Mark Allen

At the start of a week of presentations on the link between structural reform and macroeconomic policies, it might be useful to stand back and consider why this topic is being stressed. I will therefore begin by briefly discussing the 20 or so years of experience that have led the IMF to become increasingly conscious of this particular link when looking at members’ policies. I will then explain how this growing awareness has helped the IMF and the World Bank fashion their approaches to dealing with member countries. Next, I will review the various areas of linkage between macroeconomic policy and structural reform that will be discussed during the course of this seminar, not only as they relate to the economies in transition, but as they apply to the IMF’s membership as a whole. Finally, I will say something about the general conclusions that may emerge during the course of the seminar.

The Historical Origins of the Link

While I cannot give a complete history of the world economy over the last two decades, I can highlight some interesting developments that help to explain the IMF’s sharper focus on the link between structural reform and macroeconomic policy. Certainly the economic policymakers of 20 years ago had some understanding of the structural policies described here; however, the experience of coping with the many shocks the world economy has undergone since then has led to a change in thinking about the different aspects of macroeconomic policy.

A good place to start is with the oil crisis of the 1970s, which taught economists some significant lessons about formulating policy. The essence of the crisis was that the price of a crucial input to the world’s economies—energy in general and oil in particular—increased by a factor of ten. This increase came as a surprise; few policymakers had expected it, and there was a lot of very worried thinking about how economies were going to cope with such a large adjustment in energy prices. Many feared that if the oil producers could not absorb the increased revenues, or if the consuming countries were forced to reduce imports, the world would be plunged into deep recession.

However, two things happened. The first was that the economies of the oil-consuming countries, particularly the industrial countries, proved far more flexible than expected and managed to cope with the higher energy prices with relative ease. This relatively smooth transition highlighted an important lesson: the ability of markets and individual agents to adjust to economic shocks should not be underestimated. The second event involved the oil-exporting countries. These countries received an inflow of financial resources from the rest of the world—with no conditionally attached—that far outstripped what any aid program could have provided. Thus, the savings constraint on economic growth was eliminated for this group of countries. It soon became clear, however, that the extent to which these financial inflows could be converted into tangible evidence of development was limited. Several of the oil-exporting countries have thus taught analysts a second important lesson: appropriate economic structures must be put in place and practices reformed before substantial resources can be efficiently invested in growth.

A similar lesson has been learned from the debt crisis. Throughout much of the 1970s, many developing countries, particularly in Latin America and Asia, found themselves able to borrow considerable sums from international capital markets. Yet in many cases, either these resources were not invested productively or the market structures in borrowing countries prevented them from being used efficiently. At the start of the 1980s, it became clear that these loans had not been invested in ways that would generate the stream of earnings necessary for repayment; in addition, world interest rates began to rise. At this point, the lenders ceased to lend, and both the borrowing countries and the international financial system were again plunged into crisis.

While the failure of many oil-producing countries to use their windfalls effectively was perhaps just a disappointment, the debt crisis threatened both the living standards of the Latin American debtors and the countries’ economic relations with the rest of the world. These economies had to adjust. But the external resources available to them diminished as lending flows dried up, forcing the governments to utilize domestic savings much more efficiently than before. In fact, this period saw the origin of some rather successful stabilization and structural reform programs in a number of Latin American countries, the fruits of which are now visible. Before the emergence of the economies in transition, much of what economists knew about successful structural reform and its link with macroeconomic stabilization came directly from the experiences of Latin American countries.

A third important strand in the current thinking about structural reform has developed out of the industrial countries’ experience. By the start of the 1970s, there was a marked slowdown in growth in the industrial world. This slowdown was caused in part by the exhaustion of the factors that had made the postwar economic miracles possible and in part by the increase in real energy prices. The industrial countries had adopted various measures to promote economic growth, such as multilateral trade liberalization, but even these efforts could not counteract the slowdown. This flagging growth was at the root of a number of economic policy problems. The fiscal positions of the industrial countries began to deteriorate alarmingly. Stagnation and inflation persisted, revealing macroeconomic policy’s growing inability to deliver price stability and full employment simultaneously.

As a result, policymakers began casting around for new ways to encourage growth. One important outcome of these efforts was the trend toward removing impediments to market efficiency. The significant structural reforms of the industrial countries date from this period, including financial market liberalization and reform; the removal of regulatory and price controls; efforts to tackle the deep-seated causes of fiscal deterioration; initial attempts to reform labor markets; and the privatization of state enterprises. These reforms constituted a sea change in the intellectual climate surrounding economic policymaking. There was a renewed awareness of the ability of free markets and competition to ensure the efficient allocation of resources.

A doctrine was fashionable at the end of the 1970s that perhaps sounds quaint today—supply-side economics. This school of thought, which was based on the proposition that low growth was the result of policies intended to bring supply and demand into equilibrium by reducing demand, also affected the IMF. If it was necessary to restore a balance of payments equilibrium or to cut inflation, the thinking went, in principle improving supply should work just as well as reducing demand. Furthermore, increasing supply could reduce the conflict between stabilization and growth.

This supply-side critique was applied to programs the IMF had been supporting. The reason many of these programs had not succeeded, it was argued, was that the IMF had focused too narrowly on reducing demand, deflating, and lowering absorption. If action could be taken to increase supply, the programs would achieve durable results more efficiently and with less pain. The most extreme critics even went so far as to argue that the macroeconomic stabilization policies the IMF had been proposing served to reduce supply even more than demand, exacerbating the problems of the countries concerned. Of course, the corollary of this extreme position was that more expansionary policies would solve balance of payments problems or inflation. This position was somewhat difficult to sustain, even for the IMF’s critics.

As a result, the IMF engaged in some self-examination in order to determine the validity of this particular critique. The institution was familiar with demand management, but less so with the supply-side policies it was being asked to support. Such policies clearly had to raise the efficiency of resource use and to shift resources into activities with higher rates of return. Initially, the IMF identified exchange rate policy as an appropriate supply-side tool, followed closely by price liberalization and the removal of trade and exchange controls. So, like Molière’s M. Jourdain, who was delighted to discover that he had unwittingly been speaking prose all his life, the IMF found that a good part of the traditional policy mix it had always recommended in fact consisted of supply-side measures.

Supply-side economics enjoyed a rather ephemeral popularity, failing to deliver the “gain without pain” that the original proponents had promised. But it did initiate a process within the IMF and elsewhere of systematically identifying and studying, as a complement to demand management policies, the policy elements that improved the efficiency of resource use. In political terms, supply-side measures did not prove significantly more palatable than measures affecting demand. Whereas demand restraint is generally disliked because it spreads the adjustment burden throughout society, supply-side measures (exchange rate changes, tariff reform, and interest rate liberalization, for example) tend to hurt special interest groups. The benefits go to a large, unidentified group and only become apparent well into the future. This phenomenon is well known in the academic literature on trade liberalization, in which it is clear who is hurt by trade liberalization, but not who gains from it.

The final element that has influenced the IMF’s thinking on the importance of structural reform has been the transformation of the economies in transition. The bankruptcy of the central planning model had been evident to people both inside and outside these countries long before the transition began. A series of partial economic reforms was initiated in the Soviet Union and Eastern Europe in the late 1950s. The limitations of these reforms soon became abundantly clear: while they could improve matters at the margin, they could not deal with central planning’s fundamental problems. With the collapse of the old political system, then, economic policymakers in several of the countries were ready to try something completely new: the wholesale replacement of existing economic structures with those of the free market. Creating market economies from scratch has been an extremely stimulating intellectual undertaking, and economists will be absorbing the lessons of this transformation for years to come.

The defects of the Soviet model were also apparent to the Chinese authorities, who as early as 1978 embarked on a program of market-oriented reforms that have continued successfully to this day. The Chinese authorities, too, found that high investment rates are not enough to ensure continued growth but need to be accompanied by efficient resource allocation and improved incentives to generate gains in productivity. The Chinese program has involved successive but cautious removals of administrative controls in certain economic sectors and a strengthening of competitive forces. Fifteen years of gradual reform have brought China increasing prosperity and given the rest of the world valuable experience in the techniques and problems of managing structural reform.

World Bank and IMF Responses

These various developments in thinking about structural reform and its link to macroeconomic policymaking have had their impact on the methods the IMF and World Bank use to help member countries design adjustment programs. When the three international financial and economic institutions were established at the end of World War II, structural reform, insofar as the concept existed at the time, was not seen as a legitimate matter of international concern. The participants at the Bretton Woods Conference said little about the issue. As specified in the Articles of Agreement, the IMF’s role is to promote macroeconomic stabilization and an open exchange system by providing members with temporary financial assistance. The original repayment period for IMF loans was intended to be three to five years, reflecting the view that stabilization and balance of payments adjustment were relatively rapid processes. The second institution, the World Bank, was designed to supplement national savings and to finance first reconstruction and later development projects. Finally, the third member of the Bretton Woods family, the step-sister, was the General Agreement on Tariffs and Trade (GATT), designed to promote open world trade through the multilateral exchange of tariff concessions.

Twenty-five years later, in the mid-1970s, the IMF had had a considerable measure of success in its programs with developing countries. As an institution, the organization had few doubts about the fundamental soundness of the policies it promoted. However, the intractability of balance of payments problems in some cases, and the temporary nature of stabilization in others, meant that countries often returned two or three years after IMF-supported programs had been implemented with precisely the same problems that the programs were intended to resolve. This experience led to the IMF’s recognition that (1) the policy mix of its programs might be too narrow, and (2) for reform to be successful, they might have to be pursued over a longer period and involve more than just macroeconomic variables.

Consequently, in 1974, the IMF established its extended Fund facility (EFF), which is designed for countries where balance of payments viability or the pursuit of an active development policy is inhibited by serious maladjustments in production and trade and where cost and price distortions have become widespread. The authorities of countries using this facility are required to draw up a three-year program of structural reforms, supported by quantified annual financial stabilization programs. In recognition of the rather more intractable nature of the problems being addressed, the repayment period has been lengthened twice, first to four to eight years, and later to five to ten years.

The lengthening of the time frame of IMF operations was matched by a shortening of the duration of World Bank programs. Just as the IMF began to recognize that macroeconomic stabilization could be jeopardized by a failure to tackle structural reform, the World Bank arrived at the realization that development projects were likely to be successful only if the investment took place in an appropriate overall policy environment. Thus, in the late 1970s, the World Bank began to supplement its traditional project lending with policy-based lending, which required governments receiving Bank resources to adopt programs of policy reform that would create a favorable climate for development. These programs were designed, in particular, to remove the structural impediments to the development process. In time, these structural adjustment lending operations (SALs) were supplemented by sectoral adjustment lending operations (SECALs), which related conditionality more narrowly to policies in specific economic sectors.

The IMF and World Bank were not the only organizations that were beginning to understand the need to adopt and sustain policies that would support adjustment and stabilization efforts. Aid donors were expressing considerable concern about the effectiveness of their programs. Experience suggested that aid programs were more likely to work in a supportive policy environment, and many studies confirmed this fact. Donors thus pressed the IMF and the World Bank to coordinate their approaches to supporting necessary structural and macroeconomic policy reforms in the developing world, especially in areas such as Africa.

Donor agencies and their countries’ representatives on the IMF and the World Bank Executive Boards were also conscious of a number of cases in which IMF and Bank programs and policy recommendations appeared to conflict. With this problem in mind, the Fund designed a new facility, the structural adjustment facility (SAF), which was later to be succeeded by the enhanced structural adjustment facility (ESAF). Based on the principles underlying the EFF, these facilities provide resources on concessional terms to support adjustment in the poorest member countries—broadly speaking, those eligible for the International Development Association (IDA) terms at the World Bank. The facilities are built on a three-year Policy Framework Paper (PFP), which each recipient country prepares with the assistance of the IMF and World Bank staffs. The PFP provides a plan that shows how the country intends to tackle the structural and development policy issues that may be impeding its growth. Implementation of the PFP is monitored through annual program documents covering the planned structural and stabilization policies. A recent report on ESAF programs that were in effect between 1987 and 1992 indicates that the facilities have generally been highly effective.

The ten countries (seven of them in sub-Saharan Africa) that sustained their efforts and completed three-year ESAF arrangements with full disbursements dramatically improved their performance. Their average growth rate increased from less than 1 percent before adoption of the SAF- or ESAF-supported program to over 5 percent in 1991–93; the estimated growth rate for 1993 is nearly 7 percent. Strong progress was also made in these countries in increasing export and import volumes and in reducing inflation.

Key Areas of Structural Reform

Because the most direct macroeconomic policy and stabilization tool a government has under its control is its budget, budgetary and tax reforms are a good starting point for this discussion. What is the legitimate extent of public expenditure, and how much can a government afford to spend? Answering these questions leads directly to the issue of redefining the scope of government, a question that has been exercising politicians throughout the world for many years. Considerations of efficiency, of political philosophy, and of affordability have led many countries to reform their budgetary expenditures, with the aim of seeing more services provided and, if possible, financed outside the government. There are some exceptions, such as the consideration now being given in the United States to public health care. Similarly, in the reforming countries of Eastern Europe and the former Soviet Union, the process of enterprise reform has forced governments to assume a number of responsibilities that had previously belonged to the enterprise sector, such as the provision of housing, and health and child care.

More generally, though, the economies in transition are undergoing a major redefinition of the scope of government. The budget is no longer seen primarily as a tool of resource allocation, but as a macroeconomic instrument and the vehicle for providing a “basket” of public services; the task of resource allocation has been taken from the budget and given to the market. Other budgetary reforms on the expenditure side may include cutting subsidies, a move that will help create a price system that better promotes efficiency; revamping long-term entitlement programs, such as family allowances, unemployment compensation, and pension schemes; and revitalizing state administrations, which are often overstaffed and lacking in people trained to provide the sort of services the public needs and expects. These changes all have a clear link to the sustainability of budgetary expenditure patterns.

At the same time, more attention is being paid to the need for social safety nets, or measures to protect low-income groups during the adjustment process. However, with social safety nets, it is often tempting to make benefits too accessible and too generous, with the result that these outlays burden the budget and distort incentives in the labor market. Nonetheless, safety nets may have a vital role to play in maintaining public support for adjustment programs.

A Few Possible Conclusions for Practical Application

Having touched on the most important areas of linkage between structural reform and stabilization, I want to look ahead to some of the conclusions that may come out of this seminar.

The first could be that it is important to understand exactly how this linkage works if the reform process is to be sustained. If policymakers understand how these different policies interact, they are better prepared to ward off problems and less likely to be thrown off the reform track when difficulties occur.

A second conclusion can be drawn from academic studies of adjustment and the growth process. A stable macroeconomic framework is a necessary—but not a sufficient—condition for sustainable economic growth and successful reform. Economies with low inflation, solid fiscal performance, and an open exchange system have achieved higher and more sustained levels of growth than economies lacking these features. Furthermore, the causality does seem to run from sound macroeconomic policies to growth. Improved factor market efficiency (one of the primary objectives of structural reform) speeds up the work of stabilization policies themselves and makes them cheaper in terms of lost output and employment.

A third conclusion could be that structural reform may itself be necessary to create the conditions for macroeconomic control. Some macroeconomic policies may not even be sustainable without structural reforms. For example, tight monetary policy may be impossible to maintain if enterprises have a soft budget constraint or access to soft financing from complaisant banks. Structural policies can also help build and maintain the political consensus that will support macroeconomic stabilization—for example, by combating unproductive and politically unpopular rent-seeking activities. Structural reforms can help construct an economic system with little scope for the corruption that is an obstacle both to winning political support and to developing efficient markets.

One fashionable subject is sure to come up: the correct sequencing of reforms. There are those who doubt whether this is a real issue. The argument in Eastern Europe (in Poland, for example) has been that the transition economies have little time to worry about sequencing. They have so much to do that they cannot take time out to debate what should be done first. I sympathize with those who see sequencing debates as excuses for inaction, but a respectable case can be made in support of the proper sequencing of some reforms, especially as far as financial market liberalization and the elimination of capital controls are concerned. This analysis is based largely on the experiences of capital account liberalization in the Southern Cone countries of Latin America.

Two of the tenets of the sequencing argument may seem a bit obvious. They are that unstable financial market conditions, particularly large fiscal deficits and financial repression, need to be removed before the capital account is liberalized; and that it is prudent to liberalize current account transactions before removing controls on capital account transactions. It is certainly true that once the capital account is freed and exchange controls removed, a whole new set of constraints on economic and financial policies emerges. For example, interest rates and exchange rate policy will need to be coordinated to ensure that the domestic rate of return on assets is similar to what can be earned abroad. Governments also need to take a realistic view of the market’s response to the country’s exchange rate policy.

A final conclusion for this seminar might be that an improved understanding of the linkage between structural reform and macro-economic stabilization can prevent a “stop-and-go” pattern of reforms. Without such an understanding, structural reforms may be put on hold or even reversed when macroeconomic imbalances emerge. Thus, for example, a surge in inflation may tempt authorities to reintroduce price controls, or a worsening in the balance of payments may cause a government to lean toward reinstating exchange and trade controls.

There is still much to understand about the link between macroeconomic stabilization and structural reform, and the thinking on this subject is sure to change in the period ahead. For instance, several important country experiences have not yet been fully integrated into our thinking. It is rather surprising that economic policymaking has been so little affected by one of the most important economic events of the last two decades: the rapid growth of the East Asian countries, especially Hong Kong, Singapore, Taiwan Province of China, and Korea, as well as Thailand, Malaysia, and others. Perhaps it is hard to identify immediately the common strands of economic policy in these countries. The economic policy mix seems to have varied considerably from liberal in (for example) Hong Kong, to more interventionist in other economies, such as Korea. It would be more than useful to identify those features of the East Asian experience that were key to the impressive growth performance of these countries, and to learn why the bureaucrats in parts of East Asia seem to be more successful than those elsewhere.

Another experience that has yet to be fully integrated into our thinking is Japan’s postwar economic history. The Japanese authorities are encouraging both the IMF and the World Bank to consider Japan’s development more closely, with the aim of seeing how relevant aspects can be better integrated into the institutions’ policy advice.

Finally, the experience of reform in the economies in transition, including China, is particularly challenging intellectually, because it raises questions about some of the fundamentals of a market economy. As these countries struggle to create market economies from scratch, they inspire a rethinking of what is essential to a successfully functioning economy and a reevaluation of the ways the various parts of an economy work together. It will be many years before economists fully understand what they are learning from these countries. But the important point is that learning is taking place, and for this reason, the current seminar is an important event. The IMF staff who will be present here need to learn from the experience of participating countries. The IMF may offer advice and help, but it is the work of policymakers such as yourselves, who must make the difficult decisions and assume the responsibility for policy successes and failures, that supplies the material on which that advice is based. I think I speak for many in saying that we hope to learn a great deal from you during the week.