Why are Developing Countries not privileged to Fiscal and Monetary Stimuli? Are Mainstream Economic Principles different for them?

 

There is a considerable resistance from Mainstream Economists for developing country governments adopting fiscal and monetary stimuli to help the economies and living conditions recover from the global coronavirus. They contend that, although developed country governments could do it, developing country governments are not privileged to such macroeconomic principles due to risks of possible hyperinflation and currency crises. 

Therefore, their implicit recommendation is to restrict and control living standards in these countries at levels possible within the domestic resources base with a brake on fiscal and monetary space, regardless of the generational consequences of the Coronavirus. 

As a result, the general public in some of the countries is squeezed by historic shortages of staple goods and services and loss of employment opportunities. However, developed country governments go out in their way to help recover economies and living standards, regardless of the underlying economic principles and concerns.

The US Government as an Example

• Fiscal Stimulus

The US President Joe Biden has been able to canvas bipartisan politicians to get a Generation Infrastructure Spending Bill of US$ 1.2 tn signed into law on 15^th November 2021. In the same week on 19^th, the Congress passed a Social Spending bill of US$ 1.75 tn which now awaits the clearance from the Senate. These two are on the top of nearly US$ 5 tn worth of fiscal stimulus spending approved through four bills and undertaken to deal with Corona pandemic related difficulties and instabilities confronted by the US economy, i.e., businesses, households and state governments, since March 2020.

In this background, the US government debt has already risen from US$ 27.6 tn in 2019 to US$ 28.4 tn in October 2021 which is an increase from 107% of GDP in 2019 to 130% in July 2020 and 125% in October 2021 so far. This attributes to an increase in budget deficit from 4.6% of GDP in 2019 to 15% in 2020 and 12.4% in 2021 so far. Therefore, the federal borrowing had risen to pass the approved debt ceiling of US$ 28 tn in early October 2021 and the House voted to freeze the ceiling until the end of December 2021 so that the government could continue spending without any shutdown of the government as experienced in April 2011 (16 days shutdown).

All these fiscal numbers are historically big even for a country like the US when compared with the national income. For example, above stated fiscal stimulus so far of nearly US$ 8 tn is about 35% of the US national income.

• Monetary Stimulus

On the monetary policy front, the Fed (US Central Bank) has followed a historically loosened monetary policy with interest rates close to zero and printing of nearly US$ 4.4 tn of new money in 2020 and as of early November 2021, which is an increase of 105% as compared to the total money printing cumulative as at end of 2019 from the Fed’s inception in 1913. This monetary policy has immensely helped the government to raise funds in required amounts at historically low interest rates to implement the public spending projects and servicing of existing debt. Therefore, this monetary policy is known as MP3, implying three components, i.e., low interest rates, money printing/quantitative easing and fiscal deficit financing.

• Opponents of Fiscal and Monetary Stimuli and Interim Policy Outcome

Proponents of the Modern Monetary Theory (MMT) suggested prior to the Pandemic that the US government should spend US$ 500 bn for social spending such as infrastructure and unemployment benefits through an increased fiscal deficit funded by money printing/creation to generate new demand and augment the production capacity for upliftment of employment opportunities, income and living standards of the general public. Even then, Mainstream Economists led by Monetarists humorously voiced against the new economic concept by raising serious concerns over possible high inflation as predicted in the standard macroeconomic principle of aggregate demand-supply equilibrium. Their belief is that inflation is always everywhere a monetary phenomenon or a consequence of money stock growing faster than the real output or GDP in the economy.

During recent months, the US economy seems confronting high inflationary pressures, as measured by the rate of increase in the Consumer Price Index (CPI), above the monetary policy target of long-term average inflation of 2%. The inflation so far has risen to 6.2% in October from 1.4% in January 2021. Some Mainstream Economists claim that the US economy is stepping back to stagflation situation, i.e., inflation cum low growth, which was experienced in 1970s. 

Therefore, they insist that the present fiscal and monetary stimuli be reversed forthwith to stop rising inflationary pressures at the nip of the bud before getting it passed to subsequent rounds through price-wage spiral. This is their usual response as they live with a mindset full of an inflation ghost believed to be haunting in all corners of the economy.

However, other than different analyses and conceptual views, they don’t have any consensus as to the exact causes of the stagflation or inflation in the present economic dynamism connected with the global economy. Further, whether the inflation is a result of fiscal or monetary expansion has not been established so far.

• Government Policy Response

In contrast, last week the US policymakers legalized another round of fiscal spending of US$ 2.95 tn for next few years in addition to the present fiscal deficit, given the state obligation to address the socio-economic disruptions caused by the unknown, historic Corona pandemic since the beginning of the year 2020.

Therefore, the US policymakers seem to either believe in the urgent need for the recovery of the US economy and society from the pandemic weighing well above the mainstream inflation hypothesis or disbelieve the hyperinflation view. This may also be attributed to the delay in the recovery process even after printing of a historic amount of new money by the central bank coupled with a historic magnitude of fiscal spending and debt for providing stimuli to households and businesses to deal with pandemic-related socio-economic difficulties and risks. It is common sense that no economy can recover from such a catastrophic pandemic without ample financial resources provided through monetary and fiscal policies because monetary and credit delivery front in the economy is heavily controlled by the government.

However, the US policymakers do not refer or attribute such fiscal and monetary stimuli to any MMT concepts, but only act on their public mandate and social responsibility in order to stabilise the economy and society from the Pandemic as early as possible.

The MMT Concept

• The MMT is founded on several pillars

First, unlike for households and business entities, the government has the power of taxing and money printing to fund its operations. Therefore, in the event its tax revenue is not sufficient to cover spending projects, it can cause printing of money to finance the deficit. This refers to the printing of and spending in domestic currency as the government is the creator of the currency or legal tender in the country although it has been entrusted with the state central bank.

Second, government debt is the most secured financial asset domestically available to the private sector for investment. The monetary policy or money printing also is largely based on purchase of government debt. Therefore, the government has a good debt market to finance its spending through budget deficits. In fact, the government has to supply a reasonably high debt stock through its deficit to enable the private sector to invest their savings in such debt as a part of secured portfolio.

Third, the value of the domestic currency in the foreign currency market, i.e., the exchange rate, should be freely determined through market forces. This means the existence of the flexible exchange rate system. Therefore, exchange rate will function as a natural guard against any reckless spending and money printing. While the US government or central bank does not intervene in the currency value, other markets also operate largely in flexible conditions.

• Key MMT Recommendation

Accordingly, proponents of the MMT recognize the immense role of the government spending in augmenting the the production capacity and social stability of the economy that drive the growth of the economy and living standard. Therefore, they recommend the government to implement large infrastructure and social security (including employment guarantee) spending through money printing/creation without any fear of inflation if the production capacity is expected to improve. This is not a theory as everybody knows the capacity impact of the government spending whether in developed countries or developing countries. In the event of inflation rising, the government can raise taxes to decelerate private sector spending in order to contain inflation at desirable levels. As such, the control of inflation also is a fiscal policy action.

Therefore, they state that the government should spend by issuing bank checks without worrying on availability of funds as the government bankers including the central bank will pay for checks through grant of credit (secured government debt) and not let the government to default. This means that the government can spend first and look for funds later. In fact, this is what actually happens in the present world of government budgetary operations. This why the US government extends or freezes the borrowing ceiling towards the end of the year or developing countries enact supplementary provision bills in the middle of the fiscal year. The rest, i.e., macroeconomic impact of the government spending, follows the normal macroeconomic concept/principle of the multiplier effects on production, income and employment. As such, the MMT is not a theory as it is referred to but seems to be a quite practical proposition.

• Opponents of MMT

Their conceptual voice against the MMT has several facets in the conventional macroeconomic context.

First, the central bank loses the monetary policy independence and, therefore, fiscal-money creation spiral becomes politically difficult to be reversed even when the inflation is at high levels.

Second, the fiscal-targeted money printing/creation would cause inflation or increase in prices of goods and services as the amount of money in circulation grows faster than the current production or real output. This means that the money becomes cheaper as compared to the value of goods and services and, therefore, more money is required to buy the same volume of goods and services, the situation of which is known as inflation. This is the conventional, first cut response of the monetarists. They also refer to the possibility of hyper inflation as reported from countries such as Germany and Zimbabwe in the past and Venezuela at present. However, how terrible governance systems of such countries led to the destruction of the supply side of such economies that really caused the hyperinflation is not presented in such analyses.

Developing Countries - Why are they not privileged to Fiscal Stimuli?

Opponents of the MMT argue that developed countries such as the US can adopt the MMT-fashioned fiscal spending because their currencies are global reserve/hard currencies and, therefore, they can pay for imports or BOP deficits that arise as a result of fiscal and monetary expansion by using domestic currencies. However, this is not possible in developing countries as rising imports and trade deficits consequent to such expansion have to be financed through the foreign currency reserves already in short. 

Therefore, these countries have to control fiscal spending and money printing/monetary expansion in order to stabilize the foreign currency front of the economy. Further, if the rising trade deficits and foreign currency reserves are funded through foreign borrowing, the rising stock of foreign currency debt causes debt service problems and further macroeconomic risks including BOP difficulties involved in debt service. This is a fact seen from many developing countries.

However, macroeconomic principles are not different between developed countries and developing countries. If there is excessive fiscal spending and money printing, the resulting trade/BOP deficits would cause currency depreciation which will have further impact on the economy whether it is a developed economy or developing economy. There are economic principles behind the determination of currency rates and macroeconomic impact depending on differences in currency market system, i.e., peg, flexible and managed float, and flexibility of commodity and factor markets.

Therefore, the difference in ability of fiscal spending and monetary expansion across the countries arises from the degree of the control over the markets by the government. In most developing countries, the exchange rate is maintained heavily over-valued by the use of foreign currency reserves and vicious exchange controls and, therefore, fiscal and monetary expansion would cause further BOP difficulties and erosion of foreign currency reserves. Therefore, the government has to raise foreign borrowing to source foreign exchange/currency in order to keep the exchange rate overvalued and maintain the foreign currency reserve. This is the hurdle that developing countries confront in fiscal and monetary expansion.

In contrast, if the currency is allowed to depreciate or get valued freely in the foreign exchange market while labour and commodity markets are allowed to adjust accordingly as in the case of developed countries, MMT-styled fiscal operations would have the ample space for medium and long-term macroeconomic objectives. In that event, nobody can predict the precise macroeconomic outcome to the economy. For example, if the currency is excessively depreciated, domestic production and spending may well respond favourably through various sources. Free market economic principles are clear on this.

This happens in developed countries too when fiscal and monetary expansion is excessive, despite their hard currency status. For example, in the case of the US, the excess supply of dollars will outflow to developing countries through the US imports from and the US foreign investments to developing countries. In turn, such dollars will be used for more foreign demand for US products which will fuel the US aggregate demand and inflation. Further, foreign currency reserves accumulated from the US dollar inflow to those countries will be invested back in the US, mainly government securities, causing the US asset inflation and further increase in the US aggregate demand.

Therefore, if the inflation is the immediate outcome of the fiscal and monetary expansion, it is no exception to developed countries too. However, in the past three decades, the developed world did not experience inflationary pressures significantly deviating from the target 2%, especially in the last decade, despite the excessive fiscal and monetary expansion carried out for helping the recovery from the so-called global financial crisis 2007/09. Japan has confronted a three-decade deflation regime, despite the constant attempt to push the inflation towards 2% through excessive money printing by the Japanese central bank.

Concluding Remarks

The above short presentation shows that inflation or any other macroeconomic outcome is a result of the dynamism of the markets system and government policy interventions. In many developing countries, mainstream economics principles do not seem to apply, not because those principles do not cover developing countries, but because of extensive bottlenecks prevailing in the markets system of those countries mainly due to governments’ heavy policy interventions.

Therefore, these countries urgently need a good macroeconomic governance system in place of the prevailing bureaucratic macroeconomic management systems. The governance system will cover institutions, resources, macroeconomic and social principles, rules, performance, accountability, etc., aligned to the common vison and target for a long-term horizon of the economy and society. However, present macroeconomic management system is like a hit-and-run driver. There are government institutions controlling various points in markets/private economic activity in an ad-hoc and disaggregated manner without any aligned focus even on the short-term macroeconomic activity and living standards. Therefore, the present style of macroeconomic management systems is nothing but macroeconomic disruption or manipulation systems that lead to enormous economic disparities among the public.

This is why the US President Joe Biden has a new habit of publicly stating that the trickledown economics does not serve the US anymore and, therefore, his economic policy drive is geared towards pushing the bottom class (blue collar job class) up and expanding the middle class. Trickledown economics means the market mechanism that leads to the distribution of economic outcome from production to a wide range of people through markets which is known as the capitalist system. 

The two fiscal spending bills in total of US$ 2.95 tn approved in last week in addition to his first fiscal stimulus bill of US$ 1.9 tn already launched in February 2021 immediately after his appointment are major tools for this objective. His pick of the present Fed Chair Gerome Powell for the second term of four years and Lael Brainard (an existing member of the Fed Board) as the Vice Chair/Monetary Policy today is commented that this pick is based on the Dovish bias of both persons and their immense contribution so far to the US economy that will further support the implementation of macroeconomic policy strategy of Joe Biden as the monetary and financial regulatory policy of the central bank is a critical element in dealing with the present economic setback and fast recovery of the US economy while addressing the climate change risks. 

Joe Biden did not bring members of his political club to run the central bank to carryout the political policies of the new government. He could have politically disgraced them by alleging on recent conflict of interest issue on investments by high ranking central bank officials. In fact, one senator representing his political party made a similar attempt by publicly calling Gerome Powell as a very dangeorus man to supervise the banking system and opposed to the reappointment. However, the US governance system is not such a bad one to destroy its top officials for political objectives, regardless of their immense contribution to the public service within the same governance system.

Both Powell and Brainard are subject professionals devoted to serve for national public interest which is sought by any government irrespective of political visions and agendas. At the post-pick public speech, Joe Biden enumerated and commended the considerable progress of the Fed steered by Gerome Powell and Lael Brainard. Analysts commended the President for ensuring the independence and policy consistency of the central bank especially required in this pandemic time.

However, many of developing countries tend to scale down fiscal and monetary space by listening to mainstream economists under the impression that those economics principles do not apply to these countries. Therefore, both those policymakers and economists have failed to understand the nature or assumptions of mainstream economics principles and the presence of disruptive macroeconomic management systems that prevent the applicability of those principles to these countries. That is why they tend to distinguish countries between the developed countries and developing countries when new or practical ideas such as MMT are presented.

Therefore, the present global Corona pandemic should be treated as a catalyst to invent new publicly accountable macroeconomic governance systems in developing countries aligned to the global economy which will help not only the faster recovery from the Corona pandemic but also a new development drive through fiscal and monetary stimulus packages to uplift living standards of the general public. Otherwise, the most of these countries will have to struggle in the pandemic at least for the next decade pushing more and more people and families into absolute poverty.

P Samarsiri
Former Deputy Governor, Central Bank of Sri Lanka