2         22.9   16.7    30.6    30.7
Kenya                  0.3              10.9        30.0   19.0*    51.2    71.3*
Mexico               -0.6              74.5         27.2   16.7*    30.3    58.0*
Costa Rica           -0.9              28.3         26.6   23.9    59.5   100.0*
C6teD'lvoire         -3.3               6.4         28.2   11.6*    58.3   161.8*
Nigeria              -3.8              17.9         20.5     8.1*     8.9   107.1 *
Note: GNP is gross national product; GDP is gross domestic product; cpi is consumer price index.
Countries are listed in order of per capita GNP growth. Countries in which the investment-GDP ratio fell
by 10 percent or more between 1980 and 1988 are marked with an asterisk in the fourth column.
Countries in which the debt ratio increased by more than 20 percent of GDP over the period are marked
with an asterisk in the last column.
Source: World Bank data.
cies in developing countries has blossomed. Yet this literature has been domi-
nated by attention to a few Latin American countries-particularly Argentina
and Chile but also Bolivia and Brazil. For all four of these countries, economists
have been primarily concerned with analyzing the processes of reducing or
attempting to reduce high inflation. By broadening the scope of investigation
and giving a little more attention to the non-Latin American countries, one is
reminded, for example, that inflation is not a general characteristic of develop-
ing countries.
Section I of the paper deals with the public spending booms that destabilized
various developing countries at different times, usually between 1974 and 1980,
and that together with terms of trade and interest rate shocks brought about
fiscal imbalances and accumulations of debt that caused the subsequent crises
and need for adjustment. Section II deals with the crises of the early 1980s and
subsequent macroeconomic adjustments. Section III discusses the relation
between inflation and growth, and section IV treats exchange rate policy. My
major interests are in the implications of various macroeconomic policies for
growth in each of the seventeen countries and the lessons that may be derived
from looking closely at their experiences.



62 Macroeconomic Policy and Growth
1. THE PUBLIC SPENDING BOOMS
A Stylized Story of a Boom
Let us begin with a simple stylized story of a public spending boom. Of
course, this story actually varies greatly between countries, and I will consider
these variations later.
In our hypothetical case, first, there is an increase in public spending, whether
on consumption or investment, caused above all by the ready availability of
funds from the world capital market. The extra spending goes both toward
home-produced goods and toward imports. The higher demand for home-
produced goods increases domestic output, given that there is some slack in the
domestic economy. This is the Keynesian effect, which manifests itself in a
short-term rise in the growth rate. (The Keynesian effect on output may last for
a time after the growth rate declines, but it will be temporary when the boom
itself is temporary.) In addition, extra demand for imports worsens the current
account. The adverse effect of the spending boom on the budget is moderated by
higher tax revenue resulting from domestic output expansion and by the fact
that increased imports bring in more revenue from taxes on trade.
In due course-usually very quickly-domestic prices rise in response to the
higher demand. Given a fixed nominal exchange rate (or one that is not depreci-
ated much in response), this produces an appreciation of the real exchange rate,
with the usual expected effects. The higher domestic costs, including wages,
squeeze the profitability of exports. In addition, domestic demand switches
toward exportables and toward imports, especially imported inputs into domes-
tic production. Hence the current account worsens further.
The precise effects depend, of course, on such matters as the composition of
extra government spending-in particular its import content (or, more gener-
ally, its tradable content). This in turn may depend, among other things, on how
much is extra investment spending and how much is consumption spending. Its
subsequent effects-its effects on real output and income, and hence on the
medium- and long-run rates of growth-are of particular interest for this paper
and are discussed below. Obviously they depend, above all, on how much has
been extra investment spending, how efficient the investment has been, and
what debt burden has been incurred. Inevitably, the real appreciation would
have to be reversed once the spending boom comes to an end, and this can also
be regarded as an important medium-run effect.
Because of the Keynesian output and income expansions, private consump-
tion spending will rise. Private investment spending will rise if there is a favor-
able expectations effect.
At the same time, or possibly before the spending boom was embarked on,
there may have been a rise in export income caused by improved terms of trade.
This may have led directly to higher private incomes, which are then spent and
have the effects just discussed-Keynesian expansion, real appreciation,
increased imports, and a squeeze on those exports that did not benefit from the



Corden 63
boom. The rise in export income will also have led to higher government reve-
nues, which are then spent, as before, with the usual effects. The real apprecia-
tion resulting from such an export-financed spending boom leads to the familiar
Dutch disease-a squeeze on nonboom ("lagging sector") tradables. When the
spending boom is financed out of the gains from an export boom there will not
be an increase in foreign debt. Indeed, the export boom may exceed the spending
boom so that reserves are actually built up, as happened in a few countries. In
other countries the spending boom was greater.
The Booms: What Actually Happened
The stylized story gives a general indication of what happened in the seven-
teen countries, but there were great variations (for other comparative studies of
booms, see Gelb and others 1988 and Cuddington 1989). The common feature
is that all except Chile and India had a public investment boom at some stage
during the 1974-81 period, and in almost all cases this led to increased foreign
debt. The fact that this was so common is quite striking, especially considering
that during the same period, developed countries were generally going through
reduced growth and were trying to restrain public spending.5 The explanation
of the booms is a matter of political economy, and here each country appears to
have its own story. Yet there must be some common factors-the most obvious
being the easier availability of funds on the world market.
Despite some commonalities, the booms differed greatly in timing, magni-
tude, and details. India did not have a boom and borrowed very little. Did India
thereby miss opportunities? Chile experienced only a private investment and
consumer durables boom. (The debts incurred by private borrowers in Chile
were taken over by the government because of the crisis and pressure from
foreign creditors, so the net result for public external debt was much the same as
if the boom had been public originally.)
In the three oil-exporting countries-Indonesia, Mexico, and Nigeria-the
booms were clearly initiated in response to higher actual or expected export
income. In coffee-exporting Kenya the situation was similar. In Cameroon a
modest investment boom-in particular, investment in oil exploitation-
followed the coffee boom and preceded the oil boom. Morocco's public invest-
ment expenditures had already started to increase before the phosphate export
boom but then greatly increased as a result of this boom. In Costa Rica and Cote
d'Ivoire also, the public spending booms started before the export booms but
were indeed kept going longer than otherwise as a result.
It should be pointed out that Mexico actually had two spending booms. The
larger one was in 1977-81 and was clearly initiated by expectations of high oil-
export income. The smaller and earlier boom, during 1972-76, however, can be
5. This very factor caused demand for funds to decline and real interest rates to be low, and so made
banks more eager to lend to developing countries and made governments of developing countries more
ready to borrow.



64 Macroeconomic Policy and Growth
explained in domestic political terms and by the ease of foreign borrowing. It
was not associated with an actual or prospective export boom.
Colombia is a special case. It had an export boom in coffee but not a public
investment boom at all during the export boom period. Rather, the gains went
mostly to the coffee producers; the monetary effects were partly sterilized; and
the budget deficit was reduced. Colombia's story is resumed later, but it should
be noted now that Colombia finally did have a public spending boom-one that
came as a reaction to the decline in the coffee price and that was designed to
stabilize domestic demand.
The accounting so far leaves six countries that had public investment or
spending booms of some kind but no export booms at all during the period. Sri
Lanka's boom was particularly big and is discussed below. Turkey had its boom
roughly from 1974 to 1977, encouraged both by the ease of borrowing abroad
and by a 1971-73 boom in remittances from workers abroad (this was similar in
effect to an export boom). Pakistan had a public investment boom in 1974-76
and was able to finance its current account deficits through cheap loans from
some of the oil-producing Gulf countries. Korea increased its investment ratio
(private and public) from 1974, and in 1978 and 1979 it went into a short-lived
"maxiboom" resulting from a major investment drive in heavy and chemical
industries. Even cautious Thailand followed the fashion and went into a modest
foreign-financed public investment boom in 1977-78. Brazil maintained a high
level of spending despite the adverse effects of the oil price rise, and it borrowed
heavily, but the investment ratio only rose slightly in 1974 and 1975; much of
the foreign-financed investment was done by parastatal enterprises.
Many of the countries built up big debt burdens during this period. India was
an exception. Other notable exceptions were Cameroon, Colombia, and
Nigeria-all countries in which the export boom exceeded the spending boom
and in which reserves were built up. Pakistan also did not really develop a debt
problem because the concessional nature of its loans made interest payments low
and because the nation borrowed only modestly.
Implications of a Boom for Growth
This paper began by asking how macroeconomic policies have affected
growth. The public spending booms leading to fiscal deficits that have been
described here were indeed the initiating macroeconomic policies for the whole
long episode I am discussing. How has growth been affected?
For many countries the data tell a simple story. During the booms, when the
investment ratio rose, the rate of growth of output also rose, and because much
of the boom was financed by foreign borrowing, spending grew even faster.
Later, after the crises began, both the investment ratio and growth fell, often
drastically. As for retained national income, because of debt-service payments,
the rate of growth-and sometimes even the level-fell even more. What, then,
has been the net effect of the whole episode on growth and on real incomes?
First, we must distinguish effects of investment booms on rates of growth



Corden 65
from effects on levels of output. It is really rather misleading to focus on growth
rates. Suppose there is an investment boom in year t1, and this bears fruit in a
higher output level from year t3 onward. The rate of growth will then rise in
year t3 and fall back again to its trend value the next year. It is not a failure of
the investment boom that it has not led to a permanent rise in the growth rate.
Second, we should distinguish boom effects on "Keynesian growth"-or
demand-determined growth-from effects on growth of capacity. It seems
obvious that the increases in the growth rates in the years of the public spending
booms were Keynesian. They had nothing to do with the productivity of the
investment and its possible effects on long-term growth. It is not necessarily an
achievement for the macroeconomic policymakers to bring about growth of this
demand-led kind because such growth is not sustainable. As I have just sug-
gested, a Keynesian demand expansion leading to output levels above trend-a
boom-for several years may well cause the rate of growth to rise at first and
then to fall and become negative in the later years of the boom.
The issue is whether a boom yields fruit later. Let us focus on this and hence
on the possible effects on incomes and output. One possibility is that public
investment is efficient in an ex post facto sense. Perhaps output rises as a result
(when converted into tradables), and it rises sufficiently to finance the debt
service and something extra. In that case it will have had a favorable effect not
only on output but also on national income (that is, after net factor payments).
The spending will temporarily have raised the rate of growth, and it will have
made the country permanently better off. The rise in debt, even possibly in the
ratio of debt to gross domestic product (GDP), should not be a problem. The fact
that the so-called resource transfer resulting from the investment becomes nega-
tive once the investment ceases should not be a matter of concern.6
It is also possible that the investments could have been efficient in an ex ante
sense-that is, they were efficient, given available information and reasonable
expectations at the time, allowing for risk. But because of unexpected adverse
terms of trade and interest rate movements they turned out to be uneconomic.
This might be a good description of what happened in many cases, although
some of the investments were clearly not efficient even in this sense.
In any case, when investments proved inefficient it could still mean that
output growth was boosted for a time, and levels stayed higher than they would
have been otherwise. But a debt problem was generated or increased, forcing
reductions in absorption below levels that could have been sustained in the
absence of the earlier boom. Thus the effect on retained income (gross national
6. When the public investment boom is financed from a country's own export income boom, the story
has to be a little different. To judge the efficiency of the domestic investment, the stream of extra output
has to be set against the earnings that could have been obtained by investing the gains from the export
boom abroad. If domestic investment is inefficient there will have been the same sort of loss, as discussed
in the text, but it need not lead to or help to bring about a debt crisis in the direct sense. It will, however,
still reduce the country's creditworthiness (compared with investment abroad), and hence it will have an
indirect effect.



66 Macroeconomic Policy and Growth
product) was negative even though the effect on output (gross domestic product)
may have been somewhat positive.
In addition, the debt crisis had indirect adverse effects on outputs and real
incomes, and possibly growth later, and these must be attributed to the earlier
boom, which contributed to the buildup of debt. First, in some cases (notably
Brazil) the crisis led to an increase in trade restrictions. In other cases (notably
Mexico, Morocco, and Turkey) the crisis led to trade liberalization, so that
there was presumably a positive productivity-and possibly growth-effect.
Second, the crisis forced reductions in imports that caused outputs of import-
using industries to decline and, given some immobility of labor, at least transi-
tional unemployment.
Note that there is empirical support for the proposition that over a longer
period (196S-88) countries that on the average had high investment ratios
tended also to have high growth rates. Yet for the 1975-88 period, a clear time-
series relationship between investment ratios and rates of growth of output a few
years later-when the fruits of the investment would be expected-cannot be
found. But this is no surprise when we recall that during the boom period,
investment ratios and rates of growth were high, and during the crisis and early
adjustment period a few years later both were low (the earlier high growth being
explained by Keynesian effects and the later low growth by various factors,
including the consequences of the inefficient investment earlier). This has also
meant that there is a tendency toward a negative cross-country relationship
between investment booms in the 1974-80 period and rates of growth from
1982.
Lessons of the Boom
It is important to learn the lessons of this 1970s boom because some of the
circumstances that gave rise to it could come about again. The lessons should be
remembered whenever the economic situation for a country appears to be really
favorable. When the crisis comes it is too late to avoid pain.
How much macroeconomic destabilization can be tolerated? Suppose a coun-
try looks as though it is moving into a foreign-financed investment boom, public
or private, and all the evidence suggests that it is soundly based. If debt-
financed, the expected interest rate over the relevant period is low relative to
expected returns. Alternatively, the boom may be the result of direct private
investment, which is unsubsidized and sound on proper cost-benefit calculations
(though these may not necessarily be calculations that take into account the
considerations discussed here). But the boom is inevitably temporary.
Some macro-destabilization is then inevitable. During the boom the current
account will go into deficit (or greater deficit than before), the real exchange rate
will appreciate, and there will be some domestic inflation, all features described
in the stylized story earlier. It is important that price rises are perceived as
temporary adjustments, so that inflationary expectations are not generated.
Later these effects will tend to be reversed. This prospective destabilization has



Corden 67
to be recognized-and should be foreseen-but it is not sufficient reason to try
to kill a boom completely. Nevertheless, there is then a need for stabilizing or
smoothing policies-notably reducing public investment when the boom is a
private one, or moderating public and private consumption spending when the
source of the boom is the availability of funds from abroad for investment. The
adverse (Dutch disease) effects on the tradable industries of temporary real
appreciation are a particular problem; they strengthen the case for stabilizing
policies.
Unsound investment spending shows the need for a cost-benefit ap-
proach. Our study of the seventeen countries shows that some public spending
decisions were unsound on the basis of knowledge and reasonable expectations
at the time. Some projects were bound to be unsound because of the speed of the
decisionmaking processes, the rapidity with which the programs themselves
were implemented, and the massiveness of the investment. Many of the invest-
ment booms and borrowing splurges took place in very short periods and cre-
ated debt burdens that have affected the countries adversely for many years.
The obvious need is for a cost-benefit approach, preferably one that is institu-
tionalized. This lesson is as important for creditors (private or official) who are
eager to lend as it is for the governments. In particular, when the investment is in
nontradables, lenders and governments need to take into account the likelihood
of a later real depreciation. The need to reverse the resource transfer-as new
capital inflow declines and especially as interest and dividend payments have to
be remitted-means that there will have to be some real depreciation later, at
least relative to what might have happened otherwise. If new investment took
this into account it would tilt the pattern of foreign-financed investment in the
direction of tradables. At the same time, cost-benefit analysis that makes some
use of shadow pricing would tilt new investment away from highly protected
(usually import-replacing) industries. The net effect would be that investment in
export industries, or in direct or indirect inputs into exports, would be favored.
Beware of euphoria. It is well at this point to recall the experiences of three
countries-Chile, Sri Lanka, and Cote d'Ivoire.
In Chile there was massive private borrowing during a very short period-
1980 and part of 1981. This much-analyzed episode teaches at least two lessons.
The first is how quickly problems can be created that take years to solve. The
second is the need for caution against "euphoria." In this case, it was a euphoria
of the international capital market and of domestic investors about Chilean
economic prospects as a result of policy changes believed to be favorable to
private enterprise, and the building up of confidence in the private sector that
this situation would be sustained.
Sri Lanka's boom began in 1977 when a new, liberalizing government came
into power. From 1977 to 1982, public spending rose from 28 to 41 percent of
GDP. The previous government, like the Indian government, had been reluctant
to borrow abroad and possibly could not get much from official sources. When
a government came into power that liberalized trade, reduced subsidies, and



68 Macroeconomic Policy and Growth
liberalized the financial sector in a country that had been very protectionist and
regulated, funds from official sources, including the World Bank, became
readily available. Here again, as with Chile, we had euphoria, now on the part
of the government itself, which undertook an ambitious investment program
(mainly a single irrigation project), and on the part of official lenders.
Finally, Cote d'Ivoire teaches similar lessons. In 1974 public investment was
11 percent of GDP, and by 1978 it was 21 percent. Until 1974 Cote d'Ivoire was
considered a great success story because it had foilowed policies that were
sympathetic to private enterprise and foreign investment and had attained the
highest per capita growth rate in sub-Saharan Africa. This all fell apart because
of a massive public investment boom embarked on in 1974-before the coffee
boom began-whose consequences are still being felt in a very high debt burden
and low growth rate.
The foregoing are extreme cases of euphoria in which governments had a
sound record or appeared to be following or planning orthodox policies.
Another well-known example is that of Mexico in 1980-81, when the spending
boom far exceeded the oil export boom. In general, euphoria was characteristic
of the whole period among many countries that had export booms, or countries
that found it easy to borrow abroad even without such booms.
There are lessons here not only for various governments but also for potential
foreign creditors. They should be remembered whenever a government, its poli-
cies, and the country's economic prospects look "really good."
11. CRISIS AND ADJUSTMENT
The broad characteristics of the crises that befell almost all of the countries in
the study from about 1980 to 1982 (poorer terms of trade, higher real interest
rates, decline of foreign lending) are well known and will not be described here.
But once one gets beyond aggregate data and simple econometrics, one becomes
aware of the enormous differences between countries-in the extent of the
crises; in the precise origins of the crises (terms of trade, interest rates, decline of
lending, and internal factors); in the timing; and, above all, in the policy reac-
tions.
The onset of the crisis was always a decline in the availability of new loans
from the private capital market, and the countries that avoided an immediate
crisis were principally those that could and chose to continue borrowing for a
time. The timing of the terms of trade shock depended crucially on whether the
country was an oil exporter or importer, or a coffee exporter. Pakistan was the
one country in our project that did not really have an actual or potential crisis of
the kind that affected the other countries, because the adverse effect of the oil
price rise was offset by the boom in remittances from workers in the Middle East
and because Pakistan did not have a significant debt-servicing problem.
For this paper one would ideally like to determine how the immediate policy



Corden 69
reactions affected later growth. Two aspects were probably critical. First, one
might presume that if there is continued borrowing to maintain consumption
levels (as in Brazil) or to finance doubtful investment programs (as in Sri Lanka),
the increased debt burden would have an adverse effect on future growth, as
discussed earlier. Second, many countries tightened import restrictions. This is a
natural reaction at a time of balance of payments crisis, but, if maintained, it is
harmful for the growth of exports and economic growth later. The question
then is whether the tighter restrictions lasted for some time. In some countries
(Mexico, Morocco, and Nigeria) structural adjustment programs led later to
major trade liberalization measures that have more than reversed the earlier
increases in restrictions, but this was not so in other cases-notably Brazil and
Colombia.
Actual short-term outcomes depended not only on the policy reactions but
also on the initial shocks and their effects. Countries with flexible economies
and flexible policies-Indonesia, Korea, and Thailand are examples-managed
to recover quickly or keep their domestic recessions short. Going beyond the
crises to subsequent developments, some countries went through major adjust-
ment processes-Turkey from 1980, Morocco from 1984, Colombia from
1984, and Nigeria from 1986. Usually these involved a significant devaluation
and subsequent trade liberalization.
Before discussing a few countries in more detail, I would like to suggest a
general lesson. Unfavorable shocks and surprises can hardly be avoided, and it is
difficult to conceive of crisis management that does not involve at least some
pain. The most that some countries could do was to postpone the pain. The
main lesson is that countries should aim to establish favorable initial conditions
in good times. They should avoid big spending booms; keep their debt ratios
fairly low, which is primarily a matter of pursuiing conservative fiscal policies;
and keep their reserves high, especially when there is heavy dependence on a few
volatile exports. They should make their economies and policy reactions as
flexible as possible. Some initial conditions can be influenced in advance, but
once the crisis comes, all the initial conditions are beyond control.
Four Cases of Crisis Management and Adjustment
Let us now look briefly at the experiences of four countries that have been
reasonably successful and see whether there are any particular lessons that
emerge. The greatest success, Korea, is not discussed here because it is so well
known (see Aghevli and Marquez-Ruarte 1985, and Collins and Park 1989).
Colombia. When other countries were in crisis, Colombia was not, but Col-
ombia did experience a later, modest crisis of its own making. In 1978, when the
coffee boom came to an end, Colombia had no crisis because debt was low. In
fact, very sensibly, Colombia had reduced debt and had built up reserves during
the boom. In 1979 Colombia started a public investment boom to counteract
any recession the fall in coffee prices might cause. This boom involved foreign



70 Macroeconomic Policy and Growth
borrowing. The move could be regarded as a sensible countercyclical policy, and
for a while the country could afford it.
But in 1981 coffee prices collapsed, and gradually Colombia's Keynesian
strategy got out of hand, especially in 1983, when a serious recession emerged.
Colombia continued its policy of stimulating the domestic economy by fiscal and
monetary expansion into 1984, with more and more public sector and current
account deficits, supporting the policy by a fall in reserves and by heavy
borrowing.
In 1984, however, Colombia undertook an orthodox adjustment program,
involving fiscal discipline and substantial depreciation, and this program has
been so successful that by 1986-88 the current account was roughly in balance.
In retrospect, it appears that Colombian policymakers failed to depreciate the
exchange rate sufficiently from about 1981, bearing in mind the real apprecia-
tion during the boom and the need to stimulate demand when the boom came to
an end. In due course, depreciation would have fostered exports and provided
some of the additional demand for home-produced goods that the fiscal and
monetary expansion had provided instead. Still, as balance of payments prob-
lems developed in 1984, the government took quick, appropriate, and quite
drastic action. That is an example to other countries: mistakes are made even in
well-managed countries, but the art is to recognize them early and act with
sufficient firmness.
Turkey. Turkey had its spending boom, its debt crisis, and its recession
relatively early. The crisis had nothing to do with the oil price rise but rather was
the result of excessive borrowing earlier and other domestic problems.
In 1980 Turkey adopted a major (classic) structural adjustment program that
was badly needed in its very distorted economy. The World Bank-its advice
and its money-was much involved. Details need not be given here other than to
note that a big devaluation took place. That year was still a year of low growth
and of exceptionally high inflation (more than 100 percent), a by-product of
price and exchange rate adjustments. But from 1981 on, Turkey became a big
success story, with a rapid growth of exports and average per capita growth
from 1981 to 1987 of 3.2 percent. The devaluation clearly played a major role
here. This probably is the main lesson of this case, although there were also
some favorable market developments, and some degree of trade and financial
sector liberalization must have helped as well. But there has not been a very
significant overall fiscal adjustment.
There was capital inflow from official sources, offsetting the decline in private
capital inflow, so that Turkey could continue to run substantial current account
deficits even though it had faced a debt crisis. This was an important feature of
the Turkish case. Between 1981 and 1987, new funds were more or less suffi-
cient to pay for the growing interest bill so that no outward resource transfer
was needed. The result was that the ratio of debt to GNP rose from 34 percent in
1980 to 62 percent in 1987. But with the great growth in exports, the ratio



Corden 71
relative to exports fell, and this must have helped in maintaining Turkey's
perceived creditworthiness. It is still an open question how beneficial for growth
of national income this official capital inflow will turn out to have been. It
depends on how the funds have been spent. But insofar as the inflow contributed
to the improvements in structural and exchange rate policies that led to the
export boom (through conditionality and through avoiding crises), its effects
may have been very positive.
The policy improvements would not have happened without the 1978-80
crisis, so that in this instance at least the response to the crisis was clearly good
for the level, and probably the growth rate, of real income.7 This has not
generally been true in Turkey or in other countries. More often, balance of
payments crises have led to the imposition or tightening of import restrictions
that are not removed when the balance of payments problem disappears.
Thailand. Thailand was as seriously affected by the second oil shock as by
the first. The second shock cost Thailand about 4 percent of GDP. The nation
borrowed its way through the immediate period and made gradual adjustments.
Indeed, gradualism is a characteristic approach of Thailand's policymakers. As a
result, the growth rate stayed high. But the adjustment policy bore fruit. By
1986 the current account deficit had disappeared, and the fiscal situation was
thoroughly under control. Of course, the 1986 oil price decline helped.
The slow adjustment involving large current account deficits for some years
was possible because Thailand had maintained creditworthiness (so that capital
inflow from private creditors never ceased) and, more important, because the
nation had obtained strong support from official lenders. There were two rea-
sons for this favorable view held by foreign lenders, private and official. First,
Thailand started off with a relatively low debt-GDP ratio. Second, after a short
deterioration, inflation was low, sound policies were being embarked on, and an
export boom appeared to be under way. The real exchange rate had been mildly
appreciating, mainly because the baht moved with the dollar, but in 1984 there
was a 14 percent depreciation relative to the dollar to offset this, and from 1985
the real rate depreciated further, moving with the dollar.
Thailand thus suffered a considerable external shock, and yet it was able to
get over it without a crisis comparable to that of so many other countries, and
without a severe recession. Initial conditions-a relatively low debt ratio and a
tradition of fairly conservative management-helped, as did the underlying high
growth rate. And even though the policy response was rather slow, it was
credible on the basis of previous experience. Arguably, it was a stabilizing
policy, which might be favorable for long-term growth. On the other hand,
Thailand may have run undue risks by delaying full adjustment for some time
but was rescued by the 1986 oil price decline.
7. The authors of the forthcoming country study on Turkey for the World Bank project, Ziya Onis
and James Riedel, suggest in their draft that this was indeed the main effect of the crisis on long-term
growth.



72 Macroeconomic Policy and Growth
Indonesia. Indonesia suffered two shocks. One was in 1982-83 and was
caused by the world recession, which brought about an oil price fall and declines
in the prices of other export commodities. The other was in 1986 and was
caused by the further, massive, oil price fall. The responses to the two shocks
must be analyzed together. The two terms of trade shocks cost Indonesia about
10 percent of GNP.
The responses were orthodox, impressive in their speed and magnitude, and
bore fruit in a reduced current account deficit, although Indonesia is still relying
heavily on new funds from official lenders, including the World Bank. There
was severe fiscal retrenchment. From 1980 to 1987 the per capita growth rate
was modest (1.5 percent) because of the two shocks and possibly because of the
policy responses, although the long-term (1965-87) per capita growth rate of
4.5 percent has been notably high.
Compared with Thailand's, Indonesia's total shock was bigger and its
response quicker. Like Thailand, Indonesia has essentially (though no longer
formally) tied its currency to the dollar, but it has been much more ready to
devalue substantially, and it did so in response to each of the two shocks. These
devaluations had significant effects, especially because of the tight monetary
policy. From 1986 on Indonesia has taken major structural adjustment
measures-trade liberalization, deregulation, and so on-and 1987 saw the
beginning of a boom in manufactured exports.
Decisive orthodox macroeconomic and structural policies have been success-
ful in this case-with big fiscal retrenchment and big devaluations following
quickly after a shock. Since 1986, trade and other liberalizations have contrib-
uted to a nonoil-export boom. One could argue that Indonesia, like Turkey,
derived a favorable by-product from the crisis (the 1986 crisis, this time), in that
the crisis induced long-overdue structural adjustments, notably trade liberaliza-
tion. This is likely to have beneficial long-term growth effects. The debt-GNP
ratio rose from 28 percent in 1980 to 69 percent in 1988, but Indonesia avoided
a debt crisis because of strong support from official lenders, which also ensured
Indonesia's ability to continue borrowing on the private capital market.
The Four Countries: An Overview
Colombia and Thailand were slow to adjust to their adverse shocks. They
could afford to adjust slowly because their debt ratios were relatively low.
Thailand was able to borrow readily because its relatively sound macro-
economic policy record indicated that the government was in control of the
country's policies.
To a lesser extent, but for the same reasons, Colombia was also able to
borrow, but, in addition, it was able to draw on ample reserves built up during
the boom. Colombia's ability to borrow from the private market was damaged
by the spillover effects of the debt problems of other Latin American countries.
Yet Colombia was unique in Latin America in never having called for a



Corden 73
rescheduling of its debts, and one would expect a "rational" private market to
have taken more account of this.
Colombia did encounter a crisis, whereas Thailand avoided one because of its
adjustment policy and with help from the 1986 oil price decline. In neither
country did the situation get out of hand, though both might have acted sooner.
Both countries effected real devaluations. Colombia seems to have made rather
limited structural adjustments on the micro side and is still quite protectionist.
Thailand has also made adjustments, typically in a gradual way, but in any case
it was a much more open economy.
The current success of Thailand seems to make a case for gradualism in
adjustment policies, but such gradualism may be appropriate only in circum-
stances such as Thailand's-when there is no crisis situation, when distortions
do exist but are not as major as in so many other countries, and when there is a
tradition of firm conservative financial management. One should not advocate
such gradual macroeconomic adjustment for some other countries (particularly
Argentina and Brazil) because their authorities lack credibility. That is, people
would not believe that the proclaimed path of adjustment would be followed
consistently. One should also distinguish gradualism in a planned adjustment
program from slowness in making a decision to adjust adequately over a period.
Provided there is no credibility problem and new borrowing remains possible, a
case for gradualism can be made.
Turkey suffered a major debt crisis, responded with drastic measures of an
orthodox kind, and achieved favorable results for growth. But, in comparison
with heavily indebted Latin American countries, Turkey had more foreign funds
available, and this undoubtedly eased the macroeconomic adjustment process.
Thus Turkey has not really solved its fiscal problem, and it has now become a
high-inflation country, a matter discussed below.
The case of Turkey suggests a possible link between structural adjustment
policies, foreign borrowing (especially concessional borrowing), short-term
growth, and long-term growth. Structural adjustment policies bring in more
foreign funding, concessional or otherwise, and this has a beneficial effect on
short-term (Keynesian) growth. It depends on the extent to which these funds
are used for investment and the efficiency of the investment, whether this raises
long-term growth. In addition, for well-known reasons, the initiation of signifi-
cant structural adjustment policies (including policies leading to real devalua-
tion) is likely to have a directly favorable effect on long-term growth.
Indonesia has also made important structural adjustments and has also bene-
fited from continued availability of foreign funds, mainly concessional. Like
Turkey, Indonesia has acted quickly and drastically, but Indonesia has been far
more effective in its macroeconomic stabilization. Although Indonesia should
have made its microeconomic structural adjustments sooner, one can hardly
fault its response to the crisis, because the crisis resulted not from an earlier
borrowing boom but principally from the unexpected 1986 oil price decline. It is
too early to observe the effects on medium- or long-term growth in Indonesia.



74 Macroeconomic Policy and Growth
III. INFLATION AND GROWTH
The Effects of Inflation on Growth
What are the effects of inflation on growth? Inflation, of course, is not a
macroeconomic policy but rather the outcome of policies, or possibly of the
failures of policies. This subject is large, but it cannot be avoided if we want to
assess the relationships between growth and macroeconomic policies. Here, to
start, I will focus on the role of inflation as a tax. It is probably the key aspect for
the countries that have gone or are still going through significant inflationary
episodes, such as Brazil, Mexico, and Turkey.
Inflation results primarily from monetization of fiscal deficits. It is a tax that
has distorting effects that not only lower the level of real income but also lower
the rate of growth by reducing the productivity of investment. Inflation's uncer-
tainty effects may also discourage investment. But the effects of the inflation tax
on the rate of growth can only be assessed in relation to the alternatives.
If government investment expenditure were reduced to avoid a deficit that
would otherwise have to be monetized, the rate of growth would (or might) also
be affected adversely. If there were a switch from money financing to domestic
debt financing, domestic private investment would be crowded out. "Ordinary"
taxes, such as taxes on trade, might replace the inflation tax, but these would
also cause distortions that would lower the efficiency of investment and hence
the rate of growth. Increased taxation of investment goods or of corporations
would reduce private investment directly. If the alternative were more foreign
borrowing, there would be future costs. Only if the alternative consisted of
reductions in government consumption or private consumption-the latter
attained through reduced transfers or higher ordinary taxes that were not very
distorting-would the growth effect of choosing the inflation tax be clearly
adverse.
Despite this long list of ways in which various possible alternatives to inflation
can lower the growth rate, an inflation tax is surely never part of an optimal tax
structure that is carefully thought out and that takes into account the need to
minimize distortions and attain desirable redistributive and investment effects. It
is usually the tax of last resort.8 In the high-inflation countries it is the outcome
not of policy but of policy failure. The costs of a given rate of inflation can be
reduced by indexation of various kinds, but this is likely to raise the rate of tax
required to attain a given revenue. It is hard to believe that more efficient
ordinary taxes are not available.
Furthermore, the costs of inflation rise over time, and this is usually not taken
into account when the inflationary process is-by default-embarked on. First,
8. "The method is condemned, but its efficacy, up to a point, must be admitted. A government can live
by this means when it can live by no other. It is the form of taxation which the public finds hardest to
evade and even the weakest government can enforce, when it can enforce nothing else" (Keynes 1923, p.
41).



Corden 75
as expectations and financial habits adjust to higher inflation, the demand for
real balances falls, and so the rate of inflation rises for a given money-financed
fiscal deficit or rate of growth of the money supply. Second, as inflation acceler-
ates, eventually stabilization measures-often drastic-have to be taken, and
then costs cannot be avoided. Chile has been through that experience; Argentina
and Brazil have tried it unsuccessfully; and Mexico is going through it now.9
The Trade-off between Inflation and the Current Account
The inflation tax is usually the last resort for bringing about the necessary
reduction in real expenditure (absorption) in a balance of payments crisis. Given
that ordinary taxes cannot be increased nor government expenditures reduced
sufficiently, and that there are limits to domestic financing of a deficit, a govern-
ment is faced with the choice between emergency foreign borrowing-hence
allowing a continued current account deficit-and monetization of a fiscal defi-
cit, which leads to inflation. There is thus a trade-off between inflation and the
current account. I call this the "trade-off model." It is very helpful for under-
standing what happened in several (mostly Latin American) countries and for
comprehending the choices policymakers have had to make. For a given
(inflation-adjusted) fiscal balance, a country can improve its noninterest current
account (the resource transfer) by increasing inflation. This tended to happen in
the debt crisis for a number of countries-Argentina, Brazil, Mexico, and possi-
bly Turkey. The debt crisis compelled a switch from financing budget deficits
through foreign borrowing to money financing. In addition, the budget deficits
themselves had increased because of increased interest payments and poorer
terms of trade. In both Brazil and Mexico there was also a shift to domestic debt
financing, which (through increasing interest payments) tended to worsen the
deficits further.
The argument that inflation improves the current account hinges on two
assumptions: first, that it leads to higher private savings than otherwise-
savings designed to restore, at least partially, real balances-and, second, that
the nominal exchange rate is flexible or frequently adjusted. The argument
seems counterintuitive when one thinks in terms of a fixed exchange rate regime,
because in that case inflation brings about real appreciation, which tends to
worsen the current account, even though the inflation tax would still reduce
absorption and so have the opposite effect. Furthermore, there are plenty of
circumstances, including the immediate onset of the 1981-82 crises, when both
current account deficits and inflation rates increased. But this is not incompat-
ible with the model, because the model only says that for any given inflation-
adjusted fiscal deficit, there is a negative relationship between inflation and the
noninterest current account deficit. The 1981-82 crises were actually associated
with increased budget deficits.
9. There is an extensive literature on these stabilization efforts and the search for least-cost methods of
descending from a high-inflation path. See, for example, Bruno and others (1988).



76 Macroeconomic Policy and Growth
The High-Inflation Countries
With regard to inflation, the eighteen countries in our group (this time includ-
ing Argentina) can be classified as follows. Eleven were low-inflation countries,
with rates of less than 20 percent on average over the period 1980-88 (actually,
eight of these had inflation rates of less than 10 percent). Of the seven others,
Argentina and Brazil were the only consistently high-inflation countries. Costa
Rica, Mexico, and Turkey were low-inflation countries until 1973 and some-
times later. Since then they have gone through high-inflation episodes.
Brazil is an important outlier. It was a high-growth and high-inflation country
over a long period, seeming to challenge the presumption that high inflation is
bad for growth. During 1965-73, a period that embraced the "Brazilian mira-
cle," the average inflation rate was 28 percent, and the per capita growth rate
was 7.2 percent, one of the highest in the developing world. The inflation rate
was also high by the standards of those years. But during this period the Bra-
zilian inflation rate steadily fell from 61 percent to 13 percent, so that the
average figure is really rather misleading. In the actual "miracle" period, 1968-
73, the inflation rate averaged about 20 percent and the per capita growth rate
about 9 percent. In the next period, 1973-80, the average inflation rate rose to
45 percent, and the per capita growth rate was still exceptionally high at about
4.5 percent.
Recently, however, Brazil's experience seems to support the presumption that
inflation is bad for growth, or at least tends to be associated with low growth.
Brazil's per capita growth rate was still positive up to 1987 (unlike that of
Argentina, Costa Rica, Cote d'Ivoire, Mexico, and Nigeria). But from 1988
Brazil's growth rate has fallen as the inflation rate has risen. Per capita growth
became negative in 1988, as the inflation rate rapidly accelerated, reaching
hyperinflationary levels (of about 1,000 percent annually) by 1989.
The special-and much discussed-feature of Brazil is that it has been an
indexed economy. Indexation has made Brazilians more tolerant of inflation
(therefore helping to explain the continuation and acceleration of inflation), and
it has reduced the costs of a given inflation. Above all, it has avoided prolonged
overvaluations of the real exchange rate. This is surely a reason why high
inflation has not prevented high growth until recently.
Three other Latin American countries are also interesting with regard to
inflation. Colombia had moderately high inflation over long periods, and the
effects were not obviously adverse. Colombia's average inflation rate from 1980
to 1988 (it was also fairly stable) was 23 percent. This country was among the
first to practice the crawling peg exchange rate system for a prolonged period,
and hence the same comment can be made for Colombia as for Brazil. The
system has clearly avoided some of the biggest potential costs of inflation.
Mexico switched from being a low- to a high-inflation country with the 1982
crisis. Its two bursts of 100 percent annual inflation (1982-83 and 1986) can be
readily explained in terms of the trade-off model. It is now going through a



Corden 77
stabilization program that appears successful so far. This program has a strong
orthodox element (monetary and fiscal restraint). In addition, it involves a wage
restraint pact with the trade unions and the regular depreciation of the nominal
exchange rate on the basis of a predetermined scale, which is designed to reduce
inflationary expectations.
Costa Rica was a very-low-inflation country until 1982 but had a short burst
of really high inflation as part of its 1982 crisis (this is discussed below).
This leaves Turkey, which I noted earlier as a case study of successful adjust-
ment. When one takes the increase in inflation into account, especially since
1988, Turkey appears less successful. It became a high- or medium-inflation
country with the 1978 crisis. Its inflation is obviously explained by the moneti-
zation of fiscal deficits together with a steady reduction in the demand for real
balances, an adjustment of expectations to the shift to relatively high inflation
since 1978. In earlier days such deficits would have led to balance of payments
crises; in fact, they did in 1958, 1968, and 1978. The fixed exchange rate
regime ruled out continuous inflation. But, along the lines of the trade-off
model, foreign borrowing problems are now avoided by means of the inflation
tax. It is noteworthy that a period of quite high inflation has also been associ-
ated with a period of high growth rates (as in the case of Brazil earlier), but at
least until 1987 the higher inflation rate was fairly stable. The danger is that
eventually the need to deal with the inflation problem could put an end to high
growth rates, at least temporarily.
The Low-Inflation Countries
Three observations can be made about inflation in the relatively low-inflation
countries (inflation below 20 percent). First, all these countries have had short
bursts of high inflation, usually in the 1980-82 period. The bursts were usually
caused by an external shock, such as the oil price rise for oil-importing coun-
tries, or by a devaluation necessitated by the balance of payments consequences
of poorer terms of trade, higher interest rates, or the decline of foreign financing
of spending booms. But the inflationary bursts did not last.
Even Thailand, the low-inflation country par excellence, illustrates the sus-
ceptibility of nations to short-term bursts of high inflation. From 1975 to 1979
its average inflation rate was 7 percent. In 1980 the inflation rate jumped to 20
percent. By 1982 it had fallen back sharply to 5 percent. A more extreme
example is Costa Rica. Before 1973 its inflation rate had never been above 5
percent, and from 1975 to 1980 it averaged 12 percent. But, for the kinds of
reasons listed above, its inflation rate jumped to 90 percent in 1982. Yet by
1984 it had fallen to 12 percent again. Among the many similar examples that
could be given, Nigeria had a big inflation bubble in 1984, at 40 percent, and
the next year its inflation rate was down to 5.5 percent.
One can always explain these high-inflation episodes. Sometimes they repre-
sent no more than the short-term effects of a big devaluation or, more generally,



78 Macroeconomic Policy and Growth
of a necessary structural adjustment episode. In Nigeria, a severe decline in
imports was necessitated by a balance of payments crisis and implemented
through tightened import restrictions. In India droughts have produced inflation
bubbles. The episodes were brief because governments had a commitment to
low inflation-a commitment derived from historical experience-so that they
did not allow these episodes to change their basic low-inflation strategies. The
brief episodes did not stimulate inflationary expectations (and hence made it
possible to bring inflation down again without great or any cost) because of the
governments' low-inflation reputations. A record of a long period with fixed
exchange rates, or rates infrequently altered, is helpful here. This must have
been a factor in the success of the Costa Rican stabilization and also, currently,
in the Mexican success story.
A second reason for inflation in the relatively low-inflation countries is that
during boom periods some inflation was part of the process that brought about
the necessary real appreciation associated with spending booms discussed ear-
lier, given that there was a fixed nominal exchange rate or an inadequately
adjusted exchange rate. This applies particularly to Colombia, C6te d'Ivoire,
Indonesia, and Nigeria, but also to other nations in which there were private or
public spending booms. Provided that inflationary expectations are not created
during such a process, and that the government's basic anti-inflation commit-
ment (possibly signaled by the exchange rate policy) remains, such a temporary
inflation and real appreciation should not lead to continuous inflation. The
crucial issue is whether the government can keep control of the process.
A third factor in the inflationary episodes of the relatively low-inflation coun-
tries is that costs of inflation depend, above all, on the exchange rate regime.
The nominal exchange rate may be fixed, or it may not be depreciated suffi-
ciently to keep pace with the inflation differential. Given an export boom, or a
spending boom that is foreign-financed, a real appreciation might be appropri-
ate as part of the process described above. But a common situation has been that
the combination of inflation and a fixed exchange rate has led to intensified
import restrictions and hence to familiar distortions that have an adverse effect
on growth-often a severely adverse effect.
Examples of such episodes can be found in many of the seventeen study
countries, but an outstanding case is in Nigeria. There, the trade-weighted
nominal rate was pretty well fixed from 1981 to 1984, but because of a rate of
annual inflation averaging 23 percent over this period, the real rate doubled
(appreciated). In addition, the terms of trade deteriorated, mainly because of the
falls in oil and cocoa prices, so that a real depreciation was really required.
Extremely tight import restrictions were applied, and exports became highly
uncompetitive. The unavailability of essential imports for local production as
well as the decline in exports must have been a major factor in the negative
growth rates of those years. According to the available figures, per capita
growth averaged -8 percent during those four bad years. One must blame the
combination of high inflation and the fixed exchange rate for these adverse



Corden 79
effects. In this case the fixed exchange rate regime did not succeed in anchoring
the price level or the money growth rate.
An Overall View
In cross-country comparisons, can one find a direct correlation between infla-
tion rates and growth rates? Clearly other things are not equal between coun-
tries, but some econometric results suggest that inflation tends to go with low
growth, especially when post-1980 figures are used.10
It is useful to compare four countries that are clearly either low-inflation
countries (Thailand and India) or high-inflation ones (Argentina and Brazil).
Thailand is a low-inflation country with high growth; Argentina is the opposite.
That is, both in the per capita growth tables and the inflation tables they are at
opposite ends, so they confirm the presumption that inflation is bad for growth.
The matter is not quite so clear for the two biggest economies in our group,
India and Brazil, essentially because their relative growth rate positions have
changed. From 1965 to 1980, India was a low-growth country (1.5 percent per
capita), but from 1980 to 1988 India jumped to the relatively high rate of 3.7
percent. In the latter period, 1980-88, Brazil moved in the opposite direction,
from 5.7 percent to 0.6 percent. Thus a comparison based on the recent period
again confirms the presumption. A comparison over time for Brazil also con-
firms it. As the rate of inflation has climbed, the rate of growth has fallen. Yet
one cannot ignore Brazil's episodes of high growth and high inflation mentioned
earlier.
It may be generally true-even though some cases, such as Brazil, India, and
Turkey during certain periods, as well as various African countries, give a
contrary result-that low-inflation countries tend also to be high-growth coun-
tries, and vice versa. But this does not necessarily mean that high or medium
inflation is the principal cause of relatively low growth. Obviously, investment
ratios, degrees of openness of economies, and many other factors are relevant.
To some extent inflation and low growth may have a common cause. It seems
plausible that poor economic management-which may be the result of an
inability of a government to resist pressure groups and generally to ensure
adequate macroeconomic controls (clearly the case in Argentina)-leads to a
variety of policies that produce low growth. And high inflation, which is always
unplanned and is a last-resort tax imposed by default, is clearly a symptom or
consequence of poor management.
Some Lessons
An obvious lesson taught by Argentina, Brazil, Chile, and several other Latin
American countries is that high inflation, once it keeps going for some years, is
10. A satisfactory statistical relation for 1980-88 between the per capita growth rate and the rate of
inflation cannot be found for the seventeen countries. This is essentially because of the inclusion of three
African countries with low inflation and low growth, as well as Turkey, which had high inflation and
high growth (see table 1).



80 Macroeconomic Policy and Growth
hard to reduce without severe cost, both economic and political. It is best to
avoid getting started on the road. It is an inefficient tax. It yields immediate
benefits to governments that have difficulty cutting expenditures or raising other
taxes, but the costs come later, and, as the demand for money falls, the cost-
benefit ratio deteriorates. Once on the move, high inflation is difficult to control
unless counteraction is taken very quickly, so that there is no more than an
inflationary bubble, as in several of the countries in our group. The dislike of
inflation even at modest levels that is customary in many of the Asian countries
we have been considering can be very healthy.
As Brazil and Colombia show, it is possible to live with inflation over long
periods-that is, to adapt to inflation and have fairly high growth. A crucial
element in such adaptation is exchange rate adjustment to avoid real apprecia-
tion. The danger is always that the rate of inflation will accelerate. But it is an
interesting question to what extent the long period of high inflation with high
growth in Brazil can be blamed for the current hyperinflation.
Other countries-even Thailand-show that short bursts of inflation are
sometimes difficult to avoid. But they can be made short. Their significance
must not be misunderstood. Sometimes they are the consequences of a necessary
devaluation or a by-product of an adjustment to capital inflow, an export boom,
or a structural adjustment of some kind. In all cases it is important that infla-
tionary expectations do not increase and that a fundamental commitment of the
government to low inflation is clearly established. It is also important that the
exchange rate is appropriately adjusted so that increasing import restrictions
(the Nigerian case) are avoided.
IV. EXCHANGE RATE POLICY
The Exchange Rate and Growth
The central issue is whether keeping a nominal exchange rate fixed when there
is domestic inflation or an unfavorable exogenous shock can possibly be favor-
able for growth. There are obvious reasons, to which I shall return below, why
its effects would be unfavorable. But might there be a favorable aspect?
The simple answer is that devaluation or readiness to depreciate may be
inflationary, and this, for reasons discussed earlier, could be adverse for growth.
The potential problem is not the once-and-for-all rise in the domestic prices of
tradables (which may take some time to come about) but the possibility that
devaluation would set off an inflationary process. This is only possible if it
induces continuous monetary expansion.
Devaluation, or the possibility of depreciation, could lead to continuous mon-
etary expansion and hence be inflationary in two ways. First, a price-wage spiral
may be set off by devaluation, and to avoid deflation caused by a continuous
decline in the real money supply the nominal money supply may then be contin-
uously increased. Second, a fixed (or reluctantly adjusted) exchange rate may



Corden 81
have been an anchor for monetary policy-that is, a restraint on it. The
exchange rate commitment may have discouraged inflationary monetary policy
and monetization of fiscal deficits. Once the possibility of depreciation is opened
up, the constraint on inflationary tendencies disappears.
The empirical question here is whether long periods of low inflation in some
countries can be explained by the constraint imposed by their fixed rate regimes,
or whether, alternatively, the ability to maintain fixed rates was the result of
low-inflation monetary policies, the latter explained by more basic anti-inflation
attitudes, possibly historically based. This question applies to many low-
inflation countries in our group, at least up to 1982, mostly in Asia and Africa,
but also Costa Rica and Mexico up to about 1973. Can one argue that increased
inflation in many of the countries since 1982 was caused by the increased
flexibility of exchange rates, which loosened the constraint?
The question is only posed here, because there is no space to attempt an
adequate answer. It raises issues of political economy because it concerns the
motivation for inflationary, noninflationary, and monetary policies. I have con-
cluded provisionally that in several countries (for example, Mexico, Nigeria,
and Turkey) an apparent commitment to a fixed exchange rate did not prevent
accelerating inflation and that in the five Asian countries (as well as Kenya and
Morocco) a switch to more flexible exchange rate regimes left relatively low-
inflation policies intact or nearly intact. Hence, in these cases, the exchange rate
regime was not the driving force in sustaining low or moderate inflation. Rather,
low- or moderate-inflation policies were a direct and more fundamental objec-
tive, and the exchange rate followed rather than led monetary policy.
Let us now ignore the possible effects of exchange rate flexibility in inducing
expansionary monetary policy just discussed. The central concern for exchange
rate policy thus becomes its effects on the real exchange rate. There is strong
evidence that in the low- or moderate-inflation countries the nominal exchange
rate affects the real exchange rate in the same direction and, in the medium run,
to a similar extent. The issue is to "get the real exchange rate right," and in
particular to avoid or eliminate overvaluation. This is a familiar World Bank
and International Monetary Fund (IMF) theme.
We have seen that real appreciation may be a necessary element in adjustment
to a spending boom financed by an export boom or by deliberate foreign bor-
rowing or aid. Exchange rate policy that leads to real appreciation is then just an
incidental aspect of the total process, part of the transfer mechanism. In that
case, real appreciation cannot be described as overvaluation. I have already
discussed the growth implications of such a spending boom. But there remain
cases in which there is no export boom or autonomous capital inflow. The
problem may be a real appreciation that has resulted from a fixed or reluctantly
depreciated nominal rate combined with domestic inflation. Or it may be an
overvaluation caused by an adverse external shock that requires a real deprecia-
tion that does not take place because of rigidity of the nominal rate.



82 Macroeconomic Policy and Growth
There may then be various effects, all potentially adverse for growth. Epi-
sodes of real exchange rate overvaluation leading to these effects can be found in
most of the countries at some time. It is the desire to avoid these effects that
explains World Bank and IMF concern with real exchange rate overvaluation.
First, overvaluation causes import restrictions to be imposed or intensified, as
a substitute for devaluation, to "switch" demand away from imports. This
would have adverse effects on growth through the distortions created, rent-
seeking, reduced availability of imported capital goods, and so on, as in the
Nigerian example cited above.
Second, crisis borrowing takes place at interest rates far in excess of the
marginal productivity of domestic investment, or the borrowed funds finance
consumption, with fiscal expansion possibly accompanying the real apprecia-
tion to maintain demand for domestic resources. This affects growth adversely
in the way discussed earlier with regard to the borrowing of the 1970s. Third,
the expectation of devaluation induces capital flight. Fourth, as continuous
inflation brings about continuous real appreciation and hence tighter import
restrictions, devaluation does eventually take place, possibly in a crisis situation.
The real exchange rate thus may move in the right direction over time, but it
may be very unstable, gradually appreciating, suddenly depreciating in a crisis,
then appreciating gradually again, and so on. Such instability is likely to have
adverse effects on growth.
Country Experiences
Every conceivable exchange rate regime can be found among our seventeen
countries during the period under consideration. Below I look in some detail at
Indonesia and Mexico. (The example of Nigeria described earlier should be
recalled as well. In that case a fixed nominal rate failed to prevent inflation but
led, rather, to increased import restrictions.)
Many countries switched their exchange rate regime during the period 1975-
84, having had a fixed rate of some kind until the switch and then having moved
to a flexible rate, possibly a crawling peg. Aside from the two franc-zone coun-
tries, none have firm exchange rate commitments now, though three-
Indonesia, Thailand, and Kenya-have (more or less) fixed-rate regimes with
occasional devaluations. The shift to a flexible exchange rate regime of some
kind in many Asian and African countries that used to have fixed rates can be
explained in part by the shocks of the 1980-82 period and, most importantly,
by the reduced ability in all countries to restrict international capital movements
even when that is desired (and hence the reduced ability to sustain an exchange
rate for any length of time against speculative attacks).
Indonesia kept its nominal exchange rate fixed to the dollar from 1971 to
1978, a period in which there was a substantial real appreciation resulting from
inflation above world levels but justified by the higher oil income. Since 1978
Indonesia has devalued three times, in each case by about 30 percent. The 1978



Cord en 83
devaluation was quite a surprise, because there was no balance of payments
problem but rather a concern with the declining profitability of nonoil-export
industries. This was a case of exchange rate protection. The 1983 and 1986
devaluations took place very promptly in response to balance of payments prob-
lems. The 1986 devaluation was a crucial ingredient in the adjustment program.
Indonesia's monetary policy has been fairly conservative, with an average
inflation rate in the period 1982-88 of 8.5 percent. The devaluations did have
some temporary effects in raising inflation rates at the time, but one cannot
really say that the readiness to devalue made monetary policies looser, as is
implied by the argument advanced at the beginning of this section. It should be
added that capital mobility is high in Indonesia. Thus once a devaluation is
expected and hence leads to speculative outflows, it cannot be long delayed.
Remaining controls on capital movements have been removed recently, so that
in the future there will probably have to be more frequent, and less large,
exchange rate adjustments.
Mexico's exchange rate policy reflects the continuous tension between two
objectives: trying to keep down the rate of inflation through fixing the rate, and
restoring competitiveness (as well as stopping or reversing capital flight) by
devaluing. Up to 1972 Mexico was characterized by low inflation and fixed
exchange rates, but since 1973 a fixed rate has never really stopped high infla-
tion. Nevertheless, the memory of the long and successful period of a fixed
exchange rate and low-inflation regime, together with the obvious potential
benefits of having a stable rate to the U.S. dollar, has led Mexican policymakers
to attempt again and again to fix the exchange rate at a new level, even when
they regularly fail to attain the low-inflation target.
Hence, Mexico has experienced several periods of continuous real apprecia-
tion, followed by sharp depreciation (1976, 1982, and 1986). After the big
depreciation of 1986, the real rate was kept down until 1988, when it started
rising again as the result of the fixing of the exchange rate as part of a stabiliza-
tion plan. Currently, the exchange rate is effectively fixed on a predetermined
crawl. The periods of real appreciation involve obvious problems-capital flight
(recently avoided through very high domestic interest rates) and loss of compet-
itiveness for tradable goods producers. One would expect the uncertainties cre-
ated by such fluctuations in the real exchange rate to have adverse effects on
investment and growth. The contrast with Brazil is striking. Since 1973, Mex-
ico's real exchange rate has been much more unstable than Brazil's.
The lesson is not necessarily that the nominal exchange rate should have been
depreciated more, or more often. After all, experience has shown that in Mexico
the real depreciations are eroded by high inflation after a while, and it is quite
possible that greater depreciations would simply have led to more inflation. The
lesson-which in fact has been learned-is rather that policy packages are
required. Reducing inflation requires explicit monetary and fiscal policy deci-
sions supported (at least in the Mexican context) by a wage compact. The
exchange rate should be only one part of the package.



84 Macroeconomic Policy and Growth
Lessons
At the risk of oversimplifying, I suggest that this study yields three simple
lessons with regard to exchange rate policy.
1. A country has to make a commitment to a noninflationary monetary pol-
icy. This does not require a nominal exchange rate commitment, and usually
such an exchange rate commitment is not enough to achieve the objective,
although it may be helpful. A commitment to fiscal restraint is usually more
important.
2. Real exchange rate misalignment and variability should be avoided
through appropriate nominal exchange rate adjustment, preferably by frequent
small changes rather than by large discrete changes. This is an oft-repeated
message of the World Bank and the IMF. But in particular cases or episodes, the
anti-inflation objective may have to take priority.
3. Devaluation without an appropriate policy of monetary restraint-and
firm commitment to such a policy-is undesirable because it will ultimately be
ineffective. In general, policy packages-involving monetary, fiscal, and
exchange rate policies-are required.
REFERENCES
Aghevli, Bijan B., and Jorge Marquez-Ruarte. 1985. A Case of Successful Adjustment:
Korea's Experience during 1980-84. Washington, D.C.: International Monetary
Fund.
Bruno, Michael, and others, eds. 1988. Inflation Stabilization. Cambridge, Mass.: MIT
Press.
Collins, Susan M., and Won-Am Park. 1989. "External Debt and Macroecononic
Performance in South Korea." In Jeffrey D. Sachs and Susan M. Collins, eds., Devel-
oping Country Debt and Economic Performance, Vol. 3. Chicago: University of
Chicago Press.
Cuddington, John. 1989. "Commodity Export Booms in Developing Countries." World
Bank Research Observer 4, no. 2 (July): 143-65.
Gelb, Alan, and associates. 1988. Oil Windfalls: Blessing or Curse? A World Bank
Research Publication. New York: Oxford University Press.
Keynes, John Maynard. 1923. A Tract on Monetary Reform. London: Macmillan.
Reynolds, Lloyd. 1985. Economic Growth in the Third World, 18S0-1980. New
Haven, Conn.: Yale University Press.
Sachs, Jeffrey D., ed. 1990. Developing Country Debt and Economic Performance.
Vol. 2. Chicago: University of Chicago Press.
Sachs, Jeffrey D., and Susan M. Collins, eds. 1989. Developing Country Debt and
Economic Performance. Vol. 3. Chicago: University of Chicago Press.



PR OCE E DING S O F THE WORLD BANK ANN UAL CONFE RE NCE
ON D E VE L O PM E NT E C ON OM I CS 1 9 90
COMMENT ON "MACROECONOMIC POLICY AND GROWTH," BY CORDEN
John Williamson
Max Corden's paper presents the first results from the massive World Bank
comparative study of macroeconomic policy and performance in seventeen
countries over almost twenty years. As Corden emphasized, the paper does not
have any startling new insights. But it will appeal to those who believe that it is
more important to be right than to be novel.
The paper interweaves three themes. The first is the history of the seventeen
countries, which provides the background. The second is an exposition of stan-
dard macroeconomic theory for open, developing economies. Just about all
aspects of this theory are expounded at one point or another. The third theme is
the lessons that can be drawn from the experiences of these countries. It is these
lessons on which I concentrate in my remarks.
I happen to agree with all nine of the lessons that Corden draws. My only
criticism is that he might have been less cautious in phrasing them. Although
they may not be startlingly original, these lessons are important. If we do not
bring them into sharp relief, other countries may repeat the mistakes that have
been made in such profusion over the last twenty years.
Corden's first lesson is that countercyclical policy is feasible and advisable. To
paraphrase the point, countries should endeavor to restrict their spending to the
level of their permanent income. Colombia is a great example of a Latin Ameri-
can country that attempted to do this in the 1970s, and I strongly believe it is not
an accident that Colombia had by far the best growth performance of the region
in the 1980s. It is true that in the end Colombia overdid it by attempting to
sustain demand at a level that did not allow for the "permanent" deterioration in
the external environment in the 1980s. Because of that, the nation found itself
with unsustainable twin deficits. But Colombia corrected its mistake relatively
quickly. It provides a model for emulation. Mexico represents the opposite
extreme; not only did it fail to restrain spending but it used its transitory income
from high oil prices as collateral to increase spending even more than income.
Corden's second lesson is even more elementary, but it has been violated often
nevertheless. Investment projects should be carefully vetted for profitability,
remembering that real depreciation will occur when the lending boom ends and
John Williamson is a senior fellow at the Institute for International Economics in Washington, D.C.
© 1991 The International Bank for Reconstruction and Development / THE WORLD BANK.
8S



86 Comment
the debt has to be serviced, so that the rate of return in nontradables will need to
be higher than that in tradables to justify borrowing.
The third lesson is this: beware of euphoria. Corden makes the interesting
point that this lesson should be particularly addressed to the sort of governments
of which most of us tend to approve-market-oriented governments managed
by competent technocrats. A useful dictum that may help successful technocrats
avoid overconfidence is that all positive shocks should be treated as though they
were transitory and all negative shocks as though they were permanent.
The fourth lesson is that countries should be extremely suspicious of inflation.
On this point I would strongly back Corden's view as against Rudiger Dorn-
busch's suggestion in his paper (this issue) that any rate of inflation below about
50 percent per year should be accepted with equanimity. I agree with Corden
that inflation is never part of an optimal tax structure. In fact, the evidence is
that it is one of the most regressive of all taxes. Add to that the conclusion of the
accelerationist theory that there are no permanent gains in output from accept-
ing a higher long-run rate of inflation and the consideration that the occasional
corrective inflation can operate more efficiently when the contract structure is
based on an assumption that prices will generally be stable, and I see a compel-
ling case for accepting Alan Greenspan's criterion of seeking an annual rate of
inflation of 2 percent or less. This is not to argue that a minimal rate of inflation
must be the overriding priority of economic policy or that it necessarily must be
achieved in the short run. But it is to urge that no government should feel
relaxed about a rate of inflation that is "just 20 percent." Once that happens,
inflation will not stay at 20 percent.
How does one reconcile a respect for the dangers of inflation with Corden's
fifth lesson, which says that it is possible to sustain high growth with high
inflation for a long time, provided that the nominal exchange rate moves to
offset the differential inflation? Once again, Colombia provides the outstanding
example. Colombia has operated a crawling peg for twenty-three years and has
regularly had an annual rate of inflation of around 20 to 30 percent. I nonethe-
less wonder whether it might not have been sensible somewhere during those
twenty-three years to accept a significant temporary sacrifice in output to elimi-
nate inflation.
Corden's sixth lesson is that corrective inflation-a one-time rise in the abso-
lute price level undertaken to achieve a change in relative prices that is needed to
adjust to a real shock-is admissible. As I noted above, I regard the possibility of
using corrective inflation as sufficiently important to be a significant argument
justifying the attempt to eliminate trend inflation.
The seventh lesson is that macroeconomic policy needs a nominal anchor but
that this need not be a fixed exchange rate. Indeed, Corden argues explicitly that
the attempt to use a fixed nominal exchange rate as the nominal anchor has
often proved ineffective, and he could have added Chile and Costa Rica in the
early 1980s as further examples of this thesis. The alternative to a fixed



Williamson 87
exchange rate is essentially demand management policy. I favor use of a target
growth rate of nominal domestic demand as the alternative nominal anchor.
The eighth lesson is that exchange rate policy should be used to avoid mis-
alignments of the real exchange rate, subject to the same qualification that
Dornbusch emphasized earlier. This qualification admits that a temporary
freeze of the exchange rate may be a useful element in a stabilization package
designed to bring rapid inflation under control. The conventional wisdom now
seems to be that within six months of a stabilization, the exchange rate should
start to crawl again if this is necessary to prevent an overvaluation from emerg-
ing. If this is not done, and inflation has not come to a halt, the danger is that the
markets will start to demand a big premium on the domestic nominal interest
rate to compensate for the risk of a subsequent jump devaluation. One will get
the cost of a crawling devaluation without the benefits in terms of keeping
relative prices in line. Hence the freeze of the exchange rate should last for the
minimal period needed to use the international structure of relative prices as a
guide to the set of internal relative prices that will prevail after stabilization.
Corden's ninth lesson is that devaluation needs to be used as a part of a policy
package, along with fiscal, monetary, and-if helpful-income policies. The
bad academic habit of arguing that devaluation is ineffective in isolation is
irrelevant to the policy debate.
In addition to the nine lessons Corden drew in his paper, I would suggest two
others that seem clearly implied by his stories. The first is that the debt ratio
should be maintained at a low level and international reserves maintained at a
high level. The purpose is to provide a shock absorber to prevent the need for
damaging lurches in policy.
The other lesson is that when a country has the chance-which means when it
has followed the preceding lesson-it should plan for gradual adjustment but
initiate a comprehensive adjustment program promptly. Confusion over the
desirability of gradualism has arisen when policymakers have failed to note the
distinction between prompt initiation of adjustment, which is always desirable,
and immediate achievement of adjustment, which can be enormously costly. Of
course, there are circumstances in which adjustment should be achieved imme-
diately. It makes no sense to think of a gradual reduction in hyperinflation. But
it does make a great deal of sense to achieve balance of payments adjustment
over several years, as Thailand did, rather than to try to turn the accounts
around in a matter of months, as happened in Latin America in the early 1980s,
with disastrous result s.
I conclude by suggesting topics on which I hope the authors of the study will
endeavor to provide some guidance on the basis of the experiences of the sample
countries they have investigated. One of these concerns the crucial question
raised by Dornbusch: How does one get growth going again after stabilization?
Note, incidentally, that this is not the first time economists have confronted this
issue. Various phrases were used in the 1930s to indicate the conclusion that an



88 Comment
easy monetary policy was not enough for the purpose: "you can't push on a
string;" "you can take a horse to water but you can't make it drink." Similarly,
the founders of development economics toyed with ideas of big pushes and
balanced (or unbalanced) growth strategies to get the growth process going. But
gradually interest in this set of issues was displaced by concern to increase
savings, to provide adequate infrastructure, to ensure that the real exchange rate
was sufficiently competitive to nurture the growth of nontraditional exports,
and to ensure that investment passed the market test of profitability. The mes-
sage was that if the supply side and the exchange rate are appropriate, then
investment and growth will take care of themselves. Can the historical experi-
ence of the seventeen countries confirm that this is wiser than immediately
looking for drastic policy changes if growth does not return as quickly as one
might hope? Is there any evidence that an overactivist policy could prevent
reforms from taking root and actually do more harm than good? Or is there
indeed some additional ingredient that can promote a resumption of growth?
In particular, I wonder whether the historical evidence can shed some light on
Dornbusch's own prescription of massive foreign loans as necessary for reinitiat-
ing growth. It is not obvious to me that this is correct. For example, in the 1930s
countries sought to reignite growth by competitive devaluation in order to
secure a negative resource transfer. Regarding Mexico, Dornbusch is quite right
to argue that it is a question of turning the corner, and that once confidence
revives, the repatriation of flight capital will finance an investment boom. But is
a big new foreign loan the right way to revive a lack of confidence that has been
caused by a debt overhang? Perhaps the Brady Plan is more relevant, and the real
aim of policy should be to reinforce the debt settlement with the commercial
banks by doing something about public sector debt.
More generally, can the historical experience be used to illuminate the crucial
question of the relationship between policy reform and resource transfer? A
decade ago, most of us took it for granted that more resource transfer was
better. We are sadder now and tend to argue that resource transfer has often
been used to perpetuate bad policies that actually worsen a country's long-term
prospects. The condusion we draw is that additional resource transfer should be
provided only after policy reforms have been securely emplaced. How compel-
ling is the historical evidence that we are not only sadder to take this view but
also wiser?



PRO CE ED I NGS O F THE WO R L D BANK ANN UAL CONFE RE NCE
O N DE V E LOPM E NT E C ON O M ICS 1 99 0
COMMENT ON "MACROECONOMIC POLICY AND GROWTH," BY CORDEN
Susan M. Collins
This paper addresses an extremely important topic: the role of macroeconomic
policy in promoting growth. It draws on a wealth of experiences, which enables
it to cover quite a lot of ground in specific countries. It also is refreshing to find
the discussion broadened to include so many different countries. Too often, the
focus is on just a few economies, typically the large Latin American ones. These
are not representative of experiences of economies in Africa and Asia--or even
of the smaller economies in the Western Hemisphere.
Corden's paper is built on the skeleton of fiscal expansion that sets the stage
for a crisis when lending is interrupted, requiring domestic adjustment. It then
focuses on two key aspects of adjustment-inflation and'exchange rate policy-
and draws a series of lessons. I agree with many of these lessons. (A major
exception is Corden's conclusions on inflation. Here, I found his discussion
misleading, and I will explain why below.)
Although I agree with many of Corden's lessons, I would have drawn them
with a somewhat different brush, and I would have shifted the emphasis. In
particular, I do not believe that it is possible to omit the political economy of
macroeconomic policymaking in a discussion of how policy can promote
growth. Let me revisit the major lessons of the paper, then, from my own
perspective.
The role of public expenditure booms in the period before a crisis in country
after country is really striking. These experiences clearly spotlight fiscal restraint
as the cornerstone of sound macroeconomic policy. The paper could have
brought this point out even more strongly. The need for adjustment in almost all
of these countries was not created just by external shocks such as the reduced
access to foreign capital after 1982. It was also a result of unsustainable domes-
tic policies. Thus it should come as no surprise that the countries that did better
were the ones that adjusted sooner and that had not allowed basic policies
(especially the budget and the exchange rate) to get too far out of line in the first
place. For example, both the Republic of Korea and Indonesia began to adjust
macro policies before they were forced to-and before crisis hit.
Corden is exactly right in stressing the need to push good policies during good
times. This creates favorable initial conditions that ease the adjustment in bad
Susan M. Collins is associate professor of economics at Harvard University.
) 1991 The International Bank for Reconstruction and Development / THE WORLD BANK.
89



90 Comment
times. In asking how these adjustment policies affect growth, Corden is also
exactly right in pointing out that growth during the stabilization period should
not be compared with growth during an unsustainable period of poor policy.
In a few countries, one very visible element of the aftermath of the post-1982
lending crunch was runaway inflation. After looking at these episodes, Corden
reaches the very strange conclusion that "inflation improves the current
account." It is certainly not true, however, that countries with higher inflation-
or larger increases in inflation-tend to have smaller deficits or larger surpluses.
Nor is it true that an increase in inflation in individual countries leads to current
account improvement. Perhaps the author meant the causality the other way
around: Forced current account improvement without adjustment in macro-
economic policy tends to be inflationary. This is the real lesson from countries
such as Argentina and Mexico. The countries (for example, Korea) that went
from current account deficit to surplus while reducing fiscal deficits and estab-
lishing competitive exchange rates were also able to control inflation.
Corden then turns to the question of exchange rate management as part of the
adjustment. In particular, is there any rationale for keeping the exchange rate
fixed in the midst of domestic inflation? Here, I think the answer is simple and
clear. It is important to maintain a competitive exchange rate. However, a
temporarily fixed rate-at a competitive level-can help to cut inflationary
expectations in the early stages of a stabilization program. (We have seen this
most recently in the Polish and Yugoslav programs, which began with maxi-
devaluation and temporarily fixed rates.) This is the conclusion that Corden
suggests-but not strongly enough.
Arguments about pegging the value of a high-inflation country's currency to
the currency of a low-inflation country as an anti-inflation device are familiar
from discussions of the European Monetary System. There, some have argued
that pegging the Italian lira to the German deutsche mark "tied the hands" of the
Italian monetary authorities, adding to the credibility of their anti-inflation
program. But announcing a fixed exchange rate cannot possibly be enough. The
problem, of course, is that the public knows that the exchange rate can be
devalued-and that in fact it will need to be if it continues to appreciate in real
terms. The political will to cut inflation, backed by observable policy changes,
must accompany the announcement of a fixed exchange rate for the anti-
inflation policy to be credible. An exchange rate that is allowed to become more
and more overvalued erodes that credibility quickly.
Where does this leave us in terms of macroeconomic policy and growth? I
draw a different-though not inconsistent-set of conclusions from Corden's. In
my view, it helps to identify four different types of countries. The first group,
countries that have managed to keep per capita income growing, reinforces an
old lesson: stable, orthodox macroeconomic policies create a fertile environment
for economic growth. They also provide room for adjusting to bad luck and to
policy mistakes as well as room for addressing such difficult problems as reduc-
ing poverty.



Collins 91
The second group of countries includes ones that have implemented major
economic reforms after a period of poor policy and performance but that for
various reasons are not enjoying a revival of economic growth. I would include
Jamaica and Mexico here. The difficulty is that it can be politically tough to
carry through the reforms because the population gets tired of continually tight-
ening its belt. In my view, these experiences present a challenge to the United
States and other developed countries that also gain from the economic growth
and stability of developing economies. The challenge is to lend a helping hand to
support these reform efforts until they begin to pay off. In some cases, this may
entail financial assistance for public and private investment. In others, it may
mean reducing debt and debt service to free domestic resources for investment.
This leaves the issues of appropriate macroeconomic policy for countries that
are not growing and have major policy problems, which make up the third and
fourth groups. The third group includes the countries that are in the midst of
full-blown economic crisis, such as Bolivia in the mid-1980s and Poland at the
end of 1989. Here the basics of macroeconomic stabilization must come first,
and policies can be designed without dotting all the i's. Furthermore, a crisis
tends to generate popular support, particularly for a new government, to do
something, even if something begins with a difficult transition period.
The fourth group includes the countries that are not in the midst of a full-
blown crisis but that are in poor shape nonetheless. This category includes
countries with a wide range of difficulties, sometimes primarily macroeconomic
and sometimes not. In any case, this group typically faces politically difficult
environments for implementing-and carrying through-reform programs. This
is because it is not at all clear to domestic residents that an adjustment program,
which is likely to entail high transition costs, is preferable to the current "mud-
dling through." These countries pose the most important challenges for domes-
tic politicians, for policymakers abroad, and for academics. That challenge is
how to design and to support economic reform programs that are politically
feasible but also present a reasonable chance of raising growth and living stan-
dards down the road. To my mind, this is the really tough set of questions, and I
hope that it is among the questions that Corden and others focus on next.






PROCE E D ING S O F TH E W O RLD BAN K ANN U A L CON FE REN CE
ON D EV E L O PM E N T E C ON OM I C S 1 9 9 0
FLOOR DISCUSSION OF THE CORDEN PAPER
Discussion centered on the "lessons of experience" Corden raised in his paper
and particularly on the specific application of Corden's observations and recom-
mendations regarding structural adjustment, inflation, and exchange rate
policies.
Regarding structural adjustment loans (SALS), a World Bank participant noted
that for the most part the World Bank makes such loans to countries in balance
of payments difficulties. Along with the SALS, the participant pointed out, come
other aid flows, repatriation of flight capital (as in Sri Lanka), and private
foreign investment. However, "aid booms" can bring about the same damaging
effects as do export booms, including the appreciation of the real exchange rate
and all that it entails. The participant felt that sometimes the World Bank is not
mindful enough of this dilemma and of the danger of undermining gains from
the structural adjustment measures that have just been put in place.
Another participant suggested that the concept of "conservative euphoria"
that Corden mentioned in his presentation deserves greater attention both as it
seems to grip the countries themselves and the international organizations, such
as the World Bank, when they are analyzing the prospects for the gains from
reforms. The participant suggested that after the 1977-78 political changes in
Sri Lanka, the World Bank may have fallen prey to "conservative euphoria"
about economic changes there, and that the subsequent heavy capital inflows
may have been responsible for destabilizing social effects. The participant felt
that international organizations need to be particularly sensitive to the political
and social consequences of rapid structural adjustment.
A participant noted that Dornbusch's conference paper had stressed the
importance of a productive tax structure as part of adjustment, including mod-
erate, uniform rates of taxation and the absence of any significant subsidies.
This is in line with the International Monetary Fund (IMF) and World Bank
approaches and with traditional economic thinking, which distinguish between
efficiency and equity on the assumption that once we get the efficiency right, the
political process can redistribute income and arrive at equity. But the participant
was not sure how income would be redistributed if we rule out subsidies and
different tax rates. He also wondered whether there was a contradiction when
This session was chaired by 1] Sakong, visiting fellow, Institute for International Economics, Washing-
ton, D.C., and former minister of finance, Republic of Korea.
© 1991 The International Bank for Reconstruction and Development / THE WORLD BANK.
93



94 Floor Discussion of Corden Paper
Dornbusch's paper stated that public sector pricing must be corrected, and any
income distribution consequences would be resolved through the general tax
structure. He aiso recalled that Corden's early work stated that a subsidy sys-
tem, rather than tariffs, should be used to protect infant industries. Are subsidies
now ruled out in current thinking?
Turning to Corden's paper, the same participant noted the importance of
imported intermediate goods, particularly in Africa, where macroeconomic sta-
bility has been achieved through import compression. While Corden had
emphasized that there was a trade-off between inflation and the current account
deficit, it could work the other way. Letting the current account deficit expand
allows greater imports of intermediate goods, which increase domestic produc-
tion and have supply effects that reduce the inflation rate. Finally, the partici-
pant found the section on inflation ambiguous in its discussion of the relation-
ship between inflation and growth, particularly at low rates of inflation. He said
that there is some evidence to suggest that the variability of the rate of inflation
is what is crucial. He wondered whether there was evidence from the seventeen
countries Corden cited to suggest that there is a strong negative correlation
between the variance of the rate of inflation and the growth rate.
Corden conceded that an element of euphoria, as he defined it, might be
overenthusiasm by private and official lenders to jump into promising countries;
that might have been true in Sri Lanka. The domestic real exchange rate
adjustment-price changes that go with any transfers into a country, whether
from aid, loans, or an export boom and the familiar Dutch disease
phenomenon-is a quite separate aspect. He argued that it was impossible to
avoid such price changes without ruling out loans, investments, and so on. The
key, he suggested, was the scope governments gave to countercyclical measures,
which would offset the relative price effects to some extent.
On the variability of inflation, Corden advised against generalizations.
Because all high-inflation countries have variable inflation, there is a clear cor-
relation between the average level of inflation and variability. There is, how-
ever, no clear answer on the effects on growth from the country studies he had
reported on in his paper. Brazil, for years one of the highest-growth countries in
the developing world, was also a high-inflation country. But there are other
countries, in Asia for example, that have high growth and low inflation. Yet
Argentina has high inflation and low growth. A number of African countries
have relatively low inflation but also low growth. Corden also cautioned that
the choice of the time period under study also had an important effect on the
relationship between inflation and growth.
Extending his discussion of inflation and growth, Corden posed the following
question: if high inflation goes with low growth, does it not automatically
follow that high inflation caused the low growth? Incompetent governments find
themselves with high inflation because they do not have a decent tax system and
end up with many distortions; so there is a common cause for both high inflation
and low growth. Even if high inflation is not the cause but a symptom, very high
and unstable inflation has to be bad for growth prospects.



FloorDiscussion of Corden Paper 95
On the question of whether structural adjustment loans generate Dutch dis-
ease problems, John Williamson (discussant) noted that he preferred to think
about the problem in terms of the growth-maximizing exchange rate. If the
exchange rate is overvalued, even assuming there is no foreign exchange con-
straint, the incentive to invest is low, resulting in a low growth rate from lack of
demand for investment. If, in contrast, the currency is too undervalued, there is
presumably a high incentive to invest, but saving is inadequate because it has
been used to make foreign investments with a lower yield. That is not very clever
either. So what you want to find is the growth-maximizing exchange rate in the
middle. The real question then is whether there is a surplus or a deficit at this
optimal exchange rate. Structural adjustment loans are very helpful in letting
you run a deficit; conversely, with a surplus you want to guard against Dutch
disease problems by putting the loans into reserves or paying off commercial
debt. The difficulty for policy arises when money is coming into the private
sector, because then a fiscal surplus is needed in order to sterilize it.
Susan Collins (discussant) suggested that on the tax issue, Dornbusch, if he
were still in the audience, would probably cite his comparison case, Argentina,
where relatively few people are paying taxes, and tax rates are very high. The
point was that if the key objectives in designing a tax structure are compliance
and enforcement, a uniform structure makes sense. Clearly, you cannot redis-
tribute if you do not have the tax revenues to begin with; then there is some
tradeoff between being able to generate revenues and then figuring out how to
reallocate some of them. She felt that there was useful middle ground between
complete uniformity and exclusive focus on a very small group that pays taxes.
On the structural adjustment loan issue, Collins said that countries that had
achieved macroeconomic stabilization, readjusted to structural problems, and
maintained or revived growth had not done it without receiving capital inflows
to help ease the cost of adjustment. It is true that capital inflows can create
problems and become part of the problem. The real question is how to use them
properly, recognizing that they can always be used poorly.
A World Bank participant asked Corden what should be done when a country
was ignoring Corden's maxims yet was managing quite well. The participant
had India in mind. He also asked whether Corden, from his country studies, had
identified the impact of structural adjustment policies recommended by the
World Bank on growth, particularly microeconomic effects that would enhance
efficiency and speed up the return to growth.
On the first point, Corden replied that India had been doing well recently but
cannot be considered a great success story over the longer period. And even if a
country were managing well, it might be able to do better. The participant then
expanded his question to draw attention to the high budget deficit relative to
gross national product in India. Corden replied that with high private saving, as
in India, the question boiled down to whether the deficits amounted to a good
use of the saving; a cost-benefit analysis should always apply, whether funds
were borrowed from abroad or come from domestic saving.
On the effects of structural adjustment Corden said that growth depended on



96 FloorDiscussion of Corden Paper
so many factors that it was difficult to measure a direct correlation with any one
element. However, he did see a difference between policy regimes that looked
only at macroeconomic structural adjustment and those that also focused on
microeconomic policies. He added that his studies had not attempted to assess
the effects of World Bank and IMF programs but had looked at the totality of the
country's policies.
A participant contrasted Dornbusch's discussion of the need for indexation
with Corden's discussion of the need for a reduction of real wages to make
countries competitive through a devaluation. Taken together, these implied that
in countries where it was not feasible politically to reduce the large public sector
employment, indexation would have an adverse effect on the fiscal balance and
at the same time an adverse impact on the real exchange rate. How does one
handle this policy dilemma? Regarding exchange rate misalignment, the partici-
pant asked Williamson how one determined the growth-maximizing exchange
rate in reality, when, for example, countries face conservative euphoria.
A participant said that after the two major oil price shocks, the need to recycle
petrodollars led to a decline in the quality of investment at the microeconomic
level. These past misallocations of investments, he felt, had led to the need for
SALS. But the SALS themselves have partially prevented improvement in the qual-
ity of investment analysis in the World Bank. For some countries, SALs have
swamped World Bank conventional investment loans and analysis for them. The
question is: where are we going from here?
Another participant asked whether the advocacy of conservative monetary
policies automatically implies putting a brake on fiscal expenditure. In other
words, are foreign lenders and domestic lenders always more conservative than
central banks? The participant asked why some countries that had followed
anti-inflation policies still had inflation rates of 15 to 20 percent-three to four
times the world rate. The participant also expressed the view that exchange rates
and overvaluation of currency were sometimes overemphasized. For countries
that exported mainly minerals or petroleum, the exchange rate, unless absurdly
overvalued, did not really matter that much. Other distortions, such as punitive
taxation, were much more important.
Corden, referring to the question on public sector wage indexation, said that
unlike Dornbusch, he was not very sympathetic to indexation. If there is indexa-
tion of wages, it is very difficult to reduce them when a country has had an
adverse shock in the form of trade deterioration. If wages have to be reduced,
Corden said that it may be easier to reduce them in real terms rather than in
nominal terms, and there is a possible role for devaluation.
Regarding the World Bank's structural adjustment lending, as compared with
its project lending, Corden said that the real question was, is there significant
conditionality? Corden felt that it is proper for the World Bank and the IMF to be
concerned with general economic policies, not just with projects. In that sense,
conditionality inevitably involves criteria such as the level of trade restrictions,
which is hard to monitor or even measure, and there is a tendency for these loans



Floor Discussion of Corden Paper 97
to slide into becoming ordinary balance of payments support loans without real
conditionality. His interpretation of SALS was that the countries did not neces-
sarily need the money for balance of payments but rather that the loans were
incentives to encourage countries to pursue better policies.
On inflation, Corden did not think that 15 to 20 percent inflation rates were
necessarily a big problem. He cited Chile as being rather successful with a fairly
steady level of 15 to 20 percent, after a long history of erratic high inflation.
On whether the real exchange rate was overemphasized in considering
growth, Corden pointed out that this conference was concentrating on macro-
economic matters. At the same time, it was true that many factors had a bearing
on growth.
Williamson, commenting on indexation and inflation, said that indexation
certainly made it difficult to deal with inflation. But he believed Dornbusch was
saying that there are circumstances in which the alternative to indexation is
much worse; indexation can be part of a bargain in which labor accepts lower
wages as part of a stabilization package but wants a guarantee that the real wage
will not be eroded beyond a certain point. In those circumstances, he would
agree with Dornbusch that there is a role for indexation.
On the question of identifying a growth-maximizing exchange rate, William-
son replied that one uses an econometric macroeconomic model if one believes
in it. If one doesn't, one has to fall back on some rules of thumb. In his experi-
ence, the performance of nontraditional exports is a good indicator. If nontradi-
tional exports are booming and perhaps even leading to a balance of payments
surplus, the exchange rate is possibly undervalued and certainly not overvalued.
If nontraditional exports are stagnant, the exchange rate is probably overvalued,
even if one is told that some other source of payments, such as mineral exports,
is providing all the foreign exchange needed, and the exchange rate is not
perceived to be critical. So a simple short-cut rule is to look at nontraditional
exports; if they are moving, that is fine, but if they are not, then the exchange
rate is probably overvalued, and that is cause for worry.
A World Bank participant observed that the speakers had widely different
opinions on the acceptable rate of inflation. The relation between inflation and
growth appeared to be very nonlinear, with a point in the relationship after
which inflation became much worse much more rapidly. The participant asked
about the basis of this abrupt nonlinearity of the relationship and how one
determined at what inflation rate it occurred.
Another World Bank participant commented that there is misconception both
within the World Bank and outside about what the Bank did before SALS were
started. Before SALS, the Bank basically financed a subset of a country's public
investment budget. A condition of such loans in most cases was a public invest-
ment review, and endorsement of the whole public investment budget. There is
nothing that says that just because one has SALS now, one cannot have cost-
benefit analysis and a review of the public investment budget.
On the macroeconomic side, this same participant was struck by the difficulty



98 Floor Discussion of Corden Paper
of maintaining stability in real exchange rates even if there are no booms. With
the instability of real exchange rates observed even in the countries that belong
to the Organisation for Economic Co-operation and Development (OECD), the
question was whether one could expect to have exchange rate stability in the
developing world. This related to another question: what is the macroeconomic
policy role of the OECD countries in assisting the resumption of growth in the
developing countries?
Another participant noted that on the question of indexation and inflation
Dornbusch earlier had flatly stated tha, indexation does not create an inflation
problem as long as the budget is balanced. The problem, of course, was that one
did not see a country with a balanced budget and indexation. Furthermore,
indexing in the context of public sector prices is only partial indexation. Other
sectors as well have major repercussions on inflation.
On instability in real exchange rates and the implication of the variability of
OECD countries' exchange rates, Corden agreed that there is a problem. One
possibility is to fix the rate to a trade-weighted basket. In the case of Asian
economies, that means a heavy element of yen and of U.S. dollars, and there are
the inevitable problems when there are large yen-dollar rate changes. But those
are much simpler problems as compared with the bigger problems with which
the paper was concerned: the problems of changing conditions in the developing
country itself, which is trying to keep the exchange rate fixed and cannot suc-
ceed in getting inflation under control.
On the question of deciding on the "correct" level of inflation, Corden voiced
the opinion that a 20 percent rate is not harmful if it is steady. But a central
problem is that the higher the rate of inflation, the more variable it is, which of
course creates uncertainty. And if it is rising, one doesn't know where it will
stop. Thinking of the countries in his study, Corden suggested that any country
that had managed to have 20 or 25 percent inflation or less did not have a big
problem, certainly in Latin America. And countries such as Thailand, with 3 to
5 percent inflation, are to be welcomed and certainly not encouraged to work
their way up to 20 percent.
On the inflation nonlinearity issue, Collins thought that what was important
was that moderate to low inflation was qualitatively different from high infla-
tion, and the threshold at which moderate inflation becomes high inflation will
vary depending on the country, its history, and other factors, particularlv
exchange rate and fiscal policies. In a particular setting, looking at the inflation
rate, does one expect the rate to remain at that level or come down, or does one
believe it is a floor and will rise? If it is the latter, then it will generate a large
degree of uncertainty, and people devote resources to trying to hedge against
that uncertainty.
Collins felt that the difficulty of maintaining real exchange rate stability, given
the instability of bilateral exchange rates in the developed world, was really a
matter of degree. It is certainly harder if one is trading with countries that are
having large exchange rate swings between them. But most of the exchange rate



Floor Discussion of Corden Paper 99
variability comes from domestic policies and domestic responses to external
shocks.
On optimal or reasonable inflation rates, Williamson said that he began with
the view that the inflation tax is very regressive. He then embraced the accelera-
tionist position that there are no permanent benefits from a faster inflation rate;
these are purely transitory; the higher the rate of inflation at which the economy
stabilizes, the greater the regressive tax. Williamson added that the ability to use
corrective inflation, to adjust to a shock by changing the price level rather than
the rate of inflation, is so dependent on inflation expectations; if you wish to get
expectations down, the only sensible rate of inflation is 0 to 2 percent. If it is too
costly to get inflation down, you wait for an opportune moment. But you do not
tell yourself that a 10 percent rate of inflation is just fine, and there is nothing to
worry about.
Williamson endorsed Corden's position that as long as exchange rates are
fluctuating among the industrial countries, any developing country with rea-
sonably diversified trade can either stabilize the effective exchange rate, which
makes sense from a macroeconomic standpoint, or it can stabilize an individual
bilateral exchange rate, which may be more attractive from a microeconomic
point of view, but it cannot do both. One has to choose between the two, and if
trade is very diversified, on balance he would support stabilizing the effective
rate, which is done by pegging to a basket. Finally, on the indexation question,
Williamson reiterated that indexation can contribute to making a stabilization
program acceptable. However, wage indexation based on a high inherited rate
of inflation can be problematic just when the budget is first brought back into
balance and one most wants to bring down the inflation rate. Then it becomes
impossible to stabilize without a high rate of unemployment.
In closing the discussion, Sakong (chair) said that the range among speakers in
what was considered moderate inflation was somewhat confusing, and there-
fore, that country-specific studies were very useful to complement more general
conclusions. The political economy of macroeconomic policy and the resump-
tion of growth are very important, and Sakong hoped that the World Bank
would further pursue this research issue.