57743 WO R K IN G PAP E R N O .44 From Financieristic to Real Macroeconomics: Seeking Development Convergence in Emerging Economies Ricardo Ffrench-Davis WORKING PAPER NO. 44 From Financieristic to Real Macroeconomics: Seeking Development Convergence in Emerging Economies Ricardo FfrenchDavis © 2008 The International Bank for Reconstruction and Development / The World Bank On behalf of the Commission on Growth and Development 1818 H Street NW Washington, DC 20433 Telephone: 2024731000 Internet: www.worldbank.org www.growthcommission.org Email: info@worldbank.org contactinfo@growthcommission.org All rights reserved 1 2 3 4 5 11 10 09 08 This working paper is a product of the Commission on Growth and Development, which is sponsored by the following organizations: Australian Agency for International Development (AusAID) Dutch Ministry of Foreign Affairs Swedish International Development Cooperation Agency (SIDA) U.K. Department of International Development (DFID) The William and Flora Hewlett Foundation The World Bank Group The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the sponsoring organizations or the governments they represent. The sponsoring organizations do not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the sponsoring organizations concerning the legal status of any territory or the endorsement or acceptance of such boundaries. All queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA; fax: 2025222422; email: pubrights@worldbank.org. Cover design: Naylor Design About the Series The Commission on Growth and Development led by Nobel Laureate Mike Spence was established in April 2006 as a response to two insights. First, poverty cannot be reduced in isolation from economic growth--an observation that has been overlooked in the thinking and strategies of many practitioners. Second, there is growing awareness that knowledge about economic growth is much less definitive than commonly thought. Consequently, the Commission's mandate is to "take stock of the state of theoretical and empirical knowledge on economic growth with a view to drawing implications for policy for the current and next generation of policy makers." To help explore the state of knowledge, the Commission invited leading academics and policy makers from developing and industrialized countries to explore and discuss economic issues it thought relevant for growth and development, including controversial ideas. Thematic papers assessed knowledge and highlighted ongoing debates in areas such as monetary and fiscal policies, climate change, and equity and growth. Additionally, 25 country case studies were commissioned to explore the dynamics of growth and change in the context of specific countries. Working papers in this series were presented and reviewed at Commission workshops, which were held in 2007­08 in Washington, D.C., New York City, and New Haven, Connecticut. Each paper benefited from comments by workshop participants, including academics, policy makers, development practitioners, representatives of bilateral and multilateral institutions, and Commission members. The working papers, and all thematic papers and case studies written as contributions to the work of the Commission, were made possible by support from the Australian Agency for International Development (AusAID), the Dutch Ministry of Foreign Affairs, the Swedish International Development Cooperation Agency (SIDA), the U.K. Department of International Development (DFID), the William and Flora Hewlett Foundation, and the World Bank Group. The working paper series was produced under the general guidance of Mike Spence and Danny Leipziger, Chair and Vice Chair of the Commission, and the Commission's Secretariat, which is based in the Poverty Reduction and Economic Management Network of the World Bank. Papers in this series represent the independent view of the authors. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs iii Acknowledgments These issues are discussed in further detail in Reforming Latin America's Economies after Market Fundamentalism, Palgrave Macmillan, New York, 2006 (cited here as FfrenchDavis, 2006). I appreciate the comments received in a seminar of the Commission, the valuable contributions of Heriberto Tapia, and the research assistance of Rodrigo Heresi. iv Ricardo Ffrench-Davis Abstract Macroeconomic "fundamentals" are a most relevant variable for economic development. However, there is wide misunderstanding about which are the "sound macroeconomic fundamentals," contributing to sustained economic growth. The approach in fashion in the mainstream world and international finance institutions (IFIs) emphasizes macroeconomic balances of two pillars: low inflation and fiscal balances. We call it financieristic macroeconomic balances. Additionally, a frequent assertion in the conventional literature is that an open capital account contributes to impose macroeconomic discipline in emerging economies (EEs). That approach implies a clear omission of the overall macroeconomic environment for producers. As a consequence, in many EEs "a sound macroeconomics" (low inflation and fiscal discipline) is observed, in parallel with slow growth and high unemployment of labor and productive capital resulting from unstable aggregate demand, outlier macroprices, and volatile capital flows. There is strong evidence that financieristic balances have not provided a macroeconomic environment contributing to sustained growth. A third pillar must be added, linked to the productive side of the economy. The behavior of aggregate demand, at levels consistent with potential GDP, is a crucial part of a third pillar for real macroeconomic balances, which has frequently failed in neoliberal experiences. Similarly crucial parts are wellaligned macroprices, like interest and exchange rates. Frequently, these prices and aggregate demand have behaved as outliers, as reflected in economies working either well below potential GDP (the most frequent result), or overheated, with a booming aggregate demand and a large external deficit. This paper analyses alternative macroeconomic environments faced by firms and workers in the productive side of the economy (the producers of GDP), and the interrelationship between financial and real variables. We analyze alternative structural countercyclical fiscal policies, intermediate exchange rate policies, and capital account approaches. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs v Contents About the Series ............................................................................................................. iii Acknowledgments ..........................................................................................................iv Abstract .............................................................................................................................v Introduction ......................................................................................................................9 1. Real Macroeconomic Balances .................................................................................11 2. External Shocks and Real Macroeconomic Balances.............................................20 3. Financial Development, Financierism, and Productivism ...................................25 4. Domestic Policies and Macroeconomics for Development ..................................31 5. Concluding Remarks .................................................................................................41 References ....................................................................................................................... 43 From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs vii From Financieristic to Real Macroeconomics: Seeking Development Convergence in Emerging Economies Ricardo FfrenchDavis 1 Introduction The successful control of inflation and budget deficits has been a generalized trend among emerging economies (EEs) in the last two decades. However, the economic and social performance of many of those economies has been disappointing over that period. In spite of the theories that predict development convergence with developed countries, a significant part of the developing world has been diverging and experiencing a worsening in its alreadyunsatisfactory social indicators, like poverty and income distribution. As a matter of fact, while the East Asian economies have been converging with annual rates of growth in per capita GDP of 3.8 percent in 1990--2007 (compared to one of 1.7 percent in the United States), Latin America has been diverging with a modest annual average growth of 1.5 percent. One main cause of the poor performance of several EEs is the absence of a comprehensive approach to macroeconomics, beyond the necessary emphasis in the control of inflation and budget deficits. Moreover, in some countries (particularly in Latin America), the explicit consideration of the real side of the economy has been disregarded. This narrow view played a negative role in the implementation of the Washington Consensus reforms (see FfrenchDavis, 2007), and it still underlies the design of macroeconomic policies in place and policy recommendation from international financial institutions (IFIs).2 Real macroeconomic balances are crucial for achieving a more dynamic development with equity. Therefore, there is relevance in learning how these balances are obtained, how sustainable and comprehensive are they, how consistent are they with macrosocial balances, and how do they affect the variables underlying potential GDP (GDP*). 1 Ricardo FfrenchDavis is Professor, Department of Economics, University of Chile. He was Former Chief Economist of the Central Bank of Chile, and Principal Regional Adviser of CEPAL. 2 See, for example, Singh (2006). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 9 From the productive point of view, efficient macroeconomic policies must (i) contribute to the use of the available productive capacity, raising the level of utilization of labor and capital, in a sustainable manner; (ii) foster capital formation; and (iii) increase productivity by furthering improvements in factor quality and in the efficiency of their allocation. These are the three cardinal elements that can generate endogenous growth and determine the economic growth rate during the transition to a new stationary level.3 A high average rate of use of capacity implies reconciling the levels of actual aggregate demand and potential supply, attaining a suitable mix between tradables and nontradables, and achieving appropriate macroeconomic relative prices, such as interest rates and exchange rates. They are key variables for fulfilling development objectives. Capital formation and actual total factor productivity (TFP) of that capital are vitally dependent on the quality of those balances. If macroeconomic policies are to make the most effective contribution to development, it is necessary to adopt a comprehensive overall view, (i) that systematically takes account of their effects on productive development, (ii) reconciles the macroeconomic and macrosocial balances in a similarly integrated manner, and (iii) gives rise to trends that are sustainable in time. This paper takes the experience of the Latin American countries (LACs) as a paradigmatic case in terms of the effects of a "financieristic" approach in macroeconomic policy making. The performance of LACs has been driven by a macroeconomic environment where the main agents--government, entrepreneurs, workers, investors--have been facing sizable fluctuations in aggregate demand, economic activity, and macro prices. Significant successes in reducing inflation and improving fiscal responsibility have failed, by themselves, in achieving stability in the environment met by producers, both labor and capital. Consequently, although overall GDP also responds to complex processes related with micro and meso structures, macroeconomics has been one main factor behind the volatile and disappointing behavior of regional output. This has been a severe failure in LACs economies, which requires a sharp correction. It is crucial to avoid or soften deep and longlasting recessions, as well as to ensure a sustainable evolution of the main macroeconomic variables during boom periods: external and fiscal accounts, domestic and private indebtedness and, in general, a convergence between aggregate supply (the potential output or productive frontier) and effective demand. This paper focuses on the definition of macroeconomic balances, and their overall impacts on growth and equity. Since capital flows have played a dominant role in the emerging economies during the last third of the century, their effects will take a central role in the discussion. 3 Somewhat related discussions can be found in Agénor and Montiel (1996); ECLAC (2004); Easterly, Islam, and Stiglitz (2001). 10 Ricardo Ffrench-Davis Section 1 defines macroeconomic balances for sustainable growth; the analysis leads to two contrasting approaches to macroeconomic balances, emphasizing the relative weight of real versus shortterm financial factors in economic decisions: a twopillar financieristic balance, and a threepillar real macroeconomics for development. It explores why financial instability has significant real permanent effects (with references to the Latin American experience), via the gap between potential GDP and its actual utilization (called here output gap or recessive gap); the positive dynamic implications, for capital formation and actual productivity (TFP), of holding low output gaps are stressed. Section 2 examines the connection between external shocks and the macroeconomic environment, highlighting the challenges of policy making to deal with the real business cycle, and destabilizing intertemporal macroeconomic adjustments. Section 3 analyses the role played by shortterm segments of financial markets and the predominance of financial investments (speculation and rentseeking) at the expense of productive activities. Section 4 summarizes a set of key considerations on macroeconomic policies to achieve comprehensive macroeconomic balances, consistent with higher and sustained economic growth with equity; the discussion includes monetary policy, exchange rate and fiscal policies, and the regulation of capital flows. Section 5 concludes. 1. Real Macroeconomic Balances There is a broad consensus that macroeconomic "fundamentals" are a most relevant variable to enhance economic development. However, there is wide misunderstanding about what constitutes "sound fundamentals," and how to achieve and sustain them. The operational definition of macroeconomic balances has become so narrow that in many EEs (and particularly LACs, as explained below) the coexistence of "a sound macroeconomics" is observed, mirrored in low inflation and small public deficits or surpluses, in parallel with slow growth and high unemployment of labor and capital resulting from unstable aggregate demand and outlier interest and exchange rates. This section widens the view on macroeconomic balances by taking into account the macroeconomic incentives faced by firms in the productive side of the economy, analyzing also the relationship between financial and real variables, and the social effects of macroeconomic policies. A Two-Pillar Macroeconomics The approach that has been in fashion in the mainstream world and IFIs, even up today, emphasizes macroeconomic balances of two pillars: low inflation and fiscal balances. It depicts a clear omission of the overall macroeconomic environment for producers, which includes other most influential variables such From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 11 as aggregate demand, and interest and exchange rates. We call this approach financieristic macroeconomic balances. This approach evidently includes other ingredients, but assumes that the hard, relevant proof is in fulfilling those two pillars. It assumes that achieving the two pillars leads to productive development if the economy is liberalized (that is with the addition of microeconomic reforms, several of which have been in fact made). This approach has been in place for about two decades and continues to be the basis of the "remaining agenda" pushed by the IFIs (see, for example, Singh, et al. (2005); Singh (2006), by then IMF Director for the Western Hemisphere). Additionally, a frequent assertion in the more recent conventional literature is that an open capital account imposes macroeconomic discipline on EEs.4 Indeed, this approach assumes, sometimes explicitly or frequently implicitly, that full opening of the capital account would help impose external and fiscal balances and, as a consequence, automatically generate an aggregate demand consistent with productive capacity: it is well documented that that is not the usual experience in the frequent cases of external, positive and negative, financial and terms of trade shocks experienced by EEs (see FfrenchDavis, 2006, ch. VI; Williamson, 2003). Naturally, concern for those two financial balances is justified. In particular, several LACs have suffered from hyperinflation. When present, this phenomenon rightly tends to occupy such a dominant place that antiinflationary policy often becomes the leading and absolute objective of economic policies. Hyperinflation processes (see figure 1, panel C) have been the consequence of public deficits that are out of control and money printing to finance them. LACs were successful in the 1990s in reducing inflation to onedigit figures, and balancing their fiscal budgets (fiscal deficits averaged, of course with diversity among countries, between 1 and 2 percent of GDP in 1994 and 1997, the two years preceding the two recessive shifts of the 1990s).5 Expansions of the money supply to finance public expenditure had become weaker or disappeared. Thus, several LACs fulfilled the main requirements of neoliberal macroeconomic balances (see panels C and D in figure 1).6 4 A recent working paper of the IMF (Tytell and Wei, 2004) examines the "discipline effect" of financial globalization on macroeconomic balances, focusing on the two pillars in fashion--low inflation and fiscal balances--disregarding the other components of a comprehensive set of real macroeconomic balances. 5 It is inconsistent to assert that fiscal deficits have been the cause of currency or financial crises, on the basis of fiscal figures that refer to the period after the explosion (for instance to 1998­99). Obviously, that is not a cause but a consequence of crises. 6 Also, economic reforms succeeded in improving export dynamism. However, trade reforms during episodes of appreciating real exchange rates ended up, frequently, in an excessive destruction of tradable activities whose output was directed to domestic markets. Likewise, export development has remained too concentrated in commodities with low valueadded, which limits the transmission of export dynamism to the rest of the economy (see Agosin, 2007; FfrenchDavis, 2006, chs. IV and V). 12 Ricardo Ffrench-Davis Figure 1: Latin America (9): Macroeconomic Balances, 1976­2007 (weighted averages) Panel A. Current Account Balance (% of GDP) 4 2 0 Percent ­2 ­4 ­6 ­8 20 5 20 6 07 19 6 19 7 19 8 19 9 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 19 9 19 0 91 19 2 19 3 19 4 95 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 0 0 7 7 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 0 0 0 0 0 19 19 19 Year Panel B. Output Gap (% of potential GDP) 10 8 6 Percent 4 2 0 ­2 ­4 20 6 07 19 6 19 7 19 8 19 9 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 19 9 19 0 19 1 19 2 19 3 19 4 19 5 96 19 7 19 8 20 9 00 20 1 20 2 20 3 20 4 20 5 0 7 7 7 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 0 0 0 0 0 19 19 20 Year Panel C. Annual Inflation Rate (%) 120 100 80 Percent 60 40 20 0 91 92 19 3 19 4 19 5 19 6 19 7 19 8 99 20 0 01 20 2 20 3 20 4 20 5 20 6 07 76 19 7 19 8 19 9 80 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 19 9 19 0 9 9 9 9 9 9 0 0 0 0 0 0 7 7 7 8 8 8 8 8 8 8 8 8 9 19 19 20 20 19 19 19 Year Panel D. Overall Fiscal Balance (% of GDP) 0 ­2 ­4 Percent ­6 ­8 ­10 ­12 20 2 20 3 20 4 20 5 06 07 76 19 7 19 8 79 80 19 1 82 19 3 19 4 19 5 19 6 19 7 19 8 19 9 19 0 19 1 92 19 3 94 19 5 19 6 19 7 19 8 20 9 00 20 1 0 0 0 0 9 0 7 7 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 20 19 20 19 19 19 19 19 19 Year Source: Author's calculations based on ECLAC data and Hofman and Tapia (2004). Notes: Includes Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, and República Bolivariana de Venezuela (Latin America (9)). Averages were weighted using GDP at 1980 constant prices. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 13 Clearly, the twopillar macroeconomics was not enough. At the same time there was an increasing external deficit (see panel A in figure 1) that implied a rising degree of vulnerability. In boom periods, the excess of expenditure over domestic production or income was concentrated in the private sector (Marfán, 2005). In fact, in boom stages, while the external deficit worsened (financed with capital inflows), the public sector of many countries in the region registered a marked improvement between the decade of the eighties and the nineties until the arrival of the contagion of the Asian crisis. The growth of current account deficits was frequently caused by the increased net expenditures of the private sector in the 1991­98 period. This outcome was the combined result of the large supply of foreign financing and the permissive domestic macroeconomic policies, usually praised by financial markets. Consequently, after the international turbulences of 1994 (Tequila crisis) and 1997­98 (Asian crisis), a significant recessive output gap reopened, with severe costs for growth and equity (see FfrenchDavis, 2007). Toward Real Macroeconomic Balances: Three Pillars Financial macroeconomic balances are not sufficient to achieve a macroeconomic environment for high and sustained growth. A third pillar must be added, linked to the productive side of the economy. The behavior of aggregate demand, at levels consistent with potential GDP (also called productive capacity, installed capacity, or production frontier), is a crucial part of a third pillar of real macroeconomic balances, which has frequently failed in neoliberal experiences. Also important are wellaligned macroprices, like interest and exchange rates. Frequently, these prices and aggregate demand were outliers (outofequilibria), as reflected in economies working either quite below potential GDP (the most frequent result) or at full capacity but with a booming aggregate demand and a large external deficit. One of the most fundamental macroeconomic balances refers to the rate of utilization of productive capacity. In economies with inflexible price systems and incomplete factor markets, both positive and negative shocks provoke successive adjustments. The results are greater disparity between supply and aggregate demand, with a consequent gap between potential productive capacity and the use made of it, particularly in the "stop" stages that follow the "go" stages. Unstable demand, in a stopandgo setting, inevitably means a lower average net use of productive capacity and a lower average actual productivity than in a situation of stable proximity to the productive frontier. Naturally, the larger the instability, the larger will be the recessive output gap. Instability, Growth, and Equity Behind the emergence of output gaps is the extreme instability in GDP growth rates. As shown below in figure 4, Latin America has faced volatile business cycles, with intense contractions and expansions. Evidently, the production 14 Ricardo Ffrench-Davis frontier poses a limit to recoveries of actual GDP; only temporarily can actual GDP exceed potential GDP, while in recessive situations, actual GDP can be notably below potential GDP. The implication of this annoying asymmetry is that average actual GDP, under real macroeconomic instability, is significantly lower than the average production frontier. This asymmetry, intrinsic to economic reality, has significant implications for defining doses of objectives and policies, and for empirical research and econometrics (see FfrenchDavis, 2006, ch. III, section 2). The magnitude of the gap between effective demand and the production frontier has important static and dynamic effects. First, it affects the ex post productivity and profitability of the projects implemented. Second, indeed, higher rates of capital utilization mean that the average level of employment is higher and that the labor force combines with a larger stock of physical capital in actual use. Higher actual productivity does mean that the potential welfare of labor and rentiers (wages and profits) can improve at present, with the higher average rate of use of capacity. If wages and profits grow, then fiscal revenue will grow as well. Then, workers, entrepreneurs, and government will be able to sustain higher consumption and investment, with a net positive effect on overall economic welfare. Third, in the dynamic dimension, there are several effects of the degree of stability. Higher rates of utilization and the consequent increase in actual average productivity (in standard econometrics it would appear as a rise in TFP), will tend to stimulate investment in new capacity (Gutiérrez and Solimano, 2006). 7 For the supply of investment to expand effectively, investors must perceive a real improvement in the short term and foresee that the reduction in the recessive output gap will be persistent (sustained in the future). The dynamic effect will be all the more significant if solid expectations are generated, among the economic actors, that public policies will keep effective demand close to the production frontier, and that, in addition, authorities will undertake reforms to complete longterm capital markets and enhance labor training and productive innovation. Figure 2 shows the close association between the output gap and capital formation in Latin America, reflecting one of the main negative effects of the underutilization of productive factors. This connection responds to several factors:8 (i) if there is plenty of idle capacity, then there is less incentive to invest 7 One significant explanatory variable of the low investment ratio recorded in Chile in 1974­89 (the Pinochet Dictatorship) is the large average output gap predominating in that period. See Ffrench Davis (2002, ch. 11). The large size of the gap is associated with sharp and abrupt drops with gradual macroeconomic recoveries. 8 The negative effect of volatility on investment has been found statistically significant by a number of econometric studies (see, for example, Aizenman and Marion, 1999). Aghion et al. (2005) and Ramey and Ramey (1995) test econometrically the connection of volatility and growth, finding a significant negative relationship. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 15 Figure 2: Latin America (9): Output Gap and Investment Ratio, 1970­2006 (prices of 1995) Investment ratio 10 27 Output gap (% of potential GDP) Output gap 8 Investment ratio (%) 25 6 4 23 2 21 0 19 ­2 17 ­4 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 Source: ECLAC and Hofman and Tapia (2003), and updates. Notes: Averages for Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, and República Bolivariana de Venezuela. The investment ratio measures the ratio between the fixed capital formation and the GDP. The output gap measures the difference between potential and actual GDP as a share of potential GDP. in new productive assets; (ii) a volatile environment deters irreversible investment (Pyndick, 1991); (iii) the recessive gap and its fluctuations tend to deter the quality of project evaluation and innovation; (iv) intense economic fluctuations tend to depress government revenues, which induces cuts in public investment, as discussed below. Consequently, there is a clear connection between real volatility and long term economic growth, which works through its effects on actual TFP and on the volume of investment in fixed capital.9 Figure 3 shows the relationship between the growth of the stock of capital and of GDP (both variables measured per member of the labor force) for 26 economies, including 19 LACs, six East Asian countries, and the United States. In order to try to control for changes in the rate of utilization, rates of annual growth were calculated between 1980 and 2006, two years of relatively buoyant economic activity in the sample.10 It is well documented that the increase in the capital stock accounts for much of GDP growth.11 9 Other two key connections are increases in potential productivity brought by technological change and the formation of human capital. It must be recalled that technology frequently needs to be embodied in factors of production (physical and human capital) in order to be part of the production function. Even intangible technology associated with the organization and generation of institutions usually requires investment in equipment and infrastructure, and depends on a more highly skilled labor force. 10 We are assuming that all countries had rather similar high rates of utilization of factors in 1980 and 2006, in which case the rise in actual GDP is similar to that in potential GDP. That was not probably the case in countries that suffered GDP drops in one of the two years: Bolivia, El Salvador, República Bolivariana de Venezuela, the United States and the Republic of Korea in 1980. 11 The exceptions are Haiti, a country in turmoil as a result of internal conflicts that have conspired against the use of its productive capacity, and Paraguay, where the capital stock series are biased 16 Ricardo Ffrench-Davis Figure 3: EEs and United States: Capital Stock and GDP Growth, 1981­2006 (annual average growth per member of the labor force) 6 Growth of output per member of labor force, % Growth(Y/L) = 0.73 Growth(K/L) ­ 0.59 R2 = 0.68 KOR Convergence 4 THA TWN MAL CHI 2 IND USA DRE Divergence COL CRI ARG BOL PHI BRA PAN 0 URU GUAELS MEX ECU HON PER PAR VEN NIC ­2 HAI ­2 0 2 4 6 Growth of capital per member of labor force, % Source: Author's calculation. Note: Both the stock of capital and GDP are measured in 1995 prices. Capital stock was calculated through the perpetual inventory method assuming an average working life for capital of 30 years. Moreover, most of the differences in growth between Latin America and the more dynamic countries of East Asia are attributable to the rapid growth in capital stock. That is, capital formation has been performing as a leading variable of the evolution of potential GDP in the economies that have been able to converge with the more developed nations. Figure 3 also illustrates the "disappointing" nonconvergence of LACs with more advanced economies. In fact, the United States and East Asian economies have been growing faster than almost all LACs (where Chile is an outlier, but that only converges in the decade of the 1990s). Another dynamic consequence of lower macroeconomic volatility is a tendency towards greater equity.12 This links comprehensive real macroeconomic balances with the macrosocial balances (including poverty and income distribution). Indeed, lowincome sectors, with less human capital, and small and mediumsized enterprises have less capacity to react to continuous unpredictable changes. During periods of expansion, the rate of inflation normally accelerates, and it is the poor who have problems protecting their assets and income against by the construction of huge dams, whose effect on production tends to be lagged over time. Barring these two cases, the explanatory power of the regression (measured by R2) increases to 92 percent. 12 Inequality has, in turn, a negative effect on the formation of human capital, the quality of democracy and, consequently, on economic growth (Bourguignon and Walton, 2007; Alesina and Rodrik, 1994; Galor and Zeira, 1993). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 17 the "inflation tax." The period of downward adjustment tends to be accompanied by drops in wages and employment, with a shift from formal toward informal markets (Tokman, 2004). Hence, there results a negative impact on consumption and wealth of lowincome groups. A procyclical behavior of the share of lowerincome groups in overall consumption, but with a downward bias, should be expected under instability.13 Instability is a significant source of inequity, and it rewards speculation and windfall gains at the expense of productive activities and TFP. Real volatility also has an impact on public finance, given that during recessions there is a drop in tax proceeds that uses to be translated into cuts in expenditure (as happened during the debt, Tequila, and Asian crises). These cuts not only affect redundant and bureaucratic expenses, but also areas where spending was already insufficient, thus slashing expenditure which was essential for changing production patterns with social equity. In such areas as infrastructure, education, and labor training, investment--whether public or private--often is far below the appropriate levels for economies that are undergoing major processes of change (see Easterly and Servén, 2003). Maintaining excessive expenditure cuts in these essential items for several years undermines the efforts to improve factor quality and poses obstacles to the full utilization of installed capacity, thus lowering the efficiency of the changes in production that are under way. As a consequence, economies operate with less dynamic production frontiers and in actual positions markedly below those frontiers. That is, their production capacity is underutilized and tends to grow more slowly because of a lowered level of investment, with consequent negative impacts on actual productivity, employment, and profitability. The Latin American experience shows that an efficient combination of financial and real macroeconomic balances has been absent. In the 1990s, the success achieved in reducing inflation was partly due, in a number of cases, to exchangerate appreciations, under the socalled exchange rate anchor. In fact, the vast majority of LACs revalued their currencies in real terms between 1990 and 1994, and again between 1995 and 1997. Renewed access to external finance in 1990­94 and 1996­97 made possible or actually encouraged successive real revaluations that acted as an anchor for the domestic prices of tradables. Furthermore, many countries that exhibited high rates of underutilization of their productive capacity, with the renewed access to external finance and currency revaluations, were able to increase their rates of resource use while reducing inflation (see white arrows in panels A, B, and C in figure 1). Supply available in nonexports was able to respond fast to the increased aggregate demand, with generally falling average rates of inflation. See, for example, Dutt and Ros (2005); Lustig (2000); Morley (1995); Rodrik (2001); Stewart (2005); 13 World Bank (2003). 18 Ricardo Ffrench-Davis Appreciationcumtrade liberalization caused the recovery in aggregate demand, both of individuals and of firms, to be increasingly intensive in imports (see FfrenchDavis, 2006, ch. IV; and ECLAC, 1998, ch. V). Imports thus went from a low level kept down by the previous recession to an excessively high level, particularly in the case of imported consumer goods whose relative prices were sharply reduced with liberalization. In the countries that appreciated most, with bigger and fastergrowing external deficits led by financial flows, price stabilization tended to be more rapid. However, they also became more vulnerable, as the gap between domestic spending and actual GDP (the external deficit) grew wider and external liabilities rose apace. As was to be expected, external creditors became increasingly sensitive to political and economic "bad news," which led to crises in the external sector. Thus, some countries suffered traumatic setbacks in the fight against inflation in 1995 (Mexico, for example) or sank into recessions (Mexico, once again, and Argentina). When timely corrections had been made, however, the necessary adjustments could be carried out without major upsets. For instance, Chile in 1990­95 carried out miniadjustments, in a threepillar macro approach, whenever it detected starting imbalances, in order to avoid subsequent maxi adjustments. After the 1995 crisis, the return of capital flows to Latin America in 1996­97 allowed, once again, a simultaneous improvement in economic activity and in price stability, but at the expense of a rise in exchange rates and external deficits. The result was the subsequent penetration into vulnerability zones. Consequently, in 1998, when the Asian crisis did hit Latin America, there was a generalized downward adjustment in the region, especially in South America, with massive capital outflows and significant exchange rate depreciation. This time, however, inflationary processes did not take place. On the contrary, there appeared long lasting large recessive output gaps as a result of contractive monetary policy, which gave priority to price stability over real stability (see panels A, B, and C in figure 1). The sharp GDP recovery of 5.5 percent in 2004­07 is undoubtedly a positive fact, but took place after six years of large disequilibria: the significant output gap in 1998­2003.14 This fact in that long sixyear period represents a costly failure of domestic macroeconomic policies by not keeping the economy close to the production frontier. That failure was compounded by the procyclical behavior of international trade and finance. 14 In 2004­07, pulledup by a strengthened world economic activity and sharply improved terms of trade, a significant drop of the output gap took place. While potential GDP was expanding in the order of 3 percent, actual GDP rose 5.5 percent in that fouryear period. Thus, the recessive gap, part of the previous macroeconomic disequilibria, was corrected. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 19 2. External Shocks and Real Macroeconomic Balances In order to cope with real volatility it is crucial to understand its causes. External shocks are a major source of macroeconomic fluctuations in EEs. It is possible to identify at least three sources of positive external shocks, in front of which economic activity can respond positively, insofar as installed capacity is available. The first source is an increase in export prices. Once the production frontier has been reached, however, if the positive shock still persists it will cause demand pressures that give rise to higher domestic prices and/or an increased external deficit. Swings in external prices are largely transitory, however, if the economy accommodates to that abundance, and therefore the subsequent downward adjustment will be traumatic. A second source of external shocks is changes in international interest rates. Depending on the capital account regime, these fluctuations affect domestic rates to some extent and their effects are thus transmitted through relative prices to aggregate demand. They influence the volume of net capital inflows, affect national income--since a drop (rise) in external interest rates increases (reduces) the national income of a net debtor country--and they affect the foreign currency market. A third source of external shocks, which has been the main determinant of macroeconomic instability of LACs since the 1970s, is the sharp fluctuations in the volume of capital flows. In this respect, private capital flows other than FDI are particularly noteworthy because of their volatility. Figure 4 show the systematic association between swings in aggregate demand and external shocks.15 In other words, in recent decades, generally, real volatility has had an external origin: these have been notably stronger than domestically originated shocks. In the late seventies and in the nineties there were sizable capital surges, while in recent years are determined mostly by significant terms of trade changes. Figure 5 shows that changes of actual GDP have been sharply associated to fluctuations in aggregate demand. In the last four decades, aggregate demand changes have led GDP changes in both booms and recessions that have affected the region. Usually, only subsequently, domestic policies have played a role in moderating or exacerbating the effect of external shocks. In fact, the causality has been twofold. On the one hand, shocks have been essentially exogenous. The overall supply of capital flows to EEs, the world interest rates, and the main factors behind the evolution of the terms of trade (the growth of the world economy, exogenous supply of natural resources) are generally independent of economic policies in EEs. 15 External shocks are measured here as the higher (or lower) purchasing power as a result of net transfers from abroad and change in the terms of trade, measured as a share of GDP. 20 Ricardo Ffrench-Davis Figure 4: Latin America (19): Growth of Aggregate Demand and External Shocks, 1970­2006 (%) 12 10 8 6 4 Percent 2 0 ­2 ­4 EXT (% of GDP) ­6 Aggregate demand (%) ­8 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 Year Source: Author's calculations based on data from ECLAC. Includes Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Haiti, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and República Bolivariana de Venezuela. Note: EXT: external shocks, represents additional resources from abroad, resulting from net transfers (capital inflows plus factor payments) and the improvement of the terms of trade. Measured as a share of GDP. Figure 5: Latin America (19): Growth of GDP and Aggregate Demand, 1970­2006 (%) 12 10 Aggregate demand (%) 8 GDP 6 4 Percent 2 0 ­2 ­4 ­6 ­8 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 Year Source: Author's calculations based on data from ECLAC. On the other hand, the exposure to shocks and the intensity of their effects are affected by some domestic factors. Indeed, the degree to which external shocks are reflected in GDP growth is strongly determined by (i) the initial gap between actual GDP and the production frontier; (ii) the nature of the domestic From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 21 economic policies implemented, especially the macroeconomic ones; (iii) the expectations of economic agents; and (iv) political events. In an "ideal" adjustment process, in a perfectly flexible and wellinformed economy with complete and homogeneous factor markets, excess aggregate demand is eliminated without any drop in production (or, more exactly, in the rate of use of capacity). On the other hand, in an economy that was underutilizing capacity in the tradable sector, an adjustment with a balanced mix of production and expenditure switching policies can raise output. Finally, in the typical setting of an economy with price inflexibility and imperfect factor mobility, the implementation of neutral demandreducing policies usually leads to a significant drop in production, because such policies reduce demand for both tradables and nontradables, thus giving rise to unemployment especially in the latter sector. This confirms the importance of price inflexibility, factor immobility, incomplete markets, and flaws in information during adjustment processes in the real economy. They explain why adjustment usually proceeds significantly below the production frontier. In fact, in the real world, in adjustment processes intensive in demand reduction, there tends to be a drop in production, which gives rise to a lower rate of utilization of installed capacity and discourages capital formation (see figure 2). The addition of switching policies, which act over the composition of output and expenditure, can cushion the reduction of economic activity. These policies may be rather global--such as the exchange rate--or they may be more sector specific. The East Asian countries provide examples of success through extremely selective policies, and also of notably effective adjustment processes (Amsden, 2001; Kaplan and Rodrik, 2001). A mix of expenditurereducing policies and switching policies should tend to make possible an outcome closer to a full utilization of potential GDP. In periods of economic recovery, macroeconomic policy management seems to face lighter demands than when the economy is already at its production frontier. In fact, a passive policy can give positive net results in a situation under a recessive gap. Capital inflows (or improved terms of trade) increase the domestic spending capacity. Aggregate demand for domestic and imported goods expands in a context of improved expectations, fuelled by the access to foreign funds. The supply of domestic goods and services can respond to the greater demand thanks to the available installed capacity, while the resulting increased imports are covered by capital inflows. Thus, under unemployment of productive factors, the positive shock has a positive Keynesiantype effects: it eliminates the binding external constraint (BEC), making possible a higher use of productive capacity, and thus leading to a recovery in output, income, and employment (as well as investment, as documented in FfrenchDavis, 2006, ch. III). 22 Ricardo Ffrench-Davis However, most crises since the 1980s have been the result of badly managed booms (Ocampo, 2003). During the boom is when the degrees of freedom to choose policies are broader and it is when future imbalances are generated. In order to move toward a macroeconomicsforgrowth, we need to have a systematic clear differentiation between what is economic recovery and what is generation of additional capacity. This has been a common misleading factor for both leftist and rightist governments in Latin America. That pitfall leads not only to neglect of the importance of investment from the point of view of public policies, but also stimulates the private sector to run a destabilizing intertemporal adjustment. Indeed, interpreting that a recovery is a sustainable growth of potential GDP, supposedly with a high TFP, leads to feel richer and starting consuming the future, while not being really richer. Sharply distinguishing between creating capacity and using existing capacity should be guiding our macroeconomic policy. In fact, if capital inflows or improved terms of trade stimulate processes of recovery in economies with unemployment of productive factors, actual productivity rises because of an increase in the rate of utilization of potential GDP. Then agents and authorities (and also many researchers, see FfrenchDavis, 2006, ch. III) may confuse the jump in actual productivity that is based on the utilization of previously idle labor and capital with a structural increase in the sustainable speed of productivity improvements. From the point of view of `rational' consumers, they tend to assume that there is an increase in their permanent income. Consequently, the market response would tend to be an intertemporal upward adjustment in consumption, with the external gap covered with capital inflows, as long as the supply of foreign savings is available. That implies a crowding out of domestic savings that results from agents' decisions based on biased information.16 The intertemporal adjustment ends up being destabilizing. The increased availability of funds tends to generate a process of exchange rate appreciation. Then the expectations of continued, persistent appreciation encourage additional inflows from dealers operating with maturity horizons located within the expected appreciation of the domestic currency. For allocative efficiency and for exportoriented development strategies, a macroprice--as significant as the exchange rate--led by capital inflows conducted by short termist agents reveals a severe policy inconsistency. The increase in aggregate demand, pushed up by inflows and appreciation, and rising share of the domestic demand for tradables, augments artificially the absorptive capacity and the demand for foreign savings. Thus, exogenous changes (like fluctuations in the supply of funds) are converted into an endogenous process, leading to domestic vulnerability, given the potential reversibility of flows. In the case of a transitory As highlighted by Aghion and Durlauf (2007), the low savings ratios are behind the lack of 16 conditional convergence of developing countries, and particularly LACs. We stress that low savings are, partly, a consequence of recessive gaps led by twopillar macroeconomics and subsequent discouragement to productive investment. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 23 improvement in the terms of trade, a similar destabilizing process can occur, with an excessive increase in consumption and a weakening in the generation of productive capacity in tradable sectors intensive in domestic inputs (Dutch disease). Figure 6 shows that the evolution of real exchange rates has responded, to a large degree, to financial flows (rather than to the real forces behind the current account). The volatile components of flows have been the shortterm and portfolio movements of funding, with rather stable flows of greenfield FDI. In some periods, the midterm volatility of financial flows has been reinforced by significant fluctuations in the terms of trade. Actually, between 2003 (still a recessive year for Latin America) and 2007 (covering a period of significant recovery), the terms of trade explained the majority of the elimination of the binding external financial restriction that LACs had suffered in 1998­2003 (see Ocampo, 2007). Therefore when actual output is reaching the production frontier, more active policies are needed to regulate the expansion of aggregate demand. Moreover, with a closing recessive output gap, the role of policies to enhance productive development (and increase potential output) becomes crucial. In fact, it is essential to keep the rate of expansion of demand in line with the growth of productive capacity (and also with sustainable external financing). Otherwise, if passive macroeconomic policies are adopted in situations of positive external shocks (such as lower international interest rates, improved terms of trade, or increased supply of capital inflows) or of a domestic nature (a boom in the construction sector or in the demand for durable goods or stocks and bonds), then the economy will be subject to inflationary pressures and/or a growing gap between expenditure and output. In all events, a future adjustment in the opposite direction will usually be built up. Figure 6: Latin America: Net Capital Inflows and Real Exchange Rate, 1987­2007 (% of GDP; 1997=100) 6 110 Real exchange rate (1997=100) Net capital inflows (% of GDP) 5 100 4 3 90 2 80 1 0 70 ­1 Net capital inflows 60 ­2 Real exchange rate ­3 50 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 Year Source: Author's calculations based on ECLAC figures. Note: Real exchange rate defined in terms of U.S. dollars per unit of local currency. 24 Ricardo Ffrench-Davis Thus, as the production frontier is being neared, there is a growing need for more active and efficient macroeconomic policies. Otherwise, what initially is an equilibrating macroeconomic adjustment becomes a source of disequilibrium and vulnerability. In brief, it is necessary to further improve the capacity to implement real macroeconomic policies, in order to reconcile the proximity of the economy to the production frontier with sustainability and price stability: an effective pro growth countercyclical policy mix is needed. As documented by Kaminsky et al. (2004) for a sample of 104 countries, the opposite has tended to occur. Both monetary and fiscal policies (as well as the exchange rate) have been procyclical and have exacerbated the effect of the shocks of capital flows. 3. Financial Development, Financierism, and Productivism Financial development is a key ingredient for economic development.17 Channeling financial resources toward sectors of higher productivity improves overall efficiency in the economy and enhances economic growth. However, financial markets are imperfect, and quite incomplete in EEs and more so in leastdeveloped countries (LDCs). In a world of uncertainty, incomplete insurance markets, informational costs, and contagious changes of mood, ex ante and ex post valuations of financial assets may be radically different. The time gap between a financial transaction and payment for it generates externalities in market transactions that can magnify and multiply errors in subjective valuations, to the point where finally the market corrections may be abrupt, overshooting, and destabilizing (Stiglitz, 2000). Financierism Empowered by Neoliberal Reforms A distinctive feature of macroeconomic management, in the transition toward development of more advanced nations and in the most successful newly industrialized countries, has been the predominance of productive over financial dimensions. Development has been led by the "real" side, with financial aspects at its disposal. It is a policy correlation contrary to the neoliberal approach and the standard thesis of financial liberalization as a leading essential input for development. On the contrary, in EEs there has prevailed the phenomenon of "financierism"--that is, the dominance (or strong influence and powerful lobbying) of shorttermist financial agents on macroeconomic decisions.18 17 See a recent contribution in Aghion and Durlauf (2007). 18 See an interesting pioneering view developed in Bacha and DíazAlejandro (1983). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 25 The growing link with the international financial system facilitated the disassociation with the needs of domestic productive systems and encouraged capital flights during periods of domestic crises. On the other hand, since the 1970s, economic agents linked to the financial sphere gained greater overall influence in public and private enterprises, as well as in ministries and other governmental departments. This situation imposed the predominance at these levels of a shorttermist bias over concerns for productivity and additions to productive capacity. This trend was emphasized after the debt crisis, when foreign financial creditors and international financial institutions gained weight in the definition of domestic policies. In speculative markets, as Arrow (1974) pointed out, a considerable part of the efforts of economic agents focuses on acquiring information for personal benefit and leads to a zero sum or negative sum redistribution, owing to the use of real resources for these purposes. In short, total openness to the international market (such as those carried out in the 1990s in most EEs) can dismantle comprehensive efforts at domestic stabilization and encourage capital flight (Dornbusch, 1991). In fact, it could imply integration into more speculative segments of developed world markets. In contrast, insertion into the world economy should be aimed at promoting longterm capital inflows, accompanied by access to technology and export markets. From the mid1990s, campaigning and elected Latin American presidents became usual visitors to Wall Street. International mass media, in turn, began to talk about the "market's candidate," actually just referring to financial markets. The strengthening of this dimension has provoked a growing duality, worrisome for democracy, in the constituencies taken into account by authorities in EEs. The present features of globalization are increasing the distance between decision makers and financial agents visàvis the domestic agents (workers, firms, and fiscal tax proceeds) that are bearing the consequences. Thus, an outcome of the specific road taken by globalization has been that experts in financial intermediation--a microeconomic training--have become determinant, in too many cases, for the evolution of the domestic macroeconomic balances and their volatility. Pressures from international financial markets have pushed some governments to offer guaranties for financial investors as a means to gain credibility beyond what is consistent with growth and equity, and even beyond what is necessary to achieve shortrun credibility with international financial markets. As shown by the Argentinean case in the 1990s, if public commitments are beyond the capacity that a democratic country can bear, the result may be praises in the short term but a net loss in credibility in the medium and long term (see Neut and Velasco, 2003). The case of Chile, in the return to democracy in 1990, is an outstanding example of differences between the productivistic and the financieristic 26 Ricardo Ffrench-Davis dimensions: while domestic and foreign financial media praised liberalizing policies during the military rule of Pinochet, Chile recorded its lowest investment ratio in the last half century. On the contrary, the reforms to the reforms in the 1990s--including regulation of financial inflows, some tax increases, labor reforms to strengthen workers bargaining power, and significant increases in minimum wages--were received "with concern" by the large private entrepreneurs and the financial sector, while the investment ratio reached historical peaks. This successful combination was made possible by adopting a threepillar macroeconomics in the early 1990s. Contrarywise, in most of Latin America support of political authorities for the "market economy" has never been as explicit and strong as since the late 1980s, when investment ratios were at historical minimum levels. These cases show that enthusiastic praise from financial markets has, frequently, not been useful for productive development. One outstanding failure has been the incapability to progress from twopillar macroeconomics to threepillar real macroeconomic balances. Rational Pro-Cyclicality of Short-Term Financial Markets, and Irrational Macroeconomic Followers of Their Advice It becomes highly unlikely to escape from financieristic traps without a traumatic adjustment. Such adjustments usually involve an overshooting to outlier exchange or interest rates, and considerable liquidity constraints that, together, generate a very unfriendly macroeconomic environment for firms and labor. An outstanding feature of most recent macroeconomic crises in East Asia and Latin America is that currency and financial crises have been suffered by EEs that usually were considered to be highly `successful' by IFIs and financial agents.19 Actually, they were awarded with growingly improving grades from international risk rating agencies;20 accordingly, EEs were rewarded with large private capital flows, and falling spreads, in parallel with accumulating rising stocks of external liabilities. Given that voluntary flows cannot take place without the willing consent of both debtors and creditors, why did neither agent act in due time to curb flows well before a crisis? The fact is that both regions moved into vulnerability zones (we repeat the signals: some combination of large external liabilities, with a high shortterm or liquid share; a credit boom; currency and maturity mismatches; a significant external deficit; an appreciated exchange rate; high price/earnings ratios in the stock market, high luxury real estate prices; plus low domestic investment ratios in the case of LACs). In parallel, as discussed below, agents specialized in microeconomic aspects of finance, placed in the shortterm or 19 We develop this interpretation in FfrenchDavis (2006, chapter VI). Complementary analyses are found in Frenkel (2004); Williamson (2003). 20 Reisen (2003) shows that risk rating agencies usually follow the market. Nonetheless, they play a significant role because they tend to reinforce overoptimism and overpessimism. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 27 liquid segments of capital markets, acquire a dominant voice in the generation of macroeconomic expectations. There is an extremely relevant literature on the causes of financial instability: the asymmetries of information between creditors and debtors, and the lack of adequate internalization of the negative externalities that each agent generates (through growing vulnerability), that underlie the cycles of abundance and shortage of external financing (Krugman, 2000; McKinnon, 1991; Rodrik, 1998; Stiglitz, 2002; Harberger, 1985). Beyond those issues, as stressed by Ocampo (2003), finance deals with the future, and evidently concrete "information" about the future is unavailable. Consequently, the tendency to equate opinions and expectations with "information" contribute to herd behavior and multiple equilibria. Actually, we have observed a notorious contagion, first of over optimism, and then of overpessimism, in many of the financial crises experienced by EEs in the last three decades. During all three expansive processes there has been an evident contagion of overoptimism among creditors. As said, rather than appetite for risk, in those episodes agents supplying funding underestimate or ignore risk. With respect to debtors, in periods of overoptimism, the evidence is that most debtors do not borrow thinking of default and expecting to be rescued or to benefit from moratoria. Contrariwise, expectations of high yields tend to prevail: borrowers are also victims of the syndrome of financial euphoria during the boom periods. However, over and above these facts, there are two additional features of the creditor side that are crucially important. One feature is the particular nature of the leading agents acting on the supply side. There are natural asymmetries in the behavior and objectives of different economic agents. The agents predominant in the financial markets are specialized in shortterm liquid investment, operate within shortterm horizons, and naturally are highly sensitive to changes in variables that affect returns in the short run.21 The second feature is the gradual spread of information, among prospective agents, on investment opportunities in EEs. In fact, agents from different segments of the financial market become gradually drawn into new international markets as they take notice of the profitable opportunities offered by emerging economies previously unknown to them. This explains, from the supplyside, why the surges of flows to EEs--in 1977­81, 1991­94 and mid1995­98--have been processes that went on for several years rather than oneshot changes in supply. In this sense, it must be stressed the relevance for policy design of making a distinction between two different Persaud (2003), argues that modern risk management by investing institutions (such as funds 21 and banks), based on valueatrisk measured daily, works procyclically in the boom and bust. Pro cyclicality is reinforced by a trend toward homogenization of creditor agents. A complementary argument by Calvo and Mendoza (2000) examines how globalization may promote contagion by discouraging the gathering of information and by strengthening incentives for imitating market portfolio. 28 Ricardo Ffrench-Davis types of volatility of capital flows, short term upsanddowns, and the medium term instability. Mediumterm instability leads several variables--like the stock market, real estate prices, and the exchange rate--to move persistently in a given direction, providing "wrong certainties" to the market, encouraging capital flows, and seeking economic rents rather than differences in real productivity. Private capital flows; led by midterm volatility (or reversibility) of expectations, usually have a strong and costly procyclical bias. On the domestic side, high rates of return were potentially to be gained by creditors from capital surges directed to EEs. At the time of their financial opening, in the 1980s and early 1990s, Latin American economies were experiencing recession, depressed stock and real estate markets, as well as high real interest rates and initially undervalued domestic currencies. Indeed, by 1990, prices of real estate and equity stocks were extremely depressed in Latin America, and the domestic price of the dollar was comparatively high (see ECLAC, 1998; FfrenchDavis and Ocampo, 2001). In the case of East Asia, when countries opened their capital accounts during the 1990s, the international supply of funding was already booming. As compared to LACs, they were growing notably fast, with high savings and investment ratios. However, equity stock was also cheap as compared to capital rich countries (exhibited low price/earnings ratios), and liquid external liabilities were extremely low. Naturally, the rate of return tends to be higher in the productive sectors of capitalscarce EEs than in mature markets that are capital rich. Then, there is potentially space for very profitable capital flows from suppliers in the latter to the former markets. Flows should continue until rates of return (adjusted!!) converge, what naturally would happen over the long term. The direction of expected adjustments in any emerging economy moving from a closed to an open capital account, in those conditions, should tend to be similar to those recorded in LACs. The outcome in both emerging regions, for instance, was a spectacular rise in stock prices, multiplying on average the price index by four in 1990­94 and (after a sharp 40 percent drop with the Tequila crisis) by two in 1995­97 in LACs, and by two in 1992­94 in East Asia (see FfrenchDavis 2006, table VII.4). All these swings were directly associated to portfolio flows. Domestic interest rates tended to be high at the outset of surge episodes, reflecting the binding external constraint faced by most countries during periods of sharp reductions in capital inflows, the restrictive monetary policies in place, and the shortterm bias of the financial reforms implemented in Latin America. Finally, in a nonexhaustive list, the increased supply of external financing in the 1990s generated a process of exchange rate appreciation in most LACs (see figure 6, above), as well as, more moderately, in East Asia; the expectations of continued, persistent, appreciation encouraged additional inflows from dealers operating with maturity horizons located within the expected appreciation of the From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 29 domestic currency.22 The combination of open capital account, large liquid liabilities and expectations of depreciation lead, most naturally, to a large outflow, with a large depreciation if the rate is flexible. For allocative efficiency and for exportoriented development strategies, a macroprice--as significant as the exchange rate--led by capital flows conducted by shorttermist agents reveals a severe policy inconsistency. The increase in aggregate demand, pushed up by inflows and appreciation, and a rising share of the domestic demand for tradables, augments `artificially' the absorptive capacity and the demand for foreign savings. Thus, as said, the exogenous change--opened by the transformations recorded in international capital markets--was converted into an endogenous process, leading to domestic vulnerability given the potential reversibility of flows. In brief, the interaction between the two sets of factors--the nature of agents and a process of adjustment--explains the dynamics of capital flows over time and why suppliers keep pouring in funds while real macroeconomic fundamentals worsen. When creditors discover an emerging market, their initial exposure is low or nonexistent. Then they generate a series of consecutive flows, which result in rapidly increasing stocks of financial assets in the EE. Actually, the increase is too rapid and/or large for an efficient absorption, and frequently, the absorption is artificially increased by exchange rate appreciation and a rising real aggregate demand, with an enlarged external deficit as a consequence. The creditor's sensitivity to negative news, at some point, is likely to, suddenly, increase remarkably when the country has reached vulnerability zones. Then, creditors take notice of (i) the rising level of the stock of assets held in a country (or region); (ii) the degree of dependence of the debtor market on additional flows, which is associated with the magnitude of the current account deficit; (iii) the extent of appreciation; (iv) the need for refinancing of maturing liabilities; and (v) the amount of liquid liabilities likely to flow out in face of a crisis. Therefore, it should not be surprising that, pari passu with a deeper penetration into vulnerability zones, the sensitivity to adverse political or economic news and the probability of reversal of expectations grows steeply (Rodrik, 1998). The accumulation of stocks of assets abroad by financial suppliers until the boom stage of the cycle is well advanced, and a subsequent sudden reversal of flows, can both be considered to be rational responses on the part of individual agents with shortterm horizons. This is because it is of little concern to this sort of investor whether (longterm) fundamentals are being improved or worsened 22 For shorttermist agents the actual and expected profitability are increased with the appreciation process. That same process, if perceived as persistent, would tend to discourage investment in the production of tradables intensive in domestic inputs. Therefore, it is most relevant, because of its policy implications, what happens with the behavior of exchange rates during the expansive or boom stage. It is then when external imbalances and currency and maturity mismatches are, inadvertently, being generated. 30 Ricardo Ffrench-Davis while they continue to bring inflows. What is relevant to these investors is that the crucial indicators from their point of view--prices of real estate, bonds and stock, and exchange rates--can continue providing them with profits in the near term and, obviously, that liquid markets allow them, if needed, to reverse decisions in a timely manner. Thus, they will continue to supply net inflows until expectations of an imminent reversal build up. Indeed, for the most influential financial operators, the more relevant variables are not related to the longterm fundamentals but to shortterm profitability. This explains why they may suddenly display a radical change of opinion about the economic situation of a country whose fundamentals, other than liquidity in foreign currency, remain rather unchanged during a shift from overoptimism to overpessimism. Naturally, the opposite process tends to take place when the debtor markets have adjusted downward `sufficiently'. Then, the inverse process makes its appearance and can be sustained for some years, like in 1991­94 or 1995­97, or since 2004, or be shortlived like in late 1999 and 2000.23 In conclusion, economic agents specialized in the allocation of financial funding, who may be highly efficient in their field but operate with short horizons "by training and by reward,," have come to play the leading role in determining macroeconomic conditions and policy design in EEs. It implies that a financieristic approach becomes predominant rather than a productivistic approach. Growth with equity requires improving the rewards for productivity enhancement rather than financial rentseeking searching for capital gains. There is need to rebalance priorities and voices. 4. Domestic Policies and Macroeconomics for Development Domestic macroeconomic policies face the challenge of achieving an environment of reduced macroeconomic volatility, sustainable fiscal and external accounts, and price stability. This task is a major challenge since national authorities have lost several degrees of freedom as a result of liberalizing reforms in the last decades. As a consequence, the transmission of externally generated cycles has been exacerbated, especially from international capital markets. Therefore, systematic efforts are needed to ensure that the funds received can be absorbed efficiently, associated with investment in productive activities, and with a suitable proportion of that investment in the production of tradables. All this calls for active monetary, foreign exchange, and fiscal policies; strict Vulnerabilities were still significant in EEs when negative signals reappeared in the world 23 economy in 2000, including the subsequent downward adjustment in the United States and the Argentinean crisis. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 31 prudential regulation and supervision of the financial system; and regulations governing capital flows, especially of shortterm and liquid flows. Monetary Policy Monetary policy has increasingly taken the form of inflationtargeting schemes (that is, a single anchoring approach) in EEs.24 This trend has been, generally, accompanied by the adoption of flexible exchange rate regimes and an open capital account. The new policy mix imposes significant challenges to economic authorities, since it presents some crucial limitations regarding their counter cyclical capabilities. Inflation targeting schemes in small open economies (like those of most EEs, particularly small as compared to the huge size of international financial markets), present significant procyclical features. Indeed, given the importance of capital flows on business cycles in EEs, the turning point of the cycle will be probably featured, in its upper part, by the emergence of strong expectations of depreciation and downward pressures on aggregate demand and output and, in its lower part, by strong expectations of exchange rate appreciation and a recovery of aggregate demand and GDP. Given the fact that in more open economies, the incidence of the exchange rate in the general price index is greater, the expectations of exchange rate depreciation (appreciation) will also be associated with expectations of upward (downward) inflationary trends. Consequently, the incentives of a central bank with a single nominal target will be biased towards implementing a contractionary policy just when the economy begins to experience the downward part of the cycle, and toward applying an expansive monetary policy during a recovery led by capital inflows--that is a straight procyclical approach. Procyclicality implies, given the asymmetries around potential GDP, an average of actual GDP below the average potential GDP. Thus, a first challenge in the implementation of the monetary policy regime should be the elimination of this procyclical bias. There are a number of possible solutions to deal with this issue. Two examples are (i) the use of a domestic price index instead of a general price index in the definition of the inflation target (Parrado and Velasco, 2002) or (ii) the consideration of a longrun inflation target to filter the transitory effects, for instance, of exchange rate and oil price fluctuations, and their impact on CPI. Other possible solutions are to include targets on external deficits (Marfán, 2005) in order to deter the transmission of volatility from capital flows to domestic output; or the implementation (or 24 The conditions that usually define an inflation targeting scheme are (i) adoption of the inflation target as the economy's only (or dominant) nominal anchor, (ii) operational independence in the conduct of monetary policy committed to attain the inflation target, (iii) technical capability to forecast inflation and react accordingly, and (iv) high levels of credibility (see for example, Corbo et al., 2002). 32 Ricardo Ffrench-Davis strengthening) of real targets like the level of employment; or the consistency of actual GDP with its potential level.25 As a matter of fact, Chile--frequently highlighted as a successful inflation targeteer since the late 1990s (Mishkin and SchmidtHebbel, 2002)--before formally adopting inflation targeting, applied a pragmatic formula to reduce inflation, which was quite far from being solely based on the inflationary goal. Indeed, in addition to an inflation target (which aimed at a moderated rather than an abrupt reduction), Chile used an informal target in the current account deficit (around 3 percent of GDP) and an exchange rate band to avoid excessive appreciation, in combination with a monitoring of aggregate demand behavior. This comprehensive countercyclical policy was quite systematic in the first half of the 1990s, and lost coherency only gradually during the rest of the decade (FfrenchDavis, 2002).26 However, even if the procyclical bias is eliminated by adopting a set of goals (multianchoring), the problem of an insufficient power in monetary policy, and long lags of its effects, may remain. Indeed, a redefinition of the targets of monetary policy will be insufficient to develop a countercyclical policy if the central bank is unable to powerfully affect domestic expenditure in the short and medium term. During a boom, if monetary policy is managed to regulate aggregate demand by raising interest rates, then residents will try to finance their investment projects with external credits, and shortterm foreign investors will be attracted by a higher interest rate differential (frequently widened by expectations of exchange rate appreciation). As analyzed, capital flows may have a great stimulating effect in economies under significant output gaps and liquidity constraints (see FfrenchDavis and Tapia, 2005). In this context, high real interest rates use to live together with a troubled tradable sector (because of real exchange rate appreciation) and a boom in aggregate demand and in nontradable output, financed with external savings that typically crowd out domestic savings. The policy failure shows up when actual GDP approaches the production frontier. The experience of LACs in the 1990s, under a strong capital surge, was paradigmatic in this sense (Uthoff and Titelman, 1998). During a bust, in turn, the capacity of monetary policy to face shocks is even more restricted, especially if the country is already in vulnerability zones. Textbook theory states that a fall in the domestic interest rate, given the international rate, would cause capital outflows that will depreciate the exchange 25 Other policy issues include the weight given to each variable in the policy reaction function of the central bank. Under hyperinflation, its defeat should receive an overwhelming weight in the central bank policies; however, under low or moderate rates of inflation, additional efforts to reduce hyperinflation may have minor benefits and increasing costs, thus giving increasing space to employment and growth considerations. 26 Even from the point of view of developed closed economies, overemphasis on price stability is suboptimal. If, for example, there are labor market frictions, the central bank should also focus on reducing unemployment. See a theoretical discussion in Blanchard and Gali (2006). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 33 rate. Depreciation would favor the recovery in tradables output, stimulating overall GDP. In practice, however, in the short run the negative effects of depreciation on overall consumption and balance sheets are usually stronger than the positive pulls on tradables. If, on the contrary, monetary policy is used to stop the capital flight, the interest rate can be effective on the aggregate demand control (aggravating a recession), and ineffective on the capital flows under strong expectations of depreciation and contagion of pessimism. For instance, in order to compensate an expected devaluation of say 10 percent during one week a shortterm interest rate is needed that exceeds an annual equivalent of well over 500 percent. In summary, the effectiveness of countercyclical monetary policy in a context of open capital account and flexible exchange rates is quite limited.27 The main policy implication of our analysis is that it is crucial to regulate capital flows as a way of making room simultaneously for complementary counter cyclical exchange rate, fiscal, and monetary policies. Exchange Rate Regime The exchange rate regime, particularly after trade liberalization, has become an increasingly influential variable in EEs, both on trade and finance. It is subject to two conflicting demands, which reflect the more limited degrees of freedom that authorities face in a world of reduced policy effectiveness (see ECLAC, 2002). The first demand comes from trade: with the dismantling of traditional trade policies (tariff and nontariff restrictions), the real exchange rate has become a key determinant of international competitiveness and a crucial variable for an efficient allocation of resources into tradables. Indeed, a "competitive" and stable real exchange rate is an input for a sound trade development. 28 A rather depreciated real exchange rate improves export competitiveness, and its stability favors productive investment in tradables and higher valueadded activities.29 However, in the last decades, shortterm macroeconomic management and the reform agenda have been inconsistent with those goals linked to longterm development. In fact, in a number of countries, trade liberalization measures were accompanied by the liberalization of the 27 See also Fischer (2006), who discusses the limits of the "independent monetary policy" in a context of floating exchange rate and inflation targeting. 28 These goals are also present in the "Washington Consensus" Decalogue, published by John Williamson in 1990. Williamson (2003) is highly critical of this inconsistency in the implementation of the Washington Consensus. 29 Studies by Caballero and Corbo (1990), ECLAC (1998, ch. IV), Williamson (2000), Eichengreen (2007), and Rodrik (2007) have proven or discussed sympathetically the validity of this approach. For exports intensive in imported inputs there is a natural matching between revenues and costs in foreign currency. In the case of exports based on natural resources, static comparative advantages (economic rents) are stronger enough to resist exchange rate swings. In contrast, for high value added exports (for example, for those labor intensive), the exchange rate is key in defining their competitiveness. 34 Ricardo Ffrench-Davis capital account, which during the 1990s prompted considerable exchangerate appreciation (see figure 6, above) just when trade reforms urgently required a depreciation. The positive connection between a competitive level of the real exchange rate and success in economic growth of EEs has been documented by Rodrik (2007), Hausmann et al. (2005), and Williamson (2000). It is noteworthy how the two extreme proposals in fashion (corner solutions) disregard these relevant facts. The second is from the capital account. Volatility in international financial markets generate a demand for flexible macroeconomic variables to absorb, in the short run, the positive and negative shocks generated during the cycle. Given the reduced effectiveness of monetary policy, the exchange rate can play an essential role in helping to absorb shocks. This objective cannot be easily reconciled with the traderelated goals of exchange rate policy, particularly a growth strategy based on export expansion and diversification. Intermediate regimes of managed exchangerate flexibility--such as crawling pegs and bands, and dirty floating--attempt to reconcile these conflicting demands (see Ffrench Davis and Ocampo, 2001; Williamson, 2000). Completely rigid exchange rate systems tend to amplify external shocks, because they put too unrealistic requirements on domestic flexibility, in particular on wage and price flexibility in the face of negative shocks. Currency boards certainly introduce builtin institutional arrangements that provide for fiscal and monetary discipline, but they radically reduce any room for stabilizing monetary, credit and fiscal policies, which are all necessary to prevent crises during midterm capital surges and to facilitate recovery in a postcrisis environment. Convertibility (á la Argentina in 1991­2001 and Chile in 1979­82), allows the domestic transmission of external shocks, generating strong swings in economic activity and asset prices, with the corresponding domestic financial vulnerability. There is an amplification effect when agents consider that an external shock that is strong enough can induce authorities to modify exchange rate policy; this is particularly so when the rate appears to be an outlier price, too appreciated (see FfrenchDavis and Larraín, 2003). Notwithstanding the pitfalls of the family of nominal pegs, there are cases in which it can work efficiently. The currency board in Argentina, assisted by the capital surge to LACs since the early 1990s, was quite effective in contributing to defeat hyperinflation, evidently the more harmful problem of that economy in 1991. The most severe mistake of the Argentinean authorities--encouraged by the subsequent good ratings and misleading appraisals received from IFIs--was not to use the opportunity provided by the international environment, in 1992 or 1993 and again in 1996­97, to flexibilize the exchange rate when inflation and the budget already were evidently under control, capital inflows were vigorous, and spreads to EEs, quite explicitly including Argentina, were falling. It was an opportunity to shift to an intermediate regime and regain the exchange rate as a macropolicy tool. From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 35 On the other hand, the volatility characteristic of freely floating exchange rate regimes is not a severe problem when market fluctuations are shortlived; in such case they are easily faced with derivatives (see Dodd and GriffithJones, 2006). But fluctuations become a major concern when there are longer waves, a longerlasting process, as has been typical of the access of EEs to capital markets in recent decades. In this case, persistent appreciation of that macro price during capital surges tends to generate perverse effects on resource allocation of irreversible investment. Moreover, under freely floating regimes with open capital accounts, countercyclical monetary policy exacerbates procyclical exchange rate fluctuations, with significant costs derived from an inefficient resource allocation and losses in income and output. The ability of a flexible exchange rate regime to smooth out the effects of externally induced boombust cycles thus depends on the capacity to effectively manage a countercyclical monetary policy without enhancing procyclical exchange rate patterns. This is only possible under intermediate exchange rate regimescumcapital account regulations. That was, clearly, the successful case of Chile in the first half of the 1990s (see FfrenchDavis, 2002, ch. 10; Le Fort and Lehmann, 2003). In many cases bands did not behave well during the Asian crisis. That was partially induced by the actual management of the crawling band. The huge increase in capital inflows to EEs that took place between 1990 and 1997 did put severe upward pressure on exchange rates. The frequent response, in terms of expanding the size of the band or appreciating it, induced a credibility loss.30 Subsequently, bands already with a too appreciated rate--and domestic economic structures growingly accommodated to that relative price change--had trouble in adapting to the sharp shift in the market mood brought by the Asian crisis, when capital inflows suddenly stopped. These facts induced a further credibility loss. Obviously, intermediate regimes may also generate costs and exhibit shortcomings. First, intermediate regimes are subject to speculative pressures if they do not achieve credibility in markets; in critical conjunctures, particularly after the rate has clearly become an outlier price, the costs of defending the exchange rate from pressures are very high. Then, it may be advisable to move, temporarily, to full flexibility. Second, sterilized reserve accumulation during long booms may also become financially costly. The risk rises in those EEs that tend to increase TFP faster than their trade partners, implying a gradual equilibrating appreciation. Lastly, the capital account regulations needed to manage intermediate regimes efficiently reduce those costs, but are only partially 30 That policy reaction was, most probably, encouraged by the strong belief in fashion that financial crises were gone for long (or forever?). Recall, for instance, the proposal by the IMF, under the pressures from the Treasury of the United States and Wall Street, to change its articles of agreement in order to force member countries to acrosstheboard capital account opening (see a robust criticism to those pressures in Bhagwati, 2004, pp. 204­5). 36 Ricardo Ffrench-Davis effective. However, all things considered, intermediate regimes offer a sound alternative to costly outlier macroprices derived frequently from corner solutions and untamed volatility. A policy suitable for a given macroeconomic environment may not be so in another. In this sense, one crucial element to bear in mind when adopting a given policy is how costly it may be to switch to an alternative policy if needed (FfrenchDavis and Larraín, 2003). As shown above, as in the Argentinean case, pegs may be useful under a critical hyperinflation and plentiful supply of external funding. With a peg and a recessive gap, capital surges create a demand boom, pulling up asset prices, probably with a crowding out of domestic savings and a worsening of the external balance (see Frenkel, 2004). Under a floating regime, a nominal appreciation will tend to follow after a capital surge making the process of real appreciation deeper (and henceforth potentially more disruptive) than with a peg. Pegs tend to work better than floats in the upward phase of the cycle, but after the inflection point the float does better in terms of the necessary expenditure switching. Floating systems are useful in times of financial distress, when authorities have severe doubts concerning the level of the real rate, or the nature of the shock they face; flotation allows them not to put in jeopardy their reputation defending a wrong price. Finally, bands or managed flexibility contribute to stabilize the real exchange rate, improving its allocative efficiency. In brief, large deviations from equilibrium of the real exchange rate are costly for the real economy. Central banks should be concerned with both the level and the stability of this macro price. In this sense, despite the road of full flexibility taken by several LACs since the Asian crisis, managed flexibility, with or without bands, is still a policy to be considered by policy makers. They need to be reticent with acrosstheboard liberalization of the capital account since the need for real macroeconomic balances is really a priority. Indeed, the actual behavior of capital flows tends to be inconsistent with real macroeconomic stability, particularly in terms of the sustainability of the exchange rate and economic activity. In this sense, authorities need to adopt flexible policy packages rather than single rigid policy tools (FfrenchDavis and Larraín, 2003). Fiscal Policy Fiscal authorities need to provide financing to public goods in a framework of uncertainty and volatility. Indeed, fiscal policy should look at macroeconomic instability in two senses. On the one hand, since public revenues and expenditures are sensitive to business cycles, it is crucial to ensure a path of public expenditure consistent with the transitory needs that surge during the downturn (social subsidies) and with stable fulfillment of the permanent goals of the government (regular budget, including public investment). On the other hand, fiscal policy has also a macroeconomic role, in terms of the sustainability of public accounts and the regulation of aggregate demand. Given the progressive From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 37 weakness of monetary policy to regulate aggregate demand (see above), the macroeconomic role of fiscal policy should not be neglected (see Krugman, 2005; Stiglitz, 2005). Fiscal policy has been at the core of the debate on adjustment programs in EEs. Both in East Asia and Latin America the more conventional recipes recommended achieving current or annual fiscal balances, under recessionary conjunctures that had depressed tax proceeds. That is a typically procyclical behavior. In recession, usually fiscal policy has been directed towards keeping under control financial solvency, while during booms expenditure has frequently been expanded (Kaminsky et al., 2004; Martner and Tromben, 2004; Singh, 2006).31 This procyclical stance tends to restrict the room for social programs and the scope of public investment during recessive periods and, in doing so, strengthens the negative effects of volatility on living standards and future economic growth. In addition, a procyclical fiscal policy has exacerbated the boom and deepened the bust in the private sector, increasing macroeconomic instability and complicating the functioning of monetary and exchange rate policies. As part of a countercyclical policy package, the concept of structural fiscal balance is the most outstanding fiscal component. There are different varieties, but the essential component is the measurement of the balance across the business cycle, estimating at each point of time what would be the public expenditure and income in a framework of sustainable full employment of human and physical capital. If the terms of trade fluctuations are relevant for fiscal proceeds--via profits of public or private exporters--the purchasing power of potential GDP should be estimated at the trend terms of trade. Given a tax burden, that trend must guide the evolution of public expenditure (see Budget Office of Chile, 2001). Developing countries typically concentrate their trade on a few commodity exports, which are subject to highly volatile market prices. Especially, when a significant export--like copper in Chile, and oil in Colombia, Mexico, or República Bolivariana de Venezuela--is public property, the establishment of a stabilization fund can contribute to both fiscal and overall macroeconomic sustainability. Also the coffee fund in Colombia has played, for long, a significant stabilizing macroeconomic role; since coffee is privately owned, the fund contributes directly to stabilize the current account and private domestic expenditure. Above the trend or "normal" public proceeds from those sources are saved in these funds, so to finance expenditure when proceeds are below "normal". It is highly recommended to initiate it in a scenario of high prices in comparison to trend prices, so that the fund could actually finance subsequent negative price scenarios. This is consistent with the fact that, in boom stages, fiscal balances have tended to improve. See, 31 again, Marfán (2005). 38 Ricardo Ffrench-Davis All the mentioned measures help to develop a cyclically neutral fiscal policy, where current expenditure is stabilized by linking it to its structural level. In persistent recessive situations, however, it would be desirable if governments decide to carry out expansive shocks of (transitory) expenditure increases and/or tax reductions, thus running contemporaneous structural deficits, in order to stimulate domestic demand.32 Moving further, flexible tax rates have been proposed as an additional countercyclical device. For instance, it has been proposed to increase the VAT rate during booms and to compensate it with rate cuts during slack periods (Budnevich, 2003). Fiscal policy ought to be part of the flexible policy package. Given that EEs are especially vulnerable to external shocks, overreliance on monetary policy may bring poorer macro results as compared to a more balanced framework of countercyclical fiscal, exchange rate, and monetary policy, as well as prudential regulation of capital flows. The use of countercyclical fiscal policy requires as a precondition to be on a path of solvent and sustainable fiscal accounts. Moreover, spreading the adjustment burden between fiscal, foreign exchange, and monetary policies may bring better macroeconomic results, with each macro price (interest and exchange rates) closer to sustainable equilibria and an actual GDP closer to its potential level. Regulation of Capital Flows and Financial Institutions It is crucial to ensure that the volume of inflows is consistent with the absorptive capacity of the host country. The failure to address this point is at the core of recent macro instability in EEs. Absorption capacity must refer to both the use of existing productive capacity and to the creation of new one. The composition of flows is relevant on three dimensions. First, greenfield FDI (excluding acquisitions of existing assets) feeds directly into capital formation (usually intensive in imported capital goods), as do longterm loans to importers of capital goods. Second, volatile flows tend to impact more directly on foreign exchange and financial assets and real estate markets; they carry a weaker association to capital formation, which requires longterm financing (see Uthoff and Titelman, 1998). Third, temporary capital surges tend to leak into consumption, due to the faster release of liquidity constraints and capacity of consumers to respond as compared to the more lagged response of irreversible productive investment. Allowing an excessively large share of capital inflows to drain off into the stock exchange and consumption of imported goods will usually create bubbles in asset markets and imbalances in the external sector, which tend to generate growing vulnerability. Particularly, fastrising stocks of net liquid foreign liabilities generate deep vulnerabilities. Consequently, higher ratios of stable 32 The case of Korea in 1998, when the fiscal deficit reached 4.2 percent of GDP, is useful to illustrate this approach. When the economy recovered, the fiscal balance returned to a surplus (Mahani et al., 2006). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 39 longterm flows and of productive investment imply a higher capacity for efficient absorption. Under these conditions of composition and stability, the domestic economy can absorb more efficiently a higher volume of capital flows. Capital account regulations may perform as a prudential macroeconomic tool, working at the direct source of boombust cycles--that is, unstable capital flows. If effective, they provide room for action during periods of financial euphoria, through the adoption of a contractionary monetary policy and reduced appreciation pressures. If effective, they will also reduce or eliminate the usual quasifiscal costs of sterilized foreign exchange accumulation. What is extremely relevant is that, in the other corner of the cycle, of binding external constraints, they may provide space for expansionary monetary and fiscal policies.33 Overall innovative experiences in the 1990s of acrosstheboard price restrictions on liquid and shortterm financial inflows indicate that they can provide useful instruments, both in terms of improving debt profiles and facilitating the adoption of countercyclical macroeconomic policies. They are directed to provide a rather more stable macroeconomic environment during the boom and minimizing the costly adjustment during downturns from overheated disequilibria. They (i) provide a more marketfriendly environment for irreversible investment decisions; (ii) help avoid significant output gaps between actual and potential GDP; (iii) avoid outlier macro prices (exchange and interest rates); and (iv) discourage outlier macro ratios (deficit on current account/GDP, price/earnings ratios of equity stocks, and net shortterm and liquid external liabilities/international reserves). The discussion on capital controls intensified with the wellknown action of Malaysia, in 1998, imposing tough nonprice regulations on outflows. Data supports the view that they were effective in contributing to the sharp GDP recovery in 1999 (Kaplan and Rodrik, 2001). They were determinant in making feasible the active fiscal and monetary policies implemented by Malaysia. However, it is not enough to learn to get away from a crisis after suffering it. More important for significantly reducing the negative effects is to avoid the generation of external crises.34 That is the role of regulations on inflows so to deter macro policies and ratios from penetrating into vulnerability zones. The positive `marketbased' experience of Chile in the first half of the 1990s is one outstanding case (see Agosin and FfrenchDavis, 2001). On the other hand, traditional exchange controls as in China and India (for example, quantitative restrictions on shortterm financial borrowing and diverse regulations in other inflows and on outflows by domestic agents) have worked quite efficiently for 33 The market rewards prudently balanced external debt structures, because, during times of uncertainty, the market usually responds to gross financing requirements, which means that the rollover of shortterm liabilities is not financially neutral (see Ocampo, 2003). 34 In 1997, the then Minister of Finance of Canada, Paul Martin (1997), declared that "we have devoted almost all our time to make globalization happen and not to make it work right"; "we are spending energy in solving crises rather than avoiding them." 40 Ricardo Ffrench-Davis the objective of macroeconomic policy to significantly reduce the domestic macroeconomic sensitivity to international financial volatility.35 Prudential regulation and supervision of domestic financial institutions that usually is designed under microeconomic concerns also have macroeconomic implications. Consequently, prudential regulation and supervision should take into account not only microeconomic risks, but also the macroeconomic risks associated to boombust cycles (GriffithJones, 2001; Ocampo, 2003). In particular, countercyclical devices should be introduced into prudential regulation and supervision. Aside the standard regulations on currency and maturity mismatches, they should involve a mix of (i) forwardlooking provisions for latent risks, on the basis of the credit risks that are expected throughout the full business cycle; (ii) more discretionary countercyclical prudential provisions decreed by the authority on the basis of objective criteria (such as the rate of growth of credit as compared to GDP); (iii) countercyclical regulation on the prices used for assets given in guarantee; and (iv) capital adequacy requirements focused on longterm solvency criteria rather than on cyclical performance. 5. Concluding Remarks EEs are living a sharp paradox, with a consensus on the importance of macroeconomic balances, and a common situation in which the outcome has been costly disequilibria for large segments of the real economy--that is, of labor and physical capital. In order to deal with these inefficiencies, we need a macroeconomics for sustainable growth or real macroeconomics, focused not only on the stabilization of the price level and on the control of fiscal deficits (as stated by the mainstream approach), but also on external balances (key in open economies) and real variables, which affect the nexus between present and future. The main real balance is the use of the productive capacity (that is, the employment of productive factors, capital and labor, at their potential level), since it is crucial in the evolution of actual income, social equity, structural or `full employment' tax proceeds, capital formation, and future growth. The gap between the productive frontier and its rate of use implies a gross macroeconomic inefficiency, reflected in underutilized installed capacity in firms, unemployment of the labor force, and reduced actual total factor productivity. A notorious effect of these recessive situations, usually, has been a In liberalizing the capital account, a dose of prudent selectivity may also be necessary with 35 regard to outflows, especially from privately managed pension funds. These funds are increasingly allowed to invest abroad. The experience of Chile indicates that this may be dangerous, since these achieve microeconomic risk diversification at the expense of macroeconomic volatility (see Ffrench Davis, 2006, chapter IX; Zahler, 2006). From Financieristic to Real Macroeconomics: Seeking Development Convergence in EEs 41 subsequent sharp reduction in investment ratios, deterioration of labor skills, and a rise in social inequality. 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The World Bank's Office of the Publisher has chosen to print these Working Papers on 100 percent postconsumer recycled paper, processed chlorine free, in accordance with the recommended standards for paper usage set by Green Press Initiative--a nonprofit program supporting publishers in using fiber that is not sourced from endangered forests. For more information, visit www.greenpressinitiative.org. The printing of all the Working Papers in this Series on recycled paper saved the following: Trees* Solid Waste Water Net Greenhouse Gases Total Energy 48 2,247 17,500 4,216 33 mil. *40 inches in height and 6­8 Pounds Gallons Pounds CO2 Equivalent BTUs inches in diameter The Commission on Growth and Development Working Paper Series 35. Policy and Institutional Dynamics of Sustained Development in Botswana, by Gervase Maipose, August 2008 36. Exports of Manufactures and Economic Growth: The Fallacy of Composition Revisited, by William R. Cline, August 2008 37. Integration with the Global Economy: The Case of Turkish Automobile and Consumer Electronics Industries, by Erol Taymaz and Kamil Yilmaz, August 2008 38. Political Leadership and Economic Reform: the Brazilian Experience, by Henrique Cardoso and Eduardo Graeff, September 2008 39. Philippines Case Study: The Political Economy of Reform during the Ramos Administration (1992­98), by Romeo Bernardo and Christine Tang, September 2008 40. Making Difficult Choices: Vietnam in Transition, Martin Rama, based on conversations with H. E. Võ Vn Kit, with Professor ng Phong and oàn Hng Quang, November 2008 41. Policy Change and Economic Growth: A Case Study of South Africa, by David Faulkner and Christopher Loewald, November 2008 42. International Migration and Development, by Gordon H. Hanson, January 2009 43. Private Infrastructure in Developing Countries: Lessons from Recent Experience, by José A. Gómez-Ibáñez, January 2009 44. From Financieristic to Real Macroeconomics: Seeking Development Convergence in Emerging Ecomnomies, by Ricardo French-Davis, January 2009 Forthcoming Papers in the Series: Setting Up a Modern Macroeconomic-Policy Framework in Brazil, 1993­2004, by Rogério L. F. Werneck (January 2009) Real Exchange Rates, Saving, and Growth: Is There a Link?, by Peter J. Montiel and Luis Servén (January 2009) Electronic copies of the working papers in this series are available online at www.growthcommission.org. They can also be requested by sending an e-mail to contactinfo@growthcommission.org. M acroeconomic "fundamentals" are a relevant variable for economic development. However, there is misunderstanding about which "sound macroeconomic fundamentals" contribute to sustained economic growth. The Commission on Growth and Development current approach in the mainstream world and international finance institutions Montek Ahluwalia Edmar Bacha emphasizes macroeconomic balances of two pillars: low inflation and fiscal Dr. Boediono balances. We call this approach financieristic macroeconomic balances. The Lord John Browne literature also asserts frequently that an open capital account contributes to Kemal Dervis ¸ macroeconomic discipline in emerging economies. Alejandro Foxley However, there is strong evidence that financieristic balances have not Goh Chok Tong provided a macroeconomic environment contributing to sustained growth. In Han Duck-soo many emerging economies, financieristic balances occur in parallel with slow Danuta Hübner growth and high unemployment of labor and productive capital, which result Carin Jämtin from unstable aggregate demand, outlier macro-prices, and volatile capital flows. Pedro-Pablo Kuczynski A third pillar must be added for real macroeconomic balances, linked to the Danny Leipziger, Vice Chair productive side of the economy. This paper analyses alternative macroeconomic Trevor Manuel environments faced by firms and workers in the productive side of the economy Mahmoud Mohieldin (the producers of GDP), and the interrelationship between financial and real Ngozi N. Okonjo-Iweala Robert Rubin variables. We analyze alternative structural countercyclical fiscal policies, Robert Solow intermediate exchange rate policies, and capital account approaches. Michael Spence, Chair Sir K. Dwight Venner Ernesto Zedillo Ricardo Ffrench-Davis, Professor, Department of Economics, Zhou Xiaochuan University of Chile The mandate of the Commission on Growth and Development is to gather the best understanding there is about the policies and strategies that underlie rapid economic growth and poverty reduction. The Commission's audience is the leaders of developing countries. The Commission is supported by the governments of Australia, Sweden, the Netherlands, and United Kingdom, The William and Flora Hewlett Foundation, and The World Bank Group. www.growthcommission.org contactinfo@growthcommission.org