What I learnt about growth policy at the World Bank

Brian Pinto 17 December 2014

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Growth concerns have gone global. Advanced economies are beset by fears of secular stagnation, the IMF recently cut estimates of potential growth in emerging markets by 1.5 percentage points relative to 2011, and G20 leaders approved 800 new measures at Brisbane 2014 for raising G20 GDP by an incremental 2.1% by 2018.1

Advanced economies are grappling with problems long familiar in emerging markets: getting growth going, achieving sustainable debt trajectories, and implementing structural reform – an expression policymakers may find amorphous, but to which the emerging-market experience lends concrete content. I set out what I learnt at the World Bank about growth policy from emerging markets, and then sketch the applicability to advanced economies.

A pragmatic growth policy package

My learning during 1990–2008 was framed by two dominant episodes: the economic transition in central and eastern Europe; and the emerging-market crises that began with east Asia in 1997 and then went on to hit Russia, Brazil, Argentina, and Turkey. Except for Argentina, these crises elicited a large, positive change in emerging-market government behaviour that underlay the resilience of emerging markets during the global financial crisis of 2008. I draw upon these episodes and country stories from first-hand experience in India, Kenya, Poland, and Russia.

A pragmatic growth policy package emerged from good and bad – from diverse emerging-market experiences with debt crises, unanticipated growth take-offs, and complicated economic, social, and political transitions. The package centres around three elements:

  • First, sustainable public finances;
  • Second, what I call the ‘micropolicy trio’ of hard budgets, competition, and competitive real exchange rates – needed for spurring faster total factor productivity (TFP) growth;2 and
  • Third, the avoidance of self-inflicted political and economic crises, or good volatility management.

Interestingly, while supporting faster growth, this package shares much in common with policies needed for avoiding sovereign debt crises.3

Interconnections among the three elements are plentiful. A central idea is that managing the government intertemporal budget constraint, or sustainable public finances, goes far beyond primary fiscal deficits, real interest rates, and growth rates. Three examples:

  • An appreciating and overvalued real exchange rate will make the debt-to-GDP ratio look good to the extent that some debt is denominated in hard currency, but will slow growth (Russia 1998, Argentina 2001).
  • Currency mismatches on private balance sheets could derail government debt sustainability should capital outflows trigger a real depreciation, forcing a bank bailout (east Asia 1997–1998, Turkey 2001).
  • Strong microfoundations for growth based on hard budgets, product market competition, and competitive real exchange rates – the micropolicy trio – are needed for future growth and taxes to support government debt sustainability (India, Kenya, and Poland on the positive side; Russia negative before the 1998 crisis).

Links to the growth literature

This real-world distillation accords well with neoclassical and endogenous growth theory. Capital accumulation is spurred by the lower country risk and the cost of capital engendered by sustainable public finances and well-managed volatility. Higher public saving is also facilitated – in many developing countries, cutting interest payments on public debt by restoring credibility is the most effective way of doing so. In contrast, the micropolicy trio encapsulates the incentives for forcing firms to innovate and generate self-sustaining TFP growth along the lines of the creative destruction in Aghion and Howitt (1992) combined with distance from the global technology frontier.. Hard budgets and competition are vital for breaking down resistance to upgrading and innovation, with competitive real exchange rates providing breathing room. Absent compelling incentives to raise TFP growth, a much higher and continually increasing saving rate will be needed to meet given growth targets, pushing it eventually to infeasible levels – a situation China appears to be in today.4

The reader may well ask: “Where are the leadership, good governance and credible institutions that numerous studies show to be vitally important for growth?” Everywhere in the implementation. Good governance finds its most immediate expression in a healthy government intertemporal budget. Leadership is vital for implementing the micropolicy trio. This trio is the hard part of ‘structural reform’ because it gets into the rocky terrain of political economy and vested interests. And good institutions are the foundation stone for managing volatility from the fiscal and financial sectors, minimising corruption scandals, and responding to external shocks. This in turn bolsters government debt sustainability and enables the private sector to lengthen its planning horizons.

The package is canonical, the minimum countries need to do. But the how depends upon the particular episode and country context, underlining the realisation that economic truth is episodic, not universal. Two examples from Pinto (2014a):

  • Low inflation is always good for growth, right?5 Wrong. Russia’s attempt to squeeze inflation out without hardening budgets for the government or enterprise sector was a direct cause of its 1998 crisis, which almost brought down the US financial system. This crisis, which occurred six months after reducing inflation to single digits and substantially completing privatisation, underlined that genuine stabilisation demands a healthy government intertemporal budget. The big change after the 1998 crisis was that Russia at last implemented the micropolicy trio, leading to an unexpectedly large and almost immediate economic rebound.
  • India’s growth rate doubled in 2003/4, the very year eminent economists were warning of a fiscal crisis. Focusing on the macro level ignored the deep transformation that was going on at the micro, firm level because of reforms triggered by the 1991 balance of payments crisis. But there were long lags between incurring the accumulating fiscal costs of reform and the appearance of benefits, indicating the importance of staying the course and, in India’s case, the salutary benefits of slow capital account liberalisation.6

Implications for the Eurozone

The package has stark implications for advanced economies trying to get growth going while extricating themselves from unsustainable public debt situations. Italy is a good example. By 2013, its real exchange rate had appreciated 3% relative to 2007, while real GDP had contracted 8%. Over the same period, the government debt-to-GDP ratio increased by 30 percentage points, while youth unemployment went from 20% to 40%. Compare this to Poland’s transition experience. It hardened budgets by immediately cutting subsidies to state enterprises and later preventing banks from rolling over loans to loss-makers. It also summarily increased product market competition by liberalising imports. And then 17 months after the 1 January 1990 big bang, it devalued the zloty and moved to a more flexible exchange rate to avoid an unwelcome real appreciation.7 It also benefited hugely from a 50% write-down in its Paris and London Club debts.

Compare this ‘debt restructuring-cum-micropolicy trio’ agenda, which has produced some of the best growth outcomes among large EU-27 countries over the last two decades, with Italy – mired in recession even with interest rates at multi-century lows and forbearance on fiscal austerity. If Italy could grow out of its debt problems by implementing structural reform, the solution would be simple.8 But the emerging-market experience shows that structural reform is costly politically in terms of taking on vested interests, and economically in terms of output and fiscal revenue losses. Besides, growth benefits may appear only after long lags. With a debt overhang, there is no space to absorb such costs. The latter could be minimised by letting the currency depreciate, but this option is not available. The political ‘solution’ then is to procrastinate.

The usual counterargument is that the Eurozone as a whole does not look that bad. But this is cold comfort without debt mutualisation, a fiscal union, and a banking union with a common fiscal backstop – in short, putting proper fiscal and financial institutions in place, a constant criticism levelled against emerging markets but now applicable to the Eurozone. Even if all this were done – a big ‘if’ depending upon Germany’s appetite for a transfer union – the legacy debt overhang would still have to be addressed, especially with deflation in the wings. Distasteful though it may seem, some debt restructuring may be inevitable.9 This could very well result in a short-run loss of confidence and worsen the recession; but it will also lead to a large real depreciation and harden budgets, spurring Eurozone countries to complete structural reform, thereby laying the foundation for a brighter future. Based on emerging-market experience, the crux is not debt restructuring per se, but whether economic governance changes credibly for the better following it. Russia was rated investment grade just 5 years after its massive 1998 default.

References

Aghion, P and P Howitt (1992), “A Model of growth Through Creative Destruction”, Econometrica 60(2): 323–351.

Canuto, O, B Pinto, and M Prasad (2014), “Orderly Sovereign Debt Restructuring: Missing in Action! (And Likely to Remain so)”, World Bank Research Observer 29(1): 109–135.

Kornai, J (1986), “The Soft Budget Constraint”, Kyklos 39(1): 3–30.

Lo, S and K Rogoff (2014), “Secular Stagnation, Debt Overhang and Other Rationales for Sluggish Growth, Six Years On”, 13th Annual BIS Conference, June. 

Lucas Jr, R E (1988), “On the Mechanics of Economic Development”, Journal of Monetary Economics 22: 3–42.

Paris, P and C Wyplosz (2014), “The PADRE plan: Politically Acceptable Debt Restructuring in the Eurozone”, VoxEU.org, 28 January. 

Pinto, B (2014a), How Does My Country Grow? Economic Advice Through Story-Telling, Oxford: Oxford University Press. 

Pinto, B (2014b), “China’s Economic Foes”, OUPBlog, 17 September. 

OECD and IMF (2014), “Quantifying the Impact of G-20 Members’ Growth Strategies”, Brisbane, November. 

Romer, P (1986), “Increasing Returns and Long-Run Growth”, Journal of Political Economy 94(5): 1002–1037.

Solow, R M (1957), “Technical Change and the Aggregate Production Function”, Review of Economics and Statistics 39(3): 312–320.

Teulings, C and R Baldwin (2014), Secular Stagnation: Facts, Causes and Cures, VoxEU.org eBook, London: CEPR Press. 

Footnotes

[1] On secular stagnation, see the excellent and timely compilation in Teulings and Baldwin (2014). For an assessment of Brisbane 2014, see OECD and IMF (2014).

[2] ‘Hard budgets’ refers to financial discipline, the absence of politically motivated bailouts of firms, and a strong governance framework for banks. I use it in the sense of Kornai (1986) as moulded by the experience of the European transition countries after 1990. To clarify, it does not refer to fiscal austerity.

[3] Exiting a debt overhang is an entirely different matter. Experience indicates that debt restructuring usually becomes inevitable, and the sooner the better, as set out in Canuto et al. (2014). See also Lo and Rogoff (2014).

[4] For details and connections to the pioneering work of Robert Solow (1957), Paul Romer (1986), Robert Lucas (1988), and Aghion and Howitt (1992), see chapters 2 and 3 in Pinto (2014a). For China, see Pinto (2014b).

[5] This statement is made in the emerging-market context of the 1980s and 1990s. It has an entirely different connotation in advanced economies facing the spectre of deflation today.

[6] India’s headline macro indicators were significantly worse than in emerging markets that actually endured a crisis in the late 1990s. It was ‘saved’ by slow capital account liberalisation and a captive market for government debt. Otherwise, the estimated 38 percentage points of GDP in fiscal costs of reform incurred between 1991 and 2003 would probably have led to a massive crisis instead of a growth take-off. See chapter 6, Pinto (2014a).

[7] Large Polish state-owned enterprises were in the forefront of the economic recovery that started in late 1991 in spite of political delays in privatisation. Had they been punctually privatised, their good performance would very likely have been attributed to privatisation rather than the micropolicy trio. See chapter 4, Pinto (2014a).

[8] Interestingly, OECD–IMF (2014) sees the biggest growth impact from product market reform, followed by public infrastructure investment, and then labour market reform.

[9] Paris and Wyplosz (2014) craft what they consider a politically acceptable debt restructuring option that also addresses moral hazard.

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Topics:  Development Institutions and economics

Tags:  growth, secular stagnation, emerging markets, World Bank, structural reform, Transition economies, financial crisis, global crisis, debt overhang, exchange rates

Chief Economist, Emerging Markets, at GLG

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