Microeconomic myopia

The Trade and Development Report points out how microeconomic models lead to absurdities when applied as policy prescriptions to a national economy.

AFTER a few years of economic boom, in which commodity prices soared and most developing countries experienced significant increases in export revenues, the world economy suddenly seems to have become more fragile and unstable. For many people of the developing world who did not benefit from the recent boom, it may come as a surprise that these have been the good times. But it is also clear beyond doubt that these good times, such as they were, are over for the time being.

The recent period has been one in which reduced current account deficits or growing current account surpluses and substantial capital inflows were associated with the accumulating foreign exchange reserves of developing countries. This has in turn led to the paradoxical and unfortunate situation of the developing world as a whole and most of its individual member countries exporting capital to the capital-abundant developed countries, especially the United States.

While this ability to export capital to the North did reflect greater macroeconomic and balance of payments stability in the South, it also amounted to a huge missed opportunity within the South, given that the development project is far from being even partially completed in most countries.

But now, that the recent trends are being threatened, altered or even reversed by the turmoil in international financial markets, the inevitable slowdown of Northern economies and the sharply rising and very volatile prices of important primary commodities, including food and of universal intermediates such as fuel, the outlook for developing countries is much more uncertain. How do developing country governments deal with this change?

The latest Trade and Development Report (TDR) produced by the United Nations Conference on Trade and Development (UNCTAD) addresses this question directly by focussing on important macroeconomic policies that will allow developing countries to continue to pursue goals of industrialisation and diversification. (Commodity prices, capital flows and the financing of investment, TDR 2008, UNCTAD, Geneva).

The report covers a wide area, which cannot be adequately summarised here. But it is particularly important because it provides a different perspective from that of other international organisations such as the World Bank, the International Monetary Fund or the World Trade Organisation on the significance of certain prices. The emphasis of these institutions in the past, as expressed in the Washington Consensus, was on getting prices right in the microeconomic sense of aligning domestic relative prices of goods and services with international relative prices.

But UNCTAD focusses on a different set of prices: the macroeconomic prices that determine both internal economic conditions and external competitiveness. The most significant prices in this sense are defined as the exchange rate, the interest rate and the wage rate. What is significant is that all of these are seen as policy variables, or in some sense being, if not directly determined then at least strongly, affected by government policy. This, itself, is refreshing in a world in which it has been assumed for far too long that such macroeconomic prices are market-determined, despite all the insights of Keynes and Kalecki, not to mention Marx.

The malaise that has gripped the economics profession and thereby also economic policymakers is one that comes from assuming that macroeconomic issues can be analysed with the same tools that are used in microeconomic models. The TDR provides a wonderful quotation from Kaldor to illustrate this point: Primitive religions are anthropomorphic. They believe in gods which resemble human beings in physical shape and character.... [Anthropomorphic economics applies] to the national economy the same principles and rules of conduct as have been found appropriate to a single individual or family paying your way, trimming your expenditure to fit your earnings, avoiding living beyond your means and avoiding getting into debt. These are well-worn principles of prudent conduct for an individual, but when applied as policy prescriptions to a national economy they lead to absurdities.

If an individual cuts his expenditure he will not thereby reduce his income. However, if a Government cut their public expenditure programme in relation to tax rates and charges, they will reduce the total spending in an economy and hence the level of production and income. (Kaldor 1983, quoted in TDR 2008, page 67.)

So then, what are the appropriate policies with respect to these macroeconomic prices? With respect to exchange rates, the TDR notes that the recent strategy of many developing countries is to create and defend external competitive positions by undervaluing their exchange rates. This promotes exports and allows them to avoid the dependence on capital markets that results from current account deficits. Because such a strategy typically requires central bank intervention in foreign exchange markets, it has led to a rapid accumulation of foreign exchange reserves, and therefore capital outflows, in developing countries.

This strategy has stemmed from the recognition that a competitive exchange rate can be a key factor in increasing aggregate demand (in this case, export demand) in the short run and achieving more rapid growth in the long run. This positive effect of the exchange rate cannot be denied. But it is also true that this focus on keeping the exchange rate low is similar to other strategies to maintain external competitiveness, such as wage compression and lower taxes and more subsidies for corporates.

Such essentially mercantilist policies may well be counterproductive if many countries adopt them because it is impossible for all countries to achieve increasing market shares and have current account surpluses at the same time. The damage that can be caused by rounds of competitive devaluation was evident in the inter-War period of the 20th century, and the dangers are just as present today.

The second crucial macroeconomic price is the interest rate or, more precisely, the availability of adequate, reliable and cost-effective financing of investment. The TDR notes that this can actually be undermined by many measures of financial liberalisation that apparently aim at good governance or strengthening market forces. Overly restrictive monetary conditions can constrain growth and even become prohibitive for development. The TDR notes, wryly, that this may explain why the Washington Consensus was never applied in Washington: the United States, after flirting briefly with monetarist orthodoxy in the 1980s, returned to fine-tuning the interest rate and to an extraordinarily accommodative monetary policy stance over the past two decades (page 74).

The TDR, drawing from a Keynes-Schumpeter tradition, argues that the financing of investment depends primarily on savings from corporate profits and the ability of the banking system to create credit. This in turn requires the recognition of the positive effects of demand and profit expectations and incentives for domestic entrepreneurs and emphasises the need for reliable and affordable financing for enterprises of all sizes.

The contrast with the standard neoclassical model, which talks of raising savings of private households and attracting foreign savings to raise domestic investment, could not be greater. As the TDR stresses, an increase in savings is not a prerequisite for either higher investment or an improvement in the current account. Instead, changes in the current account lead to changes in the level of investment and savings.

The final, important macroeconomic price, the wage, is the one on which the TDR has relatively little discussion. But the point made is important and, once again, mostly forgotten or unrecognised today. Wage compression is both unreliable and undesirable as a method of trying to achieve external competitiveness. Indeed, sustained growth requires that domestic wage incomes grow (ideally at the same rate as productivity) so as to generate domestic demand and create the virtuous cycle of more demand, more profits, more investment, more output, more employment, more demand.

Obviously, money wage increases have to be such as to preserve price stability. But the pendulum has probably swung the other way in the recent past, such that even the accelerating inflation in food and other commodities has not really generated greater money wage pressures because of the much weakened bargaining power of the working class almost everywhere in the world. The TDR highlights the need for appropriate wage and incomes policies that can be used to support an investment-led development process without risking an acceleration of inflation (page 74).

It is actually surprising that all this sounds so fresh and different: after all these are old insights that were well known to development economists more than half a century ago. But the miasma created by the relatively simplistic market-oriented policy paradigm has been so effective that these basic truths have been forgotten or dismissed. TDR 2008 is, therefore, of great consequence, since it brings back to the international policy discussion the basic questions regarding the macroeconomics of development.