Macroeconomic Aspects

In a broad sense, an effort of adjustment in a country entails in one way or another the alignment of the level and the rate of expansion of aggregate demand and expenditure in the economy with those of its potential productive capacity and income. The considerations outlined above, as well as experience, indicate that unsustainable demand expansions are frequently associated with imbalances in the fiscal accounts and more generally in the public sector finances; hence, the need for fiscal adjustment.³

A process of fiscal adjustment is bound to be influenced importantly by two critical factors: the amount of resources on which the government can count; and the efficiency with which it uses them.⁴ These two factors interact in a variety of complex ways but, for expository purposes, it is convenient to discuss them separately.

From the standpoint of the amount of resources, a fiscal adjustment effort must ultimately be based on policy actions designed either to raise revenues to whatever level is necessary to finance fiscal expenditure on a sustained basis or to contain expenditure within bounds that are consistent with available revenues. In either or both of these ways, the aggregate demand-supply maladjustment to which the fiscal imbalance was contributing can be corrected. At this general level, the key issue at stake is the extent to which the government’s resource demands are commensurate, on a durable basis, with its ability to raise revenues. This dimension of fiscal policy can be labeled the macroeconomic aspect of fiscal management, on the grounds that the focus of analysis is mainly addressed to the attainment and maintenance of global balance between the demands for and the availability of resources in the economy.⁵

Naturally, these fiscal policy aspects bear a close relationship to the broader domain of financial policies that influence credit, money, and borrowing flows in an economy both domestically and vis-à-vis the rest of the world. Such a relationship is derived from the consequences that divergences between the flow of fiscal outlays and receipts have for the government’s borrowing requirement, both from domestic sources—with consequent effects for the amount of savings available in the rest of the economy—and from foreign sources—with important implications for the future availability of foreign exchange and savings in the economy.⁶

Efficiency Aspects

Apart from their effects on the global resource balance of the government sector, the particular type and mix of policy measures undertaken to redress a fiscal imbalance can influence significantly the general performance of the public sector as well as of the economy as a whole. For example, the implications for the private economy of a particular government policy will vary depending on whether the fiscal adjustment is mainly focused upon expenditure control or whether it stresses instead revenue raising and collection. Adjustment based on curtailment of spending seeks to restore balance to the economy by lowering the share of government in aggregate demand.⁷ In contrast, an adjustment based on the collection of additional revenues increases the government’s uptake of incomes in the economy, which, other things being equal, will tend to lower the private sector’s share in aggregate demand. But these are not the only differences that can arise from diverse fiscal policy mixes. Not only do these policy mixes vary in impact, but they also differ with regard to the certainty and speed with which they yield results. For example, measures of expenditure restraint and revenue-raising actions do not carry the same probability of yielding results of an equivalent magnitude over similar time intervals. As is the case with other economic agents, any action undertaken by governments to reduce spending carries more certainty in its impact on the fiscal imbalance than actions to raise revenues, which also depend on reactions elsewhere in the economy. Specifically, although it can be expected that actions undertaken to curtail expenditure will be reflected in a commensurate decline in the deficit, the same assurance need not obtain from actions intended to raise revenues.⁸

Fiscal policy can also be influential in enhancing productivity and efficiency in the economy. To this end, by affecting the efficiency and composition of spending, the quality of expenditure management can be critical. The effectiveness and durability of an effort to control government spending and, more generally, aggregate demand, will depend, among other things, on directing policy action toward the curtailment of unproductive outlays as well as toward the safeguard of efficient expenditure and, in particular, investment projects. A second area of importance is the quality of tax policy. In this context, the importance of an improvement in the structure of tax rates cannot be overstressed. By providing appropriate incentives toward efficient use and allocation of resources, such improvement can enhance productivity in the economy at large. A third area that can contribute to the effectiveness of fiscal policy is public pricing. This involves the issues of the economic appropriateness of administratively set consumer and producer prices and the related question of subsidies, which often loom large behind the prevalence of fiscal imbalances. These various elements of fiscal policy represent what may be called the efficiency aspect of fiscal management, which is of great importance not only for fiscal adjustment but also for the performance of the economy at large.⁹ By raising productivity, fiscal policy thus affects aggregate supply and provides a critical support to the attainment of macroeconomic balance, as it contributes to bringing output to potential.

Sectoral Aspects

There are specific sectoral issues in which public sector policies play an important role and can influence the overall level of efficiency in the economy. The most important areas concern the public enterprises. In this connection, efficiency questions often arise that relate to the impact on the operations of these enterprises of decisions concerning pricing, investment, employment, and financial management. Even in an environment where an appropriate relative cost-price structure prevails, it is not uncommon to observe public enterprises being shielded from the influence of relative price changes by means of special tax treatment, subsidized transfers, or protection from foreign competition, with obvious costs for the taxpayer and the economy as a whole.

Key areas where distortions tend to arise include the prevalence of employment at levels that exceed those associated with the efficient operation of the enterprise. Situations of this sort represent a waste of resources that add unnecessarily to the costs of production and often carry undesirable distributional effects. Access to borrowed resources (domestically and from abroad) on terms that are not consistent with the yields of the investments undertaken by the enterprises also lead to inefficiencies that eventually burden the budget, the taxpayer, and the economy at large. Related to these issues are decisions in the fields of pricing and tariffs as well as financial management, which often are intended to address issues of a noneconomic nature and consequently are frequently determined by criteria that pay little attention to budgetary or efficiency requirements.¹⁰

These various aspects of fiscal management (macroeconomic efficiency and sectoral) are mutually supporting. Indeed, lack of due regard to one of them may easily undermine the effectiveness of the other. In general terms, the conduct of fiscal policy, if it is to be effective in the adjustment process, needs to be based on measures that are both efficient and sustained. Otherwise, it can hardly be expected that their effects will be durable or significant. Thus, a global fiscal balance that has been attained by an inefficient or transitory policy package is unlikely to be maintained. When the need for fiscal adjustment is being assessed, attention is often focused on its size and speed: the size is given by the magnitude of the accumulated imbalance; the speed will be influenced by the resources at the disposal of the government. For the design of the adjustment effort, these are important questions. For its durability, however, the quality, efficiency, and sustainability of the policy action are the critical factors.¹¹

Fiscal Deficits and Debt Accumulation

As noted in the previous section, fiscal deficits and the resulting public sector borrowing requirements place claims on resources that must be obtained either from within the economy or from abroad, or both. The process by which domestic resources can be secured has been extensively examined in the context of the relationship between fiscal and monetary policies.¹² Typically, the pressure on domestic savings resulting from large public sector borrowing requirements will lead to increases in interest rates if the fiscal imbalances are accompanied by a tight monetary policy stance, or by domestic price rises (soon followed by nominal interest rate hikes as well) if they are accompanied instead by an accommodating stance of monetary policy.

The consequences of the various possible fiscal and monetary policy stances for output, price, and balance of payments developments will depend on the amount of idle resources and capacity in the economy. They will also depend on the extent, if any, to which the domestic financial policy mix brings about a containment of private sector demand to offset the expansionary impact of fiscal policy. Even though the need to undertake an adjustment effort will typically remain, the adjustment path in the economy will vary, depending on whether the fiscal imbalance is accompanied by an accommodating monetary policy. In these circumstances, the continued impact of an expansionary fiscal-monetary policy mix will put immediate pressure on output, prices, and the balance of payments. On the output and balance of payments fronts, the pressure may be released temporarily if the economy is operating below capacity and engages in foreign borrowing or uses its international reserves. Eventually, however, price increases will set in, nominal interest rates will rise and, as a result, the government borrowing requirement will be increasingly difficult to meet.¹³

The combination of an expansionary fiscal stance with a restrained monetary policy, however, will tend to contain the effects of aggregate demand on output, prices, and the balance of payments. But the public sector deficit will still require financing, which the authorities will typically have to secure by attracting savings (both domestic and foreign) by paying remunerative yields. In the process, the persistence of large public sector deficits will bring about rapid accumulation of public debt, thus converting what had begun as a flow imbalance into a potential stock problem.

There is ample evidence in the international economy of experiences along the lines summarized above. In general, those experiences have shown that the channels through which high fiscal deficits and rising public debts influence the economy are both varied and complex. A first and clear one is the rises in interest rates that are made necessary by the high absorption of savings, domestic as well as foreign. This may take place in an environment of more or less inflation and exchange rate depreciation, depending on the extent to which monetary policy accommodates or offsets the fiscal imbalance. In either case, however, the process is likely to distort incentives and worsen the performance of the economy in terms of output, employment, and growth.¹⁴ A second channel is the impact of the rise in interest rates on the scope for prospective fiscal management as debt financing preempts future resources for debt servicing. A third and related channel is the consequences of the entrenchment of inflation and inflationary expectations, which, by stimulating indexation, further complicate the task of controlling inflation and, by imparting rigidity to the debt-servicing bill, can also reduce the effectiveness of fiscal management. This is because even though the provision of attractive returns can help assure the public sector of continued availability of private savings, over time the very need to pay such returns will absorb increasing amounts of fiscal receipts unless the public sector imbalance is eliminated on a sustained basis.

The intertemporal issues that arise when fiscal imbalances are financed mainly or exclusively by domestic debt issues will not be pursued in this paper. An ample literature is available on the topic, which focuses on the scope for debt financing of budget deficits and on the implications for fiscal and monetary policy of the continuation of such a process, as well as on the derivation of the conditions of its sustainability.¹⁵

Perhaps the general point that appears most relevant in the context of the present paper is the constraint that persistent fiscal imbalances and the consequent public debt accumulation in an economy impose for the scope and effectiveness of fiscal policy (and indeed to those of monetary policy as well) over time. These issues are becoming increasingly well recognized, a development that explains the focus that is currently placed on the appropriate concepts to measure the consequences of fiscal policy on the economy. In circumstances of relative stability and in which flow fiscal imbalances have not led to large accumulations of public debt, the overall fiscal deficit or the government’s borrowing requirement is broadly used as a global indicator of the stance of fiscal policy in the economy.

However, as pointed out at the outset of the paper, in many economies imbalances have been allowed to persist for relatively long periods. The international economy has witnessed in recent years numerous instances of countries experiencing sustained pressures on resources for protracted periods of time. The pressures, as already noted, were either met by persistent borrowing and international reserve losses or resulted in domestic inflation.

With inflation under way and with inflationary expectations deeply entrenched, indexation mechanisms have become increasingly prevalent. From the perspective of the public finances, this has led to a growing debate about the relationship between fiscal deficits and inflation and their joint linkage with public indebtedness. Thus emerged the concept of the “operational balance” as an aggregate indicator to measure the impact of fiscal policy. This balance excludes the inflationary component of the budget deficit—that is, it consists of the traditional deficit net of the outlays related directly or indirectly to the phenomenon of indexation or, in other words, net of the portion of debt service that compensates public debt holders for actual inflation.¹⁶ The rationale behind this inflation-adjusted budget balance is that the demand for government debt instruments is sufficiently stable, so that the public will be willing to hold the resources provided to maintain the real value of the stock of those instruments.

Where large fiscal imbalances have not been associated with an inflationary process of the magnitude typically required to provoke extensive indexation, public debts have accumulated perhaps to an even larger extent. It is quite clear that this growth of public debt would pose severe constraints to fiscal policy over time. In these circumstances, another concept for the impact of the budget on the economy soon surfaced: the “primary balance”—that is, the traditional budget balance excluding interest payments on the public debt. The case for focusing on this concept was based on a questionable distinction between government direct expenditure on goods and services and its outlays to service debt. Proponents of both the operational and the primary balance concepts stress the lack of government control on the inflation-determined component and the interest component of fiscal spending, respectively, as one of the reasons for their usefulness for policy purposes relative to that of the traditional overall budget balance concept.

The various analytical concepts of budget balance are relevant in different contexts, but they cannot substitute for one another. Concern with inflation control continues to establish the overall borrowing requirement as a key indicator.¹⁷ This need not detract from the importance of the primary and operational balance concepts, which help shed light on the magnitude of the effective fiscal effort that may be required to restore fiscal balance after a period of sustained inflation and debt accumulation.

External Indebtedness and Fiscal Imbalances

External indebtedness assumed a brisk pace in the 1970s, and external debt continued to grow during the current decade. This is not surprising in view of the turns taken by the international economy during those periods. The characteristics and constraints of the international borrowing process have consequently been subject to intensive examination at the conceptual and the policymaking levels.¹⁸ Developments leading to the emergence of widespread external debt-servicing difficulties in many debtor economies reflected a combination of external and internal factors. Adverse relative price changes, rises in interest rates, and declining export market prospects were all events in the international environment that did not favor debtor countries. In addition, economic management in these countries often proved to be lacking in the areas of public finances and exchange rate policy and generally with regard to efficient use of foreign resources. Among the various proximate domestic factors behind the rapid accumulation of external debt and the subsequent debt-servicing problems, the incurrence of persistent fiscal deficits has been identified as perhaps the most important.¹⁹ This finding is of relevance for the design of the required adjustment effort.

In parallel with the analysis presented above on fiscal policy, external debt management can be viewed from the standpoint of its impact on macroeconomic balance—as it affects the level and composition of demand—as well as from the perspective of its effect on the efficiency and growth potential in the economy—as it influences the process of investment and capital accumulation in the country. On a global macroeconomic plane, the availability of foreign savings and the accumulation of external debt are means by which the flows of domestic expenditure and income can differ in an economy. From this vantage point, fiscal activities financed by recourse to external borrowing can be sustained only if those government activities are of the efficiency and productivity required to service the debt in the future. Experience with the accumulation of external public debt in numerous instances indicates that this has not always been the case. Instead, levels and patterns of government spending and, more generally, of aggregate demand developed in many economies that were financed by borrowing abroad, both of which became patently unsustainable as the availability of foreign savings declined.

There is a parallel here worth noting between domestic monetary policy and external debt management. When a fiscal imbalance emerges, as noted earlier in the paper, the possibility exists of its effects being contained by a tightening of monetary policy. In effect, this is equivalent to the government seeking to obtain resources from the rest of the economy at a price. This price, of course, is the acceptance of the structure of interest rates at which the government debt issues will be absorbed by the public. As long as this process continues, signals of imbalance, such as price and balance of payments pressures, will remain muted. The sustainability of the process, however, will depend on the government’s ability to invest efficiently the borrowed resources, so that its debt can be serviced, on the one hand, and to contain future imbalances within the permissible bounds of the rate of increase in the demand for government paper, on the other.

A similar set of considerations underlies the process of foreign borrowing. During its incurrence, the availability of foreign savings can muffle the alarms that might have sounded on the inflation and international reserve fronts in the absence of external borrowing. Sustainability of the process of indebtedness, as already noted, will require efficient use of the resources. These considerations indicate the importance of ensuring consistency between fiscal and monetary policy as well as between them and external debt management.

Developments in external public indebtedness pose a number of issues, which may put the fiscal authorities in a quandary. There is, first, a need to earn or save foreign exchange in order to service the debt. The most likely means for the economy to earn the needed foreign exchange is the provision of appropriate incentives for the production of traded goods and services. In turn, expenditure cuts in the public sector will contribute directly or indirectly to saving foreign exchange outlays (and to releasing resources for exports). But again, the need for incentives and, in particular, for enhanced competitiveness is evident here. There is, in addition, a need for the government to raise from the economy at large the resources required for its debt service. This will typically call for increases in taxes, which may run counter to the incentives mentioned above. If there is scope for reducing inefficient government spending, the quandary may be simplified, but experience indicates that this is not often the case. In general, high and rising external public debt service obligations compete for resources with other uses and, rather than improve incentives for productive activities, they may in effect impair them.²⁰ This is a difficult policy dilemma, which underscores the importance of efficiency in the use of savings (both domestic and foreign) and, to this end, of appropriate debt management (both internal and external).

Foreign Debt and the Structure of the Balance of Payments

Apart from its connection with fiscal policy and, more generally, with domestic financial management, the accumulation of external debt carries important implications for balance of payments analysis. The borrowing process, in general, is a vehicle to transfer command over resources from surplus to deficit sectors or economies. In a closed economy context, the domestic borrowing process channels resources from savers to investors, thereby helping the economy, with its given resource and technology endowment, to attain its potential level and rate of growth of output. In an open economy, the availability of foreign savings adds directly to the resources available in the system. If used efficiently, foreign savings can allow the economy to reach higher spending levels by making it possible for it to grow at higher sustained rates than otherwise.

Thus, linkages exist, via the current account of the balance of payments, among fiscal and monetary policies, foreign borrowing, the saving and investment balance, and the consequent long-run evolution of the economy. These considerations underscore the need for attention to be paid not only to the evolution of the overall balance of payments—that is, to international reserve management—but also to its composition or structure between the current and capital account components.

It should be noted that the prospective evolution of the current account can be strongly influenced by past foreign borrowing. This is because rising external borrowing, though it helps finance current account deficits, also pre-empts growing foreign exchange resources for the servicing of interest on the resulting debts. Thus, even when the stock of debt itself is not falling, current account prospects are affected by past borrowing. A declining stock of external debt would pose a more severe constraint on the current account, since it would have to generate the foreign exchange required to pay interest and also to provide for net repayments of principal.

On the capital account, an increasingly important issue concerns the structure of capital flows, of which debt constitutes only one—albeit extremely important—component.²¹ Just as there is an equilibrium structure of the balance of payments, there must be an equilibrium structure of capital flows that conforms to portfolio balances in the respective economies. A particularly important dimension of this issue is the balance required between debt-creating and non-debt-creating flows, or, to put it differently, between flows that separate liability from asset accumulation (debt-creating flows) and those that tie the process of asset-liability accumulation together (non-debt-creating flows), as well as those that do not generate liabilities (aid flows). For the purposes of balance of payments management, particularly in large debtor countries, restoration of balance between equity, direct investment, debt, and other flows is of primary importance.

Need for Appropriate Boundaries

The issue of the appropriate degree of participation by the Fund in economic policy decision making is not amenable to simple or categorical answers. It basically entails determining lines of demarcation between national and international considerations in the process of adjustment. In reflection of a variety of factors, views differ as to where such lines ought to be drawn. To begin with, there is a potential conflict between the desire for national policy autonomy and the limits to it imposed by the interdependence that links national economies.²³ When it arises, the conflict is dynamic and it influences the varying degrees of cohesion and divergence that prevail over time in international economic relationships.

The Fund’s early approach to the drawing of proper boundaries is clearly illustrated in the practices of conditionality that evolved in the fiscal and debt-management areas. On the fiscal front, the general principle was the sufficiency of reaching a broad but quantified set of understandings on a global indicator of the impact of the government budget or, more generally, the public sector finances on the domestic economy and the balance of payments. Attention was focused on the overall deficit and its financing as a standard of measurement for the extent of the fiscal imbalance.

The implications of keeping the understandings between the member and the Fund confined to developments in this global variable are clear in terms of the lines of demarcation mentioned above: the member retained all its policy independence to decide on the specific measures that were to be undertaken to ensure the observance of the understanding; the decision on all the necessary actions was left to the process of internal policymaking. International considerations, in contrast, were confined to judgments on the outer limits of the magnitude of the fiscal imbalance and the speed of its adjustment—that is, the size of deficit reduction and the time within which it was to be accomplished. Thus, although a variety of policy mixes could be under discussion between the Fund and the member, the scope of the latter’s commitment was limited to the commonly agreed scale and pace of reduction in the government or public sector deficit as a means to restore macroeconomic balance to the economy. Although this approach constituted the norm, there were instances where distortions had developed and where their removal would be necessary to eliminate the imbalance on a sustained basis. In those instances, understandings between the member and the Fund on specific actions to eliminate such distortions were also required. These broad considerations provided the basis for the bulk of the policy discussions undertaken between the institution and its members in the context of requests for access to Fund resources.

Although based on discussions of policies, the actual practices of conditionality focus on the process of monitoring policy implementation. From this standpoint, early procedures tended to concentrate on the sources of financing for the deficit and, in particular, on the extension of domestic credit to the public sector by the central bank or the domestic banking system. Thus, the typical fiscal policy undertaking in adjustment programs supported by Fund resources was often a commitment to confine domestic credit expansion to the government or public sector within an agreed quantified path. This commitment could be supplemented by understandings on the adoption of specific actions (for example, in the area of administered pricing policy) that would be undertaken to remove distortions.

These practices provided ample scope for independent national policy decision making and kept international considerations within strict and well-defined boundaries. It must be noted, however, that at the time, the code of conduct contained in the Articles of Agreement subscribed by members was based on the maintenance of par values for their currencies. The par value system in itself provided a clear constraint to national policy independence and, therefore, made it possible for conditionality practices to be relatively unobtrusive both with regard to policy instruments and policy objectives.²⁴

The evolution of the international economy and the willingness (or lack thereof) of countries to take international considerations into account in their national economic policy decision making interact constantly, and their interplay affects the adjustment process. Consequently, within their invariable aim of easing adjustment, conditionality practices are always undergoing adaptation. The adaptations seek to keep the lines of demarcation between national policy autonomy and international interdependence sufficiently flexible to maintain cohesion within the international financial system at large.

As noted above, this process of continuous search for appropriate boundaries and its practical translation into conditionality practices is influenced by the nature of the code of international conduct that countries agree to uphold. The more flexible such a code is, the more difficult it is to draw boundaries that keep international considerations in the background. Other factors that influence the adaptation of conditionality are the ever evolving views as to the appropriate set of objectives on which there is a legitimate international interest.

Important changes have taken place on both of these fronts since the abandonment of the Bretton Woods par value system. Accordingly, conditionality practices have evolved in a variety of ways, and adaptations have taken place with respect to the length of the adjustment period (which was extended, for example, in the context of the extended facility); the procedures on access to Fund resources (which were made more ample by means of the enlarged access policy); and the adjustment policies to be undertaken by members that request Fund resources (which have focused increasingly on the issue of efficiency and the durability of the adjustment effort).²⁵

In this process, an interesting evolution has taken place with regard to the drawing of boundaries between national and international spheres of interest. To the extent that members have access to larger amounts of Fund resources for longer periods of time, additional leeway is available for national policy implementation. From this standpoint, on the one hand, the scope for national policy independence with regard to the size and speed of adjustment have tended to increase. On the other hand, emphasis on efficiency has required both concentration on specific policy actions and understandings on concrete policy mixes, which have tended to limit the range of national policy choices in this regard. Thus, a shift in certain aspects of the boundaries has actually occurred. In earlier periods, the international presence was at its clearest in the determination of the size and speed of the adjustment effort (which—then as now—depended on the amount and maturity of Fund resources, and which at that time were lesser and shorter), and it was at its most unobtrusive in the area of specific measures and concrete policy mixes. Recently, national autonomy has been given more leeway in the former domain—as the amount of resources has risen and their term lengthened—in exchange for a broader international presence in the latter—as the range of policy-mix choices has narrowed.

Temporal Aspects of Adjustment

These developments in conditionality practices are related to the discussion in earlier sections of the paper concerning flow and stock imbalances. In turn, the characteristics of the imbalances that recur in the international economy are influenced by the undertakings that countries are willing to accept as participants in the international system.

It can be argued that there is a common thread between the requirements of the par value system (a fixed exchange rate regime), the characteristics of conditionality (its scope and pervasiveness), and the specific terms of access to Fund resources (amounts and maturity). A firm commitment to a fixed exchange rate presupposes an unequivocal constraint on domestic policies, which provides a simple but effective indicator of the development of imbalances (pressure on international reserves). Thus, such imbalances can be detected and acted upon at an early stage, a sequence of events that has obvious implications for conditionality and access to Fund resources. When the imbalance is confronted promptly, its magnitude and potential for causing further distortions are relatively limited. This implies that policy conditions can be broad in nature and that the supporting amount of Fund resources can be relatively small and remain outstanding for a relatively brief period. In this setting, it is only natural to view imbalances as a flow problem—made evident by an overall balance of payments deficit, the elimination of which is the central policy objective—and their correction as entailing use of a limited amount of resources for a short period of time.

Since the abandonment of the par value system, the international economic system has moved toward flexible exchange rate arrangements, and thus, the thread tying all these elements and events together has become less obvious. To begin with, the constraints on national economic policies, though still present, are somewhat looser. While there are benefits that flow from the more flexible arrangements, there are also costs. One of those costs is of particular relevance in the context of this discussion. Whereas in the previous regime domestic imbalances soon found their way into the external constraint and therefore brought the country and the international community together promptly, imbalances now can persist for long periods before the external constraint prompts a response.²⁶ More complex and to some extent less clear indicators are involved in the process of evaluation of the imbalance. Thus, what begins as a maladjustment of flow variables can become a stock imbalance through accumulation of debt and arrears (domestic as well as foreign), often in a setting of persistent inflation.

This sequence of events also has implications for conditionality and for access policy, both of which have consequently been adapted. Policy conditions and the supporting amount of Fund resources have continued to reflect the nature and characteristics of the imbalance. The size of the latter, typically large, determines that policies to deal with it will have to be well-defined and sustained; the amount and maturity of access will have to be commensurate; and with the implicitly longer adjustment process, policy objectives other than the balance of payments will need to be taken into consideration. Thus, the complexity of the process of demarcation of national versus international boundaries in economic policy has increased and, with it, the need for a firm consensus behind conditionality practices and procedures that stress the requirements of interdependence.

Evolving Approaches

The recent experience in the international economy provides ample evidence of the extent to which protracted flow imbalances can develop into serious stock disequilibria, which, in turn, can render the system at large subject to severe strains and tensions. Conditionality practices evolved in the direction of promoting cohesion within the system by bringing together the various interests at play. Important initiatives were taken to cope in particular with the problems confronted by large debtor countries.

The principle behind those initiatives was relatively straightforward: the debtor country in question undertook to implement a sustained adjustment effort, which would be supported by an arrangement with the Fund; besides providing its own resources, the Fund, in turn, undertook a catalyst role to enlist the support of major creditor countries and other sources of capital flows such as the commercial banks. The initial focus of the strategy to deal with the problems posed by external indebtedness in the international economy was on the design and implementation of a substantial adjustment effort on the part of the debtor country and on the assurance of the flow of external finance from official and private sources on the requisite scale. But international attention soon turned also to the terms of external financing so that they would be consistent with the prospects of adjustment and recovery. In many respects, the dimensions of conditionality thus became more complex. Besides setting the guideposts of the international interest in the process of national policy formulation and thus constraining national policy independence, Fund conditionality also sought to set the amount and terms of support required from the other parties in the system, thus also constraining their freedom of action to reflect international considerations. An important measure of symmetry was thus being developed—albeit with setbacks in practice—with regard to the efforts required from debtors—that is, adjustment—as well as from creditors—that is, financing.²⁷

In effect, the financial arrangements of the Fund provided the instrument of cohesion required to bring debtors and creditors together. As imbalances continued to prevail, pressures developed as debtors and creditors sought to protect their perceived interests and it became increasingly difficult to arrange timely concerted financing arrangements. In the circumstances, the Fund has continued to adapt its conditionality practices to maintain cohesion among members and sources of capital by seeking to establish a reasonable balance in the assignment of responsibilities. The original concerted lending approach has therefore been refined to include a large variety of financing modalities, so as to adapt the process to specific country characteristics and prospects as well as to the requirements of the various international sources of financing.²⁸

The present requirements of the international economy are such that the search for efficiency and symmetry appear of paramount importance. Efficiency in adjustment, a necessary condition for growth, will require the adoption and maintenance of policies by debtor countries that eliminate distortions, that are transparent and well-defined, and that thus provide a clear basis for economic decisions.²⁹ The search for efficiency and the attainment of policy objectives beyond those relating to the balance of payments will inevitably influence conditionality practices, if only because the number of policy instruments will have to be commensurate with the number of objectives pursued.

At the same time, an important measure of symmetry will have to be achieved between the exercise of conditionality and the fulfillment of the Fund’s surveillance responsibilities. This symmetry is required to ensure that balance obtains between individual country adjustment efforts, flows of international financing, and the stability in the world economic environment. It is clear that efficient economic policies in borrowing countries are an essential requirement for the resolution of debt-servicing difficulties. But it is also increasingly evident that such a requirement will not be sufficient unless accompanied by appropriate adjustment in other countries as well. Policy consistency in the industrial world is of the essence in this context to provide a setting for stable and balanced expansion of activity, trade, and capital flows in the international economy.

Ricardo Arriazu

The words “adjustment programs” and “stabilization programs” have been frequently—and also loosely—used to describe at least three different types of disequilibrium adjustments. In general, they describe programs aimed at: (1) the reduction of inflation rates; (2) the reduction of external current account deficits (deficits that reflect excesses of domestic aggregate demand in relation to output); and (3) the reduction of balance of payments deficits.

Although disequilibria that are reflected in inflation and deficits in the current account and the overall balance of payments often tend to be closely related, this is not always the case. In fact, all possible combinations of the performance of these economic indicators can be the result of specific economic policies.

For example, balance of payments deficits associated with current account surpluses and price stability will almost certainly be the response, under fixed exchange rates, to portfolio changes associated with increased holdings of foreign exchange involving no net wealth changes. However, persistent inflation associated with current account and balance of payments surpluses will tend to be the response to a policy of persistent devaluation of the domestic currency (crawling peg), which generates inflationary taxes in excess of nominal fiscal deficits. Attribution of other possible combinations of results to specific economic policies is left to the reader.

The relationship between economic performance and policy is recognized by Manuel Guitián early in his paper: “… an adjustment strategy must be based on an accurate assessment of the nature and characteristics of the imbalance confronting the economy” (p. 113). Nevertheless, most of his paper deals with cases where current account deficits are registered jointly with balance of payments deficits and inflationary pressures, because this is the most typical combination of disequilibria for countries confronting serious imbalances.

It is important to note that when these three indicators register the results described in the previous paragraph, the sources of the imbalances tend to be exclusively of domestic origin, reflecting excessive domestic absorption in relation to output. Furthermore, as Guitián also points out, in most cases the imbalances originate in fiscal deficits. This point can be illustrated with the use of a slightly modified absorption identity:

where

• X = exports of goods and services

• M = imports of goods and services

• X - M = current account of the balance of payments

• T = taxes, including the inflationary tax or the devaluation tax depending on the unit and purpose of the measurement)

• G = public sector expenditures

• T - G = public sector budget imbalance

• Y = national income, measured in the corresponding unit of account

• E = private sector expenditures

• Y - E - T = private sector budget imbalance.

This identity clearly shows that current account disequilibria are mirror images of imbalances in either the public sector budget, the private sector budget, or both. Current account deficits are the counterpart of domestic expenditures in excess of income. Experience tends to indicate that, in most cases, current account deficits are the mirror image of fiscal deficits. In only a few cases, such as Chile in the late 1970s and, recently, the United Kingdom, are these deficits the counterpart of private sector budget imbalances.

In the design of economic policy measures aimed at the solution of some of the problems described above, it is vitally important—as recognized by Guitián—to understand clearly the characteristics of the basic imbalances behind the problems. Thus, not only must the type of imbalance be described correctly, but also the economic sector where these imbalances originate must be identified. This latter requirement, in turn, calls for total consistency in the measurement of the different sectoral imbalances.

Economic data in most countries are based on widely accepted criteria, and with the exception of countries confronting inflationary pressures, may be considered generally consistent. For countries where inflation has been a daily experience for decades, as well as private holdings of foreign assets and capital outflows—even under strict capital movement controls—economic data and, therefore, measurements of imbalances tend not to be reliable.

The absorption identity can be of help in an illustration of this point. Most countries measure their external accounts for balance of payments reasons in terms of an international unit of account (in most cases, dollars), whereas they measure the same transaction for national accounts purposes in volume terms. At the same time, the public sector budget is measured in terms of a nominal domestic currency (even though it is also frequently transformed into “constant” national currency for the purpose of comparing the time path of budget imbalances in an inflationary environment). The private sector budget, however, is never measured in this way, even though some of its components are published in the form of flows of output, income, consumption, and investment.

It should be immediately clear to the reader that measuring the different sectoral imbalances in different units of account does not help in determining the true characteristics of the imbalances to be corrected; and that the transformation of nominal flows into “real flows” in the public sector budget is not a good substitute for uniform units of account or for an accurate measurement of the effects of inflation on financial assets.

Inflation and the Measurement of Fiscal Imbalance

The following example examines the basic distortions that inflation introduces in the measurement of fiscal imbalances. In this example, the public sector budget of a country with an assumed structure of taxes, expenditures, and debt is examined under three different inflationary conditions: price stability; prices increasing at a rate of 50 percent a year; and prices increasing at 100 percent a year. In the last two cases, monthly inflation rates are assumed to be stable throughout the year.

The basic data for financial assets and liabilities used in the example follow approximately the financial structure of heavily indebted countries like Brazil or Mexico. In the case of Argentina, the stock of domestic debt is smaller as a consequence of a stronger run out of the domestic currency. Interest rates approximately reflect current rates, even though during the last few years, real rates on domestic assets have tended to be higher in real life.

Basic Data

Basic Data

Gross national product (GNP)	100
Net external debt	50
Interest-bearing domestic debt	20
Non-interest-bearing domestic debt	10
Total net financial wealth	−80
International interest rates	8 percent a year
Real domestic interest rates	10 percent a year
Nominal domestic interest rates	inflation + 10 percent

View Table

Basic Data

Gross national product (GNP)	100
Net external debt	50
Interest-bearing domestic debt	20
Non-interest-bearing domestic debt	10
Total net financial wealth	−80
International interest rates	8 percent a year
Real domestic interest rates	10 percent a year
Nominal domestic interest rates	inflation + 10 percent

In addition to these data, it is necessary to make a few policy assumptions related to the policies to be followed in the field of exchange rate and debt management, as well as those referring to structural factors (fiscal lags) and the reaction of economic agents to inflation. The assumptions are: (1) the country is small and a price taker; (2) all goods are internationally traded; (3) the exchange rate policy is full indexation to inflation; (4) nominal tax adjustments are 90 percent of inflation rates; (5) nonfinancial public sector expenditures are constant in real terms; (6) domestic interest-bearing debt is constant in real terms; (7) domestic non-interest-bearing debt declines in real terms as inflation increases; (8) gross external debt is constant in real terms; and (9) changes in reserves are used as an adjustment variable.

Table 1 shows the time path of the domestic interest-bearing debt and the corresponding interest payments flows for the year as a whole. This table clearly shows the effects of inflation on nominal interest payments.

Table 1.

Interest Payment Flows on Domestic Debt

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

¹At 50 percent inflation, the nominal monthly interest rate is 0.04261 percent.

²At 100 percent inflation, the nominal monthly interest rate 0.06791 percent.

Table 1.

Interest Payment Flows on Domestic Debt

	Annual Rate of Inflation
	50 percent1		100 percent2
	Debt at	Nominal	Debt at	Nominal
	Beginning	Monthly	Beginning	Monthly
Month	of Period	Flows	of Period	Flows
1	20.000	0.852	20.000	1.358
2	20.687	0.882	21.189	1.439
3	21.398	0.912	22.449	1.624
4	22.134	0.943	23.784	1.615
5	22.894	0.976	25.198	1.711
6	23.681	1.009	26.697	1.813
7	24.495	1.044	28.284	1.921
8	25.337	1.080	29.966	2.095
9	26.205	1.117	31.748	2.156
10	27.108	1.155	33.636	2.284
11	28.040	1.196	35.636	2.488
12	29.004	1.236	37.755	2.564

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

¹At 50 percent inflation, the nominal monthly interest rate is 0.04261 percent.

²At 100 percent inflation, the nominal monthly interest rate 0.06791 percent.

View Table

Table 1.

Interest Payment Flows on Domestic Debt

	Annual Rate of Inflation
	50 percent1		100 percent2
	Debt at	Nominal	Debt at	Nominal
	Beginning	Monthly	Beginning	Monthly
Month	of Period	Flows	of Period	Flows
1	20.000	0.852	20.000	1.358
2	20.687	0.882	21.189	1.439
3	21.398	0.912	22.449	1.624
4	22.134	0.943	23.784	1.615
5	22.894	0.976	25.198	1.711
6	23.681	1.009	26.697	1.813
7	24.495	1.044	28.284	1.921
8	25.337	1.080	29.966	2.095
9	26.205	1.117	31.748	2.156
10	27.108	1.155	33.636	2.284
11	28.040	1.196	35.636	2.488
12	29.004	1.236	37.755	2.564

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

¹At 50 percent inflation, the nominal monthly interest rate is 0.04261 percent.

²At 100 percent inflation, the nominal monthly interest rate 0.06791 percent.

Table 2 shows income and expenditure flows under different inflationary environments. In each case, the flows are presented for two periods: the last month of the period, and the year as a whole, under the assumption of a constant monthly rate of inflation. As this table shows, as inflation increases, the following things happen: (1) taxes decline in real terms, owing to so-called fiscal lags (Olivera-Simone-Tanzi effect); (2) external interest payments are maintained in real terms, owing to the exchange rate indexation policy; and (3) real interest payments on the domestic debt rise significantly in response to the corresponding increase in the nominal interest rate.

The combination of these three events is reflected in a sharp deterioration in the nominal fiscal balance, which turns from a surplus (1 percent of GNP) to a significant deficit (almost 14 percent of GNP).

Table 2 is incomplete, because it does not include the financing of the imbalances. In Table 3, the structure of the financing of the public sector deficit is shown under the same inflationary assumptions. This table should be interpreted in the following way. The country’s financing needs, which are shown in the first line of the table, were obtained from the flows in Table 1. Since inflation also influences the nominal demand of economic agents for different financial assets, this element should be reflected in the economic policy assumptions. The assumptions used here reflect the desire of economic agents to maintain a constant real stock of interest-bearing debt instruments and a declining real stock of non-interest-bearing debt instruments. Under a fixed exchange rate, any difference between the financial needs of the public sector and the flow demand for financial assets of the private sector is adjusted through changes in reserves.

Table 3.

Financing of the Public Sector Deficit: Nominal flows

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil The figures were selected so that 100 = GDP before inflation.

Table 3.

Financing of the Public Sector Deficit: Nominal flows

		Annual Rate of Inflation
		0 percent		50 percent		100 percent
		Last Month	year as	Last Month	Year as	Last Month	Year as
Economic indicator		of Year	a Whole	of Year	a Whole	of Year	a Whole
Total financing needs		−0.0830	−1.000	1.057	9.775	2.499	20.729
Eternal debt		—	—	—	—	—	—
Domestic liability
	Non-interest-bearing	—	—	0.432	4.413	0.793	7.466
	Interest-bearing	—	—	0.097	10.000	2.245	20.000
Changes in reserves		0.0830	1.000	0.332	4.638	0.539	6.736
Memorandum items:
Changes in reserves (in foreign currency)		0.0830	1.000	0.248	3.755	0.269	4.724

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil The figures were selected so that 100 = GDP before inflation.

View Table

Table 3.

Financing of the Public Sector Deficit: Nominal flows

		Annual Rate of Inflation
		0 percent		50 percent		100 percent
		Last Month	year as	Last Month	Year as	Last Month	Year as
Economic indicator		of Year	a Whole	of Year	a Whole	of Year	a Whole
Total financing needs		−0.0830	−1.000	1.057	9.775	2.499	20.729
Eternal debt		—	—	—	—	—	—
Domestic liability
	Non-interest-bearing	—	—	0.432	4.413	0.793	7.466
	Interest-bearing	—	—	0.097	10.000	2.245	20.000
Changes in reserves		0.0830	1.000	0.332	4.638	0.539	6.736
Memorandum items:
Changes in reserves (in foreign currency)		0.0830	1.000	0.248	3.755	0.269	4.724

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil The figures were selected so that 100 = GDP before inflation.

In Table 3, accumulation of reserves is shown to increase with inflation, a result that seems incompatible with the absorption identity. A careful evaluation of the data, however, shows that this is not the case, as can be seen in Table 4.

Table 4.

Fiscal imbalance, inflationary Taxes, and Reserve Changes

(End-of-period nominal stocks)

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before Inflation.

Table 4.

Fiscal imbalance, inflationary Taxes, and Reserve Changes

(End-of-period nominal stocks)

			Annual Rate of inflation
Economic indicator			0 percent	50 percent	100 percent
Assets			1.000	5.633	9.446
Reserves			1.000	5.633	9.446
Liabilities			80.000	119.413	157.466
	Domestic
		Non-interest-bearing	10.000	14.413	17.466
		Interest-bearing	20.000	30.000	40.000
	External		50.000	75.000	100.000
Nominal net financial wealth			−79.000	−113.780	−148.018
inflation-adjusted net
	financial wealth		−79.000	−75.853	−74.009
Changes in net financial wealth
	At old prices		1.000	4.147	5.991
	At new prices		1.000	6.220	11.982

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before Inflation.

View Table

Table 4.

Fiscal imbalance, inflationary Taxes, and Reserve Changes

(End-of-period nominal stocks)

			Annual Rate of inflation
Economic indicator			0 percent	50 percent	100 percent
Assets			1.000	5.633	9.446
Reserves			1.000	5.633	9.446
Liabilities			80.000	119.413	157.466
	Domestic
		Non-interest-bearing	10.000	14.413	17.466
		Interest-bearing	20.000	30.000	40.000
	External		50.000	75.000	100.000
Nominal net financial wealth			−79.000	−113.780	−148.018
inflation-adjusted net
	financial wealth		−79.000	−75.853	−74.009
Changes in net financial wealth
	At old prices		1.000	4.147	5.991
	At new prices		1.000	6.220	11.982

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before Inflation.

Table 4 depicts the country’s financial structure after the fiscal flows of the period and the changes in net financial wealth measured in terms of the new prices and the old prices have been taken into account. As this table shows, net financial wealth has improved somewhat during the period, a result that can only be consistent with a fiscal surplus. This improvement is consistent with the reserve accumulation shown in Table 2, and also exhibits the same tendency to increase with inflation. This apparent contradiction arises because Table 2, which is based exclusively on flows, does not take into account the decline in the real value of the domestic debt derived from inflation (the so-called inflationary tax).

A brief analysis of these figures allows us to draw the following conclusions. There are several definitions of fiscal imbalances, and each has its particular usefulness. The most useful definitions are: (1) nominal flow imbalances (Table 2), which are a counterpart of the financing needs of the public sector; (2) total nominal deficit, which is the counterpart of the nominal changes in net financial wealth; (3) inflation-adjusted deficit, which is the counterpart of the “real” changes in net financial wealth (that is, the correct measurement of imbalances from a net wealth point of view; (4) dollar-adjusted deficit, which is a counterpart of variations in net financial wealth measured in dollar terms and is useful in the measurement of imbalances leading to current and balance of payments disequilibria; and (5) zero-inflation deficit. This last concept, which measures the size of fiscal imbalances under the assumption of price stability, is perhaps the most important measurement for assessing the characteristics of a disequilibrium for adjustment purposes. It should not be used in combination with the inflation-adjusted concept, which attempts to measure the size of the imbalance after all the distortions introduced by inflation have been eliminated, whereas the zero-inflation deficit includes all these distortions and, in addition, includes under revenues the amount of inflationary tax collected. In a sense, the zero-inflation deficit is an ex-ante concept that measures the magnitude of the adjustment required to eliminate inflationary and external sector pressures, whereas the inflation-adjusted deficit is an ex-post concept that incorporates the real resource transfers originating in inflation.

Inflation tends to increase the nominal flow deficit. These increases tend to be large; the larger the interest-bearing domestic debt, the larger the fiscal lag. Inflation also tends to be higher, the larger the size of the zero-inflation deficit, the smaller the non-interest-bearing debt, the larger the fiscal lags, and the faster the run out of a currency.

Reconciliation of nominal flow figures with the changes in nominal net financial wealth is feasible, but it requires elaborate measurements of the inflationary tax and other inflation-induced distortions. Table 5 shows, as an example, these calculations for the year as a whole, under the assumption of a 50 percent rate of inflation.

Table 5.

Changes in Net Financial Wealth, Inflationary Taxes, and Nominal Flow

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

Table 5.

Changes in Net Financial Wealth, Inflationary Taxes, and Nominal Flow

Component	Change
Changes in net financial wealth at new prices	6.220
Zero-inflation surplus at new prices	1.500
Cross inflationary tax	5.870
Fiscal lags	−1.137
Cross effects and interest compounding	−0.010

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

View Table

Table 5.

Changes in Net Financial Wealth, Inflationary Taxes, and Nominal Flow

Component	Change
Changes in net financial wealth at new prices	6.220
Zero-inflation surplus at new prices	1.500
Cross inflationary tax	5.870
Fiscal lags	−1.137
Cross effects and interest compounding	−0.010

Note: Figures are arbitrary, reflecting approximations to cases such as Mexico and Brazil. The figures were selected so that 100 = GDP before inflation.

In this table, the gross inflationary tax was measured not only in relation to the original stock of non-interest-bearing domestic debt (10 x 0.5), but also in terms of the monthly flow demand for this asset. The effects of inflation on taxation (fiscal lags) were measured by comparing the amount of perceived taxes in the case of full indexation with the flows shown in Table 2. The zero-inflation surplus corresponds to the financial needs figure under the heading “zero inflation,” measured at the new prices. The last item (“cross effects”) originates in the compounded effects of real interest rates and inflation.

Richard Portes

As in so much of recent macroeconomics, the stock-flow distinction lies at the heart of this excellent treatment of the macroeconomic basis of International Monetary Fund (IMF) adjustment programs for indebted less-developed countries. In particular, the relations between fiscal deficits, domestic public debt, external debt, and debt service must be elucidated. This requires a clear intertemporal perspective as well as an understanding of the complexities of actual adjustment programs.

The precise characteristics of adjustment will determine whether a current flow imbalance translates over time into a stock maladjustment, carrying its own consequences for flows. Some of the relevant issues have been analyzed by Buiter (1985) for developed countries—mainly the United Kingdom and the United States—and in the book edited by Giavazzi and Spaventa (1988)—mainly on the Italian case. I shall not repeat the arguments there and shall therefore focus on the less-developed countries, although I fully agree with Manuel Guitián that the problems are quite general in application.

Guitián stresses the need to balance available and required resources. This is surely where we must start. The first qualification I would make, however, is that the intertemporal budget constraint stressed here should not be taken as a rigid criterion for assessing fiscal stance, or rather a fiscal rule. Let us define the latter as a time path for government revenues and expenditures, or in simpler terms, a time path for government deficits and surpluses. The path may be fully specified, period by period, in a manner defined by an open-loop adjustment rule.

Consider now a fiscal rule, so defined, that respects the intertemporal budget constraint. It may still not be sustainable. First, even if the expected growth rate exceeds the expected real rate of interest, subsequent shocks may reverse that relationship—as indeed occurred in the early 1980s. Second, the tax burden determined by the rule may not be collectible. Third, the expenditures specified in the rule—for example, on the armed forces or on transfer payments—may not be enough to keep the government in power. Finally, if the tax burden implied by the rule involves some seigniorage element, its inflationary consequences may be unstable, a point to which I shall return below.

Conversely, a fiscal rule that violates the intertemporal budget constraint may nevertheless not be unsustainable. Debt can be inflated away, to the extent that it is denominated in home currency; this is of course less likely for a developing country than for a highly industrialized country. But the developing countries have other options that are perhaps more likely: they may repurchase their debt at less than its face value; or, in the extreme case, they may repudiate.

A sustainable fiscal rule, respecting the intertemporal budget constraint, may still encounter liquidity constraints if the capital market is imperfect. Cohen (1985) calculated an “index of solvency” for indebted countries that suggested that only a few were “insolvent,” even on relatively pessimistic assumptions regarding long-run growth rates and real interest rates. Nevertheless, many have since had to reschedule. Often the rescheduling has involved substantial changes in macroeconomic policies toward “adjustment,” although on this (“solvency”) definition of the intertemporal budget constraint, there was no need to adjust. The problem, of course, is that these countries cannot under current conditions maintain the levels of borrowing required by these “sustainable” long-run paths; one might suggest that this was the fundamental weakness of the Baker Plan.

Guitián points out that a stock imbalance feeds back on flows. Until recently, a particular aspect of this relation has been neglected: the relation of external debt service to domestic fiscal flows. Financing an increased burden of debt service requires as its domestic counterpart an increase in the government’s primary surplus, selling more domestic debt to the public, or raising seigniorage revenues. But increasing taxes or cutting expenditures will often hit investment rather than consumption, as the recent experience of many highly indebted countries suggests. Selling more domestic debt, where the capital market is sufficiently developed to permit it, will normally raise real interest rates, again with undesirable consequences for investment. And there are well-defined limits to seigniorage revenues—as inflation accelerates and velocity rises, the real value of seigniorage will ultimately fall.

The paper makes a point about policy that I would query. First, it is suggested that for some time at least, a country could counteract the effects of a loose fiscal stance by applying a tight monetary policy. But not all countries can apply Reaganomics successfully! The Sargent-Wallace argument gave rise to several models that can generate higher inflation as a consequence of temporary monetary restraint, and the cases of Israel in 1979 and Turkey in 1984 indicated that the theory may have some empirical content.

Perhaps more important for a country with a very limited capital market, the central bank may be the only significant source of finance for the government deficit. If the Treasury has no alternative but to require the central bank to monetize the deficit, and there is no de facto separation of powers, the growth of the central bank’s domestic assets is no longer a choice variable but is rather determined by the public sector deficit. The distinction between fiscal and monetary policies then becomes meaningless, and Guitián’s proposal cannot be operational.

I believe that for many of the highly indebted countries, the problems raised above will make it impossible for them to succeed with any adjustment in the medium term—that is, sufficiently to maintain full debt service and obtain renewed access to voluntary external finance. No conditionality will be able to bring this about. The only alternative is then some form of debt relief—voluntary or forced reduction in the debt overhang. “Debt fatigue” is becoming insupportable, and the debt burden now inhibits investment, both for the reasons sketched above and because debt service acts as a tax on the yield of investment. It thereby reduces the likelihood of successful adjustment.

To implement debt relief, I would propose substantial reliance on market-based procedures, with large-scale purchases of debt at discounted prices, often by the debtors themselves. This brings us back to the title of this conference and the relation between fiscal policy, adjustment, and financial markets. How to expand the existing secondary markets for bank debt, how they could behave in these circumstances, and how prices on these markets are related to domestic policies are questions requiring further conferences.

Salvatore Zecchini

Manuel Guitián’s paper has the undoubted merit of presenting in a condensed and general form the complex issues of fiscal adjustment that the International Monetary Fund (IMF) has had to cope with in the past decade. Fiscal imbalances are not the only cause of the severe economic imbalances that industrial and developing countries have experienced in the 1980s. But fiscal adjustment is at the center of any approach to the correction of these imbalances, no matter what the main source of the imbalance is, because it encompasses more fully than other macroeconomic policies three degrees of effects. Fiscal adjustment can contribute in a major way to the control of domestic demand expansion, while managing the impact of this control on the efficiency of resource allocation and on the distribution of income among income earners and the population at large.

Guitián’s presentation of the fiscal adjustment issues is so comprehensive and far-reaching that it can be shared by most, if not all, of us. The purpose of my contribution to this discussion is therefore to spell out briefly some of the more controversial issues that have arisen in the design and assessment of the fiscal adjustment efforts that have come under the scrutiny of the Fund.

The perspective that the IMF takes in addressing the issue of fiscal adjustment is basically that of helping the country to achieve external balance. This is also one of the underlying themes of Guitián’s paper. However, the relationship between fiscal deficit and external deficit is not a one-to-one relationship, whereby the correction of the first leads more or less automatically to the adjustment of the others, as some schools of thought have argued and as the IMF staff has tended to assume in program design. In fact, some IMF members that had upper credit tranche arrangements with the Fund in the period 1982–85 redressed their external current account imbalance without achieving the targeted correction in the fiscal area. Furthermore, other countries overperformed in terms of fiscal correction but did not achieve their objective of external balance. If we were to plot on a diagram the improvements of these countries in their external current account as a percent of gross domestic product (GDP) against the improvements in their fiscal account, the result would be a scatter of outcomes spread out at some distance from the 45-degree intercept that would support a direct relationship between the two sets of results.

Therefore, if this relationship is not so direct, one must look for the other factors that mediate between and explain the link between the two imbalances. In this respect, some useful insight can be derived from an analysis of sectoral balances between savings and investment in the framework of the flow of funds. Through this approach, we may find some interesting explanations for certain country experiences. For instance, in the case of Italy, how was it possible that the high and widening budget deficit of 1979–85 was not translated into a widening current balance of payments deficit. If, for simplicity, we consider only two sectors in the economy—the general government and the private sector—we can see that between 1979 and 1980 the widening of the external account was mainly due to a decline in net saving accumulation by the private sector. In contrast, between 1981 and 1984, when Italy experienced a gradual increase in the deficit of the public sector, its impact on the external deficit was more than offset by a rise in net savings of the private sector. As a result, the current account turned into a surplus in 1983, while the general government deficit continued to increase. Actually, the private sector, and particularly private fixed investment, had to bear a large portion of the burden of external adjustment, which had negative repercussions on the longer-term development of the economy.

The importance of an analysis of the savings-investment balances for the major sectors of any economy when an adjustment program is being designed or the surveillance function of the Fund is being implemented is underscored by several other factors. One might include among these factors the strong reluctance of some major industrial countries to include this analysis among the indicators used in the policy coordination exercise undertaken by the Group of Seven countries. I prefer to consider another argument that has recently become quite fashionable in academic circles—that is, the so-called Ricardian equivalence theory.

It is generally believed that budget deficits are generally one of the causes of excessive domestic absorption, accelerating inflation, displacement of private investment, and rising deficits in the current balance of payments. However, some economists have recently argued that according to Ricardian equivalence, this chain of cause and effect does not materialize under certain circumstances. Specifically, if there is an interdependence between private and public decisions to save, an increase in the public deficit is matched by a rise in private saving in anticipation of future taxation. The result would be a lack of responsiveness of total domestic savings to changes in the fiscal stance and, consequently, a limited role for fiscal policy in the adjustment strategy.

This line of reasoning does not seem to be supported by the statistical evidence. Recent econometric tests carried out by the IMF (Haque and Montiel (1987)) suggest that in 15 out of 16 major developing countries with IMF programs, the Ricardian equivalence proposition can be rejected at a comfortable level of statistical significance. This strengthens the belief that without fiscal correction, no viable adjustment is possible independently of the specific cause of the imbalance in the economy.

Guitián rightly emphasizes the vicious circle that has emerged between flow imbalances and stock maladjustment; the accumulation of public debt is both the result of a series of major budget deficits and the cause of further deficits in the future. Furthermore, the sheer magnitude of the stock of debt can shape the course of adjustment and the development of the economy.

However, although the importance of this stock-flow interdependence should not be underestimated, the intractable debt problem facing many developing countries is also the result of two largely exogenous factors—namely, the rise in real interest rates in world markets, and the sharp reversal in the terms of trade of the indebted countries. The climb in real interest rates was mainly determined by monetary conditions in the major industrial countries and, particularly, by the mix of macroeconomic stabilization policies pursued in the first half of the 1980s. The worsening of the terms of trade appears to be mainly the result of a weakening of demand and prices in commodity and energy markets in the early 1980s.

Overall, the fiscal imbalances of these countries can be traced back to a variety of factors and are reflected in a wide range of distortions in the economy. If one considers the multifaceted relationship of causes and effects, it becomes evident that the approach to fiscal adjustment followed by the Fund in the first half of the 1980s was too narrow in scope and, consequently, not able to produce durable results. The IMF guidelines on conditionality provide the framework for the approach to fiscal correction and have as their main goal rapid progress toward a sustainable balance of payments. Problems associated with attaining a more systemic control over inflation, limiting the impact of stabilization measures on the long-term growth potential, and restoring equilibrium between the stock of external debt and the debt-servicing capacity of a debtor country were not of primary concern for the Fund and the deficit country in the design of the adjustment strategy and performance criteria. Instead, the primary concerns were the size of the fiscal deficit and the speed of its reduction, since these were the relevant variables in the traditional model used by the IMF staff. In essence, in this model, given a predetermined demand for money, the impact of a change in the fiscal deficit on domestic credit expansion leads to the targeted changes in the current balance of the external account.

Guitián correctly stresses the evolution of the approach to conditionality that has occurred since 1985, which has been characterized not by a change in the guidelines but by a broadening of their interpretation. In this evolution, emphasis has been shifted away from the quantity of deficit correction to the quality of overall fiscal adjustment. Although Guitián does not delve into the causes of this evolution, this is an interesting area to explore. A major factor behind the change in emphasis has been the mixed success of Fund-supported programs, together with increasing signs of adjustment fatigue, as evidenced by social tensions in countries that are still far from a viable fiscal or external position. In fact, since 1983 most of the slippages in the implementation of adjustment programs occurred in the area of public finances; and even in those cases where compliance was satisfactory, the improvements were more temporary than structural. This outcome is hardly surprising, since the public budget is the main ground where the conflicting claims on the national income by the various segments of the population have to be reconciled, and where the authorities face the most rigid constraints on the political side.

The shift in emphasis toward the qualitative aspects of fiscal adjustment involves, first, a more penetrating analysis of the implications of changes made in the revenue and expenditure sides of the budget to achieve targeted objectives; and, second, a more profound modification of public intervention in the economy. Both actions are likely to elicit strong opposition from the authorities involved, unless they are aimed at other objectives, besides correction of the external balance, that are considered valuable from a social point of view. The principal additional objectives favored by authorities have been the maintenance of a satisfactory growth rate over both the medium term and the short term, and a lasting solution to the external debt overhang, possibly through debt relief. To these objectives the Fund has added better control over domestic inflationary impulses, an objective that countries with a long history of high inflation have not valued adequately. The widening of the number of objectives in the fiscal strategy requires a corresponding enlargement in the number of fiscal instruments and, consequently, the assignment of different roles to interventions in the budget deficit, the expenditure side, the revenue side, and the financing of the deficit. Let us briefly consider these aspects.

With respect to the deficit, the Fund has introduced the concepts of primary and operational balances into its conditionality, as, for example, in the case of the program with Mexico. Introducing these definitions was justified by the assumption that interest payments or the inflationary component of interest payments have a low impact, compared to other public expenditures, on other economic imbalances, particularly in sustaining inflation. Furthermore, it was believed that the reabsorption of these components of the deficit would take place over a longer period and would benefit from the easing of inflation as well as of conditions in the financial markets. However, a program that focuses on such narrow definitions of the deficit may run the risk of being based on unrealistic assumptions about the inflationary process in the country under consideration. Therefore, it would be advisable to use these definitions only in instances where other parts of the adjustment program are committed to a strong anti-inflationary stance.

An interesting innovation in some programs—such as the recent ones carried out in Argentina and Brazil—has been the use of “heterodox” measures, as opposed to “orthodox” demand management via macroeconomic policies. These heterodox measures, which include temporary price-wage freezes or compulsory de-indexation, were aimed at obtaining a quick reversal of inflationary expectations and at boosting public confidence in the complementary macro-economic strategy. The rationale was that improvements in private expectations could help minimize output losses due to fiscal stabilization. In practice, the heterodox approach proved to be successful only over a very short period, since it was not supported by more fundamental adjustments in the fiscal and monetary stance (see Blejer and Cheasty (1987)).

Among the countries undertaking adjustment programs, the weakest performance in the fiscal areas has been recorded on the expenditure side. The contribution of expenditure restraint to the reduction of domestic absorption has been much lower than the contribution of revenue-raising measures. Furthermore, capital expenditure, and investment programs in particular, has borne the brunt of the expenditure stabilization, with implications for the growth potential of the economy. At the same time, little progress has been made in limiting transfers to public enterprises or the parastatal sector, or in improving their efficiency or gaining better control over extrabudgetary expenditures.

The Fund has contributed in part to this outcome, since its approach has basically been concerned with reducing only the size of the claim of the public sector on domestically produced resources. The transition from a quantitative to a qualitative approach will require instead an analysis of the impact of the expenditure structure on long-term growth and inflation and will call for some form of conditionality on the composition of expenditure. Such an approach implies the development of microeconomic analysis as a basis for achieving macroeconomic balance in the development process. In undertaking this endeavor, the IMF should not fall prey to the frequently used assumption that any expansion of public expenditure represents a suboptimal use of domestic resources and should therefore be resisted. After all, the government sector provides, among other things, social goods that are preconditions for any economic development process. However, the Fund should encourage the authorities to scrutinize more closely the costs and benefits stemming from groups of expenditure items, as a means to strengthen the economic system. Moreover, the Fund should require that the authorities exert more control over the expenditure decisions of all public entities, and particularly the local ones.

In Fund-supported programs, tax measures have played an important role in raising revenues for the purpose of fiscal stabilization, but efforts to improve tax administration have been less successful. In the area of taxation, the Fund should work more purposefully toward achieving optimal taxation under the specific conditions of the country concerned. For instance, taxes that have a highly inflationary impact or that lessen incentives to expand production should be avoided.

Guitián’s paper also touches upon a crucial issue that has received increasing attention since 1985—the interaction between the financing of the budget deficit and the management of external debt in countries with an excessive accumulation of external debt. Guitián stresses the need to restore a balance between debt-creating and non-debt-creating financial flows. This has implications for the structuring of economic activities that are carried out directly or indirectly by the public sector. Specifically, those activities in which public interest priorities do not override economic goals should be restructured so as to attract foreign capital in the form of direct investment or equity participation. Furthermore, the decision of the public sector to borrow abroad should be consistent with a sustainable relationship between the marginal productivity of the resources invested in the country and the marginal cost of borrowing. When the second exceeds the first, it is most likely that a debt overhang will emerge in the not-too-distant future.

Another issue that has not received enough attention in the Fund’s use of conditionality is the interaction between exchange measures and fiscal stabilization. For countries with a relatively high stock of foreign indebtedness, the usual IMF recommendation to depreciate the exchange rate has brought about an increase in the burden of debt servicing for the budget. Likewise, the conversion of foreign debt into equity implies the replacement of external debt with domestic debt. If, in this process, the debtor country does not benefit from a substantial discount over the face value of previously held debt, and if domestic interest rates are relatively high, the final result will be a net increase in the budget expense for debt service. Therefore, better coordination is needed between external and fiscal measures.

As can be seen from the issues discussed above, improving the quality of fiscal adjustment within the framework of IMF conditionality implies a deeper involvement by the Fund in domestic policy decisions that governments have usually regarded as their exclusive domain. As Guitián points out, “the issue of the appropriate degree of participation by the Fund in economic policy decision making is not amenable to simple or categorical answers” (p. 127). However, two basic considerations have to be borne in mind. First, most of the qualitative aspects that have been discussed here fall within the domain of economic policies over which the Fund exercises its surveillance function under Article IV, Section 1. Second, the cooperative nature of the IMF can justify the exchange of a more penetrating conditionality for the provision of financing in an amount that is necessary to support structural improvements in an economy but is not voluntarily provided by the markets. If a country is willing to undertake a major effort to correct systemic weaknesses in the economy, then the Fund has to allow more time for adjustment and, consequently, more financing because of the persistence of external deficits over longer periods. This is also the fundamental rationale behind the enhancement of the structural adjustment facility for low-income countries.

This approach should not be available to the low-income countries alone; rather, it should be extended to all IMF members. To this end, two main conditions must be fulfilled. First, the magnitude of Fund resources should be raised to match the current scale of national products and external trade in the world economy. Second, the objective of promoting orderly economic growth, as spelled out in Article IV, Section 1, should be explicitly incorporated in the existing guidelines for conditionality.