Wednesday, May 6, 2009

African response to the global economic crisis – fiscal policy.

Colin McCarthy, a Tralac Associate, comments on an African response to the global economic crisis – fiscal policy.

In an earlier Hot Seat Comment (This, too, will pass) the question was raised of what African countries and their policy makers could do while waiting for a revival of world-wide economic growth. It is increasingly becoming clear that the global economic recession will be with us for some time, with all the talk about observed green shoots being declines in rates of decline in production and unemployment growth.

How should African governments react to this situation? In this first Comment in a series that will address this question the focus falls on discretionary fiscal policy.

Any Economics 101 student can explain that if a deflationary gap develops in an economy the remedy advocated by John Maynard Keynes is to raise government expenditure. The current crisis has brought about a revival of Keynesian thought with the governments of the large industrialised economies reverting to serious fiscal intervention. How the impact of the dramatic growth in public debt will evolve in the longer run is a serious issue but for our purposes the immediate question is whether the typical African country can also resort to similar policies to boost ailing production and alleviate growing poverty. The simple answer is ‘no’, at least not in an unqualified way.

It is difficult to identify the ‘typical’ African country. All African economies can be classified as developing countries but within this broad category the degree of heterogeneity is remarkable. The first point to mention, therefore, is that designing an appropriate policy reaction should not be like buying socks, that is, ‘one size fits all’. The fiscal policy options available to, for example, Burundi will differ widely from those available to South Africa, and responsible fiscal policy should reflect these differences.

However, within the category of developing countries Sub-Saharan African economies dominate the group that the UN defines as least developed countries (LDCs). These economies have very circumscribed capacities to use discretionary fiscal policies. By and large their tax bases are very restricted with low contributions of personal and corporate income tax revenue. Furthermore, they usually have underdeveloped financial markets which cannot fund government deficit spending through purchases in the capital market of government bonds. Should these countries grow their deficits, these, in the absence of increased foreign aid, are likely to be monetized. This means that money is created by the central bank to fund government spending.

The outcome of reverting to the money printing press in funding government deficits is escalating inflation. Higher inflation is an insidious form of taxation and it is very likely that this transfer of resources from consumers to the state as an outcome of discretionary fiscal policy will not serve the welfare of society. For the poorest economies, therefore, an increase in government spending in response to recessionary conditions will require an increase in budget assistance through more aid. ‘Trade and not aid’ as slogan in the developed world will have to be replaced by ‘aid in the absence of trade’.

Shifting attention from the funding of increased government expenditure to the nature of this spending, the need in all African economies to carefully plan and commit spending becomes of paramount importance. At least three questions should be considered in designing spending programmes. The first is whether the increase in spending will reach and benefit those whose welfare positions have become most vulnerable because of the global recession and its domestic impact. The second is whether existing and best-managed programmes can be expanded, rather than reverting to new and untried ones. Doing this allows the utilisation of existing capacities and is less likely to waste scarce resources. A third question is whether the spending can expand the production capacity of the economy.

Aiming to increase the production capacity of the economy through an increase in government spending is very important because if productivity is not increased a return to normal economic conditions will require a scaling down of government expenditure. In all economies, but in poorer countries in particular, this creates immense social and political problems. Government spending tends to be very flexible when it comes to increases but is notoriously inflexible when it needs to be cut back.

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