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Guest Article: Lessons in Economic Policymaking

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1991
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Based on Costa Rica’s experience with stabilization and economic adjustment during the 1980s, the author draws some broad lessons for national policymakers

Making economic policy is only half the battle. The other, perhaps more important element, is implementing it. As many a finance minister and central bank head has learned, both of these occupations were extremely demanding, if not hazardous, during the turbulent 1980s. Costa Rica’s experience was no exception. The economic stabilization and reform in Costa Rica produced not only a positive result but also a valuable perspective on the process of economic decisionmaking during the period of reform.

The Costa Rican case

During the quarter-century before the onset of the second oil shock, Costa Rica boasted an impressive rate of economic growth. Between 1950 and 1977, the country enjoyed 5 percent real growth per year, a doubling of per capita real income during a time when the population had also doubled in size. Costa Rica was well on its way out of underdevelopment and expected to enter the ranks of middle-income countries by the end of the 20th century.

Most of the ideas in this article are discussed in detail in the author’s “Economic Policy Making: Lessons from Costa Rica, “published as Occasional Paper No. 21 by the International Center for Economic Growth (ICEG), San Francisco, CA, USA, 1991.

At the beginning of the 1980s, however, the country underwent its most profound economic crisis since World War II. The major macroeconomic indicators clearly revealed the magnitude of the crisis. Inflation, an overvalued currency, swelling fiscal deficits, a negative trade balance, climbing unemployment, and declining per capita real income all bore clear witness to the depth and breadth of the crisis.

The causes of the crisis are well known. Costa Rica’s small, relatively open economy was hard-hit by external forces, such as rising oil prices and more costly imports overall, a worsening terms of trade, and rising interest rates on the international financial markets. These external forces were compounded by internal developments. The country adopted a flawed domestic economic policy, which, rather than counteracting the effects of the external factors, appreciably magnified them. The country was unwilling to recognize the deepening impoverishment, which derived from international economic trends. Instead, it contracted foreign loans helter-skelter, thereby managing to maintain artificially high standards of living, steep import levels, and relatively stable exchange rates in 1980/81. When private and official foreign creditors felt that the country’s borrowing capacity had reached its limits, the flow of resources dropped off sharply; the crisis became inevitable and broke quickly. The currency buckled, inflation soared, and the country ceased to pay its foreign debt, one year before Mexico.

The main issues that urgently needed to be addressed were:

• wildly unstable economic and financial indicators (inflation, unemployment, and the exchange rate);

• an inward-looking development model, based on import substitution, which had run its course;

• an economic system characterized by extensive intervention in favor of various interest groups, with concomitant distortions in both factors and goods markets; and

• foreign debt and debt service, which was far too high for an economy such as Costa Rica’s and posed a major obstacle to the country’s economic development.

To cope with these problems, a conceptual framework was developed on the basis of certain assumptions:

• the effort to restore macroeconomic stability would not bear fruit unless, at the same time, a relatively satisfactory rate of economic growth could be achieved. Stability without growth was not considered a viable option;

• because wage levels and profits of private companies are interrelated, it was essential to look not only at economic growth but also at the distribution of incomes; and

• given the volume of resources needed for debt service, the planned economic growth was incompatible with payment of Costa Rica’s foreign debt.

Four concrete objectives were given top priority:

• drastically reduce the public sector deficit, including central bank losses, as a share of GDP;

• integrate the Costa Rican economy more fully into the international economy by systematically reducing customs charges and other hindrances to international trade;

• restore real wages to precrisis levels; and

• limit interest payments on the total foreign debt to a given percentage of GDP, even if it meant accumulating past-due interest, assuming that a certain level of overseas financial help would continue.

As a result of these actions, by 1988/89, most of the objectives had been met, and the economy was moving in the desired direction.

Six basic lessons had been learned in this process of policymaking. They can be divided into two groups—those that are relevant to the formulation of economic policy and those that are appropriate to implementing it.

Formulating economic policy

The formulation of economic policy requires policymakers to be realistic, to think big and act small, and to stay the course.

Be realistic. The first part of this important lesson is to avoid being overly ambitious. Economic realities are extremely complex, and if those responsible strive to respond to them in their entirety, they risk paralysis and inaction.

Theoretically, it is always possible to conduct a detailed study of the full array of causal relationships. The myriad options available could be examined, possible outcomes projected, and finally, the deciding factors for each option could be pinpointed. If policymakers attempted all of these things, they could easily become so entangled in the theories and arguments, undeniably all very interesting, that they would be unable to make needed decisions. The fact that there are limitations on the amount of knowledge available needs to be accepted.

“One must stay the course, come what may.”

Very real constraints must be overcome in drafting an economic policy, and the time constraint is one of them. The hours available for forming an economic policy cannot be spent solely in studying every subject in depth. Decisions must be made, even when useful information is lacking and needed studies are unavailable.

A second major handicap is personnel. Bringing in a Nobel Laureate to help out at the central bank simply is not possible; so finding the best person for the job, given the time constraints, becomes a major task. Financial constraints are another problem, since the central bank or other involved institutions do not have unrestricted funds to spend on acquiring know-how or hiring staff.

In the face of all these constraints, decisions must be made. In the Costa Rican case, we chose to set a small number of objectives. Similarly, we preferred to work with only a few policy instruments. An extensive body of literature suggests that a single instrument must be assigned to meet each objective.

Obviously, the result of this approach was a simple, unsophisticated, even rudimentary, economic policy. All things considered, we economists still operate under conditions of extreme uncertainty and risks of endangering a national economy are very high. In short, the first lesson is not to take on too much.

Think big, act small. Although it is necessary to think on a large scale, action should take the form of many small steps in the same direction. It is crucial to develop a general conceptual framework, similar to that outlined earlier, which will serve as a compass for steering the ship. What policymakers believe, what they want, and where they are going, all need to be clearly stated. When they sit down to design an economic policy, however, they must keep in mind that real progress is generally marginal. Forward motion occurs in a series of small steps. Massive change is nearly always impossible. The comprehensive plan plays a major role, telling leaders where each of these small changes should take place and showing them how the changes are related to one another and how they fit into the big picture. Without this point of reference, decisionmakers could easily lose their way.

If the leadership attempts to lay out or impose large-scale changes very rapidly, at least two problems come to the fore. Most of the public has difficulty understanding even the small steps; how great, then, would the general confusion be if officials came out with very broad, relatively comprehensive policy statements? Large decisions spark much stronger reactions, both pro and con, than do small decisions.

Thus, as the Costa Rican reform unfolded, bit by bit we began to see the need to maintain a degree of balance between the general and the specific. The more general the goals, the less controversial they proved to be. When we proposed to the President or to the general public that we would strive for economic growth, there was no opposition. Such broad objectives, however, are of little use in designing specific economic policies. On the other hand, if we had gone public with specific objectives, such as increasing fruit exports by 15 percent over the course of the next year, we would have provoked immediate opposition from special interest groups. Every one who disagreed that fruit exports should have such a priority would have spoken. This is why articulating objectives is a complicated task. The goals should be neither so general that they become useless as guidelines for formulating economic policy, nor so concrete and specific as to hinder policy formulation. A good example was the way in which the exchange rate policy of a crawling peg was implemented in Costa Rica.

Stay the course. Objectives should not only be simple and few but they should also be unalterable. One must stay the course, come what may. When objectives are changed, a sense of uncertainty is conveyed. It is most unwise to give the impression that objectives are frequently being reconsidered. The practice of taking a step back in order to jump farther ahead means nothing but trouble in economic policy. Every step backward sends the wrong message to businessmen, politicians, labor leaders, and the general public.

The action phase

Implementing economic policy includes the need to build consensus, to establish leadership, and to keep the public informed. If policy formulation seems to be a quagmire of serious problems, policy implementation is equally plagued with difficulties.

Build a consensus. The first difficulty arises from the need to forge a consensus. This is perhaps the bitterest pill to swallow for an economist who comes out of academia and begins to work in economic policy. Academia teaches us that knowledge advances as old truths are broken down, replacing them with new ones, which, in time, will also be dismantled and replaced. Instead of seeking consensus, the economist attempts to refute arguments and evidence to test the provisional truths. Thus, academia is an ongoing process of “creative destruction.”

When policymakers set about implementing economic policy, however, the opposite occurs. The opinions of many different people and the pressures of diverse interest groups must be taken into account. The only way to get anything accomplished is by making compromises in the give-and-take that builds consensus. The economist must descend from the clouds of theory and sit uneasily on the field of power struggles. Only with major changes in attitude can policymakers succeed in leaving behind the endless process of destroying and creating provisional truths and taking on the task of consensus building.

The first reason for the change of attitude is that policymakers are confronted with real time constraints. In economic policy, unlike academia, decisionmakers cannot spend endless days, nights, and weeks discussing the logical structure of a given model and then examine whether or not the empirical evidence bears it out. In the central bank, it is necessary to move quickly, albeit under conditions of uncertainty, owing to insufficient knowledge or inadequate information.

The second reason for the change of attitude is that the central bank works closely with a large number of people, including the executive branch, political groups, business associations, and union organizations. They all have opinions, to a greater or lesser degree, and discord often reaches the boiling point. As if that were not enough, it is necessary to keep a close eye on relations with external parties, international organizations, foreign governments, and creditors. Forging the consensus needed for taking action is an exercise in the art of compromise, of building alliances, of concession; in short, it is a power game.

Establish leadership. Although the economic policy process demands consensus, it also requires leadership. Someone has to lead the wagon train, push things along, and see that anyone who gets out of line or blocks the way either gets back in line or is shoved aside. Instead of leading a single wagon at a time, it is preferable to lead several. In this way, the wagons can be drawn into a defensive circle; many wagons together can be defended better than one alone. For example, when restrictive measures need to be taken and the effects will be distasteful, it is important to adopt them in such a way that many groups will be affected. No single group will feel itself victimized. If, for some reason, it becomes necessary to hold down real wages, workers need to understand that companies’ profits are equally affected, as are the public budgets managed by politicians. In other words, when belts need to be tightened, everyone loses weight, not just a few. Whether workers are willing to accept the measures depends largely on what they see happening to other groups of society.

Keep the public informed. Another complicated issue is the public’s need to be kept informed. Everyone needs to understand what objectives have been set, why they were selected, what policy tools will be used, and what measures will be taken. The next question, then, is how many details of economic policy need to be communicated to the public. Certain elements of economic policy would be harmful if they were published in full and specific detail.

In introducing a crawling peg in Costa Rica, for example, the public was given enough information so that the economic players could determine, with a reasonable degree of certainty, the direction of policy. Certain details were released about the frequency and magnitude of exchange rate adjustments and about the procedure used to calculate them. We did not, however, reveal how much each devaluation would be, or when it would take place. A delicate balance had to be struck. On one side of the ledger were the demands of a democratic society, in which information should be made available to the public, economic players, and politicians—to enable them to exercise their rights and to make decisions. On the other side, we found information that, if it had been released, would have proven counterproductive to the community and would have interfered with the implementation of economic policy. Maintaining balance frequently proves to be very difficult.

In conclusion …

A critical question remains unanswered: How does the Costa Rican experience inform the academic debate on the “right kind of adjustment?” The response, in turn, should address two specific questions. First, have the adjustment programs in Costa Rica been imposed from abroad? Second, have the programs been “too tough?” Several of these points merit discussion.

First, it is of little use to procure external financial support in the absence of a firm domestic commitment to set the national house in order. In that sense, external resources can best be used as a means to trigger internal adjustment. Any country concerned with raising all the money it can from abroad, while doing as little as possible at home, is wasting its time. Its efforts will bog down in rhetoric and speculation.

Second, the concepts, conditions, efforts, and sacrifices set forth in the Costa Rican adjustment programs were, for the most part, “acceptable” and “reasonable.” These measures should have been taken in any case, with or without support from international financial institutions. The critical issue is whether or not the country has its own program, with specified targets, instruments to be used, and measures to be taken. All too often this is not the case, and the vacuum must be filled from outside. No country can afford to ignore this essential fact.

Third, what is actually meant by “soft” and “tough”? There is no way to give a practical or workable answer to this question. In any case, it is little more than an academic exercise, interesting but essentially futile for the daily workings of political economy and the effective administration of a structural adjustment program.

The idea that we must choose between a “soft” or a “tough” program is misleading. There is no sense in striving for “soft” programs, if the “soft” program allows postponement of needed actions or a half-hearted effort. “Tough” programs are also to be avoided if they impose measures that are unnecessary. The aim should be to implement truly workable programs that can be carried out “reasonably” well over a given time frame. This, to be sure, requires clear political willingness to grapple with reality.

Eduardo Lizano

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