Abstract

In analyzing the effects of Fund-supported adjustment programs on the level or rate of growth of output, it is crucial first to consider the circumstances in which such programs are introduced. Typically the need for a stabilization program, whether supported by the Fund or otherwise, arises when a country experiences an imbalance between aggregate domestic demand (absorption) and aggregate supply, which is reflected in a worsening of its external payments position. While it is true that such external factors as an exogenous deterioration of the terms of trade or an increase in foreign interest rates can be responsible for the basic demand-supply imbalances, often these imbalances can be traced to inappropriate domestic policies that expand aggregate domestic demand too rapidly relative to the productive potential of the economy and seriously distort relative prices.3 If foreign financing is available, the relative expansion of domestic demand can persist for extended periods—albeit at the cost of a widening current account deficit, a loss of international competitiveness owing to rapid domestic inflation, an inefficient allocation of resources because of the distortions in relative prices, and a heavier foreign debt burden.

Objectives

In analyzing the effects of Fund-supported adjustment programs on the level or rate of growth of output, it is crucial first to consider the circumstances in which such programs are introduced. Typically the need for a stabilization program, whether supported by the Fund or otherwise, arises when a country experiences an imbalance between aggregate domestic demand (absorption) and aggregate supply, which is reflected in a worsening of its external payments position. While it is true that such external factors as an exogenous deterioration of the terms of trade or an increase in foreign interest rates can be responsible for the basic demand-supply imbalances, often these imbalances can be traced to inappropriate domestic policies that expand aggregate domestic demand too rapidly relative to the productive potential of the economy and seriously distort relative prices.3 If foreign financing is available, the relative expansion of domestic demand can persist for extended periods—albeit at the cost of a widening current account deficit, a loss of international competitiveness owing to rapid domestic inflation, an inefficient allocation of resources because of the distortions in relative prices, and a heavier foreign debt burden.

Clearly, this disequilibrium cannot continue indefinitely, as the country steadily loses international competitiveness and eventually credit worthiness. In the absence of appropriate policy action, a cessation of foreign financing would impose adjustment on the country, and this forced adjustment is likely to be very disruptive. The basic objective of the Fund in these circumstances is to provide for a more orderly adjustment of the imbalance between absorption and aggregate supply so as to achieve a viable balance of payments position within a reasonable period of time. A viable balance of payments has two aspects. First, it implies that the balance of payments problems will not merely be suppressed but eradicated, and second, that the improvement in the country’s external position will be durable.

The Fund’s task is, in the first instance, to ensure that foreign financing attains a level consistent with the country’s present and future debt-servicing capacity. This may involve setting limits on foreign borrowing or, as has been more evident in recent years, ensuring that the requisite inflow of foreign capital is in fact forthcoming to fill the financing gap.4 The permissible rate of foreign borrowing defines the necessary degree of adjustment of the imbalances in the economy. To achieve the required adjustment, the Fund designs a stabilization program that includes measures to restore a sustainable balance between aggregate demand and supply and simultaneously to expand the production of tradables, thereby easing the balance of payments constraint.

Policy Content

Description of Fund Programs

Although stand-by arrangements with the Fund are often viewed as synonymous with devaluation and domestic credit restraint, Fund programs are in fact complex packages of policy measures geared to the particular circumstances of the country.5 More important, the choice of policies and the nature of the policy mix in programs result from extensive negotiations between the country authorities and the Fund. Aside from monetary and exchange rate policies, a typical Fund program calls for fiscal measures, such as reductions in government expenditures and increases in taxation, increases in domestic interest rates and producer prices to realistic levels, policies to raise investment and improve its efficiency, trade liberalization, and wage restraint. Considerable overlap among these various policies does not preclude the convenience of grouping them into the following three categories: demand-side policies, supply-side policies, and policies to improve international competitiveness.

Demand-side policies are measures that influence the aggregate level or rate of growth of domestic demand and absorption. Such policies include the whole range of fiscal, monetary, and domestic credit measures associated with traditional macroeconomic policy. Although these policies also affect production and supply, it is useful at this level of abstraction to label policies that primarily affect aggregate absorption as “demand-oriented” policies.

Supply-side policies are intended to increase the volume of goods and services supplied by the domestic economy at any given level of domestic demand. Such supply-oriented policies can be divided broadly into two groups. First, there are policies designed to increase current output by improving the efficiency with which factors of production, such as capital and labor, are utilized and allocated among competing uses. This category includes measures to reduce distortions caused by price rigidities, monopolies, taxes, subsidies, and trade restrictions. The second group encompasses policies designed to raise the long-run rate of growth of capacity output. Under this heading are incentives for domestic saving and investment. Also important are policies designed to increase the inflow of foreign savings, whether in the form of private lending, foreign direct investment, or increased development assistance. These two groups of supply-side policies are obviously interrelated, since policies that increase current output may, by themselves, lead to a larger flow of saving and investment and a higher rate of growth of capacity output.

Policies to improve international competitiveness contain elements of both demand-side and supply-side policies, since they are based on combinations of measures (such as devaluation cum wage restraint) intended to affect the program country’s real exchange rate. Improving competitiveness is why considerable importance often attaches to the role of exchange rate policies in stabilization programs. In general, to the extent that a combination of policies alters the real exchange rate, it will affect both real domestic absorption and the incentive to produce tradable goods.

In summary, it would be misleading to suggest that Fund programs rely exclusively on one or two policy instruments directed solely at restraining domestic demand. As the above discussion has indicated, much more is involved in the design of Fund programs than a mechanical application of the simple monetary approach to the balance of payments, supplemented perhaps by an exchange rate change.6 From this standpoint, it may be noted that many alternative policies proposed by critics, particularly those relating to the supply side, already form an integral part of Fund programs. For example, in one of the few concrete expositions of an alternative stabilization strategy, Diaz-Alejandro (1984) sets out a policy package whose general characteristics are in most respects indistinguishable from a typical Fund program.7 Considering the case of a country experiencing high inflation and facing an unsustainable balance of payments position, the author proposes a policy package including fiscal and monetary restraint, wage guidelines, increases in domestic interest rates to positive real levels, gradual tariff reductions, the introduction of incentives for import substitution and export promotion, measures to maintain and expand investment, and the adoption of a crawling-peg exchange rate regime, with emphasis placed in the direction of “undervaluation” of the real exchange rate to support export promotion and import liberalization. Other critics of Fund policies, such as Taylor (1981), have further argued for the use of controls on imports and capital flows as a substitute for demand-management policies and exchange rate action on the grounds that these are less costly alternatives.

If the guidelines for stabilization suggested by Diaz-Alejandro (1984) are taken as representative of programs typically proposed by the critics of the Fund, there is little to take issue with. The basic difference, if any, arises from some critics’ proposal to use controls as a policy to correct balance of payments problems. Fund policy leans heavily in the direction of eliminating controls and restrictions on trade and payments; nevertheless, the Fund has on occasion accepted the temporary use of import controls and export subsidies and, as an interim arrangement, the continuation of dual exchange markets. What the Fund has consistently opposed is the introduction of new restrictions, as well as the intensification on a permanent basis of existing restrictions and other distortions in the trade and payments system.8 Although a theoretical case can be made for controls and restrictions in the short run, in practice it has proved difficult to manage such systems efficiently and effectively over time. Furthermore, such policies, by introducing rigidities in the economy and creating incentives for the inefficient use of resources and forms of production, can turn out in the long run to be counter-productive in the long run and damaging to the growth potential of the economy.

Choice of Policy Instruments

A crucial concern that arises in the design of adjustment programs is how much emphasis should be placed on supply-side policies relative to demand-side policies. As the need for a stabilization program typically reflects excess demand, all programs must involve some degree of restraint of aggregate domestic demand. This does not mean, however, that adjustment should be based exclusively on reducing absorption—the imbalance could in principle also be eliminated through expanding domestic supply. In fact, demand-side and supply-side policies are closely interrelated. Policies designed to achieve a higher growth rate in the medium term generally require an increase in the rate of productive investment, while demand-management policies require a reduction in the savings-investment gap. The policy package, therefore, must be designed to reduce the level of aggregate domestic demand and simultaneously to cause a shift in its composition away from current consumption and toward fixed capital formation.

Notwithstanding the difficulties of implementing supply-side policies as part of an adjustment program, the Fund has stressed their importance in improving efficiency and the long-term rate of growth. The first difficulty is that many types of supply-side measures improve output only after a significant delay.9 For example, investment programs designed to raise the rate of growth of capacity output take time to come to fruition. Steps to create improved incentives for production and exports by eliminating distortions in the structure of relative prices take time to exert beneficial effects, particularly if labor and capital are not very mobile among different activities. In this case, major changes in the pattern of resource allocation may necessitate a long period of adjustment during which some factors of production remain unemployed. As these examples suggest, most supply-side measures—even those designed to alter output by improving price incentives rather than by increasing investment—may exert beneficial effects only over the longer term. These examples also suggest that the extent to which supply-side policies can be emphasized relative to demand-side policies in a program depends on the length of the period over which adjustment is intended to achieve its objective. This horizon is obviously constrained by the amount and duration of foreign financing that a Fund program can make available to the country through the Fund’s own resources, private banks, and other sources.

A second constraint on the use of certain supply-side measures is the possibility that they may affect the political and social objectives of governments. Many government policies that create distortions (that is, deviations of prices from marginal costs) are designed to achieve objectives other than economic efficiency and may have been implemented with full knowledge of their likely adverse effect on resource allocation. Such policies may include food subsidies, employment programs, restrictions on imports of certain categories of goods and services, and capital controls. Changes in such policies often have a strong impact on equity as well as economic efficiency, and the Fund is enjoined to respect the views of sovereign governments in these matters, although it can, and frequently does, render advice on the budgetary costs of such policies.

Even if these difficulties with supply-side policies are somehow overcome, this does not imply that demand-side policies can be dispensed with. Supply-side policies by themselves do not guarantee an improvement in the balance of payments because, other things being equal, aggregate demand can rise beyond sustainable levels even with increasing aggregate supply, unless it is restrained from doing so. Consequently, stabilization programs have to use both sets of policies, and the decision on the relative emphasis that is to be placed on demand and supply measures in Fund programs is based on a number of criteria. These include:

  • (i) The nature, magnitude, and likely duration of the external payments imbalance. For example, if a deterioration in the country’s external terms of trade causes the balance of payments deficit, the appropriate response would include supply-side measures designed to change the basic structure of production in the economy. In other words, an adverse external development may alter the mix between demand and supply measures. By contrast, if the initial disequilibrium is the result of excess aggregate domestic demand, owing perhaps to excessively expansionary fiscal and domestic credit policies, then the response would normally rely more heavily on demand restraint than on supply-side measures.

  • (ii) The initial level of the country’s external indebtedness and the amount of additional financing that can be expected. These conditions determine the length of time over which the adjustment process can take place.

  • (iii) The nature and importance of the constraints facing the government in pursuing policies that have important social and political implications.

Issues Relating to Growth

The general criticism that Fund programs are in some sense inimical to growth can be decomposed into two specific criticisms. The first is that a number of policy recommendations contained in Fund programs—particularly those relating to the restraint of aggregate domestic demand and to altering the exchange rate—are thought to exert an adverse effect on economic growth, employment, and the level of activity. The second is that the policy recommendations are also unduly harsh, deflating the economy more than is in fact needed to secure the objectives of the stabilization effort.

In addressing these criticisms, a distinction needs to be drawn between the short-term issues and the longer-term issues relating to the effects of Fund programs on growth.

Short-Term Issues

If the initial problem is excess aggregate domestic demand, then, in order to achieve the objectives of the adjustment program, absorption must be reduced in the short run. Although this reduction in absorption can be perceived as representing a decline in living standards, it should not be regarded as a “cost” of the program, since absorption is merely being brought back into line with availability of resources. The real issue is how the reduction in absorption—whether brought about by appropriate demand-side policies or by exchange rate action—will influence the level and rate of growth of output or real income. In theory, situations can be conceived in which the reduction in absorption can be achieved without diminishing output. This result would be possible, for example, if all of the adjustment is entirely confined to the current account of the balance of payments and is achieved through some combination of an increase in receipts and a decrease in payments. In practice, however, this extreme result is unlikely to occur, and the reduction in absorption necessary to achieve the objectives will generally be accompanied by some fall in the growth of output, particularly if inflation has become ingrained in the system. This decline in the growth rate is a necessary part of the adjustment to eliminate underlying imbalances in the economy. In other words, the adjustment aims at leading the economy onto a more stable and sustainable growth path from a higher but unsustainable path that generally accompanies the supply-demand imbalances. The critical question, of course, concerns the size and duration of the short-run effects of policies designed to reduce absorption.

The second line of criticism mentioned above questions the overall design of Fund programs and is more difficult to assess objectively. Fund programs are not intended to reduce a country’s absorption of goods and services below the level that can be financed (out of current savings and capital inflows) on a sustainable basis. Any reductions in absorption and growth that go beyond the levels necessary to achieve the objectives of the program can be fairly viewed as the true “costs” of a program. Since the “necessary” reduction in absorption and the consequent decline in growth, however, are not measurable precisely, such a notion of costs is difficult to quantify. To estimate these costs would require, in the first instance, a clear idea of the quantitative relationships between policy instruments and the levels and growth rates of absorption and output. Second, it would be necessary to undertake a careful study of specific stand-by arrangements to determine the amount of adjustment that would be required to achieve the target, and then set the policies accordingly. Third, the effects of a given Fund program would have to be compared with the outcomes for growth resulting from an alternative feasible set of policies that would achieve the same objectives.10 This last point involves estimating an unobserved hypothetical outcome, which as yet has proved to be a fairly intractable problem and which will be considered later.

Long-Term Issues

A longer-term aspect of the relation between Fund programs and growth also needs to be considered in any systematic analysis of the subject. Even if it was determined that stabilization programs reduce output in the short run, this deficiency could be outweighed by the long-term benefits resulting from the adoption of suitable adjustment policies. Indeed, it is a basic premise of Fund programs that balance of payments recovery does not conflict with economic growth when the time-horizon of both objectives is properly specified to be the medium term.

This view is based on a number of considerations. First, even if a reduction in absorption impairs growth over the short run, to the extent that a Fund program succeeds in avoiding the drastic cut in absorption that accompanies a complete loss of creditor support, the program can be said to protect the growth of the economy currently and in the future. Second, the supply-side, or structural, policies in adjustment programs are intended to enhance the productive potential of the economy by improving the allocation of resources and stimulating domestic savings and investment. If such policies are successful, they diminish any inescapable impact upon growth of measures that focus on reducing absorption. Furthermore, by raising the capacity of the country to service debt in the future, these structural policies allow for a higher level of sustainable capital inflows, and thus a higher rate of economic growth in the long run. Lastly, financial stability resulting from a successful stabilization program can have a beneficial effect on the state of confidence in the economy. This confidence can encourage both domestically financed and foreign-financed investment, leading to gains in employment, productivity, and output.

Empirical Analysis

Against this background, a comprehensive empirical analysis of the effects of Fund-supported adjustment programs would have to consider at least the following questions: (a) What are the short-run effects of Fund-supported adjustment programs on the level or rate of growth of output? (b) Are these effects larger than they need be to achieve the principal objectives of the program and, in particular, are they significantly larger than the effects that would result from an alternative set of policies? (c) What are the effects of Fund-supported adjustment programs on the long-run rate of growth of the economy, and how do these relate to the short-run effects?

Unfortunately, empirical evidence is available only on the first of these questions. The studies that can be used to examine whether adjustment programs of the type supported by the Fund have a short-run effect (negative or positive) on growth can be divided into two broad categories. First, certain studies use time-series data to determine the effects of specific policies. These can be viewed as “model-based” studies, in that they rely on some theoretical notion of the channels by which changes in individual policies are likely to affect the growth rate in the short run and then proceed to test the resulting relationship through the use of standard econometric methods. Such time-series studies yield no direct evidence on the effects of Fund-supported programs per se, as they do not necessarily pertain to countries that have had programs with the Fund, to the time periods over which programs were operative, to the actual policies adopted in the context of programs, nor to the circumstances typically prevailing when the programs were introduced. At the same time, however, the results reported in these studies can be used to infer the effects of programs, if these programs include the same types of policies. For example, if there is evidence in the empirical literature that devaluation or restrictive monetary policies exert an adverse impact on output in the short run, it can be inferred that, other things being equal, a Fund-supported program that relied exclusively on these measures would also initially reduce growth.

The second group of studies uses cross-country analysis to examine how economic growth is affected by a Fund-supported program, taken as a complete package of measures. Such studies have been undertaken, both within the Fund and outside, to test the overall effectiveness of programs. These cross-country studies provide more direct evidence than the time-series studies on the question of the effect of Fund programs, since they focus explicitly on the experiences of countries with programs. Furthermore, they are wider in scope, as they evaluate the impact of different combinations of policies rather than looking only at individual policies. On the other hand, such studies cannot determine how much a given outcome is due to the policies adopted rather than to other (non-program) factors.11

Comparing the quantitative effects of Fund programs with the corresponding effects of some feasible set of alternative policies—that is, providing answers to the second question—is regarded as perhaps the most appropriate approach to judging the costs of programs.12 For example, if a typical Fund program includes such policies as a reduction in the rate of credit expansion, a lowering of the fiscal deficit, and devaluation, and if the effects of such policies on growth are known, then the effects of this combination of policies can be compared with some alternative combination that yields the same targets for current account, overall balance of payments, and inflation. Clearly, counterfactual experiments of this type would determine whether Fund programs are somehow more deflationary than necessary.

The “comparison of policies” approach to judging the effects of programs, however, runs into a number of difficulties. This approach requires, first of all, detailed empirical knowledge of the links between the various policy instruments included in a typical Fund program and the ultimate objectives for the balance of payments, inflation, and the growth rate. The state of the art in econometric modeling has made significant advances but is as yet still very much in its infancy, particularly in the case of developing countries. The models that are available at present do not come close to capturing the full complexity of the relevant economic relationships.

Even if an appropriately specified model incorporating the full range of measures in a Fund program was available, a number of additional issues would still have to be faced. First, to the extent that expectations are altered when a Fund program is adopted, the effects would not depend solely on the magnitude of the announced policy changes and the coefficients relating policies to ultimate objectives based on past historical experience. For example, an announced reduction in monetary growth could lead to an immediate fall in inflation if it caused domestic residents to revise downward their expectations of the future rate of inflation. Conversely, if the policy change is not viewed as credible, inflation could persist for much longer than the underlying estimated relationship would indicate, and the adverse effects of an anti-inflation program on output and absorption would be correspondingly larger. It is for this reason that the Fund staff tries to ensure that the overall package of measures comprising a Fund adjustment program will be viewed as credible by both domestic residents and foreign creditors.

Second, the comparison of policies using model simulations would have to start by taking explicit account of the disequilibria that the country faced at the time the stabilization program was introduced. However, this is no easy task for two reasons. If the analysis is begun from a position of disequilibrium, it would be difficult to distinguish changes that occurred as a result of discretionary policy actions from those that would have occurred in any case, owing to the automatic processes that tend to adjust the balance of payments and the domestic inflation rate in an open economy. Moreover, the time path of the variables during the transition period, and indeed the transition period itself, are not independent of the initial conditions. Consequently, it would be hard to determine whether the behavior of a variable during transition is due to the policies adopted or simply to the point from which it started.

Third, the alternative sets of policies against which to compare a given Fund program must be precisely defined. These alternatives can presumably differ in the mix of policies consistent with the same objectives (more emphasis on demand-management or on structural policies) or in terms of policy instruments (controls on imports versus devaluation). These alternative programs must, however, have the following features to make them suitably comparable with Fund programs. To begin with, the alternative policies have to be defined in the context of a common set of constraints, such as the state of the international environment and the availability of foreign financing, including financing provided by the Fund. It would be pointless to compare Fund programs with alternatives that assumed a lower level of foreign interest rates and a larger volume of foreign financing. Moreover, the time frame of the adjustment would have to be the same as that faced by the Fund. Comparing programs that differ in terms of the period over which adjustment is to take place would clearly be inappropriate. Furthermore, the alternative package would have to be acceptable to the country. Since Fund programs are the outcome of detailed negotiations between country authorities and the Fund, they reflect the political feasibility of the proposed set of policy measures. Finally, the alternative policies would have to be put forward at the same level of specificity as those included in Fund programs. For example, if export promotion is to receive greater weight, the exact methods for achieving this objective have to be specified. As mentioned above, few if any alternative programs proposed in the literature have such features.

Given such problems, it is easy to see why no empirical studies are available that undertake the relevant comparisons between Fund programs and alternative programs. Consequently, there is no obvious way of determining whether or not Fund programs are “too harsh.” Of course, performing counterfactual experiments with existing models is possible, but these experiments have to be kept simple. For example, one can analyze the effects of certain policies (credit restraint, reduced government expenditures, devaluation) or compare the effects of a package including such measures with a package that also includes more supply-oriented policies.13 Because of the fairly simplistic structure of the available models and the narrow range of policy measures considered, however, these comparisons of policies can at best be only illustrative.

Little empirical evidence exists on the long-run effects of Fund programs, and none at all on the effects of various combinations of stabilization policies on economic development (question (c)). Even the informal evidence that is available is ambivalent on the relationship between financial stability and economic development. While many developing countries have achieved both price stability and high growth by adopting prudent financial policies, a number have also managed to combine high rates of inflation with strong growth performance for extended periods of time. (At the same time, of course, many countries have simultaneously experienced high inflation and low rates of growth.) Some indirect evidence, however, can be brought to bear from studies of the growth process in developing countries. For example, if the structural policies contained in Fund programs raise the level of investment and increase its efficiency, as they are intended to do, this will presumably result in a higher rate of growth in the long run. At the same time, investment is only one factor in determining growth, and little is known about the effects of stabilization policies on the other factors, such as the growth of the labor force and its productivity, development of skills, and technical progress.

For the reasons outlined above, any study of the quantitative effects of Fund programs has to be severely limited in scope. At this stage the only question on which there is some empirical evidence is whether policies designed to reduce absorption and increase supply, including exchange rate policies, have a significant effect on the growth rate in the short run, namely question (a). Accordingly, the next three sections of this paper survey the recent empirical literature that has a bearing on this question. The time-series and cross-country studies that provide the empirical evidence are examined individually, and the results are then combined to draw some conclusions about whether Fund programs have a systematic adverse effect on growth. By considering only these two types of studies, the paper interprets “empirical evidence” in a fairly narrow and specific way. In particular, the present survey excludes case studies of the experience of individual countries with stand-by programs,14 because of the difficulties in trying to generalize from the evidence on a particular country at a particular time and because the case studies do not in general subject the basic propositions to any kind of formal statistical testing. This survey will obviously not resolve the controversy associated with Fund programs and economic growth; it is meant to represent only a first step toward such a resolution.

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  • Taylor, Lance, Jeffrey A. Rosensweig, “Devaluation, Capital Flows and Crowding-Out: A Computable General Equilibrium Model with Portfolio Choice for Thailand” (unpublished, Washington: International Bank for Reconstruction and Development, November 1984).

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