Gordon Brown, who was UK chancellor of the exchequer (finance minister) before becoming Prime Minister, prided himself on having earned the nickname the iron chancellor. This sobriquet used to be associated with the former German chancellor (prime minister), Otto von Bismarck, but, unlike Bismarck’s ‘ironmongery’, which was in foreign policy, Brown’s ‘ironmongery’ was in the area of public finance. He has been praised for his resolve in not giving in to the demand for deficit spending, coming from his supporters in the public sector, who were understandably clamouring for more money after years of Conservative budget cuts. Brown constantly emphasized the importance of prudence in fiscal management, so much so that William Keegan, a leading British financial journalist, called his book on Brown’s economic policy The Prudence of Mr.Gordon Brown. Prudence, it seems, has become the supreme virtue in a finance minister.
Emphasis on fiscal prudence has been a central theme in the neo-liberal macroeconomics promoted by the Bad Samaritans. They argue that government should not live beyond its means and must always balance its budget. Deficit spending, they argue, only leads to inflation and undermines economic stability, which, in turn, reduces growth and diminishes the living standards of people on fixed income.
Once again, who can argue against prudence? But, as in the case of inflation, the real question is what exactly it means to be prudent. For one thing, being prudent does not mean that the government has to balance its books every year, as is preached to developing countries by the Bad Samaritans. The government budget may have to be balanced, but this needs to be achieved over a business cycle, rather than every year. The year is an extremely artificial unit of time in economic terms, and there is nothing sacred about it. Indeed, if we followed this logic, why not tell governments to balance its books every month or even every week? As Keynes’s central message had it, what is important is that, over the business cycle, the government acts as a counterweight to the behaviour of the private sector, engages in deficit spending during economic downturns and generates a budget surplus during economic upturns.
For a developing country, it may even make sense to run a budget deficit on a permanent basis in the medium term, as long as the resulting debt is sustainable. Even at the level of individuals, it is perfectly prudent to borrow money when you are studying or raising a young family and to re-pay the debt when your earning power is higher. Similarly, it makes sense for a developing country to ‘borrow from future generations’ by running budget deficits in order to invest beyond its current means and thereby accelerate economic growth. If the country succeeds in accelerating its growth, future generations will be rewarded with higher standards of living than would have been possible without such government deficit spending.
Despite all this, the IMF is obsessed with developing country governments balancing the books every year, regardless of business cycles or longer-term development strategy. So it imposes budget balancing conditions, or even the requirement to run a surplus on countries in macroeconomic crisis that could actually benefit from deficit spending by the government.
For example, when Korea signed an agreement with the IMF in December 1997 in the wake of a currency crisis, it was required to generate budget surplus equivalent to 1% of GDP. Given that a huge exodus of foreign capital was already pushing the country into a deep recession, it should have been allowed to increase government budget deficits. If any country could afford to do this, it was Korea – at the time, it had one of the smallest stocks of government debt as a proportion of GDP in the world, including all the rich nations. Despite this, the IMF barred the country from using deficit spending. Little wonder that the economy nose-dived. In the early months of 1998, over 100 firms a day were going bankrupt and the unemployment rate nearly trebled – no surprise, then, that some Koreans dubbed the IMF ‘I’M Fired’. Only when this uncontrollable downward economic spiral looked set to continue did the IMF relent and allow the Korean government to run a budget deficit – but only a very small one (up to 0.8% of GDP).[24] In a more extreme example, following its financial crisis in the same year, Indonesia was also instructed by the IMF to cut government spending, especially food subsidies. When combined with a rise in interest rates to 80%, the result was widespread corporate bankruptcy, mass unemployment and urban riots. As a result, Indonesia saw a massive 16% fall in output in 1998.[25]
If they were in similar circumstances, the rich Bad Samaritan countries would never do what they tell the poor countries to do. Instead they would cut interest rates and increase government deficit spending in order to boost demand. No rich country finance minister would be stupid enough to raise interest rates and run budget surplus during economic downturns. When the US economy was reeling from the aftermath of the burst of the so-called dot.com bubble and the September 11 bombing of the World Trade Center at the beginning of the 21st century, the solution taken by the supposedly ‘fiscally responsible’, anti-Keynesian republican government of George W. Bush was – you’ve guessed it – government deficit spending (combined with a monetary policy of unprecedented laxity). In 2003 and 2004, the US budget deficit reached nearly 4% of its GDP. Other rich country governments have done the same. During 1991–1995, a period of economic downturn, the ratio of government deficit to GDP was 8% in Sweden, 5.6% in the UK, 3.3% in the Netherlands and 3% in Germany.[26]
The ‘prudent’ financial sector policies recommended by the Bad Samaritans have also created other problems for macroeconomic management in developing countries. The BIS capital adequacy ratio, which I explained above, has been particularly important in this regard.
The BIS ratio requires that a bank’s lending changes in line with changes in its capital base. Given that the prices of the assets that make up a bank’s capital base go up when the economy is doing well and fall when it is not, this means that the capital base grows and shrinks along with the economic cycle. As a result, banks are able to increase their loans in good times even without any inherent improvement in the quality of the assets that they hold, simply because their capital base expands due to asset price inflation. This feeds into the boom, overheating the economy. During a downturn, the capital base of the banks shrinks, as asset prices fall, forcing them to call in loans, which, in turn, pushes the economy down further. While it may be prudent for individual banks to observe the BIS capital adequacy ratio, if all the banks follow it, the business cycle will be greatly magnified, ultimately hurting the banks themselves.*
When the economic fluctuations become bigger, the swings in fiscal policy have to become bigger too, if they are to play an adequate counter-cyclical role. But big adjustments in government spending generate problems. On the one hand, a big increase in government spending during an economic downturn makes it more likely that the spending goes into ill-prepared projects. On the other hand, making large cuts in government spending during an economic upturn is difficult due to political resistance. Given this, the greater volatility created by strictly enforcing the BIS ratio (and the opening-up of capital markets, as discussed in chapter 4) has actually made good fiscal policy more difficult to conduct.[27]
24
On the evolution of IMF policy in Korea following the 1997 crisis, see S-J. Shin & H-J. Chang (2003),
*
More recently, the BIS has suggested an even more ‘prudent’ system called BIS II, where the loans are weighted by their risk rating. For example, riskier loans (e.g., corporate lending) need to be supported by a larger capital base than safer loans (e.g., mortgaged loans for house purchase) of the same nominal value. This will be particularly bad for developing countries, whose firms have low credit ratings, as this means that banks would have a particular incentive to reduce their lending to developing country corporations.